Securities Fraud: How the SEC Calculates Ill-Gotten Gains in Disgorgement Actions
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Securities Fraud: How the SEC Calculates Ill-Gotten Gains in Disgorgement Actions
Securities fraud is a big problem that can hurt a lot of investors. The SEC tries to stop it and make fraudsters give back any money they got illegally. This article explains how the SEC calculates the amount fraudsters have to pay back, called “disgorgement.”
The SEC’s job is to protect investors. When someone commits securities fraud, like insider trading or accounting fraud, the SEC steps in. They want to make sure any money the fraudster made unfairly gets paid back to victims.
What is Disgorgement?
Disgorgement is when a securities fraudster has to pay back their “ill-gotten gains.” This means all the money they made illegally from the fraud.
For example, say a CEO does insider trading and makes $1 million in illegal profits. The SEC would try to make them “disgorge” the full $1 million.
Courts have said disgorgement is meant to prevent fraudsters from profiting from their wrongdoing. It also deters future violations.
How the SEC Calculates Disgorgement
Figuring out how much money someone made from securities fraud can be tricky. The SEC has to prove what illegal profits were made and how much should be paid back. They use forensic accountants and financial analysts to study bank records, trading data, shell company transfers, etc.
According to law professor James Jalil, the SEC generally uses one of two methods:
- The amount lost by victims. This is common in Ponzi schemes where money from new investors went directly to pay fake returns to earlier investors.
- The fraudster’s actual profit. For example, how much they made from illegal insider trades or accounting manipulation.
The SEC aims to make the disgorgement amount match what the fraudster gained as closely as possible. They can’t just pick an arbitrary high number as punishment. Courts want disgorgement to be “reasonable approximation” of profits.
What Counts as Illegal Profit?
Things get messy when part of the fraudster’s profits came from legal activity. What if they used some ill-gotten money to make more legal investments?
According to attorney Mike Henning, the SEC tries to only disgorge the amount directly from illegal acts. But fraudsters often argue the SEC is overreaching.
For example, in an insider trading case, the fraudster may admit to making $500,000 on illegal trades. But if they reinvested that and made $2 million more through legal trading, should the disgorgement be $500,000 or $2.5 million?
Courts have gone both ways on this. The Supreme Court said disgorgement shouldn’t exceed the gains from the specific fraud. But also said all gains “attributable” to the fraud should count, even if reinvested.
How Are Victims Repaid?
The SEC tries to return disgorged funds to harmed investors through a “Fair Funds” program. This identifies victims and distributes money to repay losses.
For example, after the Bernie Madoff Ponzi scheme, the SEC collected over $13 billion in disgorgement and penalties. This went to a Fair Fund that has steadily paid back Madoff’s thousands of victims.
But Fair Funds don’t always succeed. Some schemes have too many victims to identify. Or the money can’t be evenly distributed. Critics say the funds also benefit investors who weren’t directly harmed.
What About Penalties?
On top of disgorgement, the SEC often imposes civil penalties on securities fraudsters. These penalties go to the U.S. Treasury, not victims.
Penalties are meant to punish fraudsters above and beyond repaying their illegal profits. Critics argue penalties have become “draconian” and “excessive.” But the SEC says they’re a key deterrent against white-collar crime.
The Bottom Line
Disgorgement aims to achieve two goals: 1) Take away all ill-gotten gains from securities fraud; and 2) Repay harmed investors whenever possible. Calculating the exact amount can get murky with complex schemes involving both legal and illegal activities.
The SEC has broad powers to recover funds for victims of securities fraud. But the disgorgement remedy remains controversial, especially when amounts exceed direct illegal profits. Still, it remains one of the main tools for combating securities fraud and recouping losses.
References
Jalil, James. “How the SEC Calculates Disgorgement.” Fordham Law Review.
Henning, Mike. “Disgorgement: The Devil Is In the Details.” The CLS Blue Sky Blog.
Kokesh v. SEC. Supreme Court of the United States.