In a recent opinion, the U.S. Supreme Court held the Securities and Exchange Commission (SEC) has the authority under Section 78u(d)(5) to seek disgorgement as an equitable remedy as long as the amount of disgorgement does not exceed a wrongdoer's net profits and is awarded for victims. In the underlying action, the SEC brought a civil case against the petitioners. The complaint alleged petitioners violated offering documents by misappropriating millions of dollars. The district court ordered disgorgement of the full amount petitioners raised from investors minus the money remaining in corporate accounts for the project at issue. Petitioners argued the disgorgement failed to account for their business expenses, but the district court and the U.S. Court of Appeals for the Ninth Circuit disagreed.

While the Supreme Court upheld the SEC's ability to seek disgorgement (which is the repayment of improper gains by a wrongdoer) based on "longstanding" equitable principles, the holding places limitations on such relief in order to prevent a transformation of the remedy into a punitive sanction. As a result, the opinion creates two substantial answered issues. First, the Supreme Court said that disgorgement is limited to "net profits," but provided no guidance on what constitutes "net profits" for purposes of disgorgement. Second, the opinion held the SEC's use of disgorgement is limited to circumstances where the money will be returned to identifiable victims, but did not make clear what options the SEC has if there are no identifiable victims.

But what do these limitations mean for SEC litigation in the disgorgement context? In the practical sense, there is little doubt the Liu opinion will increase litigation around what constitutes "net profits," and the SEC (and the courts) will face difficulties in determining the amount in each particular case. Specifically, extensive discovery and expert analysis will become commonplace on this facet alone. While the court recognized other equitable remedies have limited awards to a profit-based measure, such limitation has not been widely recognized in the SEC disgorgement context, see also Tilghman v. Proctor, 125 U.S. 136, 145-46 (1888); Porter v. Warner Holding, 328 U.S. 395 (1946); Petrella v. Metro-Goldwyn-Mayer, 572 U.S. 663, 668, n.1 (2014); SEC v. Whittemore, 659 F.3d , 7 (D.C. Cir. 2011). In the past, however, the Supreme Court (as well as many lower courts) has recognized disgorgement is a "limited form of penalty" meant to "restore the status quo"—signaling the need for a profits-based limitation. See Tull v. United States, 481 U.S. 412 (1987); see also SEC v. Teo, 746 F.3d 90, 106 n.29 (3d Cir. 2014) (discussing remedial versus punitive relief); SEC v. Contorini, 743 F.3d 296, 301 (2d Cir. 2014) (holding disgorgement should not serve a punitive function); Hateley v. SEC, 8 F.3d 653, 656 (9th Cir. 1993) (holding disgorgement cannot be a punishment); SEC v. MacDonald, 699 F.2d 47, 54 (1st Cir. 1983) (en banc) (holding disgorgement should not be punitive in nature). Lower courts had already gone as far as recognizing that limitation. See SEC v. Blatt, 583 F.2d 1325, 1335 (5th Cir. 1978) ("Disgorgement is remedial and not punitive. The court's power to order disgorgement extends only to the amount with interest by which the defendant profited from his wrongdoing.  Any further sum would constitute a penalty assessment.").

Post-Liu, in every disputed case it is likely the SEC will need to employ an expert to calculate "net profits" disgorgement. And in every disputed case the SEC will also face expansive and legitimate arguments about which expenses are deductible when calculating "net profits" disgorgement. These questions will likely include: are wages and salaries deductible? are trading costs deductible? are marketing costs deductible? and are litigation costs deductible? Thus, the Supreme Court's decision presents practical pitfalls in terms of enforcement by the SEC while providing some potentially advantageous ambiguity for defendants. In the short run, there could be an increase in litigation until the district courts weigh in and begin interpreting Liu and crafting the boundaries of what costs are deductible when calculating "net profits" disgorgement.

The second prong of the court's opinion in Liu also requires the disgorged net profits be awarded for victims and gives rise to at least two significant open questions. First, there are a handful of securities violations that have no readily obvious victims. The most prominent of these is insider trading, where the SEC usually focuses on the markets and the broader economy as the "true victims." Insider trading litigation has been a vehicle to prevent unfairness in the markets rather than as a way to identify and compensate individual victims. Thus, even where an alleged insider trader made a significant gain there is often no loss due to identifiable victims. The SEC investigates and litigates hundreds of insider trading cases a year. Prior to Liu, the SEC usually deposited disgorgement from insider trading cases with the United States Treasury. But Liu certainly calls into question whether the SEC may pursue disgorgement in these cases. In light of this restriction, the SEC could identify the issuer company as the victim in an insider trading case to satisfy Liu. And in addition to insider trading, there are a number of other more technical securities laws violations that have no victims— implying an even broader effect from Liu.

Second, what happens when the victims are not readily identifiable? Federal criminal law defines a "victim" as "a person directly and proximately harmed as a result of the commission of a Federal offense or an offense in the District of Columbia." As is clear from the definition, being deemed a "crime victim" in and of itself requires an analysis of direct or proximate harm as a result of the specific violation.

However, in cases of securities violations such as market manipulation, identifying victims can be difficult, if not impossible. While the opinion requires the profits go to the victims, it only does so in a general sense. The opinion falls short of providing guidance on the circumstances that allow disgorgement to go to the government as opposed to individuals. Yet, the Supreme Court does vaguely imply that, where it is infeasible to distribute the funds to victims, the SEC may be able to deposit them with the Treasury. One thing is clear: equitable principles will apply to disbursement. Thus, the SEC will likely have to show how equity supports a finding that any disgorgement proceeds should be collected even if there are no victims or the victims are not identifiable.

While it is certain that, in the wake of Liu, there will be significant litigation regarding these issues, the SEC does have tools that it can employ to work around the restraints the Supreme Court imposed in Liu. For instance, instead of litigating the scope of disgorgement the SEC may instead more aggressively use penalties. The securities laws provide three separate tiers of potential penalties that increase depending upon the seriousness of the violation. "The third [tier] provides the highest maximums for violations that involved fraud and 'resulted in substantial losses or created a significant risk of substantial losses to other persons." Under each tier, the court is authorized to impose the greater of the defendant's "pecuniary gain" from the violation, or the applicable tier of the penalty amount per each violation.  In the case of insider trading, the SEC can seek triple penalties for insider trading. Accordingly, it would not be surprising to see the SEC seek bigger penalties where there is difficulty in establishing disgorgement.

The Supreme Court's opinion in Liu clearly established the SEC's right to disgorgement but it undoubtedly created a significant amount of litigation concerning when that disgorgement is appropriate.

Timothy D. Katsiff, a partner at Ballard Spahr, represents companies, as well as directors and officers, in securities class actions, derivative actions, and merger litigation. David L. Axelrod, a partner with the firm, is co-practice leader of the firm's securities enforcement and corporate governance litigation group. Brittany M. Giusini-Tsoflias is an associate with the firm.