In Liu v. Securities and Exchange Commission, the Supreme Court made a series of pronouncements about the “disgorgement” remedy traditionally ordered by courts in cases brought by the SEC to redress violations of the securities laws.
Although Liu did not work the sea change many had expected when the court announced it would hear the case, the ruling will give some individuals and companies in the SEC’s cross-hairs greater leverage in settlement negotiations with the agency, and potentially produce lower total monetary awards.
In brief, the opinion (authored by Justice Sonia Sotomayor for an 8-1 majority) upheld the federal courts’ authority to order a defendant to “disgorge,” or pay back, the profits from a fraud or other violation of the securities laws.
At the same time, the court emphasized certain limits on that authority. First, the court wrote, “the equitable nature” of disgorgement “generally requires the SEC to return a defendant’s gains to wronged investors.” However, the court left open whether disgorged funds must always be returned to investors, and gave no real guidance on what to do when the SEC contends that “it is infeasible to distribute the collected funds to investors.”
Second, the Supreme Court focused intensely on an accused’s “net profits”—as opposed to either gross gain or the total losses suffered by victims—as the proper measure of disgorgement. The federal courts thus “must deduct legitimate expenses” in calculating a disgorgement award.
Finally, the court cast a skeptical eye on the SEC’s practice of imposing “disgorgement liability on a wrongdoer for benefits that accrue to his affiliates,” or in other words vicarious liability for proceeds received by someone else.
The court did, however, allow for the possibility that the challengers in Liu, a married couple, could be found liable for one another’s profits “as partners in wrongdoing,” and sent the case back to the lower courts for a fresh look at that issue and at whether any expenses should have been deducted from the disgorgement award at issue.
Complications, Uncertainty for the SEC
The Liu opinion creates complications and uncertainty for the SEC. The agency traditionally seeks to distribute disgorgement awards to harmed investors when feasible, but it has frequently exercised discretion to turn the awards over to the Treasury in a variety of circumstances, including when it is impractical to identify or locate victims, when the amounts at issue don’t justify the administrative expense associated with a distribution, when there simply are not any identifiable victims of the misconduct, or when any identifiable victims are relatively unsympathetic (for example, if they are also complicit in underlying wrongdoing, or if they are sophisticated institutions able to look out for themselves).
After Liu, the SEC will face increased pressure to distribute disgorged funds. And in cases in which the disgorgement award cannot feasibly be distributed to identifiable, sympathetic victims, the SEC may be deterred from seeking disgorgement at all, at least pending more legal clarity on whether and when it is permissible for the disgorged funds to be paid into the U.S. Treasury.
Cases that are likely to be impacted by this new dynamic include those involving alleged insider trading and market manipulation (except in rare cases when the amounts involved are extraordinarily large) and violations of the Foreign Corrupt Practices Act (whose victims are normally not the shareholders of the companies committing foreign bribery).
In addition, Liu’s relentless focus on net profits (and its related criticism of vicarious disgorgement liability) will sometimes dampen the size of the disgorgement award that the SEC can reasonably expect to obtain. All of this is likely to give those under investigation by the SEC greater leverage in settlement negotiations with the agency, and potentially to result in smaller (or no) disgorgement payments.
SEC May Seek Higher Civil Penalties
But disgorgement is only one of the SEC’s remedial tools. The Liu decision does not impact the SEC’s separate authority to obtain fines, known as civil penalties. Traditionally, the SEC seeks to vindicate its deterrence objectives with both disgorgement and penalties.
Going forward, to the extent there is doubt about the availability (or proper amount) of disgorgement in a given case, the SEC—and the courts—may attempt to accomplish with penalties alone (or with a smaller disgorgement award and an increased penalty award) what would otherwise have been accomplished with the traditional combination of penalties and disgorgement.
Whether the SEC and courts can, in effect, make up in penalties what is lost in disgorgement will depend on the circumstances of each case.
It will be easiest and most tempting for the SEC to dispense with disgorgement in insider trading cases, where the statutes generally authorize a penalty in an amount up to three times the unlawful profits.
On top of that, Justice Sotomayor’s discussion of vicarious liability specifically questioned the SEC’s practice of forcing a “tipper” (that is, a corporate insider who did not trade but instead illegally passed information on to someone else) to give up the trading profits of the “tippee” who used the illegal tip—creating an additional reason for the SEC not to seek disgorgement from tippers.
In cases not involving insider trading, court-ordered penalties face a different ceiling: for each “violation,” the penalty cannot exceed the defendant’s “gross amount of pecuniary gain,” or, if larger, a prescribed dollar maximum that varies depending on the severity of the case. (In cases resolved via in-house administrative proceedings, penalties are based only on prescribed dollar maximums for each unlawful “act or omission,” not on “pecuniary gain.”)
Although there is no agreed-upon way of counting “violations,” and judges have a fair amount of flexibility in setting penalty amounts, the SEC and courts could find it difficult in some cases to calculate penalties in a way that both strips the defendant of unlawful profits (as disgorgement traditionally does) and also imposes whatever additional deterrent the SEC would have obtained in the pre-Liu regime.
To sum up: barring some other legal change (such as an intervention from Congress to address Liu), going forward, disgorgement awards may be lower (or not obtained at all) in some cases, and penalty awards may increase in some cases, especially those involving insider trading.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.