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How the SEC is Dealing With Critical SCOTUS Hamstring

By Bruce Love October 6, 2017

Earlier this year, the U.S. Supreme Court made it easier for dodgy financial advisors to avoid paying for their crimes — as long as they can avoid detection for five years.

That’s the view many defenders of financial crime victims have taken on a landmark decision handed down in June.

“The decision clearly imposes a limit on SEC enforcement powers and may force the staff to rely more on civil money penalties,” says Harvard Law School professor Howell Jackson.

Such news may not bode well for retirement savers and defined contribution schemes relying on the watchdog to bring bad brokers to heel. Equally, that small sub-section of the wealth management community which doesn’t play by the rules may be rejoicing. The regulator has long used disgorgement successfully to prevent bad actors profiting from their crimes. Official figures show from 2007 to 2016 the SEC recouped $20.61 billion in disgorgements compared to $9.08 billion in penalties.

But even shackled with a new stricture, the SEC believes it can still catch the vast majority of crooks, and it may also have another weapon in its arsenal to help victims of bad brokers.

In Kokesh v. SEC, the Supreme Court unanimously agreed that disgorgement — a method the SEC uses to recoup ill-gotten gains from persons guilty of violating federal securities laws — can only be levied on misdeeds unearthed within the five-year statute of limitations that already applies to other financial penalties.

The ruling is significant because previously there was no time limit on how far back the SEC could seek disgorgement for federal securities law violations.

Jackson thinks the decision raises questions about the authority of the SEC to seek any form of disgorgement — even within the applicable statute of limitations.

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The regulator has not provided figures on how much of that $20.61 billion in disgorgement would have been invalid had Kokesh been in place. But the SEC is quick to point out disgorgement remains a useful tool for pursuing wrongdoers and that the majority of relevant enforcement actions would still likely fall within the five-year statute of limitations.

The decision also doesn’t stop defined contribution programs or retirement savers from suing advisors for recompense in private courts.

But Eben Colby, a litigation partner in the Boston office of Skadden, Arps, Slate, Meagher and Flom, warns the decision could keep the SEC from going after offenders whose frauds are perpetrated over decades. If the SEC can’t find signs of wrongdoing within the previous five years, explains Colby, it will generally be barred from suing for misdeeds or seeking disgorgement of gains from illegal activity beyond the five-year mark.

While the decision may seem unjust to the clients of bad brokers and wayward wealth managers, the ruling was no surprise for most Supreme Court watchers, according to Columbia Law School professor John Coffee. “The Court was not willing to tolerate regulators’ having a potentially infinite period in which they could sue for damages that had grown to an immense level over decades of alleged violations — with interest running,” he says.

The Court’s argument, Coffee adds, is that the regulator should not be able to hold financial companies at ransom indefinitely.

Since prior to Kokesh there was no time limit, the SEC could press for disgorgement against accused financial advisors regardless of when an alleged misdeed took place or when it was identified by the regulator; a broker could have perpetrated a fraud decades ago and the SEC could still extract disgorgement. Theoretically, the oldest firms could face disgorgement for wrongdoing committed over a hundred years ago.

In oral arguments on April 10, SEC lawyers insisted the five-year restriction did not apply to disgorgement, since the purpose of disgorgement was not to penalize behavior but was instead a method for recouping ill-gotten gains.

“The SEC had a fine linguistic argument but a politically flawed one that placed no limit on the prosecution, and this offended even the moderate members of the court,” says Coffee.

The court’s problem with the SEC’s argument? Rarely had these recouped funds ever made their way into the hands of victims. Instead such monies usually end up in the coffers of the Department of the Treasury. If the purpose of disgorgement wasn’t to reimburse injured investors, wrote Associate Justice Sonia Sotomayor for the unanimous court, how could it be anything but a penalty?

“Investors want the government to have the authority to catch wrongdoers, but they fear the government having an endless reach,” says Coffee.

Clinton Marrs

Clinton Marrs of Marrs Griebel Law — the attorney who brought the case to the Supreme Court — tells FA-IQ that the decision incentivizes the government to go after truly bad actors and allocate resources effectively.

“It’s a plus for investors to have a more efficient regulator. After this decision, the SEC should think twice about chasing marginal cases,” Marrs says.

But those bad actors who have kept their crimes hidden for five years may not be out of the woods just yet. Skadden’s Colby believes the SEC is pursuing a “workaround” which effectively extends the regulator’s investigation time frame beyond the five-year statute of limitations.

“It’s likely the SEC will now make greater use of a legal technique where, if the regulator suspects wrongdoing, they can pause or delay the five-year statute of limitations by agreement with the party being investigated,” Colby says.

These so-called “tolling agreements” give the SEC longer time to make its case. The SEC declined to comment on how it planned to use tolling in its enforcement policy, but Colby says he has already seen an uptick in its use.

Either way, the Supreme Court has left an indelible mark on investor protections. Unless, of course, Congress simply changes the statute and lifts the statute of limitations itself. But while such an action is theoretically possible, Harvard Law’s Jackson notes it would be rather unlikely in the current political climate.

A shorter version of this article appeared in the Financial Times.