Securities Litigation, Investigations & Enforcement Alert | June.25.2020
On Monday, June 22, 2020, the Supreme Court decided in Liu v. SEC by an 8-1 vote that the Securities and Exchange Commission (SEC) can continue to collect disgorgement awards as equitable relief, but limited the award to the amount of the wrongdoer’s net profits and required that it be distributed to victims.
In 2017, the Supreme Court held in Kokesh v. SEC that SEC disgorgement operates as a penalty under 28 U. S. C. § 2462 and is thus subject to a five-year statute of limitations. That case left open the issue of whether federal courts may order equitable relief in SEC actions pursuant to 15 U.S.C. § 78u(d)(5). That issue was squarely raised in Liu v. SEC, which affirms the SEC’s ability to collect disgorgement awards, but places limits on such awards in order to prevent them from constituting penalties.
Petitioners Charles Liu and Xin Wang solicited nearly $27 million in investments from foreign nationals under the federal EB-5 Immigrant Investor Program (EB-5 Program), which allows noncitizens to apply for permanent residence to the United States by investing in commercial enterprises that are based on proposals for promoting economic growth. Liu sent potential investors a private offering memorandum that specified that only amounts collected from a small administrative fee would fund “legal, accounting and administration expenses” and the bulk of the contributions would go towards the construction costs of a cancer-treatment center. An SEC investigation found, however, that only a fraction of the funds was put towards a lease, property improvements, and machines for cancer treatment. Instead, the majority of the funds was spent on marketing expenses, salaries, and for the defendants’ personal uses.
The SEC brought a civil fraud action against the Petitioners seeking, among other things, disgorgement equal to the full amount that had been raised from investors. The district court found for the SEC and the Ninth Circuit affirmed. In the Supreme Court, Petitioners argued that the disgorgement award is outside the bounds of equitable relief because the disgorgement SEC seeks fails to return funds to victims, imposes joint-and-and several liability, and does not deduct business expenses from the award.
The Supreme Court decided that a disgorgement award is permitted as equitable relief under 15 U.S.C. § 78u(d)(5), finding disgorgement to fall within “those categories of relief that were typically available in equity.” Liu v. SEC. The Court noted that equity practice allows courts to strip wrongdoers of their ill-gotten gains – also referred to as “unjust enrichment” – and return those amounts to victims. However, the Court found that over the years courts have occasionally awarded disgorgement in SEC actions 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 – that is, making defendants responsible for other parties’ ill-gotten gains – and declining to deduct even legitimate expenses from the receipts of fraud.
First, the Court agreed that the equitable nature of the disgorgement remedy requires the SEC to return a defendant’s gains to wronged investors. The Court noted that the SEC “must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains.” However, because the SEC had not been able to return the funds to the investors because the funds had not been recovered, it remains unanswered whether an order directing the proceeds be paid to the Treasury is sufficient return of the funds to the victims. The Court left it to the lower court to determine on remand whether an order for payment to the Treasury in this case would be “for the benefit of investors” as required by Section 78u(d)(5).
Second, the Court held that disgorgement liability could not be imposed on a wrongdoer for benefits that accrue to his affiliates; they must be individually liable, not joint and severally liable. However, in this case, involving a married couple, neither of whom was a passive recipient of profits, the Court directed the lower court to determine whether Petitioners could be found liable for profits as partners in wrongdoing or whether individual liability is required.
Third, and most notably, the Court ruled that disgorgement awards cannot exceed the net profits of the scheme after taking into account both receipts and payments. Thus, courts must deduct legitimate expenses before ordering disgorgement. The Court did not give detailed guidance on what expenses are legitimate, but noted that the expenses must have value independent of “fueling a fraudulent scheme.” This leaves it to the Ninth Circuit to decide whether expenses such as lease payments and cancer-treatment equipment have independent value separate and apart from the fraudulent scheme sufficient to justify their exclusion from an equitable disgorgement order.
Justice Thomas dissented, arguing that disgorgement can never be awarded under 15 U.S.C. § 78u(d)(5) because it is not a traditional equitable remedy. However, prior Supreme Court opinions speak contrary to this, and the general takeaway of the opinion makes clear that the other factors are of greater importance.
The Supreme Court’s decision in Liu v. SEC affirms the SEC’s ability to seek equitable relief in civil proceedings under 15 U.S.C. § 78u(d)(5). However, the disgorgement award cannot go beyond the defendant’s net profits from wrongdoing, discounting legitimate business expenses, and the disgorgement award must be for the benefit of investors. These are important limitations on disgorgement available to the SEC and creates opportunities for defendants to argue against a disgorgement award. The decisions leaves open several questions: