Graeme Sloan/Sipa USA via AP Images
Given the Court’s decade-long campaign to blunt the SEC’s enforcement tools, it seems unlikely that disgorgement will survive in its present form after Supreme Court scrutiny.
During the last ten years, the Supreme Court has made it much more difficult for the Securities and Exchange Commission (SEC) to punish those who commit securities fraud. Today the Court will hear argument on whether to strip the SEC of its most important remaining enforcement tool, the ability to require fraudsters to “disgorge,” or give up, their illicit profits. There is good reason to fear that the result will be yet another loss for investors, including the millions of Americans whose 401(k), IRA, and other retirement funds rest uneasily in the hands of Wall Street.
Undermining Individual Liability
It is unlawful to knowingly “make an untrue statement of material fact” in connection with the purchase or sale of stocks, bonds, or other securities. Prior to 2010, an individual who participated knowingly and substantially in preparing a false press release or some other corporate statement could be liable along with the company. This recognized that corporate documents do not arrive out of thin air: Actual human beings like the company’s officers, executives, and employees collaborate to prepare them.
The 2008 financial crisis revealed pervasive financial manipulation and outright fraud by corporations and financial institutions. Many senior executives were potentially exposed to personal liability. But the Supreme Court came to the rescue. In a 5-4 decision in Janus Capital Group (2011), the Court’s conservative majority declared that the only individual who can be held accountable in connection with a false company statement is the individual with “ultimate authority over the statement.” As Justice Thomas’s opinion acknowledged, this new standard meant that most of those who “participat[e] in the drafting of a false statement” cannot be found liable for that statement.
Janus was a serious blow to enforcement of the securities laws and a major reason that so few senior corporate officers were held personally accountable for the abuses that led to the 2008 financial crisis and subsequent recession.
Jandos Rothstein
Limiting Penalties
Money penalties hit fraudsters where it matters most, in the pocketbook. However, in 2013 the Supreme Court effectively curtailed the SEC’s ability to impose penalties in many cases.
A legal claim must ordinarily be filed within a certain period after the misconduct. However, in some situations the “clock does not start ticking” until the misconduct is discovered or should have been discovered. This “discovery rule” recognizes that those who violate the law should not be allowed to escape liability by concealing their actions. Not surprisingly, the discovery rule is widely applied in cases of financial fraud, which almost always involve some attempt at concealment.
Nevertheless, the Supreme Court ruled in Gabelli v. SEC (2013) that the SEC could not rely on the discovery rule. In that case, two mutual fund managers secretly permitted a favored investor to earn returns of up to 185 percent while lying to others, who consistently lost money. Because the fund managers successfully hid their fraud, the SEC argued that its lawsuit was timely even though it was filed after the usual filing deadline.
In a classic example of anti-government illogic, the Court declared that the discovery rule was available to private parties but not to the SEC, because the SEC should be expected to discover violations without delay. That reasoning is astonishingly unrealistic. Most securities fraud is committed by white-collar professionals who take great pains to conceal the misconduct. Moreover, the SEC has a small enforcement staff attempting to enforce securities laws throughout the large and complex financial industry. The SEC simply cannot uncover all or even most securities law violations in “real time.” The reasoning offered by the Court in Gabelli is so unconvincing that it highlights the Court’s antipathy to effective regulation of Wall Street.
Limiting Disgorgement
Prior to 2017, the federal courts could compel securities law violators to surrender all of their illicit gains. In Kokesh v. SEC (2017), the Supreme Court drastically reduced the reach of this key anti-fraud remedy.
After a jury found that Kokesh misappropriated $34 million, the lower courts ordered him to disgorge everything he took in from the scheme, including profits obtained more than five years before the SEC’s case was filed. Because disgorgement requires only that fraudsters give up their illegal gains, to most minds disgorgement is simply a matter of fair play. And much of the money recovered via disgorgement is returned to harmed investors.
