April 02, 2014 Articles

    Blurred Lines: Disgorgement, Forfeiture, and Punishment

    The Second Circuit has blurred the line between the equitable nature of disgorgement and the punitive nature of forfeiture.

    By Jay Musoff, Nathan J. Muyskens, and Emily H. Stone

    Until recently, criminal-forfeiture and civil-disgorgement actions had related goals. Generally, forfeiture sought to punish an offender by depriving him or her of ill-gotten gains, while disgorgement would restore the status quo by depriving violators the fruits of illegal conduct. In other words, although forfeiture’s aim and nature was punitive, and the equitable goal of disgorgement was to make breaking the law unprofitable, both sought to deprive the offender.

    SEC v. Contorinis
    The Second Circuit has significantly blurred this line in its recent panel opinion in SEC v. Contorinis, changing the landscape of who may be forced to disgorge profits realized from insider trading by blurring the equitable nature of disgorgement with the punitive nature of forfeiture. In 2010, Joseph Contorinis, a portfolio manager at Jeffries & Co., was convicted of insider trading based on tips he received from an investment banker. The trades resulted in $7.2 million in profits for the fund, while Contorinis received about $425,000 in compensation from those profits. The district court’s order that Contorinis forfeit the $7.2 million of the fund’s profits was overturned by the Second Circuit because Contorinis did not control the profits sought. While this analysis appeared to limit exposure of insider-trading defendants to amounts gained directly from the trading, a new opinion with respect to the Securities and Exchange Commission (SEC) civil suit filed against Contorinis for the same trading has changed the game. In that case, the District Court for the Southern District of New York ordered Contorinis to disgorge the $7.2 million in profits that the Second Circuit had held could not be forfeited. The Second Circuit panel affirmed. The opinion likened Contorinis’s case to that of a tipper who can be ordered to disgorge profits made by others on the basis of the tip. Accordingly, the court reasoned, requiring a defendant who trades on another’s account to pay disgorgement was consistent with that practice.

    While the opinion argued the disgorgement was consistent with the case law, this stance marks a true departure in the nature of civil disgorgement: It now goes well beyond criminal forfeiture. Whereas both criminal forfeiture and civil disgorgement previously intended to deprive a defendant of ill-gotten gains, civil disgorgement has now been stretched beyond those shared precepts. It is no longer enough for a defendant to disgorge what he or she has “obtained.” Nor is disgorgement limited to those situations where a defendant is jointly and severally responsible for the concerted actions of others. Instead, the SEC now may seek to hold a defendant responsible for gains obtained by third parties who did not act jointly with the defendant and whose gains were never in his or her possession or control.

    This position was criticized by Judge Chin in his dissenting opinion, which stated that the disgorgement of profits never in the possession or control of Contorini was inconsistent with the nature and purpose of disgorgement. He also found the majority opinion inconsistent with its prior holding in Contorinis’s criminal case, which reversed the $7.2 million in the form of forfeiture. The dissent highlighted that while disgorgement is not intended to be punitive, ordering a defendant to pay $7.2 million he or she never received, in addition to $2.5 million in interest, could not be regarded as anything but. Now civil disgorgement goes well beyond criminal forfeiture.

    Implications for Future Enforcement
    The Second Circuit’s opinion has broadly increased the SEC’s power, although it is yet to be seen whether other circuits will follow suit. The Second Circuit recognized in a footnote that it was the first to address the issue. It is also true, as noted in the opinion, that the imposition of disgorgement in the insider-trading context is not mandated, but rather remains within the discretion of the district court. Despite these unknowns, the fact remains that the majority of insider-trading cases are brought within the Second Circuit, and other circuits may indeed follow the circuit’s lead. The threat of disgorgement is a powerful new weapon for the SEC and one that can be wielded to great effect. This could have far-reaching consequences, not the least of which is an even larger bargaining chip for the SEC in the settlement context.

    Because disgorgement is designed to equitably deprive those who have obtained ill-gotten gains of their unjust enrichment—unlike forfeiture, which is a statutory legal penalty—it may be imposed on innocent third parties who have no legitimate claim to their ill-gotten gains. One curious aspect of this case is that the SEC could have sought to recover the $7.2 million in illegal-trading profits from the fund under well-established principles of disgorgement. Instead, it sought to recover the $7.2 million from Contorinis, leaving the fund and its participants with a $7.2 million profit based on Contorinis’s insider trading. Could Contorinis seek to recover the $7.2 million from the fund under a theory similar to the one the SEC could have used to recover it? Presumably, the SEC cannot also seek to recover $7.2 million from the fund and from Contorinis or it would obtain an impermissible windfall.

    While there is no question that insider trading must be punished, the question must be asked whether civil disgorgement should be transformed into another punishment, despite its equitable nature. At the time of this opinion, Contorinis was a convicted felon. He had been sentenced to six years in prison and been ordered to pay almost half a million dollars in criminal-forfeiture penalties. An order of disgorgement representing almost 15 times his financial gain appears more a punishment than an equitable remedy designed to disgorge trading profits, particularly where it is unclear if he will ever be able to pay it. This is an area of the law to be closely followed in the coming year. With ample opportunities in present cases for the SEC to seek similar disgorgement, it likely will not be long before it becomes clear whether this sea change is here to stay.

    Keywords: criminal litigation, disgorgement, forfeiture, SEC, insider trading

    Jay Musoff, Nathan Muyskens, and Emily Stone are with Loeb & Loeb LLP.

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