Reflections on <b><I>Kokesh v. SEC</I></b>

The relevant facts and case history are straightforward.

The SEC filed its civil action against Charles Kokesh, the owner of two investment advisers that advised business development companies, in October 2009. The Commission alleged that between 1995 and 2009, through his firms, Kokesh violated antifraud and other provisions of the federal securities laws by misappropriating $34.9 million from business development companies, and causing the filing of “false and misleading SEC reports and proxy statements.”

After a jury verdict in the SEC's favor, the court ordered Kokesh to pay a $2,354,593 civil monetary penalty, $34.9 million in disgorgement, and $18.1 million in prejudgment interest, calculated based on the disgorgement amount. The district court applied 28 U.S.C. § 2462's five-year limitations period to the civil monetary penalty, but agreed with the Commission that the statute of limitations did not apply to disgorgement because it was not a “penalty.”

On appeal, Kokesh argued that the disgorgement amount should have been only $5 million because the five-year statute of limitations in § 2462 also applied to disgorgement. But the U.S. Court of Appeals for the Tenth Circuit upheld the district court. The Tenth Circuit's opinion, which reflected the majority view among federal courts, created a split with the U.S. Court of Appeals for the Eleventh Circuit's decision in SEC v. Graham, 823 F.3d 1357, 1363 (11th Cir. 2016) (holding that disgorgement is a “forfeiture” under § 2462). The Supreme Court subsequently granted certiorari to resolve the circuit split. The Supreme Court unanimously and unambiguously reversed the appellate decision. Although the Court could have ruled narrowly by ruling that disgorgement as applied in this case constituted a penalty, it took a different approach by ruling much more broadly: “We hold that SEC disgorgement constitutes a penalty.” The Court also held that “the 5-year statute of limitations in §2462 therefore applies when the SEC seeks disgorgement.”

The Court determined that three principles demonstrated that SEC disgorgement is a penalty within the meaning of § 2462.

• First, SEC disgorgement is imposed as a consequence for violations where the victim is the public at large, rather than an aggrieved individual.
• Second, SEC disgorgement's primary purpose is to deter future violations, which is inherently punitive.
• Third, SEC disgorgement does not directly compensate victims, because a court has discretion over whether disgorged funds will be distributed to harmed investors or transferred to the U.S. Treasury. As a result, the Court held, “[w]hen an individual is made to pay a noncompensatory sanction to the Government as a consequence of a legal violation, the payment operates as a penalty.”

The Court dismissed the Commission's argument that disgorgement is “remedial.” Because SEC disgorgement sometimes exceeds profits, the Court found that disgorgement in such cases “does not simply restore the status quo … [but] leaves the defendant worse off.” For example, the opinion noted that SEC disgorgement may not consider defendants' expenses that reduced illegal profits, and courts have ordered insider trading tipper defendants to disgorge the profits of their tippees, even though the tippers never received any profits. Thus, according to the Court, SEC disgorgement is not a remedy that simply returns defendants to their prior position, but rather goes beyond and penalizes defendants for their conduct.

Potential Ramifications

Most commentators have focused on Kokesh's impact on the SEC enforcement landscape. But as we describe here, the Supreme Court's ruling that “SEC disgorgement constitutes a penalty” has more far-reaching ramifications.

Can Defendants and Respondents Still Seek Indemnification or Insurance Coverage?

The SEC's standard settlement papers have long prohibited settling defendants from seeking or accepting reimbursement or indemnification for “penalties,” while staying silent on that topic with respect to disgorgement and pre-judgment interest. This issue can be particularly important to individual defendants, who often would not be able to afford to pay disgorgement without indemnification from their former employer, insurance company or some other source.

In the wake of Kokesh, there now is an argument that settling defendants may not be able to accept indemnification or insurance coverage for disgorgement without violating their agreement with the Commission. Indeed, within days after the Kokesh decision, counsel for a group of insurance companies argued that their policy did not require payment of penalties in a long-running dispute over coverage for disgorgement paid by Bear, Stearns & Co., Inc. for its 2006 market-timing settlement by the SEC.

