Liu v. SEC: The U.S. Supreme Court Upholds SEC’s Power to Disgorge Profits Obtained Through Fraud, with Limits
In the 2017 decision Kokesh v. SEC, the Supreme Court held that disgorgement in an SEC enforcement action constitutes a “penalty” for the purposes of the applicable statute of limitations, but did not answer the question as to whether disgorgement can qualify as “equitable relief” under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).2 In Liu, the Supreme Court held, in an 8-1 opinion authored by Justice Sonia Sotomayor, that a disgorgement award, in an SEC civil enforcement action, that does not exceed a wrongdoer’s net profits and is awarded for victims is permissible as equitable relief under the Exchange Act.3 The Court’s decision to permit disgorgement stems from the long history of equity courts depriving wrongdoers of their net profits from unlawful activity, a foundational principle being that it is “inequitable that [a wrongdoer] should make a profit out of his own wrong”.4
The Court further discussed traditional limits placed on disgorgement as 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. 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 notes that the SEC’s disgorgement remedy is occasionally in tension with these traditional limits where courts (i) order the proceeds of fraud to be deposited in Treasury funds instead of disbursing them to victims, (ii) impose joint-and-several disgorgement liability, and (iii) decline to deduct legitimate expenses from the receipts of fraud.5
The case was remanded for the lower courts to ensure that the award in Liu was appropriately limited. While the Court 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” (by failing to return funds to victims, imposing joint-and-several liability, and declining to deduct business expenses from the award), the court did discuss principles that “may guide the lower courts’ assessment of these arguments on remand.”6 First, the “equitable nature of the profits remedy generally requires the SEC to return a defendant’s gains to wronged investors for their benefit.” Second, the SEC’s practice of seeking to impose joint-and-several liability in disgorgement cases is often “at odds with the common-law rule requiring individual liability for wrongful profits” (the Court did acknowledge that on remand joint-and-several liability may be appropriate in Liu because the petitioners were married and thus could be sufficiently “commingled” where joint-and-several liability would be appropriate). Finally, the Court clearly stated that courts must deduct legitimate expense before ordering a disgorgement order, something that the district court in Liu did not do and should be revisited on remand.
The Liu decision builds off of Kokesh in establishing additional guidance for the SEC and federal courts in the application of its disgorgement powers, and will likely impact future SEC practices with regard to seeking disgorgement in civil actions.
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