Limits on SEC Agression: Liu v. SEC

Ro Reynolds

 

Of the numerous methods the Securities and Exchange Commission (“SEC”) employs to remediate securities violations, disgorgement is one of the most frequently used. In effect, it is an order requiring a wrongdoer to “disgorge” or return the funds they earned through some illegal act. The SEC has long sought and often secured disgorgement in the courts, which have not explicitly listed it as an equitable remedy, leading to considerable speculation as to whether or not disgorgement could indeed be obtained. The SEC’s authorizing statutes state that the SEC may seek “any equitable relief that may be appropriate or necessary for the benefit of investors,” which the SEC often interpreted to include disgorgement.[1] So often, in fact, that over the last five years, roughly 70% of the SEC’s monetary recoveries consisted of disgorged funds.[2]

In 2017, the Supreme Court issued its opinion in Kokesh v. SEC, which contained a footnote stating that it remains an open question “whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.”[3] This issue was litigated three years later in Liu v. SEC. In that June 2020 ruling, the Supreme Court allowed the SEC to continue its practice of seeking disgorgement in judicial proceedings. Specifically, the Court held that “a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under §78u(d)(5).”[4] The Court’s decision in Liu changes the circumstances under which the SEC may seek disgorgement by significantly limiting those circumstances compared to past practices. Given the vast percentage of monetary recoveries that disgorgement counts for, the SEC will be under considerable pressure to figure out a workaround, while defendants’ now have increased bargaining power while negotiating settlements.

In its “split the difference” approach, the Court discussed several limitations on disgorgement. Seeking to prevent disgorgement from becoming a penalty, as plaintiffs Liu and Wang contended it was, Justice Sotomayor noted three instances in which disgorgement could be in “considerable tension with equity practices.”[5] Because Liu focused only on the broad question of the availability of disgorgement, the cases’ principles have no binding authority. Nonetheless, they likely indicate the Court’s views on the subject and are so intended to “guide the lower courts’ assessment of these arguments on remand.”[6]

First, as to where the disgorged funds are distributed, the Court noted that Section 78u(d)(5) only allows equitable relief that is “appropriate or necessary for the benefit of investors.”[7] Indeed, the Court seemed to find this a valid requirement of equitable relief and stated that disgorged funds must therefore do “more than simply benefit the public at large by depriving a wrongdoer of ill-gotten gains.”[8] In past disgorgement cases, the SEC would often simply deposit such funds into the Treasury. The Court left open the question of whether and in what circumstances funds may now be deposited into the Treasury but cast serious doubt on the practice.

Second, the Court recognized that an individual is traditionally liable only for their own wrongful profits but not for the wrongful profits of others, such as would be the case under a joint-and-several liability theory. This new limitation stands in contrast to the SEC’s practice of often imposing joint-and-several liability in disgorgement cases. On the other hand, the Court also acknowledged that the common law has permitted “liability for partners engaged in concerted wrongdoing,” which could very well be the situation in the case at hand.[9] So, there again appears to be no clear answer as to whether joint-and-several liability would sometimes be appropriate (e.g., where on remand a lower court could find that a husband and wife with comingled finances could be partners in concerted wrongdoing).

Finally, and perhaps the Court’s most clear directive is that “courts must deduct legitimate business expenses before ordering disgorgement.”[10] Previously, the SEC would seek, and courts would grant, disgorgement of all revenues, often leaving the defendant worse off than they were before their wrongdoing. Such a practice resembles a penalty and would be hard to reconcile with disgorgement as an equitable remedy.

Because Liu’s effects will limit the amount and circumstances under which the SEC may seek disgorgement in the courts, it is likely that the Commission will shift increasingly to administrative proceedings in actions that are likely to be contested along the lines of the principles limiting disgorgement. Administrative proceedings, as previously discussed, are governed by express statutory authority granting the Commission the power to seek disgorgement without the limits imposed by Liu. In essence, the Supreme Court has left the SEC a loophole, in that the narrowly construed decision in Liu applies only to disgorgement in judicial cases, not administrative proceedings.

Given that the SEC has been bringing more and different types of cases as administrative proceedings in recent years and taking into account the SEC’s “home court” advantage in these proceedings, it is likely that this trend will continue with new vigor post-Liu. The effects of Liu will result in lower amounts and fewer circumstances in which the SEC may successfully obtain disgorgement in federal courts. However, Liu applied only to federal courts, where disgorgement had not previously been explicitly authorized as a remedy for the Commission. No such limitation applies in administrative proceedings, where Congress did explicitly authorize disgorgement. So, without further limits, and because of the vast funds disgorgement provides, the SEC will probably shift marginal cases, and those otherwise potentially effected by Liu’s limitations to administrative proceedings, where not only will the limiting factors not apply, but the SEC already enjoys several advantages.

If the SEC opts to continue its aggressive recovery policies, Congress should enact an amendment to the Remedies Act of 1990, which originally authorized disgorgement in the SEC’s administrative proceedings. This amendment should continue to authorize disgorgement; however, it should do so pursuant to the limiting principles laid out in Liu. The amendment could simply add the three principles in Liu to the language of the existing act. Such an amendment would ensure equitable consistency between both administrative proceedings and judicial actions, and would prevent a shift to administrative proceedings and their “home court advantage” to the SEC.

The SEC’s long history of aggressive action coupled with the enormous amount of funds obtained through disgorgement ultimately make Congressional action the most likely solution. Again, Liu’s principles do not currently apply to disgorgement in administrative proceedings because the issue before the Supreme Court only pertained to judicial actions. Without Congressional action in the form of the amendment above, the SEC will almost certainly continue along the lines of its past practices, namely that of aggressive recovery tactics. This is all the more likely given the vast amount of funds that the SEC currently recovers in the form of disgorgement, and their disinclination to significantly lower that amount which would be the result of following Liu’s principles.

 

 

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[1] See 15 U.S.C. § 78u(d)(5) (2018).

[2] See SEC, Division of Enforcement, Annual Report (2019), https://www.sec.gov/files/enforcement-annual-report-2019.pdf.

[3] Kokesh v. SEC, 137 S. Ct. 1635 (2017).

[4] Liu v. SEC, 140 S. Ct. 1936, 1946 (2020).

[5] Id. at 1946.

[6] Id. at 1947.

[7] Id.

[8] Id. at 1948.

[9] Id. at 1949.

[10] Id. at 1950.