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Circuit Upholds Rajaratnam SEC Civil Penalty

In an appeal arising in the aftermath of Raj Rajaratnam’s criminal conviction for insider trading, the Second Circuit (Lynch, Raggi, Droney) issued an opinion upholding an almost $93 million Securities and Exchange Commission (“SEC”) civil penalty that was imposed based on the same conduct that served as the basis for Rajaratnam’s conviction.  The case, Securities and Exchange Commission v. Raj Rajaratnam, No. 11-5124-cv, demonstrates that an individual convicted of insider trading may be required to pay a sizable fine under Section 21A of the Securities Exchange Act, despite having already paid a significant criminal penalty.  Despite some provocative comments by the district court about the defendant, the Circuit held that the imposition of the maximum possible fine under the statute was supported by law.

Background

In 2009, Rajaratnam, the former managing general partner and director of portfolio management of Galleon Management, LP, was indicted on nine counts of securities fraud based on insider trading and on five counts of conspiracy to commit insider trading.  After trial in 2011, Rajaratnam was found guilty on all counts and sentenced to 132 months’ imprisonment and to a $10 million fine.  He was also ordered to pay $53.8 million in restitution, an amount based on the profits gained or losses avoided in Galleon accounts as a result of all offenses with which Rajaratnam was charged.

On the same day that he was arrested, the SEC filed a civil action charging Rajaratnam with the same insider trading for which he was indicted.  The SEC action sought a civil monetary fine under Section 21A of the Exchange Act, 15 U.S.C. § 78u-1 (“Section 21A”).  Section 21A allows the SEC to bring a civil action against a person who engages in insider trading, and authorizes the court to impose a financial penalty of up to triple the amount of profits gained or loses avoided as a result of such insider trading.  The statute ultimately authorizes the district court to determine the appropriate fine “in light of the facts and circumstances.”  This phrase gives the district court discretion to do justice as it sees fit, so long as it does not abuse its discretion.

The SEC sought the maximum financial penalty of $92,805,705, triple the amount of the $30,935,235 in profits gained or losses avoided as a result of Rajaratnam’s substantive insider trading conduct.  The SEC argued that the policy interest in deterring insider trading supported the imposition of the maximum fine.  Rajaratnam argued that he should pay no penalty in light of his criminal sentence, but that if the court were to impose a civil penalty, it should calculate the fine based only on the $4.7 million in profits Rajaratnam personally received as a result of his conduct.

The district court ruled that a criminal financial penalty did not preclude a civil financial penalty for the same conduct since the penalties serve different functions: criminal penalties address moral blameworthiness while civil penalties seek to deter the conduct at issue.  Because the district court found no language in the text of Section 21A to support the position that the civil penalty should be based only on the profits one personally gains, it imposed the maximum penalty of $92.8 million.

The Second Circuit’s Decision

In a decision authored by Judge Lynch, the Court held that Section 21A authorizes penalties based on the profitability of the total violation, not the profitability to the defendant.

The Court began with the statute at issue, noting that Section 21A permits the SEC to bring suit against “the person who committed” a violation of securities laws by “purchasing or selling” securities on the basis of inside information, seeking a fine not to “exceed three times the profit gained or loss avoided as a result of such unlawful purchase, sale, or communication.”  See Section 21A.  The Court considered other federal securities statutes that limit the penalty imposed on a defendant to, for example, the “gross amount of pecuniary gain to such defendant as a result of the violation,” and found such language absent in Section 21A.  The Court also looked to previous penalties imposed for violations of Section 21A and found them to have been based on the total profitability of the violation, not on the profitability to the defendant alone.  The Court relied on the fact that the statute permits penalties against individuals, such as tippers, who do not benefit financially at all from their unlawful activity.   Finally, the Court pointed to the purpose of the statute—to deter insider trading—and determined that a penalty tied to the “total scope of the scheme,” rather than to the defendant’s personal financial benefit, would better serve that purpose.  The Court concluded that the statute “permits a violator’s civil penalty to be calculated based on the third parties’ profit gained or loss avoided, i.e., the profits gained or loss avoided from the defendant’s violation.”

