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Article: August 2017: Disgorgement in SEC Cases Limited to Five Years

August 01, 2017
Business Litigation Reports

On June 5, 2017, the Supreme Court unanimously held in Kokesh v. Securities and Exchange Commission, 581 U.S. , No. 16-529 (2017), that the Securities and Exchange Commission’s (“SEC”) claims for disgorgement are subject to the five-year statute of limitations set forth in 28 U.S.C. § 2462. The impact of this decision on the SEC’s enforcement program is profound, as the SEC has been seeking, and obtaining, disgorgement since the 1970s without regard to a statute of limitations. Kokesh will significantly limit the availability of disgorgement to the SEC going forward, and it remains to be seen how the SEC will shift the other remedial levers at its disposal to compensate for the loss.

Facts in Kokesh
Kokesh began in late 2009, when the SEC alleged that Charles Kokesh used two investment adviser firms he owned to misappropriate approximately $34.9 million from four registered funds between 1995 and 2009. Kokesh did so by using the authority of his investment adviser firms to cause the funds to transfer money to the advisers that were not included in their advisory contracts, including salaries for Kokesh and his officers and rent for the advisers’ offices. The SEC sought both civil monetary penalties and disgorgement—a remedy intended to recover the defendant’s ill-gotten gains. A jury found Kokesh liable for the misappropriation, and the district court then turned to determining remedies.

Section 21(d) of the Securities Exchange Act of 1934 authorizes the SEC to bring civil injunctive actions against alleged violators of the federal securities laws. The Supreme Court has previously held that the five-year statute of limitations of 28 U.S.C. § 2462 applies to the imposition of civil monetary penalties in those proceedings. See Gabelli v. SEC, 568 U.S. 442, 454 (2013). The limitations statute provides a five-year limit for the government to seek any “fine, penalty, or forfeiture, pecuniary or otherwise.” The district court ordered Kokesh to pay a penalty of $2,54,593, or “the amount of funds that [Kokesh] himself received during the limitations period.” Kokesh at 4.

The district court next considered the SEC’s request for disgorgement of $34.9 million—$29.9 million of which was attributable to Kokesh’s conduct outside the statute of limitations. Kokesh objected, arguing that disgorgement was limited by the same five-year limitations period as the civil monetary penalty. The district court disagreed, holding that disgorgement was not a “fine, penalty, or forfeiture” and therefore not subject to it. The district court ordered Kokesh to pay the full disgorgement requested by the SEC, representing his gains from the scheme for the entire 15 year period. Kokesh appealed to the 10th Circuit Court of Appeals, which affirmed the lower court’s ruling that disgorgement was not a penalty subject to the five-year statute of limitations.

The Supreme Court’s Opinion
The key question for the Supreme Court was whether the SEC’s disgorgement was a “fine, penalty, or forfeiture” as described in 28 U.S.C. § 2462. The Circuit Courts of Appeals had split on this question, with the Eleventh Circuit Court of Appeals holding that the statute of limitations did apply to disgorgement claims (see SEC v. Graham, 823 F. 3d 1357, 1363 (11th Cir. 2016)) and the First, Tenth, and D.C. Circuit Courts of Appeals holding that it did not (see, e.g., Riordan v. SEC, 627 F. 3d 1230, 1234 (D.C. Cir. 2010)).

The Supreme Court stated that whether the relief sought is considered a “penalty” turns on two basic principles: (1) whether the wrong to be redressed is a wrong to the public or a wrong to an individual; and (2) whether the relief sought is for the purposes of punishing the offender and deterring others from engaging in the same behavior or compensating the victim. The Supreme Court found that disgorgement in SEC actions was a penalty because: (1) the SEC sought disgorgement for the violation of public laws as wrongs against the United States; (2) disgorgement has been used historically as a deterrent against other persons committing the same violation; and (3) disgorgement in many cases is not “compensatory,” or returned to the victim of the defendant’s wrongdoing, because the district court overseeing the action determines how the disgorgement proceeds are distributed.

