courthouseThree years ago, the Supreme Court issued its decision in Kokesh v. U.S. Securities and Exchange Commission, 581 U.S. ___ (2017), holding that the remedy of disgorgement in SEC civil enforcement proceedings constitutes a penalty for statute of limitations purposes. Kokesh was issued alongside the decision in Honeycutt v. United States, 581 U.S. ___ (2017), which dealt with criminal forfeiture and held that the remedy could only be applied to the recipient of ill-gotten gains and not jointly and severally.

Although these cases dealt with different types of proceedings, this author and another posited at the time that Kokesh and Honeycutt should be read together and foretold that the Court would continue to curtail the SEC’s remedies in enforcement cases.

Today’s decision in Liu v. SEC –authored by Justice Sotomayor for a nearly unanimous court – confirms this prior prediction by addressing an issued explicitly reserved in Kokesh: Whether the SEC properly can obtain disgorgement. Although many headlines on the Liu decision imply a win for the SEC by reporting that the Court upheld disgorgement as a permissible equitable remedy, a closer reading of the majority opinion reveals the Court, like in Kokesh, continues to restrict the SEC’s powers by narrowly defining the scope of permissible disgorgement.

In Liu, Justice Sotomayor canvasses 200 years of jurisprudence to hold that courts long have recognized some form of equitable remedy of “disgorgement” that requires the return of ill-gotten profits to victims. The statute permitting the SEC to seek “equitable” remedies for violations of the securities laws, 15 U.S.C. §78u(d)(5), was adopted against this background and thus, according to the Court, incorporated the remedy of disgorgement of ill-gotten profits.

Relying on this legal framework, Justice Sotomayor explained that in order for a disgorgement remedy to be equitable and thus permissible under §78u(d)(5), it had to satisfy three criteria: (1) it must be made for the benefit of the victims; (ii) it had to be based on the ill-gotten net profits, meaning any legitimate expenses had to be excluded; and (iii) it could only be imposed as to those net profits that actually accrued to an individual, meaning that it could not be awarded on a joint-and-several liability basis. Although the Court declined to rule on the specifics of the disgorgement order before it in Liu, noting that the issues had not been fully briefed, it did opine on all three criteria vis-à-vis that order.

First, the Court expressed skepticism of any disgorgement award that failed to try to distribute the disgorged funds to the victims. This includes the order before it, which directed the disgorged funds to be placed into the Treasury Fund that had been created for such purposes. The Court made clear that the SEC had to make reasonable efforts to identify and return funds to victims before placing them in the Treasury Fund in order for the disgorgement not to be an impermissible penalty.

Second, the Court emphasized that disgorgement could not be imposed jointly and severally against multiple defendants; rather, disgorgement has to be imposed against a defendant based on his or her individual liability. The exception to the rule is if two partners were “engaged in concerted wrongdoing.” Thus, in the case of the petitioners, the Court noted that although they were married and appeared to act together equally in the fraud, the lower court on remand still had to determine if disgorgement could be awarded against both of them together consistent with these equitable principles.

Third, the Court made clear that “legitimate expenses” cannot be part of disgorgement, unless the “‘entire profit of a business or undertaking’ results from wrongdoing.” In the instant case, the Court noted there was some evidence that – despite the widespread fraud in petitioners’ business – some expenses of the scheme were for items that could have value independent of the fraud. If that were the case, the Court remarked, the lower court would have to exclude those expenses from disgorgement, which it did not do in the original order.

Liu, like Kokesh, narrows the scope of remedies available to the SEC in civil enforcement cases by further restricting disgorgement to the specific net profits obtained by a defendant as a result of the violation of the securities laws. As the SEC previously had sought and obtained broad orders of disgorgement premised on a defendant’s gains without accounting for expenses and imposing joint and several liability on multiple defendants despite their complicity or receipt of gains, Liu drastically reduces the exposure for many defendants in SEC civil enforcement proceedings. In so doing, Liu hopefully will reduce the inordinate leverage previously wielded by the SEC in such cases.