Securities Law Blog

On Monday, June 22, 2020, in Liu v. SEC, the United States Supreme Court reaffirmed the Securities and Exchange Commission’s authority to recover disgorgement as part of its civil enforcement powers against fraudulent investment schemes. However, the ruling limited the SEC by defining disgorgement to include only the wrongdoer’s net profits, rather than the wrongdoer’s gross revenues, which was the previous standard recognized by most federal courts. The much-followed case was decided by an 8-1 vote, with only Clarence Thomas dissenting.

The legal issue before the Supreme Court was whether the Securities Act of 1933 (the “Securities Act”), which governs the SEC’s enforcement powers, permits the SEC to recover fraudulently obtained investments even though the statute does not explicitly authorize such a remedy. The statutory language permitted federal courts to grant “equitable relief” without further definition. Over the years, federal courts interpreted the “equitable relief” phrase to include all sums of money fraudulently obtained, regardless of whether the money was actually retained by the wrongdoer. Defendants in SEC cases argued that having to repay money they no longer possessed amounted to a penalty, and the Securities Act does not authorize penalties. Such arguments usually met with limited success but, in recent years, defendants have been making headway with such arguments, setting the stage for Liu v. SEC to be decided by the Supreme Court.

In a ruling that benefits both sides, the Supreme Court took a middle ground, refusing to uphold the SEC’s ability to recover all of the money fraudulently obtained from investors, but also rejecting the defendants’ argument that any form of disgorgement constitutes an improper penalty.

Disgorgement, decided the Supreme Court, is a permissible type of equitable relief so long as it does not exceed the wrongdoer’s net profits. In her opinion for the majority, Justice Sonia Sotomayor wrote, “Courts may not enter disgorgement awards that exceed the gains made upon any business or investment, when both the receipts and payments are taken into the account. Accordingly, courts must deduct legitimate expenses before ordering disgorgement under §78u(d)(5) [of the Securities Act.] […] A rule to the contrary that makes no allowance for the cost and expense of conducting a business would be inconsistent with the ordinary principles and practice of courts of chancery” (internal citations omitted).

The underlying facts of Liu v. SEC, broadly speaking, were that defendants Liu and Wang raised more than $27 million from investors, falsely claiming they would use the funds to build and operate a cancer treatment center. A district court in the Central District of California determined that the couple kept about $8.2 million for themselves and never obtained permits to build the cancer center. The rest of the $27 million was spent on salary, marketing and other business expenses. Liability is no longer in dispute, but the district court ordered disgorgement of the entire amount raised from investors. The district court imposed civil penalties equal to the $8.2 million the couple had personally received from the project.

The specific question before the Supreme Court was whether Liu and Wang should be forced to disgorge the entire $27 million, or just the amount they retained as their profits. Because the Ninth Circuit had affirmed an award of the full $27 million, the Supreme Court vacated the ruling and sent the case back to the district court for a recalculation of the disgorgement under the new rule.

Finally, the Supreme Court did not decide whether the SEC, whenever it recovers disgorgement, should be required to return the funds to the investors, as opposed to depositing the funds with the Treasury Department.

Although Liu v. SEC is ostensibly limited to the SEC context, this ruling will have repercussions that affect the Federal Trade Commission and Food & Drug Administration. Like the statute governing the SEC, Section 13(b) of the FTC Act is silent about disgorgement, but courts have allowed it as a form of equitable relief. In a case entitled FTC v. Credit Bureau Center, LLC, the Supreme Court has been asked to address the identical issue in the FTC context. The FDC Act, which governs the FDA, is even more vague, permitting the FDA to “restrain violations.”

TAKEAWAY: The Supreme Court’s ruling, though in the SEC context, has far-reaching implications. While defendants are no longer responsible for returning funds they no longer possess, the SEC’s right to significant disgorgement powers is now unassailable. Both the FTC and FDA have similar enforcement powers and, as a result of this ruling, eventually those governmental agencies will almost certainly face the same (or greater) limitations to which the SEC is now subject.