April 2014

In a sharply-divided 2-1 vote, the Second Circuit Court of Appeals found that a civil disgorgement amount can exceed the profit that the defendant personally received. Although the case facts and opinion directly involved insider trading in an action brought by the Securities and Exchange Commission, the rationale could presumably be applied to other wrongful conducts.

Disgorgement is an equitable remedy to deprive a defendant of any ill-gotten gains, often called unjust enrichment.  It is an economic calculation which captures the incremental profits obtained through wrongful activity and is not intended as a punitive measure.

In SEC v. Contorinis, (Case 12‐1723‐cv, February 18, 2014), the Second Circuit upheld a trial court decision that Joseph Contorinis, the former managing director of an investment fund, disgorge over $7 million in unlawful gains from insider trading profits that the investment fund obtained. It was undisputed that Mr. Contorinis received little of the benefit (approximately $400,000, which was required as forfeiture in the related criminal trial) from these profits. The Second Circuit rejected Mr. Contorinis’s argument that disgorgement is limited to his personal, as opposed to institutional, profit.

The Second Circuit Opinion included the following explanation for allowing this result:

“Whether 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.

Thus, given our precedent establishing that tippers may be held liable to disgorge the gains of their tippees, it would be inconsistent to deny the district court the discretion to impose equivalent liability for conduct such as Contorinis’s. Indeed, to the extent that this case can be distinguished from the tippertippee situation, the case for disgorgement is stronger here. The tipper in possession of material nonpublic information who passes that inside information to another, even with full knowledge that the tippee will use the information to trade, has no control over, and likely no knowledge of, the extent to which the tippee will trade. …

It thus necessarily follows from existing Circuit precedent, and from the logic of the disgorgement remedy, that Contorinis may be held responsible for disgorgement of the [the party actually receiving the] illegal profits. To conclude otherwise would permit greater liability in a relationship (tippertippee) which is, in all material respects, more tenuous than the relationship here (controlling manager – financial vehicle).”

The Court also points out that without the ability to enforce such a broad remedy, inside traders could circumvent enforcement by trading via a relative, acquaintance or through reciprocal tips between insiders in different corporations. In order to have tools to combat this, the Court wished to provide the election (but not the requirement) that disgorgement liability for insider trading extend to gains accrued to innocent third parties.

Notably, the SEC could have pursued the investment fund who actually received the bulk of the profit as a “relief defendant”, but instead elected to target only Mr. Contorinis. The Court explained that this election was within the SEC’s rights:

“When certain conditions are met, innocent third parties (“relief defendants”) may be ordered to disgorge the proceeds generated by the illegal conduct of a fraudulent investor.  However, imposing such liability upon innocent third parties is elective rather than mandatory….Here the SEC could have sought to recover illegal gains from the Paragon Fund as a relief defendant, but chose, as our case law has indicated is an established and legitimate alternative, to seek damages from the wrongdoer Contorinis directly.  While many factors may be relevant to deciding what remedies are appropriate in particular circumstances, we note that one argument in favor of requiring disgorgement from the trader is that he is culpable, while the third‐party recipients, though unjustly enriched, may have been unaware of any wrongdoing”

As described above, there was strong dissent on the part of one of the judges, who emphasized that this decision does not return Mr. Contorinis to his status quo position prior to the wrongdoing and therefore this application is inequitable.  Importantly, it remains to be seen how the principles and rationale described above could potentially be applied to other applications of disgorgement outside of the insider trading environment. If this were to occur, the remedy of disgorgement would change dramatically.

Fulcrum Inquiry performs damages analysis and related expert testimony.