Relief Defendants Defeat CFPB Claim for Disgorgement

When a law enforcement agency like the Federal Trade Commission or Consumer Financial Protection Bureau seeks disgorgement of “ill-gotten gains” from alleged wrongdoers, and has reason to believe some of the funds were passed to a third party who had no hand in the wrongdoing, it can name that party as a “relief defendant” and seek disgorgement from it as well.  A claim against a relief defendant does not allege liability but only that it is in receipt of ill-gotten gains from a defendant as to which it has no legitimate claim, and thus must relinquish those funds upon a final monetary judgment against the defendant.  To allow otherwise, according to the law, would result in the unjust enrichment of a third-party recipient of illegally acquired monies.    

The legal test of a claim against a relief defendant is whether it has an ownership interest in and legitimate claim to the funds it received from an alleged wrongdoer.  The FTC, CFPB and other enforcement agencies typically plead relief claims quite generally, alleging few if any predicate facts to support an allegation of lack of an ownership interest in and legitimate claim to the funds in question.  This pleading practice was put to the test recently in a case brought by the CFPB against a mortgage lender and student loan debt relief affiliates that were accused of using consumer credit reports in an unlawful way and misleading consumers seeking loan modifications.  In addition to the defendants, the complaint named a number of relief defendants, including two – an investment entity and its owner – who the author represented.  These relief defendants were named because they were investors in the student loan debt relief entities and had received profit distributions in return for their investment.  The CFPB complaint sought disgorgement of those profits.

A claim against a relief defendant that has no ownership interest in the funds, but is a mere custodian, such as a trustee, agent or depository, is straightforward.  As there is no dispute over ownership, the relief defendant merely holds the funds pending the outcome of the case and turns them over to the government at the end if the defendant is found monetarily liable.  It becomes more complicated, however, when a relief defendant credibly asserts an ownership interest in and legitimate claim to funds received from a defendant in return for fair consideration paid for those funds.  In that case, a real dispute exists and the court’s jurisdiction over the relief defendant – who has not been charged with wrongdoing and is before the court only as an alleged possessor of funds with no valid claim to them – is called into question.

In the CFPB case, the relief defendants moved to dismiss the complaint on the dual grounds that it did not adequately allege that they lacked a legitimate claim, and that the court lacked jurisdiction over them upon a factual showing that they had paid valuable consideration for the distributions and thus there would be no unjust enrichment in allowing them to keep the money – even though it was paid from proceeds of alleged unlawful conduct.  The motion further asserted that the pleading deficiency was incurable because the complaint alleged that the relief defendants had limited partnership interests in the student loan debt relief defendants, thus affirmatively admitting their ownership interest in the distributions.  The CFPB opposed, arguing the complaint was adequately pled and the court had jurisdiction over the relief defendants even though they were investors who had paid consideration in the form of capital contributions to the entities, because investors as a class (in contrast to, say, creditors) have no legitimate claim to profits derived from ill-gotten gains – a position for which there is scant support in the law.

Last month, a federal court, in the Central District of California, granted the motion to dismiss on the ground that the complaint was not pled adequately.  It wrote that:

…the Complaint insufficiently alleges that the Relief Defendants lacked a legitimate claim to the profits they received…. The Complaint conclusorily alleges that the Relief Defendants “have received…distributions of profits from the Student Loan Debt Relief Companies that are traceable to funds obtained from consumers through the violations…” and that “[t]hey have no legitimate claim to such funds and would be unjustly enriched if not required to disgorge the funds….” The allegation that the Relief Defendants “have no legitimate claim to such funds” is a bare assertion that lacks adequate factual enhancement.

(Emphasis in original.)

Picking up on relief defendants’ point that the CFPB had made a damning admission, the court reinforced its conclusion by noting that the complaint “affirmatively alleges facts showing that the Relief Defendants have a legitimate claim to the funds, because [they] “owned limited partnership interests in each of the Student Loan Debt Relief Companies….That [relief defendants] were investors in the entities – rather than trustees, agents, or depositories – counsels in favor of granting the motion.”  (Emphasis in original.)

