(Originally published in the Columbia Law School Blue Sky Blog)
Wall Street whistleblowers had a lucrative 2018. It’s about to get even better.
To incentivize whistleblowing, the SEC awards qualifying tipsters who supply credible information resulting in successful enforcement actions up to 30% of monetary sanctions paid by the securities violators. In 2018 alone, the SEC awarded more than $168 million to thirteen tipsters. Because the size of a whistleblower bounty is a percentage of the associated sanction, the potential for a significant award correlates with the size of the underlying penalty. For example, in one recent and particularly significant case, three tipsters blew the whistle onMerrill Lynch’s misuse of customer cash. The SEC awarded $83 million to the whistleblowersafter reaching a $415 million settlement with the company. In total, since the whistleblower program’s launch in 2011, the SEC has awarded over $376 million out of nearly $2 billion in sanctions to 61 tipsters. Suffice it to say that the program is a success.
Deciding whether to blow the whistle is not an easy decision. However, potential tipsters ofinsider trading violations will likely find comfort in knowing that the potential for large awardshas just become greater thanks to a decision by the Second Circuit Court of Appeals, the federal court responsible for deciding many of the nation’s highest-profile white collar and Wall Street cases.
In a recent case, SEC v. Rajaratnam, the Second Circuit approved a $92.8 million penalty against the insider-trading hedge-fund billionaire and convicted fraudster Raj Rajaratnam. This massive civil penalty is in addition to Rajaratnam’s sentences in a related criminal case.
Rajaratnam founded the now-defunct Galleon Group, one of the world’s largest hedge-funds in its heyday. In 2009, Galleon collapsed after Rajaratnam, and several of his colleagues, became ensnared in an insider trading scandal. After a criminal trial in 2011, Rajaratnam was convicted on 14 counts of securities fraud for insider trading, sentenced to 11 years in federal prison, and ordered to pay more than $50 million in restitution.
The SEC brought a parallel civil case against Rajaratnam seeking the maximum civil monetary penalties allowed under Section 21A of the Securities Exchange Act of 1934, 15 U.S.C. § 78u-1,for some of the same insider trading conduct that formed the substance of the criminal case. Given his prior criminal conviction for that conduct, finding him civilly liable for the illegal trades was easy, but determining the amount of the civil penalty was more complicated.
Under 15 U.S.C. § 78u-1, courts can penalize an insider trader up to “three times the profit gained or loss avoided” from the illegal trading. But the statutory formula does not explain whose “profits gained or losses avoided” it refers to. One plausible interpretation is the totalgains caused by illegal trading. Another possible interpretation is the insider trader’s personalstake in the profits generated from the trades. Rajaratnam had executed illegal insider trades in Galleon’s accounts and in an Intel executive’s account. The total gain to Galleon and its investors from these illegal trades was nearly $31 million. However, Rajaratnam’s personal share of those gains was the $4.7 million he derived from management fees and his stake in Galleon’s funds. The SEC argued that the court ought to treble the total amount of profit gained, or loss avoided,attributable to the illegal trades (i.e., $31 million) which would translate into a nearly $93 million penalty. Not surprisingly, Rajaratnam argued that only his personal gain (i.e., $4.7 million) was eligible for trebling. The district court sided with the SEC and imposed the nearly $93 million penalty.
Rajaratnam appealed to the Second Circuit and lost. Among other things, he argued the lower court should have trebled only his personal gains from the illegal trading, the court wrongfully considered his personal wealth when deciding on the size of the penalty, and that his civil penalty should be offset by the amount of his criminal penalties. The Second Circuit firmly rejected these arguments. Most importantly, it affirmed the lower court’s interpretation of 15 U.S.C. § 78u-1 when it considered the total gain derived from illegal trading. The court took it step further and held the statute makes insider traders eligible for trebled penalties calculated based on third parties’ profits even if the tippers themselves did not receive “pecuniary gains for their tips.” The court also held that the magnitude of a defendant’s wealth may be considered when calculating the size of a penalty so long as the lower court does not demonstrate a “vindictive bias or hostility towards persons of means,” and that courts are not required to offset civil penalties by the amount of criminal penalties.
What Rajaratnam’s case means for potential whistleblowers is that the SEC has a green light topursue impactful sanctions against extremely wealthy insider traders for the total gains resulting from the illegal trades even if the trading occurred, and profits were gained, in others’ accounts.This is the first time that any court of appeals has seriously grappled with 15 U.S.C. § 78u-1.Given its physical presence in the nation’s financial capital, the Second Circuit deeply influences the direction of securities law nationwide, and reverberations of the decision will be felt throughout the country. Post-Rajaratnam, a qualifying tipster that triggers or materially advances a large insider trading case against a deep-pocketed fraudster may be eligible for a life-changing amount of money. Doing the right thing by blowing the whistle on corporate wrongdoing takes enormous courage. Thankfully, it can also be financially rewarding.