The U.S. Supreme Court in a long-awaited has decision preserved the critical right of the Securities and Exchange Commission to seek and federal courts to grant disgorgement of illicit profits as a permissible form of equitable relief. But the Court imposed important limitations on disgorgement, including allowing wrongdoers to deduct “legitimate business expenses.”
In Liu v. SEC, the SEC brought an enforcement action in federal court against a husband and wife accused of misappropriating nearly $27 million intended to fund a cancer treatment center. After finding the defendants violated the securities laws, the district court issued an order, affirmed by the Ninth Circuit, requiring the defendants to repay the full amount raised from investors, less a small amount of remaining funds. The defendants argued that disgorgement was a penalty and therefore not permissible equitable relief, citing Kokesh v. SEC, 137 S. Ct. 1635 (2017), which held that disgorgement was a penalty for purposes of the federal five-year statute of limitations. A decision barring disgorgement of illegal profits could have crippled the SEC’s enforcement program.
However, in an 8-1 decision, with Justice Thomas dissenting, the Court ruled that courts acting in equity long had stripped wrongdoers of unlawful gains. But the opinion by Justice Sotomayor also held that disgorgement must be carefully circumscribed to avoid becoming a penalty beyond the courts’ equitable powers. First, the Court doubted whether illicit profits could be paid to the Government rather than to defrauded investors. The Court did not have to address the issue in Liu because there was no order directing proceeds to be paid to the Treasury. But it does call into question whether disgorgement may be directed to the Government to fund the SEC’s payment of whistleblower bounties or in cases where there are no defrauded investors, such as in violations of the Foreign Corrupt Practices Act.
Second, the Court also questioned whether disgorgement liability could be imposed on a wrongdoer for benefits paid to others under a joint-and-several liability theory, while noting that historically individuals engaged in “concerted wrongdoing” were held jointly liable. The Court left to the Ninth Circuit to determine on remand whether the defendants could be held liable jointly for the profits or whether individual liability must be assessed. That said, the Court’s analysis casts a cloud over the SEC’s efforts to force a primary wrongdoer to disgorge profits that benefited individuals who were not equally culpable, such as tippers in insider trading cases being held liable for the profits of remote tippees.
Finally, the Court held that defendants must be allowed to deduct legitimate business expenses. The Liu defendants argued that they were entitled to deduct $12.5 million in such costs. The lower courts followed longstanding precedent holding that wrongdoers should not be able to deduct expenses incurred in establishing a fraudulent scheme. Rather than provide guidance concerning when expenses might be considered fraudulent, the Court directed the Ninth Circuit to consider whether some of defendants’ expenses had “value independent of fueling a fraudulent scheme,” such as lease payments and the purchase of a cancer treatment machine. This holding undoubtedly will inject even greater complexity in a court’s calculation of disgorgement, such as determining when ostensibly legitimate expenses were intended only to create the appearance of an ongoing enterprise.
For more information regarding strategy involving government investigations, please contact one of Alto Litigation’s partners: Bahram Seyedin-Noor, Bryan Ketroser, Ellen London.
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