The US Supreme Court’s decision in Liu v. SEC will likely increase litigation regarding the calculation of disgorgement and reduce disgorgement awards. The opinion imposes a much more rigorous review of disgorgement methodology on the SEC and will likely result in a number of changes to its approach.
In an 8–1 decision, the US Supreme Court held on June 22 that the US Securities and Exchange Commission (SEC) retains the right to seek disgorgement as an equitable remedy under the Exchange Act. However, while recognizing the remedy, the Court identified a number of ways that historic SEC disgorgement requests and lower court jurisprudence were inconsistent with principles of equity and the statute.
After the ruling in Liu v. SEC, disgorgement must be “for the benefit of investors,” must be a “profits-focused” remedy tied to the actual benefits received by the individual or entity, and cannot include “legitimate expenses.” The result is yet another Supreme Court decision that will force the SEC to reevaluate traditional practices and adapt moving forward. The practical effect of the decision will be reduced disgorgement awards and increased litigation regarding the calculation of disgorgement.
To understand the origins of Liu, one must begin with the Supreme Court’s June 5, 2017 decision in Kokesh v. SEC. In Kokesh, the Supreme Court unanimously held that the five-year statute of limitations in 28 USC § 2462 applies to claims for disgorgement in enforcement actions brought by the SEC. In reaching this result, the Court concluded that disgorgement is a penalty under 28 USC § 2462 because it seeks to redress a wrong against the United States instead of a private individual and because its primary purpose is to serve as a deterrent and is not compensatory. The Court expressly declined to consider whether, having found disgorgement to be a penalty for the purpose of the statute of limitations, it was an appropriate equitable remedy under the Exchange Act, stating “[n]othing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.” This limitation set the stage for Liu.
In May 2016, the SEC brought a civil action against petitioners Charles Liu and his wife, Xin Wang, alleging that they violated the terms of a private offering memorandum by misappropriating more than $27 million of funds that foreign nationals invested through the EB-5 Immigrant Investor Program. The bulk of the investor funds were supposed to go toward the construction costs of a cancer treatment center, but (according to the SEC) only a fraction of those investor funds was put toward the cancer treatment center. Nearly $20 million of investor money was spent on ostensible marketing expenses and salaries, and a sizeable portion of the funds was diverted to Liu’s personal accounts and a company under Wang’s control.
The district court found in favor of the SEC in April 2017 and ordered, among other things, that petitioners pay disgorgement equal to the full amount that they raised from investors, less the $234,899 that remained in the corporate accounts for the project. The petitioners objected that the “disgorgement award failed to account for their business expenses,” but the district court disagreed and ordered the petitioners jointly and severally liable for the full amount that the SEC sought.
Relying on the Supreme Court’s ruling in Kokesh that disgorgement was a penalty, the petitioners argued on appeal that the district court lacked the power to order disgorgement of ill-gotten gains as an equitable remedy in SEC enforcement actions.
In October 2018, the US Court of Appeals for the Ninth Circuit rejected the petitioners’ arguments and affirmed the district court’s decision, acknowledging that “Kokesh ‘expressly refused to reach’ the issue whether the District Court had authority to order disgorgement.”
On June 22, 2020, the Supreme Court answered the question that it left open in Kokesh: “[W]hether, and to what extent, the SEC may seek ‘disgorgement’ in the first instance through its power to award ‘equitable relief’ under 15 U.S.C. § 78u(d)(5).” The Supreme Court held that a “disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims, [and] is considered equitable relief under § 78u(d)(5).”
Writing for the majority, Justice Sotomayor (who also wrote the decision in Kokesh) opened the opinion by describing the Supreme Court’s “task” at hand as a “familiar one” of statutory interpretation. It begins with analyzing whether or not disgorgement—a remedy that the SEC has been requesting and courts have been awarding for many years—“falls into those categories of relief that were typically available in equity.”
Citing historical Supreme Court decisions and other equity jurisprudence, the Court concluded that “a remedy tethered to a wrongdoer’s net unlawful profits, whatever the name, has been a mainstay of equity courts.” The Supreme Court discussed two “longstanding equitable principles” that equity courts have followed in order to avoid transforming this profits-based remedy into a penalty: (1) generally restricting awards to net profits from wrongdoing after deducting legitimate expenses and (2) assessing remedies against culpable actors and for victims.
