Punishment or Payment? SEC Loses Again on Sanctions in the Supreme Court


Supreme Court

Ruth Bader Ginsburg and Clarence Thomas don’t agree on a lot of things, but in Kokesh v. SEC, they joined in a unanimous opinion that limited the ability of the SEC to reach back in time to require securities law violators to disgorge ill-gotten gains. The Court, rejecting the SEC’s claims that disgorgement orders are remedial in nature, found that the five-year statute of limitations in 28 U.S.C. §2462 applicable to “any civil fine, penalty, or forfeiture” foreclosed the dated claims. The case marks the second time that the SEC lost before the high court on a limitations question. In Gabelli v. SEC, 568 U.S. 133 (2013), a unanimous Supreme Court held that the five-year period in civil penalty actions began when the fraud occurred, and not when discovered by the government. The decision is likely to have a significant impact on the SEC enforcement program far beyond the facts of the particular case.

In Kokesh, the SEC charged an individual with misappropriating funds from four SEC-registered business development companies over a period of nearly 20 years. As charged, Charles Kokesh engaged in a scheme where he improperly withdrew nearly $29 million from the business development investment funds he managed to pay for undisclosed salaries, bonuses and expenses of the fund advisers. He also allegedly withdrew $6.1 million from the funds for "tax distributions," even though he only paid approximately $10,000 in federal taxes for the period. The district court limited the penalty it imposed to reflect the five-year limitations period, in accordance with Gabelli. The district court did, however, order Kokesh to disgorge his profits recognized throughout the entire generation-long scheme, with prejudgment interest dating from the initiation of the fraud, for a total of approximately $53 million. The Tenth Circuit affirmed the sanctions, finding that the disgorgement order was remedial and not subject to the §2462 limitations period.

Justice Sotomayor initially cited a 19th-century Supreme Court case which stated that a penalty is a “punishment, whether corporal or pecuniary, imposed and enforced by the State, for a crime or offen[s]e against its laws.” She said that the definition of a penalty turns on two questions:

  • whether the wrong sought to be redressed is a wrong done to the public, or a wrong to an individual; and
  • whether the remedy is sought for the purposes of punishment and deterrence or to compensate a victim for a loss.

The SEC conceded that when it seeks disgorgement, "it acts in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties." Disgorgement orders also serve a punitive purposes, as courts have regularly held that these orders serve to deter others from similar misconduct. Disgorgement is also not compensatory, reasoned the Court, because disgorged profits are paid to the district court, and it is within the court’s discretion to determine how the money is distributed.

The Court rejected the SEC's claim that disgorgement merely restores the status quo before the illegal conduct. It is not clear, wrote Justice Sotomayor, that the remedy "simply returns the defendant to the place he would have occupied had he not broken the law." She noted that the amounts disgorged can exceed the profits gained as a result of the violations, citing cases where tippers have been ordered to surrender profits realized by their tippees. Disgorgement orders will also often cover gross amounts received, without consideration of the defendant's costs and expenses, and only need to be a rough estimate of profits rather than an accurate accounting of net gains.

The decision has an immediate and significant impact on Charles Kokesh, as almost $30 million of the disgorgement total resulted from violations outside the limitations period. Beyond this case, however, the decision will have a considerable impact on the SEC’s enforcement program. With the clock running on both penalties and disgorgement from day one of the fraud, a resource-challenged Enforcement Division will be faced with making cases ready to prosecute much more quickly. The availability of disgorgement dating back to the beginning of the fraud made it possible for the Commission to take the long view in many cases, but a five-year limitations period will foreclose many actions that might have been potential sources of large payoffs. The limitations period will also change the dynamics of the settlement process, as potential defendants will be facing far less risk exposure and the division will have far less leverage.

The decision may also support the IRS in its assertions that amounts paid in disgorgement are not deductible under IRC §162(f). This section provides that “[n]o deduction shall be allowed … for any fine or similar penalty paid to a government for the violation of any law.” A 2016 IRS Chief Counsel Advice Memorandum found that amounts disgorged in the course of settling SEC claims under the Foreign Corrupt Practices Act were not deductible. The payments did not go toward making any injured party whole, and in language similar to that used by Justice Sotomayor, the IRS stated that "we think disgorgement can be primarily punitive for tax purposes in some cases, where it serves primarily to prevent wrongdoers from profiting from their illegal conduct and deters subsequent illegal conduct." The memorandum concluded that there “simply is nothing indicating that the purpose of the disgorgement payment was to compensate the United States Government or some non-governmental party for its specific losses caused by Taxpayer's violations of the FCPA.”

There also remains an interesting question that was not before the Court on the future of disgorgement as an available enforcement tool. Disgorgement is a remedy developed in practice with no specific statutory underpinning. The Court took care in a footnote to emphasize that “[n]othing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.” With a new conservative justice on the bench and the prospect for future changes in the makeup of the Court, however, the justices may see fit to further narrow the SEC’s arsenal of enforcement weapons.