July 28, 2020
On June 22, 2020, the U.S. Supreme Court ruled in Liu v. SEC, No. 18-1501, that the Securities Exchange Commission (“SEC”) may disgorge profits obtained through fraudulent practices, provided that such award does not exceed the defendant’s net profits. The 8-to-1 opinion was largely a victory for regulators and investors, since disgorgement is a longstanding, critical tool in the SEC’s enforcement arsenal.
In Liu, petitioners Charles Liu and Xi Wang contested a civil action brought against them by the SEC in federal court. The petitioners had raised $27 million from foreign nationals which, according to a private offering memorandum, was earmarked for the construction of a cancer treatment center. An investigation by the SEC, however, revealed that the petitioners had violated the terms of the offering documents, had never intended to build a cancer treatment center, and had misappropriated millions of dollars of investor money. The Ninth Circuit Court of Appeals held in favor of the SEC, affirming the district court’s order of disgorgement equal to the full amount petitioners had raised from investors, less the funds that remained in corporate accounts for the project.
In a 2017 decision, Kokesh v. SEC, 137 S. Ct. 1635 (2017), the Supreme Court had held that disgorgement in an SEC enforcement action constitutes a “penalty” for the purposes of the applicable statute of limitations. It did not, however, decide whether disgorgement can also qualify as “equitable relief” under the Securities Exchange Act of 1934, as amended (“Exchange Act”). Certain dicta in Kokesh, however, raised the distinct possibility that if brought before it, the Supreme Court would find that disgorgement could not qualify as “equitable relief” under the Exchange Act, depriving the SEC of this important remedy. Nonetheless, in Liu, the Supreme Court held, in an opinion authored by Justice Sonia Sotomayor, that a disgorgement award in an SEC civil enforcement action can qualify as equitable relief under the Exchange Act. As the Supreme Court explained, its decision to permit disgorgement stems from the long history of equity courts depriving wrongdoers of their net profits from unlawful activity, a foundational principle since it is “inequitable that [a wrongdoer] should make a profit out of his own wrong.”
In the opinion, the Supreme Court discussed certain traditional limits placed on disgorgement to avoid transforming it into a penalty outside of a court’s equitable powers. First, the disgorged profits should be returned to the victims of the fraudulent scheme, if possible. Second, courts traditionally ordered disgorgement awards against individuals or partners engaged in “concerted wrongdoing” and not against multiple wrongdoers under a joint-and-several liability theory. Finally, except in cases where the entire profits of a business or undertaking results from the wrongful activity, the remedy is limited to “net profits”—that is, the court must deduct legitimate expenses before ordering disgorgement under the Exchange Act. The Court noted that the SEC’s disgorgement remedy is occasionally in tension with these traditional limits in cases where courts (i) order the proceeds of fraud to be deposited in U.S. Department of Treasury funds instead of disbursing them to victims, (ii) impose joint-and-several disgorgement liability, or (iii) decline to deduct legitimate expenses from the receipts of fraud.
The Supreme Court remanded the case for the lower courts to ensure that the award in Liu was in accordance with these traditional limits. While it did not decide the narrower questions raised by the petitioners of whether the award granted by the district court crossed these “bounds of traditional equity practices,” the Court did discuss principles that “may guide the lower courts’ assessment of these arguments on remand.”
First, the Court said the “equitable nature of the profits remedy generally requires the SEC to return a defendant’s gains to wronged investors for their benefit.” However, the Court did not foreclose the possibility that disgorged funds could be used to fund the SEC’s other investor protection activities, such as whistleblower or investor education programs, in the event that returning disgorged funds to investors was either impossible or not cost effective. Notably, the SEC returns disgorged funds to victims in the overwhelming majority of its cases. The money goes to the U.S. Treasury only when the nature of the fraud does not result in easily identifiable victims (such as in insider trading cases), victims are difficult to identify or reach (as can be the case with foreign nationals like the victims in Liu), or the amount each victim is entitled to is too small to justify the expense of identifying the victims and returning the money to them. Even then, the SEC typically uses the disgorged funds for activities related to investor protection.
Second, the Liu opinion said the SEC’s practice of seeking to impose joint-and-several liability in disgorgement cases may be “at odds with the common-law rule requiring individual liability for wrongful profits.” At the same time, however, the Court acknowledged that joint-and-several liability may be appropriate in Liu because the petitioners were married and thus could be sufficiently “commingled” to a point where joint-and-several liability would be appropriate. The same may be true with other co-defendants in future cases due to the nature of the fraud and the comingling of assets.
Finally, the Court held that courts must deduct legitimate expenses before ordering a disgorgement order. Whether any of the expenses spent in Liu can properly be qualified as “legitimate” in light of Liu’s fraud seems unlikely, particularly given that the record reflects that Liu never intended to build a cancer treatment center and the items the defendants purchased were made to entice more victims to invest, not for legitimate business purposes.
In sum, while the Liu decision places certain minor limitations on the SEC’s ability to seek and obtain disgorgement, it upheld the SEC’s critical ability to protect investors and deter fraud through the equitable remedy of disgorgement and its limitations are generally consistent with existing SEC practice.