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In April, the Supreme Court will hear Sripetch v. Securities and Exchange Commission. This case has gotten less attention than many other cases this term. But its outcome could have significant consequences for the Securities and Exchange Commission, one of the country’s most influential and powerful federal agencies, by limiting its discretion to punish wrongdoers and therefore reining in some of this agency’s considerable – and more controversial – authority.
Background
In the midst of the Great Depression, Congress passed the Securities Exchange Act of 1934 authorizing the SEC to act as an independent agency with the mission of reinstating trust to capital markets by investigating and prosecuting violations of the federal securities laws. To carry out its mission, the Exchange Act granted the SEC the power to seek equitable relief in federal courts in order to protect investors. Initially, such actions were limited to permanent injunctions against ongoing or future violations – effectively, orders enjoining someone from breaking the law.
This changed in the 1960s. In the absence of a statutory definition of insider trading, the SEC adopted the approach of tackling insider trading through enforcement actions that led to courts crafting common law theories to fill the gap. This eventually led to a recognition of the SEC’s ability to seek relief from wrongdoers through common law remedies such as restitution rather than simply injunctions. Such “ancillary equitable relief,” as it was initially called, would come to be known as disgorgement, or the act of having wrongdoers return the ill-gotten gains obtained from their fraudulent activities.
For some time, the SEC relied on the combination of injunctions and disgorgement – the equivalent of requiring a defendant to “put the cookies back in the cookie jar.” Nevertheless, worries of inadequate deterrence convinced Congress to further empower the SEC with the ability to impose monetary penalties, essentially large fines on companies and individuals who committed financial fraud. Thus, as time went on and the SEC’s enforcement arsenal expanded, so did the scope of the relief.
After the Sarbanes-Oxley Act was passed in 2002, the SEC argued that the main objective of disgorgement was to deny the wrongdoers their unlawful profits – as opposed to necessarily making victims whole. Hence, the SEC sought, and the lower courts awarded, disgorgement in ways that exceeded the equitable, non-punitive purpose of restitution by depositing ill-gotten gains in U.S. Treasury funds instead of victims’ accounts, imposing joint and several liability for acts of misconduct, and declining to deduct legitimate expenses from the receipts of fraud. That version of disgorgement prompted the question of whether disgorgement had evolved into a form of punishment.
The Supreme Court steps in
In the 2017 case of Kokesh v. SEC, the Supreme Court considered whether the statute of limitations applied to disgorgement in the same way that it applied to traditional civil penalties. Specifically, the court asked whether the SEC’s enforcement actions were meant to penalize and deter financial misconduct or to account for and rectify investor loss in line with traditional principles of equity. The answer that the court gave in Kokesh was that disgorgement in the securities-enforcement context leaned more toward punitive rather than purely a remedial sanction and if the purpose was the same, the limitations applied equally.
The Supreme Court revisited this issue in the 2020 case of Liu v. SEC, which examined whether and when disgorgement can be a permissible form of equitable relief. In doing so, the court in Liu distinguished equitable relief from punitive disgorgement by stating that disgorgement is deemed to be equitable relief so long as it is confined to conventional practices of equitable relief. In reaching this determination the court enunciated these practices, starting with the fact that there would have to be a victim of fraudulent conduct, individual and not joint liability, and limited disgorgement to net profits from wrongdoing after deducting legitimate expenses. The justices also noted that the disgorged funds should eventually be put in the victim’s jar rather than stay indefinitely in the government’s jar, but they ultimately placed the burden on the lower courts to apply principles to facts.
Sripetch
In considering whether to grant equitable relief, the lower courts have diverged on who, exactly, is a victim in the securities fraud context. Specifically, Sripetch is about the scope of harm incurred by an investor in connection to the misconduct of the wrongdoer. The question presented is whether the statutory basis of disgorgement imposes a requirement of pecuniary harm or simply an actionable interference with the investor’s legal interests. The petitioner, Mr. Sripetch, contends that to secure a disgorgement order against him, the SEC has to prove that investors have suffered actual financial loss beyond just being misled or manipulated.
On the law, Sripetch presents a fascinating case which resurfaces the questions that appeared in Kokesh and Liu: has disgorgement developed in a way that penalizes and deters financial misconduct in general, or is it for the purpose of rectifying concrete investor harm? And when, if ever, do remedial actions in the context of public enforcement of securities laws transcend the bounds of restitution and enter into punitive territory? Should the court decide that disgorgement’s purpose is punitive, the evidentiary threshold for the SEC in lower courts will be notably higher as it will need to prove pecuniary loss to a judge, thus limiting its flexibility in enforcement actions.
On the facts, Sripetch paints a fairly bleak picture for the petitioner: even if the court agrees with the requirement of pecuniary harm, the SEC contends that it can prove that he caused such harm on remand. But one of the amicus briefs filed – which concerns a similar case currently pending before the U.S Court of Appeals for the 9th Circuit, SEC v. Barry – presents an even more compelling version of the question in Sripetch that could amplify the court’s skepticism toward the expanding scope of disgorgement. Specifically, in Barry, the SEC has pursued a novel theory of pecuniary harm which is based on the “loss of the time value of money,” essentially money not being used productively as an investment, to justify a new form of disgorgement outside of fraud violations.
Conclusion
The SEC has long relied on common law and the flexibility of equitable relief to carry out its mission of protecting investors from fraud and misrepresentation. Over its history, the agency was able to convince the lower courts, Congress, and occasionally even the Supreme Court to allow a gradual expansion of its enforcement power through its increased ability to seek disgorgement. In more recent years however, the court has not only scrutinized the SEC’s prosecutorial discretion in administrative law proceedings, but weakened judicial deference to the agencies. It is therefore an open question if the SEC can continue on this track, or if – in the case of disgorgement – it has gone too far. Sriptech may provide at least a partial answer.
