In SEC v. Govil, No. 22-1658, 2023 WL 7137291 (2d Cir. Oct. 31, 2023), the United States Court of Appeals for the Second Circuit made clear that, in the Second Circuit, the disgorgement remedy available to the SEC pursuant to both 15 U.S.C. § 78u(d)(5) and (7) is equitable. That means it can be awarded only if there are “victims”—i.e., persons who have suffered “pecuniary harm.” The Govil decision solidifies the Second Circuit’s split with the Fifth Circuit, which previously held that Congress’s 2021 amendments to § 78(d)(7) authorized “disgorgement in a legal—not equitable—sense.” SEC v. Hallam, 42 F.4th 316, 338 (5th Cir. 2022)
The circuit split amplifies the uncertainty over how courts in other circuits will interpret the express disgorgement remedy Congress recently adopted in § 78(d)(7), and it increases the likelihood that the Supreme Court will resolve this issue. But, in the meantime, that uncertainty also presents opportunities for those facing SEC investigations and enforcement actions. They and their attorneys should use the ambiguity to push for disgorgement calculations that are more creative and defense-oriented than the calculations the SEC normally would demand.
The SEC alleged that Govil used his position as controlling shareholder to cause the company he founded, Cemtrex, to engage in a variety of fraudulent conduct. As part of his fraud, the SEC contended that Govil caused Cemtrex to issue three securities offerings, and to falsely promise investors that the proceeds from these offerings would be used for corporate purposes and to satisfy outstanding debt. Instead, the SEC claimed that Govil diverted at least $7.3 million of the proceeds from the offerings for his personal use.
Under an agreement with Cemtrex, Govil repaid Cemtrex $7.1 million through a promissory and a return of company preferred shares and unexercised options, which Cemtrex then canceled. Thereafter, Govil entered into a two-part Consent Agreement with the SEC. In the first part, he consented to the entry of judgment against him on all counts of securities fraud and the entry of several permanent injunctions, and to the imposition of civil penalties. In the second part of the Consent Agreement, Govil agreed that the district court would determine whether he should “pay additional disgorgement” with respect to the Cemtrex securities offerings.
In January 2022, the SEC filed a motion seeking $7.3 million in disgorgement pursuant to 15 U.S.C. § 78u(d)(5) and (7). Over Govil’s opposition, the district court awarded the SEC its requested $7.3 million in disgorgement. After crediting Govil for the $1.5 million promissory note he paid to Cemtrex, the district court concluded that Govil owed the SEC $5.8 million in disgorgement related to the Cemtrex offerings. In doing so, the district court rejected Govil’s argument that the entire value of the settlement with Cemtrex, including the returned securities, should be credited against disgorgement. The district court held that the value of the surrendered securities, which Cemtrex promptly canceled, should not count as a payment offsetting disgorgement, because the surrendered and canceled stock did not have value to the investors. Interestingly, the district court noted that the investors may not have suffered any financial harm at all, despite Govil’s fraud, because they may have profited from the rise in value of the securities they received in the fraudulent offerings.
Govil appealed to the Second Circuit. On appeal, Govil argued that (1) disgorgement was not authorized under the Exchange Act because (a) 15 U.S.C. § 78u(d)(5) only authorizes “equitable relief,” which, under Liu v. SEC, 140 S. Ct. 1936 (2020), requires the SEC to demonstrate that there are victims who any disgorgement can be awarded to—a showing the SEC did not make, and (b) the district court improperly did not evaluate whether disgorgement was available under 15 U.S.C. § 78u(d)(7); and (2) even if disgorgement was authorized under the Exchange Act, the district court erred in failing to credit the value of Govil’s surrendered stock against the disgorgement award.
The Second Circuit agreed with Govil on both points.
The Second Circuit’s Conclusions and Reasoning
First, the Second Circuit concluded that the disgorgement remedy under both 15 U.S.C. § 78u(d)(5) and (7) is equitable, which means it is only available if it can be awarded to “victims.” And “victims,” the Second Circuit held, are persons who have suffered “pecuniary harm.” Because the district court never determined whether “the defrauded investors suffered pecuniary harm,” the Second Circuit vacated the district court’s opinion and remanded the case for it to conduct this analysis.
