Identifying ‘legitimate expenses’ is just the first step in determining net profits in a disgorgement settlement

In their commentary piece in the Recorder in Law.com, Legitimate Expenses or Ill-Gotten Gains? How the SEC’s Revamped Disgorgement Remedy is Playing Out, Jorge deNeve, Michael Simeone and David Cohen of O’Melveny & Myers, discuss the Supreme Court’s decisions in Kokesh v. SEC, and Liu v. SEC, as well as  the National Defense Authorization Act passed by Congress and how these actions impact the SEC’s ability to obtain disgorgement of ill-gotten gains.  The authors state, “The permissible scope of legitimate expenses remains fertile territory for defense counsel and poses thorny challenges for the SEC and the courts.”

In Liu v. SEC, the Supreme Court ruled that disgorgement is limited to “net profits” and that “legitimate expenses” are to be deducted from any disgorgement amount.  While the interpretation of what constitutes “legitimate expenses” will likely play out in various court decisions over time, the inclusion of legitimate expenses in a net profit calculation is essentially a threshold, or starting point, in a well-developed disgorgement analysis.

When a company and defense counsel find themselves on the threshold of a negotiated settlement with government authorities, including the SEC or the DOJ, they have a valuable opportunity to minimize the amount of a disgorgement payment, which can often run into the hundreds of millions of dollars, while also satisfying the government authority’s statutory requirements.

The determination of net profits in connection with a settlement requires a thoughtful approach along with a detailed analysis in order to obtain the best financial outcome for the company.  A robust profit disgorgement analysis that provides reasonable and supportable assumptions to government authorities can result in a significant reduction in the amount of a negotiated settlement payment.  

At a high-level, some of the key elements of a successful profit disgorgement analysis include:

• Deep knowledge of the company’s business operations and the ability to harness and associate relevant data from both financial and operational systems at a granular level.
• Identification, mapping and assessment of expenses that can be reasonably attributed to the alleged revenues at issue.  This will likely include associating costs at a geographical and product/service line level to the alleged revenues at issue, while also examining corporate-level costs that may exhibit a corollary relationship to such revenues.
• Incorporation of all of the relevant revenue and expense data into a dynamic model that quantifies different disgorgement scenarios based on various assumptions to enhance settlement strategies.
• Preparation and delivery of an effective and credible presentation for negotiation discussions with government authorities.

As the standards for what constitutes “legitimate expenses” evolve through the legal system, significant opportunities exist for companies and defense counsel to limit the amount of “net profits” as part of a regulatory settlement through a thorough and effective profit disgorgement analysis.