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"Kokesh, Lucia, and Their Impact on SEC Enforcement"


Two recent Supreme Court decisions addressing disgorgement and administrative law judges have significant negative implications for the SEC’s enforcement program. They also foreshadow a Court more willing to place limitations on the SEC’s enforcement efforts going forward.

In recent years, the United States Supreme Court has dealt two substantial blows to the Securities and Exchange Commission’s (SEC) enforcement efforts. In June 2017, the Supreme Court issued a unanimous opinion in Kokesh v. Securities and Exchange Commission, holding that the SEC’s disgorgement remedy constitutes a “penalty” and is therefore subject to a five-year statute of limitation. Approximately one year later, the Supreme Court issued an opinion in Lucia v. Securities and Exchange Commission, holding that the manner in which the SEC appointed its administrative law judges (ALJs) was unconstitutional. Both of these opinions have negative implications for the SEC’s enforcement efforts; the former substantially decreased the total damages the SEC can recover for securities law violations and the latter increased the SEC’s administrative burden related to certain enforcement actions. Apart from their immediate effects, these opinions, along with recent changes to the Supreme Court, foreshadow a Court more willing to place limitations on the SEC’s enforcement efforts moving forward.

Kokesh v. Securities and Exchange Commission


Initially, the only statutory remedy available to the SEC in an enforcement action was an injunction barring future violations of securities laws. Given this limited and oftentimes inadequate remedy, the SEC began petitioning courts to order parties who were found to have violated the securities laws to disgorge their ill-gotten gains, which courts began ordering in the 1970’s. The purpose of ordering disgorgement was twofold: to “deprive . . . defendants of their profits in order to remove any monetary reward for violating” securities laws and to “protect the investing public by providing an effective deterrent to future violations.” In 1990, Congress further strengthened the SEC’s enforcement remedies by passing the Securities Enforcement Remedies and Penny Stock Reform Act, which authorized the SEC to also seek civil penalties related to the violation of securities laws.

Despite its humble beginnings, the disgorgement remedy has evolved into one of the most imposing tools available to the SEC. Unlike civil penalties which are subject to a five-year statute of limitations, the SEC’s ability to collect disgorgement was not subject to a statute of limitations before Kokesh. As a result, potential disgorgement-based damages easily could reach epic proportions, which served as a powerful inducement for defendants to settle their disputes with the SEC. To put the magnitude of this remedy into perspective, the SEC obtained roughly $2.81 billion in disgorgement in fiscal year 2016 (as compared to roughly $1.27 billion in penalties) and roughly $2.96 billion in disgorgement in fiscal year 2017 (as compared to the roughly $832 million in penalties).

The Kokesh Opinion

In 2009, the SEC brought suit against an investment advisor named Charles Kokesh for allegedly using investment-adviser firms he owned to misappropriate approximately $34.9 million from clients between 1995 and 2005. In its lawsuit, the SEC requested disgorgement of the $34.9 million in mis- appropriated funds, a civil monetary penalty, and an injunction against Mr. Kokesh.

After the SEC prevailed at trial, the district court considered the SEC’s request for damages. The Court first held that the SEC’s attempt to impose penalties against Mr. Kokesh was subject to the five-year statute of limitations period set forth in 28 U.S.C. § 2462. As a result, the SEC was precluded from obtaining any penalties for misappropriation that occurred prior to October 27, 2004, which was exactly five years prior to the date the SEC filed its complaint. Therefore, Mr. Kokesh was ordered to pay approximately $2.3 million in penalties.

The district court agreed with the SEC that disgorgement was not a “penalty”.

However, when it came to disgorgement, the district court was of a different opinion. Specifically, the district court agreed with the SEC that disgorgement was not a “penalty” within the meaning of § 2462. As a result, the SEC’s disgorgement remedy was not subject to any limitations period, meaning that, for the purposes of calculating disgorgement, the court could reach back to 1995, which is when the misappropriation allegedly started to occur. The impact of this holding was draconian: it resulted in the imposition of an additional $29.9 million of damages and millions more in prejudgment interest that otherwise would have fallen outside of the five-year statute of limitations. All told, the Court ordered Mr. Kokesh to pay roughly $34.9 million in disgorgement, $18.1 million in prejudgment interest, and a civil penalty of $2.3 million.

