Disgorgement: One Less Arrow in the SEC’s Quiver?

Financial Services Law

Can the Supreme Court’s 2017 decision in Kokesh v. SEC, which found that disgorgement is a penalty and not an equitable remedy for statute of limitations purposes, be logically expanded to spell the end of the SEC’s long-standing and widely accepted practice of seeking disgorgement from parties in civil actions commenced by the SEC?

The Supreme Court has agreed to answer the question this term.

What happened 

In Kokesh, the Court held that disgorgement in an SEC civil action represents a “penalty” and is therefore subject to the five-year statute of limitations found in 28 U.S.C. § 2462. In doing so, the Court explicitly left unanswered “whether courts possess authority to order disgorgement in SEC enforcement proceedings …” After Kokesh, every court of appeals and every district court that has considered the issue has determined that Kokesh does not prevent the SEC from seeking disgorgement in enforcement actions. However, Justice Kavanaugh, concurring in a 2017 decision of the Court of Appeals, D.C. Circuit, observed that Kokesh had “overturned a line of cases from the D.C. Circuit that had concluded that disgorgement was remedial and not punitive.”

Now the justices will face the issue head-on.

The case involves husband and wife defendants Charles Liu and Xin Wang. The pair raised approximately $27 million from Chinese investors under the EB-5 Immigrant Investor Program, which allows foreign citizens to obtain visas in exchange for investments in job-creating projects in the United States.

Liu and Wang sold membership interests in an LLC, which would then lend the proceeds of those sales to a second LLC, which was supposed to use the funds to construct and operate a cancer treatment center in California.

Each investor was required to put up a $500,000 “Capital Contribution” and a $45,000 “Administrative Fee.” According to the Private Offering Memorandum provided to investors, the Capital Contribution would be used for construction costs, equipment purchases and other items needed to build and operate the cancer treatment center, while the Administrative Fee was slated for legal, accounting and administration expenses related to the offering.

The SEC filed an action against Liu and Wang, alleging that they violated Section 17(a)(2) of the Securities Act by misappropriating most of the money raised. Almost $13 million was paid to marketing firms to solicit new investors, the agency alleged, while Liu and Wang pocketed more than $8 million in salaries—despite the fact that they never even obtained permits to break ground for the cancer center.

A district court judge granted summary judgment in favor of the SEC and ordered disgorgement of the entire amount that had been raised from investors: $26,733,018.81.

The defendants appealed the order to the U.S. Court of Appeals, Ninth Circuit, arguing that the SEC lacks the power to seek disgorgement. Noting that the Supreme Court expressly refused to reach the issue in Kokesh, the panel relied upon “our longstanding precedent on this subject” and affirmed the order.

Liu and Wang filed a petition for writ of certiorari to the Supreme Court. The SEC’s statutory authority is limited to the pursuit of injunctive relief, equitable relief or civil money penalties, they argued, and based on Kokesh—which found disgorgement to be a “penalty” and not “equitable relief”—the agency lacks the power to seek disgorgement.

Liu and Wang further argued that Congress never specifically granted the SEC disgorgement authority, and that the SEC can no longer claim that disgorgement is part of the SEC’s equitable remedies because the Court has held that disgorgement is a penalty. In response, the agency attempted to distinguish Kokesh as a statute of limitations case. The Court’s conclusion that disgorgement constitutes a “penalty” in that context is not inconsistent with the understanding that disgorgement represents a form of equitable relief, the SEC said.

“A remedy thus can qualify as a form of equitable relief even though it might also be considered ‘penal’ for some purposes,” according to the SEC’s brief.

The Court granted cert to hear the case.

To read the Ninth Circuit opinion in SEC v. Liu, click here.

To read the defendants’ cert petition, click here.

To read the SEC’s brief in opposition, click here.

Why it matters

The case raises serious questions about the ongoing legitimacy of the SEC seeking disgorgement in civil enforcement actions—even where fraud is apparent. Oral argument will likely be held in the spring, with a decision expected by the end of the term in June 2020.