The Court’s holding rested on its review of the legislative history of 15 U.S.C. § 78u(d)(5) and (7), and its own recent decision in SEC v. Ahmed, 72 F.4th 379 (2d Cir. 2023). It first recognized that the Supreme Court’s 2020 Liu decision clarified that, under § 78u(d)(5), a disgorgement award is equitable relief and, therefore, is permissible only if it “does not exceed a wrongdoer’s net profits” and is “awarded for victims.” Id. (citing 140 S. Ct. at 1940). Although the Court noted that, six months after Liu was decided, Congress amended 15 U.S.C. § 78u(d) by adding § 78u(d)(7) to expressly empower the SEC to seek, and courts to grant, disgorgement, id., it held that it was bound to follow its recent opinion in Ahmed, which held that the Liu principles apply to disgorgement awards under § 78u(d)(7). In the Second Circuit’s view, Congress codified Liu‘s equitable disgorgement remedy in § 78u(d)(7); it did not change or expand the remedy. Consequently, the Court held that “disgorgements under both § 78u(d)(5) and (7) are constrained by Liu.” 2023 WL 7137291 at *7.
Having determined that Liu applies to both § 78u(d)(5) and (7), the Second Circuit next addressed an issue left unresolved by Liu: Who is a “victim”? A “victim” in the securities context, the Govil court held, is someone who has suffered “pecuniary harm.” The Court emphasized that it was not enough for a party to be defrauded; indeed, to allow defrauded investors who had not lost money to receive proceeds from a disgorgement award would confer a “windfall on those who received the benefit of the bargain.” 2023 WL 713291 at *9. Instead, the defrauded party must also suffer a pecuniary loss to be deemed a “victim” for purposes of disgorgement. The Second Circuit then remanded the case to the district court to determine whether the investors were “victims,” given the possibility that they may have in fact profited from their participation in the offerings. Id. at *12.
Second, the Second Circuit held that “a wrongdoer returns ‘value’ for the purpose of disgorgement whenever he returns property that holds value in his own hands,” id. at *13 (emphasis added). It does not matter that the returned property is worthless to the victim, because the primary purpose of disgorgement is “to divest profits, not to compensate victims.” Id. The Court concluded that the district court erred in failing to credit Govil for the value of the shares he surrendered to Cemtrex, even though they had no value to Centrex, which canceled them, or to the investors. Because those shares had value to Govil when he surrendered them, the Court held that the district court should have offset their value against any disgorgement award. Id. at *14.
Since the congressional amendment adding § 78u(d)(7) in 2021, courts and practitioners have questioned whether the equitable limits articulated in Liu remain good law. See, e.g., SEC v. Sharp, 626 F. Supp. 3d 345, 371-72 (D. Mass. 2022) (characterizing Liu as superseded by the NDAA); SEC v. Barry, No. 2:15-cv-02563 DDP (MAAx), 2023 U.S. Dist. LEXIS 120200, at *4 (C.D. Cal. July 12, 2023) (stating that it “is not clear whether Congress intended [ ] to override Liu . . . ” in enacting the NDAA). Govil deepens the circuit split between the Second and Fifth Circuits as to whether the equitable limits articulated in Liu remain intact. They do in the Second Circuit, but not in the Fifth Circuit.
The practical reality of this circuit split means that—unless and until the Supreme Court decides to resolve it—the ability of defendants of SEC enforcement actions to argue against, or to limit, disgorgement awards will likely depend on their geographic location, with defendants in the Second Circuit finding arguments open to them that may be foreclosed in the Fifth Circuit.
In the rest of the country, the issue remains an open question. Defendants and their counsel should take advantage of this uncertainty while it lasts. It is an opportunity to push disgorgement theories and calculations that are more in line with the Second Circuit’s Govil opinion than the Fifth Circuit’s decision in Hallam. Although the SEC likely will object, at least initially, to proposed disgorgement theories that require proof of pecuniary harm to investors or that give the defendant credit for the return of property that might have value only to the defendant, it should also recognize that there exists substantial litigation risk that courts in other circuits will choose to follow the Second Circuit’s Govil decision. That risk creates an opportunity for defendants and their counsel, as well as the SEC staff, to negotiate disgorgement settlements that are less rigid and onerous than the SEC’s traditional disgorgement calculations.