The courts’ authority to order disgorgement in Securities and Enforcement Commission enforcement actions has been the law of the land for more than 40 years and the SEC’s primary tool to deter violation of securities laws. Yet what has been considered settled law supporting the SEC’s authority to seek disgorgement may soon be overturned.
The U.S. Supreme Court has agreed to hear Liu v. SEC, which directly challenges the SEC’s authority to seek disgorgement. This challenge was invited by the court’s recent decision in Kokesh v. SEC, wherein the court determined that disgorgement, as sought by the SEC, is a penalty and not an equitable remedy for statute of limitations purposes.
This dramatic shift by the court left cracks in what has been a foundational aspect of the SEC’s regulatory authority. Indeed, it is anticipated that the court, having already reclassified disgorgement as a penalty, may well overturn the authority previously used to support the SEC’s use of the remedy as its primary enforcement mechanism.
The outcome has the potential to change the regulatory landscape for many years, not to mention the immediate impact such a change would have on the currently pending investigations and enforcement actions.
The Regulatory Context
Disgorgement has been widely used by the SEC as an “equitable” remedy, whereby violators forfeit their ill-gotten gains. Yet, the Supreme Court in Kokesh, held that "[b]ecause SEC disgorgement operates as a penalty under §2462, any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued.”
The court further questioned by implication, in its now infamous Footnote 3, “whether courts possess authority to order disgorgement in SEC enforcement proceedings.” It should be no surprise then, in this era of regulatory roll-back, that the SEC’s very ability to seek disgorgement is at risk.
The Kokesh decision gave rise to an inventible wave of challenges. The Supreme Court granted review in Liu on Nov. 1, 2019, indicating that it will take up the issue of whether the SEC has the authority to seek disgorgement. Disgorgement is now on the chopping block.
The SEC’s Authority to Seek Disgorgement
The Securities Exchange Act of 1934 established the SEC to enforce federal securities laws. Congress granted the SEC broad authority to promulgate rules and conduct investigations. However, the only statutory remedy available to the SEC was an injunction against future violations.
The Second Circuit’s decision in SEC v. Texas Gulf Sulphur is widely credited as the source of the SEC’s authority to seek disgorgement. In TGS, the court found “that § 27 of the Act confers general equity power upon the district courts” and, critically, that “the SEC may seek other than injunctive relief in order to effectuate the purposes of the Act, so long as such relief is remedial relief and is not a penalty assessment.”
As a result, "[b]eginning in the 1970’s, courts [have] ordered disgorgement in SEC enforcement proceedings in order to ‘deprive . . . defendants of their profits in order to remove any monetary reward for violating’ securities laws and to ‘protect the investing public by providing an effective deterrent to future violations.’”
The Supreme Court Redefines Disgorgement as a Penalty
The decision in Kokesh up-ended 46 years of generally accepted regulatory law that permitted the SEC to seek disgorgement in enforcement actions. In reversing the Tenth Circuit, the Supreme Court determined that “SEC disgorgement operates as a penalty under §2462.”
The SEC argued that disgorgement is not punitive but a remedial, and equitable, sanction. The court was not convinced. The court did not reach the issue of “whether courts possess authority to order disgorgement in SEC enforcement proceedings,” but left that door wide open raising the question in a footnote.
The Supreme Court Invited Challenge to Disgorgement
Following the holding in Kokesh, defendants had a new defense in regulatory actions—i.e., that the SEC could not seek disgorgement and, even if it could, such a penalty is subject to the five-year statute of limitation. The SEC was even the subject of a class action lawsuit seeking to recover $14.9 billion in allegedly improper penalties paid to the SEC as disgorgement.
Nonetheless, courts have continued to uphold disgorgement as a remedy, struggling to apply and distinguish the Kokesh decision. The Supreme Court will now address the issue head-on in Lui and is expected to bring the issue to resolution and, along with it, perhaps the end of an era in regulatory enforcement.
Delay, Stay, Object, Challenge and Appeal
If the court affirms the Ninth Circuit that disgorgement is authorized and for the full amount lost, it will need to square that with its decision in Kokesh.
But if the court holds that the SEC lacks the authority to seek disgorgement, then it could change the enforcement landscape as we know it, with far reaching impacts throughout the global market. And the momentum is going in the direction of rolling back regulatory authority, in particular in light of the current make-up of the court.
As a result, entities and individuals finding themselves in the cross-hairs of the SEC should make every effort to delay or stay investigations and litigation, pending the court’s ruling in Liu. Parties should further take every opportunity to object to, challenge, and appeal disgorgement as a remedy. Or, use the current uncertainty, as leverage for a more favorable settlement.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Perrie M. Weiner is the partner in charge of Baker McKenzie’s Los Angeles office. He is also the chair of the firm’s North America Securities Litigation Group. With over 30 years of experience, Weiner’s practice focuses on securities litigation and enforcement matters and complex business litigation.
Edward D. Totino is a partner in the North America Securities Litigation Group of Baker McKenzie’s Los Angeles office. His practice focuses on class actions, complex commercial litigation and securities litigation.
Aaron T. Goodman is of counsel in Baker McKenzie’s Litigation & Government Enforcement, Global Compliance & Investigations, and Securities Litigation groups. He is a knowledge-lead in securities litigation.