In SEC v. Contorinis, 2014 U.S. App. LEXIS 2927 (2d Cir. Feb. 18, 2014), the United States Court of Appeals for the Second Circuit upheld the authority of the Securities and Exchange Commission (“SEC”) to obtain “disgorgement” from a money manager profits earned by another party from trades based material nonpublic information known to the money manager, even though the manager did not receive any of those profits.  Citing the intangible benefits received by the manager and the underlying misuse of inside information, the appellate panel’s decision upheld a broad view of insider trading liability in civil enforcement actions brought by the SEC.

In October 2010, Joseph Contorinis was convicted of trading on inside information about the acquisition of supermarket chain Albertson’s Inc.  In a subsequent civil action, the SEC alleged that the former Jefferies Group portfolio manager used that inside information to generate a profit for the Jefferies Paragon Fund (the “Fund’).  The SEC sought to recover from Contorinis $7.26 million in profit earned by the Fund, plus an additional $2.5 million in interest.  Following Contorinis’ criminal conviction, the SEC moved for summary judgment in the civil case.  Contorinis acknowledged that the criminal conviction had a preclusive effect that required a finding of liability in the civil action.  The United States District Court for the Southern District of New York granted the SEC’s summary judgment motion, ordering the defendant to disgorge all of the profits made by the insider trades and pay prejudgment interest on the disgorgement amount. Notably, Contorinis did not directly receive or control that $7.26 million. Instead, the profit went to the Fund. Contorinis appealed.

By a 2-1 majority, a panel of the Second Circuit affirmed.  The appellate panel held that Contorinis could be required to disgorge the profit that he did not personally realize because he gave the Fund the benefit of his inside information, just as a tipper “can be required to disgorge profits realized by their tippees’ illegal insider trading.”  In fact, the majority reasoned, Contorinis had greater control over the fund’s trades and profit than a tipper does over a tippee, as he obtained the information, executed the trades, and was “entirely responsible for the size of the Paragon Fund’s gains.”

Although Contorinis did not receive the direct profits from the trading activity, the panel explained that other, more intangible benefits conferred on him by the insider trades justified the disgorgement amount.  According to the majority decision, “[w]hether the defendant’s motive is direct economic profit, self-aggrandizement, psychic satisfaction from benefitting a loved one, or future profits by enhancing one’s reputation as a successful fund manager, the insider trader who trades for another’s account has engaged in a fraud, secured a benefit thereby, and directed the profits of the fraud where he has chosen them to go.”  The majority reasoned further that prior case law supported this outcome, specifically precedent holding that “an insider trader may be ordered to disgorge not only the unlawful gains that accrue to the wrongdoer directly, but also the benefit that accrues to third parties whose gains can be attributed to the wrongdoer’s conduct.”

In a strong dissenting opinion, Circuit Judge Chin described the underlying district court order as “inconsistent with both the nature and purpose of disgorgement.”  Judge Chin emphasized that disgorgement is an equitable remedy designed to “deprive violators of their ill-gotten gains,” not a punitive measure.  Here, according to Judge Chin, the district court’s order was an abuse of discretion, as it “penalized” Contorinis by requiring him “to pay an amount substantially above what he acquired through his wrongdoing.”  Additionally, Judge Chin noted that the appellate panel had previously held that Contorinis “could not be required to forfeit profits that the Fund earned through his illegal use of inside information” in the related criminal case.  Criminal forfeiture and civil disgorgement are “largely the same” conceptually, Judge Chin argued, and therefore any differences between the two remedies do not justify opposite results in cases with “the same defendant, the same investment fund, and the same proceeds.”  The dissenting opinion also distinguished the situation of a tipper and tippee as involving “concerted actors,” whereas Contorinis’ trading activity involved proceeds that went “directly to an innocent third party and [were] never possessed by the defendant.”

This decision upholds an expansive view of civil liability to the SEC for insider trading and boosts the SEC’s power to deter that activity.  As the profits in these cases are oftentimes substantial, concern regarding potential disgorgement orders for the full profit amount — instead of just the portion of the profit that a trader personally receives — may curb future trading on inside information.  Further, the issue may not yet be settled in the Second Circuit, as Contorinis could petition for en banc review based upon the panel’s split decision and Judge Chin’s strong dissent in a case involving a novel issue of federal securities law enforcement.