Second Circuit Narrows SEC Disgorgement Powers and Deepens Circuit Split

In a significant recent decision, Securities and Exchange Commission v. Govil,^[1]the Second Circuit substantially narrowed the scope of the Securities and Exchange Commission’s (SEC) disgorgement powers to cases in which the SEC can demonstrate that investors suffered a pecuniary harm. The decision may curtail the SEC’s ability to seek disgorgement as a remedy for a wide range of regulatory violations. The court’s opinion also deepens a split with the Fifth Circuit Court of Appeals, raising the potential for forum shopping and increasing the likelihood that the Supreme Court may be asked to clarify the scope of the SEC’s disgorgement powers.

Litigation Background

The underlying action dates back to 2021, when the SEC brought an enforcement action alleging that Aron Govil, a controlling shareholder of Cemtrex, used his position to cause the company to engage in three fraudulent securities offerings. The SEC alleged that Govil represented to investors that Cemtrex would use the offering proceeds to satisfy outstanding corporate debts and for general corporate purposes, when in fact Govil diverted over $7.3 million of the offering proceeds to his own private accounts. Pursuant to a settlement agreement with Cemtrex, Govil repaid the company $7.1 million through a $1.5 million promissory note and a surrender of all company securities in his control, which Cemtrex then canceled. 

Govil also entered into an agreement with the SEC and consented to the entry of judgment on all counts of securities fraud. However, the agreement left the question of the disgorgement amount unresolved. After securing a partial judgment consistent with the consent agreement, the SEC moved for additional disgorgement of approximately $7.3 million, pursuant to 15 U.S.C. §§78u(d)(5) and (d)(7).^[2]Govil opposed the motion, arguing that any additional disgorgement amount should be reduced by the amount Govil agreed to pay under the Cemtrex settlement agreement. The district court concluded that the investors, rather than Cemtrex, were the victims of Govil’s misconduct, and ordered Govil to pay additional disgorgement of approximately $5.8 million for distribution to the harmed investors. In calculating the disgorgement amount, the district court credited the $1.5 million due to Cemtrex under the promissory note but did not credit the value of the securities Govil surrendered to Cemtrex.

Govil appealed the disgorgement order and argued two grounds for reversal: (1) Disgorgement, except as an equitable remedy within the meaning of Liu v. SEC, was not authorized under 15 U.S.C. §§78u(d)(5) and (d)(7), and (2) the district court erred when it failed to credit the value of Govil’s surrendered securities against the disgorgement award. 

The Second Circuit’s Opinion

First, the Court of Appeals concluded that §§ 78u(d)(5) and (d)(7) did not authorize additional disgorgement. The court observed that in Liu v. SEC, the Supreme Court established two equitable limitations to disgorgement under § 78u(d)(5): (1) Disgorgement must not “exceed a wrongdoer’s net profits,” and (2) disgorgement should be “awarded to victims.”^[3]Shortly after Liu, Congress enacted §78u(d)(7), which gave the SEC the power to “seek” and federal courts the power to “order” the remedy of disgorgement.  

In SEC v. Ahmed, a Second Circuit panel concluded that §78u(d)(7) merely authorized a remedy consistent with the equitable limitations set forth in Liu.^[4]In deciding Ahmed, the Second Circuit expressly disagreed with the Fifth Circuit Court of Appeals’ holding in SEC v. Hallam that §78u(d)(7) authorizes disgorgement in a legal sense and therefore Liu’s equitable limitations are not applicable.^[5]The Govil court recounted in some detail the Fifth Circuit’s analysis in Hallam. First, the Fifth Circuit reasoned that §78u(d)(5) specifically referred to “equitable relief” while §78u(d)(7) omitted that language, suggesting that §78u(d)(7) was not intended to codify Liu. The Fifth Circuit further emphasized that §78u(d)(7) is a statutory amendment that was enacted shortly after Liu, and therefore concluded that Congress intended this amendment to curtail, rather than codify, Liu. Finally, the Fifth Circuit noted that the structure of §78u(d) distinguishes between disgorgement and equitable remedies, supporting a finding that “disgorgement” as authorized by §78u(d)(7) was not an equitable remedy. By contrast, the Second Circuit in Ahmed concluded that §78u(d)(7)’s use of the word “disgorgement,” along with a cross reference to “unjust enrichment,” indicated that the amendment referred to equitable remedies subject to the limitations articulated in Liu, including that disgorgement be awarded to “victims.”

Bound by Ahmed’s holding and applying Liu’s equitable limitations, the Govil court found that a “victim” for purposes of § 78u(d)(5) must suffer pecuniary harm from the securities fraud. In the court’s view, allowing defrauded investors who suffered no pecuniary harm to receive the proceeds of disgorgement would confer a windfall on those investors and frustrate §78u(d)(5)’s equitable purpose. Because the district court did not determine whether any of the investors defrauded by Govil suffered pecuniary harm, the court concluded that disgorgement was not authorized. The court vacated the district court’s order and remanded with instructions to determine whether the investors suffered pecuniary harm as a result of the fraud. 

Second, the Govil court found that even if disgorgement was authorized, the district court erred in its calculation of the disgorgement award. The court observed that disgorgement’s primary aim is to divest a defendant of ill-gotten profits rather than to compensate victims. Accordingly, the court held that a wrongdoer returns “value” for the purpose of disgorgement when he returns property that holds value “in his own hands.” In this case, because the surrendered securities held value to Govil, the return of those securities to Cemtrex should have been credited against the disgorgement award, regardless of whether those securities held any value to Cemtrex or investors. The court then instructed that if the district court determined on remand that disgorgement is authorized, it must value the surrendered securities and credit that value against the overall disgorgement award.

Looking Ahead

The Second Circuit’s decision limits the SEC’s ability to seek disgorgement as a remedy in cases where investors have not suffered pecuniary harm. Such cases may include, for example, books and records violations, unregistered securities offerings, or failure to register as an investment adviser. The decision also solidifies the Second Circuit’s split with the Fifth Circuit. Given the significance to both regulators and defendants of the question of available remedies, the Supreme Court may be asked to resolve this divide among the appellate courts and clarify the scope of its holding in Liu in light of Congress’ subsequent amendments to §78u(d).

^[1]_{No. 22-1658, 86 F.4th 89 (2d Cir. 2023). The panel consisted of U.S. Circuit Judge Denny Chin, U.S. Circuit Judge Steven Menashi and U.S. District Judge Eric Komitee, sitting by designation, with Judge Menashi authoring the opinion.}

^[2]_{SEC v. Govil, No. 21-CV-6150 (JPO), 2022 WL 1639467 (S.D.N.Y. May 24, 2022).}

^[3]_{Liu v. SEC, 140 S. Ct. 1936 (2020).}

^[4]_{SEC v. Ahmed, 72 F.4th 379, 396 (2d Cir. 2023).}

^[5]_{42 F.4th 316 (5th Cir. 2022).}