Should individuals sued by the SEC have to give up, or “disgorge,” corporate gains resulting from a fraud, or just their own direct gains? In an Aug. 29 summary order, SEC v. Metter,¹ the U.S. Court of Appeals for the Second Circuit avoided wrestling with this question, but it may be one of the next major battles in the wake of the Supreme Court's June 5, 2017 decision in Kokesh v. SEC, 137 S. Ct. 1635. Kokesh held that the disgorgement remedy in SEC enforcement actions is a “penalty” for purposes of the five-year limitations period for the “enforcement of any civil fine, penalty, or forfeiture.” 28 U.S.C. §2462. Many have assumed, on the basis of a footnote in the decision, that courts will soon be considering whether they have authority to order disgorgement at all in SEC enforcement actions. That issue certainly lurks, but I suspect that courts first will revisit the proper scope of the remedy, including whether a court may force a defendant to “disgorge” ill-gotten gains that the defendant did not personally receive but that went to third parties, such as individuals and entities associated with the defendant.

Background

Kokesh arose from Charles Kokesh's use of investment-adviser firms he owned to misappropriate funds from clients. 137 S. Ct. at 1641. Kokesh himself did not pocket all the proceeds from this scheme, some of which were paid to other officers of the firms and to a landlord for office rent. SEC v. Kokesh, 834 F.3d 1159, 1161 (10th Cir. 2016); SEC v. Kokesh, 2015 WL 11142470, at *9-10 (D.N.M. March 30, 2015). Kokesh was nevertheless ordered to pay the government, as disgorgement of ill-gotten gains, the full amount of the misappropriated funds (about $35 million) plus prejudgment interest of about $18 million. Most of the money was misappropriated more than five years before the SEC filed suit. 137 S. Ct. at 1641.

Key to the legal backdrop is that there is no express statutory authority for “disgorgement” in an SEC enforcement civil action.² Rather, since the remedy first appeared in the early 1970s, the SEC and courts have defended it as an exercise of the court's inherent equitable powers, analogous to restitution used to prevent unjust enrichment.³ In 2002, the Sarbanes-Oxley legislation amended the Securities Exchange Act of 1934 to provide that in an SEC enforcement action, “the Commission may seek, and any federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors,”⁴ and courts have occasionally cited this provision as authority to order disgorgement.⁵ The SEC has long argued that disgorgement is not subject to the five-year time bar because it is an “equitable remedy” rather than a “fine, penalty, or forfeiture.”

Supreme Court Decision

The Supreme Court resolved the case without expressly addressing whether disgorgement is “equitable,” or even really using the word. The court concluded, in a unanimous opinion authored by Justice Sonia Sotomayor, that disgorgement operates as a “penalty” for purposes of the statutory time bar because it is imposed “as a consequence of violating a public law,” is intended for “punitive purposes,” namely deterrence, and is not “compensatory” in that funds are not necessarily distributed to victims. 137 S. Ct. at 1643-44.

The court also rejected the SEC's view that disgorgement is not punitive but remedial because it “'restor[es] the status quo.'” Id. at 1644 (quoting the SEC's brief). Sotomayor noted that “SEC disgorgement sometimes exceeds the profits gained as a result of the violation,” and that a wrongdoer, such as an inside-trader, can be ordered to disgorge “'not only the unlawful gains that accrue to the wrongdoer directly, but also the benefit that accrues to third parties whose gains can be attributed to the wrongdoer's conduct.'” Id. at 1644 (emphasis added and quoting SEC v. Contorinis, 743 F.3d 296, 302 (2d Cir. 2014)⁶).