Opinion analysis: Justices accept, but cabin, SEC’s right to disgorgement in securities litigation
The decision this morning in Liu v. Securities and Exchange Commission struck a middle ground, rejecting the broad argument that the SEC could never obtain disgorgement of profits from unlawful activity in securities litigation, but sharply cutting back the remedy as the SEC has envisioned it in recent years.
As securities cases go, the issue in the case was simple, involving the scope of relief in SEC enforcement actions brought in federal court, as opposed to agency administrative proceedings. The specific question was whether the SEC can obtain an equitable remedy of disgorgement in addition to remedies available under specific statutory provisions for penalties and injunctive relief. Faced with the SEC’s challenge to a fraudulent investment fund operated by petitioners Charles Liu and Xin Wang, the lower courts held that the SEC could force disgorgement of substantially all of the funds that investors had contributed, with no deduction even for legitimate expenses of operating the enterprise.
Justice Sonia Sotomayor wrote for a nearly unanimous bench, joined by all except Justice Clarence Thomas, who would have held disgorgement wholly unavailable because, in his view, “disgorgement is not a traditional equitable remedy.” The court’s opinion first considers the availability of disgorgement. Sotomayor emphasizes the long tradition of equity practice that has “routinely deprived wrongdoers of their net profits from unlawful activity, even though that remedy may have gone by different names.” She points to the long tradition of restitution to “force disgorgement of [a defendant’s] gain.” Recognizing that “the label” might have shifted from time to time, Sotomayor nevertheless discerns a “foundational principle” set out in a Supreme Court opinion from the 19th century: “[I]t would be inequitable that [a wrongdoer] should make a profit out of his own wrong.”
Two threads dominate her reasoning. One is that the remedy must be “tethered to a wrongdoer’s net unlawful profits,” ensuring that the wrongdoer “should not be punished by” (in the words of another 19th century opinion) “‘pay[ing] more than a fair compensation to the person wronged.’” The second is the “‘protean character’ of the profits-recovery remedy,’” which the court has sometimes compared to restitution and at other times to an accounting for profits. In her view, though, even if the label of disgorgement is relatively new, the body of authority establishes that “equity courts habitually [have] awarded profits-based remedies” as a matter of general first principles of equity.
Sotomayor turns next to a discussion of what limits on disgorgement are appropriate. On this question, Sotomayor observes that in recent years, courts seem to have forgotten that the traditional equity practice “circumscribe[d] the award in multiple ways to avoid transforming it into a penalty outside their equitable powers.” She identifies three specific limits on the traditional equitable remedy. First, the effect of the “profits remedy,” as Sotomayor calls it, was to “impos[e] a constructive trust on wrongful gains for wronged victims.” The remedy made sense only as a way to return the defendant’s wrongful gains to those harmed by the defendant’s malfeasance. Second, because the remedy was limited to the defendant’s profits, it traditionally was confined to the profits obtained by each individual defendant; it would not justify relief “against multiple wrongdoers under a joint-and-several liability theory.” Third, the remedy was limited to the “net” profits, or the “gain made upon any business or investment, when both the receipts and [expenses] are taken into the account.”
The closing section of the opinion points out that the SEC’s pursuit of disgorgement in general, and arguably in this case, has transgressed each of those three limits. Sotomayor notes that the SEC “does not always return the entirety of disgorgement proceeds to investors, instead depositing a portion of its collections in a fund in the Treasury.” That is difficult to reconcile with the court’s view that “[t]he equitable nature of the profits remedy generally requires the SEC to return a defendant’s gains to wronged investors for their benefit.” Sotomayor is unimpressed by the SEC’s broad argument that “the very fact that it conducted an enforcement action” is enough to show that the relief benefits investors, concluding that the SEC’s conception of investor benefit would “render [the statute] meaningless.” The opinion leaves open the possibility that the government might retain funds in a case in which “it is infeasible to distribute the collected funds to investors,” but it would not be easy to fashion such a remedy consistently with the court’s analysis.
Similarly, the opinion criticizes the SEC’s common imposition of “joint-and-several liability” in disgorgement cases, which Sotomayor finds to be “at odds with the common-law rule requiring individual liability for wrongful profits” because it “could transform any equitable profits-focused remedy into a penalty.” Again, the opinion allows that the lower court could find on remand that joint-and-several liability is appropriate in this case because the finances of the two defendants here (husband and wife) were so “commingled” that both spouses “enjoy[ed] the fruits of the scheme,” but that circumstance may be absent in many disgorgement cases.
Finally, Sotomayor flatly rejects the practice (followed by the lower court here) of ordering disgorgement of all revenues, explaining that “courts must deduct legitimate expenses before ordering disgorgement.” Sotomayor acknowledges the possibility that “personal services” expenses should be disallowed as “inequitable” in a case in which defendants operated an “entirely fraudulent scheme.” But the record here showed a variety of ordinary expenses to third parties for such items as leases and cancer-treatment equipment. To the extent those items “have value independent of fueling a fraudulent scheme,” the lower court should have permitted their deduction from the award.
Liu may not be regarded as a major securities decision. It should, though, bring a significant shift to the SEC’s disgorgement practice, to which the lower courts have been much more receptive than has the Supreme Court.