Disgorgement In An SEC Action When The Fund Has Profits But Not The Trader
Earlier this month the Third Circuit resolved an issue regarding causation, intervening causes and disgorgement in an SEC enforcement action. SEC v. Teo (here). Now the Second Circuit has handed down a ruling on the measure of disgorgement in an action against a portfolio manager with inside information who placed trades in a fund that were profitable but did not personally profit from the trading. SEC v. Contorinis, No. 12-1723-cv (2nd Cir. 2014). The 2-1 ruling requires the trader to disgorge the fund’s profits and creates a split in the circuits on the question, according to the Court.
Joseph Contorinis was a Managing Director at Jeffries & Company. In January 2006 Mr. Contorinis obtained inside information regarding the then pending acquisition talks for supermarket chain Albertson’s, Inc. UBS Investment banker Nicos Stephanou, whose firm was involved in the talks, furnished Mr. Contorinis with information on the then pending transaction. Mr. Contorinis executed trades in the securities of Albertson’s while in possession of the information for the fund he co-managed, Jeffries Paragon Fund. He did not trade for his own account. Paragon Fund realized profits of $7,304,738 and avoided losses of $5,345,700 as a result of the transactions.
In February 2009 Mr. Contorinis was indicted on one count of conspiracy to commit securities fraud and nine counts of securities fraud. A jury convicted him on all but two counts of securities fraud. He was sentenced to serve six years in prison and pay $12,650,438 in criminal forfeiture penalties. Following an appeal the Circuit Court reversed the forfeiture penalties, concluding that the governing statutes do not authorize the forfeiture of proceeds that go directly to an innocent third party and are never possessed by the defendant.
The SEC also named Mr. Contorinis as a defendant in an insider trading complaint based on the Albertson’s transactions. The district court granted the Commission’s summary judgment motion, relying on collateral estoppel based on the criminal jury verdict. The District Court then entered a permanent injunction against Mr. Contorinis and directed that he pay disgorgement of $7,260,604 (less any amounts paid in the criminal case), prejudgment interest and a $1 million civil penalty.
The key question before the Circuit Court was whether an insider trader who has no trading profits, but placed trades for a fund which was unaware that he possessed inside information, can be directed to disgorge the profits of that fund. Disgorgement is an equitable remedy the Court began, designed to ensure that wrongdoers do not profit from their illegal conduct. “By forcing wrongdoers to give back the fruits of their illegal conduct, disgorgement also has the effect of deterring subsequent fraud,” according to the Second Circuit (citations omitted). Since disgorgement does not have a punitive function or purpose, the “amount may not exceed the amount obtained through the wrongdoing.”
In this case Defendant Contorinis argued that he should only be required to disgorge what he “personally swallowed,” that is, the money he obtained. The SEC claimed that he should be required to return “not only those profits from the fraud that he has reserved for his own use, but also those that he bestowed on others.”
The Court concluded that the SEC is correct based on a series of tipping cases. In those cases the Court held that a “tippee’s gains are attributable to the tipper, regardless whether benefit accrues to the tipper.” This is because a potential “tipper in possession of inside information who seeks to confer a benefit on a friend or to curry favor with someone who can confer reciprocal benefits in the future can do so either by trading on the information himself and passing the profit on to the intended beneficiary, or by passing the information to the beneficiary and thus allowing the tippee to realize the profit himself.” (emphasis original). This rule makes perfect sense the Court found.
Based on the tipper—tippee cases it “must follow” that a person with inside information such as Mr. Contorinis, who uses it to trade for the and benefit of the fund, is responsible for its profits. This conclusion “prevents insider traders from evading liability by operating through or on behalf of third parties,” the Court stated. Thus the district court can, but need, require the payment of disgorgement under the circumstances here since it is discretionary.
In reaching its conclusion the Court acknowledged that other courts on related issues have reached different results. While no other circuit “has spoken to the precise question . . . [here] Circuits which have considered related issues are mixed regarding the extent to which a party can be ordered to disgorge total gain from an unlawful act, when the party has not personally received the full benefit of the wrongdoing.”
Judge Denny Chin dissented, arguing that disgorgement is an “equitable remedy that requires a defendant to give up the amount by which he was unjustly enriched.” (emphasis original). The focus is equitable, not punitive. Requiring that a defendant give up more than he got goes beyond the basic theory of the remedy.
The tipper and tippee cases are inapposite, according to Judge Chin. In that situation the “tipper and tippee are concerted actors, jointly engaged in fraudulent activity – the tipper breaches a fiduciary duty by disclosing inside information; the tippee trades on that information, knowing of the breach and without disclosing that he knows; and the tipper obtains a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.”
This is not the case here. Mr. Contorinis was not a tipper. The fund was not a tippee engaged in fraudulent conduct. To the contrary, the fund was an innocent party. Accordingly, the tipper-tippee cases are inapplicable. Rather, the basic equitable principles on which disgorgement is based should govern.