Trading on Tips: SEC May Seek Disgorgement from Trader for Gains in Investment Fund

A trader who uses material nonpublic information to execute trades but does not personally benefit from the resulting gains may nonetheless face disgorgement of all profits, according to a recent Second Circuit opinion.  In Securities Exchange Commission v. Contorinis, No. 12-1723, the Second Circuit affirmed a judgment from the Southern District of New York requiring defendant Joseph Contorinis, a former hedge fund manager at Jeffries & Co., to disgorge nearly $7.3 million in profits realized through an investment fund he had managed.  The court rejected the argument a person can only disgorge profits that are personally enjoyed and instead found that disgorgement may also apply unlawful gains that flow to third parties.  Relying on a principle that the limit for disgorgement is the total amount of gain flowing from illegal action, the Second Circuit concluded that district courts may impose disgorgement liability for gains that flow to third parties.

In reaching its decision, the court analogized to principles of disgorgement in the context of tippers and tippees.  In the classic scenario of insider trading, tippers may be forced to disgorge gains by tippees even if the tippers do not receive any direct economic benefit.  The court reasoned that since tippers must disgorge profits even if they passed the benefit (through cash or information) to a third party, similarly a person who directly trades in another’s account must also disgorge benefits obtained.  This reasoning suggested that if Contorinis had given his inside information to the fund, just as a tipper would to a tippee, he should be liable for the resulting profits.  The court also emphasized that Contorinis had more control over the fund’s profits from the tip than a dipper does over a tippee.

In his dissent, Justice Chin noted that this supposed remedy was actually functioning more like a penalty and was inconsistent with the purpose of disgorgement, which should be remedial in nature.  Rather than returning the Contorinis to the status quo, the disgorgement order penalized him by forcing him to account for profits he did not personally realize.  Thus, Chin concluded, the district court’s decision went “beyond the permissible scope” of the disgorgement remedy.

This opinion gives the SEC power to seek higher disgorgement amounts from defendants who trade on information for the benefit of others.  In the wake of losses in insider trading cases, it is a new arrow in the quiver of the SEC’s enforcement of insider trading laws.