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Client alert: Supreme Court upholds SEC’s power to obtain disgorgement, with limits

Financial, Executive and Professional Risks (FINEX)

By John M. Orr | July 6, 2020

In this article, we discuss the U.S. Supreme Court’s recent decision impacting the SEC’s enforcement powers.

On June 22, 2020, the United States Supreme Court ruled that a disgorgement award in a civil enforcement action brought by the Securities and Exchange Commission (SEC) is “equitable relief” permissible under federal law, provided it does not exceed a wrongdoer’s net profits and is awarded for the benefit of victims. The ruling may have an impact on the reach of the SEC’s enforcement powers, as well as potential coverage under corporate directors and officers (D&O) liability insurance policies. The decision is preliminarily cited as Liu v. Securities and Exchange Commission, 591 U. S. ____ (2020) (opinion here).

In brief, in the underlying litigation, the defendants had raised approximately $27M from Chinese investors under a federal immigration program designed to allow foreign citizens to obtain visas in exchange for U.S. investments. The SEC alleged, however, that defendants had acquired the money through fraud and had misappropriated the funds. The district court found the defendants liable under Section 17(a)(2) of the Securities Act of 1933, which prohibits “obtain[ing] money or property by means of any untrue statement of a material fact” in the offer or sale of securities. It further ordered the defendants to, among other things, disgorge gains associated with their purported wrongdoing. The U.S. Court of Appeals affirmed the district court’s order.

The defendants’ appeal emerged from the Supreme Court’s 2017 decision in Kokesh v. SEC, 137 S. Ct. 1635 (2017). There, the Court determined that disgorgement was a penalty within the meaning of federal law for purposes of applying a five-year statute of limitations. The defendants challenged the authority of the SEC to obtain disgorgement as an equitable remedy, principally asserting that sums paid as disgorgement cannot be both punitive and remedial. Kokesh did not resolve the issue. Instead, it stated in a footnote that it was not addressing “whether courts have properly applied disgorgement principles in this context” or “whether courts possess authority to order disgorgement in SEC enforcement proceedings.” Appeal to the Supreme Court stemmed from these open questions.

Writing for the majority, Justice Sonia Sotomayor noted:

Equity courts have routinely deprived wrongdoers of their net profits from unlawful activity, even though that remedy may have gone by different names. [“accounting,” “restitution,” “accounting for profits”] … No matter the label, this “profit-based measure of unjust enrichment,” … reflected a foundational principle: “[I]t would be inequitable that [a wrongdoer] should make a profit out of his own wrong” … At the same time courts recognized that the wrongdoer should not profit “by his own wrong,” they also recognized the countervailing equitable principle that the wrongdoer should not be punished by “pay[ing] more than a fair compensation to the person wronged.” … Decisions from this Court confirm that a remedy tethered to a wrongdoer’s net unlawful profits, whatever the name, has been a mainstay of equity courts. [citations omitted]

By an 8-1 vote, the near unanimous opinion appears soundly to uphold the SEC’s power to obtain disgorgement. Nevertheless, the ruling further provides the awards may only be issued under two conditions: that they do not exceed the wrongdoer’s “net profits,” and that they are awarded to the victims of financial wrongdoing. In allowing defendants to deduct “legitimate expenses” to establish “net profits,” the decision arguably affords defendants the grounds for pushing back on more aggressive attempts by the agency to seek broader disgorgement remedies.

Subject to their terms and conditions, D&O insurance policies generally cover the legal and/or professional costs for corporate directors and officers in regulatory enforcement proceedings, though it is worth noting that some policies can exclude enforcement actions in the US. However, coverage for civil fines and penalties, whether punitive or remedial, as well as for disgorgement and restitution relief, can be challenging, requiring analysis of policy language, underlying facts and public policy considerations.

For example, in some policies, fines and penalties may be exempted from the policy’s definition of covered “Loss,” while policies may also potentially cover civil fines and penalties to the extent the underlying conduct was unintentional. In contrast, the Liu opinion refers to its stated limitations as preventing transformation of an equitable profits-focused remedy into a “penalty,” thus arguably removing disgorgement awards from these policy restrictions. Likewise, coverage for “disgorgement” and “restitution” awards can be the subject of disagreement among insurers and policyholders. On the other hand, legal authority appears to be inconsistent in developing a bright line rule, instead generally determining that insurability may be based on case-specific facts and interpretations of state law and conflicting public policy factors.

We encourage you to reach out to a Willis Towers Watson FINEX professional to evaluate your company’s D&O program’s coverage relating to government investigations and proceedings. These and other policy terms and limitations may be subject to broad negotiation and enhancement, and with attention to important emerging authority.

Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us.In North America, Willis Towers Watson offers insurance products through licensed subsidiaries of Willis North America Inc., including Willis Towers Watson Northeast Inc. (in the United States) and Willis Canada, Inc.


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