The US Supreme Court has unanimously ruled in Kokesh v. SEC, that SEC disgorgement is a penalty and, therefore, subject to a five-year statute of limitations. The decision upends long-held views that SEC disgorgement is an equitable remedy not subject to time constraints.
The case below
Charles Kokesh owned two investment-adviser businesses. In an enforcement action filed in 2009, the SEC alleged that he had violated the securities laws between 1995 and 2009. After a jury found Kokesh liable at trial, the district court ordered him to pay both civil penalties and disgorgement. The court applied the five-year limitations period of 28 USC §2462 to the civil penalty, capping it at approximately $2.4 million, the amount of funds that Kokesh had received during the five-year limitations period.
The trial court also ruled that disgorgement was not a "penalty" and, thus, not subject to such a cap. Accordingly, it ordered Kokesh to disgorge the entire $34.9 million – covering alleged gains for all years back to 1995 – plus $18.1 million in prejudgment interest. On appeal, the Tenth Circuit affirmed, agreeing that disgorgement was not a penalty.
The Supreme Court's ruling
The Supreme Court reversed, holding that disgorgement is a penalty. Reaching back to its 19th century precedent, the Court defined a "penalty" as a punishment imposed and enforced by the government for a crime or offense against its laws. Writing for the unanimous Court, Justice Sonia Sotomayor identified two governing "principles" at issue: (1) a sanction is more likely a "penalty" if the underlying wrong is a "wrong to the public," as opposed to a "wrong to the individual"; and (2) a sanction is a penalty if it serves to punish and to deter others.
The Court said that these two principles "readily demonstrate" that disgorgement is a penalty. First, the Court noted that the underlying securities violation was committed against the United States and that the SEC "acts in the public interest" when it seeks disgorgement. Second, because general deterrence is an essential goal in seeking disgorgement, the Court found that it is punitive in nature. The Court also recognized the fact that disgorgement is not an exclusively compensatory remedy.
In its analysis, the Court rejected the SEC's position that disgorgement is remedial because it "restores the status quo." Using insider trading as an example, the Court noted that individuals who illegally provided inside information but who themselves did not profit from any subsequent trading have been forced to pay disgorgement equal to trading profits by others. "In such cases," the Court reasoned, "disgorgement does not simply restore the status quo; it leaves the defendant worse off."
So what now?
Formally, the Kokesh opinion resolved a narrow issue. The SEC can still obtain disgorgement but is subject to a five-year statute of limitations. The impact of Kokesh, may, however, go much further:
- Whither disgorgement? Although the opinion resolved the issue presented, it did not foreclose further attacks against disgorgement orders; in fact, it may well invite them. In footnote 3 of the opinion, the Court expressly cautioned against interpreting its opinion as deciding "whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context." This language suggests that the Court may have some doubt about whether the SEC is authorized to seek – or courts are authorized to order – disgorgement at all, particularly since disgorgement is not a remedy contained in federal securities laws. Indeed, several justices posed skeptical questions along these lines during oral argument in the Kokesh case. So while the SEC may well begin requesting tolling agreements more frequently and earlier in its investigations, those who litigate with the SEC may see footnote 3 as inviting a future challenge to the very concept of disgorgement.
- Be careful what you wish for. As the facts in the Kokesh case indicate, the Supreme Court's decision significantly reduces the potential financial exposure for companies and individuals facing SEC enforcement actions involving violations that extend beyond the five-year limitations period, but the math may not be so clear – after taxes. The tax code prohibits a deduction for a "fine or similar penalty paid to a government for the violation of any law." Previously, courts and the IRS generally agreed that this provision did not apply to disgorgement – and, thus, that disgorgement payments were deductible – because disgorgement was "remedial" in nature. But last year an IRS lawyer, in a memorandum sent to a particular field-audit team, concluded that disgorgement was not deductible because it was punitive in nature. The tax issue was raised in passing during the Kokesh oral argument, but the opinion does not address it. Nonetheless, the Supreme Court has now held that disgorgement is a penalty. How Kokesh will affect the IRS's and courts' positions with respect to past and future disgorgement deductions is now an open – and potentially expensive – question, at least for those facing disgorgement of amounts within the five-year limitations period.
- A potential Congressional fix? The Kokesh opinion may provide fresh momentum to one of the rare bipartisan bills that has been introduced on Capitol Hill. Among other things, the Stronger Enforcement of Civil Penalties Act of 2017 (the SEC Penalties Act), introduced in the Senate in April, seeks to increase substantially the size of penalties that the SEC can seek. Specifically, fines would be set at $1 million per violation for individuals and $10 million per violation for institutions, or three times the money gained by the violation, or lost by the victims, whichever is greater. The press release associated with the bill's introduction focused on the need to create "an effective deterrent to crack down on fraud." To the extent legislators view Kokesh as weakening the deterrent value of securities enforcement, the Supreme Court's ruling may spur bipartisan action on stiffening penalties.
See the Court's opinion here.