Out of the Penalty Box: The SEC’s Chastened Disgorgement Remedy Survives

Financial Services Law

The Supreme Court’s 2017 decision in Kokesh v. SEC found that, for statute of limitations purposes, the Securities and Exchange Commission’s disgorgement remedy represents a “penalty.” This created peril for the SEC’s disgorgement remedy because, by statute, the SEC is authorized to seek “equitable relief” in its civil enforcement proceedings (15 U.S.C. §78u(d)(5)) and equity typically excludes penalties. However, the Kokesh court explicitly refused to address this larger question, leaving the viability of the SEC’s disgorgement remedy in a civil enforcement proceeding to another day. Predictably, parties subject to disgorgement orders challenged the SEC’s authority based on Kokesh and the issue made its way to the Supreme Court in SEC v. Liu.

On June 22, 2020, the Supreme Court answered the question by confirming the legitimacy of the disgorgement arrow in the SEC’s quiver, finding it to be an equitable remedy. Accordingly, the SEC retains authority to seek disgorgement in a civil enforcement action—as long as the SEC follows certain guidelines identified by the Court.

What happened

SEC v. Liu involved husband-and-wife defendants Charles Liu and Xin Wang, who fraudulently 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 U.S. Court of Appeals for the Ninth Circuit affirmed the order.

Liu and Wang filed a petition for writ of certiorari to the Supreme Court challenging the SEC’s authority to seek disgorgement in civil enforcement proceedings based primarily on the holding in Kokesh.

In an 8-1 decision, the Court upheld the SEC’s authority to obtain disgorgement but did not affirm the Ninth Circuit. Instead, the Court vacated the judgment and remanded the case for further proceedings consistent with its opinion. Writing for the majority, Justice Sotomayor held that, no matter what label is used, equitable relief may include stripping wrongdoers of ill-gotten gains (such as unjust enrichment) by employing remedies such as restitution and accounting. In fact, Justice Sotomayor acknowledged the “protean character” of an equitable remedy designed to recover improper profits. The Court was not troubled by its holding in Kokesh, because the meta issue of viability explicitly was not decided and also because applying a “penalty” statute of limitations to an equitable remedy that takes the form of stripping profits from wrongdoers does not impact the equitable nature of the remedy.

However, the Court specifically held that profit-stripping equitable remedies may cross over from “equity” into “penalty.” The Court identified “three main ways” that disgorgement orders “test the bounds of equity practice.” Thus, the Court held that disgorgement orders requiring that the fraudulent proceeds be deposited into Treasury funds instead of disbursed to victims, that seek to impose joint and several disgorgement liability, and that fail to deduct legitimate expenses from fraudulent receipts are “in considerable tension with equity practices.” Accordingly, the Court vacated the judgment below and remanded the case to (i) calculate what business expenses should be deducted from the disgorgement order, (ii) determine whether the husband-and-wife defendants were “partners” in the fraudulent enterprise to support collective liability for disgorgement or whether individual liability is required, and (iii) make sure that the disgorgement proceeds will be distributed to the actual victims of the fraud to the extent a subsequent disgorgement order directs payment to the Treasury.

To read the Supreme Court’s opinion in SEC v. Liu, click here

Why it matters

Given the high stakes presented by the strong challenge to the legitimacy of disgorgement remedies sought by the SEC in a civil enforcement proceeding, it would be easy to say that the SEC dodged a bullet. However, upon closer inspection, the Supreme Court clearly and convincingly took issue with how the SEC (and the courts) have stretched the limits of equity jurisprudence through disgorgement orders that funnel money into the Treasury instead of returning it to the harmed investors, impose joint and several disgorgement liability on multiple wrongdoers, and fail to deduct legitimate business expenses from the amount ordered to be disgorged. Although the Court found that disgorgement is not a penalty outside the context of statute of limitations, it nonetheless admonished the SEC to rein in this equitable remedy or else lose the ability to use it.

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