Since the court was able to decide the motion on the pleading alone, it did not reach the jurisdictional question, including the evidentiary showing that relief defendants had made in support of their claim to an ownership interest in and legitimate claim to the distributions.                  

The CFPB was given a chance to replead, which may not be easy given that the court has already found that it has “affirmatively” alleged the relief defendants have a legitimate claim to the funds by virtue of its acknowledgement, in the dismissed complaint, of their limited partnership interests in the student loan debt relief defendants.  In any event, the takeaway for current and future relief defendants and their counsel from the court’s ruling is: do not be afraid to challenge the FTC, CFPB, or other enforcement agencies at the pleading stage if you feel the relief claim is pled too generally, or you were an investor in a defendant or held some other capacity in which you gave consideration for the funds the government is trying to take away from you.  You might just win.  

Did the Supreme Court Just Save the FTC’s Disgorgement Authority?

In March, in “Will the Supreme Court Save the FTC’s Disgorgement Authority,” I wrote about the oral argument before the Supreme Court in Liu v. SEC, which considered whether the Securities and Exchange Commission possesses disgorgement authority over federal securities law violators, requiring them to cough up their “ill-gotten gains.” The issue is of great interest and relevance to the Federal Trade Commission community because of arguable similarities between the SEC’s and the FTC’s statutory schemes and because a case raising a similar question about the FTC’s disgorgement authority, FTC v. Credit Bureau Center, is also before the Supreme Court on a pending petition for certiorari.  What could a decision in Liu potentially mean for the FTC’s own disgorgement powers?  I wrote in March that from the oral argument, it was my judgment that both the SEC and the FTC hade more reason to be optimistic about the outcome than the defendants in the two cases.

This week, Liu was decided.  Was I right?  In boxing terms, the result could be called a split decision.  The SEC has definite cause to be happy because the Court, in an 8-1 decision, upheld its disgorgement authority, and, as I explain, the FTC could have reason to breathe easier, too, over the survival of its own authority.  But the SEC cannot be happy about the limitations the Court placed on disgorgement, and neither can the FTC given the Court’s reasoning underlying those limitations which could apply to its disgorgement power.

While the two agencies’ statutes have some broad similarity, one difference, which potentially disfavors the FTC on the disgorgement question, is that the SEC statute explicitly provides for any equitable relief that may be appropriate or necessary for the benefit of investors,” while the FTC statute only explicitly allows for an injunction and make no mention of other equitable relief.  While Liu interpreted the scope of express equitable relief in the SEC statute to include disgorgement, the decisionseems to rest less on the fact that the SEC’s equitable authority emanatesfrom statute, and more on a conclusion that disgorgement fits within traditional common law equity principles and practice.  The Court’s reasoning in holding disgorgement is compatible with the traditional exercise of equity would seem to apply with equal force whether an enforcement agency is acting under express permission from Congress to seek equitable relief or under a federal court’s historically recognized inherent equitable authority, which the Court majority seemed to reaffirm in its decision (“[u]nless otherwise provided by statute, all . . . inherent equitable powers . . . are available [to the federal courts] for the proper and complete exer­cise of that jurisdiction.”

To be sure, since the SEC’s statute explicitly provides for equitable relief, the issue of the federal courts’ inherent equitable powers was not squarely at issue in Liu, as it would be in Credit Bureau Center or another case the Court might hear addressing the implications of the lack of explicit equitable relief in the FTC’s statute.  Liu therefore by no means forecloses the possibility that the Court could find that the FTC lacks disgorgement authority by virtue of the absence of express equitable relief in its statute.  Given the virtually unanimous Court’s passing nod to the federal courts’ inherent equitable powers in Liu, however, which was not necessary to its decision, should the Court take up the FTC’s disgorgement authority, and should it apply the Liu reasoning, then it seems a decent if not sure guess that the absence of explicit equitable relief in the FTC statute should not prove fatal to the survival of its disgorgement power  as well.        