But to a Supreme Court highly sensitive to financial-industry concerns, disgorgement of all the gains from a fraud, regardless of when those gains were obtained, seemed like a penalty. As a result, the Court concluded that violators cannot be required to surrender gains resulting from misconduct that took place more than five years before the case was filed, the same limitation imposed on the collection of penalties.
The Kokesh decision was a massive financial gift to fraudsters. According to the SEC, fraudsters will keep at least $1.1 billion that would otherwise have been recovered in cases already filed by the SEC.
Withdrawing Whistleblower Protections
In response to the 2008 financial crisis, Congress determined that employees should be encouraged to report securities fraud. Consequently, Congress provided in the Dodd-Frank legislation (2010) that no employer could retaliate against a whistleblower for making a disclosure protected under the federal securities laws. Dodd-Frank was intended to provide strong protection for workers who disclose false statements, insider trading, accounting fraud, market manipulation, or other misconduct affecting stocks, bonds, or financial investments.
The vast majority of whistleblowers who report securities fraud have always made their disclosures to their employers. Prior to 2018, Dodd-Frank was widely understood to protect those who made such internal disclosures, regardless of whether or not the whistleblower also reported the violations to the SEC.
The Supreme Court took a jackhammer to this protection in 2018. In Digital Realty Trust v. Somers, the Court ruled that Dodd-Frank anti-retaliation protection is limited to those who report securities violations directly to the SEC. As a result, most whistleblowers reporting securities fraud to their employer receive no protection under federal securities law. While employees of publicly traded companies and their affiliates receive limited protection (under pre–Dodd-Frank provisions), if they report securities fraud internally, even for that minority the supposed “protection” is usually too little, too late.
The Digital Realty decision is striking for its disregard of congressional intent and common sense. A company can retaliate for a disclosure only when the company is aware of the disclosure. But employers rarely know that a whistleblower has filed a tip with the SEC, which must hold such tips in confidence. In most situations, the only disclosure made by the whistleblower is made directly to the employer—which is exactly the form of disclosure denied Dodd-Frank protection by the Digital Realty decision.
Will Fraudsters Be Allowed to Keep All of Their Illicit Gains?
In today’s case, the Court will consider whether those who violate the securities laws can ever be ordered to disgorge any of their illicit gains, even when the SEC files suit during or soon after the fraud.
The case before the Court, Liu v. SEC, arose when the SEC alleged that two California residents obtained almost $27 million by defrauding Chinese investors who hoped to secure permanent residence in the U.S. The trial court found that the defendants engaged in “a thorough, longstanding scheme to defraud” and ordered them to surrender their gains.
For almost 50 years, the courts have been ordering securities violators to disgorge ill-gotten gains. In fiscal year 2019 alone, the SEC recovered more than $3 billion via disgorgement. The defendants in Liu ask the Court to discard this half-century of precedent and hold that the federal courts have no authority to require disgorgement. It is hard to imagine that this argument would be considered seriously, except that the Supreme Court took the highly unusual step, in a footnote in an earlier decision, of essentially announcing its interest in this issue and inviting the defense bar to bring forward an appropriate case.
Securities industry representatives and conservative think tanks have flocked to join in the attack on disgorgement. Unfortunately, the SEC is represented in this matter by Attorney General Barr’s Justice Department, which has mustered only a lukewarm defense. Given the Court’s decade-long campaign to blunt the SEC’s enforcement tools, it seems unlikely that disgorgement will survive in its present form after Supreme Court scrutiny.
Looking Forward
Ideally, Congress would intervene to offset the Supreme Court’s relentless attack on investor protections. The House has already passed bills that would reinstate certain whistleblower protections (H.R. 2515) and protect the SEC’s ability to recover disgorgement (H.R. 4344). But neither bill has moved forward in the Senate or can be expected to do so. It is more likely that congressional action to restore the investor protections being systematically undermined by the Supreme Court will depend, as with so many other critical national issues, on the outcome of the November elections.
