Disgorgement

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"Enforcement Actions",
"Equitable Relief",
"Unjust Enrichment",
"Fiduciary Duty",
"Civil Penalties",
"Insider Trading",
"Securities Fraud",
"Investment Scams",
"Damages",
"Investor Protection",
"Regulatory Compliance",
"Settlement",
"Financial Markets",
"Shareholders",
"Gross Revenue",
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"external": [
"https://www.sec.gov/enforce/how-we-determine-remedies",
"https://www.reuters.com/markets/us/sec-gets-19-bln-win-disgorgement-case-against-investment-adviser-2024-03-27/",
"https://www.ft.com/content/1381e05d-e06e-444a-8f9f-b7a5e8f47051",
"https://www.sec.gov/news/press-release/2020-143",
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}

What Is Disgorgement?

Disgorgement is a legal remedy that compels individuals or entities to surrender profits or benefits obtained through illegal or unethical conduct. It falls under the broader category of Regulatory Compliance within financial law, aiming to strip wrongdoers of their ill-gotten gains and deter future misconduct. The core purpose of disgorgement is to prevent unjust enrichment, ensuring that no party profits from their wrongdoing. While often associated with punitive measures, disgorgement is primarily considered a form of equitable relief, designed to restore the status quo and compensate those who have been harmed. Regulatory bodies, such as the Securities and Exchange Commission (SEC), frequently employ disgorgement in their enforcement actions to uphold the integrity of financial markets.

History and Origin

The concept of disgorgement has deep roots in equity jurisprudence, where it traditionally served to prevent individuals from profiting from their wrongful acts. Its application in securities law gained prominence in the 1970s, as the Securities and Exchange Commission began utilizing it as a key remedy in its enforcement actions.³³ This expansion allowed the SEC to not only seek injunctions but also to recover illicit gains, enhancing its ability to enforce securities laws effectively.³² Over decades, disgorgement became a cornerstone of the SEC's enforcement strategy, leading to billions of dollars in ordered payments.³¹

A significant legal development occurred with the U.S. Supreme Court's 2017 ruling in Kokesh v. SEC, which classified disgorgement as a "penalty" for statute of limitations purposes, raising questions about its nature and the SEC's authority.³⁰ However, the Court later clarified its stance in the 2020 case of Liu v. SEC. In Liu, the Supreme Court affirmed that disgorgement awards could indeed be issued as equitable remedies by the SEC, provided they did not exceed the wrongdoer's net profits and were returned to defrauded investors.²⁹ This decision, though affirming the SEC's power, introduced limitations and emphasized the compensatory rather than punitive nature of disgorgement.²⁸

Key Takeaways

• Disgorgement is a legal remedy compelling the surrender of ill-gotten gains from illegal or unethical activities.
• Its primary goal is to prevent unjust enrichment and restore funds to victims, not to punish the wrongdoer excessively.
• Regulatory bodies like the SEC frequently use disgorgement in cases involving securities fraud, insider trading, and other financial misconduct.
• The amount ordered in disgorgement is typically limited to the wrongdoer's net profits, reflecting its equitable nature.
• Funds obtained through disgorgement are often distributed to harmed investors.

Formula and Calculation

Disgorgement does not typically involve a rigid formula in the same way a financial ratio might. Instead, the calculation of disgorgement aims to determine the wrongdoer's "ill-gotten gains" or "net profits" derived from the illegal activity. This process can be complex, especially when multiple parties are involved or varying amounts of money have been lost.²⁷ The goal is to reach a "reasonable approximation of the profits which are causally connected to the violation."²⁶

The basic principle is:

• Gross Revenue from Illegal Activity: This represents all income or benefits directly obtained as a result of the wrongful conduct.²⁵ For example, in an insider trading case, this would be the profits made from the illicit trades.
• Direct Legitimate Expenses Related to the Activity: These are genuine costs incurred in generating the ill-gotten gains that are directly related to the scheme, which may be deducted. The Supreme Court's Liu v. SEC decision emphasized that disgorgement awards should be limited to "net profits," allowing for the deduction of legitimate expenses.²³, ²⁴

It's important to note that expenses unrelated to the illicit scheme, or those that merely facilitate the fraud, are generally not deductible. The intent is to deprive the wrongdoer of their actual profit, not to penalize beyond that.