The Tenth Circuit subsequently affirmed the district court’s holding and the Supreme Court granted certiorari. Writing for a unanimous Court, Justice Sotomayor held that disgorgement imposed as a sanction for violating a federal securities law was a “penalty” within the meaning of § 2642 and therefore subject to a five-year statute of limitations.

The Court based its holding on three findings: First, the Court found that the disgorgement remedy being sought by the SEC was for a violation committed against the United States, not an aggrieved individual. In support of this point, the Court noted that a securities-enforcement action “may proceed even if victims do not support or are not parties to the prosecution.” Even the SEC conceded that it was acting “in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties.” Second, the Court found that disgorgement was imposed for “punitive purposes” and its “primary purpose” was to “deter violations of the securities laws by depriving violators of their ill-gotten gains.” Third, the Court found that, in many cases, disgorgement obtained by the SEC was not compensatory. To the contrary, although some funds obtained through disgorgement are paid to victims, other funds are paid to the United States Treasury.

Although the holding in Kokesh has far-reaching implications for the SEC’s enforcement efforts, a footnote to that opinion ultimately may prove to be even more consequential:

Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context. The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to § 2462’s limitations period.

This footnote, when combined with questions from certain justices during oral argument expressing skepticism as to whether the SEC can obtain disgorgement in federal court, has given rise to questions surrounding the very basis for the SEC’s disgorgement remedy. Indeed, since Kokesh, this issue is being litigated in lower courts and may come before the Supreme Court in future terms.

Lucia v. Securities and Exchange Commission


The SEC can prosecute enforcement actions via administrative proceedings. Although the Commission may preside over these hearings itself, it more often “delegate[s] that task to an ALJ.” Presently, the SEC has five ALJs. Prior to Lucia, these ALJs were not appointed directly by the Commission, a “head of department.” Instead, the SEC assigned this task to its staff.

ALJs presiding over enforcement actions have “extensive powers,” including and not limited to:

supervising discovery; issuing, revoking, or modifying subpoenas; deciding motions; ruling on the admissibility of evidence; administering oaths; hearing and examining witnesses; generally regulating the course of the proceeding and the conduct of the parties and their counsel; and imposing sanctions for contemptuous conduct or violations of procedural requirements.

These duties make the Commission’s ALJs akin to federal trial judges with Article III powers.

After hearing an administrative proceeding, the ALJ issues an initial decision containing findings of fact and conclusions of law. An ALJ’s initial decision is subject to de novo review by the SEC, which may affirm, reverse, modify, set aside, or remand the decision. This review by the Commission is discretionary. The respondent may request review, the SEC might review the case sua sponte, or it might deny review and issue an order making the ALJ’s findings the final decision. The respondent’s next recourse is an appeal to the appropriate United States Court of Appeals.

In 2012, the SEC initiated an enforcement action against Raymond Lucia, bringing fraud charges under the Investment Advisers Act. The SEC alleged that “Lucia used misleading slideshow presentations to deceive prospective clients.” Judge Elliot presided over the nine-day administrative proceeding and ultimately found that Lucia violated securities laws. The ALJ imposed hefty sanctions on Lucia: (1) a monetary fine of $300,000; and (2) a lifetime ban from the investment industry.

Lucia appealed to the Commission, seeking to invalidate the ALJ’s decision by arguing that Judge Elliot was an “Officer of the United States,” subject to the Appointments Clause, and therefore lacking the constitutional authority to hear this matter because Judge Elliot was not constitutionally appointed. The SEC overruled the argument and affirmed the ALJ’s decision, holding that the SEC’s ALJs lacked sufficient independence to qualify as “officers of the United States” and instead served as “mere employees” not subject to the Constitution’s Appointments Clause. The D.C. Circuit Court of Appeals affirmed, but Lucia requested review en banc. The ten-member en banc court split evenly on the issue, resulting in a per curiam opinion, upholding the lower courts’ decision. The Supreme Court granted certiorari.

