In its June 2017 decision in Kokesh v. SEC (discussed here), the U.S. Supreme Court held that disgorgement in an SEC enforcement action represents a “penalty,” and therefore a SEC enforcement action claim for disgorgement is subject to a five-year statute of limitation. The Court emphasized that it was only deciding the statute of limitations issue, and was emphatically not reaching the larger issue of whether the SEC has the proper authority to order disgorgement in enforcement proceeding. As discussed here, last November, in the case of Liu v. SEC, the U.S. Supreme Court agreed to take up the larger issue to determine whether or not the SEC may seek may seek and obtain disgorgement as “equitable relief” for a securities law violation. On June 22, 2020, the Supreme Court issues its opinion in the Liu case. As discussed below in a guest post written by David Topol of the Wiley law firm, the court has ruled that the SEC may collect disgorgements as “equitable relief,” subject to important constraint. I would like to thank David for allowing me to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is David’s article.
The Supreme Court’s June 22 decision in Liu v. Securities and Exchange Commission addressed important issues about the SEC’s authority to obtain “disgorgement” and the meaning of the term. This article summarizes the Court’s ruling in Liu, including the Court’s characterization of the term disgorgement and limitations on the SEC’s ability to obtain the remedy. It then identifies practical implications of the decision in the context of SEC enforcement, as well as potential insurance coverage implications of the decision.
Summary of the Decision
Facts in Liu
Charles Liu and his wife raised $27 million from investors, pursuant to a private placement, for construction costs for a cancer-treatment center. An SEC investigation revealed that $20 million of the investor money was used to pay marketing expenses and salaries and that “[o]nly a fraction of the funds were put toward a lease, property improvements, and a proton-therapy machine for cancer treatment.”
The SEC prevailed in a civil action against Liu and his wife, alleging that they violated the terms of the offering documents by misappropriating millions of dollars. By way of remedy, the district court (1) issued an injunction barring Liu and his wife from future participation in the program at issue, (2) a civil penalty at the maximum tier permitted, and (3) disgorgement of all amounts raised from investors, less $234,899 remaining in the corporate account for the project.
The SEC’s Right to Seek Disgorgement
In an 8-1 decision written by Justice Sotomayor, the Supreme 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 15 U.S.C. § 78u(d)(5). The Court confronted the issue because in the statute authorizing the SEC to bring civil actions, Congress empowered the SEC to seek civil penalties and “equitable relief” without specifically mentioning disgorgement. Id. By contrast, in the statute authorizing the SEC to bring administrative proceedings, Congress empowered the SEC to seek certain civil penalties and “disgorgement.” Liu therefore argued that the SEC cannot obtain disgorgement as a remedy in a civil proceeding.
The Court’s initial analysis focused on whether disgorgement falls into the categories of remedies typically available in equity. The Court concluded that disgorgement is such a remedy because “equity practice long authorized courts to strip wrongdoers of their ill-gotten gains, with scholars and courts using various labels for the remedy.” Justice Sotomayor’s opinion looked to Supreme Court decisions dating back to the 1800’s, the Restatement (Third) of Restitution and Unjust Enrichment and other sources to demonstrate that the concept that a wrongdoer cannot retain his profits from the wrongdoing has long been considered an equitable remedy.
Constraints on the SEC’s Right to Seek Disgorgement
Although the Supreme Court authorized the SEC to obtain disgorgement as a remedy, the decision is not a complete victory for the Commission. The Court also imposed significant limitations on what amounts the SEC can obtain in disgorgement and what it must do with the funds it recovers.
First, the Supreme Court held that in most cases disgorged sums must be distributed to investors. The Court explained that 15 U.S.C. § 78u(d)(5) allows the SEC to seek equitable relief that “may be appropriate or necessary for the benefit of investors.” Citing to the SEC’s 2019 Annual Report from the Division of Enforcement, the Court noted that the SEC does not return all its disgorgement proceeds to investors, but instead deposits a portion into the Treasury. For example, in fiscal year 2019, the SEC reported that it collected $3.25 billion in disgorgement and distributed $1.2 billion to harmed investors.
The Supreme Court concluded that, in general, the SEC’s practice of retaining disgorged funds is improper: “The equitable nature of the profits remedy generally requires the SEC to return a defendant’s gains to wronged investors for their benefit.” In so holding, the Court rejected the government’s argument that it is sufficient that the SEC deprive the wrongdoers of the benefit of their investments, reasoning that this argument ignores the statutory language requiring that the equitable relief be “for the benefit of the investors.” The Supreme Court did note that there might be a limited exception where it is infeasible to distribute collected funds to investors.
Second, the Supreme Court explained that the remedy of disgorgement may not be available against parties who are being pursued under a theory of joint and several liability. The Court reasoned that allowing disgorgement in those circumstances is inconsistent with its reasoning that disgorgement is permitted in order to deprive the wrongdoer of his profits and would transform the remedy into a penalty. However, the opinion did not provide further guidance as to the circumstances in which it would be permissible to obtain disgorgement from a co-defendant, noting that there could be a wide range of potentially culpable conduct.
