Nearing the end of its spring term, the US Supreme Court handed down a vital securities enforcement ruling yesterday, holding that the SEC can continue to collect 'disgorgement' as a form of equitable relief. However, the justices limited disgorgement to the net profits at issue. In this article we interview Nicholas Morgan, a partner at the US law firm of Paul Hastings (pictured) on the subject.

Morgan once served as a senior trial counsel at the Securities and Exchange Commission’s Division of Enforcement and has followed the case of Liu v SEC through from the trial stage to the appeal process. The case centres around the concept of disgorgement, the process by which a court orders a financial firm to repay its ill-gotten gains to its victims.

The rest of this article is in the form of a question-and-answer session.

Q: The court decided that the SEC can continue to collect disgorgement as a form of equitable relief. What does this mean?

A: Disgorgement looks at the benefits that the recalcitrant firm has received and it's a civil matter, not a criminal one. The court pointed out that in most cases the SEC does not give the money to the victims. When that happens, the disgorgement looks less like an equitable remedy than it ought to. An extreme example of this might be disgorgement after a firm has been found to have facilitated insider trading. In such a case it's usually difficult to find an actual victim, beyond the market at large, so instead of giving it to a victim the SEC hands it over to the US Treasury.

There are two other important aspects to the Liu ruling: (i) the court says that the money has to go to some victims; and (ii) the issue of net profits. The court said that when the SEC seeks to make a firm disgorge the gross profits that it received as opposed to netting out expenses, the remedy looks less like an equitable remedy than it ought to. You need to net out expenses.

Q: Did the judgment say that firms can deduct remediation costs? And in this case, is remediation the process of putting it right?

A: Yes. It is important to note that the disgorgement can only apply to the monies received by this particular defendant, the defendant in the case. Let us look once again at the example of insider trading. I'm the tipster. I tell you some juicy information that implies that somebody's stock is about to rise. You trade, you make money. The SEC then tries to force me to disgorge the profits that you received. This happens all the time - the SEC seeks to force the tipster to disgorge the profits that the other person received.

Q: So have they been going ultra vires all the time?

A: They have. Now, the SEC can only demand the disgorgement of money that the perpetrator received.

Q: The case comes three years after the Supreme Court ruled in Kokesh v SEC. What is the story behind that?

A: Before Kokesh there was no rule for how long the SEC has to bring a case. Now, thanks to that case, it only has five years on from the date of commission of the offence. Kokesh said that the SEC can only wait five years after the conduct. After that, it can no longer get disgorgement. For decades before Kokesh, the SEC pretended that the five years mentioned in the statute didn't apply to disgorgement. The Supreme Court said 'wrong!' It said that because disgorgement is often more of a penalty than it is a required remedy, the SEC cannot talk as though it is a required remedy.

Justice Sotomayor raised the possibility during Kokesh: can we be sure that the SEC has the ability to require disgorgement? The present case, therefore, was a case that everyone was waiting for. The Supreme Court's answer to the question was "yes it is, but with limitations."

Q: So this case happened because she wanted it to?

A: Yes it did.

Q: The Supreme Court held that disgorgement is a penalty rather than a remediation and that the SEC had expanded it to include gains instead of just profits or compensation. What is the important point here?

A: The court said that the SEC can impose disgorgement as long as it's equitable. It pointed out limitations on a court's powers to impose disgorgement. It looks more like a penalty and less like an equitable remedy if the SEC does those three things we talked about. So in the present case, the court starts out by giving the SEC a win: yes, you can seek remediation as an equitable remedy. They win on the threshold issue but it only looks like that when it's not being punitive.