Interpreting Disgorgement

Interpreting a disgorgement order involves understanding its purpose as an equitable remedy within the legal framework, particularly in financial law. When a court or regulatory body, such as the SEC, orders disgorgement, it signifies a legal determination that an individual or entity has improperly gained financially through illegal or unethical conduct.²² The resulting amount represents the illicit profits that must be relinquished.

The primary interpretation of a disgorgement amount is not as a fine or civil penalties levied for punishment, but rather as a corrective measure to restore economic fairness. The goal is to ensure that wrongdoers do not benefit from their illegal actions and to return funds, where possible, to the victims.²¹ For shareholders or other affected parties, a disgorgement order signals an attempt to recover losses incurred due to misconduct, contributing to overall investor protection. The specific amount can vary significantly depending on the scale and nature of the illicit gains.

Hypothetical Example

Imagine a fictitious investment adviser, "Alpha Advisors," runs an investment scam. Alpha Advisors promises clients guaranteed, unusually high returns by falsely claiming to invest in a proprietary algorithm that consistently beats the market. Over a year, they collect \$10 million from unsuspecting investors. However, instead of investing the funds as promised, the principal, Mr. Smith, uses \$2 million for personal expenses and places the remaining \$8 million into low-yield, legitimate investments, generating an additional \$200,000 in interest before the scheme is uncovered.

In this scenario, a regulatory body would pursue disgorgement to recover the ill-gotten gains.

1. Calculate Gross Revenue: The total funds received from investors due to the fraudulent scheme are \$10,000,000. The interest earned on the legitimately invested portion, \$200,000, is also considered an ill-gotten gain because the principal funds were obtained illegally. Therefore, the total gross revenue from the illegal activity is \$10,200,000.
2. Identify Legitimate Expenses: In this hypothetical, there are no legitimate expenses directly related to generating the illegal profits. The \$2 million spent on personal expenses are not legitimate business expenses that would be deductible.
3. Determine Disgorgement Amount: $$\text{Disgorgement Amount} = \text{\$10,200,000} - \text{\$0} = \text{\$10,200,000}$$ Mr. Smith would be ordered to disgorge \$10,200,000. These funds would then be sought to be returned to the defrauded investors.

Practical Applications

Disgorgement is a critical tool in the enforcement arsenal of financial regulators, designed to reinforce fair practices and maintain confidence in the financial markets. Its practical applications are evident across various domains of finance and law:

• Securities Law Enforcement: The U.S. Securities and Exchange Commission (SEC) is a primary user of disgorgement, applying it in cases of securities fraud, insider trading, and other violations of federal securities laws. For instance, the SEC frequently seeks disgorgement to recover profits gained from illicit trading activities or schemes that defraud investors. In 2020, the SEC's Enforcement Division reported that it obtained judgments and orders of disgorgement totaling nearly $4.7 billion.²⁰ The SEC outlines its approach to determining appropriate remedies, including disgorgement, to ensure that wrongdoers do not profit from their illegal conduct. SEC.gov: How the SEC Determines Remedies
• Breach of Fiduciary Duty: In situations where an individual or entity breaches a fiduciary duty and profits from it, disgorgement may be ordered to compel them to return those gains. This is common in cases where a trusted advisor misuses client assets for personal benefit.
• Anti-Trust Violations: While less common than in securities cases, disgorgement can also be applied in anti-trust cases to recover profits obtained through anti-competitive practices, aiming to restore market fairness.
• Contract Disputes: In specific instances of contract breaches where one party unjustly benefits at the expense of another, courts may order disgorgement to prevent unjust enrichment.¹⁹
• Foreign Corrupt Practices Act (FCPA) Violations: The SEC and the Department of Justice frequently seek disgorgement in cases where companies or individuals have made improper payments to foreign officials to obtain or retain business.¹⁸

These applications underscore disgorgement's role in deterring illicit gains and protecting the integrity of financial dealings. For instance, a recent Reuters article detailed a court order for disgorgement against an investment adviser, emphasizing the ongoing use of this remedy by the SEC. Reuters: SEC gets $1.9 bln win in disgorgement case against investment adviser

Limitations and Criticisms

Despite its importance as a legal remedy, disgorgement faces certain limitations and criticisms, primarily concerning its practical application and the extent of its reach.