By incorporating these equitable principles into 15 USC § 78u(d)(5), the Supreme Court found that Congress “prohibited the SEC from seeking an equitable remedy in excess of a defendant’s net profits from wrongdoing.” The Court noted, however, that lower courts have “test[ed] the bounds of equity practice” of disgorgement awards by
Notably, the Supreme Court did not decide these “narrow questions,” but rather discussed “principles that may guide the lower courts’ assessment of these arguments on remand.”
Disgorgement Must Be for the Benefit of Investors
Under 15 USC § 78u(d)(5), equitable relief is restricted to that which “may be appropriate or necessary for the benefit of investors.” The Supreme Court rejected the SEC’s contention that the element is satisfied by simply “depriving wrongdoers of profits,” which “den[ies] them the fruits of their ill-gotten gains.” The Court concluded that the “SEC’s equitable, profits-based remedy must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains. To hold otherwise would render meaningless the latter part of § 78u(d)(5)”—“the phrase ‘appropriate or necessary for the benefit of investors’ must mean something more than depriving a wrongdoer of his net profits alone.”
Distribution of disgorgement paid by a defendant to the victims of the subject fraud will satisfy the requirement that disgorgement be for the benefit of investors. However, the opinion leaves open the question of whether the SEC’s practice of depositing a portion of disgorgement proceeds into a Treasury fund when it is infeasible to distribute the collected funds to investors satisfies the statute.
Joint and Several Disgorgement Liability
Citing specifically to insider trading cases, the Supreme Court recognized that the SEC’s practice of imposing disgorgement liability on a wrongdoer for benefits that accrue to his affiliates, sometimes through joint and several liability, is “seemingly at odds with the common-law rule requiring individual liability for wrongful profits.” The Supreme Court cautioned that this “practice could transform any equitable profits-focused remedy into a penalty” and also runs contrary to “holding defendants ‘liable to account for such profits only as have accrued to themselves . . . and not for those which have accrued to another, and in which they have no participation.’”
On the other hand, the Supreme Court acknowledged that common law permitted liability for “partners engaged in concerted wrongdoing” and the “historic profits remedy thus allows some flexibility to impose collective liability.”
Ultimately, the Supreme Court declined to “wade into all the circumstances where an equitable profits remedy might be punitive when applied to multiple individuals.” Instead, the Court focused on the facts before it, and left it to the lower courts to “determine whether the facts are such that petitioners can, consistent with equitable principles, be found liable for profits as partners in wrongdoing or whether individual liability is required.” The Court noted, however, that the petitioners are married and did not introduce any evidence to suggest (1) that one spouse was a mere passive recipient of profits, (2) that their finances were not comingled, (3) that one spouse did not enjoy the fruits of the scheme, or (4) that “other circumstances would render a joint-and-several disgorgement order unjust.”
Legitimate Expenses Must Be Deducted from Disgorgement Award
The Supreme Court held that “courts must deduct legitimate expenses before ordering disgorgement under § 78u(d)(5).” Recognizing that “when the ‘entire profit of a business or undertaking’ results from the wrongdoing, a defendant may be denied ‘inequitable deductions,’” the Supreme Court went on to find that this exception still “requires ascertaining whether expenses are legitimate or whether they are merely wrongful gains ‘under another name.’”
Thus, while the district court declined to deduct expenses from the SEC’s disgorgement award on the theory that they were “incurred for the purposes of furthering an entirely fraudulent scheme,” the Supreme Court noted that some of the expenses from the petitioners’ scheme went toward lease payments and cancer treatment equipment, which “arguably have value independent of fueling a fraudulent scheme.” It will be up to the lower court to “examine whether including those expenses in a profits-based remedy is consistent with the equitable principles underlying § 78u(d)(5).”
Historically the SEC has been given substantial leeway when calculating and distributing disgorgement. The law relied upon by the Ninth Circuit in affirming the district court opinion that calculated disgorgement as the entire amount raised, less the money paid back to investors, has been repeatedly relied upon by the SEC. Similarly, in the past the SEC has only been held to a reasonable approximation of profits when calculating disgorgement. This opinion imposes a much more rigorous review of disgorgement methodology on the SEC and will likely result in a number of changes to its approach.
