Corporate criminals beware: Morgan Stanley wants to make you pay

November 13, 2012

In April 2011, Morgan Stanley paid $32 million to resolve a Securities and Exchange Commission case against Joseph “Chip” Skowron, the Morgan Stanley hedge fund manager who pled guilty to insider trading charges in August 2011. Skowron, who trained as a physician, ran a healthcare hedge fund called FrontPoint, which Morgan Stanley acquired in 2006. Over the next four years, until he was fired in December 2010, Skowron earned more than $32 million from Morgan Stanley, which also fronted almost $5 million in legal fees to defend its erstwhile trading star before he finally admitted his guilt.

Morgan Stanley believes that Skowron owes the bank all of that money: the legal fees, the compensation and the cost of the SEC settlement. In an unusual complaint filed in federal court in Manhattan on Oct. 31 (but first disclosed Nov. 9), Morgan Stanley’s lawyers at Marino, Tortorella & Boyle asserted that Skowron was a faithless employee who defrauded Morgan Stanley, breaching his employment contract and his fiduciary duty. That misconduct, the bank argued, entitle Morgan Stanley to recover from Skowron every penny that his insider trading cost the bank.

It’s not unusual for employers (or their insurers) to demand repayment of the legal fees they put up for defendants who turned out to be guilty; in a piece last June on Goldman Sachs footing the legal bill for former director Rajat Gupta, Peter Lattman of The New York Times reported on several examples of white-collar legal fee reimbursement cases, including Hollinger’s suit against former chairman Conrad Black and Computer Associates’ claim against former CEO Sanjay Kumar. Since indemnification agreements often feature a repayment provision in the event of a conviction or guilty plea, suits to recover legal fees make sense as long as you’re suing someone who still has assets. But demanding repayment of compensation — and especially demanding repayment of the cost of an SEC settlement — is quite rare. In fact, Karen Mariscal of White and Williams, who represents D&O insurers seeking to recoup legal fees from convicted defendants, told me she has never before seen a case in which a former employer (or insurer) sues for repayment of the cost of an SEC settlement.

There is precedent for Morgan Stanley’s demand, but it comes from the bank’s own previous attempt, in Skowron’s criminal proceeding, to recoup the cost of the SEC settlement. That’s right: This is Morgan Stanley’s second crack at Skowron. The civil suit is a reformulation of arguments the bank already made earlier this year before U.S. District Judge Denise Cote of Manhattan, when it claimed $44 million in restitution, including the $32 million cost of the SEC settlement, as a purported victim of Skowron’s crimes.

In a thoughtful 28-page opinion in March, Cote found Morgan Stanley was indeed a victim of Skowron’s insider trading. She awarded the bank $3.8 million for Skowron’s defense fees and $6.4 million (or 20 percent) of his compensation, calculating that Skowron had deprived Morgan Stanley of his honest services. The judge denied Morgan Stanley’s claim to repayment of the SEC settlement, however. She said that the money Morgan Stanley paid to the SEC represented the losses Skowron avoided when he dumped stock based on inside information. Morgan Stanley was never entitled to that $32 million, Cote wrote, and permitting the bank to recover it would undermine the public interest in disgorgement.

Skowron posted a $10.2 million bond and appealed Cote’s ruling to the 2nd Circuit Court of Appeals. Skowron’s lawyers at SorinRand argued that the judge erroneously defined Morgan Stanley as a victim and misapplied the U.S. Supreme Court’s 2010 precedent on honest services in Skilling v. United States. Moreover, Skowron said, his compensation isn’t Morgan Stanley property subject to restitution. Morgan Stanley, which is represented by Marino Tortorella at the 2nd Circuit as well as in the civil suit, countered that it is indeed entitled to recover what it paid Skowron because the bank was victimized by “his false denials and fraudulent concealment of his criminal conduct.” Had Morgan Stanley known that Skowron traded on inside information in 2007, the bank argued, he never would have received millions of dollars in compensation in the years that followed.

Morgan Stanley didn’t bring a cross-appeal of Cote’s ruling on the SEC settlement, so it’s quite interesting that the civil suit — filed immediately after final briefing in the 2nd Circuit appeal — revives that claim, despite Cote’s finding that the $32 million represents the disgorgement of money the bank was never legally entitled to. By Morgan Stanley’s reckoning, it paid the $32 million under an indemnification deal with Skowron that it was deceived into entering. That’s one reading of the payment. The other is that Morgan Stanley is trying to recover money that never belonged to the bank in the first place, but is legitimately the property of investors on the wrong side of Skowron’s illegal trades. (Morgan Stanley counsel Kevin Marino didn’t return my call; Skowron counsel Joshua Epstein declined to comment.)

White-collar defense lawyers should pay close attention to both Skowron’s appeal of Cote’s restitution order and Morgan Stanley’s new civil suit. If the bank succeeds in either case, wealthy defendants face the prospect of post-conviction claims by former employers that could wipe out their remaining assets. As insurance lawyer Mariscal pointed out to me, if Morgan Stanley wins against Skowron, defendants will have to consider that prospect when they think about pleading guilty. For a defendant like Skowron, who has enough remaining money to post a $10 million bond, it’s one thing to contemplate five years in prison if you’re going to come out with a cushion of assets. It’s another if you emerge from prison with nothing.

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