A fund manager was tipped by an investment banker about a pending acquisition on which the banker was working. The fund manager bought shares of the target for the fund, which he did not control, and sold them at a $7.2 million profit when the acquisition was announced. The court affirmed the order of the district court that the fund manager "disgorge" the $7.2 million the fund earned and an an additional $2.5 million in post-judgment interest. The process by which the Second Circuit reached this result was tortuous and a petition for rehearing by the panel and en banc would appear sure to follow.
|SEC Chair Mary Jo White|
What makes this case doubly interesting is not just the weak doctrinal support for the panel's decision, but also the fact that a separate panel of the Second Circuit, in affirming the fund manager's criminal conviction for the same wrongdoing, reversed the finding of another district judge that the fund manager be required, under the criminal forfeiture statute, to make restitution of $12,000,000, the amount of the Fund's profits and avoided losses as a result of the use of material non-public information about the acquisition. The criminal panel, including the dissenting judge in the subsequent Second Circuit S.E.C. decision (Judge Chin), held that the criminal forfeiture statute requires the forfeiture of only those funds "acquired" by the defendant or someone working in concert with him or as a result of his criminal conduct. The court explained: "While property need not be personally or directly in the possession of the defendant, his assignees, or his co-conspirators in order to be subject to forfeiture, the property must have, at some point, been under the defendant's control or the control of his co-conspirators in order to be considered 'acquired' by him. Thus, the Second Circuit held that the amount that the fund manager could be required to forfeit was his "salaries, bonuses, dividends, or enhanced value of equity in the Fund," which turned out to be $427,000.
Ironically, the nature of a criminal forfeiture order is penal while the nature of the equitable remedy of disgorgement in a civil case is remedial and not "punitive." It is difficult to square those two concepts in trying to explain the disparate results in the Contorinis civil and criminal cases. What the "criminal" panel held that the criminal forfeiture statute commands -- a criminal defendant cannot be required to forfeit money he or a confederate did not acquire, i.e., control -- was said by the "S.E.C." panel to place no limit on the potential reach of a trial court's equitable authority. The end result makes no common sense.
"Disgorgement" is a judicial construct, said to derive from the court's equitable authority once it is invoked by the filing of an S.E.C. civil injunctive action. Disgorgement has been recognized as an available "equitable remedy" in such actions since at least the 1960s, and there is a long litany of principles that the courts have announced in fashioning the contours of that remedy. All are faithfully recited (and basically ignored) in the S.E.C. v. Conorinis decision:
- Disgorgement "serves to remedy securities law violations by depriving violators of the fruits of their illegal conduct."
- "The paramount purpose of enforcing the prohibition against insider trading by ordering disgorgement is to make sure that wrongdoers will not profit from their wrongdoing.”
- "Disgorgement is an equitable remedy, imposed to force a defendant to give up the amount by which he was unjustly enriched. By forcing wrongdoers to give back the fruits of their illegal conduct, disgorgement also has the effect of deterring subsequent fraud.”
- "Because disgorgement does not serve a punitive function, the disgorgement amount may not exceed the amount obtained through the wrongdoing.
- "Because disgorgement is not compensatory, it forces a defendant to account for all profits reaped through his securities law violations and to transfer all such money to the court, even if it exceeds actual damages to the victim.
- "Because disgorgement’s underlying purpose is to make lawbreaking unprofitable for the law-breaker, it satisfies its design when the lawbreaker returns the fruits of his misdeeds, regardless of any other ends it may or may not accomplish."
All of this verbiage, culled from decades' worth of Second Circuit cases familiar to securities practitioners and judges throughout the federal system, leads one to believe that the court would follow the same rationale as its fellow panel in the criminal case: since the fund manager did not control the profit made by the fund, and since the fund was not the manager's alter ego, he would not be required to disgorge that profit. But that was not the result.
The court recognizes that the case presented "an ambiguity in the concept of disgorgement." On the one hand, disgorgement embodies the "equitable principle that wrongdoers should not benefit from their misdeeds, and thus should relinquish any profits obtained from them." On the other, while the defendant "did not pocket the profits from his trades, it was he who utilized the inside information, executed the trades, and secured the resulting profit for the benefit of his clients." The issue, the court states, is "whether an insider trader can be required to disgorge not only the profit that he personally enjoyed from his exploitation of inside information, but also the profits of such exploitation that he channeled to friends, family, or clients."
The court starts by drawing a parallel to the tipper-tippee relationship. The cases admitted have held that a tipper who provides inside information to one who he expects will trade on that information is required to disgorge the tipper's profits. (An interesting case on this issue is S.E.C. v. Gowrish, a 2011 Northern District of California decision in which the court, on equitable grounds, limited the defendant tipper's disgorgement to what he personally received from the scheme, equal to 3% of the total profits earned by the tippers and sub-tippees and the defendant himself.) Assuming that these cases are properly decided, what use do they have in this case?
