In Liu v. SEC, the United States Supreme Court confirmed the Securities and Exchange Commission’s (SEC) ability to seek disgorgement of ill-gotten gains as an equitable remedy in SEC enforcement actions in federal court.* However, the court limited the SEC’s ability to obtain such relief, holding that equitable principles require that a disgorgement award not exceed the wrongdoer’s net profits and be set aside to reimburse victims. This decision has clear implications for defendants charged with liability under the federal securities laws, who may now challenge any proposed disgorgement award that fails to deduct the defendant’s legitimate business expenses or does not set aside disgorged funds for fraud victims.
The Liu decision also impacts another frequent target of SEC enforcement action: so-called relief defendants, or parties who have not themselves violated the securities laws but have received some or all of the wrongdoer’s ill-gotten gains. Although Liu’s holding allows relief defendants to argue that their legitimate business expenses should be deducted from any disgorgement order, the equitable principles underlying the decision may, in certain cases at least, equip relief defendants to challenge the SEC’s ability to obtain disgorgement from them at all.
Relief Defendant Disgorgement
In its efforts to enforce the federal securities laws, the SEC regularly seeks disgorgement of proceeds from a defendant’s alleged fraudulent conduct. Often, however, the defendant no longer possesses some or all of the ill-gotten gains, but has disbursed the property to third parties who played no role in the alleged wrongdoing. The SEC frequently seeks to obtain disgorgement from these innocent third parties on the theory that they are not being sued in their individual capacities, but are rather nominal “relief” defendants who hold assets that, in reality, are fraudulent proceeds from the violative conduct of the wrongdoer.
Relief defendants are not alleged to have engaged in any wrongdoing and are therefore not liable for any underlying securities law violations. Instead, courts have found these defendants to be simply “trustee[s], agent[s], or depositor[ies]” for the wrongdoer, with no real ownership interest in the property in their possession. Given that a relief defendant is merely a trustee for the wrongdoer’s profits, equitable principles counseling against the wrongdoer’s unjust enrichment usually apply, and the relief defendant steps into the shoes of the wrongdoer solely for the remedial purpose of recovering the wrongdoer’s ill-gotten gains.
Courts have developed a two-part test to determine the propriety of ordering disgorgement from a relief defendant. First, the SEC must show that the third party received funds from the alleged wrongdoing and, second, that the third party does not have a “legitimate claim” to those funds. Federal courts have interpreted this test expansively, requiring innocent third parties to disgorge any property derived from the liability defendant’s wrongdoing for which the third party did not pay adequate consideration. In SEC v. George, for instance, the United States Court of Appeals for the Sixth Circuit affirmed a disgorgement order requiring a wrongdoer’s fiancée to disgorge her diamond engagement ring purchased with proceeds from the wrongdoer’s Ponzi scheme and given to the fiancée as a gift. Further, the court ordered three other relief defendant investors to disgorge the entirety of the profits distributed to them by the wrongdoer from the unlawful scheme, when those investors failed to rebut the SEC’s evidence that the money they received from the scheme came from the investments of others, rather than profits of the relief defendants’ investments. The Sixth Circuit, like other federal courts that have examined the issue, held that because these relief defendants did not have a “legitimate claim” to the disputed property, disgorgement relief was both equitable and appropriate.
The Liu Decision
In Liu, the Supreme Court addressed whether federal district courts have authority to order disgorgement in SEC enforcement actions at all. This question was left open by the court’s 2017 decision in Kokesh v. SEC, holding that disgorgement is a “penalty” for the purposes of 28 U.S.C. § 2462, which imposes a five-year statute of limitations on SEC enforcement actions seeking “any civil fine, penalty, or forfeiture.” There is no statutory authority for the SEC to obtain disgorgement in federal court actions. In fact, pursuant to 15 U.S.C. § 78u(d), the SEC may seek only civil monetary penalties and “equitable relief.” Prior to Kokesh, lower federal courts routinely authorized disgorgement in SEC enforcement actions on the premise that disgorgement is a form of equitable relief. However, given that equitable relief typically does not include punitive sanctions, Kokesh left open the issue of whether the SEC could pursue disgorgement in its civil enforcement actions.
