By John Filar Atwood
A district court applied the disgorgement standard established in the Fifth Circuit’s SEC v. Hallum ruling and found that the SEC’s request for disgorgement request complies with the “legal disgorgement” standard under 1934 Act Section 78u(d)(7). However, the court denied a request for civil penalties on the grounds that the defendants’ conduct was isolated and not recurrent, and affected only one investor who has been repaid (SEC v. Morris, October 14, 2022, Boyle, J.).
The case involves the commingling and misappropriation of funds designated for client investors by investment adviser Lakeside Capital Partners. The SEC’s suit alleged violations of the Investment Advisers Act because Lakeside and its president (the defendants) misappropriated more than $120,000 from two investment funds that were managed by Lakeside.
Specifically, a fund investor loaned Lakeside some money which Lakeside was obligated to repay with investment returns. Instead, Lakeside’s president allocated the $65,000 in investment returns to his personal bank account for use on personal expenses such as credit-card and car payments.
After the suit was filed, Lakeside’s president reached an agreement with the affected investor to repay the full balance of the loan plus the $65,000 that he had taken. Lakeside and its president agreed to assign the investor warrants for 100,000 common shares that Lakeside owns in another company. Both the investor and the SEC accepted the arrangement as fully satisfying the defendants’ obligations to the investor, including the $65,000 that the president used for personal expenses.
The SEC filed a motion asking the court to determine whether disgorgement and/or civil penalties are appropriate and, if so, how much. The SEC sought disgorgement from Lakeside and its president, jointly and severally, of the $65,000 in investment returns that the president transferred to his personal account plus $8,783.68 in prejudgment interest. The SEC asked the court to deem the defendants’ obligations to pay the total of $73,783.68 in disgorgement and prejudgment interest satisfied by the post-suit arrangement with the investor. Finally, the SEC moved for $65,000 in civil penalties against Lakeside and its president.
Is disgorgement appropriate? In considering whether disgorgement was appropriate, the court noted that until recently the 1934 Act was the sole statutory basis for a disgorgement remedy. The Act allows a court to grant “equitable relief that may be appropriate or necessary for the benefit of investors.”
However, in Liu v. SEC the Supreme Court addressed the SEC’s power to seek disgorgement under the statutory umbrella of “equitable relief,” holding that disgorgement was permissible under the statute so long as the award went to victims and did not exceed the wrongdoer’s net profits. Congress addressed that ruling in 2021legislation that expanded the 1934 Act to give district courts jurisdiction to require disgorgement of any unjust enrichment by the person who received such unjust enrichment, and by adding a provision stating that “the Commission may seek, and any Federal court may order, disgorgement.”
Fifth Circuit’s impact. In SEC v. Hallum, the Fifth Circuit addressed the Congressional amendment, finding that Congress’s action was consistent with a desire to curtail the Supreme Court’s Liu decision and to permit the sort of disgorgement awards that preceded Liu. It ruled that 1934 Act Section 78u(d)(3) and (d)(7) authorize legal disgorgement apart from the equitable disgorgement permitted by Liu. Further, the Fifth Circuit deemed that “legal disgorgement” applies the pre-Liu burden-shifting framework in which the SEC must reasonably approximate the defendant’s ‘unjust enrichment’ attributable to a securities violation.
When considering the SEC’s disgorgement request against Lakeside, the Texas court determined that consistent with the text of the new amendment’s emphasis on “unjust enrichment,” disgorgement pre-Liu was focused on preventing the wrongdoer’s enrichment from ill-gotten profits. The court noted that the SEC sought no more in principal than the $65,000 that Lakeside’s president wrongfully took which is a reasonable approximation of the unjust enrichment attributable to the securities violation. Accordingly, the court found that the SEC has carried its burden as to the disgorgement award.
Prejudgment interest. The court also granted the SEC’s request for prejudgment interest of $8,783.68. The court noted that the consent judgments explicitly provide for the payment of prejudgment interest should the court find disgorgement appropriate. In addition, in the court’s view prejudgment interest is consistent with the pre-Liu disgorgement framework and was explicitly recognized as appropriate in Hallam.
Regarding the SEC’s request that disgorgement and prejudgment interest be deemed satisfied by the defendants’ post-suit arrangement with the investor, the court noted that at least one court has raised concerns about ordering disgorgement that is “purely symbolic.” However, the Texas court found that much of the reasoning behind that concern was based on Liu and Section 78u(d)(5)’s requirement that the equitable relief be “appropriate or necessary for the benefit of investors.”
The court concluded that the concern may apply with less force to the new Section 78u(d)(7) which contains no such limiting language. Because the disgorgement is ordered under Section 78u(d)(7), the court also ordered that the disgorgement award is deemed satisfied by the defendants’ post-suit arrangement with the investor.
No civil penalties. Finally, the court denied the SEC’s request for $65,000 in civil penalties. In reaching this conclusion the court considered five factors: 1) the egregiousness of the defendant’s conduct; 2) the degree of the defendant’s scienter; 3) whether the defendant’s conduct created substantial losses or the risk of substantial losses to other persons; 4) whether the defendant’s conduct was isolated or recurrent; and 5) whether the penalty should be reduced due to the defendant’s demonstrated current and future financial condition.
The court noted that the defendants’ conduct was isolated and not recurrent, and that the conduct affected a single person who has been repaid. Additionally, the court considered that Lakeside’s president has filed for Chapter 7 bankruptcy and that Lakeside has debt many times greater than its assets and revenue. Further, Lakeside’s president is 69 years old and has Parkinson’s disease, so the court concluded that a penalty is not necessary to punish the violator and deter future securities law violations.
The case is No. 3:20-cv-02958-B.