Court ruling ties SEC’s hands over investor fraud
New restrictions on regulator’s power to force fraudsters to repay illegal gains will affect victims of insider trading
US regulators face new restrictions on their powers to force fraudsters to repay illegal gains after a Supreme Court ruling that will affect victims of insider trading, market manipulation and accounting fraud.
The Securities and Exchange Commission wins disgorgement orders — repayments from wrongdoers — worth more than a billion dollars a year from federal courts. The SEC can also impose fines as punishment.
The Supreme Court ruled in a case known as Liu vs SEC that the regulator should return disgorged funds to investors that have suffered harm rather than send this money to the US Treasury.
Identifying victims that have been directly harmed can be difficult, particularly if they are individual investors in pooled vehicles, such as mutual funds, affected by scams including insider trading.
“The impact on disgorgement in insider trading cases, in particular, will be hotly debated. Victims of insider trading are typically difficult to identify and thus unlikely to receive any disgorgement award that the SEC distributes,” said Charles Clark, a partner at the lawyers Schulte Roth & Zabel.
New avenues for defendants to challenge cases brought by the SEC have been opened by the Supreme Court, which ruled that disgorgement awards should not exceed a wrongdoer’s net profits. Legitimate business expenses must be deducted from any repayments. But the question of when business expenses are “legitimate” remains unclear and will be contested in future cases brought by the SEC.
In addition, a defendant cannot be held liable for any trading profits earned illegally by others. This raises questions about so-called “tipper-tippee” relationships, where a defendant has passed on sensitive information but did not profit directly from unlawful behaviour.
“The Liu ruling will fundamentally reshape the amount the SEC can obtain as disgorgement in enforcement actions,” said Mr Clarke, who led the investigation into the Enron scandal as a senior member of the SEC’s division of enforcement.
Anthony Kelly, a partner at Dechert, said the SEC would “need to rethink” its approach if it was no longer able to send money to the Treasury or to clearly identify wronged investors.
“There are questions if a victim even exists in cases involving insider trading or the foreign corrupt practices act,” said Mr Kelly.
One remedy might involve paying any disgorgements to an investment fund or the manager of a pooled vehicle.
“If the offence happened in the past, this approach raises the question of whether newer investors are receiving a windfall payment instead of the victims being compensated,” said Mr Kelly, a former co-chief of the SEC enforcement division’s asset management unit.
The SEC also uses disgorgement awards to pay whistleblowers that help the regulator to investigate crimes. It has paid more than $500m to whistleblowers but the Supreme Court ruling casts doubt over whether these awards benefit wronged investors.
“It would be a blow to the SEC if it lost the ability to use disgorged funds to issue awards designed to create financial incentives for whistleblowers to come forward,” said Susan Hurd of Alston & Bird.