The cost of insider trading just got more expensive for those
who get caught. In a February 18, 2014 decision by the U.S.
Court of Appeals for the Second Circuit, a split appeals court
panel found that an individual held liable for civil insider
trading while working at an investment fund can be required to
disgorge not only the profits he or she individually made by
arranging for the winning trades for the fund, but can also be
required to personally disgorge all of the profits that the fund
reaped as a result of the illegal trades.
Background
In Securities and Exchange Commission v. Contorinis, the
defendant, Joseph Contorinis had previously been employed as a
Managing Director at Jeffries & Company, Inc. where Contorinis
was the co-manager for the Jeffries Paragon Fund (the "Paragon
Fund"). An employee at another investment bank disclosed
to Contorinis details regarding a merger, and Contorinis "made
several opportune trades" in the target company's stock on
behalf of the Paragon Fund. As a result of these insider
trades, the Paragon Fund realized profits of $7,304,738, and
avoided losses of $5,345,700.
Contorinis was prosecuted both criminally by the U.S.
Attorney's Office for the Southern District of New York and
civilly by the SEC for insider trading. He was convicted at
the criminal trial and sentenced to a term of six years'
imprisonment, and ordered to forfeit $427,875, the amount of
Contorinis' "personal profit" in the form of
"linked compensation from the trades."
In the civil SEC insider trading case, the SEC sought from
Contorinis, among other things, the disgorgement of $7,260,604 in
unlawful profits obtained by the Paragon Fund (equivalent to the
total profit from insider trading less trading commission
costs). Following the criminal conviction, the District Court
granted the SEC's motion for summary judgment on the civil
insider trading case. It ordered Contorinis to disgorge
$7,260,604 (less any amount paid pursuant to the criminal
forfeiture), ordered Contorinis to pay $2,485,205 in prejudgment
interest on the disgorgement amount, and imposed a civil penalty of
$1,000,000.
Second Circuit Decision
On appeal, Contorinis challenged the disgorgement order, arguing
that because he never personally controlled the profits that
accrued to the Paragon Fund – although he could make
investment decisions, he did not control disbursement of the
proceeds – ordering him to disgorge the entire amount gained
through his insider trading was a misapplication of the
disgorgement principle. Contorinis did not trade for his own
account with his own funds, but rather on behalf of an investment
fund that he managed and whose assets belonged to third-party
investors. Therefore, he did not personally enjoy the
proceeds of the resulting gain (beyond the increase in his
compensation linked to the performance of the Paragon Fund) and
should not be required to disgorge the Fund's profits. In
response, the SEC argued that a fraudster should be compelled to
return not only those profits from the fraud that he has reserved
for his own use, but also those that he has bestowed on
others.
In rejecting Contorinis' argument, the Second Circuit held that
an insider who directly trades for the account of another must
disgorge the benefit he obtained for his favored beneficiary.
It reasoned,
"Contorinis both obtained the inside information that facilitated the illegal trade and executed the trade on behalf of the Paragon Fund. He controlled the size and timing of the trades, and was then entirely responsible for the size of the Paragon Fund's gains. Moreover, it was Contorinis's business to make trades on behalf of the Paragon Fund. Not only did he profit directly from the additional incentive compensation he received based on his successful (but corrupt) trades, but by making profitable trades on behalf of his clients he enhanced his reputation and increased the likelihood of his receiving future benefits as a fund manager."
The Court concluded, "There is no injustice, therefore, in
making him responsible for the profits he made for others, as well
as for himself, through his fraudulent insider trades."
The Court held that district courts may — but not
"must" — impose, in appropriate circumstances,
disgorgement liability for insider trading upon wrongdoers when the
gains accrue to innocent third
parties.1
Take Away
In finding that Contorinis may be held responsible for disgorgement
of the Paragon Fund's illegal profits, in a case of first
impression, the Second Circuit created yet another financial risk
for those engaged in insider trading. For fund managers,
their potential individual liability has now increased
exponentially. An individual found liable for securities
fraud who traded on behalf of a fund, in addition to disgorging any
personal remuneration he or she received in connection with the
trades, can now be required to personally disgorge the fund's
profits. In other recent cases, courts have held that the
individual can also be required to repay the salary paid by a
financial institution during the time the individual was an
"unfaithful employee" by violating the securities laws,
as well as restitution to the financial institution in the form of
the cost it incurred in conducting an internal investigation into
the alleged fraud. Combined with the loss of one's
securities licenses, for a fund trader, even a civil finding of
insider trading can now absolutely destroy an individual
financially.
1 Notably, the panel's decision was divided, 2 to 1. Judge Denny Chin dissented from the decision.
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