The Supreme Court’s Decision in Liu and Insider Trading Enforcement

As brief background, in 2017 the Supreme Court held in Kokesh v. SEC that disgorgement constituted a penalty for statute of limitations purposes. Prior to Kokesh, the SEC had taken the position that, unlike civil monetary penalties, its authority to recover illicit profits stemming from violations of the federal securities laws was not subject to the five-year statute of limitations set forth in 28 U.S.C. § 2462. In Kokesh, the Supreme Court rejected that view and included a footnote that caused considerable angst for SEC enforcers, inviting the challenge that made its way to the Court three years later in Liu. That footnote read (in relevant part):

Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings… .

Last month, in a 7-1 opinion, the Liu Court answered that question in the affirmative. The Court concluded that the SEC’s authority to seek “equitable relief” pursuant to 15 U.S.C. § 78u(d)(5) included disgorgement, and that the SEC was authorized to seek illicit profits from wrongdoers in a federal court so long as it did so in a manner consistent with principles of equity.

Limitations on Disgorgement Imposed by Liu

The SEC’s victory in Liu was not unqualified. In upholding the SEC’s authority to seek ill-gotten gains, the Supreme Court imposed three important limitations on the scope of the disgorgement remedy. First, based on the plain language of 15 U.S.C. § 78u(d)(5), the Court noted that “equitable relief”—including disgorgement—is confined to that which “may be appropriate or necessary for the benefit of investors.” (emphasis added). Although the SEC attempts to disburse recovered funds to investors when its staff can identify harmed parties and it is otherwise practical to do so, in many cases disgorgement collected from defendants remains with the U.S. Treasury. Liu strongly implies that this practice runs afoul of the statute. Interestingly, in reaching this conclusion, the Court explicitly rejected the SEC’s contention “that the primary function of depriving wrongdoers of profits is to deny them the fruits of their ill-gotten gains, not to return the funds to victims as a kind of restitution.” The Court’s rejection of the SEC’s historical view of disgorgement may have profound implications going forward.

Second, the Court raised questions regarding the SEC’s longstanding practice of imposing disgorgement on multiple respondents or defendants on a joint-and-several basis. By way of example, the Court noted that in the insider trading context, tippers of material non-public information are often required to disgorge the profits of their tippees. Although the Court declined to establish a per se prohibition on joint-and-several disgorgement, Liu leaves the door open for lower courts to determine “whether the facts are such that [parties] can, consistent with equitable principles, be found liable for profits as partners in wrongdoing or whether individual liability is required.”

Third, the Court made clear that the SEC’s disgorgement calculation must deduct legitimate expenses to avoid “making no allowance for the cost and expense of conducting a business.” The Court did, however, carve out an exception for expenses that are “wholly fraudulent”—i.e., those where an “entire profit of a business or undertaking” results from unlawful conduct. Lower courts—and the SEC’s staff—likely will devote substantial efforts to determine the contours of this general principle.

The Impact of Liu on Insider Trading Enforcement

Lower courts and the SEC will continue to resolve issues implicitly raised, but unanswered, by Liu—including the availability of disgorgement in insider trading enforcement actions.

No Class of Harmed Investors

As a threshold matter, the Enforcement Division and courts will have to grapple with the question of whether 78u(d)(5)’s requirement that disgorgement be “appropriate or necessary for the benefit of investors” serves as a blanket prohibition on seeking disgorgement where it is impossible to identify a class of harmed investors. If Liu compels that conclusion, it is difficult to conceive of how the SEC could force those who illegally trade on material nonpublic information to forfeit their illicit gains (at least in the context of publicly traded equities).

The SEC could attempt to sidestep this concern by filing insider trading enforcement actions as administrative proceedings. The Commission’s authority to impose disgorgement on respondents in its administrative forum was not directly at issue in Liu because the statutory authority for that relief in the SEC’s homecourt is clear. (See 15 U.S.C. §77h-1(e) (“In any cease-and-desist proceedings, the SEC may enter an order requiring accounting and disgorgement.”).) But the majority opinion in Liu suggests that the limitations applicable to disgorgement in a District Court might also apply in the administrative forum because “absent other indications, [equitable remedies are] deemed to contain the limitations upon [their] availability that equity typically imposes.” In a dissenting opinion, Justice Thomas pointed out that the applicability of the limitations on disgorgement imposed by the majority opinion to administrative proceedings remains an open question. We would not be surprised if the Enforcement Division searches for an appropriate case to test this proposition.

Unrealized Gains

Even if courts were to conclude that the requirement to return disgorgement to investors does not apply to insider trading (or to matters brought in the SEC’s administrative forum), the SEC may nonetheless continue to face obstacles to recovering disgorgement in insider trading matters. Based on a 1983 First Circuit case (SEC v. Macdonald, 699 F.2d 47 (1st Cir. 1983)), the SEC has taken the position that disgorgement in insider trading cases should be calculated based on a defendant’s unrealized profits. The SEC’s rationale for seeking unrealized gains—adopted by the First Circuit in Macdonald, along with subsequent lower court decisions—is that once the full gains from misconduct are available in a trader’s account, those funds fall within the ambit of the SEC’s disgorgement powers.

Liu did not directly address the proprietary of seeking unrealized profits under 78u(d)(5), but insider trading defendants will be able to point to several principles from the Court’s opinion to argue that such profits are not available to the SEC. The Court’s opinion was particularly interested in ensuring that an equitable remedy like disgorgement must not be punitive. Future defendants might reasonably argue that it would be a punishment to force them to disgorge the value of appreciated securities that remained in brokerage accounts. This reasoning is particularly compelling when coupled with the argument that, even if recovered by the SEC, those unrealized profits are unlikely to be distributed to any harmed investor.

Potential Workarounds: Greater Reliance on Civil Penalties and Increased Criminal Enforcement

Insider trading is a longstanding enforcement priority and the SEC likely will do everything within its power to preserve the tools at its disposal to detect and prosecute those who illegally trade on confidential information. As a long-term solution to the challenges posed by Liu, the SEC might hope—and lobby—for a Congressional fix in the form of a statute that redefines disgorgement to include the forfeiture of ill-gotten gains rather than the Supreme Court’s restitution-like measure in Liu. Ideally for the SEC, a legislative fix also would resolve the impediment created by Kokesh and eliminate the current five-year statute of limitations applicable to disgorgement claims.

In the short term, the SEC is likely to take steps to maintain its robust insider trading enforcement program. First, the SEC is likely to increasingly rely on civil monetary penalties not only to punish those who illegally trade on confidential information, but to ensure that such trading is not profitable. While the SEC historically sought penalties in an amount equal to an insider trading defendant’s ill-gotten gains (absent aggravating factors, which could lead to penalties of up to three-times the amount of ill-gotten gains), the enforcement staff might routinely seek greater penalties if disgorgement is generally unavailable.

Additionally, the enforcement staff could refer an increasing amount of insider trading cases to the Department of Justice, which has the authority to seek a defendant’s illicit trading profits through the criminal forfeiture statutes.

Conclusion

While Liu undoubtedly is a win for the SEC, the Supreme Court’s opinion created several obstacles for the SEC’s Enforcement Division, particularly in relation to seeking ill-gotten gains from insider trading violations. Expect the next battles in this ongoing struggle to be fought in the lower courts for years to come. In the interim, the SEC will likely need to employ creative tactics to pursue its aggressive approach to insider trading matters.