Court Decision Makes Fund Managers Engaged in Insider Trading Personally Liable for Fund Trading Profits

February 20, 2014

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.

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.

For more information contact:

Howard R. Elisofon +1 212 592 1437 or [email protected]

© 2014 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.

1 Notably, the panel's decision was divided, 2 to 1. Judge Denny Chin dissented from the decision.