Supreme Court Limits SEC’s Recovery on Disgorgement Claims

On June 5, 2017, the U.S. Supreme Court rendered a decision of significant consequence to securities industry participants, holding that disgorgement claims under the federal securities laws are “penalties” under 28 U.S.C. § 2462, and therefore are subject to a 5-year statute of limitations. The Supreme Court’s unanimous decision in Kokesh v. Securities and Exchange Commission severely limits the SEC’s potential recovery on the disgorgement claims that are nearly always brought in connection with enforcement actions alleging violations of the securities laws. In enforcement cases involving sustained periods of misconduct, the SEC can now obtain disgorgement only over a period of five years, regardless of the amounts involved. The Supreme Court’s definition of SEC enforcement as a “penalty” may also have broader consequences, affecting, for example, whether insurers will cover such payments, as well as whether disgorgement payments can be counted as income tax deductions.

Facts of the Case

28 U.S.C. § 2462 is a federal statute that applies a 5-year statute of limitations to any “action, suit or proceeding” by the government “for the enforcement of any civil fine, penalty, or forfeiture[.]” The issue in Kokesh was whether § 2462 applies to a disgorgement judgment in the amount of $34.9 million plus prejudgment interest that had been assessed against the principal of two investment advisory firms that were the subject of an SEC enforcement action alleging violations of the securities laws from 1995 to 2009. In the damages phase of the trial, the government argued that disgorgement is not a “penalty” within the meaning of § 2462, such that the government could obtain disgorgement for acts and omissions taken throughout the entire 15-year period. The defendant Charles Kokesh argued, on the other hand, that the statutory 5-year limitations period precluded disgorgement for wrongdoing that occurred prior to October 27, 2004, five years prior to the date that the Commission filed its complaint against him. The district court sided with the SEC, holding that disgorgement is not a “penalty” under §2462. The Court assessed a disgorgement judgment of $34.9 million and $18.1 million of prejudgment interest, where $29.9 million of the judgment was attributable to violations outside the limitations period. On appeal to the U.S. Court of Appeals for the Tenth Circuit, the district court’s decision and judgment were affirmed.

The Supreme Court’s Holding

In a unanimous 9-0 decision, the Supreme Court reversed. Looking to its own definition of “penalty” over the nearly 200-year history of the statute, the Court found that SEC disgorgement constitutes a “penalty.” The Court relied upon its 121-year-old decision in Huntington v. Atrill which defined “penalty” as a “punishment, whether corporal or pecuniary, imposed and enforced by the State, for a crime or offen[s]e against its laws.” Quoting from Huntington, the Kokesh Court articulated a two-pronged analysis: (1) that “whether a sanction represents a penalty turns in part on ‘whether the wrong sought to be redressed is a wrong to the public, or a wrong to the individual[;]'” and (2) that “a pecuniary sanction operates as a penalty only if it is sought ‘for the purpose of punishment, and to deter others from offending in like manner’ – as opposed to compensating a victim for his loss.”

Acknowledging its application of these principles in previous decisions, specifically Brady v. Daly (1899) and Meeker v. Lehigh Valley R. Co. (1915), the Court then turned its attention to the subject of SEC disgorgement. First, the Court found that “violation for which the remedy is sought is committed against the United States rather than an aggrieved individual-this is why, for example, a securities enforcement action may proceed even if victims do not support or are not parties to the prosecution.” Thus, the Court concluded, “[w]hen the SEC seeks disgorgement, it acts in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties.” Secondly, the Court found that disgorgement “is imposed for punitive purposes,” citing numerous cases that had cited the deterrent effect of disgorgement awards, as well as cases where disgorgement awards served no compensatory purpose (such as when the awards were paid to the U.S. Treasury). Based on this analysis, the Court determined that the 5-year limitations period codified in § 2462 applies to SEC disgorgement because it “bears all the hallmarks of a penalty: It is imposed as a consequence of violating a public law and it is intended to deter, not to compensate.”

Conclusion

The Supreme Court’s decision in Kokesh should provide some measure of comfort to investment managers and advisors who may be potentially subject to SEC disgorgement claims. The decision is of particular consequence to market participants in the Second Circuit, where at least two courts have recently held that § 2462 does not apply to disgorgement claims. See, e.g., SEC v. Ahmed, No. 3:15-CV-675 (JBA), 2016 WL 7197359, at *5 (D. Conn. Dec. 8, 2016); SEC v. Saltsman, No. 07-CV-4370 (N GG), 2016 WL 4136829, at *24-29 (E.D.N.Y. Aug. 2, 2016). It remains to be seen whether and to what extent the SEC will adjust its civil enforcement activities, e.g. by bringing cases earlier rather than first engaging in lengthy investigation, in the wake of this stricter limitations period.