Can a criminal be held responsible for what others gained from his violation? An appeals court answered “yes” when the crime was insider trading and the profits went to a hedge fund rather than directly to the defendant.
Because so many insider trading cases are filed in the Federal District Court in Manhattan, the United States Court of Appeals for the Second Circuit has become the focal point for shaping the law in this area. An opinion it issued last week empowers the Securities and Exchange Commission to seek money from defendants even when they did not personally receive proceeds from insider trading activity.
The law requires a defendant who is convicted to forfeit all gains realized from the violation. That includes the actual proceeds of the crime, plus any other assets needed to repay the profits derived from the crime. Forfeiture is a type of punishment, like a prison term and fine, that is intended to ensure that crime does not pay.
That is exactly what prosecutors tried to do after Joseph Contorinis was convicted in 2010 of insider trading based on tips he received from an investment banker at UBS. As a portfolio manager at Jefferies & Company, Mr. Contorinis made trades based on confidential information on behalf of the fund he managed that generated $7.2 million in profits, from which he received about $427,000 in compensation.
After his conviction, the district court ordered Mr. Contorinis to forfeit the $7.2 million in profits obtained by his fund. But the appeals court overturned that order, finding that he could only be held responsible for what he obtained personally through the insider trading.
The appeals court said, “Because the ‘proceeds’ sought by the government here were ‘acquired’ by the fund over which appellant lacks control,” Mr. Contorinis could not be responsible to forfeit money he had never received. That analysis would appear to limit an insider trading defendant’s potential exposure to only those amounts flowing directly from the trading.
But that was not the end of the matter. The S.E.C. also filed civil charges against Mr. Contorinis over the same trading.
In some insider trading cases, the S.E.C. and the Justice Department pursue parallel civil and criminal charges for the same transactions. This is permitted because the civil case does not result in any punishment, so the constitutional protection against double jeopardy does not apply. The criminal prosecution almost always goes first because of the potential for a jail term, and a conviction means the S.E.C. can simply point to that result to prove the civil violation.
Based on the criminal conviction in the S.E.C.’s civil case, the Federal District Court for the Southern District of New York ordered him to disgorge the same $7.2 million that he could not be required to forfeit. He also appealed this order to the Court of Appeals for the Second Circuit, which summarized his argument as “one can only ‘disgorge’ what one has personally ‘swallowed.’”
In an interesting twist, however, a majority of the three-judge panel of the appeals court decided that disgorgement was different from forfeiture, even though both take money from a defendant. “Because disgorgement’s underlying purpose is to make lawbreaking unprofitable for the lawbreaker, it satisfies its design when the lawbreaker returns the fruits of his misdeeds,” the court said.
The majority opinion pointed to insider trading cases involving tipping– in which others obtain the profits from information supplied by the defendant. In that context, the tipper can be ordered to disgorge profits realized by others, even if that person never personally traded on the inside information.
The appellate judges concluded it would be inconsistent to allow the defendant who trades for another person’s account to avoid disgorging profits, while holding the tipper who gave away the information responsible when it is used for profitable trading.
One of the circuit Judges, Denny Chin, dissented, arguing that disgorgement is intended to put a defendant back in the same position he held before the violation. By ordering Mr. Contorinis to repay the $7.2 million obtained by the fund he managed, he is being punished by having to pay money he never actually received. But Judge Chin was in the minority, and as the ruling stands, Mr. Contorinis will be responsible for coming up with that sum.
With the appeals court’s decision, the S.E.C. can use its disgorgement authority in other cases. Last week, it filed insider trading charges against Frank Perkins Hixon Jr., a former investment banker at the Evercore Group, in a Federal District Court for the Western District of Texas. Mr. Hixon is accused of directing trades based on confidential information from his firm in the account of a former girlfriend as a means to pay support for a child he had with the woman. If the Texas court accepts the analysis from the Contorinis opinion, then he can be held responsible to disgorge those profits even though they never flowed directly to him.
It remains to be seen how the disgorgement policy can be applied to trading by hedge funds and other investment vehicles when the defendant did not actually make the trading decision. The recent conviction of Mathew Martoma illustrates how broadly this remedy could be used against defendants receiving confidential information that is used by their employer to make profitable trades.
Mr. Martoma obtained information about a drug trial that led SAC Capital Advisors, where he was a portfolio manager, to sell out its positions in two companies involved in developing the drug and then shorting the shares of one. The actual trading decision was made by Steven A. Cohen, SAC’s founder and primary owner, after a 20-minute conversation with Mr. Martoma. SAC netted about $275 million in gains and losses avoided.
Mr. Cohen did not testify at trial, indicating that he would assert the Fifth Amendment privilege if called as a witness, so we don’t know whether the inside information actually led to the trading decision. But it was clear at trial that Mr. Martoma did not have the authority to direct the trades, only to make a recommendation to Mr. Cohen about the two companies.
The question is whether the lack of direct involvement in the trades might insulate an analyst or portfolio manager from an order to disgorge profits obtained by the firm. The approach taken by the appellate court’s ruling in the Contorinis opinion supports extending the remedy to someone in a position like Mr. Martoma because the goal is to hold the defendant responsible for any gains traceable to the inside information.
So technical niceties about who had the actual authority to make a trade are unlikely to stand in the way of the S.E.C. seeking to deprive a defendant of any possible benefit from the misuse of confidential information. Thus, every goose and gander gets the same sauce.
A complicating factor in Mr. Martoma’s case is SAC’s settlement with the S.E.C., which resulted in the firm paying about $275 million in disgorgement as part of its $600 million settlement with the agency. Its willingness to repay its illicit gains may insulate Mr. Martoma from any liability for SAC’s trading, although he will certainly face a claim for his own compensation tied to the transactions.
The appellate court’s decision on the broad scope of disgorgement means the S.E.C. has a tool to recover money from insider trading that is not available to the Justice Department through forfeiture. Although disgorgement is not intended to operate as a punishment, defendants will have a hard time avoiding a demand to repay any benefits realized from the misuse of confidential information.