In SEC v. Teo, 746 F.3d 90 (3d Cir. 2014), the Third Circuit affirmed a jury verdict in favor of the SEC which, at trial, successfully obtained disgorgement from an investor who, in connection with stock market investments, profited by using false statements on certain SEC filings as to the extent of his investments. More significantly, the Third Circuit in affirming the SEC victory at trial, approved a broad construction of disgorgement when applied to prevent unjust enrichment. The Third Circuit affirmed the award of disgorgement of approximately $17 million in profit from the sale of stock and over $14 million in pre-judgment interest.
The case stems from the actions of an individual, Teo, who invested as an individual and through a trust where he was the beneficial owner. Over the course of time, through his trust, Teo directly and indirectly purchased stock in a corporation, Musicland. Musicland had a “shareholder rights plan,” commonly known as a “poison pill,” which could be activated when any individual or group reached an ownership in excess of 17.5% of the company stock to prevent a hostile takeover. Once the critical percentage was reached, shareholders were able to dilute the individual’s shares by purchasing stock at a lower percentage.
Beginning in 1998, Teo filed or caused to be filed false SEC Schedule 13D forms; he underreported his stock ownership as below 17.5% when, in fact, it exceeded 17.5% and continued to increase until it reached 35.97% by the end of 2000. Also, Teo falsely noted in a report that he ceased to have control over the Trust and later a Schedule 13D falsely claimed his sister-in-law had sole power to buy and sell stock for the Trust.
In December 2000, Best Buy Co. (“Best Buy”) announced an all-cash tender offer of all Musicland stock, which occurred in January 2001. Teo sold all of his stock— some in the market and the rest to Best Buy as part of the tender. Teo’s original cost of acquisition of the stock was approximately $89 million and the gross proceeds from the sale yielded almost $155 million. When the District Court calculated the profit from the date of the first false report, the net profit was approximately $21 million, which based on other offsets, was ultimately entered as a judgment of approximately $17 million.
In April 2004, SEC filed the civil enforcement seeking disgorgement of profit based on a host of violations of 10(b), 13(d), and numerous SEC rules and regulations. In August 2004, Teo was indicted and later pled guilty to insider trading from June 2006.
A jury trial was held on certain of the civil counts and Teo and the Trust were found to have violated various SEC sections and rules. The District Court found Teo and the Trust jointly and severally liable and entered judgment in the amount of over $17 million and awarded pre-judgment interest of $14 million. Teo and the Trust appealed.
The Third Circuit affirmed and, in so doing, addressed several issues raised on appeal from the trial.¹ The key issue to highlight in this discussion is the analysis concerning the standards applied when SEC seeks disgorgement and the breadth of disgorgement here. By way of background, the Court first distinguished the difference between the purposes of an SEC action versus a private investor claim inasmuch as the SEC pursues its claims “independent of the individual investors” and noted that the SEC reinforces this principle by consistently stressing “it is not a collection agency for defrauded investors.” The Court further noted, however, that where the SEC seeks disgorgement, the difference between the burden on private plaintiff and SEC does not entirely eliminate need in SEC action for proof of a causal connection between the securities violation and the disgorged funds. The Third Circuit adopted the analysis and approach that the SEC burden is more like a “but for” test and relied on the DC Court of Appeals holding in SEC v. First City FinCorp., quoting as follows:
Since disgorgement primarily serves to prevent unjust enrichment, the court may exercise its equitable power only over property that is causally related to the wrongdoing. The remedy may well be a key to the SEC’s efforts to deter others from violating securities laws, but the disgorgement may not be used punitively.
746 F.3d at *103.
After applying the threshold standard to the record in this case, the Court affirmed that the SEC had easily met their burden.
