Margaret A. Dale and Mark D. Harris
Margaret A. Dale and Mark D. Harris ()

For nearly a half-century, when bringing enforcement proceedings for violations of federal securities laws, the U.S. Securities and Exchange Commission has sought “disgorgement”—i.e., a sanction which forces defendants to fork over some or all of their ill-gotten gains—regardless of how long before the initiation of the proceeding the wrongful conduct generating those gains occurred. SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 91 (S.D.N.Y. 1970), aff’d in part and rev’d in part, 446 F.2d 1301 (2d Cir. 1971). But on June 5, in Kokesh v. Securities and Exchange Commission, __ S. Ct. __, No. 16-529 (June 5, 2017), a unanimous U.S. Supreme Court put a stop to the SEC’s end-run around the limitations period otherwise applicable to agency enforcement proceedings. Resolving a circuit split, the court held that disgorgement is a “penalty” within the meaning of 28 U.S.C. §2462, and therefore subject to the five-year limitations period set forth therein.

Kokesh closes the limitations loophole that the SEC has stepped through with increasing frequency since 2013, when the Supreme Court held that the SEC, unlike private litigants, cannot utilize the discovery rule to toll the applicable statute of limitations even when the underlying allegations sound in fraud. Gabelli v. SEC, 568 U.S. 442 (2013). The decision is thus the second big blow the court has dealt to the SEC’s ability to obtain sizeable money judgments in recent years. And reading between the lines, the decision signals that the court might soon be ready to deliver the knock-out punch and divest the SEC of the authority to seek disgorgement altogether.

‘Kokesh’ Background

In late 2009, the SEC filed a civil enforcement action against Charles R. Kokesh, alleging that he violated various securities laws by concealing the misappropriation of $34.9 million from four business-development companies between 1995 and 2006. After a five-day trial, the jury found in favor of the government. The SEC then sought a judgment ordering Kokesh to pay a civil money penalty and disgorge the misappropriated funds. Kokesh argued that 28 U.S.C. §2642—which provides that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”—precluded the imposition of a penalty or the disgorgement of funds attributable to wrongful conduct that occurred before 2004 (i.e., five years before the SEC initiated the proceeding). As to the civil penalty, the court agreed. As to disgorgement, however, it concluded that §2462 was inapplicable. It therefore ordered Kokesh to pay the full $34.9 million (plus $18.1 million in prejudgment interest) that had been misappropriated between 1995 and 2006, even though only $5 million could be traced to conduct that took place since 2004.

On appeal, the Tenth Circuit affirmed. It reasoned that disgorgement was not punitive, but instead remedial, because it “just leaves the wrongdoer ‘in the position he would have occupied had there been no misconduct.’” 834 F.3d 1158, 1164 (10th Cir. 2016) (quoting Restatement (Third) of Restitution and Unjust Enrichment §51 cmt. K (Am. Law. Inst. 2010)). In the court’s view, requiring Kokesh to disgorge more than he personally received did not make the remedy punitive, either, since he had chosen where to divert the funds. Turning to whether disgorgement qualifies as “forfeiture,” the court relied on its historical meaning to conclude that the term referred only to the turning over of in rem property. Accordingly, the court held §2462 inapplicable and upheld the disgorgement order for $34.9 million.

Supreme Court Holding

In contrast to all of the courts that had previously addressed the issue,1 the Supreme Court, in a unanimous opinion penned by Justice Sonia Sotomayor, reversed the Tenth Circuit and held that disgorgement is a “penalty” as used in 28 U.S.C. §2462. According to the court, two principles govern whether a sanction represents a penalty. The first is “whether the wrong sought to be redressed is a wrong to the public, or a wrong to the individual.” The second is whether the sanction is sought “for the purpose of punishment, and to deter others from offending in like manner, rather than to compensate victims.”

Applying these principles, the court concluded that SEC disgorgement constitutes a penalty for three main reasons. First, it noted that SEC enforcement proceedings attempt to redress wrongs committed against the United States, not private individuals. Second, it observed that courts impose disgorgement to deter people from violating public laws, and that “deterrence is not a legitimate nonpunitive governmental objective.” And third, it pointed out that disgorgement is often not compensatory, since district courts are not obligated to distribute the funds that are collected to victims, and instead may direct them into the U.S. Treasury’s coffers. In sum, the court held: “When an individual is made to pay a noncompensatory sanction to the government as a consequence of a legal violation, the payment operates as a penalty.”

