Securities Fraud: How the SEC Calculates Disgorgement in Civil Cases

The Securities and Exchange Commission (SEC) frequently pursues disgorgement as an equitable remedy in civil enforcement actions alleging securities fraud. Disgorgement requires wrongdoers to give up – or disgorge – their ill-gotten gains obtained through fraudulent or illegal conduct. But how exactly does the SEC calculate disgorgement amounts? Recent court decisions have helped clarify and set some limitations around the SEC’s ability to obtain disgorgement.

Supreme Court’s Decision in Liu v. SEC

In 2020, the Supreme Court issued an important ruling in Liu v. SEC that placed constraints on the SEC’s disgorgement powers. Prior to Liu, courts often awarded the SEC disgorgement in the full amount of money raised by defendants through securities violations, without deducting legitimate business expenses.

But in Liu, the Supreme Court held that disgorgement amounts must be limited to a wrongdoer’s “net profits” – meaning revenues less legitimate expenses. The Court also said disgorgement must be “awarded for victims,” meaning paid out to harmed investors. So Liu seemed to require a more exacting analysis of expenses and profits connected to the fraud.

However, as discussed below, Liu’s impact has been blunted by lower courts continuing pre-Liu practices that provide the SEC flexibility in approximating net profits.

How Courts Calculate “Net Profits” after Liu

Despite Liu, courts today continue to use flexible approaches that often allow disgorgement based on the SEC’s reasonable estimates of net profits:

The “Reasonable Approximation” Standard

Courts still follow pre-Liu practice in ordering disgorgement amounts that are just a “reasonable approximation” of net profits tied to the securities violations. Even legitimate profits and expenses are sometimes disregarded under this analysis if they are deemed small enough.

Burden Shifting

Once the SEC shows a reasonable approximation of fraud-connected profits, the burden shifts to defendants to conclusively demonstrate that the figure does not reasonably approximate actual net profits. Given the difficulties defendants face in proving this, courts frequently accept the SEC’s profit estimates.

Blaming the Defendant

Courts often cite difficulties in calculating precise net profits as stemming from defendants’ own misconduct – such as poor record-keeping or commingling funds. This makes courts more prone to use a reasonable approximation standard for disgorgement amounts rather than scrutinize expenses and profits closely.

The “Entirely Fraudulent Entity” Exception

Courts also continue applying a pre-Liu exception that where the “entire profit of a business or undertaking” resulted from wrongdoing, defendants cannot deduct any business expenses. This exception is commonly applied when overarching misrepresentations underlie the whole business or offering.

Scrutinizing “Legitimate” Expenses

Moreover, even when deducting expenses, courts require defendants to show that claimed expenses have value independent of fueling the fraudulent scheme – such as marketing costs for fraudulent investments. Given difficulties meeting this burden, far fewer expenses tend to be deducted post-Liu.

So in many ways, while the Supreme Court in Liu seemed to mandate a more precise determination of actual net profits – in practice, courts have retained flexibility to award disgorgement based on reasonable estimates. And defendants still bear the burden of proving approximations unreasonable.

Recent Expansion of Disgorgement Powers

Beyond retention of pre-Liu flexibility, Congress has also expanded the SEC’s disgorgement authority to reduce limitations from Liu. Specifically, Liu required disgorgement be “awarded for victims” – meaning paid out to harmed investors. But in 2021, Congress amended the Securities Enforcement Remedies Act to allow courts to order disgorgement paid to the U.S. Treasury if returning funds to victims is impracticable.

This change allows disgorgement even absent identifiable victims – overriding Liu on that specific point. Already, an August 2022 federal court decision used this expanded authority to order $115,000 in disgorgement to the Treasury in an SEC action – despite lack of identifiable victims.

So Congress has provided extra momentum to SEC disgorgement efforts by reducing the need to identify victims and demonstrate investor harm.

Implications for Securities Fraud Defendants

The various developments above have maintained (or even expanded) the SEC’s powers to pursue disgorgement as an equitable remedy for securities fraud. Key implications for defendants include:

• Disproving the SEC’s reasonable approximation of net profits remains an uphill battle given courts’ burden-shifting framework. Thorough profit and loss evidence is essential.
• Entirely commingling fraudulent and legitimate funds risks triggering the “entirely fraudulent entity” exception – preventing deduction of any business expenses. Careful financial tracking is key.
• Even where expenses can be deducted, defendants must prove their complete independence from fueling the fraud scheme – a formidable challenge.
• The lack of identifiable victims or provable investor harm is less likely to preclude disgorgement after recent Congressional expansion of powers.

So despite Liu’s limits, flexibility retained by courts combined with expanded SEC authority have maintained disgorgement as a potent SEC remedy. Careful accounting and demonstrable separation of fraudulent profits is critical for defendants seeking to minimize disgorgement exposure. Consultation with securities litigation counsel can help assess disgorgement liability risk and craft arguments to reduce damages.