As a result, counsel for individuals, companies and insurers will be evaluating their rights and obligations, and may consider seeking appropriate modifications to the language of governing documents, including SEC settlement documents, going forward.

Is Disgorgement Paid to a Government Deductible for U.S. Federal Tax Purposes?

Kokesh says absolutely nothing about taxation, but it may hold implications for the deductibility of certain payments to a government made pursuant to a court judgment or settlement. The Internal Revenue Code permits deductions of “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” 26 U.S.C.A. I.R.C. § 162(a). Payments made pursuant to court judgments or settlements in a business context generally satisfy the “ordinary and necessary” requirement of § 162(a) and may be deducted by the taxpayer. Section 162(f), however, imposes a limitation on deductions under § 162(a), stating that “no deduction shall be allowed … for any fine or similar penalty paid to the government for the violation of any law.” This limitation applies to actual fines and penalties, as well as to amounts “[p]aid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal).” Treas. Reg. § 1.162-21(b)(1)(iii).

Courts have wrestled with questions of what types of payments to a government are penal and nondeductible, as opposed to compensatory and deductible. A payment imposed by criminal statute will generally not be deductible, but a payment characterized in settlement documents as “compensation” or “restitution” likely will be deductible.

The proper treatment of a payment that is characterized as a forfeiture or disgorgement is less clear. The IRS Chief Counsel has recently opined that disgorgement in the securities context is sometimes compensatory and sometimes penal. Specifically, where the amount of the disgorgement equals the damages incurred by the victims of the illegal activity and the SEC uses the disgorgement to compensate those investors, the IRS recognized that SEC disgorgement might be compensatory.

On the other hand, where the disgorgement is intended to deprive the wrongdoer of illegal profits or deter future illegal conduct, it is more likely to be penal for tax purposes. Additional situations suggesting that disgorgement is penal include where a settlement agreement mandates that disgorged amounts paid by the government to harmed investors may not offset subsequent recoveries by those investors in civil suits against the wrongdoer, or where the disgorgement is imposed as a substitute for a civil penalty.

Last year, in Nacchio v. United States, the U.S. Court of Appeals for the Federal Circuit held that a payment required under a criminal forfeiture statute for violations of the securities laws was a fine or penalty within the meaning of § 162(f). Nacchio v. United States, 824 F.3d 1370, 1378 (Fed. Cir. 2016), cert. denied, 582 U.S. ___ (2017). In reaching this holding, the Federal Circuit cited two factors that the Supreme Court would cite in Kokesh. The Federal Circuit noted that although the government may direct forfeiture payments to the victims of a crime, this does not make forfeiture a species of compensation. First, whereas compensation is measured by the damages incurred by the victims, forfeiture is measured by the illicit gains to the perpetrator. Forfeitures may thus exceed or fall short of the amount necessary to compensate victims. Second, the Federal Circuit noted that even where the government subsequently distributes a forfeiture payment to victims of the criminal activity, the forfeiture is first and foremost a remedy for public harms, not private harms.

Because the Federal Circuit found these features of forfeiture to weigh against deductibility under § 162(a), the fact that the Supreme Court cited those same features in Kokesh as supporting the penal nature of disgorgement supports the likely conclusion that the Federal Circuit (and other courts of appeals) could use Kokesh to extend Nacchio and cases like it to deny the deduction of payments characterized as disgorgement. The IRS will undoubtedly be attuned to this possibility, and thus the implications of Kokesh and Nacchio remain to be seen.

Can Those Who Paid Disgorgement for Conduct Outside the Five-Year Statute of Limitations Get Money Back?

Based on Kokesh, defendants who previously litigated unsuccessfully against the SEC or settled enforcement actions likely will wonder whether they are entitled to recover disgorgement payments that they were ordered to make for conduct outside the five-year statute of limitations. The answer may depend on the forum in which the action was brought and whether the case was litigated or settled.