One key limitation stems from the distinction between disgorgement as a remedial measure versus a punitive one. While intended to prevent unjust enrichment and return ill-gotten gains, the U.S. Supreme Court's Kokesh v. SEC decision in 2017 classified it as a "penalty" for statute of limitations purposes.¹⁷ This ruling cast a shadow over the SEC's long-standing practice and led to questions about whether courts truly possessed the authority to order disgorgement as an equitable remedy without explicit statutory authorization.¹⁶ Although the subsequent Liu v. SEC ruling largely affirmed the SEC's power, it established that disgorgement awards must be limited to a wrongdoer's net profits and ideally be returned to identifiable victims.¹⁵ This "net profits" limitation means that legitimate business expenses incurred, even within the context of an illicit scheme, might be deductible from the gross revenue, potentially reducing the amount recovered.¹⁴

Another criticism revolves around the practical challenges of calculating the exact amount of ill-gotten gains. Determining the "net profits" can be a complex accounting exercise, especially in elaborate fraud schemes or when multiple parties are involved.¹³ Critics argue that the institutional setup can encourage the "privatization of gains while socializing losses," making fair and full disgorgement difficult to achieve in practice.

Furthermore, questions have been raised regarding cases where it is difficult to identify specific victims who have suffered direct pecuniary harm. A recent Second Circuit ruling, Securities and Exchange Commission v. Govil, held that the SEC is not entitled to disgorgement unless it can show that allegedly defrauded investors suffered pecuniary harm.¹² This decision could significantly impact the SEC's ability to seek disgorgement in certain regulatory violations that do not result in obvious financial harm to investors, such as offering securities without registration.¹¹ The evolving legal landscape surrounding disgorgement highlights ongoing debates about its appropriate scope and implementation. The Financial Times has covered some of the challenges faced by regulators in recouping funds from wrongdoers. Financial Times: Why it's so hard for regulators to recoup funds from wrongdoers

Disgorgement vs. Restitution

While both disgorgement and restitution are legal remedies aimed at rectifying financial wrongs, they differ fundamentally in their focus and application.

Disgorgement centers on the wrongdoer's gains, compelling them to surrender any profits derived from illegal or unethical conduct, regardless of the victim's actual losses. The purpose of disgorgement is to prevent unjust enrichment and deter future misconduct by ensuring that no one profits from illicit activities. It focuses on the defendant's benefit.⁹, ¹⁰

In contrast, restitution focuses on the victim's losses, aiming to restore the injured party to the position they were in before the harm occurred. Restitution seeks to compensate for damages suffered, making the victim "whole" again. It directly addresses the plaintiff's deprivation.⁷, ⁸

The distinction is crucial: disgorgement can be ordered even if the victim suffered no direct financial damages, as long as the wrongdoer obtained a benefit. For example, if an insider trades on non-public information and makes a profit, they may be ordered to disgorge those profits, even if their actions didn't directly cause a measurable loss to a specific investor. Restitution, however, requires a demonstrable loss to the plaintiff that corresponds to the defendant's gain.⁶ While both serve as equitable remedies, disgorgement targets the wrongdoer's illicit profits, whereas restitution seeks to compensate the victim for their losses.⁵

FAQs

What types of financial misconduct commonly lead to disgorgement?

Disgorgement is frequently ordered in cases involving securities fraud, insider trading, embezzlement, and violations of the Foreign Corrupt Practices Act (FCPA). These are instances where individuals or entities have gained illicit profits through deception or illegal means.⁴

Is disgorgement considered a punishment?

No, disgorgement is generally considered an equitable relief or remedial action, not a punitive one. Its primary goal is to strip wrongdoers of their ill-gotten gains and return those funds to the victims or the appropriate authority, preventing unjust enrichment. It is not intended to inflict additional punishment beyond recovering the illicit profits.³

How are disgorged funds distributed?

When possible and appropriate, disgorged funds are typically returned to the investors or parties who were harmed by the illegal activities. The Securities and Exchange Commission (SEC), for example, prepares disgorgement plans to identify injured investors and distribute the collected funds to them.¹, ²

What is the difference between disgorgement and a civil penalty?

Disgorgement seeks to recover the specific profits gained through illegal acts, aiming to prevent the wrongdoer from benefiting from their misconduct. A civil penalty, on the other hand, is a fine imposed as a punishment for violating a law or regulation, and its amount is often determined by the severity of the violation, not necessarily tied to the actual profits gained. Both can be ordered in addition to each other in enforcement actions.