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From Securities Regulation Daily, February 18, 2014

Disgorgement can be based on profits not personally gained by insider trader

By Amanda Maine, J.D.

A panel of the Second Circuit Court of Appeals said the district court’s inclusion of profits gained due to trades executed by a fund manager on behalf of the fund could be used in the calculation of disgorgement for insider trading, even though those profits did not personally accrue to the manager (SEC v. Contorinis, February 18, 2014, Lynch, G.).

Background. Joseph Contorinis, a former managing director at Jefferies and Co., was convicted on seven counts of securities fraud and one count of conspiracy for his role in an insider-trading scheme. Contorinis was accused of using inside information received from a UBS employee to trade for a fund he co-managed. The UBS employee tipped Contorinis about an acquisition involving supermarket chain Albertsons. Contorinis used that information to trade in Albertsons’ stock on behalf of not himself, but on behalf of the Jeffries Paragon Fund. As a result, the Paragon Fund realized profits of over $7.3 million and avoided losses of over $5.3 million.

Following his conviction, Contorinis was sentenced to six years in prison and ordered to pay over $12.6 million in criminal forfeiture penalties, an amount equal to the combined value of the Paragon Fund’s realized profits and avoided losses. On appeal, the Second Circuit vacated the criminal forfeiture amount because criminal forfeiture penalties are usually based on the defendant’s actual gain. On remand, the district court ordered forfeiture of the amount of Contorinis’s compensation from his trading activities, less than half-a-million dollars.

SEC action. Following Contorinis’s criminal conviction, the SEC moved for summary judgment in its parallel civil action. The district court ordered Contorinis to disgorge $7.2 million (less any amount paid pursuant to the criminal forfeiture) and to pay $2.5 million in pre-judgment interest on the disgorgement amount. Contorinis was also ordered to pay a civil penalty of $1 million and to be permanently enjoined from violating the securities laws. Contorinis appealed.

“Tipper-tippee” relationship. On appeal, Contorinis argued that ordering him to disgorge the entire amount gained through his insider trading is a misapplication of the disgorgement principle because he never personally controlled the profits that accrued to the Paragon Fund. A majority of the appellate panel disagreed, likening his role in the scheme to that of a tipper. The panel noted that insider traders have been ordered to disgorge benefits that accrue to third parties whose gains can be attributed to the wrongdoer’s conduct, such as when a tipper passes on inside information to a friend, colleague, or family member. It would be inconsistent, in the panel’s view, to deny a district court the discretion to impose the same liability for conduct such as Contorinis’s. In fact, in this situation, Contorinis had even more control over the Paragon Fund’s illegal profits than a tipper would in a typical tipper-tippee situation, the panel observed. “The amount a court may order a wrongdoer to disgorge may not exceed the total amount of gain from the illegal action, but that does not entail that the gain must personally accrue to the wrongdoer,” the panel stated.

Criminal forfeiture and disgorgement. Contorinis also argued that the Second Circuit in his criminal case had limited the extent of his criminal forfeiture to his personal gain and that the same principle should apply to disgorgement. The panel again disagreed, noting that the two remedies reflect different characteristics and purposes. Where disgorgement is an equitable remedy designed to prevent unjust enrichment, criminal forfeiture is a statutory penalty that imposes punishment. Because criminal forfeiture is punitive, it would be “irrational” to impose it upon “innocent third parties,” according to the panel. In contrast, disgorgement’s purpose of preventing unjust enrichment would be thwarted if insider traders were allowed to “pass their illicit gains to affiliates,” the panel reasoned.

The majority of the panel concluded that the district court did not abuse its discretion in ordering Contorinis to disgorge the profits that accrued to the Paragon Fund through his illegal actions. It also found that there was no abuse in discretion in ordering pre-judgment interest on that disgorgement amount.

Dissent. Judge Chin disagreed with his colleagues that the disgorgement ordered was not an abuse of discretion. By ordering Contorinis to “disgorge funds he never had and to pay back profits he never received,” the district court was effectively punishing him, and disgorgement is not intended to be punitive, but remedial, he observed. He, like Contorinis, also found the majority’s position to be inconsistent with the Second Circuit’s prior holding in the criminal case that he could not be required to forfeit the profits earned by the Paragon Fund’s from his illegal activity.

In addition, he took issue with his colleague’s analogizing the relationship between Contorinis and the Paragon Fund to the relationship between a tipper and a tippee. In the later situation, Judge Chin explained, the tipper breaches a fiduciary duty by disclosing the information to the tippee, who trades on the information, and the tipper obtains some benefit from the disclosure. Here, Contorinis was not a tipper and there was no evidence that the Paragon Fund knew that he had breached a fiduciary duty. The Fund did not act in concert with Contorinis and he never possessed or controlled its profits. As the profits made by the Fund were improperly included in the disgorgement calculation, Judge Chin stated that, in his view, the disgorgement amount was an abuse of discretion by the district court.

The case is No. 12-1723-cv.

Attorneys: Allan Armistead Capute for the SEC. Farrah Robyn Berse (Paul, Weiss, Rifkind, Wharton & Garrison LLP) for Joseph Contorinis.

Companies: Jefferies and Co.; The Paragon Fund; Albertsons LLC; UBS Investment Bank

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