The Supreme Court Limits The Remedy of Disgorgement in SEC Enforcement Actions
On June 22, 2020, the United States Supreme Court ruled that “disgorgement” – a remedy that the Securities and Exchange Commission (SEC) routinely seeks in enforcement actions – is limited to the net profits a defendant receives from a securities law violation.
When the SEC seeks disgorgement as a remedy from defendants, the SEC’s position has been that the amount of disgorgement is the entire amount obtained by the defendant, less any amounts paid back to investors. Many lower courts had adopted this position, and as a result, disgorgement awards were not be reduced by any amounts – legitimate or otherwise – paid from the gross proceeds of the securities transactions in question. This often resulted in disgorgement awards far in excess of the actual benefits that the defendants received from the violations.
In Liu, the Supreme Court rejected this position, and in so doing, drastically reduced the amount of financial exposure a defendant faces in the face of an SEC enforcement action. The Court explained that the Securities Exchange Act does not specifically authorize the SEC to seek disgorgement but does authorize the SEC to seek “equitable relief.” The Court further determined that disgorgement is a remedy that falls within “those categories of equitable relief that were typically available in equity” because it is a functional equivalent of traditional remedies such as restitution or an accounting of profits. The Court noted that these remedies all served the same function, which is to deprive wrongdoers of their net profits from unlawful activity. Having existed in equity since at least the 1800s, the functional remedy was typically available in equity, whether it was called restitution, an accounting, or, as the SEC now terms it, disgorgement.
The Court reasoned that, since disgorgement is simply another name for a remedy that deprives wrongdoers of their net profits from unlawful activity, the remedy afforded by the Securities Exchange Act – i.e. equitable relief – cannot exceed that remedy by depriving wrongdoers of more than their net profits. Accordingly, courts that order disgorgement under the Securities Exchange Act must deduct legitimate expenses incurred in conducting the enterprise. However, the courts may deny expenses it deems illegitimate or are wrongful gains “under another name”, such as excessive compensation for personal services of the wrongdoer.
For defendants in SEC enforcement actions, the ability to deduct legitimate expenses of the enterprise reduces their disgorgement exposure, in many cases, significantly. For example, the defendants in Liu had raised nearly $27 million in a fraudulent offering, but they had expended about $7 million on expenses of the business such as lease payments, purchases of equipment, payments to innocent employees, and vendors. The Court instructed the lower court to determine whether these expenses were legitimate. A finding that they are would reduce the disgorgement amount by $7 million.
In addition to limiting disgorgement to net profits, the Court further limited the disgorgement remedy by requiring that a disgorgement order be for the benefit of investors. Historically, the SEC had sought to deposit some disgorgement proceeds to the United States Treasury as a fund for whistleblowers and for the activities of the Inspector General. The Court held that the statute requires the disgorgement award to be for the benefit of investors and required lower courts to determine whether payments to the Treasury satisfied this element of the statute.
Finally, the Court addressed the SEC’s practice of seeking joint and several liability for a disgorgement award among several defendants. The Court noted that this practice creates a risk of turning an equitable remedy into a punitive penalty. The Court left it for lower courts to determine, on a case by case basis whether a disgorgement award can be imposed jointly and severally among multiple defendants without violating the equitable principle that a disgorgement award must not be punitive.
Before this ruling, many defendants in SEC enforcement actions had contended that the SEC was using the disgorgement remedy as a punishment by seeking amounts far beyond the amount of benefit the defendant actually received and imposing joint and several liability for such amounts. The Court’s ruling extinguishes that concern and confirms that the SEC’s enforcement powers are limited to those granted by Congress.
The Court’s full opinion can be found here.