The SEC’s Expanded Disgorgement Powers Raise Important D&O Coverage Questions
With the new year came a new wrinkle in securities regulation. On January 1, Congress passed the National Defense Authorization Act (NDAA) for Fiscal Year 2021. Despite its name, this bill did not authorize military spending only. In fact, it codified the Securities and Exchange Commission’s (SEC) ability to collect disgorgement, which could have notable implications for buyers of directors and officers liability (D&O) insurance.
Countermanding Kokesh and Liu
Two of the most notable Supreme Court rulings of the last decade — at least in the realm of securities law — are Kokesh v. SEC, handed down in 2017, and Liu v. SEC, which was announced last June. In these two decisions, the court limited the SEC’s ability to seek disgorgement — the repayment of illegally obtained profits by violators of securities law.
Perhaps added into the bill in response to the decisions in Kokesh and Liu, section 6501 of the defense authorization bill amends the Securities Exchange Act of 1934, giving the SEC more power to seek disgorgement and other equitable relief for violations of securities laws.
The NDAA expressly authorizes the SEC to seek disgorgement in any SEC action or proceeding in federal court, brought under any provision of the securities laws where any person received unjust enrichment as a result of the violation. Previously, federal securities laws did not expressly authorize the SEC to seek disgorgement in federal court actions, although the agency had often pursued disgorgement under its authority to seek equitable relief.
Section 6501 essentially countermands the decisions in Kokesh and Liu. In Kokesh, for example, the court recognized disgorgement as a penalty, subjecting it to a five-year statute of limitations. Section 6501 maintains the five-year statute of limitations for non-scienter-based allegations — those that do not allege intentional wrongdoing — but extends the statute of limitations period to 10 years for scienter-based allegations. Section 6501 also automatically tolls the limitations period for any defendant who remains outside of the US.
In Liu, meanwhile, the court upheld the SEC’s right to seek disgorgement as a form of equitable relief, but set limits on it. Among other things, the ruling required that any disgorgement be returned to, or benefit, the victims of securities crimes. Section 6501, however, amends the Securities Exchange Act to specifically grant the SEC the authority to pursue disgorgement in court actions, which enforcement officials may argue voids the restrictions set by the court in Liu.
What Does This Mean for D&O Insurance Programs?
In assessing the insurance impacts of section 6501, companies and their directors and officers should consider the potential for changes in the SEC’s approach to enforcement. This is especially important given that the changes under section 6501 coincide with the arrival of a new administration that may seek greater enforcement of federal securities laws.
For example, under the new regulations, the SEC may be more likely to assert scienter-based claims, in an effort to take advantage of the new 10-year statute of limitations period. The agency could also assert that it has the right to claw back disgorgement from that full 10-year period, instead of just five years — and may be less willing to settle without some type of disgorgement payment from an individual.
It’s also worth noting that defense costs will likely rise. The amount of discovery required in any SEC proceeding subject to the 10-year period could be much more expansive and costly to produce. And the SEC may focus more on pursuing charges against individual directors and officers — and not just against companies.
Given these possibilities, D&O insurance buyers should work with their advisors to determine whether and how the new regulations could affect their insurance programs. Among other things, consider:
- Whether you are currently buying sufficient D&O limits.
- Whether a traditional six-year period is sufficient when buying runoff coverage, or if the runoff period should be extended to 10 years.
- Whether it makes sense to purchase entity investigation cost coverage.
2021 could bring a more aggressive enforcement stance from the SEC, which is why it’s critical to ensure your D&O insurance program is robust. Talk to your broker today about what section 6501 means for your organization and its directors and officers, and how you can ensure you have adequate protection in place.