This is only half the story, though.  While the SEC (and, if my guess is right, the FTC) gets to keep its disgorgement authority, Liu promises to place some real reins on its use.  This is bad news for the SEC (and likely the FTC) since for years the threat and imposition of disgorgement has been one of their biggest weapons of deterrence and enforcement.  While the Court emphasized that its holding is limited to a finding that the SEC possesses disgorgement authority, it signaled in crystal clear terms that its proper exercise is subject to three restrictions: (1) disgorgement limited to “net profits,” allowing for deduction of legitimate business expenses, rather than of all revenue; (2) limitation of a defendant’s disgorgement liability to only its net profits, rather than having “joint and several liability” for the net profits of multiple defendants; and (3) distribution of disgorged net profits to the victims of the wrongdoing, rather than to the federal treasury.

Disgorgement has to be limited to net profits, the Court explained, to ensure that it serves the purpose of equity, which is to restore the status quo and not to punish (“the wrongdoer should not be punished by ‘pay[ing] more than a fair compensation to the person wronged’”).  Past decisions in SEC cases, it said, had violated this equity principle by allowing disgorgement of a wrongdoer’s total take, without deduction of legitimate business expenses.  Unless the “entire profit of a business or undertaking” results from the wrong­ful activity, the Court stated, expenses such as salaries, rent, equipment and vendor payments should be deducted in calculating the disgorgement award.  In an FTC context, this presumably would include as well advertising, marketing, media, fulfillment, customer service and other expenses not directly tied to the alleged unfair or deceptive business practice.  The potential impact of a “net profits” limitation on disgorgement on both the FTC and FTC defendants cannot be overstated.  In any give case, it could make a difference of millions or tens of millions in the size of a monetary judgment, or result in no disgorgement at all from a defendant that has no net profits.      

The doctrine of joint and several liability does not fit with disgorgement, the Court concluded, because in equity liability is limited to one’s own ill-gotten gains, and does not extend to the illicit net profits of others.  To apply it, to make an individual liable for another wrongdoer’s net profits, could transform disgorgement into a prohibited punitive sanction.  An exception, however, where collective liability could be appropriate, the Court said, is in the case of “partners…equally culpable codefendants…engaged in concerted wrongdoing.”  In an FTC context, this exception could swallow the rule, at least where multiple defendants either directly participated to a substantial degree in the wrongdoing and/or had authority over the conduct.  

The Court strongly stressed that to be consistent with the practice in equity that the fruits of wrongdoing go to the victim, the SEC must return disgorged net profits to those harmed by it, unless it can show that their deposit in the U.S. Treasury would somehow be for the “benefit of investors.”  Like the SEC, the FTC does not always return disgorged funds to injured consumers but instead passes them to the Treasury.  While there is no express statutory command to effect equitable relief “for the benefit of consumers” in the FTC Act, under Liu, the FTC’s future discretion to reward the government rather than victims with disgorged ill-gotten gains would seem to be sharply, if not entirely, circumscribed.

While preserving the SEC’s disgorgement authority, Liu dramatically alters the legal landscape on which it can now be exercised, and tilts the playing field toward defendants, both in settlement negotiations and in litigation.  Under its reasoning, the same should hold true for the FTC.  Will the Court grant certiorari in Credit Bureau Center, to let the FTC and those it regulates know sooner rather than later if that is the case, or will it let lower courts decide whether, how and to what extent the equity principles laid out in Liu apply to the FTC.  That is the next big unanswered question in the unfolding legal drama over the traditionally assumed, but now heavily disputed, power of the FTC to take money from its defendants.  Stay tuned….

The FTC Finally Takes Down A CBD Marketer, Over COVID-19 Claims

Since hemp-derived CBD containing less than 0.3% THC was decriminalized by Congress at the end of 2018, the Federal Trade Commission has policed CBD health claims with a soft touch. On three different occasions (April, September, October, 2019), seeing unsubstantiated claims that CBD treats virtually every disease under the sun (i.e., cancer, heart disease, Alzheimer’s, MS, PTSD, schizophrenia, ALS, stroke, Parkinson’s, diabetes, AIDS), it has allowed the makers of those claims to get off with a simple warning.  A claim by a company that received one of those warnings, however, that its product treats Covid-19, apparently was a bridge too far. 

