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In mid-November, the SEC announced its enforcement results for fiscal year 2023, which included the second-highest disgorgement total in history at approximately $3.4B. Additionally, on October 4, 2023, Deputy Attorney General Lisa Monaco also announced a new Safe Harbor Policy for voluntary self-disclosures made in connection with mergers and acquisitions indicating the DOJ will seek disgorgement in situations where corporations self-report misconduct identified at acquired companies. Disgorgement, or the return of “net profit,” is a longstanding cornerstone of DOJ and SEC resolutions involving corporations determined to have obtained ill-gotten gains connected to violations of law.[1] These recent announcements serve as reminders to defense and corporate counsel on the importance of developing well-reasoned disgorgement analyses when negotiating a resolution with the government.
Prior to engaging in resolution discussions or negotiations with the DOJ, SEC, or other regulators, counsel should invest time and resources to develop and advocate a defensible “net profit” calculation. Understanding and analyzing the drivers of these calculations can yield incredibly favorable results in the form of significantly reduced disgorgement resolutions; but doing so can be complicated, particularly when the revenue and expenses at issue are associated with complex contracts, transactions, or other commercial arrangements. Moreover, corporate expenses are often recognized, measured, and attributed using involuted cost pooling or other allocation methodologies.
The specific exercise that defense and corporate counsel need to perform is nuanced, and first requires the identification of revenues at issue. Various but-for scenarios should be considered to determine if it can be credibly argued that certain revenues would have been earned regardless of the alleged illegal activities. Once the tainted revenues at issue are ascertained, the complicated task of identifying the costs associated with generating those revenues begins. Here, a real opportunity exists to incorporate an array of accounting information, including appropriately performed analyses and calculations, into a dynamic disgorgement model where various “net profit” outcomes can then be evaluated on the merits.
With this in mind, we suggest eight things for defense counsel to consider when modeling disgorgement scenarios for corporate clients and preparing to engage with the government on the topic of net profits. While our suggestions are directed at the defense bar, corporate counsel and executives should also be mindful of the opportunities that exist to drive an improved disgorgement result.
1. Don’t procrastinate
The full benefits of conducting your own disgorgement analysis can only be realized if you begin well in advance of engaging the government in discussions designed to reach a resolution. Failing to do so exposes the client to time pressures that may not be negotiable once conversations with the government commence. Moreover, defense counsel should avoid communicating numbers to the government until sufficient time has been devoted to developing a well-reasoned disgorgement analysis, as these preliminary calculations can often be difficult to walk-back. There is often a direct correlation between the time invested to build a dynamic disgorgement model and favorable outcomes. For example, analyses can inform counsel’s strategy in advance of Filip factors[2] presentations by framing the financial impact of various arguments in advance of those meetings. In other instances, analyses enable defense counsel to shape the conversation with SEC staff regarding what an appropriate disgorgement theory and calculation methodology should entail given unique sets of facts.
2. Look beyond expenses
While a detailed analysis of costs is critical, it’s important to remember that the starting point for any net profit analysis is identifying the revenues at issue. Analyzing the factual record and developing various but-for scenarios to determine whether certain revenues were generated separate and apart from alleged violations of law is a critical part of this process. For example, a government argument that all revenues associated with a new product launch are tainted may be rebutted with data and analysis indicating that the product (absent any alleged violation of law) could reasonably be expected to gain market entrance at some point in the near future.
3. Do sweat the small stuff
Once a thorough understanding of the facts and circumstances of the matter is obtained, an exercise should be undertaken to identify and classify all potential costs associated with the tainted revenues at issue. This phase of the analysis often requires a deep dive into product- and service-level costs, as well as corporate- and subsidiary-level costs. Digging into seemingly minor expenses can open avenues of inquiry into other potentially relevant costs to include in the dynamic model. For example, unpacking the costs associated with manufacturing a seemingly insignificant product component can open a door to an array of costs incurred to design that same component to technical specification.
4. Think creatively
Post-Liu, where disgorgement is limited to the net profits from wrongdoing, there is a greater ability to leverage forensic accounting expertise to argue for the inclusion of various costs that may have been historically ignored (e.g., R&D and production set-up costs). Defense counsel will be better positioned to assist clients with identifying and analyzing certain costs that may initially appear to be indirect in nature but are in fact direct costs associated with the tainted revenues, thereby reducing the net profit to be disgorged.
5. Build a model that incorporates multiple scenarios
A dynamic disgorgement model presents various net profit outcome scenarios based on changes in assumptions such as duration of time and the inclusion or exclusion of certain geographies, revenues associated with products and services, and associated costs. Understanding these drivers enables defense counsel to tailor their strategy and maximize focus on the material elements of the net profit calculation, while also providing an opportunity to strike a cooperative tone with the government relating to categories of revenues and costs having minimal impacts on modeled outcomes.
6. Think like the government
Analyzing net profit scenarios through the lens of a regulator enables defense counsel to better calibrate arguments regarding why certain revenues should be excluded in a net profit calculation, as well as categories of costs included. Aligning with forensic accountants who have advocated for disgorgement methodologies and calculations both for and against the government can be a valuable advantage. Moreover, defense counsel would be wise to consider whether leveraging independent expertise to develop and perform a net profit calculation engenders a higher degree of credibility with the government than an analysis performed by the company.
7. Don’t go it alone
Opting to not leverage accounting expertise in advance of government engagement can place the respondent at a tremendous disadvantage. Seasoned government agents know to not approach disgorgement theories and calculations as a post-op exercise. Rather, they can use their in-house accountants to develop and fine-tune methodologies and calculations throughout the investigative process. Defense counsel should be prepared to confront the government’s net profit theory and calculation with well-developed, intellectually honest analyses of its own. Failing to do so exposes the company to the real risk of overpayment.
8. Look under the hood
Defense counsel should seize upon any opportunity presented to scrutinize the revenue and costs assumptions underlying the government’s own net profit calculation. Here, too, leveraging forensic accounting expertise to guide the review of the government’s methodology and calculation can lead to the identification of significant points of disagreement. Paradoxically, these significant points of disagreement can inform constructive conversations with the government that accrue to the benefit of the company.
In today’s environment, substantial disgorgement claims have become the new normal when dealing with law enforcement and regulatory agencies around the world. By following the steps above, defense counsel can capture a strategic advantage when negotiating a reduced net profit result, potentially saving corporate clients tens of millions of dollars. Corporate counsel and executives can also play a key role in driving improved disgorgement outcomes by proactively engaging with defense counsel to probe the merits of undertaking a thorough net profit analysis early in the investigative process.
This article originally appeared in Law360.
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[1] The Supreme Court determined in Liu v. Securities and Exchange Commission that disgorgement is limited to the net profits obtained from violations of federal securities law, and that the calculation of net profits should consider legitimate expenses that have “value independent of fueling a fraudulent scheme.” Liu v. Securities & Exchange Commission, 140 S. Ct. 1936, 1940, 1941 (2020)
[2] More formally referred to as the DOJ’s Principles of Federal Prosecution of Business Organizations (see https://www.justice.gov/jm/jm-9-28000-principles-federal-prosecution-business-organizations#9-28.300), Filip factors refer to the circumstances prosecutors give consideration to when determining whether to charge a crime.
