Deception Under Section 10(b): Stoneridge And Policy Concerns Which Can Limit SEC And DOJ Enforcement Actions

The Second Circuit handed down a significant decision last week on deception under Section 10(b) and Rule 10b-5. In U.S. v. Finnerty, Docket No. 07-1104-cr (July 18, 2008), the Court affirmed the ruling of the district court granting a post trial motion for acquittal following a jury verdict of guilty. The defendant, a New York Stock Exchange specialist, was charged with securities fraud in violation of Exchange Act Section 10(b) for “interpositioning or engaging in arbitrage of the gap between customer orders to buy and sell shares.

In 2006, Mr. Finnerty was charged with three counts of securities fraud. A superseding indictment alleged that between 1999 and 2003 he caused 26,300 instances of interpositioning, yielding profits to his dealer account of about $4.5 million. The indictment also charged defendant Finnerty with trading ahead in 15,000 instances, causing about $5 million in customer harm. This conduct, according to the indictment, violated Section 10(b) and Rule 10b-5.

The district court granted in part Mr. Finnerty’s pre-trial motion to dismiss, concluding that the allegations did not violate subsection (b) of the Section and Rule regarding omissions. Citing NYSE Rules, which require specialists to place the interests of their public customers above their own however, the court concluded that the conduct alleged may violate subsections (a) and (c) of the antifraud provisions, because the claimed practices would subordinate the interests of the public to those of the specialists, contrary to what the public would expect.

Following a trial to a jury, and after the government abandoned the trading ahead claims, the jury found Mr. Finnerty guilty. The government submitted proof which established multiple NYSE Rule violations, the trading profits, the fact that bonuses at the defendant’s firm were paid on profits from the proprietary trading account and testimony suggesting that Mr. Finnerty tried to cover up his conduct. Mr. Finnerty demonstrated that the trades on which the government relied represented about 0.94% of his trades. Following the jury’s verdict, the district court granted a post trial motion for acquittal. The government appealed.

The Second Circuit affirmed. To establish a violation of Section 10(b) and Rule 10b-5, the government must prove the use of any “manipulative or deceptive device or contrivance.” Citing the Supreme Court’s decision last term in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 128 S. Ct. 761 (2008) (discussed here), the Court concluded that conduct can violate the Section even absent a specific oral or written statement. In the end however, there must be “some act that gives the victim a false impression,” according to the Second Circuit.

In this case, the government failed to identify any way in which defendant Finnerty communicated “anything to his customers, let alone anything false. Rather, viewing the evidence in the light most favorable to the government, the government undertook to prove no more than garden variety conversion,” a simple state law claim. Invoking the Supreme Court’s reluctance to intrude into an area governed largely by state law in Stoneridge, and quoting the opinion, the Second Circuit went on to hold that “[t]o impose securities fraud liability here, absent proof that Finnerty conveyed a misleading impression to customers, would pose ‘a risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.'”

The Court concluded by rejecting arguments by the government that Mr. Finnerty violated Section 10(b) because may have violated NYSE Rules on which some members of the public may have relied. Even if the public relied on these rules, the Circuit Court concluded that did not constitute reliance on a statement of Mr. Finnerty. While Mr. Finnerty’s conduct may have been unfair, the Circuit Court noted that “‘not every instance of financial unfairness constitutes fraudulent activity under Section 10(b)’ quoting Chiarella v. United States, 445 U.S. 222, 232 (1980).

Finnerty is one of a number of cases brought against NYSE specialists. Other criminal cases are discussed here. The SEC also brought an administrative proceeding. In the Matter of David A. Finnerty, Adm. Proceeding File No. 3-11893 (action against 20 specialists).

The Finnerty opinion is important not just for its ruling, but for its reasoning. Here, the Second Circuit extracted conservative themes from cases like Stoneridge and Central Bank of Denver, N.A. v. First Interstate Bank, N.A., (511 U.S. 164 (1994) (discussed here) which were crafted to constrict liability in private damage actions to limit the scope of Section 10(b) in a government enforcement action. Concepts such as not intruding into areas typically governed by state law, requiring that there be an express representation on which the victim relied and that Section 10(b) is a limited remedy are notions typically invoked in cases like Stoneridge to justify limiting liability in cases where a business organization is facing a class action for damages.

While the Supreme Court may have been rendering what many call pro-business decisions in Stoneridge and other cases, it was also invoking principles and reasons for not reading Section 10(b) in an expansive fashion. Finnerty does the same – the limitations it imposes come not so much from the text of the statute as from the policy reasons decisions such as Stoneridge use to justify their conclusions. Since Section 10(b) is typically the weapon of choice in government enforcement actions – SEC civil cases and DOJ criminal cases – Finnerty suggests that going forward SEC enforcement officials and DOJ prosecutors should carefully assess the limits such principles impose on the application of Section 10(b).