Could the SEC lose its primary enforcement tool of disgorgement?

  • Posted on February 5, 2020 | Updated on February 12, 2020 | 5 min read

The SEC has used disgorgement to deter the violation of securities laws. But a challenge of that authority — initiated by a couple found guilty of defrauding EB-5 investors — could dramatically change SEC enforcement, and even the SEC itself. If the Supreme Court decides disgorgement is a penalty and not an equitable sanction, could it possibly “gut” the SEC?

Since the 1970s, disgorgement has been in order in SEC proceedings to strip violators of securities laws of their profits and to protect the investing public by having a real deterrent to other potential violators. Disgorgement has been a real and effective tool for the courts. But a recent EB-5-related case, Kokesh v. Security and Exchange Commission, has raised the question of whether or not disgorgement will have a future in SEC enforcement.

The Kokesh originally case revolved around a couple who defrauded 50 Chinese EB-5 investors. While a district court upheld the SEC’s authority to use disgorgement in this case, the Supreme Court later reversed this decision.

The Supreme Court, in a unanimous decision, determined in the Kokesh case that SEC disgorgement is a penalty; it also determined that claims for disgorgement must be made within five years from the date the claim accrued. What makes this decision historic is the court’s determination that disgorgement for the SEC is not an equitable remedy but a penalty. This distinction is substantial and could alter the future for how regulatory authorities deal with fraud.

Two principles were used as the basis for the Supreme Court’s decision to do so:

1) whether a sanction is a penalty is based on whether the wrong being redressed is a wrong to the public or the individual.

2) A monetary sanction is a penalty if it is being used to punish and to deter others from making a similar violation, instead of it being used to compensate the victims.

The court also determined that “deterrence is not a legitimate nonpunitive governmental objective” and that SEC disgorgement is often not used to compensate victims. Disgorged profits go to district courts, which then make the determination of where that money should go; it could be distributed to the victims, but this is not mandated.

While the SEC argued that disgorgement is not a penalty but an equitable sanction, the Supreme Court did not agree and instead stated this: “Disgorgement does not simply restore the status quo; it leaves the defendant worse off and is therefore punitive.”

This Kokesh decision has thrown into uncertainty a traditional enforcement authority and has given new violators a new defense that the SEC cannot use disgorgement, and if it can, that must be within a five-year statute of limitations. Since then, the SEC was involved in a $14.9 billion — yes, billion — class-action suit to recover monies paid to the agency as disgorgement. The case was dismissed by a district court but is on appeal.

And now, in another recent EB5 Green Card -related case, that defense has been used. In Liu v. the S.E.C., Charles Liu and his wife Lisa Wang were found guilty of defrauding 50 Chinese EB-5 investors. They misappropriated $26 million of funds the investors believed were going into a cancer research center. The court ordered Liu and Wang to return the investors’ capital and to pay an $8.2 million civil penalty.

But that decision was made two months prior to the Supreme Court’s Kokesh decision. And now Liu and Wang are challenging at the Supreme Court level whether disgorgement can be used. Since the Kokesh case, federal circuit courts have continued to use disgorgement as a remedy but the Supreme Court’s imminent judgment in the Liu case will bring closure to the matter of whether or not an enforcement tool used for decades by the SEC can still be applied.

So what next? The SEC’s annual report for the fiscal year 2019 (despite citing “significant headwinds” from the Kokesh decision) has claimed a record year of more than $4.3 billion in disgorgement and penalties, with almost $1.2 billion going back to victimized investors. But if the Supreme Court will decide that disgorgement is not equitable relief. Then disgorgement will no longer be used by the SEC, how will that impact the investment landscape?

Three lawyers from multinational law firm Baker McKenzie believe that such a decision will have repercussions throughout the global investment market. And the lawyers also don’t see such a decision as boding well for the SEC itself: “The elimination of disgorgement could also largely de-fund the SEC and result in layoffs, hiring freezes, lowered compensation, which would, in turn, inhibit recruitment and hiring, possibly gutting the SEC.” Grim words, indeed.

One would hope that for EB5 investments in particular, and the investment world in general, that disgorgement remains a tool for the SEC to strip fraudsters of their ill-gotten gains, restore funds to victims, and deter would-be violators of laws that exist for very good reason.

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