Earlier this summer, the US Supreme Court handed down a highly anticipated decision clarifying the powers of the Securities and Exchanges Commission in civil enforcement proceedings. The court ruled by a margin of 8 to 1 that the SEC can obtain disgorgement from a defendant because disgorgement is a form of equitable relief. As such, the remedy is based on district courts’ inherent powers to enter remedies based on fairness and equity. But we anticipate that the lower courts will still have difficulty in answering questions relating to the equitable remedy with uniformity, most likely resulting in those questions eventually coming back to the high court for resolution.
The case, Liu v. SEC, involved a lower court’s order that a married couple must pay $27 million in disgorgement as a result of the husband’s raising that amount from Chinese investors in a fraudulent EB-5 offering. The funds were ostensibly raised to fund a new cancer clinic, but ultimately the funds were misused. The husband funneled some of the money to the wife and some to other related companies. Both husband and wife were paid millions of dollars in salaries alone. The disgorgement award held both husband and wife jointly and severally liable for the full amount.
The trial court ordered the couple to disgorge the full amount raised in the fraudulent scheme as “ill-gotten gains.” The defendants challenged the amount of disgorgement imposed on several grounds, including that the amount should be offset by legitimate expenses incurred by the defendants. A disgorgement award that was not limited to net profits, they argued, constituted a penalty and therefore, could not be imposed consistent with other limitations on awards of civil penalties.
The decision addressed a burning question the Supreme Court had left open when deciding a case involving statutes of limitations in 2017, SEC v. Kokesh. There, the court held that, as imposed in that case, disgorgement was, in fact, a penalty, and therefore was subject to a five-year statute of limitations. At that time, the court expressly reserved the issue of whether disgorgement could be imposed as a form of equitable relief. In Liu, however, the court simply stated that equitable relief consistent with the court’s holding, in this case, is a permissible remedy.
But while upholding the courts’ power to impose disgorgement, the high court also limited the amount that could be imposed. According to the court, only an award that is limited to a defendant’s illegal profits is authorized. Thus, any legitimate expenses must be deducted in order to arrive at an enforceable disgorgement award. The Justices did not elaborate on how such a calculation should be made, leaving that question one for lower courts to determine. The court also stated that such awards must be used as a way to return wrongful gains to wronged individuals, opening additional questions such as whether the wife in this case engaged in wrongdoing, as opposed to passively receiving funds, and if not, whether she could be held liable for the entire amount.
Another open question is whether the remedy is appropriate if the funds recovered will not, in fact, be returned to the wronged investors. The SEC does not routinely return disgorged amounts to affected investors, especially when such a process is impractical.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.