The Supremes And Congress Ponder Disgorgement
ATTORNEY: CARA DAVID
POMERANTZ MONITOR NOVEMBER/DECEMBER 2019
The Kokesh Decision. The Supreme Court’s 2017 decision in Kokesh v. SEC held that SEC actions seeking disgorgement were subject to a five-year statute of limitations. However, the SEC—and investors—might find relief in recent bills now pending before Congress. On the other hand, there is a chance the SEC will lose its ability to seek disgorgement as an equitable remedy entirely unless the securities laws are amended.
With its decision in Kokesh, the Supreme Court left the SEC struggling to collect on long-running frauds. The disgorgement remedy is a powerful one—it forces defendants to cough up ill-gotten gains they obtained by violating the securities laws. While civil penalties are meant to function as both punishment and deterrent, disgorgement in theory functions under the premise that a wrongdoer should not be able to keep the ill-gotten gains from the fraud. In dollar terms, disgorgement awards often dwarf other remedies available to the SEC. The SEC never possessed explicit statutory authority to seek disgorgement, but federal district courts have been allowing them to do it for years on the premise that it was a form of “equitable relief.” The Kokesh decision held that disgorgement constituted a “penalty” for statute of limitations purposes and, therefore, was subject to the five-year statute of limitations that applied to civil fines or other statutory penalties. This prevented the SEC from recovering, according to agency estimates, more than $1.1 billion in proceeds, and hurt retail investors who could no longer hope to share in these disgorged funds.
Despite defense attorneys’ attempts to extend the Supreme Court’s reasoning to other forms of relief, Kokesh has almost universally been held to apply only to disgorgement. Even that has had a profound impact, however, not only by restricting the amount of money that could be recovered by the SEC when it brings a case, but as a deterrent to the SEC pursuing a case when the majority of ill-gotten gains will never be recouped. Indeed, in its year-end report, the SEC Office of the Investor Advocate itself raised “fewer investigations involving aged conduct” as one of the potential impacts of Kokesh. This has repercussions on private class actions, as SEC complaints often help plaintiffs in private actions.
“[A]s I look across the scope of our actions, including most notably Ponzi schemes and affinity frauds, I am troubled by the substantial amount of losses that we may not be able to recover for retail investors…,” SEC Chairman Jay Clayton stated on December 11, 2018 in testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs. “Allowing clever fraudsters to keep their ill-gotten gains at the expense of our Main Street investors—particularly those with fewer savings and more to lose—is inconsistent with basic fairness and undermines the confidence that our capital markets are fair, efficient and provide Americans with opportunities for a better future.”
Congress Reacts to Kokesh. Investors and the SEC might be in for some help, though when that help will come, what it will look like, and to what degree it will benefit victims, are still up for debate. In March, Sen. John Kennedy (R-La.) partnered with Sen. Mark Warner (D-Va.) to introduce the Securities Fraud Enforcement and Investor Compensation Act, which would not overturn Kokesh but would grant the SEC more power than it currently has. Their bill would explicitly grant the SEC the authority to seek disgorgement, subject to the same five-year limitations period under Kokesh, but would also allow the SEC to seek restitution for an investor, in the amount of the loss that the investor sustained, subject to a ten-year statute of limitations. Unlike disgorged funds, whose disposition is subject to SEC discretion, restitution directly compensates the defrauded investors.
As that bill remains in committee, members of the House have progressed further. The Investor Protection and Capital Markets Fairness Act, proposed by Reps. Ben McAdams (D-Ut.) and Bill Huizenga (R-Mi.), passed the House Financial Services Committee in September by a bipartisan vote of 49-5. On November 18, it passed a full House vote by a margin of 314-95. This bill would give the SEC fourteen years to seek disgorgement of ill-gotten gains from fraudsters. McAdams’ original draft of the legislation had no statute of limitations, but the fourteen years was included as a compromise with those that believe the SEC should be restrained in their abilities. This bill has been referred to the Senate’s Committee on Banking, Housing, and Urban Affairs, on which both sponsors of the Senate bill sit.
