Last week, the Supreme Court decided in Liu v. SEC that the SEC may continue to seek disgorgement in judicial proceedings as a form of equitable relief under the Securities Exchange Act.  A ruling to the contrary would have deprived the SEC of its most significant tool, in dollar terms, for obtaining monetary relief.  Although the decision preserves the SEC’s disgorgement power, it restricts how courts may disgorge ill-gotten gains in three ways: in general, (1) disgorgement should be limited to the wrongdoer’s net profits (i.e., disgorgement awards should be net of wrongdoers’ legitimate business expenses); (2) the SEC should return disgorged funds to victims rather than deposit it in the U.S. Treasury; (3) courts should not disgorge profits accrued by a wrongdoer’s affiliates. Yet the Supreme Court articulated (potential) exceptions to each of these general rules without saying when – or in one case if – they apply. Thus, considerable uncertainty remains as to the extent to which the SEC may disgorge profits.

Questions Liu Leaves Open

First, courts may decline to deduct legitimate expenses when “the entire profit of a business or undertaking results from the wrongdoing.” (Although the Court framed this as an exception to the general rule that disgorgement awards should be net of legitimate business expenses, it is really an application of the rule to a case where the value of legitimate business expenses is $0 because the business is entirely illegitimate.) Yet the Court did not say when business expenses are “legitimate.” Instead, it noted only that, in the case before it, which involved a fraud on investors in China through the petitioners’ use of funds intended for a cancer treatment center on marketing and their own salaries, the wrongdoers’ leases and cancer treatment equipment “arguably have value independent of fueling a fraudulent scheme,” and left the question for the lower courts. But what would make, say, the cancer treatment equipment legitimate? Must a patient have used it? Must the wrongdoers have intended them to use it? What if the wrongdoers intended patients to use it but only because they judged this as an effective way to increase their fraudulent profits?

Second, the SEC should return disgorged funds to victims when feasible. But what happens when this is not feasible? The Court did not address the question, and its opinion leaves open two categorically opposed options: the SEC can disgorge but deposit the award in Treasury’s coffers, or the SEC can’t disgorge at all. The Court also gave no guidance on the threshold question of what makes returning funds infeasible. Must it cost more to return the funds than the value of the ill-gotten gains? Is there some other standard? Who bears the burden to prove infeasibility?

Third, the Court seemed to say that there are some circumstances where the rule that courts should not disgorge profits accrued by a wrongdoer’s affiliates rule does not apply – namely, when partners are engaged in “concerted wrongdoing.” The Court noted the “wide spectrum” of relationships among participants in a scheme, ranging from “equally culpable co-defendants” to “unrelated tipper-tippee arrangements,” suggesting that there exists – but not identifying – a line dividing where courts can disgorge affiliates’ profits and where they can’t.

More Administrative Proceedings?

The SEC can bring actions either judicially or administratively. Before Liu, it was clear that the SEC could seek disgorgement in administrative proceedings – the statute explicitly authorizes “accounting and disgorgement.” Yet the provision governing judicial proceedings does not explicitly refer to disgorgement. The Liu Court instead held that disgorgement was available under a section of the statute allowing courts to order “equitable relief,” but limited disgorgement based on the meaning of “equitable.” It might thus seem that Liu has no effect on the extent to which the SEC can seek disgorgement in administrative proceedings – the word “equitable” does not appear in the administrative provision. Given this, it might be tempting to predict – as I did in a previous post – that a decision limiting disgorgement in judicial proceedings would steer the SEC toward bringing more actions administratively.

This conclusion could be premature. While the administrative provision doesn’t refer to “equitable relief,” the Liu Court signaled that “accounting and disgorgement” – the terms used in the administrative provision – are themselves forms of equitable relief. If so, then presumably disgorgement in administrative proceedings is subject to the same equitable limitations as disgorgement in judicial proceedings. Whether the SEC will construe Liu this way is an open question (and, if it doesn’t, defendants would do well to argue that it should). It is thus unclear whether Liu will steer the SEC towards administrative proceedings in the long term.

Civil Penalties?

The SEC also might rely more on civil penalties in judicial proceedings. These can equal the gross amount of a wrongdoer’s pecuniary gain in certain situations involving fraud, and three times the wrongdoer’s gain in insider trading cases. (Penalties in SEC administrative proceedings are based on prescribed statutory amounts per violation rather than gross pecuniary gain.)  This tack is especially likely in the near term if victims are hard to identify – without lower court decisions holding that Treasury can receive the proceeds in these situations, the SEC might not want to risk the prospect of foregoing monetary relief altogether.