SEC’s $3 Billion Enforcement Tool on Murky Path as Courts Split

Cemtrex Inc. founder Aron Govil, who settled charges he lied to shareholders, could save millions of dollars simply because securities regulators sued him in New York, rather than a place like Louisiana.

US appeals courts disagree about what the Securities and Exchange Commission needs to show to take back profits from alleged wrongdoers: Is it about the person making money from illegal activities, or investors losing money? A patchwork of different requirements is starting to develop, with courts in different parts of the country operating under different rules.

At stake is one of the SEC’s most potent tools for collecting profits from illegal trading activity, which brought in some $3.37 billion in fiscal 2023—more than twice what the agency recovered in fines.

The New York-based Second Circuit, where Govil is fighting a $5.8 million disgorgement order, says the SEC can’t obtain those funds without showing investors actually lost money. The Fifth Circuit, headquartered in New Orleans, only requires that the SEC give a reasonable estimate of how much the defendant made from the illegal acts.

SEC enforcement actions targeting unregistered crypto transactions and Wall Street insider trading are among those where remedies could be limited if the Second Circuit’s approach takes hold, since the agency can’t always show investors suffered losses in those cases, SEC watchers said.

“It could have massive consequences for the SEC if that’s the rule everywhere,” said Thomas McKay, a Morvillo Abramowitz Grand Iason & Anello PC partner and former federal prosecutor.

‘Bridge Too Far’

The lingering questions about recouping ill-gotten gains stem from a 2020 US Supreme Court decision, Liu v. SEC. The high court in that case said the SEC could seek disgorgement, but that it must be “awarded for victims.”

Months later, Congress passed legislation (Public Law 116-283) to explicitly codify the SEC’s disgorgement powers. There was confusion about how the amendments impacted Liu.

The Fifth Circuit’s 2022 decision in SEC v. Hallam found Congress effectively restored the framework that existed before the Supreme Court’s decision. The Second Circuit has taken a different view, however, finding Liu’s limitations survived the changes from lawmakers.

The Second Circuit went a step further when it tossed a disgorgement order against Govil, finding “victims” meant people who “suffered pecuniary harm.” Someone wasn’t a victim, for example, just because they were lied to.

“My supposition is that really was a bridge too far for” the SEC, said Daniel Hayes, a Venable LLP partner and former supervisory trial counsel at the SEC. “They don’t like the idea of a bad actor getting to keep the fruits of his fraud.”

The SEC raised alarms about the Second Circuit’s “pecuniary harm” requirement, telling the appeals court it’s a novel condition that could prevent the agency from obtaining disgorgement even when “there is no dispute that defendants profited from victimizing investors.”

The full Second Circuit rejected the agency’s request for a rehearing in SEC v. Govil earlier this year.

Pecuniary Harm

Without acknowledging Govil, the Eleventh Circuit used similar language in a February decision upholding a disgorgement order against a man who flipped penny stocks and was accused of acting as an unregistered dealer.

The court said disgorgement was appropriate when “the Commission is able to identify investors who have suffered pecuniary harm.” The court noted the SEC in the case at hand planned to distribute money to people who were negatively affected by the price impact of the defendant’s stock-flipping.

That doesn’t clearly align with the Second Circuit, where some attorneys said the SEC likely would have to show the losses were caused by the defendant’s failure to register as a dealer.

The Atlanta-based Eleventh Circuit could address the issue again soon, in another case where “pecuniary harm” may not be readily apparent.

Island Capital Management LLC, a shuttered Florida transfer agent, is fighting a decision requiring it to disgorge tens of thousands of dollars after it was found to have made false statements while helping bring penny stock companies to public markets.

Island Capital, which argued its case at the Eleventh Circuit in September, has pointed to Govil as supporting its argument that disgorgement wasn’t appropriate because “there are no harmed investors, let alone ones that suffered pecuniary harm.”

A loss for the SEC on the question of investor harm could further complicate the agency’s enforcement strategy.

Big Hurdles

The fight over SEC disgorgement continues to percolate, with the agency pushing back against the Govil standard.

In a case against an investment adviser, the SEC told the First Circuit pecuniary harm isn’t required for disgorgement, saying the Govil decision was “incorrect” and shouldn’t be followed. The case was argued Monday in Boston. The SEC also told the Eleventh Circuit that Govil was wrong.

Conditioning disgorgement on the SEC’s ability to show investors lost money will require more work from the agency at the front-end of some cases, attorneys said. It’s a hurdle the agency can’t always clear.

The SEC in court filings has pointed, in particular, to cases involving investment advisers’ alleged breach of duty where disgorgement may be “substantially constrain[ed].” Investor losses can also be difficult to ascertain in cases against companies for unregistered securities transactions, the SEC said. The agency has sued a number of crypto companies for registration violations.

Identifying harmed investors could also be a challenge in insider trading cases, attorneys said.

“The idea that you have to have harm, you have to be able to find the people who were harmed, it doesn’t fit in every kind of violation that the SEC pursues,” said Amy Jane Longo, a Ropes & Gray LLP partner and former regional trial counsel for the SEC’s Los Angeles office.

The lingering circuit split creates its own challenges for an agency tasked with enforcing securities laws nationwide. Whether disgorgement will be available in a given case could impact the agency’s decisions about where to file, or whether to bring an action at all.

“If I knew that I could not get disgorgement and that there were no real victims as a result, if I were within the SEC, it certainly would factor into my charging decisions,” Hayes said. “It doesn’t make for a great court case when you don’t have victims.”

Barring Supreme Court intervention, Govil and the SEC will return to the district court, where the judge will have to decide whether any defrauded investors suffered pecuniary harm. Those proceedings will likely provide guidance on how courts following a similar standard should approach the question.

It remains unclear, for example, how exact the SEC must be in matching profits to investor losses.

“I think we’re really still at the beginning of that,” Longo said.