Judge Scheindlin of the Southern District of New York recently rejected the SEC’s attempt to seek disgorgement of almost $500,000,000 from Samuel Wyly and Donald R. Miller Jr., the Independent Executor of the Will and Estate of Charles J. Wyly Jr. (collectively, “defendants”). According to the SEC, this amount represented the total profit that the defendants gained from their illegal conduct, which included securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Section 17(a) of the Securities Act of 1933 and failure to make certain disclosures in violation of Sections 13(d), 14(a), and 16(a) of the Securities Exchange Act of 1934.

The court explained, “Because disgorgement does not serve a punitive function, the disgorgement amount may not exceed the amount obtained through the wrongdoing.” SEC v. Wyly, No. 10-cv-5760, 2014 WL 3739415, at *2 (S.D.N.Y. July 29, 2014) (internal quotations and citation omitted). In addition, “where benefits result from both lawful and unlawful conduct, the party seeking disgorgement must distinguish between the legally and illegally derived profits.” Id. (internal quotations and citation omitted). Stated differently, the SEC must “establish both a reasonable approximation of profits and the causal connection between the approximation and the violations.” Id. at *5.

The SEC could not satisfy the first prong—a reasonable approximation of profits—“merely by proving the violations and then calculating the total profits on each of the trades during the existence of the unlawful scheme.” Id. at *6. This case was not like those in which the unlawful conduct is insider trading or purposeful market manipulation; rather, here, there was no evidence that the defendants’ conduct “resulted in any market distortion, price impact, or profit tied to the violation” or that the defendants were “motivated by the expectation of such profits.” Id. Without this proof, Judge Scheindlin said, the impact of the unlawful conduct is speculative.

She also rejected the SEC’s argument that the legislative assumption that public disclosures provide valuable information to investors supports a finding that all the defendants’ gains should be subject to disgorgement. Such a holding, Judge Scheindlin ruled, would “eliminate the requirement that the government provide a reasonable approximation of the profits that are causally connected to the violation.” Id. Finally, Judge Scheindlin disagreed that the defendants’ trades were unlawful; the Wylys’s scheme to hide their ownership of the securities in which they traded was illegal, but the trading itself was not.

Given the important deterrent effect of disgorgement, Judge Scheindlin afforded the SEC the opportunity to refine its disgorgement theory. It remains to be seen whether the SEC can articulate a theory on the facts of this case that meets the stringent burden associated with disgorgement, rather than one that “smacks of punishment.” Id. at 7.