By Caleb Kruckenberg| New Civil Liberties Alliance | Litigation Counsel
As the Supreme Court has signaled that it may be inclined to rein in one of the Securities and Exchange Commission’s most powerful, and abused, enforcement tools, a bill currently pending in the Senate would seek to expand that same authority. The Senate should reject this invitation.
The SEC originally only had the power to seek injunctions barring bad behavior when it enforced the securities laws. Thinking that this wasn’t strong enough to deter abuses in the industry, starting in the late 60s, the SEC also tried to convince courts that it should have the power to seek “disgorgement” of ill-gotten gains. Essentially, the SEC argued that it should be able to force bad actors to give back the money they shouldn’t have earned in the first place, to the people that were cheated. This rather limited idea of disgorgement was accepted by the courts and started becoming a routine part of SEC enforcement proceedings. The courts agreed that they had the equitable power to make bad actors give back money they shouldn’t have gotten in the first place. But the courts were also clear that disgorgement would only be permitted so long as “it does not serve to punish or fine the wrongdoer, but simply serves to prevent the unjust enrichment.”
Meanwhile, the securities laws changed, and Congress gave the SEC explicit and comprehensive authority to seek well-defined fines and monetary penalties for violations of the law. But, at the same time, the SEC’s pursuit of disgorgement had already expanded well past its original purpose. Even though the money was meant to only go to those had been cheated out of their funds, as the Supreme Court recently noted, “in many cases, SEC disgorgement is not compensatory,” and instead “disgorged profits are paid to the district court,” which then has the discretion of paying the funds either to aggrieved parties, or, often, “to the United States Treasury.” Indeed, the government can obtain disgorgement “even if victims do not support or are not parties to the prosecution.”
Unlike traditional restitution, the government doesn’t have to prove the exact amount of money wrongly obtained. Instead, the government just needs to provide a disgorgement amount that is a “reasonable approximation of profits causally connected to the violation.” Then the burden is on the person being prosecuted to show that the amount is unfair, with “any risk of uncertainty” falling on the alleged “wrongdoer.” In other words, once the government comes up with a plausible guess about the correct amount to pay, it is up to a defendant to prove otherwise.
The amount a defendant must pay in disgorgement also doesn’t have to be money he or she actually received. If they wrongly obtained funds from someone else, and the defendant is liable for a violation of the securities laws, he or she is responsible for all of the cash in question, even if they never saw a dime of it. And the amount of money subject to disgorgement means gross amounts moving through transactions, not the amount of profit received by anyone. If some else made money at someone’s expense, a defendant might be obligated to pay back the full amount, even if the other person’s profit was much less, and even if the defendant never received a dime.
Finally, the SEC routinely seeks punitive disgorgement orders that are much more severe than the fines available under the law. For example, in 2018, the SEC collected $2.5 billion in disgorgement judgments as compared to about $1.4 billion in penalty assessments.
And if disgorgement wasn’t already a powerful enough tool on its own, until recently the SEC was allowed to seek disgorgement for violations of the securities laws no matter when they happened; since the remedy was “equitable,” there was no statute of limitations for recovery. The Supreme Court–signaling a new willingness to cut back on the implied disgorgement power–held in Kokesh v. SEC that disgorgement was a “penalty” subject to the same five-year statute of limitations applicable to all other penalties in enforcement actions.
But while it was at it, at least five members of the Court questioned the underlying validity of disgorgement in the first place. At oral argument, Justice Gorsuch bluntly said of disgorgement, “[T]here’s no statute governing it. We’re just making it up.” Meanwhile Chief Justice Roberts, Justice Kennedy, Justice Alito and Justice Sotomayor all emphasized that there didn’t seem to be any statutory basis for disgorgement. Ultimately, the Court declined to rule “on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context,” because the “sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to § 246’s limitations period.”
The Court has now granted review of this question in Liu v. SEC, to decide once and for all whether disgorgement is, in fact valid.
In response to these developments, the House recently passed H.R. 4344, the Investor Protection and Capital Markets Fairness Act. The bill, now pending in the Senate, essentially makes three changes with respect to disgorgement. First, it would allow a court to order “[d]isgorgement in the amount of any unjust enrichment obtained as a result of the act or practice with respect to which the Commission is bringing such an action or proceeding,” for any violation of any securities laws. Second, it would set a 14-year statute of limitations for seeking this remedy. Third, the bill would apply the new disgorgement remedy to all future cases, as well as any enforcement action “pending or commenced” when the bill becomes law.
While there is nothing wrong with giving the SEC the power to seek restitution for victims of fraud, this bill entrenches past abuses of disgorgement, denies compensation for victims, and sets unfair requirements for regulated entities.
First, even if the Supreme Court invalidates disgorgement, there’s no need for this particular penalty. Today, unlike when courts implied the disgorgement remedy, the SEC has a host of penalty provisions to choose from. It can seek injunctions barring bad behavior, it can bar wrongdoers from participating in the industry, and it can seek statutory civil penalties. More significantly, many securities law violations can be prosecuted criminally and, in addition to seeking decades of prison time for wrongdoers, the SEC can also seek millions of dollars in fines and court-ordered restitution to be paid directly to victims.
Second, disgorgement as it has evolved in the courts is unfair to regulated entities and does nothing for victims of fraud. The bill appears to adopt disgorgement exactly as it has been applied in the courts, but, as discussed, this allows the government to take money from regulated parties directly, even without the approval of any victims. This also allows the government to recoup massive punitive fines equal to gross receipts by all parties to a transaction, even when the fines bear no relation to money obtained from a victim. Disgorgement in this form is not really meant to effectuate restitution—it is, as the Supreme Court noted, purely a “penalty.”
Third, the statute of limitations is far too long. Many regulated entities, like investment advisers, are only required to keep records of their accounts for five years. Even public company accountants only have to keep audit records for seven years. The new 14-year limitations period would force companies to defend themselves without any records that they could use in their defense. And because the burden of proving the inappropriateness of a disgorgement amount falls on the regulated party, this places companies in an unfair and untenable position.
Making the new statute of limitations retroactive to pending cases also means that companies who have followed their record-keeping obligations in good faith will now be forced to account for activities for years for which they have no records. The government should not be switching industry obligations midstream, particularly when the consequences potentially implicate millions of dollars in liability.
The Investor Protection and Capital Markets Fairness Act would be a step in the wrong direction. It would entrench and expand an enforcement tool that has already been abused by the SEC. The SEC already uses disgorgement liability to coerce settlements from people who may not have done anything wrong. Even in a defensible case, the threat of massive liability that bears very little relationship to any misconduct is often so great that regulated parties have little choice but to settle quickly. Expanding the scope of liability far beyond existing record-keeping provisions would just make this worse, all while continuing to cut actual victims out of the “remedial” orders.
For additional information, please contact Caleb Kruckenberg at caleb.kruckenberg@ncla.legal.