On 5 June 2017, a unanimous United States Supreme Court issued its eagerly anticipated opinion in Kokesh v. SEC, No. 16-529 (US 5 June 2017). In the opinion, the Court held that disgorgement operates as a penalty, rather than an equitable remedy, in the context of enforcement actions brought by the US Securities and Exchange Commission (SEC). To date, taxpayers have typically been able to argue, successfully, that disgorgement payments are deductible under 26 U.S.C. section 162, despite section 162(f)'s disallowance of deductions for "fines or similar penalties." In deeming disgorgements as penalties, the Supreme Court in Kokesh has placed the deductibility of disgorgement payments in doubt.
The SEC has long used disgorgement as a basis for securing the return on "ill-gotten gains" or improperly obtained profits earned by wrongdoers as a result of federal securities laws violations, including in instances where the conduct extended beyond the five-year statute of limitations set forth in 28 U.S.C. section 2462 for fines and penalties in SEC enforcement cases. Unlike restitution, which focuses on making the victims of a crime whole, the SEC's claim had been that disgorgement focuses on depriving the wrongdoer of gains it would not have enjoyed but for the illegal conduct, and, therefore, disgorgement preserved the status quo and wasn't punitive. Prior to the Court's decision in Kokesh, the SEC had argued — and many courts had agreed — that disgorgement was an equitable remedy not subject to section 2462, which states that any "action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued [. . . ]" Most lower courts agreed with the SEC's position. See, e.g., Riordan v. SEC, 627 F.3d 1230, 1234 (D.C. Cir. 2010); SEC v. Rind, 991 F.2d 1486, 1491-91 (9th Cir. 1993).
In May 2016, however, the US Court of Appeals for the Eleventh Circuit reached a different outcome in SEC v. Graham, 823 F.3d 1357, 1363-64 (11th Cir. 2016). The Graham court held that the five-year statute of limitations in section 2462 applies to SEC claims for disgorgement because "the remedy of disgorgement is a 'forfeiture'" for purposes of section 2462. While the SEC had argued that disgorgement differs from forfeiture, the court held that, even under the SEC's definition, "disgorgement is imposed as redress for wrongdoing and can be considered a subset of forfeiture." A number of courts subsequently rejected the Graham court's holding, including the US District Court for the Eastern District of New York and the US District Court for the Southern District of New York.
On 23 August 2016, the Tenth Circuit in SEC v. Kokesh, 834 F.3d 1158 (10th Cir. 2016), also rejected the Graham court's holding, instead holding that disgorgement is not subject to the five-year statute of limitations, as it is an equitable remedy. See id. at 1164-67. In so doing, the Tenth Circuit explicitly rejected the Graham court's interpretation of disgorgement as a "forfeiture," and instead held that disgorgement is neither a penalty nor a forfeiture within the meaning of section 2462. See id.
Following the Tenth Circuit's decision, the Supreme Court granted certiorari in Kokesh.
The Kokesh Opinion
The SEC argued that, in seeking disgorgement, "it act[ed] in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties." Kokesh v. SEC, Brief for the United States at 22. Thus, the SEC claimed, disgorgement is not intended to punish, but, rather, to return the wrongdoer to the status quo prior to the violation.
In holding against the SEC, the Supreme Court unanimously rejected that view, noting that, as the SEC's disgorgement orders go beyond the compensation of wronged investors and are, by contrast, intended to punish and label defendants wrongdoers, they constitute a penalty subject to the five-year standard of limitations. See Kokesh, slip op. at 11. Specifically, the Court held that "[b]ecause disgorgement orders 'go beyond compensation, are intended to punish, and label defendants wrongdoers' as a consequence of violating public laws, Gabelli, 568 US, at 451-452 (2015), they represent a penalty and thus fall within the 5-year statute of limitations of § 2462." See id. Citing Huntington v. Attrill, 146 US 657 (1892), the Court based its holding on a two-prong test for determining what constitutes a penalty. First, it asked whether the sanction sought to remedy a public wrong or a wrong against an individual. See Kokesh at 5-6. Second, it asked if the purpose of the disgorgement was to punish and deter others from engaging in the same wrongdoing or to compensate victims. See id. at 6.