The Lucia Opinion

Justice Kagan, writing for the majority—joined by Chief Justice Roberts, and Justices Kennedy, Thomas, Alito, and Gorsuch—set out to decide one issue: Are the Commission’s ALJs “officers of the United States” subject to the Appointments Clause, or are the ALJs merely employees of the United States Government? Relying on existing precedent, the Court answered: SEC ALJs are officers of the United States subject to the Appointments Clause, and because Judge Elliot was not appointed by a head of department, here the SEC, Lucia is entitled to a new hearing before a constitutionally appointed ALJ (that cannot be Judge Elliot).

Two previous cases laid the foundation for the Court’s decision: United States v. Germaine and Buckley v. Valeo. In Germaine, the Supreme Court decided that “civil surgeons” did not hold “continuing position[s] established by law,” but instead per- formed “occasional or temporary” duties. Thus, “civil surgeons” are employees of the United States and not officers. Buckley addressed “members of a federal commission” who “exercised significant authority pursuant to the laws of the United States,” and therefore are officers subject to the Appointments Clause.

Relying on these foundational holdings, the Court then turned to a third prior decision: Freytag v. Commissioner. In Freytag, taxpayers challenged the authority of the United States Tax Court’s Special Trial Judges (STJs). STJs “take testimony, conduct trials, rule on the admissibility of evidence, and have the power to enforce compliance with discovery orders,” all while “exerc[ing] significant discretion.” STJs also hold “a continuing office established by law.” The significant discretion, the ongoing nature of their positions, and the establishment of STJs under the law collectively make STJs officers of the United States, subject to the Appointments Clause.

The Lucia majority analogized STJs to the SEC’s ALJs and found that Freytag controls. Like STJs, ALJs hold continuing offices established by law, the positions are continuing (SEC ALJs hold career appointments), ALJs have significant discretion, and with “nearly all the tools of federal trial judges,” ALJs have substantial authority to ensure the fair and orderly disposition of the administrative proceedings. Specifically, ALJs take testimony, receive evidence, examine witnesses, conduct trials, administer oaths, rule on motions, regulate hearings and the conduct of the parties, rule on the admissibility of evidence, shape the administrative record, enforce orders, punish conduct, and issue decisions that can become final. Although the Lucia Court left open the question of which of these duties “is necessary for someone conducting adversarial hearings to count as an officer,” the totality of these duties mandate that the Commission’s ALJs be constitutionally appointed as officers of the United States pursuant to the Appointments Clause.

Judge Elliot, an officer of the United States but appointed by the Commission’s staff, did not have the authority to hear Lucia’s administrative proceeding. The Supreme Court remanded the case for new administrative hearing before a constitutionally appointed ALJ. That ALJ, however, cannot be Judge Elliot. Instead, the Court held, “another ALJ” must hear the matter, because Judge Elliot “cannot be expected to consider the matter as though he had not adjudicated it before.”

Implications of and Developments since Kokesh and Lucia

Apart from their financial and administrative implications for the SEC’s enforcement efforts, Kokesh and Lucia display a Supreme Court will- ing to place limitations on the SEC’s enforcement efforts. They also leave open the possibility that the Supreme Court will place additional limitations on the SEC’s enforcement efforts in the future; a possibility made all the more likely by Justice Kavanaugh’s recent appointment to the Supreme Court. Indeed, before joining the Supreme Court, Judge Kavanaugh, then a Circuit Judge, had demonstrated a willingness to limit the SEC’s enforcement efforts. In Saad v. Securities and Exchange Commission, Judge Kavanaugh filed a concurrence arguably in favor of expanding Kokesh’s application in which he noted that pursuant to Kokesh, the expulsion or suspension of a securities broker is also a “penalty” and therefore, presumably, subject to a five-year statute of limitations.

