SEC may keep its disgorgement remedy

Last week, the U.S. Supreme Court heard argument in Liu v. SEC, which threatened to upend perhaps the most important sanction in the Securities and Exchange Commission's arsenal -- disgorgement. The petitioners in Liu, who were found liable for bilking investors of almost $30 million, are challenging whether the SEC has the power to seek that remedy in court at all. Just a couple of years ago, the Supreme Court labelled disgorgement a "penalty" in Kokesh v. SEC, giving defendants a new line of attack on this important SEC sanction. Picking up that gauntlet, the Liu petitioners argued that the SEC should be barred from seeking disgorgement because the agency, by statute, can only seek "equitable" remedies in court and those remedies, by their very nature, cannot be penal. Having granted the Liu petition without any split among the federal courts of appeals on the SEC's power to obtain disgorgement, the Supreme Court, with a conservative majority that favors strict adherence to statutory text and limits on agencies' power, seemed primed to rule against the SEC.

What happened at oral argument, however, may signal a different result. The bench was fairly quiet, perhaps because the Liu argument followed on the heels of a blockbuster argument about the constitutionality of the structure of the Consumer Financial Protection Bureau. But if the justices' questions are any indication of their ultimate ruling, the SEC may keep its disgorgement remedy, or at least part of it.

At its core, disgorgement is meant to deprive wrongdoers of the "ill-gotten gains" from their fraud. But without any express statutory authorization for the SEC to seek that remedy, courts have been left to define the contours of that form of relief on their own. By the time the Supreme Court decided Kokesh, disgorgement had blossomed into an expansive and far-reaching remedy. For example, as Kokesh pointed out, courts had ordered insider-trading defendants to disgorge not only their own profits but also the profits of those they tipped. And courts had often forced defendants to disgorge more money than they actually kept for themselves. In fact, that is what happened in Liu -- defendants Charles Liu and his wife were ordered to disgorge almost $27 million for defrauding investors in their securities offering, even though they had kept only about $9 million for themselves. Worse, the Supreme Court in Kokesh lamented, the SEC did not always return disgorged profits to defrauded investors, instead sending the money to the U.S. Treasury. Faced with those practices, the Supreme Court held that the disgorgement remedy was a penalty, and thus subject to the general federal statute of limitations that applies to "any civil fine, penalty, or forfeiture."

At oral argument in Liu, the justices did not seem restrained by the rationale of their earlier Kokesh ruling. Just minutes into the argument by Liu's counsel, Justice Ruth Bader Ginsberg posited that "Kokesh was in a specific context" and that "the notion that because we categorize [disgorgement] in one context ... as a penalty[] does not necessarily carry over to another." Quickly the questioning, led by Justices Samuel Alito and Brett Kavanaugh, focused not on whether the disgorgement remedy should exist at all, but on whether it had been "interpreted too broadly." From there, most of the argument was about how to limit the scope of the remedy. Two guiding principles emerged in the questioning -- whether disgorgement, in the words of Justice Kavanagh, should be limited to the defendant's "net profits" and whether it should be "returned to victims."

If the Supreme Court ends up adopting those two conditions for disgorgement to remain a remedy for the SEC, that would be a big win for the agency. For one, were the court to hold that the SEC must take reasonable steps to return disgorged money to investors, that would not change the SEC's practices much, if at all. Historically, the SEC has typically tried to return money disgorged by a fraudster to investors wherever possible. Although it is true that the SEC has not returned sizable chunks of the billions of dollars in court-ordered disgorgement judgments it obtains each year, that is mainly because many defendants don't pay everything they owe. It is also because some of those disgorgement awards arise from cases, like insider trading or Foreign Corrupt Practices Act cases, where there are no identifiable victims to repay. In reality, the SEC usually tries to return what it has collected, often with the help of court-appointed receivers, unless the amounts are so small, and the number of defrauded investors so large, that it's not worth it.

The other guiding principle that was discussed during the Liu argument -- that disgorgement be limited to a defendant's net profits -- is likewise a condition that the SEC will happily take on. In 2017, the SEC obtained $2.9 billion in disgorgement orders. Then came the Supreme Court's decision in Kokesh, which appeared to question the breadth of the remedy. In response, the SEC Enforcement Division scaled back. Since Kokesh, disgorgement awards have dropped more than 20% -- dropping 15% in 2018, the first year after Kokesh, and another 8% in 2019 (if you exclude a single case that accounted for almost 30% of the total reported disgorgement that year). That decrease came because the Enforcement Division, with Kokesh fresh in its mind, has been seeking less in disgorgement in court and in settlements.

That being said, a Supreme Court ruling that disgorgement should be limited to a defendant's net profits may not be an easy principle to follow in many cases. The difficulty was barely addressed during the Liu argument. Justices Elena Kagan touched on it, asking what the SEC would "have to deduct" if the court were to adopt a "net profits rule." When Liu's counsel argued that the SEC would have to take out "legitimate business expenses" like his clients' lease payments for the medical facility they promised to (but never did) build, Justice Stephen Breyer joined the fray, asking whether the lease payments would be deductible if they were "just a printout, only used for more fraudulent stuff" to further dupe the investors.

And that would be the difficulty here -- determining what the legitimate expenses in a fraud really are. The facts of the Liu case show just how complex that question can be. Liu and his wife raised about $26.9 million, promising to build a proton-therapy cancer treatment center. Instead, the court found, they spent almost $9 million for themselves and another $13 million on overseas marketers to solicit Chinese investors. One of those marketers was run by Liu's wife and owned by her mother. The Lius also claimed that they spent about $1 million leasing and developing the land for the center. Under a "net profits rule," courts would have to grapple with whether the millions paid to marketers (which may have flowed back to the Lius or their family) and the Lius' alleged lease payments were truly legitimate expenses or simply a means of carrying out their fraud. Even if the Supreme Court were to adopt a "net profits rule" for disgorgement, it is unlikely to give much more guidance on what that means. That will be up to the lower courts to figure out in the first instance.

So, while the Liu ruling may be more favorable to the SEC than many originally thought, it could leave many unanswered questions about the scope of the SEC's disgorgement remedy. Indeed, if lower courts are asked to interpret a "net profits rule" for disgorgement, then the remedy phases of SEC enforcement cases, which have usually not been heavily contested, will become lengthy, complex and hard fought. And we may find ourselves back at the Supreme Court as the circuits split over how to calculate disgorgement under such a rule. 

Mr. Berry was the lead counsel for the SEC in SEC v. Liu in federal district court.