One Question Answered, Others Left Open
In a recent Supreme Court decision, the nation’s highest court limits the SEC’s power to recover ill-gotten gains. It’s a seeming victory for Wall Street and a blow to regulatory authorities’ enforcement powers. But, as Tom Fox discusses, this decision raises more questions than it answers.
This article was republished with permission from Tom Fox’s FCPA Compliance and Ethics Blog.
In the case of Kokesh v. SEC, the U.S. Supreme Court held that profit disgorgements operate as a penalty under the Securities and Exchange Act of 1934, as amended. As such, “any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued.” The position of the Securities and Exchange Commission (SEC) at the Supreme Court and in all other matters involving this issue was that profit disgorgements were not punitive, hence not a penalty, but rather remedial in nature, so the SEC could clawback all monies generated as a result of the illegal action.
The decision, authored by Justice Sotomayor, was a 9-0 opinion which, in the rarified world of Supreme Court decisions, is about as clear a message as one can get. The Court first determined that profit disgorgement met the definition of a “penalty” on two conditions: “First, whether a sanction represents a penalty turns in part on ‘whether the wrong sought to be redressed is a wrong to the public, or a wrong to the individual.’ Second, a pecuniary sanction operates as a penalty if it is sought ‘for the purpose of punishment, and to deter others from offending in like manner’ rather than to compensate victims.” [citations omitted] Thus, if a statute provided a compensatory remedy for a private wrong, it should not be characterized as penalty.
Under this definition, profit disgorgement is a penalty for three reasons. First, “SEC disgorgement is imposed by the courts as a consequence for violating public laws (i.e., a violation committed against the United States rather than an aggrieved individual). Second, SEC disgorgement is imposed for punitive purposes. Sanctions imposed for the purpose of deterring infractions of public laws are inherently punitive because ‘deterrence [is] not [a] legitimate non-punitive governmental objectiv[e].'” [citations omitted] Finally, when a defendant “is made to pay a non-compensatory sanction to the government as a consequence of a legal violation, the payment operates as a penalty.”
This decision has significant impact on Foreign Corrupt Practices Act (FCPA) enforcement actions brought by the SEC going forward. There have been massive monies paid out by corporations as profit disgorgement back to the government. The FCPA Blog has kept a running tally of the Top 10 Disgorgement Amounts, and its most recent list was as follows:
- Siemens, $350 million in 2008
- Teva, $236 million in 2016
- Och-Ziff, $199 million in 2016
- KBR, $177 million in 2009
- VimpelCom, $167.5 million in 2016
- Alcoa, $161 million in 2014
- Total S.A., $153 million in 2013
- JPMorgan Chase, $130.5 million in 2016
- Snamprogetti, $125 million in 2010
- Technip, $98 million in 2010
Clearly, the numbers can be massive for this type of damage alone. However, what is not known from simply reviewing this list is how much of these damages arose from conduct more than five years before the enforcement action was brought. Moreover, as noted by Kevin LaCroix writing in the D&O Diary, “The Court’s unanimous decision should provide future defendants with greater certainty about the scope of their potential liability and spare them having to litigate issues relating to long-past conduct. The Court’s ruling should also reduce the potential monetary recoveries available to the SEC through its use of disgorgement claims. In some instances, the operation of the statute of limitations could make the availability of the disgorgement remedy entirely unavailable.”
Yet there were other issues raised in the Supreme Court’s opinion which in turn raise issues for a Chief Compliance Officer (CCO), compliance practitioner or counsel advising a company on potential damages from a FCPA violation. Justice Sotomayor disagreed with the SEC’s position that “disgorgement is not punitive but ‘remedial’ in that it ‘lessen[s] the effects of a violation’ by ‘restor[ing] the status quo.'” Most interestingly, it was due to the fact that the SEC has required disgorgement which “sometimes exceeds the profits gained as a result of the violation.” This is when the SEC obtains disgorgement “without consideration of a defendants expenses that reduced the amount of illegal profit.”
The Court went on to explain, a “defendant is entitled to a deduction for all marginal costs incurred in producing the revenues that are subject to disgorgement. Denial of an otherwise appropriate deduction, by making the defendant liable in excess of net gains, results in a punitive sanction that the law of restitution normally attempts to avoid.” In such cases, profit disgorgement did not return the status quo, but left the defendant “worse off.”
This last point brings up a couple of additional issues for consideration. The first is the ongoing debate about what, if any, portion of an FCPA fine and penalty is deductible. Miller & Chevalier Chartered, in a client alert entitled “Disgorgements of Profits in FCPA Cases: Deductions for Tax Purposes,” discussed a 2016 Internal Revenue Service (IRS) Memorandum regarding the tax deductibility of certain FCPA settlements which included profit disgorgement. The Supreme Court opinion makes clear that profit disgorgement is a penalty damage and not compensatory. Under the IRS position, penalties are not deductible. Kokesh would seem to end the taxpayer position that such damages are deductible.
However, the IRS Memorandum and the Supreme Court decision leave open the question of whether pre-judgment interest assessed on profit disgorgement is deductible. Equally interesting is the question of a defendant’s properly deductible business costs in creating the ill-gotten profit that becomes the subject of a disgorgement order. The Supreme Court’s discussion of this issue may give rise to both new scrutiny in the overall amount assigned to disgorgement and – if there are no deductions granted by the SEC in its negotiation with a defendant – whether that defendant may seek deductions under the tax code.
Another issue raised by the Kokesh decision is profit disgorgement under the FCPA Pilot Program for companies not subject to the jurisdiction of the SEC. Daniel Patrick Wendt, writing in an FCPA Blog piece entitled “Are those DOJ disgorgements really disgorgement?,” raised the issue around two cases from last year, HMT LLC and NCH Corporation, in which the parties received declinations based upon the criteria laid out in the Pilot Program, yet the “DOJ and the two companies established a predicate for disgorgement. They agreed to a brief statement of facts indicating each company had violated the FCPA’s anti-bribery provisions and that it had received profits from those violations. This sounds like disgorgement.” In the HMT matter, the declination read, “HMT agrees to disgorge $2,719,412 (the ‘Disgorgement Amount’), which represents the profit to HMT from the illegally obtained sales in Venezuela and China.” In the NCH matter, the declination read, “NCH agrees to disgorge $335,342 (the ‘Disgorgement Amount’), which represents the profit to NCH from the illegally obtained sales in China.”
Wendt contrasted the position of the DOJ – which held that any payment under the Pilot Program was punitive in nature – with that of the SEC, which held that disgorgement was compensatory and, therefore, subject to deductibility. This distinction may now be gone with the dicta and companies may now seek deductions from disgorgements whether assessed by the DOJ or SEC.
Regardless of the Kokesh decision’s impact on IRS or DOJ rules on deductions, the case makes this clear: conduct that occurs more than five years prior to the date the matter is brought cannot be the subject of profit disgorgement. This decision strengthens the hand of companies in their negotiations with the SEC and DOJ. It could also lead to a change the calculus around the decision to self-disclose.
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