The SEC argued that its use of disgorgement was not punitive because it served to re-establish the “status quo” that the defendant had disrupted through his or her illegal actions. The Supreme Court was not persuaded—it stated that disgorgement was not remedial for a number of reasons, including: (1) in some cases, a defendant can be ordered to disgorge more than his gains from his illegal conduct, such as in an insider trading case in which a tipper who does not trade is ordered to disgorge the trading profits of a downstream tippee who did; and (2) disgorgement can be ordered without accounting for the defendant’s expenses in generating the illegal profits.

The Supreme Court’s decision will likely have a significant impact on the SEC and the consequences will be felt immediately in ongoing litigation or investigations. Kokesh itself is a telling example, as the Supreme Court’s opinion noted that only approximately 14% of the disgorgement ($5 million of the $34.9 million originally awarded) could be traced to conduct that fell within the limitations period. Additionally, in In the Matter of Lynn Tilton, et al., File No. 3-16462, the SEC’s Enforcement Division originally sought approximately $208 million from the defendants in disgorgement. Shortly after Kokesh was decided, however, the Division admitted that $45,447,417 of the requested disgorgement was tied to misconduct outside the limitations period and it informed the administrative law judge that it was no longer seeking disgorgement of those funds.

For those who find themselves in the Division of Enforcement’s crosshairs, there are several practical considerations to navigating an investigation in the aftermath of Kokesh. First, the staff may respond to Kokesh by attempting to seek larger penalty amounts, where the statutory guidelines give it considerable flexibility in imposing penalties “for each violation.” See, e.g., 17 U.S.C. § 78u(d)(3) (Exchange Act Section 21(d)(3)). So, in a case where a significant amount of disgorgement would be lost to the statute of limitations, it is possible the staff will now instead seek a commensurately larger penalty than it otherwise would have. For example, in a typical offering fraud, the staff may view each misleading offering document sent to investors as a separate violation warranting its own penalty as a mechanism to increase recovery where the action is brought after the statute had run on some of the conduct.

Second, in cases that are headed toward settlement, the staff may ask that a defendant voluntarily undertake to repay harmed investors disgorgement that would otherwise be foreclosed by the statute of limitations, particularly where getting the money back to investors would be straightforward.

Third, barring voluntary undertakings, the SEC may attempt to have courts appoint more receivers. Receivers are appointed by a federal district court judge and are officers of the court, not employees of the SEC. They have broad powers to recover and protect assets for stakeholders and the court. Because receivers operate under the broad equitable powers of the court, they enjoy significant latitude to marshal assets and fashion plans of distribution. Receivers, however, are costly and therefore whether to seek to have one appointed can depend on the value of the potential receivership estate. Post-Kokesh, where the SEC may be limited in its ability to recover disgorgement directly, it is possible the SEC will shift its typical cost-benefit analysis for those decisions.

Finally, and importantly, it remains to be seen how Kokesh will affect the SEC’s—and potential defendants’—approach to tolling agreements. The SEC uses tolling agreements to suspend the statute of limitations, allowing the SEC more time to complete its investigation after it discovers the potential misconduct. See Gabelli, 568 U.S. at 454 (holding that statute of limitations of § 2642 begins to tick after the alleged fraud occurs, and the government may not take advantage of the discovery rule). However, those being investigated must agree to the tolling agreement, which they typically do to avoid hasty (and potentially unwarranted) action by the SEC, and to gain time to persuade the SEC to not pursue or to reduce potential charges. When a civil penalty was previously the only SEC relief subject to the limitations period, granting tolling agreements to the SEC was relatively pro- forma for those under investigation. Now Kokesh may persuade parties to resist, or negotiate, tolling agreements more strenuously because the tolling agreement also preserves additional disgorgement exposure.

While it is true that Kokesh will fundamentally limit the SEC’s ability to recover disgorgement, we can be sure that the agency will also adapt its existing approaches to compensate. Precisely how it addresses this new challenge remains to be seen. Kokesh and others may benefit in the short term from this decision, but those under investigation now and in the future should carefully watch the signals from the Division of Enforcement for new approaches to the issue.