The U.S. Supreme Court on Monday determined that the Securities and Exchange Commission (SEC) can only issue and collect disgorgement awards that are actually for victims and that the size of those awards cannot exceed a wrongdoer’s net profits.
In the case stylized as Liu v. SEC, Charles Liu and his wife Xin (Lisa) Wang scammed foreign investors out of $20 million by running a cancer treatment center with much higher operating costs than originally promised in promotional materials–and by diverting some of those funds into their personal accounts and a separate company entirely. All told, investors contributed $27 million toward the severely mismanaged cancer therapy center.
The SEC sued and won a court order for a disgorgement award equal to the full $27 million minus the small amount of money still left in the cancer center’s corporate accounts.
Liu and Wang contested that award–claiming that the SEC has no power to use disgorgement because there is no statutory authority for that type of action and because the SEC was acting punitively.
Codified at 15 U.S.C. §78u(d)(5), the relevant statute notes:
In any action or proceeding brought or instituted by the [Securities and Exchange] Commission under any provision of the securities laws, the Commission may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.
The key issue in the case is whether or not disgorgement qualifies as equitable relief. Writing for an 8-1 majority, Justice Sonia Sotomayor found that it does. Under-girding that more basic question, however, is whether or not the government’s disgorgement theory was in accord with the law. Sotomayor found that it was not.
Essentially, this is a case where both sides lost major aspects of their arguments–but some lost more than others.
Liu and Wang claimed the SEC has too much power under the guise of “disgorgement” because any sort of disgorgement action is effectively a penalty and therefore illegal.
The government wanted the court to give the SEC more power. To wit: carte blanche authority to act under the auspices of “disgorgement” and do with any such funds as it pleases.
Both extreme approaches were rejected here. Sotomayor’s prose and determination adroitly walked along the edge of paring knife blade in order to sustain disgorgement awards in general but to severely limit exactly how the SEC is able to calculate and apply such awards.
The majority opinion was guided by two over-arching principles:
First, equity practice long authorized courts to strip wrongdoers of their ill-gotten gains, with scholars and courts using various labels for the remedy. Second, to avoid transforming an equitable remedy into a punitive sanction, courts restricted the remedy to an individual wrongdoer’s net profits to be awarded for victims.
The threshold issue consumes the lone dissent authored by Justice Clarence Thomas. Per his brief disagreement, “disgorgement” is not an action the SEC can take because it is “not a traditional equitable remedy” that was “available in the English Court of Chancery at the time of the founding” of the United States.
But those objections amount to littler more than word games, the majority insists, noting that courts and legal treatises through the ages have allowed and applied the basic idea behind disgorgement even if they have not always used that exact word. Other term for “disgorgement” which, in effect, mean the same thing include: “restitution,” “an accounting” and/or “an accounting for profits.”
“Equity courts have routinely deprived wrongdoers of their net profits from unlawful activity, even though that remedy may have gone by different names,” Sotomayor said.
In fact, the opinion makes clear, the Supreme Court has repeatedly signed off on the basic idea–and they’ve even used the term “disgorgement” to refer to said process. The dissent complains that those prior references to “disgorgement” by the nation’s high court were “merely” made “in passing.” That argument didn’t fare too well.
Liu and Wang argued their behavior was precluded from such an equitable remedy because disgorgement only applies to certain business crimes they were not accused of and because Congress had not specifically mentioned “disgorgement” in the statute. Those arguments were also dismissed because “equity courts habitually awarded profits-based remedies” in various sorts of cases.
After establishing disgorgement is an appropriate action the SEC can take, the court pared down the way in which the SEC can use it.
“While equity courts did not limit profits remedies to particular types of cases, they did circumscribe the award in multiple ways to avoid transforming it into a penalty outside their equitable powers,” Sotomayor wrote–ultimately ominously for the government’s theory.
Recall: the SEC argued they should be allowed to recoup the full $27 million from Liu and Wang. They also wanted the ability to keep it for the United States. Neither of those arguments were sustained.
The court easily dispatched with the government’s first argument:
Courts may not enter disgorgement awards that exceed the gains “made upon any business or investment, when both the receipts and payments are taken into the account.” Accordingly, courts must deduct legitimate expenses before ordering disgorgement under §78u(d)(5). A rule to the contrary that “make[s] no allowance for the cost and expense of conducting [a] business” would be “inconsistent with the ordinary principles and practice of courts of chancery.”
The SEC, aided by the lower courts, claimed the $7 million or so spent towards actual cancer therapy was subject to the disgorgement award in addition to the misspent and misallocated $20 million. Liu and Wang argued that their legitimate business expenses should be subtracted and the court agreed, noting: “some expenses from petitioners’ scheme went toward lease payments and cancer-treatment equipment. Such items arguably have value independent of fueling a fraudulent scheme.”
Addressing the SEC’s claim that it can basically do whatever it wants with a disgorgement award, the court was similarly unimpressed.
“The equitable nature of the profits remedy generally requires the SEC to return a defendant’s gains to wronged investors for their benefit,” Sotomayor notes. “After all, the Government has pointed to no analogous common-law remedy permitting a wrongdoer’s profits to be withheld from a victim indefinitely without being disbursed to known victims.”
Moreover, the government claimed an almost limitless ability to commandeer seized funds and attempted to justify it by claiming that their mission statement is more akin to punishment than seeking justice for victims. Notably, this argument all-but undercut the SEC’s original position on disgorgement awards and effectively made the petitioners’ argument for them–that disgorgement was actually a penalty and thus impermissible. In other words, an unforced error.
Again, the court, at length:
The Government maintains, however, that the primary function of depriving wrongdoers of profits is to deny them the fruits of their ill-gotten gains, not to return the funds to victims as a kind of restitution. Under the Government’s theory, the very fact that it conducted an enforcement action satisfies the requirement that it is “appropriate or necessary for the benefit of investors.” But 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).
“[T]he phrase ‘appropriate or necessary for the benefit of investors’ must mean something more than depriving a wrongdoer of his net profits alone,” the court concluded.
[image via Justin Sullivan/Getty Images]
