In June the Supreme Court in Liu vs. SEC conditionally preserved the Securities and Exchange Commission's ability to collect disgorgement to deprive wrongdoers of the "ill-gotten gains" resulting from illegal conduct. Although the SEC has express statutory authority to collect disgorgement in its in-house administrative proceedings, the agency's ability to seek disgorgement as "equitable relief" awarded by federal courts under the Securities Exchange Act was under attack. The court held that disgorgement that "does not exceed a wrongdoer's net profits and is awarded for victims is equitable relief permissible under Section 78(u)(d)(5)."
The parties in Liu focused on the threshold question of whether the SEC could seek disgorgement. Accordingly, the Supreme Court remanded the case for the District Court to measure the disgorgement award. In doing so, however, the court provided guidance as to when such awards are appropriate. The Supreme Court observed that some courts had "test(ed) the bounds of equity" in three ways: by ordering that disgorged funds be deposited directly into the Treasury instead of returned to victims; imposing joint and several disgorgement awards; and refusing to deduct valid business expenses from the fraudulent proceeds. All three observations engender important considerations of how disgorgement awards will operate in the pension and investment funds space.
As to the first observation, the court did not address the issue of what equitable principles govern when it may be difficult for the SEC to disburse disgorgement proceeds to victims, as is often the case in matters involving investment funds that include pension funds and other institutional investors. Rather, the court instructed lower courts to fashion disgorgement awards "for the benefit of investors" and "consistent with equitable principles." And the court noted that "SEC's equitable, profits-based remedy must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains."
In the fund context, determining the individual victims of wrongdoing can be challenging, particularly if investors hold interests in a widely distributed fund through a broker-dealer, retirement account or other intermediary. For example, in the case of an open-end fund with redeemable securities, ownership changes daily and may be held through various types of intermediaries. Funds often do not have transparency into their underlying beneficial owners and therefore may have difficulty identifying actual victims of wrongdoing. Accordingly, determining how best to return an award to victims may be impossible without the input of intermediaries. Under these circumstances, the court's order casts doubt on whether the SEC can seek disgorgement in federal court proceedings where victims cannot be practicably identified.
With respect to the second observation, the court disfavored blanket joint and several disgorgement awards with no analysis of the nature of the relationship between the parties and their respective efforts to further the illegal conduct. The court allowed that certain relationships (marriage in the case of the Liu petitioners) permitted a consideration of whether there was concerted wrongdoing of a nature where joint and several disgorgement may be equitable.
The government introduced evidence that Mr. Liu formed the entity, solicited investments and misappropriated funds and that his wife, Ms. Wang, held herself out as the entity's president and as a management team member of the entity which received the misappropriated funds. By contrast, the Liu petitioners failed to introduce evidence that either spouse was a passive recipient of the ill-gotten gains, that their finances were not commingled, "that one spouse did not enjoy the fruits of the scheme, or that other circumstances would render a joint-and-several disgorgement order unjust."
In light of the highly intermediated distribution of registered funds, such funds and their intermediaries should carefully evaluate their contractual and business relationships to determine if their relationships may expand potential exposure to joint and several awards. Indeed, registrants should expect that courts and the SEC will consider this issue when formulating disgorgement awards. Registrants and their intermediaries would therefore be well served to fully understand and document the nature of current business relationships that could impact future joint and several liability.
Finally, and as to the third observation, the court concluded that there can be expenses that have "value independent of fueling a fraudulent scheme" and allowed that it could be consistent with equitable principles for a lower court to permit deduction of such expenses. In other words, legitimate business expenses may be accounted for in determining the amount of disgorgement. Funds and their intermediaries should therefore ensure that they fully understand and document expenses incurred in various lines of business and distribution relationships. Being able to justify legitimate business expenses may enable a registrant to exclude such expenses from disgorgement in a future federal court enforcement matter.
The Supreme Court's decision makes clear that disgorgement that does not exceed a wrongdoer's net profits and that is awarded for the benefit of victims of the wrongdoing constitutes equitable relief. Left unresolved, however, is how SEC disgorgement might be structured to be for the "benefit of investors" if it is not structured to be returned to individual victims of the wrongdoing. Additionally, the level and type of relationships that may give rise to joint and several liability and the types of expenses that could be considered to be legitimate business expenses has been left to the lower courts to determine. Thus, although the Liu decision preserved the SEC's ability to seek disgorgement as a remedy in federal court, and registrants should expect that the agency's enforcement staff will continue to do so, the decision reveals key considerations for pensions and funds.
Kelley Howes is counsel at Morrison & Foerster LLP and vice chairwoman of the investment management group based in Denver, and Haimavathi V. Marlier is a partner in the firm's securities litigation, enforcement and white-collar practice group based in New York. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.