Applying the Huntington test, the Court held that SEC disgorgement constitutes a penalty under section 2462. See id. at 11. As to the first Huntington prong, the Court noted that SEC disgorgement targets violations "committed against the United States rather than an aggrieved individual," and explained that this targeting explains why securities enforcement actions may proceed without the actual victims supporting or participating in the prosecution. Id. at 7-8. Turning to the second Huntington prong, the Court held that "SEC disgorgement is imposed for punitive purposes," because a principal purpose of disgorgement is deterrence. Id. at 8. The Court further observed that "SEC disgorgement sometimes exceeds the profits gained as a result of the violation," and that "SEC disgorgement sometimes is ordered without consideration of a defendant's expenses that reduced the amount of illegal profit." Id. at 10. Citing decisions from the Second and Ninth Circuits, the Court noted that deterrence is a major objective of disgorgement, and held that "[s]anctions imposed for the purpose of deterring infractions of public laws are inherently punitive." Id. (citing Bell v. Wolfish, 441 US 520, 539, n. 20 (1979); United States v. Bajakian, 524 US 321, 329 (1998)).
The Court provided additional rationale for its finding that disgorgement is punitive, noting that SEC disgorgement is not always compensatory in nature. Although district courts occasionally distribute disgorgement funds to victims, the Court observed, "such compensation is distinctly a secondary goal" Id. at 9 (quoting SEC v. Fischbach Corp., 133 F.3d 170, 175). The Court further noted that disgorgement is punitive because the SEC does not consider defendants' expenses in calculating disgorgement (which can be high in U.S. Foreign Corrupt Practices Act ("FCPA") and other securities cases given the complexity of the cases), thereby leaving the defendant worse off than the status quo. See Kokesh at 10.
Notably, however, the Court did not find that disgorgement must, by definition, constitute a penalty in every case. Despite agreeing with the Eleventh Circuit in limiting the use of disgorgement by the five-year statute of limitations, the Court did not agree with the Eleventh Circuit's reasoning in SEC v. Graham, 823 F.3d 1357 (11th Cir. 2016), which held that disgorgement was included within the meaning of "forfeiture" and limited the breadth of its ruling, holding that "[d]isgorgement, as it is applied in SEC enforcement proceedings, operates as a penalty under § 2462." Id. at 11. (Emphasis added.)
By so limiting its holding, the Court's opinion in Kokesh does not affect all other disgorgement-related jurisprudence. Thus, the Court has left open a path for the SEC to continue to use disgorgement and have that use construed instead as an equitable remedy if the SEC can meet the test set forth in Kokesh. First, the SEC can no longer stand in the shoes of the public at large, but must instead act on behalf of the victims and compensate the victims, rather than the United States Treasury, from the disgorgement. In so doing, the SEC may successfully contend that disgorgements reflect mere compensation to aggrieved individuals and are, thus, non-punitive in nature. Second, the SEC will have to consider defendants' expenses in calculating disgorgements. Third, the SEC must not
use disgorgements to "label defendants wrongdoers."
Impact on Taxpayers
While taxpayers generally may claim a deduction of certain ordinary and necessary expenses under section 162, section 162(f) disallows a deduction "for any fine or similar penalty paid to a government for the violation of any law." The Tax Court has previously found that disgorgement as applied in SEC proceedings is not a penalty paid to the government within the meaning of section 162(f). See, e.g., Wang, T.C. Memo. 1998-389 (Nov. 2, 1998). In an Internal Legal Memorandum released in May 2016, however, the IRS concluded that the disgorgement of profits made under a consent agreement between the SEC and the taxpayer for civil violations of the FCPA is punitive in nature and, thus, section 162(f) prohibits a deduction for such disgorgement payments. See I.R.S. Legal Memorandum 2016-19-008 (May 6, 2016).
By deeming disgorgements of profits as penalties rather than as equitable remedies, the Supreme Court in Kokesh has blessed the IRS's position that disgorgement payments, at least insofar as the SEC currently applies disgorgements in the context of its enforcement proceedings, are non-deductible under section 162(f). Given this ruling, we expect that US courts will now consider such disgorgement payments as penalties and thus as non-deductible under section 162(f).
As noted above, the SEC may, in the future, amend its disgorgement practices to comply with the test set forth in Kokesh. Until that time, however, taxpayers should take caution in entering into consent agreements or settlements with the SEC regarding the disgorgement of profits for civil violations of the FCPA, as courts will likely now disallow deductions claimed for disgorgement payments in light of the Supreme Court's opinion. Taxpayers, further, are now unlikely to receive favorable treatment of such claimed deductions at Exam or Appeals.