United States: Second Circuit Holds That Primary Securities Fraud Violations Require Deception Attributable To The Defendant

Originally published July 24, 2008

Keywords: deception, New York Stock Exchange, appeal, United States v. Finnerty, federal securities, criminal, Second Circuit, securities, fraud, NYSE Rules, stock market, fraud-on-the-market doctrine, Department of Justice, Securities Act

In a recent decision addressing the meaning of deception under the federal securities laws, the US Court of Appeals for the Second Circuit affirmed the acquittal of David Finnerty, a former specialist on the floor of the New York Stock Exchange who had been charged with criminal securities fraud (United States v. Finnerty). The Second Circuit held that the district court properly set aside the jury's verdict finding Mr. Finnerty guilty, because the government failed to prove that Mr. Finnerty's conduct constituted deception, a necessary element under the federal securities fraud statute.

Background

On April 12, 2005, the US Attorney's Office for the Southern District of New York returned indictments charging fifteen New York Stock Exchange ("NYSE") specialists, including Mr. Finnerty, with securities fraud. On the same day, the Securities and Exchange Commission instituted proceedings against those fifteen and five other former specialists alleging fraud and NYSE Rules violations.

An NYSE specialist runs and participates in the auction market in securities traded there. A specialist has obligations to act both as a principal, trading on behalf of the specialist firm's account, and as a representative of customer orders brought to the floor. The criminal indictments and order instituting civil proceedings allege that these former specialists profited by improperly trading from their specialist firms' principal accounts ahead of contemporaneous orders placed by the public through the NYSE's electronic order system.

After two defendants pled guilty to securities fraud, five of the other defendants stood trial before a jury. Juries convicted the first two defendants of securities fraud but acquitted the next defendant¹ to go to trial. A jury also returned a guilty verdict against Mr. Finnerty, the fourth defendant to proceed to trial. After a jury acquitted the fifth defendant to go to trial, the US Attorney's Office dropped all criminal charges against the remaining defendants.

Mr. Finnerty sought judgment notwithstanding the verdict, arguing that the government had failed to prove deception. The district court (Chin, J.) overturned the conviction, reasoning that the government had not proven that Finnerty deceived the alleged victims—the customers who placed the electronic orders. The government appealed.

The Second Circuit's Opinion

Section 10(b) of the Exchange Act and Rule 10b-5, promulgated thereunder, are frequently described as "catch-all" provisions prohibiting securities fraud. They have been interpreted over time as proscribing a broad array of misrepresentative statements and deceptive conduct. Regardless of the type of statement or conduct at issue, however, manipulation or deception is a necessary element of any fraud charge. Because the Second Circuit found no evidence that Finnerty himself had said or done anything deceptive—and the government had abandoned any claim of market manipulation—it agreed with the district court that the jury's verdict could not stand.

The Second Circuit reasoned that even though, viewed "in the light most favorable to the government," the evidence may have proven "garden variety conversion" or theft, that does not suffice "[t]o impose securities fraud liability": "the government has attributed to Finnerty nothing that deceived the public or affected the price of any stock: no material misrepresentation, no omission, no breach of a duty to disclose, and no creation of a false appearance of fact by any means."

The court rejected three theories posited by the government to support Finnerty's conviction. First, the court rejected the argument that NYSE customers have an underlying expectation that specialists will follow NYSE Rules, and were therefore deceived by Finnerty's conduct, which, according to the jury's verdict, was not in conformity with those Rules. The court found that these allegations, even if true, did not involve any assurances or misleading statements directly attributable to Finnerty and, as such, did not constitute deceptive conduct by him.

Next, the Second Circuit rejected the argument that Finnerty's conduct was "'self-evidently deceptive.'" The court declared that theory "conclusory" because, even if Finnerty had "unfairly profited from superior information," the government had failed to attribute deceptive statements or conduct to him.

Finally, the court rejected the government's assertion that Finnerty's conduct was deceptive because it violated "'common sense notions of fair play and honest dealing in the securities market.'" This theory borrowed from the fraud-on-the-market doctrine, which, in the civil context, allows a presumption of reliance on "'public, material misrepresentations'" that affected "a stock's market price." But such a presumption of reliance depends on the existence of deceptive statements or conduct, and, the Second Circuit concluded, the government had pointed to "nothing" that Finnerty had said or done that deceived anyone.

Implications for Other Securities Fraud Cases

The appeals of the two other defendants convicted at trial remain pending before a different panel in the Second Circuit. They, too, challenge whether the government proved deceptive conduct. It remains to be seen whether the Department of Justice will seek rehearing en banc or petition for review in the Supreme Court. In either event, the civil enforcement action brought against Finnerty and several other former specialists remains pending before an SEC Administrative Law Judge.

Of greater import, though, is what this case may mean for criminal and civil securities fraud actions more generally. On the one hand, the specialist function, at least as it existed on the floor of the NYSE through the early part of this century, is a dying profession. As automation increased, the oral outcry market that was the specialists' unique domain became more and more anachronistic, and that job as it used to be performed is now all but extinct. On the other hand, there is nothing in the Second Circuit's opinion that limits its logic to the particular idiosyncrasies of the specialist function.

The opinion is squarely focused on the basic requirements of Section 10(b) of the Exchange Act and, by extension, Section 17(a) of the Securities Act: the need to prove that a primary violator communicated to customers through statements or conduct a false appearance of material fact. The court was careful to point out that it was not deciding "whether some form of communication by the defendant is always required to prove deception," but pointedly noted that imposing securities fraud liability without proof that the defendant himself conveyed a misleading impression to customers would risk "'invit[ing] litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees,'" quoting the Supreme Court's landmark decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta. By underscoring that the reach of the federal securities laws has its limits, the Second Circuit's decision may have a substantial impact on future criminal and civil securities fraud enforcement actions.

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Footnote

^{1. That defendant was represented by Mayer Brown attorneys Andy Schapiro, Matthew Ingber and Deborah Frey.}

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