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When the Supreme Court in 2020 issued its decision in Liu v. SEC, placing limits upon the Securities and Exchange Commission's ability to obtain disgorgement, many observers believed that the decision would significantly diminish the SEC's capability to seek and obtain significant disgorgement recoveries in civil enforcement actions alleging violations of the securities laws. Now nearly three years since Liu, it is clear that the decision has had no real significant effect on disgorgement awards.

Post-Liu cases reveal that district courts have largely retained their pre-Liu approach to disgorgement, including allowing a "reasonable approximation" of net profits to substitute for a more precise analysis of unjust gains and placing any risk of uncertainty about the disgorgement amount upon the defendant. The retention of these and other elements of the pre-Liu approach to disgorgement have substantially blunted the impact of Liu.

Liu, which was decided in 2020, appeared, at the time, to significantly constrain the SEC's ability to obtain disgorgement as equitable relief for violations of the securities laws. The principal issue in Liu was whether disgorgement was a punitive sanction, and therefore unavailable as a remedy under the SEC's power to award "equitable relief." The issue had been left unresolved in Kokesh v. SEC, decided in 2017, which held that disgorgement was a penalty for the purposes of limiting its statute of limitations to five years.

Liu held that disgorgement is an appropriate equitable remedy, and therefore appropriate in SEC enforcement actions, so long as the amount does (1) not exceed the defendant's "net profits" from the wrongdoing; and (2) is "awarded for victims."

Because the district court in Liu had awarded disgorgement in the total grossproceeds from the alleged fraud, declining the defense request to deduct even legitimate business costs expended on the venture, the Court vacated the disgorgement award. Liu's constraints on disgorgement — particularly its limitation on recoveries to net, rather than gross, proceeds — were predicted to substantially curtail disgorgement as a remedy in SEC enforcement actions.

But because district courts have largely continued to apply the same framework for analyzing disgorgement that had been used prior to Liu, that decision has had far less of an effect on disgorgement than anticipated.

The main pre-Liu principles regarding disgorgement courts continue to apply include:

•The "reasonable approximation" standard: Courts continue to follow the pre-Liu practice of ordering disgorgement in amounts based upon just a "reasonable approximation" of net profits causally connected to the securities violations. Even where there may be some legitimate profits or expenses, it is often found that those sums are small enough that they may be disregarded under a reasonable approximation analysis.

•The burden shifting analysis: As courts held and applied long before Liu, once the SEC establishes a reasonable approximation of the profits causally related to the fraud, the burden shifts to the defendant to demonstrate that the disgorgement figure is not a reasonable approximation. Defendants post-Liu, as before, are often unable to overcome the burden of disproving reasonableness, particularly because courts give wide berth to the SEC's approximation of net profits.

•Placing the risk of uncertainty on the defendant: Post-Liu, courts continue to apply the longstanding principle that any risk of uncertainty as to the disgorgement amount should fall on the wrongdoer whose alleged illegal conduct created the uncertainty. This is perhaps the most significant hurdle for defendants seeking to challenge disgorgement to overcome. It is frequently difficult or burdensome for courts to conduct the often-nuanced and meticulous "net profits" calculation apparently required by Liu. Courts in the post-Liu era therefore remain as inclined as ever to side with the SEC's proposed disgorgement figure on the basis that the difficulty in calculating the true "net profits" is the result of the defendant's conduct, e.g., by failing to keep proper records or commingling funds.

•The "entirely fraudulent entity" exception: As approved in Liu, courts continue to apply a longstanding limited exception to Liu's "net profits" requirement in circumstances where the "entire profit of a business or undertaking" results from wrongdoing. In such cases, courts will deny a defendant "inequitable deductions," such as for personal services. This "exception" is frequently applied when the scheme involves overarching misrepresentations underlying the entire business or undertaking.

•Scrutinizing the "legitimacy" of the business expenses: Even where courts do undertake to determine what expenses equitably should be deducted from disgorgement, the defendant has the burden of showing that the proposed expenses have value independent of fueling a fraudulent scheme. Thus, for example, marketing expenses are often not deemed legitimate where the marketing was for investments that were themselves part of the fraud. While this scrutiny of business expenses was less a feature of pre-Liu law, it has nonetheless become a potent SEC argument in fending off Liu-based challenges to disgorgement awards.

The standards to be applied for the "net profits" analysis required by Liu were at issue in a case just denied consideration this week by the United States Supreme Court. In Goulding v. SEC, the Court was asked to consider, among other things, the degree to which Liu's "net profits" standard may be estimated using a blunt "gross proceeds" or "cash-in cash-out" analysis as a stand-in for "net profits."

The facts of Goulding are illustrative of the way the issue often arises. Goulding owned and operated an investment advisory firm called the Nutmeg Group LLC. Nutmeg managed and acted as an investment adviser to more than a dozen investment funds.

In 2018, the SEC charged Goulding, as owner and operator of Nutmeg, with violating various provisions of the Investment Advisors Act of 1940 by, among other things, making false statements to investors in Nutmeg's funds concerning the fund's investments and the valuation of the funds' assets, and with commingling investor money with his own.

Following a bench trial, Goulding was found liable for violating the Investment Advisors Act and the district court ordered him to disgorge approximately $650,000.

The district court calculated disgorgement by subtracting the monies Goulding had contributed to the Nutmeg accounts from the amount he had personally withdrawn from the Nutmeg accounts — i.e., the gross payments Goulding received from Nutmeg over the relevant period. The district court did not include in its calculations any alleged legitimate business expenses incurred by Nutmeg — as Liu expressly requires — nor did it account for profits and commissions earned by Nutmeg.

In explaining its blunt instrument approach to calculating disgorgement, the district court blamed Goulding's pervasive commingling of monies for the difficulty in conducting a net profits analysis and found that the gross proceeds approach represented "the cleanest calculation of ill-gotten gains." The 7th U.S. Circuit Court of Appeals last July affirmed the disgorgement award.

The Supreme Court's summary denial of certiorari to consider Goulding reflects the lack of any real dissonance in the lower courts regarding the continued application of many of the pre-Liu principles described above that have long made disgorgement such a potent remedy.

Courts considering disgorgement invariably apply the pre-Liu principles described above to awarding disgorgement in much the same magnitude and under the same broad conditions as before Liu. The upshot is that while Liu may have had some effect on cases at the margin, it has not appreciably changed the heavily pro-SEC legal landscape for obtaining disgorgement.

 

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