Second Circuit Reverses Fraud Conviction with Notable Nugget for Alleged Insider Traders
Guest blogger Valerie A. Gotlib of Sher LLP writes:
Buried in the impressive reversal of the fraud conviction of Mark Kaiser, an executive at U.S. Food Services (“USF”) in United States v. Kaiser, 609 F.3d 556 (2d. Cir. 2010), issued last summer, is a quotable acknowledgement that insider trading is a very different and unique kind of securities fraud, deserving of a heightened level of scienter. As the Court notes, “[u]nlike securities fraud, insider trading does not necessarily involve deception, and it is easy to imagine an insider trader who receives a tip and is unaware that his conduct was illegal and therefore wrongful. The same cannot be said of one who deliberately misleads investors about a security.”
In addition to that notable dictum, the court held that the district court committed two independent errors. First, the district court instructed the jury with respect to conscious avoidance without informing the jury that it could find that Kaiser had knowledge of the fraud if he was aware of a “high probability” of its existence unless he “actually believed” that it did not exist. Second, the district court admitted double hearsay when it allowed a USF employee, Tim Lee, to testify that USF’s CEO had told Lee that USF’s general counsel wanted to go to the SEC to expose Kaiser’s improper accounting entries. The Second Circuit found that both errors were grounds for reversal.
Facts
As one of the largest food distributors in the United States, USF was in the business of purchasing food products from manufacturers and selling them to restaurants. Between 1994 and 2001, Kaiser managed the company’s dealings with its food vendors. An important source of revenue for USF was derived from “promotional allowances,” or “PAs,” a type of rebate paid to USF by vendors upon satisfaction of certain purchasing targets. Part of Mr. Kaiser’s job included negotiating PAs with vendors. Early in 2001, Mr. Kaiser was named Chief Marketing Officer of USF, but he continued to be involved in negotiating PAs.
The indictment alleged that Mr. Kaiser fraudulently inflated USF’s PA income for the years 2001 and 2002, hid the inflated numbers from outside auditors, and made various misrepresentations to the auditors concerning the PA agreements with vendors. The scheme included recording prepayments from vendors as income and, thereby, artificially inflating the amount of revenue earned from PA payments to ensure that USF met its earnings and other budgetary targets. USF’s executives, including Mr. Kaiser, received bonuses only if USF met these targets.
At trial, the government presented a case based primarily on the testimony of three alleged coconspirators, including Tim Lee, who cooperated with the government and testified pursuant to plea agreements. Kaiser argued in his defense that he had been setup by the three USF employees and had been unaware of the fraud. Kaiser was convicted of securities fraud, making false filings with the SEC, conspiracy to commit those crimes, and conspiracy to falsify books and records. Kaiser appealed.
Conscious Avoidance Jury Instruction
On appeal, Kaiser argued that the district court’s jury instructions with respect to conscious avoidance omitted two necessary elements: “that knowledge of the existence of a particular fact is established 1) if a person is aware of a high probability of its existence, 2) unless he actually believes that it does not exist.” United States v. Schultz, 333 F.3d 393, 413 (2d Cir. 2003) (internal quotations marks omitted) (emphasis added). The court reviewed Kaiser’s conscious avoidance argument for plain error because he had failed to raise an objection to the instruction at trial.
The court held (and the government conceded) that the district court erred in instructing the jury on conscious avoidance because it “did not contain either the ‘high probability’ or the ‘actual belief’ language,” which the court had “long held is essential for an accurate conscious avoidance instruction.” 609 F.3d at 566. The government argued nonetheless that there was no prejudice from the instruction in light of the overwhelming evidence that Kaiser had actual knowledge of the fraudulent scheme. The court disagreed and found that there was a risk that the jury convicted Kaiser based on its conclusion that he was merely negligent and could have convicted him even if it found that Kaiser actually believed the PA numbers were correct. Because there was ample evidence for the jury to question the credibility of the government’s witnesses, the court concluded that there was a reasonable probability that the jury convicted Kaiser based on a conscious avoidance theory and would not have done so but for the instructional error. The court further held that the error seriously affected the fairness, integrity or public reputation of judicial proceedings and thus met all of the requisite elements for a finding of plain error.
Admission of Hearsay Statement of USF’s General Counsel
Kaiser also argued on appeal that the district court erred in admitting certain testimony. Lee testified that the CEO of USF told him that USF’s general counsel had discovered that Kaiser improperly had booked $18.5 million in prepayments as income and that the general counsel wanted to report this to the SEC. Kaiser objected at trial on the ground that it was double hearsay. The government countered that the testimony was admissible as a statement of an unindicted coconspirator under FRE 801(d)(2)(E) and that the statement was in furtherance of the conspiracy. The district court held that the statement was admissible for the limited purpose of explaining why Lee and the CEO engaged in certain subsequent acts.
On appeal, the Court held that the statement constituted hearsay and did not fall into any of the hearsay exceptions. The court observed that even if the government could have overcome the hearsay objection, the statement would have been inadmissible under FRE 403 because its prejudicial effect outweighed its probative value. Indeed, because of the highly prejudicial nature of the testimony and the risk that the jury could have given it more credence since it came from USF’s general counsel, who was not a co-conspirator, the court concluded that the error was not harmless.
