Yesterday, the U.S. Court of Appeals for the Second Circuit issued an interesting ruling in the case of SEC v. Contorinis that provides the SEC with an additional weapon in its effort to deter insider trading.

The defendant in the case, Joseph Contorinis, was a portfolio manager at Jeffries & Company, Inc. who had investment control over the Jeffries Paragon Fund. The SEC alleged that Contorinis learned confidential information about an upcoming acquisition of the supermarket chain Albertson's, and used that information to engage in insider trading on behalf of the Paragon Fund. According to the SEC, the Paragon Fund realized illegal profits of $7.6 million from these trades. 

The SEC obtained a judgment against Contorinis ordering him to disgorge the $7.26 million, pay a civil penalty of $1 million, and also pay $2.485 million in prejudgment interest on the disgorgement amount. Contorinis appealed this judgment, however. As the Second Circuit summarized it, the question before it was:

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.  Contorinis argues, in effect, that one can only “disgorge” what one has personally “swallowed”; the SEC argues 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 a 2-1 decision, the court found that Contorinis could be required to disgorge the profits he channeled to the Paragon Fund, reasoning that the situation was not unlike one where a defendant passes inside information to a tippee and therefore allows the tippee to realize the profit by themselves. In such a case, the court stated, "the insider would unquestionably be liable to disgorge the profit." Accordingly, the court continued, "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." 

Judge Denny Chin dissented from the majority opinion. In a separate dissent, Judge Chin wrote that disgorgement "should have the effect of returning a defendant to his status quo prior to the wrongdoing." Here, however, Contorinis was required to pay an amount "substantially above what he acquired through his wrongdoing" and ordered to "disgorge funds he never had and to pay back profits he never received." As such, Judge Chin wrote, Contorinis should not be ordered to disgorge the profits the Paragon Fund accrued as a result of his activity.

Bradley J. Bondi, a partner at law firm Cadwalader, told the WSJ that the Contorinis decision should give the SEC a "large hammer to apply in insider trading cases." He added, however, that it remained to be seen whether other circuits would follow the Second Circuit in future disgorgement cases. 

Russ Ryan, a former Assistant Director in the SEC's Division of Enforcement who is now a partner at King & Spalding, recently wrote a paper on this specific topic ("The Facade of SEC Disgorgement"). Ryan says that the law governing SEC disgorgement is in a "state of complete disarray" and that the Contorinis decision just "muddies the water even further." Ryan believes that Judge Chin's dissent gets to the right result, but that both the majority and the dissent still completely overlook the fact that disgorgement of someone else's money "is not a remedy in equity but rather a remedy at law, and thus the SEC has no lawful power to seek it under the federal securities laws and courts have no lawful power to order it.”

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