An irreverent Wall Street Blog
[In]Securities Guest Blog: Good, Bad and Ugly by Aegis Frumento Esq
July 9, 2020
"Alas, poor Yorick!" says Hamlet. "I knew him, Horatio. . . . He hath bore me on his back a thousand times, and now how abhorr'd in my imagination it is! My gorge rises at it."
At this point, some may ask, "What's a gorge?" A good question with which to start today's tale.
A gorge is the stomach. More properly, the contents of the stomach. To rise one's gorge is to barf.
And, English being what it is, "gorge" is the root of many other words. The verb "to gorge" means to fill one's stomach by overeating. To be "engorged" means to have a distended stomach, and by extension to have an enlarged . . . anything. To be gorgeous, well, is nothing -- it comes from a different root in Middle French. Gorge comes from the Latin gurga for throat, from which also comes "regurgitate," another way of saying "the gorge rises." And a simpler way to say both is to use the opposite of "engorge," which happens to be "disgorge." Disgorgement is the act of vomiting. Keep that in mind to keep from getting nauseous reading the rest of this column.
Over the years, disgorgement has also become one of the SEC's favorite ways to make securities law violators cough up their ill gains. Except in the SEC's hands, disgorgement could have the perpetrator cough up a lot more than his profits. SEC disgorgement became like puking up your liver along with your lunch. Which was, I think, the SEC's plan all along.
Then came Charles Kokesh, who was charged with securities fraud and made to suffer penalties that, because of a 5-year statute of limitations, could only apply to conduct in the prior 5 years. But the SEC wanted disgorgement of all profits made going back way past 5 years, and amounting to about $35 million. The SEC argued that the statute of limitations didn't apply to disgorgement, because disgorgement was not a "penalty." Rather, it was an "equitable remedy" intended only to deprive Kokesh of his ill-gotten gains. It wasn't punishment (hence not a "penalty") to force him to give back the money he stole.
That case went all the way to the Supreme Court, where in 2017 a unanimous decision ruled that disgorgement, as the SEC had historically used it, was in fact a penalty, so the 5-year statute of limitations did apply. Kokesh v. SEC, https://www.supremecourt.gov/opinions/16pdf/16-529_i426.pdf. See also http://www.brokeandbroker.com/3492/kokesh-supreme-court/. To prove its point, the Court laid out example after example of how the SEC's use of the disgorgement remedy was more punitive than remedial. The Court noted that disgorgement had required defendants to return all monies received from victims, whether they profited from it or not. Defendants in insider trading cases were required to return not only their own profits, but also the profits earned by all of their "tippees." The Court noted how defendants subject to disgorgement never got any credit for legitimate expenses. And finally, the Court observed how more often than not the funds received from disgorgement did not go back to the victims, but ended up in the US Treasury.
Obviously, the SEC had, over the years, gorged itself on its disgorgement powers. The SEC had argued that disgorgement simply returned stolen money to the victim, but that has hardly ever been the case. It was an easy call for the Supreme Court to say disgorgement was not merely a remedy but a punishment, and therefore subject to the 5-year statute of limitations.
But the Supreme Court left a ticking time bomb in its Kokesh decision. In a footnote, it specifically reserved judgment on whether the SEC had the power to order that kind of disgorgement at all. That was left for another day.
Last month the bomb went off. The husband-and-wife team of Charles Liu and Lisa Wang solicited foreign investors to invest in a cancer treatment center in the United States. Those investments were to have won the investors permanent resident visas to the United States under the EB-5 immigration program, which is one of those ways how, if you're rich enough, you don't have to worry about any stinkin' Wall. To make a long story predictably short, the cancer center never got built and the investors' money "disappeared" into the hands of Liu and Wang. The SEC sought disgorgement. The defendants, latching onto that footnote in the Kokesh case, argued that the SEC didn't have the authority to seek disgorgement.
Back up to the Supremes. This time, the Court ruled against the SEC by an 8 to 1 decision. Liu v. SEC, https://www.supremecourt.gov/opinions/19pdf/18-1501_8n5a.pdf. See also http://www.brokeandbroker.com/5283/sec-liu-disgorgement/. There was no doubt that the SEC has the right to seek "equitable remedies." The only question was whether disgorgement, as the SEC envisions it, is an equitable remedy. The Supreme Court ruled that it's not -- but that it could be if properly limited.
The key to the case is an understanding that equitable remedies are by definition not punitive. Equitable remedies only extend to depriving the wrongdoer of profits so as to compensate the victim. So, to the extent that disgorgement is limited to taking away profits to give to the victim, it is "equitable" and the SEC is empowered to seek it. However, when the SEC uses disgorgement to seize more than the wrongdoer's profits, and when it gives that money to the treasury instead of to victims, then disgorgement ceases to be an equitable remedy and becomes a penalty, and the SEC is not entitled to it. (The SEC is still entitled to other penalties under other sections of the securities laws, so don't feel too bad).
Squaring Kokesh and Liu is a little tricky. Kokesh says that disgorgement as used by the SEC is really a penalty and subject to a 5-year statute of limitations. Liu says that the SEC doesn't even have the right to impose disgorgement in the manner in which it did in the Kokesh case. So, who knows if Kokesh is even relevant anymore. Also, since the Kokesh decision imposed a 5-year statute of limitations on a kind of disgorgement that Liu invalidated, does that mean that proper remedial disgorgements are not subject to any statute of limitations?
The lone dissenter in the Liu case was Justice Clarence Thomas. He agreed that the SEC didn't have the right to impose disgorgement as it had been doing it. He disagreed with the majority because they allowed for the possibility that the SEC could have disgorgement if it was properly tailored. Justice Thomas took the somewhat extreme position that the only equitable remedies permitted under the Constitution were those recognized by the English Chancery Courts when the Constitution was made. "The history is clear: Disgorgement is not a form of relief that was available in the English Court of Chancery at the time of the founding." Since no English Chancery Court had ever heard of disgorgement, other than as a digestive problem, back in the 1790s, the SEC couldn't use it in 2020. Justice Thomas can be a bit pedantic, and here he is at his most.
The story of SEC disgorgement is not fully told. The Supreme Court sent the Liu case back down to the lower courts to fashion a kind of disgorgement that is limited to seizing net profits to reimburse victims. I think that will be the first writing of a new jurisprudence of SEC disgorgement. Equitable remedies are only supposed to do good by the parties. In the SEC's hands, it became a bad use of its penalty powers. Whether SEC disgorgement now develops to be good, bad or just ugly will be interesting to see.
ABOUT THE AUTHOR
Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters. Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.
Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.
He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.
NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog.