Disgorgement has long been one of the Security and Exchange Commission's most powerful enforcement tools. The courts' authority to order disgorgement in SEC enforcement actions has been the law of the land for more than 40 years, and the SEC's primary tool to deter violation of securities laws. Yet, what has been considered settled law supporting the SEC's authority to seek disgorgement, may soon be overturned. The US Supreme Court has agreed to hear Liu v. Security and Exchange Commission, which directly challenges the SEC's authority to seek disgorgement. This challenge was invited by the court's recent decision in Kokesh v. Security and Exchange Commission, wherein the court determined that disgorgement, as sought by the SEC, is a penalty not an equitable remedy. This dramatic shift by the court left cracks in what has been a foundational aspect of the SEC's regulatory authority. Indeed, it is anticipated that the court, having already reclassified disgorgement as a penalty, may well overturn the authority previously used to support the SEC's use of the remedy as its primary enforcement mechanism. The outcome has the potential to change the regulatory landscape for many years, not to mention the immediate impact such a change would have on the currently pending investigations and enforcement actions.

The Regulatory Context

Disgorgement has been widely used by the SEC as an "equitable" remedy, whereby violators forfeit their ill-gotten gains. Indeed, "disgorgement is designed to deprive a wrongdoer of unjust enrichment, and to deter others from violating securities laws by making violations unprofitable." See Security and Exchange Commission v. JT Wallenbrock & Associates., 440 F.3d 1109, 1113 (9th Cir. 2006). Yet, in June 2017, the Supreme Court in Kokesh v. Security and Exchange Commission, in a unanimous decision, held that "because SEC disgorgement operates as a penalty under Section 2462, any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued." The Supreme Court further questioned by implication, in its now infamous Footnote 3, "whether courts possess authority to order disgorgement in SEC enforcement proceedings." It should be no surprise then, in this era of regulatory rollback, that the SEC's very ability to seek disgorgement is at risk. The Kokesh decision gave rise to an inevitable wave of challenges. This came to a head when, on Nov. 1, 2019, the court granted cert., in Liu, indicating that it will take up the issue of whether the SEC has the authority to seek disgorgement. Disgorgement is now on the chopping block.

The SEC's Authority to Seek Disgorgement

The Securities Exchange Act of 1934 established the SEC to enforce federal securities laws. Congress granted the SEC, in the Exchange Act, power to prescribe "'rules and regulations … as necessary or appropriate in the public interest or for the protection of investors," see Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 728, 95 S. Ct. 1917, 44 L. Ed. 2d 539 (1975). This included broad authority to promulgate rules and "conduct investigations into possible violations of the federal securities laws," as in SEC v. Jerry T. O'Brien, Inc., 467 U.S. 735, 741, 104 S. Ct. 2720, 81 L. Ed. 2d 615 (1984). Where an investigation uncovers evidence of wrongdoing, the SEC may bring an enforcement action in federal district court. "Initially, the only statutory remedy available to the SEC in an enforcement action was an injunction barring future violations of securities laws." Without statutory authority to seek financial remedies, either as equitable remedies or penalties, the SEC sought disgorgement as an exercise of the court's "inherent equity power to grant relief ancillary to an injunction," see SEC v. Texas Gulf Sulphur, 312 F. Supp. 77, 91 (SDNY 1970), aff'd in part and rev'd in part, 446 F. 2d 1301 (2d Cir. 1971).

The U.S. Court of Appeals for the Second Circuit's decision, in SEC v. Texas Gulf Sulphur, is widely credited as the source of the SEC's authority to seek disgorgement. In Texas Gulf, the court rejected the appellants' argument that "the SEC does not have authority under the act to seek anything but injunctive relief." The court further rejected the argument that the restitution sought by the SEC, and ordered by the district court, was a penalty, since no element of compensation went to those who may actually have been damaged. Rather, the court found that there was "little doubt that Section 27 of the act confers general equity power upon the district courts" and, critically, that "the SEC may seek other than injunctive relief in order to effectuate the purposes of the act, so long as such relief is remedial relief and is not a penalty assessment." ("Restitution of the profits on these transactions merely deprives the appellants of the gains of their wrongful conduct."). As a result, "beginning in the 1970s, courts have ordered disgorgement in SEC enforcement proceedings in order to 'deprive … defendants of their profits in order to remove any monetary reward for violating' securities laws and to 'protect the investing public by providing an effective deterrent to future violations,'" see Kokesh v. SEC, 137 S. Ct. 1635, 1640 (2017)  (quoting Texas Gulf, 312 F. Supp., at 92). It has been the basis for the use of disgorgement in enforcement ever since.