SEC Chairman Clayton has expressed support for the Senate bill but has not publicly commented on the House bill. And many still oppose any extension of the five-year cutoff. For example, the Securities Industry and Financial Markets Association (SIFMA)–the leading trade association for broker-dealers, investment banks and asset managers operating in the U.S. and global capital markets–sent a letter to the House Financial Services Committee expressing its opposition to H.R. 4344. The letter, released to the public, read: “SIFMA strongly opposes increasing the limitations period of 5 years to 14 years, particularly where the SEC has historically used disgorgement to punish respondents, rather than recover monies for investors, as the Court found in Kokesh. The Court appropriately curtailed the SEC’s use of disgorgement to a 5-year limitations period in recognition of its historical overreach in wielding it against respondents.”
The issue SIFMA highlights is the same one that appears to have motivated the Supreme Court’s unanimous decision: the purpose of disgorgement. Though penalties and interest can be awarded to victims via a Fair Fund, there is something about disgorgement being premised in equity that almost compels the conclusion that it should be used to restore victims to where they were prior to the fraud. But that is often not how disgorged funds have been used. In the Kokesh decision, Justice Sotomayor, writing on behalf of a unanimous Court, noted that the disgorgement order in that case “bears all the hallmarks of a penalty: It is imposed as a consequence of violating a public law and it is intended to deter, not to compensate. … Disgorged profits are paid to the district courts, which have discretion to determine how the money will be distributed. They may distribute the funds to victims, but no statute commands them to do so. … True, disgorgement serves compensatory goals in some cases; however, we have emphasized the fact that sanctions frequently serve more than one purpose.” In this case, disgorgement, according to the Court, was a penalty because it served “retributive or deterrent purposes.”
Some commentators have queried whether Kokesh would have been decided differently if the disgorgement order in that case directed that the recovered funds be distributed entirely to defrauded investors.
Liu Raises the Stakes. The Supreme Court stated in a footnote in Kokesh that it was declining to take a position on “whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.” However, several of the justices questioned that authority during oral arguments.
Now they will get a chance to rule on it—on November 1, 2019, the Supreme Court agreed to hear the case Liu v. SEC, which squarely presents the issue of whether the SEC may seek and obtain disgorgement. In that case, the district court had ordered defendants to disgorge approximately $26.7 million and also imposed other monetary penalties. The court of appeals affirmed. The defendants petitioned the Supreme Court to take another look, arguing, among other things, that the treatment of disgorgement as an “equitable remedy” does not survive Kokesh. With Liu, the Supreme Court faces yet another case where the district court order does not specify that the disgorged funds will be returned to victims.
The race is on. With Congress not known for its speed, it’s likely the Supreme Court will rule before any bill becomes law. If it rules for petitioners, the SEC could lose its ability to impose disgorgement as an equitable remedy altogether until Congress acts.
Of note, both of the proposed bills would grant the SEC explicit authority to seek disgorgement, but neither of them requires that monies recovered go to victims. The Senate bill does get closer because the amendment currently in committee in the Senate includes “restitution” in addition to “disgorgement.” Under the restitution section, the SEC “may seek, and any Federal court, or, with respect to a proceeding instituted by the Commission, the Commission, may order restitution to an investor in the amount of the loss that the investor sustained as a result of a violation of that provision by a person that is—(A) registered as, or required to be registered as, a broker, dealer, investment adviser, municipal securities dealer, municipal advisor, or transfer agent; or (B) associated with or, as of the date on which the violation occurs, seeking to become associated with, an entity described in subparagraph (A).” This goes further than prior law but only covers a subdivision of fraudsters and, additionally, it does not mandate the SEC seek restitution. Under the bill, if the agency is proceeding after five years following the unjust enrichment, but before ten years, the agency would seek restitution because it could not seek disgorgement. That seems obvious but does not really get investors all the way there. Perhaps a better bill would require a certain amount of disgorged funds go to investors regardless of when the action is brought. Time will tell whether, as these bills proceed, amendments will alter them in accordance with the concerns the Supreme Court expressed in Kokesh and/or whether the opinion in Liu will alter the process.