The Supreme Court’s opinion in Kokesh has had, and will continue to have, a profound impact for the SEC’s enforcement efforts. Speaking earlier this year to Congress, Steve Peikin, the co-director of the SEC’s Enforcement Division, acknowledged that as a result of Kokesh, the SEC has been unable to recover approximately $800 million in disgorgement of ill-gotten gains since the issuance of that opinion.

Although this lost recovery is substantial, the impact of Kokesh goes far beyond dollars and cents. Now that disgorgement damages are subject to § 2462’s five-year statute of limitations, fewer parties will be faced with exceedingly large disgorgement demands and corresponding prejudgment interest. The removal of this threat undoubtedly will embolden parties alleged to have violated securities laws to test their luck at trial as opposed to settling with the SEC, which will further burden the SEC’s enforcement resources.

But the biggest potential implication from Kokesh can be found in the third footnote to that opinion where the Supreme Court left open the question of whether the SEC may obtain disgorgement in federal court. Indeed, litigants already have begun challenging the SEC’s disgorgement authority. This issue is likely to make its way to the Supreme Court in the future, where it will be ruled on by nine justices, some of whom have expressed skepticism concerning the SEC’s ability to obtain disgorgement and most of whom already have approved of limiting the SEC’s disgorgement remedy.

On the other hand, Lucia’s most immediate impact can be seen in action that the SEC has taken to insulate itself from challenges to its administrative proceedings. On November 30, 2017, the SEC “ratified” its staff’s prior appointments of its existing ALJs. The SEC explicitly stated this was its attempt to “resolv[e] any concerns that administrative proceedings presided over by its ALJs violate the Appointments Clause.” In Lucia, the Supreme Court saw “no reason to address” this ratification, noting, “[t]he Commission has not suggested that it intends to assign Lucia’s case on remand to an ALJ whose “authority rests on the ratification order.”

Post-Lucia, the SEC issued another order noting, in pertinent part, that respondents in approximately 130 enforcement actions would be given the opportunity for a rehearing by an ALJ who previously had not heard their case, and reiterating its prior approval of the ALJs’ appointments as the SEC’s own under the Constitution. Apart from any Lucia-based challenges to the SEC’s administrative proceedings that may be forthcoming, this order has the potential to place a substantial burden on the SEC’s enforcement resources in the coming years.

Advice to Practitioners

When faced with a SEC enforcement action or administrative proceeding, practitioners may be able to use Kokesh and Lucia to their client’s advantage. As it relates to Kokesh, practitioners should first and foremost make sure that any demand for disgorgement is limited strictly to the five-year statute of limitation. Practitioners also should review the basis for the SEC’s demand for disgorgement and consider challenging that demand. If, for example, the disgorgement being sought by the SEC cannot or will not be returned to alleged victims of a securities law violation, that type of disgorgement demand (and possibly, more broadly, courts’ authority to order disgorgement in SEC enforcement proceedings) may be subject to increased judicial scrutiny. Apart from disgorgement, practitioners also should consider arguing for the application of the five-year statute of limitation at issue in Kokesh to other forms of relief being sought by the SEC. Applying Kokesh to, for example, industry suspensions or expulsions would be a natural extension of that opinion and appears to be favored by the Supreme Court’s newest justice.

When it comes to Lucia, practitioners facing an administrative proceeding should consider whether to raise challenges to actions taken by a “ratified” ALJ. This includes raising challenges to the appointment of and judicial actions taken by the presiding ALJ that explicitly were referenced in Lucia or, more broadly, resemble actions taken pursuant to the authority vested in an Article III judge. Likewise, if the decision is made to raise these challenges, practitioners should work to preserve diligently these challenges at every step of the process. Because the timing required to challenge an ALJ remains unclear, a failure to raise these challenges throughout the administrative proceeding, and on appeal, has the possibility to result in a party waiving that defense.


Originally published in The Corporate & Securities Law Advisor (Wolters Kluwer), November 1, 2018

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