Teo argued the intervening act of Best Buy in tendering an offer for Musicland stock was independent from his violations, thus the Best Buy tender offer was responsible for the sale and profits and not his securities violation. The Third Circuit again adopted the First City approach applied to intervening acts: “In First City, the Court endorsed a burden shifting approach to causation in which the SEC is required to produce evidence supporting a reasonable approximation of actual profits on the tainted transactions, which is essentially satisfying a but-for standard.” Id. at 105. From First City, it drew two immediate points —“First, intervening causation is not an element of the SEC’s evidentiary burden in setting out an amount to be disgorged that reasonably approximates illegal profits. Second, if the issue of an intervening cause is to be raised, it will normally be the defendant’s burden to do so.” Id. at 105-06.
In applying the announced standard, the Third Circuit not only found that the SEC had carried its burden to show the profits were related to the wrongdoing , but also concluded that Teo failed to carry the burden of showing that an intervening act of the Best Buy offer diminished the amount of profit attributable to the wrongdoing.² The Court ruled it insufficient that Teo merely asserted Best Buy’s tender offer was an intervening factor, which either was responsible for all or some of the profit separate and apart from his wrongdoing. The dissent by Circuit Court Judge Jordan, however, sharply disagreed with the majority on the weight and effect to be given the Best Buy tender offer. While Judge Jordan agreed with the majority’s approach as to the standards that apply in an SEC action both for disgorgement and when an intervening act is alleged, he concluded the Best Buy action was clearly an independent and intervening act and the premium offer by Best Buy and was not in any fashion related to Teo’s conduct; additionally, it was readily known and therefore should not have been included in the disgorgement. Id. at 113-114(citing SEC v. MacDonald, 699 F.2d 47, 55 (1st Cir. 1983)). Teo has filed a writ of certiorari to the US Supreme Court raising, inter alia, the breadth of disgorgement.³
Suffice it to say, anyone involved in an SEC enforcement action seeking disgorgement, should be mindful of the analysis in Teo and follow to see if the US Supreme Court grants certiorari. In most cases, the criminal matter is deemed to be the more severe punishment and there is certainly something to be said for the consequences of a criminal conviction and its non-monetary consequences. Here, however, it appears that far greater financial consequences resulted from the civil enforcement disgorgement (over $31 million) largely as a consequence of the breadth of disgorgement approved by the Third Circuit; whereas, the criminal case resulted in a $3 million penalty from the consequences of the amount attributable to insider trading. Finally, this case demonstrates the fragile relationship, and dangers associated, between a criminal case (insider trading) and civil disgorgement action.
¹ For instance, the Court addressed the appropriateness of the use of Teo’s guilty plea colloquy from his criminal plea under the standards of Rule 404(b) when his under oath statements were used to cross examine Teo when he testified at trial (See 746 F.3d at *94-*97); the Third Circuit found it was appropriate and approved the cautionary instruction by the trial court.
² The dissent argued:
The Majority states, without any supporting authority, that the Appellants’ “burden is not simply one of carrying the ball back across the fifty-yard line” but one of “adduc[ing] — at a minimum — specific evidence explaining the interplay (or lack thereof) among the violation(s) at issue.” I fundamentally disagree with that assertion. It is axiomatic that “the SEC bears the ultimate burden of persuasion.” First City, 890 F.2d at 1232. Therefore, once a defendant has pushed back with evidence of what is more likely than not an intervening cause, it is the SEC’s responsibility to carry the ball.
Id. at 113
³ The Petition for Certiorari argued:
“The Third Circuit’s decision endorses a limitless conception of disgorgement that conflicts with the decisions of four other circuits, disregards the settled equitable limitations on disgorgement, and exposes defendants in SEC civil enforcement actions to staggering liability untethered to the scope of their violations”….the Third Circuit’s ruling is at odds with decisions by the First, Second, Tenth and D.C. circuits holding that a district court can’t use disgorgement to recover profits attributable to intervening events with no connection to a defendant’s securities-law violations.
Jeff Sistrunk, Musicland Investor Asks High Court to Ax $32M Disgorgement, LAW360, http://www.law360.com/articles/556797/musicland-investor-asks-high-court-to-ax-32m-disgorgement(quoting Petition for Cert., SEC v. Teo, 746 F.3d 90 (3d Cir. 2007), petition for cert. filed, (No. 14-19).