Federal Rule of Civil Procedure (FRCP) 60(b) permits courts to vacate final judgments when the judgment is “void” (FRCP 60(b)(4)), “based on an earlier judgment that has been reversed or vacated; or applying it prospectively is no longer equitable” (FRCP 60(b)(5)), or for “any other reason that justifies relief” (FRCP 60(b)(6)). Fed. R. Civ. P. 60(b)(4), (5) and (6). For recently litigated cases, parties can file a motion to alter or amend the judgment under FRCP 59(e) “no later than 28 days after the entry of the judgment.” Courts have discretion to grant such a motion due to changes in controlling law. SEC. v. Bilzerian, 729 F. Supp. 2d 9, 13 (D.D.C. 2010) (citing Firestone v. Firestone, 76 F.3d 1205, 1208 (D.C. Cir. 1996) (per curiam)).

Courts have held that Rule 60(b) is a “provision for extraordinary relief” and that “[t]he general purpose of Rule 60(b) is to strike a proper balance between the conflicting principles that litigation must be brought to an end and that justice must be done.” See SEC v. Holley, 2015 WL 5554788, at *3 (D.N.J. Sept. 21, 2015) (internal citations and quotations omitted). Although the case law is mixed on whether changes in the law due to Supreme Court decisions can qualify parties for relief under FRCP 60(b), some circuits appear to be more open to such an argument than others.

There is no direct counterpart to FRCP 60(b) in the SEC's Rules of Practice, which govern administrative proceedings. Defendants in litigated administrative proceedings may appeal an administrative law judge's decision to the Commission, file a motion for reconsideration of a final order issued by the Commission, and ultimately may seek judicial review of Commission orders. SEC Rule of Practice 410, 470, and 490. 17 CFR §§ 201.410, 470, and 490.

Of course, most SEC enforcement cases settle. While a proposed settlement of a district court action requires judicial approval and the entry of judgment that could be subject to FRCP 60(b), a defendant that wishes to resolve an administrative proceeding submits an offer of settlement that is either accepted or rejected by the Commission, with no requirement of federal court approval. Indeed, a defendant submitting an offer to settle an administrative proceeding waives, subject to Commission acceptance of the offer, “all post-hearing procedures” and “judicial review by any court.” SEC Rule of Practice 240, 17 CFR § 201.240.

In general, it may be more difficult for settling defendants to successfully pursue such a motion. In one recent case, a defendant who had settled an insider trading case sought to have his consent judgment vacated following the U.S. Court of Appeals for the Second Circuit's decision in U.S. v. Newman, et al. The U.S. District Court for the District of New Jersey held that the defendant had not demonstrated “a significant change in the law which makes legal the conduct for which Defendant accepted liability or that any intervening change in the law represented by the Newman decision represents an extraordinary circumstance justifying relief” from the judgment. See Holley, 2015 WL 5554788, at *5.

On the other hand, following Newman, the SEC did not oppose requests to have two hedge funds' settlements for insider trading violations vacated, allowing the return of $21.5 million in penalties and disgorgement to Level Global investors and $9 million in penalties and disgorgement to Diamondback Capital.

As a result, entities and individuals would be well-advised to consult with counsel to assess whether a prior disgorgement payment should be revisited in light of Kokesh.

Conclusion

While at first blush the Kokesh opinion seems relatively straightforward, the Court's ruling raises a number of complicated legal and strategic questions. It will take time to see how these issues play out, but entities and persons who either face an SEC investigation, previously were the subject of an SEC enforcement action, or have obligations to indemnify persons subject to an SEC action should consider consulting counsel to assess whether the decision impacts their rights and obligations.

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M. Alexander Koch and Dixie L. Johnson are partners in the Special Matters and Investigations group of King & Spalding LLP. Ms. Johnson co-leads the firm's Securities Enforcement and Regulation practice. Mr. Koch specializes in defending public companies, regulated entities, and individuals in government investigations, with a particular focus on securities enforcement.