Supreme Court Redefines Disgorgement as a Penalty

In the June 2017 decision in Kokesh v. SEC, the Supreme Court upended 46 years of generally accepted regulatory law that permitted the SEC to seek disgorgement in enforcement actions. The court was presented with an enforcement action, in which the appellant violated various securities laws by concealing the misappropriation of $34.9 million. As is typical in such cases, the SEC sought monetary civil penalties, disgorgement of the $34.9 million, and an injunction barring Kokesh from future violations. The district court determined that 28 U.S.C. Section 2462, which establishes a five-year limitations period for "an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture," only applied to the monetary civil penalties. The court "concluded that Section 2462 did not apply because disgorgement is not a 'penalty' within the meaning of the statute. The Tenth Circuit affirmed, reasoning that disgorgement was neither a penalty nor a forfeiture." Kokesh v. SEC, 137 S. Ct. 1635, 1637-39 (2017). The Supreme Court disagreed.

In reversing the Tenth Circuit, the court determined that "SEC disgorgement operates as a penalty under Section 2462," and, as a result, "any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued." The court cited two principles to supports this conclusion. First, that whether a sanction represents a penalty turns in part on "whether the wrong sought to be redressed is a wrong to the public, or a wrong to the individual." See Huntington v. Attrill, 146 U.S. 657, 667, 13 S. Ct. 224, 227 (1892). Second, that a pecuniary sanction operates as a penalty if it is sought "for the purpose of punishment, and to deter others from offending in like manner" rather than to compensate victims. The court concluded that the "application of these principles readily demonstrates that SEC disgorgement constitutes a penalty within the meaning of Section 2462." The court's reasoning breaks down, as follows: "SEC disgorgement is imposed by the courts as a consequence for violating public laws, i.e., a violation committed against the United States rather than an aggrieved individual."

• SEC disgorgement is imposed for punitive purposes.
• Sanctions imposed for the purpose of deterring infractions of public laws are inherently punitive because "deterrence is not a legitimate nonpunitive governmental objective."
• SEC disgorgement is often not compensatory.
• Disgorged profits are paid to the district courts, which have discretion to determine how the money will be distributed. They may distribute the funds to victims, but no statute commands them to do so.

When an individual is made to pay a noncompensatory sanction to the government as a consequence of a legal violation, the payment operates as a penalty, (quoting and citing Bell v. Wolfish, 441 U.S. 520, 539, n. 20, 99 S. Ct. 1861, 1873 (1979) and Porter v. Warner Holding Co., 328 U.S. 395, 402, 66 S. Ct. 1086, 1091 (1946), respectively). The commission argued that disgorgement is not punitive but a remedial, and equitable, sanction. The court was not persuaded. Kokesh v. SEC, 137 S. Ct. 1635, 1637-39 (2017) ("disgorgement does not simply restore the status quo; it leaves the defendant worse off and is therefore punitive"). The court did not reach the issue of "whether courts possess authority to order disgorgement in SEC enforcement proceedings," but left that door wide open by raising the question in a footnote. Kokesh v. SEC, 137 S. Ct. 1635, 1642 n.3 (2017).

Supreme Court Invited Challenge to Disgorgement

Following the holding in Kokesh, defendants had a new defense in regulatory actions—i.e., that the SEC could not seek disgorgement and, even if it could, such a penalty is subject to the five-year statute of limitation. To make matters worse, in an incredible turn of events, the SEC was targeted with a class action lawsuit seeking to recover at least $14.9 billion allegedly improper penalties paid to the SEC as disgorgement. See Jalbert v. Security Exchange Commission, USDC Massachusetts, Case No. Case 1:17-cv-12103, Filed 10/26/17. That cased was subsequently dismissed by the district court and is on appeal to the First Circuit. See U.S. Court of Appeals for the First Circuit, Case No. 18-02043. However, the issue is ripe for resolution and, on Nov. 1, 2019, the Supreme Court decided to consider the issue on appeal from the Ninth Circuit, in Liu.

In Liu, a case decided in April 2017 and two months before the Supreme Court's decision in Kokesh, the defendants raised nearly $27 million of international investment through the EB-5 immigrant investor program. Defendants then funneled over $20 million from those funds to themselves and companies associated with them. The SEC brought an enforcement action in the Central District of California, seeking judgment against defendants for permanent injunctive relief, disgorgement of their ill-gotten gains, prejudgment interest, and civil penalties. Defendants did not, then, directly challenge the SEC's authority to seek disgorgement. Rather, Defendants argued that the amount of disgorgement should be offset by their business expenses and, in either case, should not encompass the total amount raised, well in excess of the funds actually misappropriated by defendants. The district court rejected defendants' arguments and, agreeing with the SEC, ordered that the defendants disgorge "the total investment minus funds remaining." The Kokesh decision was issued two months later and the Liu defendants appealed to the Ninth Circuit.