Accordingly, late last month, the FTC finally brought its first law enforcement action against a CBD marketer, Whole Leaf Organics, a California-based company, and its supplement, Thrive. The complaint alleges that the company falsely claimed that the product, which consists mainly of Vitamin C and herbal extracts, prevents, treats or reduces the risk of COVID-19. It also contests a cancer treatment claim for a CBD product sold by the firm.  Whether or not the FTC would have sued Whole Food Organics for ignoring its warning to cease the CBD cancer claim if it hadn’t also started making an entirely bogus Covid-19 health claim, only the FTC knows.  But the company was certainly inviting more serious attention by doing that, especially since the FTC also has been publicizing warning letters it has sent to companies making baseless Covid-19 health claims since the pandemic began.      

While it should not be surprising that the FTC would finally crack down on untrue health claims made by CBD marketers, especially by one who was also touting an unproven treatment that preys upon the pandemic health anxieties of consumers, the procedural approach the FTC took was highly unusual and could signal some concern on its part about the continuing viability of its authority to obtain consumer restitution in federal court.  Normally, when the FTC sues a false advertiser, it will bring a single action in federal court, under its so-called Section 13(b) authority, seeking a preliminary and permanent injunction and monetary relief, including disgorgement of “ill-gotten” gains and restitution.  This time, for the first time in a long time, it brought a bifurcated action, seeking, and obtaining, by stipulation, only a preliminary injunction in federal court (under a different statutory authority (Section 13(a)), with the rest of the case to be adjudicated in an administrative proceeding. While this route doesn’t foreclose the FTC from ultimately forcing Whole Food Organics to cough up assets and make restitution, it is a more circuitous and difficult one than the direct, one track path of Section 13(b).  First, it has to prevail in the administrative trial, and then, if it wants money, it has to go back to federal court and prove that the Covid-19 and cancer claims were not only false and unsubstantiated, but, under another provision of the FTC statute (Section 19), “dishonest or fraudulent.”  This requirement, to essentially have to prove intent to defraud, is absent from a Section 13(b) case, where the judge has broad equitable authority to order monetary relief, without any finding of willful wrongdoing.

While the FTC was deciding on this legal strategy, a petition for certiorari in the Credit Bureau Center case, which challenges the FTC’s ability to obtain equitable monetary relief under Section 13(b), remains before the Supreme Court, as does a final decision expected to be handed down soon in a Securities and Exchange Commission case presenting the same issue under its statute, which has similarities to the FTC’s.  Could these pending judicial developments, which bear so heavily on the FTC’s enforcement capabilities, have been on its mind when it embarked anew on a long-disused and less efficient procedural path against Whole FoodOrganics, or were other, more prosaic factors at play?  Again, only the FTC knows, but that doesn’t prevent FTC watchers from wondering.  Perhaps the answer as to whether this case was a “one off” or the start of a trend will become clearer when we see what procedure the FTC follows in its next enforcement cases.        

Will the Supreme Court Save the FTC’s Disgorgement Authority?

In January, I wrote about emerging caselaw questioning the long-held view in the federal courts that federal law enforcement agencies, like the Federal Trade Commission and Securities and Exchange Commission, have the legal authority to require violators of their statutes to disgorge their “ill-gotten” gains. (See “Is the FTC’s Most Fearsome Power Now in Peril Before the Supreme Court?”)  I discussed two cases in particular that are before the Supreme Court now.  In one, FTC v. Credit Bureau Center, the FTC is asking the Court to hear and reverse a decision of the Seventh Circuit Court of Appeals holding that the FTC lacks disgorgement authority under its statute. The Court has not yet decided whether to take the case.  In the other, SEC v. Liu, which the Court has accepted, it heard oral argument this month and will be issuing a decision by the end of June.  Because of arguable similarities between the SEC’s and the FTC’s statutory schemes, I and other FTC attorneys and observers have been keenly interested in how the Court decides the disgorgement question in Liu because of what it could mean for the FTC’s own disgorgement powers.  From the oral argument, we now have our first insights into the justices’ thinking on the issue and perhaps our first clues as to what the decision will be and its implications for the FTC’s disgorgement authority.  In my judgment, having listened to the argument, both the SEC and the FTC have more reason to be optimistic about the outcome than the defendants in the two cases.

