Supreme Court Affirms But Limits SEC's Authority to Seek Disgorgement in Judicial Proceedings

The U.S. Supreme Court on June 22, 2020, issued its decision in Liu v. SEC, a case in which the petitioners, Charles Liu and Xin Wang, challenged the U.S. Securities and Exchange Commission's (SEC) authority to pursue the remedy of disgorgement in judicial proceedings. While the Supreme Court ultimately affirmed the SEC's authority to seek the remedy of disgorgement in judicial proceedings, the court articulated three limitations on the SEC's authority that could have significant implications for future cases.

Background

As discussed in a previous Holland & Knight alert on the March 3, 2020, oral argument, Charles Liu and Xin Wang were business partners who operated an investment fund that solicited investments from foreign nationals by falsely promising investors that the $27 million raised through the fund would be used to develop a cancer research center in California. After the SEC instituted a judicial proceeding against Liu and Wang, the trial court issued an order 1) barring Liu and Wang from participating in the immigrant-investor program through which they solicited the $27 million, 2) imposing penalties equal to the amount of the $8 million personal gain that Liu and Wang received as a result of the fraud, and 3) ordering Liu and Wang to "disgorge" the remaining $19 million that they received from investors but did not personally pocket.

On appeal at the Supreme Court, Liu and Wang challenged the district court's disgorgement award. First, they argued that because 1) the SEC is not explicitly authorized to seek disgorgement in a judicial proceeding and 2) the SEC's authority to seek disgorgement as an "equitable" remedy was significantly undermined by the Supreme Court's 2017 decision in Kokesh v. SEC, which held that disgorgement was a penalty rather than an equitable remedy, the SEC has no authority to seek disgorgement, in any form, in judicial proceedings. Second, they argued that, even if the SEC has the authority to seek certain forms of disgorgement in judicial proceedings, the disgorgement award issued in their case was unlawful because it 1) fails to return funds to the victims of the fraud, 2) imposes joint-and-several liability, and 3) declines to deduct legitimate business expenses from the award. The Supreme Court addressed each of those arguments in turn.

Supreme Court Affirms the SEC's Authority to Seek Certain Forms of Disgorgement in Judicial Proceedings

Justice Sonia Sotomayor, writing for an eight-justice majority, began with the question of whether 15 U.S.C. § 78u(d)(5), which provides that the SEC can seek "equitable relief" in a judicial proceeding, permits the SEC to seek disgorgement awards, in any form, in those proceedings. The Supreme Court answered the question in the affirmative. In doing so, the Supreme Court analyzed how courts of equity have historically "circumscribe[d] the[ir] [equitable] award[s] in multiple ways to avoid transforming [them] into . . . penalt[ies] outside their equitable powers." The Court noted that equity courts of old 1) "often imposed a constructive trust on wrongful gains for wronged victims," 2) "generally awarded profits-based remedies against individuals or partners engaged in concerted wrongdoing, not against multiple wrongdoers under a joint-and-several liability theory," and 3) "limited awards to the net profits from wrongdoing, that is, 'the gain made upon any business or investment, when both the receipts and payments are taken into account.' " It was these "longstanding equitable principles" — "restrict[ing] awards to net profits from wrongdoing after deducting legitimate expenses [and] assess[ing] [them] against only culpable actors and for victims" — that Congress incorporated in § 78u(d)(5), thereby permitting the SEC to seek disgorgement under certain conditions. As long as disgorgement awards comport with these principles, the Supreme Court held, then § 78u(d)(5) authorizes the SEC to seek them and federal courts to issue them.

Supreme Court Remands the Question of Whether the Disgorgement Award Issued in Liu is Lawful But Provides Guiding Principles

After deciding that the SEC may seek and federal courts may order certain forms of disgorgement in judicial proceedings, the Supreme Court remanded to the U.S. Court of Appeals for the Ninth Circuit the question of whether the disgorgement award issued in Liu is lawful. The court did not do so, however, without first "discuss[ing] principles that may guide the lower courts' assessment of the[] [issue] on remand." The Supreme Court began by observing that "courts have occasionally awarded disgorgement in three main ways that test the bounds of equity practice:

• by ordering the proceeds of fraud to be deposited in Treasury funds instead of disbursing them to victims,
• imposing joint-and several disgorgement liability, and
• declining to deduct even legitimate expenses from the receipts of fraud."

"The SEC's disgorgement remedy in such incarnations," the court concluded, "is in considerable tension with equity practices."

In analyzing the issues presented by the disgorgement award issued in Liu, the Supreme Court provided additional guidance on each of the three ways in which previously issued disgorgement awards have tested the limits of courts' equitable powers. First, with respect to the SEC's practice of depositing the proceeds of fraud into the Treasury rather than dispersing them to victims, the court made clear that "[t]he equitable nature of the profits remedy generally requires the SEC to return a defendant's gains to wronged investors for their benefit." Indeed, "the SEC's equitable, profits-based remedy must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains." Second, with respect to the SEC's practice of seeking to impose disgorgement liability on an individual for benefits that accrue to others, the court noted that the practice is "at odds with the common-law rule requiring individual liability for wrongful profits." Although the court recognized the exception "permit[ting] [joint] liability for partners engaged in concerted wrongdoing," it cautioned against employing the practice more broadly. Finally, with respect to SEC's practice of seeking disgorgement awards in excess of the net profits from fraud, the court stated that "courts must deduct legitimate expenses before ordering disgorgement under §78u(d)(5)." Again, while the court recognized the exception permitting courts to deny deductions "when the 'entire profit of a business or undertaking' results from the wrongdoing," it indicated that where expenses have "value independent of fueling a fraudulent scheme," they must be deducted from the disgorgement award.

Conclusion

Although the Supreme Court's decision in Liu v. SEC provides some guidance as to how lower courts should assess the SEC's requests to impose the remedy of disgorgement in future cases, those with questions pertaining to the individual circumstances of their case should contact experienced counsel. If you have specific questions about a pending or potential SEC enforcement action, Holland & Knight's Global Compliance and Investigations Team, White Collar Defense and Investigations Team, and Financial Services Regulatory Team can provide additional information. The teams are comprised of individuals with extensive experience handling investigations conducted by the SEC, the U.S. Department of Justice (DOJ) and other federal regulators, and can provide advice on how to best navigate those investigations as well as how to avoid them altogether. Please contact the authors with any questions.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.