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ANALYSIS: Oral Arguments Portend SEC Disgorgement Changes

March 6, 2020, 6:36 PM

Predicting the outcome of Supreme Court cases from oral arguments is an inexact science at best. The recent questioning by the justices in an SEC enforcement case suggests, however, that the disgorgement remedy will survive a significant challenge with just a few bruises.

The U.S. Supreme Court heard oral arguments in Liu v. SEC on the question of whether federal courts may order disgorgement in civil enforcement actions. After reading the transcript, it appears likely that the Court will scale back the ability of courts to order disgorgement. Several justices appeared willing, however, to leave the equitable core of the remedy intact, and to accept a remedy that would be based on the net gain wrongfully realized and returned to investors who suffered harm.

Kokesh‘s Unanswered Question

In SEC v. Kokesh, the Court’s previous ruling on disgorgement, Justice Sonia Sotomayor included a rather interesting footnote in the unanimous opinion. She noted that "[n]othing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.”

The Court in Kokesh found that disgorgement orders are penalties for limitations purposes, but left the other questions unanswered. In Liu, the Court is now faced with one of those questions. In this case, Charles Liu has urged the Court to find that federal courts have no such authority to compel disgorgement in securities actions.

Charles Liu is not a particularly sympathetic defendant. The Ninth Circuit affirmed a trial court finding that Liu and his wife misappropriated most of the $26 million they raised from international investors through the EB-5 Immigrant Investor Program. (Liu had pitched investors that they were funding a cancer care center that was never constructed.) The appeals panel also affirmed the disgorgement order, which covered almost all the funds raised from investors, along with prejudgment interest.

The issue in Liu stems from the fact that the securities statutes do not specifically authorize the SEC to seek disgorgement in district court actions. Exchange Act §21C provides that “the Commission may enter an order requiring accounting and disgorgement, including reasonable interest,” but no comparable provision applies to court actions. Section 21(d)(5) of the Exchange Act does provide, however, that "[i]n any action or proceeding brought or instituted by the Commission under any provision of the securities laws, the Commission may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.”

The question becomes, then: Does the Kokesh holding that disgorgement is a penalty for limitations purposes preclude its use as an equitable remedy to deny wrongdoers their gains and return money to investors? The oral argument questioning by the justices suggests that it may not.

Oral Argument

In his first question, Justice Samuel Alito asked Liu’s counsel if it “is your argument that disgorgement is never possible or that disgorgement has been interpreted too broadly by the courts?” Alito continued: “Suppose it were limited to net profits and suppose every effort was made to return the money to the victims of the fraud. Would that not fall within a traditional form of equitable relief?”

Justice Sotomayor added that she “wasn’t sure why” the Section 21(d)(5) grant of equitable authority was not sufficient, “assuming, as Justice Alito has just stated, that the accounting is only for net profits that are given to the actual people injured.” Justice Ruth Bader Ginsburg similarly stated that a remedy such as disgorgement “can be punishment in one context and it can be an equitable remedy in another context.”

Justice Neil Gorsuch asked counsel for the government if the SEC would “have any difficulty with a rule that the money should be returned to investors where feasible.” Deputy Solicitor General Malcolm L. Stewart agreed that a court could do so “as a general equitable principle.” The deputy solicitor general also agreed with Justice Brett Kavanaugh when the justice asked, “Would it be appropriate for this Court to say that’s the rule; namely, that it has to be returned to investors where feasible?”

It is apparent that the justices were stressing two separate things. The first was a remedy based on the actual profits wrongly realized by fraud defendants, and the second was the distribution of disgorged funds to harmed investors.

The Experts Weigh In

The questions from the justices on the equitable powers of the federal courts reflect the reasoning of an amicus brief filed by a group of academic and professional experts on remedies. The brief, headed by University of Virginia law professor Douglas Laycock, stated that “all parties in this case seek to lead the Court into serious error.”

According to the brief, Liu’s argument to abolish disgorgement in federal courts in securities cases is flawed, because disgorgement is an equitable remedy that has been authorized by Congress and long recognized by the courts. The brief also claims that the SEC has improperly extended disgorgement beyond its equitable origins of collecting defendants’ unlawful profits, and turned disgorgement into a penalty. Exchange Act Section 21(d)(5) expressly authorizes equitable relief from federal courts. As the brief noted, “the Commission’s claim for gross receipts is not ‘equitable relief’ within the statute, but a claim for net profits would be classic ‘equitable relief’ within the meaning of the statute.”

The Consequences

An adverse ruling in Liu could significantly hamper an SEC enforcement program that is still struggling to deal with the fallout from Kokesh.

The Commission could, of course, resort to administrative actions to seek disgorgement, but this option is not without risks. First, courts have the authority to act in ways that administrative law judges do not. For example, an ALJ may not order an asset freeze to protect against an imminent loss.

There is also a perception problem. Respondents and other critics have long argued that the in-house forum gives the SEC an unfair “home court advantage.” More frequent use of the venue would only exacerbate the image issue.

Finally, administrative enforcement may face its own infirmities before the high court. The agency still may face challenges to the constitutionality of the ALJ system due to removal power issues left unresolved in SEC v. Lucia.

The Crystal Ball

It is risky to read too much into oral argument questioning. But the justices seem to be in general agreement on some basic points. The days of the SEC using disgorgement as a cudgel are likely over, but it appears that the Court will likely retain the equitable core of the remedy. A majority of the justices appeared to support a scaled-back remedy that includes only the net profits wrongfully realized, and not gross receipts. It would also not be surprising if the Court required the Commission to demonstrate the amount of profit realized by each particular defendant rather than imposing joint and several liability on all for the total. An order that places a defendant in worse financial position than before the fraud would likely fail as a penalty.

In addition to the amount of money subject to disgorgement, the justices were particularly interested in what happened to those funds that would be paid out by defendants. The questions from the bench certainly emphasized the importance of the return of monies to harmed investors as an element of an equitable remedy.

Based on my review of the oral argument, along with the requisite tea leaves and Tarot cards, I anticipate that the Court, in a not particularly close vote, will reverse and remand the Ninth Circuit’s decision in the case. The remand will likely include directions to the lower court to craft a disgorgement order that reflects the net profits individually realized by each defendant, and to establish a procedure for returning funds to harmed investors. Disgorgement will in all probability be trimmed back and significantly reshaped, but the remedy itself will likely survive to see another day.

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