Update: IRS, SEC, and Courts Diverge on Nature of Disgorgement

We previously wrote about decisions in SEC v. Graham from the Eleventh Circuit,  __ F.3d __, No. 14-13562, 2016 WL 3033605 (11th Cir. May 26, 2016), and the U.S. District Court for the Southern District of Florida, 21 F. Supp. 3d 1300 (S.D. Fla. 2014), considering whether disgorgement claims and other remedies were subject to five-year statute of limitations on actions “for the enforcement of any civil fine, penalty, or forfeiture” codified in 28 U.S.C. § 2462. The Eleventh Circuit affirmed the decision of the lower court that the SEC’s disgorgement claims were time-barred, holding that “disgorgement” is synonymous with the plain meaning of “forfeiture” as it is used in the statute.

On May 6, 2016—shortly before the Eleventh Circuit issued its ruling in Graham—the IRS published non-precedential Chief Counsel Advice (“CCA”) on whether Internal Revenue Code Section 162(f) bars business expense deductions for disgorgement paid to the SEC of profits stemming from alleged violations of the Foreign Corrupt Practices Act (“FCPA”). The disgorgement payments were part of a consent agreement between the SEC and the taxpayer, whose subsidiary allegedly falsified accounting records in order to conceal gifts it made to officials of a foreign government in exchange for business benefits. The taxpayer paid additional penalties for which it specifically agreed it would not seek a tax deduction in a parallel agreement with the DOJ relating to the criminal case against taxpayer’s subsidiary. The IRS concluded that the taxpayer’s disgorgement payments were not deductible business expenses under § 162(f), which prohibits deduction of any “fine or similar penalty paid to a government for the violation of any law” as a business expense.

As explained in the CCA, § 162(f) has been interpreted to bar deductions of civil penalties where they are “imposed for purposes of enforcing the law and as punishment,” but to allow deduction of civil penalties if “imposed to encourage prompt compliance with a requirement of the law”—for example, “late filing charges or other interest charges”—or “as a remedial measure to compensate another party.”  Emphasizing that disgorgement in securities cases has deterrent aims, is a discretionary remedy, and might be required even if there is no injured party or in amounts exceeding actual losses, the IRS determined that whether disgorgement is primarily punitive or primarily compensatory for the purpose§ 162(f) is a fact-specific inquiry. Additionally, disgorgement imposed as a “discretionary equitable remedy” or where the proceeds are used to compensate victims might still be primarily punitive if it resembles forfeiture, which remains non-deductible even when used to compensate victims. With respect to the FCPA disgorgement the taxpayer had made to the SEC, the IRS concluded that its purpose was primarily punitive, and therefore it could not be deducted, because there was no evidence that it was meant to compensate the government or some other party for loss.

The SEC, the IRS, and the Eleventh Circuit have thus articulated three distinct characterizations of disgorgement. To avoid the limitations period of § 2462, the SEC’s position, adopted by the D.C. Circuit in Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996), has been that disgorgement is a non-punitive equitable remedy. In the IRS’s view, disgorgement to the SEC may—but perhaps does not always—have a punitive purpose that bars tax deduction. The Eleventh Circuit has equated the statutory definitions of disgorgement and forfeiture, without commenting on whether disgorgement to the SEC is a “penalty.”

Update: Eleventh Circuit Affirms Dismissal of Claims for Declaratory Relief and Disgorgement in SEC v. Graham, __ F.3d __, No. 14-13562, 2016 WL 3033605 (11th Cir. May 26, 2016)

We previously wrote about a decision out of the U.S. District Court for the Southern District of Florida in SEC v. Graham, 21 F. Supp. 3d 1300 (S.D. Fla. 2014), which involved claims by the SEC in connection with an alleged $300 million real estate Ponzi scheme. Echoing the Supreme Court’s reaffirmation in SEC v. Gabelli, 133 S. Ct. 1216 (2013), of the importance of statutes of limitation “to the welfare of society,” the district court had held that the five-year statute of limitations in 28 U.S.C. § 2462 is jurisdictional rather than a “claim-processing rule” and that the limitations period provided by § 2462 applies not only to civil penalties but also to equitable relief including injunctions, declaratory relief, and disgorgement. On May 26, 2016, the Eleventh Circuit affirmed in part, reversed in part, and remanded this decision for further proceedings.

The Eleventh Circuit disagreed with the district court’s characterization of injunctive relief as “nothing short of a penalty” and therefore subject to the § 2462 time limit on actions “for the enforcement of any civil fine, penalty, or forfeiture.” Noting that it was bound by its previous holding that “[t]he plain language of section 2462 does not apply to equitable remedies,” United States v. Banks, 115 F.3d 916, 919 (11th Cir. 1997), the court additionally explained that injunctions are not “penalties” because they are forward-looking rather than backward-looking relief.

Nevertheless, the court affirmed dismissal of the SEC’s claims for declaratory relief and disgorgement. The court reasoned that unlike injunctive relief, declaratory relief is backward-looking and “operate[s] as a penalty under § 2462” because “[a] public declaration that the defendants violated the law does little other than label the defendants as wrongdoers.” With respect to disgorgement, the court held that there is “no meaningful difference” between the plain-language definitions of “forfeiture” as used in § 2462 and “disgorgement,” and the court rejected the SEC’s distinction of the terms as “technical definitions” that Congress cannot be assumed to have meant to apply in the absence of clear indication in the statute. Having determined whether § 2462 applies to injunctive relief, declaratory relief, and disgorgement, the court declined to reach the issue of whether the limitations period is jurisdictional in nature.

Although the court agreed with the SEC’s position on injunctive relief, this holding is likely to be of little comfort to the agency. While reasoning that it would be “premature to review the precise nature of” an injunction the district court had not yet issued, the court noted that the injunction requested in the Graham complaint was the type of “obey-the-law” injunction—that is, an injunction prohibiting “the defendants from violating federal securities laws”—it has consistently held to be unenforceable. While the court reasoned that the issue was appropriate for consideration because it “is at least possible that the SEC could seek injunctive relief that would be specific and narrow enough that the parties would be afforded sufficient warning to conform their conduct,” it offered no opinion on what enforceable injunctive relief might look like.