At the Ninth Circuit, Liu argued that the district court lacked the power to order disgorgement for the full amount of the investment funds raised. In granting summary judgment, the district court had "ordered disgorgement of the entire amount that had been raised from investors, imposed civil penalties equal to the $8.2 million the appellants had personally received from the project, and permanently enjoined the appellants from future solicitation of EB-5 program investors." The Ninth Circuit punted—holding that "Kokesh expressly refused to reach this issue" and, as such, the case was not "clearly irreconcilable" with the longstanding precedent on disgorgement. Rather, the court affirmed that "the proper amount of disgorgement in a scheme such as this one is the entire amount raised less the money paid back to the investors." The court further affirmed the "imposed civil penalties [which are perhaps more in the nature of true disgorgement] equal to the undisputed amounts each of the Appellants directly received."

Lui gave the Supreme Court the opportunity to address the question the court itself raised in Kokesh and its footnote by calling into question the SEC's authority to seek disgorgement. In the short time since Kokesh, federal circuit courts have continued to uphold disgorgement as a remedy, struggling to apply and distinguish the Kokesh decision. See, e.g., SEC v. De Maison, 785 F. App'x 3 (2d Cir. 2019) ("We conclude Kokesh does not constitute an intervening decision such that our precedent on disgorgement in SEC enforcement proceedings is disturbed. De Maison's argument concerning Kokesh must therefore await consideration by this Court en banc or by the Supreme Court."); SEC v. Gentile, 939 F.3d 549, 562 (3d Cir. 2019) ("There is one puzzle we feel compelled to address. The Kokesh Court held SEC disgorgement is a penalty—despite the maxim that a civil penalty was a type of remedy at common law that could only be enforced in courts of law … SEC disgorgement is both an equitable remedy and a Section 2462 penalty"); United States v. Dyer, 908 F.3d 995, 1003 (6th Cir. 2018) ("The statement in Kokesh that disgorgement is a 'penalty' is not a game changer … If anything, Kokesh reinforces the long-held understanding that SEC disgorgement is civil in nature."); FTC v. AMG Capital Management, 910 F.3d 417, 427 (9th Cir. 2018) ("Because Kokesh and Commerce Planet are not clearly irreconcilable, we remain bound by our prior interpretation of Section 13(b)"). The Supreme Court will now bring that issue to resolution and, along with it, perhaps the end of an era in regulatory enforcement.

The Future of Disgorgement

The SEC recently issued the Enforcement Division's Annual Report for Fiscal Year 2019. The preface acknowledges "significant headwinds" from the "adverse Supreme Court decision in Kokesh," impacting its "ability to recover ill-gotten gains." This is, perhaps, the government's canary-in-the-coal-mine. Nonetheless, the SEC celebrates the past year as a "success," citing judgments and orders including "more than $4.3 billion in disgorgement and penalties" with "nearly $1.2 billion returned to harmed investors." Yet, these record recoveries are overshadowed, as the entire banking and regulatory sector holds its collective breath in anticipation of a decision in Liu that could significantly and permanently diminish the SEC's enforcement power. If the court affirms the Ninth Circuit—that disgorgement is authorized and for the full amount lost—it will need to square that with its decision in Kokesh. But if the court holds that the SEC lacks the authority to seek disgorgement, then it could change the enforcement landscape as we know it, with far reaching impacts throughout the global market. And the momentum is going in the direction of rolling back regulatory authority, in particular in light of the current make-up of the court. See, e.g., Lorenzo v. SEC, 432 U.S. App. D.C. 420, 439, 872 F.3d 578, 597, 602 (2017) (Kavanaugh, J., dissenting) ("the majority opinion—invoking a standard of deference to the SEC that, as applied here, seems akin to a standard of 'hold your nose to avoid the stink'…"). The elimination of disgorgement could also largely de-fund the SEC and result in layoffs, hiring freezes, lowered compensation, which would in turn inhibit recruitment and hiring, possibly gutting the SEC.

Perrie M. Weiner is the partner in charge of Baker McKenzie's Los Angeles office. He is also the chair of the firm's North America securities litigation group. Perrie's practice focuses on securities litigation and enforcement matters and complex business litigation.

Edward D. Totino is a partner in the North America securities litigation group at the firm's Los Angeles office. HIs practice focuses on class actions, complex commercial litigation and securities litigation.

Aaron T. Goodman is of counsel in the firm's litigation and government enforcement, global compliance and investigations, and securities litigation groups. He is a knowledge-lead in securities litigation.