Second Circuit, Affirming Judgment of Acquittal, Defines “Deceptive Conduct” for Purposes of Securities Fraud Conviction

Securities fraud under § 10(b) of the Securities Exchange Act of 1934 may be “a catchall provision,” the Second Circuit observes in United States v. Finnerty, 2008 WL 2778830 (2d Cir. July 18, 2008), “but what it catches must be fraud” (quoting the Supreme Court in Chiarella v. United States, 445 U.S. 222, 232 (1980)).  In an important decision that puts up a significant roadblock to the criminalization of Wall Street practices (and remarkably cites more civil than criminal precedents), the Court holds in Finnerty that profiting on superior information and other instances of “financial unfairness” – even if they involve violations of New York Stock Exchange rules – do not necessarily constitute securities fraud. 

Facts

Finnerty, a specialist at the NYSE, was charged with securities fraud, arising out of the practice of “interpositioning” – whereby he prevented the normal agency trade between matching public orders, and instead interposed himself between the matching orders in order to generate profits for his firm’s account.  In other words, he “act[ed] as an arbitrager by taking a profit on the spread between the bid price and the ask price of customers’ orders.”  A securities fraud charge may be based on manipulative or deceptive conduct.  Here, since the government conceded that Finnerty’s conduct was not manipulative, the sole question on appeal was whether the government sufficiently proved that it was deceptive.

Deception Requires Creating A False Impression

Pointing out that “ ‘deception’ ... irreducibly entails some act that gives the victim a false impression,” the Court held that the government had “identified no way in which Finnerty communicated anything to his customers, let alone anything false.”  Perhaps shooting itself in the foot, the government had compared Finnerty in summation to a bank teller who occasionally pockets one of the hundreds of withdrawals he makes everyday.  Like that thieving bank-teller, the Court agreed, Finnerty had, at most, engaged in “garden variety conversion.”  But, in the absence of “proof that Finnerty conveyed a misleading impression to customers,” there were no grounds to impose securities fraud liability here, especially when to do so may simply “invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees” (citation omitted). 

Violation of NYSE Rule Not Enough

At most, the government proved that Finnerty violated a NYSE rule, but “violation of an NYSE rule does not establish securities fraud in the civil context, let alone in a criminal prosecution.” This is true even if Finnerty knew he violated the rule and tried to cover it up.  While some customers may have assumed that he complied with NYSE rules, “unless their understanding was based on a statement or conduct by Finnerty, he did not commit a primary violation of § 10(b) – the only offense with which he was charged.”