By Andrew Ceresney
Andrew Ceresney is a partner and Co-Chair of the Litigation Department at Debevoise & Plimpton. He was Director of Enforcement at the SEC from April 2013 to December 2016. David Imamura, an associate at Debevoise, assisted in drafting this article.
Much ink has been spilled in the past few weeks about the impact of the Supreme Court’s decision in Kokesh v. SEC holding that a five-year statute of limitations applies to Securities and Exchange Commission actions seeking disgorgement. 581 U.S. __ (2017). A lot of the focus has been on the implications of the decision for actions where the conduct extends beyond the statute of limitations, such as is common in Foreign Corrupt Practices Act actions or Ponzi schemes. But less has been said about the implications of the decision for disgorgement that falls within the statute of limitations. And the decision is likely to have significant impact on such actions, in ways that may be felt just as broadly as the impact of the decision on older conduct.
The Supreme Court’s decision was definitive in holding that disgorgement is considered a penalty. That holding has significant implications for two issues that often arise in connection with disgorgement sought for conduct within the statute of limitations (and outside the limitations period). First, whether a party can seek or obtain indemnification for any disgorgement order from an insurer will in certain circumstances turn on whether disgorgement is considered a penalty. Second, whether disgorgement is tax deductible also likely turns on whether disgorgement is considered a penalty or not. These two issues have significant implications for parties to enforcement actions. Whether parties can obtain indemnification from an insurance policy or otherwise, and whether the disgorgement is tax deductible, can sometimes have an impact of tens of millions of dollars. And those implications exist even for conduct within the statute of limitations. The Kokesh decision therefore likely will have a significant impact well beyond its impact on conduct older than the five-year statute of limitations.
In Kokesh, the Supreme Court held that the SEC’s remedy of disgorgement was a penalty that was subject to a five-year statute of limitations. 581 U.S. __, __ (2017) (slip op., at 9). In 2009, the SEC alleged that Charles Kokesh misappropriated tens of millions from investors. The district court ordered Kokesh to disgorge $34.9 million, including gains from the misappropriation reaching back to 1995. The Supreme Court applied a two-part test to determine whether disgorgement is a “penalty” subject to a five-year statute of limitations under 28 U.S.C. § 2462. First, the Court examined “whether the wrong sought to be redressed is a wrong to the public, [rather than a] wrong to [an] individual.” Second, the Court analyzed whether disgorgement “is sought ‘for the purpose of punishment, and to deter others from offending in like manner’—as opposed to compensating a victim for his loss.” The Court found that: (1) the SEC sought disgorgement more in the interest of the public rather than any individual; and (2) disgorgement’s purpose was more punitive than remedial. Id. at 7–9. As such, the Supreme Court held that disgorgement is a penalty under 28 U.S.C. § 2462 and thus subject to the five-year statute of limitations that applies to penalties.
One issue that may arise in enforcement actions is whether the monetary remedies imposed may be indemnified. Insurance policies often contain provisions which prohibit or limit indemnification for penalties. And cases in a number of districts have held that indemnification of penalties is repugnant to public policy. Globus v. Law Research Serv., Inc., 418 F.2d 1276 (2d Cir. 1969); Eichenholtz v. Brennan, 52 F.3d 478 (3d Cir. 1995); Heizer Corp v. Ross, 601 F.2d 330 (7th Cir. 1979); First Golden Bancorporation v. Weiszmann, 942 F.2d 726 (10th Cir. 1991); City of Fort Pierre v. United Fire & Cas. Co., 463 N.W.2d 845 (S.D. 1990).
At the same time, the insurability of disgorgement is much more unclear. There is a line of cases holding that disgorgement, because it involves the return of improperly acquired funds, does not constitute “loss” or “damages” within the meaning of insurance policies. Level 3 Communications Inc. v. Federal Ins. Co., 272 F.3d 908, 910 (7th Cir. 2001); Vigilant Ins. Co. v. Credit Suisse First Boston Corp., 10 A.D.3d 528, 528 (1st Dept. 2004). Some courts have also held that public policy prohibits an insured from receiving indemnification for the disgorgement of its own illicit gains. Bank of the West v. Superior Ct., 833 P.2d 545, 555 (Cal. 1992). On the other hand, some courts have ordered indemnification for disgorgement. For example, in J.P. Morgan Securities Inc. v. Vigilant Ins. Co., 21 N.Y.3d. 324 (2013), Bear Stearns was ordered to disgorge $160 million to the SEC for trading violations. After paying the judgment, Bear Stearns sought indemnification from its insurers. Because the parties’ contract did not explicitly preclude reimbursement for disgorgement and the $160 million disgorged to the SEC arose from profits of its customers (rather than Bear Sterns itself), the New York Court of Appeals ordered the insurers to fully reimburse Bear Stearns for the disgorgement amount. Other states (including Delaware) take even stronger stances in favor of the insurability of disgorgement claims. U.S. Bank Nat’l Ass’n v. Indian Harbor Ins. Co., No. 12-cv-3175, 2014 BL 186122 , at *3 (D. Minn. July 3, 2014) (applying Delaware law and holding that “no Delaware authority has held that restitution is uninsurable as a matter of law”).
SEC settlements for many years have precluded a party from obtaining indemnification for penalties. The settlements typically contain a provision stating that a defendant “shall not seek or accept, directly or indirectly, reimbursement or indemnification from any source, including, but not limited to, payment made pursuant to any insurance policy, with regard to any civil penalty amounts that [Defendant] pays pursuant to the Final Consent Judgment.” Final Judgment, at 8, SEC v. Stifel Nicolaus & Company, Incorporated, Case No. 11-cv-755 (Dec. 6, 2016 E.D. Wis.).