The SEC statute in question authorizes the agency to seek an injunction against a violation and any equitable relief that may be appropriate or necessary for the benefit of investors.”  It says nothing about disgorgement. The question presented to the Court, therefore, is whether “equitable relief”, as provided for in the statute, includes disgorgement.  In SEC v. Kokesh, in 2017, the Supreme Court held that disgorgement was a penalty, thus making it a legal, rather than an equitable, remedy.  It did so, however, only in the context of deciding whether a federal statute of limitations, which covers actions seeking penalties, applied to a case in which the SEC was seeking disgorgement.  Further, in holding the statute of limitations did apply, it emphasized that it was expressing no view on the underlying issue of whether the SEC possesses disgorgement authority. During argument, Justice Ginsberg was quick to note this disclaimer and the distinction between the two cases, pointedly observing that the fact the Court held that disgorgement is a penalty (thus, not equitable relief) in one context does not mean it would reach the same conclusion in another.

While there was much esoteric argument and questioning about the parameters of “equitable relief” in the statute in light of the historical development of equitable remedies in the law, a number of justices – liberal and conservative alike – honed in on a couple of very practical questions, in a way that suggested they were looking for a solution to save the SEC’s disgorgement power.  One was to inquire how often the SEC actually returns disgorged assets to victimized investors, versus simply turning the money over to the U.S. Treasury.  This led to some justices suggesting that the SEC, as a condition of obtaining disgorgement, be required to return recovered funds to victims wherever feasible.  The other was to ask how the disgorgement calculation worked in actual practice, specifically, what if any business expenses were excluded from the calculation.  The justices seemed to show an interest in narrowing the profits to be disgorged by permitting deduction for  expenses except those that directly contributed to the securities violation (i.e., expenses associated with making misrepresentations about an investment).  It is always hazardous to predict an outcome in a case based on oral argument, but several members of the Court certainly seemed to be looking for a practical way to save the SEC’s disgorgement authority, while placing limits on it.

Like the SEC’s statute, the FTC’s authorizes injunctions, but unlike it, makes no provision for “equitable relief.”  Because of this difference, how the Court interprets “equitable relief” in the SEC statute vis a vis disgorgement may tell us very little about how it would construe the FTC’s statute on the same question, since it does not contain those two important words. Without the “hook” of those words, the Court, should it hear Credit Bureau Center or another case challenging the FTC’s disgorgement authority, conceivably could have a harder time finding that authority in the FTC’s statute than it did in Liu.  As a matter of statutory interpretation, it could come down to whether the single word “injunction,” an equitable remedy employed to prevent future harm, encompasses disgorgement, a tool used to redress past harm.  If so, and if it were to be as determined to save the FTC’s disgorgement powers as it seems to be to save the SEC’s, the Court could look for inspiration to the dissenting opinion in the 7th Circuit decision in Credit Bureau Center.  It argues that injunctions come in many varieties, mandatory as well as prohibitory; they are flexible enough to contain a disgorgement component for equitable restitution; and disgorgement of ill-gotten gains has a forward-looking purpose of deterrence, not just a backward-looking function of redress.

Pending the Court taking up Credit Bureau Center or a similar FTC case directly, a decision in Liu upholding but limiting the SEC’s disgorgement authority could circumscribe the FTC’s disgorgement authority in the same way.  The FTC, like the SEC, has complete discretion whether to return disgorged assets to harmed consumers or give the money to the Treasury, and frequently opts for the latter.  It also routinely seeks disgorgement not just of a defendant’s illicit profits, but its entire gross revenue from the challenged business activity, less chargebacks and credits.  A decision in Liu limiting the SEC’s discretion in disposing of disgorged assets, by mandating their return to victims whenever feasible, and requiring deduction of business expenses not directly incurred in furtherance of the illegal scheme in the disgorgement calculation, appropriately should carry over to the FTC as well.  While this would not represent the total victory that opponents of the FTC’s disgorgement authority might want, it could make a meaningful difference to FTC defendants in individual cases, and certainly provide fresh legal ammunition to their counsel as they oppose disgorgement, or seek to limit its impact on their clients.                                                   

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