For all the complexities inherent to securities enforcement litigation, the law of available remedies has been comparatively simple. There are monetary penalties, there are officer-and-director (or other) bars, and there is “disgorgement.” And while penalties are frequently pursued by the Securities and Exchange Commission’s enforcement Staff, and imposed by judges, based on an opaque hash of factors ranging from the seriousness of the offense to the defendant’s personal character and circumstances, demands for the disgorgement of ill-gotten gains traditionally have been straightforward in both theory and application. Because disgorgement ostensibly is not intended to be punitive, and its principal purpose is to prevent culpable defendants from retaining the financial benefits of their transgressions, disgorgement-related fights between the SEC and litigants historically have centered on fixing, and then forfeiting, the amounts actually received by defendants through their own wrongdoing.
However, the line between classic disgorgement and punitive penalties now appears to be blurring. Last month, in SEC v. Contorinis, a divided panel of the U.S. Court of Appeals for the Second Circuit endorsed an expansive theory of disgorgement, affording the SEC broad leeway to demand disgorgement of funds that the defendant never even received in the first place. In a majority opinion by Judge Gerard E. Lynch, the Second Circuit affirmed an order requiring a former Jefferies & Company, Inc.Managing Director to disgorge $7.2 million in insider trading profits previously realized by the Jefferies investment fund he had co-managed. The defendant inContorinis had received only approximately $400,000 in personal gains from his alleged insider trading activities, and argued that any disgorgement award (which was in addition to both a $1 million penalty and injunctive relief) should be limited to those profits. However, the court held that an insider trader may be required to “disgorge” the full measure of profits generated as a result of his or her illegal actions – including profits that the defendant never actually realized. The Second Circuit reasoned that such defendants are no different from insider trading “tippers” who may be forced to disgorge the gains made by their associated “tippees.”
As a powerful dissent by the Honorable Denny Chin underscored, however, the outcome in Contorinis is fundamentally inconsistent with the basic remedy of disgorgement. Specifically, by extending the disgorgement remedy to cover personal assets that had not been obtained as the result of unlawful activity, Contorinis contorts a narrow remedy, intended solely to deprive violators of their “ill-gotten gains,” into a fundamentally punitive remedy that imposes virtually no limits on the amounts that regulators may seek from defendants accused of having committed securities fraud offenses. This outcome is at odds with the basic purpose of disgorgement, which even the majority recognized is not intended to serve a punitive function. Moreover, to the extent that the result in Contorinis was at all dictated by the Second Circuit’s concern for the fate of the full $7.2 million in illegal gains obtained by Jefferies, the decision itself observes that the SEC’s Staff was perfectly capable of seeking disgorgement directly from the investment fund as a “relief defendant.” The Second Circuit’s decision never addresses why the SEC failed to do so, just as it never fully explains why the SEC should be allowed to pursue Contorinis, but not Jefferies, for the full measure of Jefferies’ gains.
Basic fairness aside, Contorinis raises fundamental questions about how disgorgement remedies may be applied going forward, including in cases outside the insider trading context. The Second Circuit’s conclusions logically could be extended to include any and all gains broadly attributable to any participant in an illegal securities fraud scheme. In the accounting fraud context, for example, Contorinis offers no limiting principle as to why the Second Circuit’s reasoning could not similarly be applied to order corporate officers to disgorge the full measure of their employers’ inflated corporate profits resulting from an accounting fraud. For Ponzi schemes or other cases involving outright frauds and confidence schemes, the logic of Contorinis likewise could be extended to allow funds stolen by one defendant to be disgorged by codefendants – regardless of their respective shares of the spoils of unlawful activity.
As the Contorinis majority recognized, no other circuit has addressed this precise question as of yet, and decisions from other circuits that have considered related issues are mixed and imprecise in their reasoning. Decisions by the Second Circuit in this arena tend to have outsized influence. But whether other circuits will adopt the Second Circuit’s sweeping holding, or whether the Second Circuit as a whole will reconsiderContorinis’ conclusions, remains to be seen.