Strange Bedfellows – How a Recent Security Fraud Opinion May Impact Consumer Fraud Class Actions


The U.S. Supreme Court’s recent decision in Liu v. SEC, No. 18-1501 (June 22, 2020), limiting the SEC’s ability to obtain monetary equitable relief in securities fraud litigation, may seem an odd topic for this blog.  But Liu is worth some attention because it may foreshadow an impact on calculation and distribution of monetary awards in consumer fraud class actions.  The decision may influence the calculation of disgorgement or restitutionary remedies, and it may signal another hurdle for the controversial judge-made distribution mechanism, cy pres.

Liu v. SEC

In Liu, the SEC won summary judgment in an enforcement action for securities fraud, obtaining an award for “disgorgement” of the funds acquired by defendants from their fraudulent scheme.  The district court declined to deduct any of defendant’s business expenses to offset the “ill-gotten gains,” awarding all sums fraudulently raised from investors.  The Ninth Circuit affirmed, rejecting challenges to both the SEC’s authority to obtain disgorgement and its gross method of calculating the disgorgement award.

On certiorari, the Supreme Court upheld the SEC’s authority to recover disgorgement, but imposed limitations on that authority, grounded in traditional notions of equity.  The Court’s analysis yields potential ramifications for consumer fraud cases.

By statute, the SEC is authorized to seek “equitable relief” in civil proceedings.  The Court decided that disgorgement may qualify as equitable relief, so long as it is not punitive, because historically, courts at equity could not impose punitive sanctions.  The SEC’s authority was therefore grounded in the equitable distinction between compensatory and punitive relief.

The Court located that distinction by considering traditional limits on equitable powers.  Disgorgement remedies sound in equity because they strip “wrongdoers of ill-gotten gains” and compensate victims.  However, to avoid crossing over into “punishment,” courts typically (1) restrict the award to the wrongdoer’s net profits and (2) distribute those profits to the victims of the wrongdoing.

So limited, the Court rejected the challenge to the SEC’s authority to seek disgorgement, but reversed and remanded for deduction of legitimate business expenses.

Importantly for our purposes, the defendants argued that the SEC’s disgorgement practices were impermissibly penal in nature because the SEC often deposits some of the award – for example, funds that could not feasibly be returned to bilked investors – into the Treasury for other SEC enforcement endeavors.  The Court declined to decide the issue because it was not adequately briefed, and there was no order permitting the SEC to deposit the funds in this case.  The Court left it to lower and future courts to determine whether this practice runs afoul of equitable limits, but left little doubt that distributions to non-victims risk running afoul of equity.  It ultimately held “that a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under” the law.

How Liu May Influence Consumer Fraud Class Actions

Because Liu was based in large part on the Court’s interpretation of the boundaries of equity jurisdiction, it may transcend the securities fraud context and affect exercise of equitable powers in other contexts.

Operation of Disgorgement Remedies

Consumer fraud claims for violations of state laws prohibiting false or misleading advertising and/or unfair business practices are often classified as equitable in nature.  See Nationwide Biweekly Admin., Inc. v. Superior Court, 9 Cal.5th 279 (2020).  Monetary remedies in such cases typically are restorative, grounded in restitution or disgorgement measures designed to retrieve ill-gotten gains and restore them to the victims.  Liu’s reasoning suggests that calculation of the gains should be calculated on a net-profit basis to avoid transforming into a penalty and exceeding equitable powers.

An award for “restitution” of monies paid by consumers does not as neatly fit the balance struck in Liu, but the opinion repeatedly lumped restorative remedies like disgorgement and restitution together categorically and conceptually.  Liu suggests that in at least some cases seeking restitutionary relief, equity requires some offset for the defendant’s legitimate business expenses.

The Future of Cy Pres

Liu’s discussion (without resolution) of equity’s need to direct the award to victims of the wrongdoing, rather than divert it into public coffers, has ominous overtones for another “equitable” remedy, the judge-made doctrine of cy pres distribution.

The cy pres doctrine comes from the law of charitable trusts, used to salvage a grant that fails its testamentary purpose by directing the property to a somewhat related recipient or use.  The term “cy pres” derives from a Norman French expression, cy pres comme possible, which roughly translates to “as near as possible.”  The doctrine has been modified and adopted by courts to distribute unclaimed or undeliverable funds from a class recovery to third parties, usually charities or nonprofit institutions or organizations that bear some subject matter nexus with the class claims.

The cy pres remedial doctrine is problematic because it essentially redistributes a defendant’s assets to third parties who are neither before the court nor themselves injured by the misconduct.  Numerous issues have been raised about its use and operation, including conflicts of interest in the selection of beneficiaries, its exploitation to overcome manageability and superiority objections to class certification and to aggrandize class counsel’s attorney fee requests, and its enlargement of substantive rights in violation of the Rules Enabling Act.

On the other hand, there are few palatable alternatives to address problems of unclaimed or undeliverable funds and other difficulties in delivering relief to the injured class members.  And proponents (including, situationally, defendants) appreciate it as a tool to facilitate settlement of burdensome class actions.

The Supreme Court has expressed concerns over the validity and operation of the doctrine in recent years, first in an unusual opinion on the denial of certiorari in Marek v. Lane, 571 U.S. 1003 (2013) (Roberts, C.J.).  Then last term the Court took up a case to address cy pres but wound up remanding the case due to concerns over Article III standing.  Franks v. Gaos, 139 S. Ct. 1041 (2019).  Meanwhile, the Rule 23 Subcommittee to the Advisory Committee on Civil Rules unsuccessfully proposed to recognize cy pres in what became the 2019 amendments to Rule 23(e).

Whatever one’s views on the wisdom and legitimacy of cy pres, Liu’s insistence that a court of equity ordinarily is required to direct restorative awards to the victims, and its concerns about the legitimacy of redirecting funds into the treasury, raises further doubts about the fate of distributive justice mechanisms like cy pres.

Of course, the Supreme Court’s views do not directly affect the vitality of the doctrine in state courts, though they may independently decide to recognize similar limitations on their equitable powers.  And, formal adoption of cy pres options in state statutes, like California Code of Civil Procedure § 384, raises complicated issues for federal courts, including Erie issues and Rule 23 preemption issues.  But any limitations on the availability of cy pres could have a significant impact on how we litigate and resolve federal consumer fraud class actions.  Stay tuned.

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