The Supreme Court Claws Back SEC Clawback Authority
POMERANTZ MONITOR | SEPTEMBER OCTOBER 2020
By Cara David
Investors breathed at least a partial sigh of relief on June 22, 2020 when the Supreme Court handed down its decision in Liu v. SEC. Some feared the Supreme Court might rule the SEC was unable to obtain disgorgement, but those fears were not realized. The Supreme Court instead struck a middle ground, accepting the SEC’s ability to obtain disgorgement but curtailing its use.
As I reported in the Monitor in November 2019, the disgorgement remedy is a powerful one—it forces defendants to cough up 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.
Liu was the first time the Supreme Court tackled the SEC’s use of disgorgement since the Court’s 2017 decision in Kokesh v. SEC. The SEC never possessed explicit statutory authority to seek disgorgement, but federal 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 a five-year statute of limitations. In that decision, the court explicitly withheld decision on “whether courts possess authority to order disgorgement in SEC enforcement proceedings[.]”
The Liu case was fairly straightforward. Defendants/petitioners Charles Liu and wife Xin Wang operated an investment fund that solicited investments from foreign nationals seeking to qualify for immigrant visas to the United States by investing in U.S. businesses. Fifty investors paid almost $27 million for construction of a cancer-treatment center in California. Liu sent a private offering memorandum to prospective investors, pledging that amounts collected from a small administrative fee would fund “legal, accounting and administration expenses” and the bulk of the money contributed would be used to fund construction of the center.
However, an SEC investigation uncovered that almost $20 million of the funds collected went to alleged marketing expenses and salaries, with a large chunk of that ending up in personal accounts and another company under Wang’s control. In the lower court, the SEC was granted summary judgment with the couple being held jointly and severally liable for approximately $8.2 million in civil penalties and approximately $26.7 million in disgorgement. The district court did not allow defendants to deduct expenses incurred on the center and did not require the SEC to distribute the disgorged funds to investors, thereby allowing the disgorged monies to go into the U.S. Treasury. The Ninth Circuit affirmed.
During oral argument in Kokesh, some of the Supreme Court Justices seemed concerned about whether the disgorged funds were being used to compensate the victims. Therefore, Liu offered a good opportunity for the Court to make its position on disgorgement clear, as the case dealt with a large award that might not end up in investors’ hands. In an 8-1 decision, the Supreme Court vacated the Ninth Circuit decision and remanded the case to the lower court for a reduction in the disgorgement amount.
Before the Supreme Court, defendants argued, inter alia, that the disgorgement award was improper because the SEC did not have statutory authority to seek disgorgement. The Supreme Court held that the SEC could seek disgorgement, but that any award of disgorgement had to be in line with equitable principles. Courts had been granting disgorgement beyond what would be warranted in equity, according to the high Court. Specifically , the Supreme Court held:
“[C]ourts must deduct legitimate expenses before ordering disgorgement” in SEC enforcement actions. In other words, if defendants spent money on anything with “value independent of fueling a fraudulent scheme,” those funds cannot be disgorged. Only fraudulent net proceeds can be disgorged.
Disgorgement must be “appropriate or necessary for the benefit of investors.” The Supreme Court left as an “open question” whether disgorged funds could ever go into the U.S. Treasury instead of being distributed to investors, but certainly expressed that disgorged funds should go to harmed investors whenever possible. This is because, according to the Supreme Court, the disgorgement award “must do more than simply benefit the public at large by depriving a wrongdoer of ill-gotten gains.” Equity requires it be used to repay investors.
Imposing joint-and-several liability when ordering disgorgement is not generally in line with equity which imposes “individual liability for wrongful profits.” The exception would be if the defendants were partners in “concerted wrongdoing,” i.e. partners in crime. (In the Liu case, where defendants were married and were both accused of wrongdoing, the lower court is left to determine whether each defendant was subject to individual liability or they were true partners in the fraudulent endeavor.)
Interestingly, while Justice Thomas drafted a strong dissent, he also believed the Ninth Circuit decision should not be affirmed. He wrote that the SEC is not entitled to seek disgorgement because it is not an “equitable remedy.” He therefore was in favor of reversing the Ninth Circuit decision, instead of vacating it and remanding the case.
The long-term implications of the Liu decision are not yet known. But it will certainly have an impact on the SEC and implications for other federal agency enforcement actions brought in federal court, including those brought by the Federal Trade Commission (FTC).
In terms of what the SEC will do in the future, there are several open questions which will impact investors. Some suspect that the SEC will now try to bring more actions as administrative proceedings. It is unclear what impact this ruling will have in those proceedings. In his dissent, Justice Thomas noted a fear that Liu would in fact “cause confusion in administrative practice,” and that the result may be that “disgorgement has one meaning when the SEC goes to district court and another when it proceeds in house.”
However, undoubtedly, there will continue to be many federal court cases brought by the SEC, and the Supreme Court’s decision that disgorgement must “not exceed a wrongdoer’s net profit” will limit future awards. Liu will also create new disputes within cases, including what expenses are considered “legitimate” such that they must be deducted from monies raised as a result of the fraud.
Additionally, the focus on individual liability raises many questions, but will inevitably decrease the amount of money collected over the course of years (if not in every individual case) because it reduces the number of people the SEC can look to for money. Based on Liu, for example, it is now unclear whether the SEC can continue with its practice of requiring tippers to disgorge trading profits earned by tippees.
One possible result of Liu may be the SEC relying more heavily on statutorily-authorized monetary penalties. These funds often go to the Treasury, though they can be, and sometimes are, distributed to defrauded investors.
Of course, defendants will now use these limitations as leverage in negotiations with the SEC to try to bring down settlement awards. It will be interesting to see in future years just how much this impacts the amounts the SEC is able to collect, both in court and as a product of behind-the-scenes negotiations.
And, while Liu and Kokesh are currently the disgorgement law of the land, Congress could still step in and explicitly grant the SEC the power to seek disgorgement. Two bills in the Senate (one of which has passed the House) would do just that. There has been no action on either since last year, but Liu could very well reignite discussions about congressional action. However, given the more pressing issues the Senate must deal with when it returns to session in September, it seems unlikely disgorgement will take center stage anytime in 2020.