Calculating SEC Disgorgement and Civil Penalties

Calculating SEC Disgorgement and Civil Penalties

What is the SEC?

The Securities and Exchange Commission, or SEC, is the primary regulator and enforcer of U.S. securities laws. The SEC is an independent federal government agency responsible for protecting investors, maintaining fair and efficient markets, and facilitating capital formation. It was created by Congress in 1934 after the stock market crash of 1929 and the ensuing Great Depression. The SEC’s mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. It achieves this through regulation, rulemaking, oversight, and enforcement actions.

The SEC oversees key participants in the securities markets, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. It requires public companies to disclose meaningful financial and other information to the public. This provides investors with the data they need to make informed investment decisions.

When companies or individuals violate securities laws and regulations, the SEC can bring civil enforcement actions seeking sanctions like fines, disgorgement of ill-gotten gains, and civil penalties. The SEC works to promote compliance while also punishing securities law violations through enforcement actions. This deters wrongdoing and returns funds to harmed investors when possible.

Disgorgement of Ill-Gotten Gains

Disgorgement is an equitable remedy designed to prevent wrongdoers from profiting from illegal conduct. The Supreme Court has recognized disgorgement as an appropriate equitable remedy within the SEC’s authority in cases like SEC v. Texas Gulf Sulphur Co. and SEC v. First City Financial Corp.

However, in Kokesh v. SEC, the Supreme Court held that SEC disgorgement operates as a penalty for purposes of the five-year statute of limitations under 28 U.S.C. §2462. This potentially limits the SEC’s ability to reach far back in seeking disgorgement.

The SEC frequently seeks disgorgement of all ill-gotten gains received as a result of securities law violations. This is meant to deprive violators of their unlawful profits and prevent unjust enrichment. Ill-gotten gains subject to disgorgement may include, but aren’t limited to:

• Profits obtained from fraudulent schemes like Ponzi schemes or affinity fraud
• Gains resulting from manipulative trading practices like spoofing or layering
• Benefits derived from misappropriating and trading on confidential information in violation of insider trading laws

Courts have recognized that determining precise disgorgement amounts can be difficult. As a result, disgorgement calculations need only be a reasonable approximation of illegal profits. Common approaches include:

• Calculating gains from specific unlawful transactions identified by the SEC
• Estimating gains based on patterns of suspicious trading volume and timing
• Using statistical sampling of transactions to infer total gains from misconduct

The SEC may also seek pre-judgment interest on disgorgement amounts to fully deprive violators of wrongful gains. Interest is calculated using IRS underpayment rates and accrues from the date of the violation under SEC v. Moran.

Tiered Civil Penalty Amounts

In addition to disgorgement, the SEC frequently imposes civil monetary penalties under the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (“Remedies Act”). The Remedies Act established tiered penalty amounts based on the severity of the violation:

• Tier 1 penalties apply to violations that did not result in direct investor harm. Maximum tier 1 penalties are currently $9,239 for individuals and $92,383 for companies.
• Tier 2 penalties apply to violations that did involve some harm to investors through unjust enrichment. Maximum tier 2 penalties are currently $92,383 for individuals and $461,917 for companies.
• Tier 3 penalties apply to violations that directly or indirectly resulted in substantial losses or created significant risk of loss to investors. Maximum tier 3 penalties are currently $184,767 for individuals and $923,831 for companies.

Penalties are assessed per violation, so total penalties can quickly multiply for ongoing misconduct. However, maximum penalties per proceeding are limited to the greater of the gross pecuniary gain from the violations or a specified dollar ceiling. The current ceiling is $184,767 for individuals and $923,831 for companies.

Factors Considered in Calculating Penalties

The SEC considers several factors when determining appropriate civil penalties within the maximum tiers described above as laid out in the Remedies Act. Key considerations include:

• The egregiousness of the defendant’s conduct
• The degree of the defendant’s scienter i.e. intent to defraud
• Whether the conduct created substantial losses or risk of losses to investors
• Whether the conduct was isolated or recurrent
• Whether the defendant has admitted wrongdoing and cooperated
• The defendant’s financial condition and ability to pay

The SEC may reduce penalties based on cooperation and remediation. However, penalties are rarely waived entirely even for cooperative defendants. The SEC remains focused on deterrence and preventing unjust enrichment.

Mitigating Financial Hardship Arguments

Defendants often argue financial hardship when facing SEC disgorgement and civil penalties. However, courts generally give hardship arguments limited weight, especially from corporate or high-net-worth defendants.

To successfully argue financial hardship and gain possible penalty reductions:

• Thoroughly document assets, liabilities, income, expenses, and net worth
• Emphasize good faith efforts to obtain legitimate employment and repay amounts owed
• Consider offering an extended installment payment plan