The court concludes that there is no reason to have a different rule for a person who simply enters a trade for the other person's account. The problem with the analysis is that this is not a "tipping" case (at least insofar as what the defendant did with the material non-public information he received). It should be analyzed on its own terms: The defendant received the information and put it to use for the benefit of the fund he managed but did not control. His benefit was the $400,000 he was required to forfeit in the criminal case. Analogizing this situation to a tipping case does not clarify the propriety of the disgorgement order in this case.
After drawing the tipping analogy, the court turns to the fact that the defendant directed the transactions and thus controlled what would occur. This, the court reasons, means that he was at fault and benefited from his wrongdoing: "[I]t 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." This is mushy thinking based on a mushy principle from Dirks: that the defendant must expect to benefit from the tip. The S.E.C. goes to great lengths to argue "personal," meaning psychological, benefit. Some courts have rejected such arguments. A good example is the Commission's unsuccessful attempt in a 2004 Ohio district court case to argue that the tipper benefited from tipping his barber despite the fact that there was no evidence of any business or even personal relationship between the two.
According to the court, the case is even closer than a tipper case to "the bedrock disgorgement case of the insider who executes illegal trades using his own money, and donates the profit to a third party." This case is not that "bedrock disgorgment case." In the bedrock case, the defendant personally profits and decides to send the money to someone else. In this case, however, he never receives -- controls -- the profit of his wrongdoing. The court's formal recitation of its holding makes the anomaly of this decision crystal clear: "[T]he district courts possess discretion to allocate disgorgement liability for insider trading to those responsible for the illegal acts, including to those with investment power over third-party accounts used to make illegal investments as well as to tippers." This sounds not of unjust enrichment but of punishment for wrongdoing. Again, the issue is not whether the defendant has committed a violation of section 10(b) and rule 10b-5; it is whether this supposedly equitable remedy can be stretched to encompass money that the defendant never controlled and could never control.
There are other arguments that the court tosses out: the "uncertainty" principle ("A wrongdoer’s unlawful action may create illicit benefits for the wrongdoer that are indirect or intangible. Because it would be difficult to quantify the advantages of an enhanced reputation or the psychic pleasures of enriching a family member, to require precise articulation of such rewards in calculating disgorgement amounts would allow the wrongdoer to benefit from such uncertainty. As our precedents make clear, the risk of uncertainty in the amount of disgorgement is not properly so allocated."); and the distinction between the purposes of disgorgement in a civil case and forfeiture in a criminal case ("disgorgement is an equitable remedy that prevents unjust enrichment, and criminal forfeiture a statutory legal penalty imposed as punishment … "unjust enrichment may . . . be prevented by requiring the violator to disgorge the unjust enrichment he has procured for the third party").
None of these particular arguments is convincing. The uncertainty argument is misplaced: it has been used in other cases but deals with the difficulty of measuring the amount of profit caused by sloppy bookkeeping by the defendant. The court's analysis of the differences between civil disgorgement and criminal forfeiture appears to be a conclusion is search of a rationale: if the basis of disgorgement is the doctrine of unjust enrichment, then the issue is whether the defendant was enriched, not whether he engaged in unjust conduct.
The court's decision is unmoored. It fails to deal with the central issue: that unjust enrichment requires that the person against whom a restitution or disgorgement order must have controlled the money, at least momentarily. In this case, the defendant was convicted in a criminal trial. Punishment would or will follow. The issue left unanswered is whether an equitable remedy designed to prevent a wrongdoer from personally profiting from his wrongdoing can apply to profits earned by an entity that the defendant did not control. Analogies carry the remedy and the S.E.C. only so far. The dissent by Judge Chin dismantles the majority's opinion in short order: this is not a tipping case, because the "tippee" (the fund) was not in cahoots with the defendant; requiring him to "return" money he never received is in conflict with the rule that disgorgement not be used as a penalty; and the applicability of the reasoning of the Contorinis criminal decision -- that forfeiture cannot be extended "to a situation where the proceeds go directly to an innocent third party and are never possessed by the defendant."
The Court would have been well advised to base its decision on the principles underlying the equitable remedy of disgorgement or restitution rather than on analogies to cases in which the theory has been applied. Its review of the Restatement of the Law, Restitution and Unjust Enrichment (Third), would have made clear that the remedy of disgorgement or restitution is focused on depriving a wrongdoer of the profits of his wrongdoing ("A person is not permitted to profit by his own wrong.") The courts' extension of the disgorgement over the years beyond that basic limiting principle (tipping and "joint and several liability" being the doctrinal vehicles for that extension) reflect more a concern lest the remedy be insufficient to the regulatory goal than a thoughtful exercise in equitable judging.