The notion of hitting someone where it really hurts - in the wallet - is being taken a step further these days when it comes to violations of securities laws.
The government has many avenues of recourse at its disposal when settling cases involving insider trading and investment fraud. Efforts to impose even greater costs on defendants were shown in two cases last week.
In one, Joseph F. Skowron, a portfolio manager at a hedge fund owned by Morgan Stanley who is serving a sentence for insider trading, was ordered to return approximately $25 million in compensation to the firm because of his misconduct. In the other, the Securities and Exchange Commission is asking a federal judge to impose significant monetary penalties on Fabrice Tourre after he was found liable for fraud in the sale of a collateralized debt obligation. The S.E.C. is also seeking an order to keep him from accepting reimbursement of any penalty from his former employer, Goldman Sachs.
Mr. Skowron had received a five-year prison sentence for insider trading and was ordered to pay $3.8 million in restitution to Morgan Stanley for its legal costs from the criminal and civil investigations and another $6.4 million that represented 20 percent of his compensation from 2007 to 2010. In July 2013, the United States Court of Appeals for the Second Circuit rejected his challenge to the restitution order, finding that the firm was a victim of the crime because it was deprived of his honest services.
Morgan Stanley also filed a lawsuit against Mr. Skowron, accusing him of being a “faithless servant,†meaning that he violated the obligations of loyalty and good faith by putting his own interests ahead of the employer. Under New York State law, which governs in this case, an employee forfeits all compensation received during the time when the person was faithless, regardless of whether the employer suffered any damages from the violation.
Last week, Judge Shira A. Scheindlin of the Federal District Court in Manhattan issued an opinion finding Mr. Skowron acted faithlessly by violating Morgan Stanley’s internal code of conduct that clearly prohibited trading on inside information. She rejected the argument that this was only a single violation that did not support ordering repayment of all his compensation for over three years.
She explained that “Skowron knowingly committed insider trading, explicitly lied to the S.E.C. under oath, and failed to disclose his participation to Morgan Stanley over the course of several years.â€
This means that Mr. Skowron will have to repay Morgan Stanley the compensation - approximately $25 million - that he received from April 2007, when he began receiving the inside information, through November 2010, when his tipper was arrested. Judge Scheindlin concluded that insider trading permeated Mr. Skowron’s work, so that the faithlessness could not be apportioned just to the particular trades involving confidential information.
Her decision gives a firm whose employees engage in securities fraud another weapon to seek compensation for the harm they cause to its reputation. Defendants like Rajat Gupta, a former director of Goldman Sachs who was convicted of tipping with information learned during board meetings, may face a similar claim for acting as a faithless servant.
Mr. Tourre was found liable for securities fraud after a trial in July. Goldman Sachs had earlier settled S.E.C. charges related to the sale of the collateralized debt obligation in 2010, paying a $550 million civil penalty.
The firm continued to pay for Mr. Tourre’s lawyers under a provision in its corporate articles requiring the advance of such expenses to employees accused of misconduct in connection with their work. This obligation continues at least through the first appeal, and can even include the payment of penalties related to a violation.
The S.E.C. has long been concerned that defendants will pass along the cost of civil penalties to a company or an outside insurer, reducing the impact of a finding of a violation. For example, $20 million of the $67.5 million that the former Countrywide Financial chief executive, Angelo R. Mozilo, paid as part of a settlement of civil securities fraud charges was provided by Bank of America under an indemnification provision in his contract.
The S.E.C., however, wants defendants feel the pain of a civil penalty. Therefore, the agency has been including provisions in settlements that prohibit a company from seeking reimbursement from insurers and deducting the payments on its taxes. As part of the 2003 settlement with a number of Wall Street firms over conflicts of interest in their stock research, they were prohibited from treating the $875 million penalty as tax deductible or eligible for payment under insurance policies.
In a filing last week, the S.E.C. asked the Federal District Court in Manhattan to impose a $910,000 civil penalty on Mr. Tourre for what it described as “egregious†violations. To make the penalty sting, it also asked that the final order in the case require him “to pay civil penalties personally and barring him from accepting reimbursement from any person or entity, including†Goldman Sachs.
This is a clever way to keep a defendant from asserting a claim against an employer by asking for an advance of the penalty before the case is completed, an amount the firm may never try to recover. Goldman is no longer a party to the case, so it cannot be ordered to refrain from paying any penalty imposed. The next best thing is to try to prohibit Mr. Tourre from taking money to cover a penalty, on pain of violating a court order that could result in a contempt proceeding.
Whether the S.E.C. will succeed in limiting corporate payment of penalties is another question. Issues of indemnification and advancement of costs are a matter of state law, and in Delaware, where Goldman Sachs is incorporated, the courts take a broad view of a company’s obligation to make payments on behalf of an employee. The S.E.C.’s end run around this may not trump the firm’s obligation to pay the costs of a penalty imposed on Mr. Tourre.
Wall Street is facing increased scrutiny from regulators and prosecutors over how it conducts business. Employees who find themselves caught in an investigation have even more to fear because the costs of an adverse judgment can include efforts by employers to claw back compensation and the prospect of paying any penalties out of their own pocket.
SEC v Tourre Memorandum of Law December 16 2013
Morgan Stanley v Skowron Opinion Dec 19 2013
