So let’s say you work for a hedge fund or some other financial institution that engages in proprietary trading , and you’re inclined to do some insider trading on your employer’s behalf. You make your trades, but you’re a company man and the profits go to the fund, not your own pocket. And let’s also say you get caught and the SEC sues you for the illicit trading. Not a very fun thought so far, right? It gets worse. Because if the SEC wins its case, it can force you to disgorge your fund’s profits.
The Second Circuit just addressed this issue in a split decision in SEC v. Contorinis. There, Joseph Contorinis had been a managing director at Jeffries & Company, and had executed several trades in the shares of grocery store chain Albertson’s that were based on material, nonpublic information. Contorinis made the trades on behalf of the Jeffries Paragon Fund, and realized profits of $7.3 million and avoided losses of $5.3 million. He didn’t use his own funds or directly profit himself.
Contorinis argued that because he never personally controlled the profits that accrued to the Paragon Fund – he could make investment decisions, but he didn’t control disbursement of the proceeds – ordering him to disgorge the entire amount gained through his insider trading misapplied the disgorgement principle. As the court put it, “Contorinis argue[d], in effect, that one can only ‘disgorge’ what one has personally ‘swallowed.’ ”
The court, or at least Judges Lynch and Carney, wouldn’t have it. They looked at this case through the tipper-tippee lens, in which tippers are liable for third parties whose gains can be attributed to the wrongdoer’s conduct. They held that “it must follow that the insider who, rather than passing the tip along to another, directly trades for that other’s account must equally disgorge the benefit he obtains for his favored beneficiary.”
I wonder, though, if this result squares with Great-West Life & Annuity Ins. Co. v. Knudson, 534 U.S. 204 (2002). Remember, disgorgement is available in SEC enforcement actions under a federal court’s inherent powers and under Section 21(d)(5) of the Exchange Act. But Great-West has this to say about ill-gotten money that a defendant has already spent:
[W]here “the property [sought to be recovered] or its proceeds have been dissipated so that no product remains, [the plaintiff’s] claim is only that of a general creditor,” and the plaintiff “cannot enforce a constructive trust of or an equitable lien upon other property of the [defendant].” Thus, for restitution to lie in equity [and not at law], the action generally must seek not to impose personal liability on the defendant, but to restore to the plaintiff particular funds or property in the defendant’s possession.
That is to say, if the court isn’t taking the money from the defendant itself, what it’s doing is a legal remedy and not an equitable one. And if it isn’t an equitable remedy, it’s not available to the SEC. This isn’t my idea; it’s Russ Ryan’s. I don’t know that Contorinis argued this theory. The court doesn’t acknowledge it in the majority opinion or Judge Chin’s dissent. But I think it could apply equally to a situation where a defendant has traded on behalf of his employer. Regardless, this decision gives a lot of leverage to the SEC in similar situations.