Insider trading was once said to be a victimless crime. Yet, many parties can claim that they were harmed by such actions, including those who were on the other side of the actual trades, the stock market, the corporation whose shares were involved in the inside trades or even a hedge fund used as the vehicle for the trading.
To that end, leading Wall Street firms are suing two convicted defendants, seeking millions in compensation. They are relying on a federal law, the Mandatory Victims Restitution Act, which has been interpreted to allow companies that incur costs in cooperating with the government to seek repayment of their expenses from defendants. The statute requires a court to order the reimbursement to victims of “other expenses incurred during participation in the investigation or prosecution of the offense.â€
One recent case involves Joseph F. Skowron III, a portfolio manager at a hedge fund owned by Morgan Stanley, ho pleaded guilty to trading on information about a failed drug trial that allowed the fund to avoid approximately $30 million in losses.
A United States district judge in Manhattan, Denise L. Cote, sentenced Mr. Skowron to five years in prison and ordered restitution to Morgan Stanley of $3.8 million for its legal costs related to the criminal and civil investigations of the trading. In addition, the court required him to return $6.4 million, which represented 20 percent of his compensation from 2007 to 2010.
Mr. Skowron’s appeal of the restitution order was presented last week in the United States Court of Appeals for the Second Circuit.
Another case seeks to recover money from Rajat Gupta, who was convicted last year of tipping Raj Rajaratnam with inside information about Goldman Sachs while he was a director of the firm.
Judge Jed S. Rakoff of the Un! ited States District Court for the Southern District of New York sentenced Mr. Gupta in 2012 to two years in prison and is now considering Goldman’s request to be reimbursed nearly $7 million it spent in legal fees related to the case.
Insider trading cases usually require companies to conduct internal investigations to aid the government in determining who might be a source of any secret information. These cases almost always involve dealing with the Securities and Exchange Commission and the Justice Department in their parallel investigations, and the two agencies often file tandem civil and criminal cases.
But the crucial word in the Mandatory Victims Restitution Act is “incurred,†and there isn’t a consensus among federal courts over what expenses are covered.
Companies want it to include all costs related to any part of the case, including dealing with the S.E.C. even though it can only pursue a civil enforcement case. Defendants take a much narrower view, arguing that mandatry restitution covers only expenses arising as direct result of the criminal prosecution by the Justice Department.
The United States Court of Appeals for the District of Columbia Circuit adopted a restrictive view of the statute in United States v. Papagno, a case in which a government agency sought to recover $160,000 it spent on an internal investigation of suspected theft. The court held that only those expenses related to a specific request by prosecutors as part of the criminal case are recoverable, like responding to a subpoena or wearing a wire.
The court stated: “We have trouble seeing how a victim can be said to participate in the criminal investigation or prosecution when (as here) it is conducting its own internal investigation for its own purposesâ€"an internal investigation neither required nor requested by criminal investigators or prosecutors.â€
The Court of Appeals for the Second Circuit took a ! broader v! iew of what can be reimbursed in United States v. Amato, in which a company’s internal investigation of a complex fraud by its employees resulted in a restitution order of more than $3 million for legal fees and accounting costs.
The Court of Appeals found that those costs were a direct and foreseeable consequence of the criminal conduct by the defendant, concluding that “this fraud would force the corporation to expend large sums of money on its own internal investigation as well as its participation in the government’s investigation and prosecution of defendants’ offenses is not surprising.â€
The prosecutions against Mr. Skowron and Mr. Gupta were held in the Federal District Court for the Southern District of New York , so the more liberal standard of the Amato case applies. That makes it more likely that at least the claim for legal fees sought by Morgan Stanley and Goldman will be required.
Given the split i how the appeals courts deal with this issue, however, the Supreme Court may have to step in and resolve just what expenses are incurred as part of a criminal case.
Whether the order to repay Morgan Stanley a portion of Mr. Skowron’s compensation is a more difficult issue. Judge Cote relied on a different provision of the restitution statute that allows for reimbursement for any property of the victim’s that was damaged or lost as a result of the crime.
Judge Cote concluded that Mr. Skowron deprived Morgan Stanley of his honest services by trading on inside information that was prohibited by the firm, and therefore he damaged its property - meaning $6.4 million of his pay.
He was not charged with honest services fraud, which was limited by the Supreme Court in Skilling v. United States to cases involving bribes or kickbacks. It is not clear how his compensation damaged Morgan Stanley or whether the 20 percent ! represent! s his gains from the illegal trading.
If the Court of Appeals for the Second Circuit allows for this type of claim for reimbursement, then this is likely to be another avenue for firms to seek recovery when employees engage in misconduct that results in harm to the firm.
The Mandatory Victims Restitution Act is not the only means by which a firm can seek to recover from a defendant in an insider trading case. Morgan Stanley filed a lawsuit [attached] in Federal District Court for the Southern District of New York last October accusing Mr. Skowron of fraud, breach of fiduciary duty and being a “faithless servant.†It seeks to claw back $32.5 million in compensation that he received and reimbursement of the $33 million the firm paid to settle the S.E.C.’s civil enforcement case from his insider trading.
It would not be a surprise if Goldman Sachs filed a suit against Mr. Gupta asserting the same violations from his tipping of Mr. Rajaratnam to reclaim at least some of his director’ fees.
The wave of insider trading cases has cost companies millions of dollars in dealing with the S.E.C. and Justice Department, which expect corporations to cooperate with the investigations. Look for Wall Street firms to increase efforts to recover at least some of those expenses from dealing with the government.
US vs. Rajat Gupta Restitution Memo by
Morgan Stanley vs. Joseph F. Skowron III Civil Complaint by