Third, the Supreme Court held that the disgorgement remedy is limited to net profits of the wrongdoer and that courts must therefore “deduct legitimate expenses before ordering disgorgement.” The Court did explain that there is a limited exception where the “entire profit of the business” is for purposes of furthering a fraudulent scheme and, in that circumstance, the defendant may not be able to deduct certain expenses such as personal services. The Court observed that some of the expenses incurred by Liu went toward lease payments and cancer-treatment equipment and that such costs have value independent of the fraud.
Implications of Liu
The Supreme Court’s ruling in Liu has a number of important implications for matters in which the SEC is seeking disgorgement. In addition, it will also impact insurance coverage under D&O and FI policies.
The SEC Can Continue to Obtain Disgorgement in Civil Actions. Petitioners, as well as some of the amici, in Liu argued that the SEC does not have the authority to obtain disgorgement. The Supreme Court rejected that argument.
The Disgorgement Remedy Is Limited to Net Profits. The Liu decision holds that in bringing civil actions in court the SEC’s disgorgement relief is limited to “net profits,” and the amount of disgorgement will be reduced based on legitimate expenses. Liu is an extreme case in that most of the enterprise was fraudulent. However, the holding could have greater impact in a case where the defendant was operating a legitimate business but violated the law in an effort to increase its profits. The SEC will not be able to have the defendant disgorge all revenue, which will reduce the exposure for many defendants.
An interesting question will be the application of this principle outside of the context of SEC civil actions. For example, will that same limitation apply in an SEC administrative proceeding? The opinion in Liu suggests that it should since Justice Sotomayor explained that “it makes sense that Congress would expressly name the equitable powers it grants to an agency for use in administrative proceedings” because, unlike courts, administrative agencies do not have inherent equitable powers. And what about state government actions pursuing disgorgement under state law? In those cases, state courts will have to consider whether and how to apply this limiting principle.
The SEC Must Return Disgorged Funds to Investors. The Supreme Court has now held that, in most circumstances, it is improper for the SEC to recover funds through disgorgement and then keep the funds. Instead, the SEC must attempt to distribute the money to injured investors. Since there is often private securities litigation by investors in cases where there is an SEC action, this holding has the potential to benefit defendants and their insurers by putting more money into the hands of the injured investors, thereby reducing damages.
There Will Be Continued Coverage Disputes Over the Meaning and Insurability of “Disgorgement.” In recent years, there have been a number of coverage cases concerning the insurability of disgorgement. These disputes turn in part on particular policy language as well as state law governing the issue. However, the disputes may also turn on how to characterize the nature of the relief. Policyholder counsel often argue that the relief is akin to “damages.” In other circumstances, the relief may appear to be more like a “penalty,” which generally would not be covered.
The Supreme Court addressed the characterization of disgorgement two years ago in Kokesh v. SEC, 137 S. Ct. 1635 (2017). That case arose after the SEC brought litigation against an investment adviser, alleging that he misappropriated over $34 million from four development companies he was managing. The issue before the Supreme Court was whether the five-year statute of limitations applicable to claims in which the SEC seeks penalties applies when the Commission seeks disgorgement. The Court held that, notwithstanding the label used by the SEC, the payment was a “penalty” because it was imposed for “punitive” purposes. In so ruling, the Court relied in part on the fact that the SEC often does not distribute disgorged sums to investors, a practice it has now held is inconsistent with the equitable remedy of disgorgement.
In the Liu opinion, Justice Sotomayor noted that the term “disgorgement” is of “relatively recent vintage,” but that the concept has existed for many years under “various labels,” including “restitution,” “unjust enrichment,” and “accounting for profits.” For purposes of deciding Liu and whether the remedy can be deemed equitable relief, the opinion stated that “casting aside a form of relief solely based on the particular label affixed to it would elevate form over substance.”
In a similar vein, in considering the insurability of disgorgement damages, the key issue may not be the label used in the award, but rather the nature of the relief. Is insurance coverage available to a party who must “disgorge” his profits and return them to investors? Nearly twenty years ago, the Seventh Circuit decided Level 3 Communications, Inc. v. Federal Insurance Co., 272 F.3d 908 (7th Cir. 2001), which held that disgorgement damages are not covered because “loss” does not include the restoration of ill-gotten gains. In his opinion, Judge Posner emphasized the need to focus on the nature of the relief, rather than the label, stating: “How the claim or judgment order or settlement is worded is irrelevant. An insured incurs no loss within the meaning of the insurance contract by being compelled to return property that it had stolen, even if a more polite word than ‘stolen’ is used to characterize the claim for the property’s return.” Id. at 911.
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The decision in Liu v. Securities and Exchange Commission resolves important issues regarding the SEC remedy of disgorgement, including that the SEC can obtain the remedy, that disgorgement is limited to net profits and that those profits should generally be returned to the victims, not go into the government’s coffers. This is not the last word, however, as lower courts will need to address how to determine the “net profits,” the application of the remedy to other defendants and mechanisms for distributing funds to the victims. Federal and state courts will have to grapple with the application of the decision outside of the SEC context. And, finally, the decision provides guidance for addressing the insurability of disgorgement damages.
David Topol is a partner in the insurance practice at Wiley, where he represents insurers on a wide range of coverage matters. He has substantial experience over the past fifteen years representing insurers as monitoring counsel and in coverage litigation on professional liability policies, including D&O policies and FI policies issued to banks, investment advisers, private funds and broker-dealers.