In United States v. Finnerty, 2008 U.S. App. LEXIS 15296 (2d Cir. July 18, 2008), the United States Court of Appeals for the Second Circuit set aside a guilty verdict imposing securities fraud liability against a New York Stock Exchange Specialist who engaged in “interpositioning” and “trading ahead” transactions, on the ground that the prosecution failed to prove that the defendant’s conduct constituted deceptive conduct under the federal securities laws.  The court held that absent proof that the defendant actually conveyed a misleading impression to customers, finding securities fraud liability would “invite litigation beyond the immediate sphere of securities litigation.”  This decision provides yet another instance where courts have retained and applied traditional limits to securities fraud liability.

This case is one of several arising from a general investigation into the trading practices and transactions of New York Stock Exchange (“NYSE”) specialists who trade on the NYSE trading floor.  The investigation into the conduct of NYSE specialists focused primarily on two trading practices that violate NYSE Rule 104 and NYSE Rule 92(a), respectively:  “interpositioning” and “trading ahead.”  “Interpositioning” transactions are those in which the specialist “prevent[s] the normal agency trade between matching public orders and instead interpose[s] himself between the matching orders in order to generate profit for the principal account.”  In other words, these transactions are those where there is a buy order and a sell order present at the same time, and, instead of the specialist executing them against each other, the specialist trades separately with each of them, thereby increasing profit for the principal account.  A specialist engaged in a “trading ahead” transaction when “he trades for his own account before undertaking trades for public investors.”

Defendant David Finnerty was charged with three counts of securities fraud because he allegedly engaged in approximately 26,300 instances of interpositioning and approximately 15,000 instances of trading ahead.  Finnerty’s interpositioning resulted in profits to his dealer account of approximately $4.5 million.  His trading ahead allegedly resulted in approximately $5 million in customer harm.  Finnerty moved to dismiss the indictment on the ground that neither interpositioning nor trading ahead is deceptive or manipulative, and, as a result, his conduct did not constitute fraud under Section 10(b) of the Securities Exchange Act of 1934 and Securities & Exchange Commission Rule 10b-5 promulgated thereunder.

The district court granted Finnerty’s motion to dismiss, but only in part.  The government went ahead with its prosecution solely on the interpositioning allegations.  After the jury found Finnerty guilty on three counts of securities fraud, the district court granted Finnerty’s post-trial motion for acquittal, holding that the prosecution failed to prove that “interpositioning constituted a deceptive act within the meaning of the federal securities laws because the government did not provide proof of customer expectations.”  The government appealed.

The only issue before the Second Circuit was to determine whether Finnerty’s interpositioning conduct constituted a deceptive act under federal securities laws.  The government relied upon the following chain of premises and inferences to argue that Finnerty’s violation of the respective NYSE rules required imposition of criminal liability:

(1) brokerage houses are “members” of the NYSE; (2) as members, brokerage houses know about (and are subject to) the NYSE rules against interpositioning; (3) brokerage houses were customers of Finnerty; so (4) Finnerty’s violation of the NYSE rules deceived the brokerage houses.

The court was not persuaded.  Relying upon prior precedent, the court held that there must be an “actionable misstatement” to support Section 10(b) liability.  “[U]nless the public’s understanding is based on an articulated statement, the source for that understanding, whether it be a regulation, an accounting practice, or something else, does not matter.”  Accordingly, the court held that although some customers may have understood that the NYSE rules prohibit specialists from interpositioning, unless their understanding was based definitively upon a statement or conduct by Finnerty himself, he did not commit a primary violation of Section 10(b) — which was the only offense with which he was charged.  Accordingly, the court found that the government could not identify any way in which Finnerty communicated anything to his customers, let alone anything false.

The government also argued that Finnerty’s conduct was “self-evidently deceptive” because he had “two critical advantages” over his customers: he was able to “see all pending orders to buy and sell a particular stock, and he determined the price ultimately paid.”  The court held that although this amounted to superior information, not every instance of financial unfairness constitutes fraud within the meaning of Section 10(b).  The court reiterated that there must be some proof of a “manipulation or a false statement, a breach of a duty to disclose, or deceptive communicative conduct” to impose criminal liability.

In short, the court held that “a violation of a NYSE rule does not establish securities fraud in the civil context, let alone in a criminal prosecution.”  Although Finnerty violated a NYSE trading rule, and even tried to cover it up, it does not “bespeak criminally fraudulent conduct with the context of the securities laws.”  Although the Department of Justice has tried to advance new theories of liability for securities fraud, this case shows the courts’ commitment to traditional theories and limitations on the scope of Section 10(b) and Rule 10b-5.

For further information, please contact Bob Rose at (619) 338-6661 or Frank Polek at (619) 338-6662.