The court rejected the SEC’s argument that disgorgement is remedial, rather than punitive, because it restores the status quo. It explained that disgorgement often exceeds the profits gained as a result of a violation by failing to take into account, for instance, expenses incurred which reduce the amount of illegal profit. Additionally, the court noted that although disgorgement is sometimes compensatory, that fact does not alter the conclusion that it is a penalty since “sanctions frequently serve more than one purpose.”

Interestingly, in deciding whether the sanction is remedial or punitive, the court took a blanket approach and held that disgorgement constitutes a “penalty” in all circumstances. Based on the principles articulated, it could have held that the question should be analyzed on a case-by-case basis. For example, it is not all that difficult to imagine a rule that draws a line between judgments ordering a wrongdoer to turn over only the amount by which he was personally enriched and those that do not, and deciding that the former are not subject to §2462′s time limits. Nevertheless, the court chose not to draw any such lines.

Disgorgement Sanction’s Future

Kokesh thus puts an end to the SEC’s ability to obtain pecuniary relief for violations of the federal securities laws that occurred more than five years before the initiation of an action. Although the SEC likely will soon feel the financial sting imposed by Kokesh (it obtained disgorgement orders totaling more than $3 billion in 2015 alone), a silver lining for the government is that the court’s holding appears to strengthen its (seemingly inconsistent) position that disgorgement does, in fact, constitute a penalty in other contexts; for instance, the government has previously argued that disgorgement payments, as penalties, are not dischargeable in bankruptcy or deductible under the Internal Revenue Code. See Brief of Petitioner, Kokesh v. SEC, No. 16-529 at 37-38 (Oct. 18, 2016).

Going forward, the decision raises serious doubts about whether the SEC may validly seek disgorgement as a sanction in enforcement proceedings at all. First, the blanket (as opposed to case-by-case) approach employed by the court to categorically limit the temporal reach of the disgorgement sanction does not bode well for the SEC. Second, tracing the remedy’s origins, the court pointed out that the SEC originally urged courts to order disgorgement as an exercise of their “inherent equity power to grant relief ancillary to an injunction.” Now that the Supreme Court has determined that disgorgement is punitive, imposing such relief would appear to go beyond courts’ inherent equitable powers. Third, the court seemed irked by the fact that even though Congress expressly authorized the SEC to seek monetary penalties in 1990, it nonetheless continues to seek disgorgement as a sanction. Fourth, and perhaps most tellingly, the court expressly stated in a footnote that nothing in its decision “should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings … .” This is especially significant given that the court utilized a footnote in Gabelli to foreshadow the result it eventually reached in Kokesh. That is, by taking the unusual step of noting that the district court in Gabelli had held §2462′s statute of limitations inapplicable to disgorgement, but that the issue was not presently before it (see Gabelli, 133 S. Ct. at 1220 n.1), the Gabelli court all but teed the issue up for the defense bar to raise in a later case—namely, Kokesh. It very well may be that the days the SEC has left to seek disgorgement at all are numbered.

Endnotes:

1. See SEC v. Graham, 823 F.3d 1357, 1363-64 & n.3 (11th Cir. 2016) (holding “disgorgement” is a “forfeiture,” but declining to address whether disgorgement is a “penalty”); Riordan v. SEC, 627 F.3d 1230, 1234 & n.1 (D.C. Cir. 2010) (although not a “penalty,” allowing for possibility that “disgorgement” is “forfeiture,” but concluding circuit precedent implicitly foreclosed argument); SEC v. Tambone, 550 F.3d 106, 148 (1st Cir. 2008) (summarily dismissing argument that §2462 applies to disgorgement in single sentence and citing case law that did not even mention §2462); SEC v. Saltsman, No. 07-cv-4370 (NGG) (RML), 2016 WL 4136829, at *24-29 (E.D.N.Y. Aug. 2, 2016) (collecting S.D.N.Y. and E.D.N.Y. case law holding “disgorgement” is neither “penalty” nor “forfeiture”).