What does the shift from "gross profit "to "net profit "signal for the calculation of gains from corrupt activity?
The ongoing legal debate over the use of disgorgement remedies by the US Securities and Exchange Commission ("SEC") opened a new chapter last month in the case of Liu v. SEC, in which the US Supreme Court ruled in favour of the SEC regarding the agency's right to disgorge ill-gotten gains. There were three key elements to the Court's ruling, but this article will focus on one in particular: that any disgorgement should "not exceed a wrongdoer's net profits".
What has shifted?
The issue at hand was the extent to which legitimate business expenses should be deducted from a disgorgement calculation. In essence, the Court evaluated whether legitimate expenses should be deducted in arriving at an equitable disgorgement level. In Liu v. SEC, the question was whether these costs, cited as "lease payments and cancer treatment equipment", should be taken into consideration in determining net profit for the purpose of calculating disgorgement, or whether these expenses were merely "fuelling a fraudulent scheme".
Encouragingly, the ruling did emphasize the distinction between legitimate business expenditure and costs incurred in "fuelling a fraudulent scheme". The key is recognizing that continued fraudulent behaviour or a fraudulent enterprise is different from a commercial contract secured through illicit means and ultimately delivering legitimate economic benefit or utilization to the customer. The Ninth Circuit Court now has to decide whether or not such a benefit was indeed delivered in Liu's case - an issue the Supreme Court has remanded for further action. This principle consideration was omitted in Liu v. SEC and arguably conflicting with the position the SEC has often taken in past cases.
In this case, the ruling referenced the accounting term "net profit "as the appropriate basis of illicit profit to be disgorged. From a financial calculation perspective, the Court's specific reference to net profit presents an updated benchmark as to where disgorgement should sit. Those working in the arena know that net profit sits far lower down on a company's Income Statement than other levels of profit, leading implicitly to smaller disgorgement levels.
What does it mean for future calculations?
Companies found guilty of wrongdoing and ordered to disgorge their ill-gotten gains have traditionally done so by using gross profit as their starting point. Gross profit is essentially the difference between project revenues and the direct cost of generating those revenues. It is a common financial accounting term which is readily identifiable in most published financial statements. From there, the companies and their advisors would typically examine which other costs below the gross profit line might be considered legitimate business expenditure and argue for their inclusion in any disgorgement exercise, thereby reducing the amount to be disgorged. This may include other directly attributable costs or other variable costs associated with the project, although the onus to demonstrate their eligibility rests very much with the company.
The shift toward "net profit "in Liu v. SEC, however, may effectively ease that burden on companies if costs below the gross profit line can be presumed deductible. These costs would more likely be considered legitimate business expenditure and therefore worthy of deduction. More companies will start to base their calculation of profits to be disgorged on net profit. This new approach of working one's way up the Income Statement might then mean the SEC will need to justify the exclusion of some costs from legitimate expense, instead of the company arguing for inclusion.
What does it mean for the SEC, financially?
The SEC Division of Enforcement's latest annual report notes that the agency ordered disgorgement of $3.2 billion in 2019 - an increase of $742 million from 2018. Including $1.1 billion in penalties, the SEC will receive a total of $4.3 billion from last year. Despite this noticeable increase in disgorgement, the report cited the "significant impact "of the Supreme Court's June 2017 decision in Kokesh v. SEC, i.e. that the SEC must claim for disgorgement within the five-year statute of limitation. The SEC reported that it had to forgo approximately $1.1 billion in disgorgement in 2019 as a result. A change in focus to net profit as a point of departure for gain calculations could further encumber the SEC's ability to order maximum disgorgement amounts, ultimately resulting in fewer orders.
Consider the separate example of the June 2020 order against Novartis AG, wherein Novartis was ordered to pay $92.3 million as a result of being unjustly enriched by said amount (no civil penalty was imposed by the SEC). The difference between the Novartis Group's 2019 annual gross profit and net profit was an estimated 74%, or a reported gross profit of $34 billion versus an income before tax of $9 billion. If the "net profit "approach is applied, the company could argue for a reduction in the imposed disgorgement. Even a conservative argument for a 50% reduction (as opposed to the full 74%) would mean an estimated $46 million in revised disgorgement for Novartis.
By our estimation, applying a closer "net profit view "to the overall 2019 SEC disgorgement figures could mean a total reduction in disgorgement of between $800 million and $1.6 billion.
Is it really that simple?
As with most disgorgement matters - no. Some questions still need to be answered as we explore the boundaries between gross and net profit. Whilst the business would still need to demonstrate the connection to the project in question and the legitimacy of the costs, perhaps it is not so much a question of whether the costs are directly attributable or not, but rather the validity of the business expense in the context of the project. Did the project obtain any benefit from the salaries or overheads allocated from head office? Does the on-charging of capital overheads or financing costs appear valid in the context of such a big undertaking by the organisation, which could otherwise not have been feasible without an investment?
The proof provenance could very well be shifting slightly from the company to the SEC, which may lead to greater scrutiny and understanding of the detailed management accounts and reports that make up net project profit. Supporting these legitimate business expenditures could significantly reduce the overall disgorgement. The use of internal management reports could become more important in showing the allocation of legitimate business expenditure, and result in more companies spending time and effort to understand and highlight these costs during the disgorgement proceedings.
Even if the "net profit "standard does play out in the companies' favour, the SEC holds another arrow in its quiver. As calculating disgorgements requires an increasing investment of time and effort, combined with the mounting pressure from Kokesh v. SEC, the SEC might just place more emphasis on civil penalties instead. For the SEC, a civil penalty would still have the desired effect of removing ill-gotten gains from corrupt actors. For companies, the shift towards net profit could just be a case of winning on one hand only to lose from the other.
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