For several decades, the Securities and Exchange Commission routinely has sought and obtained from the federal courts orders directing defendants to return the ill-gotten gains of their securities law violations. Such disgorgement recoveries have become a billion dollar industry for the SEC. A footnote in Justice Sonia Sotomayor’s recent opinion in Kokesh v. SEC – the agency’s second straight significant loss before the High Court – may foreshadow a view by the Court that disgorgement is not a remedy routinely available to the SEC.

The Court’s decision in Kokesh, like its 2013 decision in Gabelli v. SEC, rejects an attempt by the SEC to dodge the five-year statute of limitations applicable to SEC enforcement actions. These decisions rein in what many in the past saw as an SEC overzealous in its enforcement function. Perhaps, however, the ticking time bomb in Kokesh is its footnote 3. There, SCOTUS seemingly opens the door to an argument that the SEC lacks authority to seek disgorgement in enforcement actions brought in federal court. Similar warnings were heard during oral argument. Justice Anthony Kennedy asked if “specific statutory authority … makes it clear that the district court can entertain [the disgorgement] remedy.” Both Justices Samuel Alito and Sotomayor asked for the source of authority seeking disgorgement. Justice Neil Gorsuch specifically noted that there was no statute governing disgorgement. He said, “We’re just making it up.”

In Kokesh, the Court rejected the SEC’s position that the five-year statute of limitations did not apply to the agency’s supposedly equitable disgorgement claims. While the holding is relatively narrow, the opinion may foretell a much broader impact. The decision begins with an unusual and detailed review of the history of the SEC’s creation by Congress and lawmakers’ progressive but quite specific establishment of the agency’s powers and enforcement tools. Notably, the SEC’s toolkit as set forth in various statutes does not include disgorgement in an enforcement action brought in federal court. Given the Court’s apparent focus on the fact that the SEC is a creature of statute that derives its powers from the Congress that created it, the unavoidable question is whether Congress’s silence on the issue means that it has not authorized the SEC to pursue disgorgement in those cases.

The Remedy of Disgorgement and the SEC

The concept of disgorgement is said to be an equitable remedy rooted in restitution. The SEC has employed the sanction of disgorgement to recoup billions of dollars from defendants in enforcement cases – often more than the amount recouped in congressionally authorized monetary penalties. For example, in 2015, the SEC obtained $3 billion in disgorgement orders as compared to about $1.2 billion in penalty orders. The agency’s ability to achieve such large recoveries is attributable in large part to the breadth of activity to which disgorgement can apply. Defendants historically have been required to disgorge funds that they never possessed, but that instead went to an unrelated third-party, so long as those funds can be traced to the alleged violation. Further, the amount of disgorgement need only be a “reasonable approximation of profits casually connected to the violation.”

Congress has authorized the SEC to enforce a wide range of misconduct by individuals who violate the securities laws in various statutes, including the Securities Exchange Act of 1934, the Investment Advisers Act of 1940, the Securities Enforcement Remedies and Penny Stock Reform Act, the Sarbanes-Oxley Act, and, most recently, the Dodd-Frank Wall Street Reform and Consumer Protection Act. These laws specifically empower the agency to seek injunctions, administrative cease-and-desist orders, monetary penalties, and bars and suspensions from certain types of employment in the securities industry. In addition, Sections 77h-1(e), 78u-2(e), and 78u-3(e) of Title 15 of the United States Code provide that the SEC can order disgorgement in an administrative proceeding. Despite congressional authorization in the context of an administrative hearing, lawmakers have never explicitly authorized the SEC to seek disgorgement in cases brought in federal court.

Nevertheless, since 1970, the SEC has sought and federal courts have granted disgorgement on the theory that disgorgement was ancillary to and authorized by the federal courts’ inherent power to order equitable relief. Before 1990, in the absence of statutory authorization for monetary remedies, the SEC urged courts to order disgorgement as an exercise of their “inherent equity power to grant relief ancillary to an injunction” so as to avoid the appearance that securities law violators avoid punishment by suffering only injunction and no monetary consequence. This argument became less persuasive after Congress authorized the SEC to seek monetary civil penalties as part of the Securities Enforcement Remedies and Penny Stock Reform Act in 1990.

Equitable Relief or a Penalty?

The question in Kokesh of whether the five-year statute of limitations applied to disgorgement actions brought by the SEC revolved around whether or not disgorgement is a “penalty” or forfeiture under the law. The SEC and a handful of federal appeals courts have maintained that it is not a penalty, but an equitable remedy – an analysis employed seemingly by rote by courts since 1970.

A 2013 article in the Harvard Business Law Review notes that a review of court opinions issued in SEC enforcement actions revealed “dozens of opinions each year in which courts begin their disgorgement analysis with the assumed premise that disgorgement is equitable.” The article went on to argue that this premise, at least some of the time, is wrong and that disgorgement is more properly characterized as a “remedy at law” or penalty.

In Kokesh, the Supreme Court agreed with this characterization. The Court held that disgorgement carried all the hallmarks of a penalty because it was used to deter rather than compensate and is sought by the SEC on behalf of the United States and not the aggrieved individuals. The Court rejected the SEC’s argument that disgorgement simply restored the “status quo,” pointing out that SEC disgorgement sometimes exceeds profits gained as a result of the violation and does not allow for a deduction from the amount owed for all costs incurred in producing the revenues. Thus, the Court reasoned, disgorgement frequently leaves the defendant worse off than the status quo and is, therefore, a punitive rather than remedial sanction. Accordingly, the five-year fallback statute of limitation set forth in 28 U.S.C. § 2462 applied.

The decision arguably calls into question the foundation on which the SEC and federal district courts have relied in issuing disgorgement orders in SEC enforcement cases over the past almost three decades. If so, then because the agency’s powers derive only from statute, congressional action would be necessary for the SEC to pursue disgorgement orders in federal court. Until that happens, defendants of SEC enforcement actions might be advised to use the Court’s recent decision in Kokesh aggressively to resist disgorgement claims brought by the SEC. In addition, to the extent disgorgement orders are issued, defendants should argue that the amounts awarded are limited to the profits gained and that appropriate deductions be taken.

From The Insider Blog:  White Collar Defense & Securities Enforcement