Public Enforcement after Kokesh: Evidence from SEC Actions

On September 20, 2019, the U.S. House Financial Services Committee approved by 49-5 votes a now-bipartisan Investor Protection and Capital Markets Fairness Act (H.R. 4344), also known as the Kokesh-fix. The Bill authorizes the SEC to bring claims for disgorgement in actions filed in court (the SEC has had express statutory authority to bring disgorgement claims in administrative proceedings since 1990) and extends the statute of limitations for disgorgement, injunctions, and officer & director bars to 14 years (from 5 years today).

The fix is necessary because of a 2017 Supreme Court decision in Kokesh v. SEC, which held that disgorgement was a penalty, like a civil fine or forfeiture, and as such subject to the 5-year statute of limitations set out in section 28 U.S.C. 2462. According to an earlier Supreme Court decision in Gabelli v. SEC, the 5-year clock begins to run the moment the violation is completed, not when the agency discovers it. That means that the SEC must detect the violation, investigate, and file a lawsuit within the 5-year window. Any violations outside that window cannot be prosecuted, even if part of a long-running fraudulent scheme such Allan Stanford’s or Bernard Madoff’s Ponzi schemes.

The Kokesh decision has reverberated through federal enforcement. Most directly, it has barred SEC disgorgement claims for long-running frauds, costing the agency $900 million in FY 2018 alone. Because it is a court decision, rather than a statute or a regulation, Kokesh also raised more questions than it answered. If disgorgement is a penalty, then most other enforcement remedies are also penalties and thus time-limited to five years. Moreover, disgorgement in SEC civil actions is not expressly authorized in any statute. If disgorgement is a penalty, then the SEC cannot seek disgorgement in court actions at all, and several SEC defendants have already set out to litigate that. More than two years after the Kokesh decision, its impact remains uncertain.

In my recently posted article, forthcoming in the Georgetown Law Journal, I set out to study the impact of the Kokesh decision and document the need for a Kokesh-fix by using a unique dataset of 8,197 SEC enforcement actions filed between 2010 and 2018. Depending on how broadly lower courts interpret Kokesh, anywhere between 20 and 80 percent of SEC disgorgement is at risk. A more precise estimate is difficult to offer. In addition to the uncertain meaning of the decision, the available data is limited, and the SEC’s response could mitigate its impact. The SEC settles most of its cases and could negotiate greater disgorgement in exchange for a more limited injunction (as the SEC has been doing since the 1940s). Moreover, the SEC could refer a greater number of cases for criminal prosecution where limitations periods are considerably more relaxed.

But some things can be said about the impact of Kokesh. First, the SEC frequently prosecutes violations older than 5 years. Based on charges included in the filed complaints and OIPs, 37 percent of cases filed in FY 2010 to 2018 included at least some violations that were completed more than five years before the SEC filed suit. That share has gradually increased from fewer than 30 percent in FY 2010 to almost half in 2018.

Second, some types of violations are much more likely to be discovered, investigated and prosecuted during the 5-year window: insider trading and market manipulation are prosecuted significantly more quickly than the average case, whereas FCPA violations are almost never prosecuted within the limitations period. What insider trading and pump-and-dump schemes have in common is that they typically take place on the well-monitored public markets, where FINRA and the SEC will detect possible suspicious trading almost the moment that it takes place. Foreign bribery, on the other hand, remains hidden from view for years until a whistleblower reports the violation either internally (and the firm self-investigates and self-reports), or to the SEC. A close second in terms of the aggregate amount of disgorgement affected by Kokesh are securities offering violations—Ponzi and pyramid schemes, as well as structured offerings by some of the largest financial institutions.

Third, the SEC settles many of the cases it brings (45 percent for all cases in the dataset but the share has increased in recent years, to 52 percent in FY 2018). In cases moving towards a settlement, the SEC regularly secures an agreement tolling the statute of limitations during the investigation to protect its claims for civil fines and disgorgement. In addition, in settlements the SEC can trade away some remedies in exchange for greater monetary penalties. For example, Elon Musk agreed to pay $20 million for a single false statement in violation of section 10(b) (a violation that would otherwise carry a much smaller fine), presumably to avoid an officer & director bar. It is typical for public companies and public-company subsidiaries to settle with the SEC to negligence-based violations (in lieu of scienter-based charges) and agree to a larger monetary penalty. The SEC should be able to continue that practice post-Kokesh and preserve some of its disgorgement that way.

For the same reason, the SEC’s ability to compensate defrauded investors should not change substantially after Kokesh. The SEC includes investor compensation in about 11 percent of the cases where it imposes monetary penalties. A large majority of those, almost 80 percent, are in cases settled during the investigation and over 90 percent of distributed disgorgement is in settled cases with public firms and public-firm subsidiaries. Such firms continue to face strong incentives to settle after Kokesh, and so the SEC’s ability to compensate investors should remain largely unaffected.

But, the SEC cannot do that in cases that do not typically settle during the investigation. Of contested cases that include disgorgement for violations older than 5 years, more than 70 percent are for securities offering and investment advisory violations, like those committed by Charles Kokesh, and they result in almost 85 percent of aggregate disgorgement in such cases. Parallel proceedings—with the exception of the occasional criminal prosecution—are unlikely. Injured investors have little monetary incentive to prosecute because the chance of recovery is low. Charles Kokesh specifically targeted smaller investors (investing $5,000 or less) because “they were less likely to sue.” Unless the SEC has been referring many more fraudsters for criminal prosecution, the primary beneficiaries of the Kokesh decision have been the least sympathetic of the fraudsters: Ponzi schemers and bad advisors who take illegal distributions, overcharge their clients fees, and reimburse unauthorized expenses so that they can buy “a gated mansion, renovate a private polo ground, and keep a personal stable of more than 50 horses.”

Such violators will not be deterred by the likely extension of the limitations period to 14 years because they are not deterred by the prospect of prosecution. But, the statutory amendment is nonetheless essential because it will change settlement incentives for public firms that violate the FCPA and public-firm subsidiaries that skim money off the top of conflicted transactions, and, importantly, reduce the perception that the law favors fraudsters and fails to protect the victims of fraud.

The full article is available here, and my testimony before the House Financial Services committee is available here.