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(Article from Securities Law Alert, June 2020)

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On June 22, 2020, in Liu v. SEC, 2020 WL 3405845 (2020) (Sotomayor, J.), the Supreme Court resolved the question it raised but left open just a few years ago in Kokesh v. SEC, 137 S. Ct. 1635 (2017): whether the SEC is authorized to seek disgorgement in federal court proceedings. In an 8-1 decision, the Court upheld but circumscribed the SEC’s ability to seek disgorgement.  Specifically, the Court held that disgorgement constitutes permissible “equitable relief” under 15 U.S.C. § 78u(d)(5), but only where disgorgement is based on net profits and ordinarily where disgorged funds are distributed to victims.

When the SEC brings enforcement actions in federal court, it is authorized by statute to seek a range of remedies, including “any equitable relief that may be appropriate or necessary for the benefit of investors.”  In Kokesh, the Court held that disgorgement of profits is a “penalty” for the purposes of statutes of limitations.  However, the Kokesh Court explained in a footnote that “[n]othing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.”[1] In Liu, on the heels of Kokesh, the petitioners argued that disgorgement was not an equitable remedy, and therefore, not within the statutory authorization.

Although the briefing in Liu focused on the all-or-nothing question of whether the SEC could seek (and courts have the power to order) disgorgement in federal court proceedings, the oral argument focused instead on what aspects of a disgorgement award might make it punitive instead of equitable.  The Justices asked petitioners’ counsel if the disgorgement in the case would have been equitable if it were returned to investors (instead of turned over to the U.S. Treasury) and seemed focused on how the SEC calculates disgorgement awards, foreshadowing the focus of the Court’s decision.

While petitioners argued that disgorgement is not “equitable relief” within the meaning of § 78u(d)(5), the Court said: “Not so.”  The Court held that a disgorgement award is proper so long as it (1) does not exceed the wrongdoer’s net profits, and (2) in the ordinary case, is given to victims of the wrongdoing.  The Court further questioned the practice of imposing the disgorgement remedy on a joint-and-several basis.

The Court observed that equity practice has historically allowed courts to deprive wrongdoers of ill-gotten gains and that these remedies are equitable (instead of punitive) so long as they are restricted to net profits and awarded to victims. In light of this history, the Court held the SEC is well within its statutory authority to seek disgorgement in civil suits.  The Court declined to extend Kokesh’s conclusion that disgorgement is a penalty beyond the statute of limitations context, noting that “that decision has no bearing on the SEC’s ability to conform future requests for a defendant’s profits to the limits outlined in common-law cases awarding a wrongdoer’s net gains.”  The Court did acknowledge three trends in the SEC’s use of the disgorgement remedy that might not comport with a traditional equitable remedy.

First, the Court questioned the practice of depositing disgorgement awards into the U.S. Treasury, noting that § 78u(d)(5) authorizes equitable relief “for the benefit of investors.”  The Court explained that the equitable nature of the profits remedy would ordinarily require the SEC to return profits to wronged investors, not the Treasury.  The Court allowed that the SEC might be able to send disgorgement awards to the Treasury when it is not feasible to distribute funds to the investors, but noted that this issue was not before the Court.

Second, the Court expressed concern about the SEC’s practice of seeking joint-and-several liability for disgorgement awards, stating: “That practice could transform any equitable profits-focused remedy into a penalty,” especially if the SEC sought to disgorge from one defendant profits earned by another defendant.  The Court explained that joint-and-several liability might be appropriate in cases of concerted wrongdoing and shared profits (e.g., by partners in a partnership), but that lower courts would have to assess the facts in each case to see if equitable principles permitted such an award.

Third, the Court explained that courts must deduct legitimate business expenses from disgorgement awards.  This shifts the focus from gross profits to net profits.  The Court explained that courts should not deduct illegitimate personal expenses, but that ordinarily defendants should not be required to disgorge funds they spent on business expenses.  The Court also acknowledged that in rare cases where the defendant’s entire enterprise was fraudulent, then no business expenses would be legitimate and gross profits would be the correct measure of disgorgement.

Justice Thomas dissented, writing that he would hold that disgorgement is not an “equitable remedy” within the meaning of § 78u(d)(5). In his view, “[d]isorgement is not a traditional equitable remedy” but is instead “a creation of the 20th century.”