At the same time, SEC settlements and regulations have not explicitly precluded indemnification for disgorgement, thereby allowing defendants to obtain indemnification for the disgorgement portion of any settlement, to the extent the disgorgement amount is otherwise subject to indemnification. It is interesting to note that, by contrast, in the past three years, the Department of Justice (DOJ) has begun to preclude indemnification for disgorgement. For example, the 2016 settlement with the General Cable Corporation provided: “The Company shall not seek or accept directly or indirectly reimbursement or indemnification from any source with regard to the penalty or disgorgement amounts that the Company pays pursuant to this Agreement or any other agreement concerning the facts set forth in the Statement of Facts entered into with an enforcement authority or regulator.” DOJ began to preclude indemnification for disgorgement several years ago, likely because of increased scrutiny by Congress and others of available indemnification for monetary remedies imposed as part of settlements. Up till now, though, the SEC has not followed suit.
Whether disgorgement is subject to indemnification can have significant consequences. For example, Angelo Mozilo, the former CEO of Countrywide Financial, agreed to disgorge $45 million to settle a securities fraud case with the SEC. However, Mozilo was indemnified for $20 million of the disgorgement and ultimately only disgorged $25 million from his own money. Similarly, David Sambol, the former president of Countrywide, disgorged $5 million as part of his settlement with the SEC and was reimbursed in full by the company. Peter Henning, When Disgorgement Comes Cheap, N.Y. TIMES (Oct. 18, 2010), https://dealbook.nytimes.com/2010/10/18/when-disgorgement-comes-cheap/?_r=0.
Kokesh calls into question whether disgorgement orders, under any circumstances, will continue to be indemnified by insurance policies. If disgorgement amounts to a penalty, as the decision clearly holds, it will likely be subject to the provisions of insurance policies which preclude indemnification for penalties, and such indemnification may also be against public policy. It also is not clear whether the holding in Kokesh that disgorgement amounts to a penalty will lead the SEC to alter their settlements to have similar language to DOJ precluding indemnification for disgorgement. Accordingly, the Kokesh decision could have a significant impact on the availability of indemnification for disgorgement judgments.
Another issue of significant relevance to parties to enforcement actions is whether disgorgement orders are tax deductible. If a settlement is tax deductible, it may reduce the financial impact of the order by as much as 50% of the amount of disgorgement, depending on the applicable tax rate. For large settlements, that can have a very significant impact on the ultimate expense of a settlement.
Under the tax code, penalties may not be deducted as business expenses. 26 CFR § 1.162-21. However, historically, parties have taken a tax deduction for disgorgement paid as part of settlements. Peter Henning, Deducting the Costs of a Government Settlement, N.Y. TIMES (March 24, 2014), https://dealbook.nytimes.com/2014/03/24/deducting-the-costs-of-a-government-settlement/?_r=0; Robert W. Wood, Insurance Industry Settlements Revive Old Questions: When Is a Payment A Nondeductible Penalty? , 103 J. Tax’n 47, 48-49 (2005). If, as Kokesh held, disgorgement amounts to a penalty, then presumably the tax code would preclude any deduction as an expense.
In fact, even prior to Kokesh, the deductibility of disgorgement was already in some doubt in light of an IRS Chief Counsel opinion issued in January 2016. In that matter, the IRS Chief Counsel stated that disgorgement payments made to the SEC as part of FCPA settlement were not tax-deductible because the disgorgement order effectively amounted to a penalty. Office of the Chief Counsel, Internal Revenue Service, Memorandum No. 201619008 (May 6, 2016), https://www.irs.gov/pub/irs-wd/201619008.pdf. The IRS noted that disgorgement is not tax deductible if it is primarily punitive as opposed to compensatory, and that such a determination depended on the facts and circumstances of a particular case. Id. at 6. Where, for example, the amount of the wrongdoer’s profits equal the victim’s losses, or where the SEC is using disgorgement to obtain compensation for harmed investors, those factors may weigh in favor of treating disgorgement as compensatory. On the other hand, where disgorgement serves primarily to prevent wrongdoers from profiting from their illegal conduct and deter subsequent illegal conduct, or where disgorgement is essentially a substitute for a penalty or similar to forfeiture, then disgorgement will be primarily punitive. In that FCPA books and records case, the Chief Counsel noted that there was nothing indicating that the purpose of the disgorgement payment was to compensate the government or a non-governmental party for losses caused by the violations, and therefore the disgorgement was not tax deductible.
A Chief Counsel’s opinion does not have binding effect. But after Kokesh, even the facts and circumstances approach of the IRS Chief Counsel opinion may no longer govern, as Kokesh is rather definitive that disgorgement should always be considered a penalty. The bottom line is that Kokesh’s holding that disgorgement is a penalty means that the section of the Internal Revenue Code precluding deductions for penalties likely applies to disgorgement. And this clearly will impact disgorgement ordered for conduct within the statute of limitations.
The Supreme Court’s decision in Kokesh was viewed by many as a victory for defendants, providing a firm statute of limitations for disgorgement actions. But the decision may also have implications that disadvantage defendants, precluding indemnification or deductibility of such disgorgement settlements. This may make future negotiations with defendants more complicated, as parties must now readjust their expectations to account for the actual cost of settlements. At a minimum, Kokesh will have important consequences even for conduct within the statute of limitations, making its implications even broader than initially anticipated.
Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to email@example.com.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to firstname.lastname@example.org.
Put me on standing order
Notify me when new releases are available (no standing order will be created)