The Liu court—faced with a direct challenge to the SEC’s ability to seek disgorgement orders in federal court—upheld the practice, albeit subject to some significant limitations. Initially, the court held that disgorgement is not punitive when its effect is limited to the well-established equitable practice of “strip[ping] wrongdoers of their ill-gotten gains.” Noting that “it would be inequitable that [a wrongdoer] should make a profit out of his own wrong,” the court held that to avoid transforming disgorgement into a punitive sanction, equitable disgorgement relief must be limited to a wrongdoer’s net profits from the illegal conduct, deducting legitimate business expenses, and may be assessed “against only culpable actors and for victims.” Expansion of the practice beyond this scope runs the risk of turning an appropriate equitable remedy into an improper penalty. Though unmentioned in Liu, this equitable analysis has important implications for innocent third parties who have found themselves with assets causally connected to a wrongdoer’s illegal conduct.
Significance of Liu for Relief Defendants
Although Liu does not expressly discuss relief defendant disgorgement, the opinion does offer relief defendants various avenues for challenging attempts by the SEC and other federal agencies to seek disgorgement awards. Most obviously, relief defendants are now relying on Liu to contest disgorgement orders in instances where the issuing court arguably failed to deduct the nominal defendant’s legitimate business expenses from its disgorgement order. Indeed, the Liu decision equips parties to challenge disgorgement orders that bar innocent investors from subtracting the amount they invested in the wrongdoer’s fraudulent scheme from the disgorgement award. Courts have ordered such relief on the premise that it is inequitable to allow these unwitting investors in a fraud scheme to recover all or the majority of their investments when other investors are unable to do the same. However, after Liu, these relief defendants may be able to argue that any disgorgement award that exceeds the investor’s net profits is punitive and therefore improper, even if other innocent investors cannot recover their initial investments.
Given the equitable principles supporting the Liu holding, however, relief defendants may in certain cases be able to rely on the opinion to challenge not only disgorgement of legitimate business expenses, but whether equitable disgorgement is even appropriate at all. The argument against disgorgement is perhaps most clear in cases like SEC v. Forex Asset Management LLC, where the United States Court of Appeals for the Fifth Circuit ordered a handful of innocent investors to disgorge not only their initial investments in the wrongdoer’s fraudulent scheme, but also their profits that were directly traceable to those investments (as opposed to gains coming from the investments of others). This practice appears to conflict with language in Liu suggesting that equitable disgorgement is unavailable where the defendant is “merely a passive recipient of profits” from the illegal scheme, rather than a partner in the wrongdoing. Going forward, we should expect to see relief defendants argue that such disgorgement is improper without a finding that the third party acted in concert with the alleged wrongdoer.
More broadly, after Liu, relief defendants may be able to argue that third-party disgorgement is punitive and therefore improper in any case where the relief defendant cannot clearly be characterized as a trustee, agent, or depository for the wrongdoer’s ill-gotten gains—regardless of whether the relief defendant paid adequate consideration for the disputed property. The Liu opinion authorizes equitable disgorgement only when such disgorgement is assessed “against only culpable actors.” Accordingly, although relief defendant disgorgement appears consistent with Liu to the extent the relief defendant is a mere trustee or agent for the culpable actor—for instance, a bank with “only a custodial claim to the [the wrongdoer’s] property”—the more attenuated the relationship between the wrongdoer and the relief defendant, the less likely disgorgement may be to pass muster under Liu.
Take, for instance, the SEC v. George case discussed above. There, the SEC was able to obtain disgorgement of an engagement ring that the wrongdoer purchased with profits from his illegal scheme and then gifted to his fiancée, with no evidence that the fiancée, in accepting the ring, was acting as a mere trustee for the wrongdoer’s ill-gotten gains. As the recipient of a gift derived from illegal profits, rather than, for instance, a fraudulent transfer of those profits, the relief defendant in George arguably does not stand in the shoes of the wrongdoer. Accordingly, any assessment against her or similar defendants may exceed the bounds of equity under Liu, even if the relief defendant failed to pay consideration for the property in her possession.
Whether lower courts will accept these and similar arguments against relief defendant disgorgement remains to be seen. Still, the Liu decision opens up several avenues for innocent third parties to challenge attempts by the SEC and other federal agencies to obtain equitable disgorgement, and we should expect to see federal agencies and courts grappling with the implications of Liu for relief defendants in the months and years to come.
*Jay Dubow is a partner in the Philadelphia office of Troutman Pepper; Ghillaine Reid is a partner in the New York office; and Kaitlin O’Donnell is an associate in the Philadelphia office.