On June 22, the Supreme Court issued an opinion in Liu v. SEC holding that the Securities and Exchange Commission may pursue, and courts may grant, disgorgement under 15 U.S.C. § 78u(d)(5), but only when the disgorgement award “does not exceed a wrongdoer’s net profits and is awarded for victims.”
Because the parties in Liu focused on whether disgorgement is permissible at all, rather than on whether the specific underlying disgorgement award exceeded the lower court’s authority, the Supreme Court remanded the case for the district court to consider the precise measure of appropriate disgorgement. In doing so, the court provided guidance as to when disgorgement awards are appropriate and instructed district courts to fashion such awards consistent with several principles articulated in its opinion.
Writing for an 8–1 majority, Justice Sonia Sotomayor explained:
- The disgorgement award “must do more than simply benefit the public at large by depriving a wrongdoer of ill-gotten gains.”
- The disgorgement remedy should be limited to the wrongdoer’s net unlawful profits or the “gain made upon any business or investment, when both the receipts and [expenses] are taken into account.”
- Disgorgement should be limited to the profits obtained by each individual defendant. The court expressly called into question more expansive bases for disgorgement awards, such as pursuit of profits under a joint-and-several liability theory.
Although these broad guidelines leave many questions unanswered, the decision in Liu should not materially alter how disgorgement operates in the investment adviser space, an area that has been an SEC enforcement priority for several years.
Given the existence of the Enforcement Division’s Asset Management Unit and the priorities of the SEC’s Office of Compliance Inspections and Examinations (OCIE), the SEC will likely continue focusing on investment advisers and investment companies as part of its enforcement efforts.
As SEC Chairman Jay Clayton remarked, “[i]nvestment advisers play a vital and trusted role in our markets … Regardless of the scope and duration of the investment advisory services, investment advisers are fiduciaries and, as such, their duties of care and loyalty require them to disclose their conflicts of interest, including financial incentives.”
While there are categories of cases, such as Foreign Corrupt Practices Act and insider trading cases, where the SEC may need to justify disgorgement in the absence of any return of ill-gotten gains to injured investors, in the investment adviser context, the court’s focus on returning money to victims should be easier to address. Notably, disgorgement awards in share class disclosure cases or in cases involving excessive fees are frequently returned to victims (often funds). Netting out expenses is also much simpler in most investment adviser cases, where fees tend to be set.
For example, disgorgement amounts in Rule 12b-1 cases are easily calculated by determining the fee that the advisers obtained by placing their clients in a 12b-1 fee-paying share class. Indeed, under its Share Class Selection Disclosure Initiative, the SEC routinely obtained disgorgement of fees collected by advisers and directed disgorged sums to harmed clients, including $135 million paid to victims in Fiscal Year 2019.
To be sure, Liu may still affect certain aspects of SEC cases in the investment adviser space. For example, the SEC has sought disgorgement under joint-and-several liability theories in certain past investment adviser enforcement actions — a practice the SEC might curtail after Liu found it to be “in considerable tension with equity practices.”
Also, the court embraced consideration of a wrongdoer’s “legitimate expenses” in calculating appropriate disgorgement awards. And however district courts may interpret Liu, as Justice Clarence Thomas wrote in dissent, “[i]t is unclear whether the majority’s new restrictions on disgorgement will apply to [the SEC’s administrative] proceedings as well.”
In short, we expect the SEC will likely continue to focus on investment advisory cases as an enforcement priority and the Supreme Court’s decision in Liu will have a modest impact on the staff’s analysis to seek disgorgement in these types of cases, whether litigated or settled. The SEC’s ability to pursue disgorgement in such cases will allow the SEC to continue to bring adviser cases as a significant part of its docket in the months and years ahead.
Michael D. Birnbaum, Haimavathi V. Marlier and Jina Choi are partners of Morrison & Foerster LLP and each held previous roles with the Securities Exchange Commission. Gerardo Gomez Galvis is an associate with the firm.