Is disgorgement still permissible in an SEC federal court action after Liu v SEC?
The Supreme Court said yes but with limits. Disgorgement is permissible but only if it complies with the traditional definition of equitable relief and not penalty. In an 8-1 vote, the United States Supreme Court held that disgorgement is permitted under 15 U.S.C. §78u(d)(5) if the amount awarded does not exceed an individual wrongdoer’s net profits; is awarded to the victims; and is imposed on an individual and not based on joint and several liability, unless it falls under the exception.
The Lius, a husband and wife team, solicited $27 million of investments from foreign nationals to build a cancer treatment center. Under the U.S. immigration laws, foreigners who invest over $1 million (in 2019 it was increased to $1.8 million) in an approved commercial enterprise are eligible to receive permanent residency in the United States. The SEC alleged that the Lius, in their solicitations, misrepresented that the bulk of the investment would be applied towards the construction of the center. Instead, the majority of the funds were used for salaries, marketing materials and were diverted to personal accounts. Only a fraction of the amount collected was used towards construction. The SEC brought a civil action for injunctive relief in federal court. The trial court granted the injunction barring the Lius from participating in the immigration investor’s program and ordering them to pay disgorgement for the full amount collected and held them jointly-and severally liable.
The Lius claimed that the “disgorgement”, as awarded by the District Court, was effectively a penalty not permissible under the statute in a federal court action. The Lius argued that only equitable relief is authorized by Congress under the statute. The Court analyzed whether the order of disgorgement can be viewed as a traditional relief under equity. The Lius argued that their disgorgement order was unlawful because it contradicted the traditional practice in equity in three ways: by ordering disgorgement of the total profits and not deducting legitimate expenses, imposing joint-and-several disgorgement liability, and ordering the profits be deposited in Treasury funds instead of disbursing the entire amount to victims. The Court agreed.
In its analysis, the Court found that courts have traditionally granted victims the “ill-gotten gains” from wrongdoers whether it is called restitution, disgorgement or accounting. Justice Sotomayor, in writing the opinion, stated that a fundamental principle behind equitable relief is that the wrongdoer should not be permitted to make a profit from his/her malfeasance. The profit, though, should exclude legitimate business expenses. The Court exempted those situations where the “entire profit of a business or undertaking” results from the wrongful activity.” In the Lius’ case, the Court held that there were legitimate expenses, such as a lease and the purchase of certain cancer treatment equipment, that were legitimate and thus, should be deducted from the profits.
The Court further held that imposing joint-and-several liability on multiple defendants can “transform any equitable profits-focused remedy into a penalty”. This practice, explains the Court, is contrary to the common law rule imposing liability on individuals for ill-gotten profits. The Supreme Court did carve out an exception where “partners engaged in concerted wrongdoing” such as a husband and wife team whose bank accounts are co-mingled and who were in concert with each other in undertaking the fraud.
The Court discussed the SEC’s practice of depositing disgorged funds into the Treasury. It stated that although there is little guidance to determine whether or not returning the ill-gotten profits to the victims satisfies the statute’s mandate that any remedy must be “appropriate or necessary for the benefit of investors”, the Court stated that the “equitable nature of the profits remedy generally requires the SEC to return a defendant’s gains to wronged investors for their benefit.” The Court rejected the SEC’s argument that depriving the wrongdoer of his/her profits is the benefit to the public. The Court did not decide the issue of whether depositing disgorged funds into the Treasury benefited the investors because there was no evidence that the disgorged funds were ordered to be deposited into the Treasury. Instead, the Court remanded the case to the lower court to determine whether there was such an order and, if so, to decide whether depositing disgorged funds into the Treasury benefited the investors.
Although the Court decided that disgorgement is to be viewed as an equitable relief and not punitive, lower courts will still have to grapple with whether costs are legitimate; whether multiple defendants are engaged in a concerted wrongdoing and be so financially intertwined as to render them jointly and severally disgorgement liable; and whether depositing the ill-gotten gains into the Treasury benefits the investors. Defendants facing disgorgement liability need to be cognizant of this ruling and seek competent attorneys who can prepare a defense on these issues from the start of the case.”