Next, the Court addressed Rajaratnam’s contention that the district court impermissibly considered his wealth, and failed to consider the magnitude of the criminal penalties already imposed on him, in setting the $92.8 million penalty.  The Court noted that district courts may consider various factors in determining the appropriate penalty, including egregiousness of conduct, scienter, pecuniary loss to other persons, whether the conduct was isolated or recurrent, and the defendant’s current and future financial conditions.  Applying an abuse of discretion standard, the Court held that the district court did not err in determining that these factors all weighed in favor of imposing the maximum penalty in this instance.

Further, the Court held that the district court did not err in considering the extent of Rajaratnam’s wealth.  The Court noted that the district court “did not want to enter a ‘symbolic’ judgment that lacked a ‘reasonable possibility that it gets paid,’” and that the court “was not looking to impose a fine that would meet or exceed Rajaratnam’s resources and leave him penniless.”  The district court made clear that even after paying the $92.8 million penalty, “Rajaratnam and his family would still possess significant wealth,” the Court explained.  The Court dryly noted that the district court reviewed Rajaratnam’s presentence investigation report and “concluded (in what, after reviewing that Report, we regard as an understatement) that his net worth ‘considerably exceed[ed] the financial penalties imposed in the criminal case[.]’”

The Court did note some of the colorful statements by the district court, including a quotation of a former SEC chairman who hoped to leave insider traders “worthless, homeless, and maybe clothesless” and considered whether the district court acted out of an improper motivation.   But while the Court agreed that “a vindictive bias against or hostility towards persons of means would be an inappropriate consideration in setting a penalty for securities fraud,” it ultimately concluded that bias did not lie behind the district court’s imposition of the maximum penalty.

Finally, the Court concluded that the district court did not abuse its discretion in declining to offset the civil penalty by the amount Rajaratnam had paid in criminal penalties.  The Court noted that the district court was not under any obligation to do so, as Section 21A contemplates the imposition of civil penalties in additional to criminal ones.  See Section 21A(d)(3).  Moreover, the Court acknowledged that one of the reasons the district court articulated for the $92.8 million penalty was to serve as a deterrent for future insider trading, a purpose that would have been undercut had Rajaratnam been allowed to offset the fine.

Commentary

This decision highlights the possible duplication of punishment from the existence of criminal and civil penalties for insider trading.  Those found guilty of criminal insider trading may face steep penalties in the form of incarceration, hefty fines, and orders of restitution.  Separate from those criminal penalties, the SEC is also concerned with deterring and punishing future securities violations, and it is empowered to seek significant fines for the same conduct that gives rise to a criminal conviction.  The imposition of criminal financial penalties does not prohibit or limit the imposition of civil penalties.  Nor are the former treated as an “offset” to the latter.  As the Court makes clear, these fines are not imposed for the sake of additive punishment, but rather are meant to advance different societal purposes.  Civil penalties are not intended to compensate victims of illegal activity (as criminal restitution is) nor can either criminal or civil penalties be imposed in order to render the defendant destitute.  Indeed, the Court took care to note that the civil penalties imposed in this case would allow Rajaratnam’s family to continue to possess significant wealth.  Because these penalties serve different purposes, SEC fines may be imposed at the same time as criminal fines, and for the same conduct.

At the same time, courts will take care to ensure that civil penalties are appropriate to the circumstances.  In this case, the Court found the penalty imposed by the district court reasonable because the district court considered the defendant’s scienter, how elaborately the scheme was planned, for how long the defendant engaged in the scheme, and the defendant’s ability to pay the penalty so that it would not be purely symbolic.  By engaging in this inquiry, the Court demonstrated that it will examine whether an SEC fine is objectively appropriate, but that sizable fines coupled with significant criminal penalties are not inherently unreasonable.  No doubt the Circuit was influenced by the “brazenness, scope, and duration of Rajaratnam’s insider trading” when it affirmed the district court’s decision, and one can expect that in a case with less extreme facts, the maximum penalty will not be imposed or affirmed “in light of the facts and circumstances” of that future case.