First, the Supreme Court’s emphasis that disgorgement proceeds must be “appropriate or necessary for the benefit of investors” will be particularly meaningful in those cases where it is simply not feasible for the SEC to distribute funds to investors. Disgorgement proceeds from insider trading cases, for example, routinely go to the Treasury often because it is too difficult to ascertain the victims of the fraud. Under Liu, the lower courts must evaluate whether that practice nevertheless satisfies the SEC’s obligation to award relief “for the benefit of investors” and is consistent with the limitations of 15 USC § 78u(d)(5). By refusing to conclude that the inability to distribute disgorgement due to infeasibility can still satisfy the “benefit of investors” element, the Court left open the possibility that it cannot. “To the extent that feasibility is relevant at all to equitable principles, we observe that lower courts are well equipped to evaluate the feasibility of returning funds to victims of fraud.” We expect that the SEC will now focus on plans for distribution going forward and, in cases of infeasibility, may seek to increase a demanded civil penalty to account for a possible denial of disgorgement.
Second, while Liu involved a fraudulent offering, the opinion will have an effect on disgorgement in insider trading cases. The Supreme Court’s acknowledgment that disgorgement may be an impermissible remedy when applied to multiple individuals or in situations where benefits have “accrued to another” does not portend well for the SEC’s practice of seeking disgorgement from nontrading tippers for downstream tippee profits. Indeed, insider trading cases are frequently used by the Court to demonstrate disgorgement in the nature of a penalty. The opinion cites multilevel tipper-tippee insider trading cases as examples of when the SEC seeks disgorgement “in a manner sometimes seemingly at odds with the common-law rule requiring individual liability for wrongful profits.” It also later suggests that “unrelated tipper-tippee arrangements” would fall on the side of the spectrum where “an equitable profits remedy might be punitive.” This is consistent with the opinion in Kokesh that noted the disgorgement of profits gained by others “does not simply restore the status quo; it leaves the defendant worse off.” We expect substantial challenges to SEC tipper disgorgement theories going forward and an increased reliance by the SEC on civil penalties that are tied to “communications.”
Third, the Supreme Court’s finding that “legitimate expenses” must be identified and deducted before making a disgorgement award will bring significant challenges to the SEC’s practical ability to seek disgorgement. In cases where individuals or entities raise money through fraudulent statements, the SEC typically considers all of the money raised to be illegal gains that should be disgorged. Under Liu, lower courts must now “ascertain” whether certain expenses are legitimate and should be deducted from the disgorgement award. We expect defendants to argue that the SEC bears the burden of demonstrating that proceeds for which disgorgement is sought were used for “illegitimate” purposes. Having to meet this burden will force the SEC to conduct a much more extensive analysis of the use of proceeds than it may have done in the past, and defendants will now be able to exclude “legitimate” expenses for the underlying business. And notably, this comes at a time when the SEC is already facing challenges and difficulties post-Kokesh in bringing claims for disgorgement within the applicable five-year statute of limitations period.
Finally, before the decision there was concern that defendants may be faced with possible forum shopping if the disgorgement remedy in federal court was eliminated entirely or differed from that available to the SEC in administrative proceedings. Justice Thomas’s dissenting opinion notes that the majority did not explicitly answer this question, and concludes that disgorgement may have “one meaning when the SEC goes to district court and another when it proceeds in-house.” While this is a possibility, we expect that defendants will use the opinion to argue that disgorgement is similarly restricted in the administrative context and that the SEC will not obtain more relief in that forum than it could obtain in federal district court.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Michael M. Philipp
John F. Hartigan
 15 U.S.C. § 78u(d)(5).
 Liu v. SEC, No. 18-1501, 2020 WL 3405845, at *4 (U.S. June 22, 2020).
 Kokesh v. SEC, 137 S. Ct. 1635 (June 5, 2017).
 Id. at 1642 n.3.
 Liu, 2020 WL 3405845, at *4.
 Id. at *4.
 Id. at *2.
 Id. at *5.
 Id. at *8.
 Id. at *9.
 Id. at *10.
 Id. at *10.
 Id. at *11.
 Id. at 11.
 Id. at *12.
 Id. at *10 n.5.
 Id. at *10 (emphasis added).
 Id. at *11.
 137 S. Ct. at 1639.
 Id. at *15 (Thomas, J. dissenting) (citing 15 U.S.C. § 77h-1(e)).