Willfulness Instruction
The Court, however, rejected the defense challenge to the district court’s instruction on willfulness. Acknowledging that insider trading is different (as noted earlier), the Court concluded that securities fraud charges like those at issue in Kaiser required merely that the defendant “had an awareness of the general wrongfulness of his conduct” and “do not require a showing that a defendant had awareness of the general unlawfulness of his conduct.” Here, the jury was charged that they had to find that Kaiser knew the statements were “false and fraudulent” and that he made those statements “with intent to create a deception,” and the government had to prove “the contrary of the idea of mistake or good faith.” If the jury found that Kaiser possessed such an intent, as it did, “it follows necessarily that it also concluded that there was “a realization on the defendant’s part that he was doing a wrongful act.”
Lawyers: Alexandra Shapiro (Macht, Shapiro, Arato & Isseries, LLP) and Richard Morvillo, Andrew Frey, Peter White, Charles Rothfeld, Daniel Brown and Michael Passaportis (Mayer Brown LLP) for defendant; AUSAs Daniel Chung, Daniel Braun.
Buried in the impressive reversal of the fraud conviction of Mark Kaiser, an executive at U.S. Food Services (“USF”) in United States v. Kaiser, 609 F.3d 556 (2d. Cir. 2010), issued last summer, is a quotable acknowledgement that insider trading is a very different and unique kind of securities fraud, deserving of a heightened level of scienter. As the Court notes, “[u]nlike securities fraud, insider trading does not necessarily involve deception, and it is easy to imagine an insider trader who receives a tip and is unaware that his conduct was illegal and therefore wrongful. The same cannot be said of one who deliberately misleads investors about a security.”
In addition to that notable dictum, the court held that the district court committed two independent errors. First, the district court instructed the jury with respect to conscious avoidance without informing the jury that it could find that Kaiser had knowledge of the fraud if he was aware of a “high probability” of its existence unless he “actually believed” that it did not exist. Second, the district court admitted double hearsay when it allowed a USF employee, Tim Lee, to testify that USF’s CEO had told Lee that USF’s general counsel wanted to go to the SEC to expose Kaiser’s improper accounting entries. The Second Circuit found that both errors were grounds for reversal.
Facts
As one of the largest food distributors in the United States, USF was in the business of purchasing food products from manufacturers and selling them to restaurants. Between 1994 and 2001, Kaiser managed the company’s dealings with its food vendors. An important source of revenue for USF was derived from “promotional allowances,” or “PAs,” a type of rebate paid to USF by vendors upon satisfaction of certain purchasing targets. Part of Mr. Kaiser’s job included negotiating PAs with vendors. Early in 2001, Mr. Kaiser was named Chief Marketing Officer of USF, but he continued to be involved in negotiating PAs.
The indictment alleged that Mr. Kaiser fraudulently inflated USF’s PA income for the years 2001 and 2002, hid the inflated numbers from outside auditors, and made various misrepresentations to the auditors concerning the PA agreements with vendors. The scheme included recording prepayments from vendors as income and, thereby, artificially inflating the amount of revenue earned from PA payments to ensure that USF met its earnings and other budgetary targets. USF’s executives, including Mr. Kaiser, received bonuses only if USF met these targets.
At trial, the government presented a case based primarily on the testimony of three alleged coconspirators, including Tim Lee, who cooperated with the government and testified pursuant to plea agreements. Kaiser argued in his defense that he had been setup by the three USF employees and had been unaware of the fraud. Kaiser was convicted of securities fraud, making false filings with the SEC, conspiracy to commit those crimes, and conspiracy to falsify books and records. Kaiser appealed.
Conscious Avoidance Jury Instruction
On appeal, Kaiser argued that the district court’s jury instructions with respect to conscious avoidance omitted two necessary elements: “that knowledge of the existence of a particular fact is established 1) if a person is aware of a high probability of its existence, 2) unless he actually believes that it does not exist.” United States v. Schultz, 333 F.3d 393, 413 (2d Cir. 2003) (internal quotations marks omitted) (emphasis added). The court reviewed Kaiser’s conscious avoidance argument for plain error because he had failed to raise an objection to the instruction at trial.
The court held (and the government conceded) that the district court erred in instructing the jury on conscious avoidance because it “did not contain either the ‘high probability’ or the ‘actual belief’ language,” which the court had “long held is essential for an accurate conscious avoidance instruction.” 609 F.3d at 566. The government argued nonetheless that there was no prejudice from the instruction in light of the overwhelming evidence that Kaiser had actual knowledge of the fraudulent scheme. The court disagreed and found that there was a risk that the jury convicted Kaiser based on its conclusion that he was merely negligent and could have convicted him even if it found that Kaiser actually believed the PA numbers were correct. Because there was ample evidence for the jury to question the credibility of the government’s witnesses, the court concluded that there was a reasonable probability that the jury convicted Kaiser based on a conscious avoidance theory and would not have done so but for the instructional error. The court further held that the error seriously affected the fairness, integrity or public reputation of judicial proceedings and thus met all of the requisite elements for a finding of plain error.
Admission of Hearsay Statement of USF’s General Counsel
Kaiser also argued on appeal that the district court erred in admitting certain testimony. Lee testified that the CEO of USF told him that USF’s general counsel had discovered that Kaiser improperly had booked $18.5 million in prepayments as income and that the general counsel wanted to report this to the SEC. Kaiser objected at trial on the ground that it was double hearsay. The government countered that the testimony was admissible as a statement of an unindicted coconspirator under FRE 801(d)(2)(E) and that the statement was in furtherance of the conspiracy. The district court held that the statement was admissible for the limited purpose of explaining why Lee and the CEO engaged in certain subsequent acts.
On appeal, the Court held that the statement constituted hearsay and did not fall into any of the hearsay exceptions. The court observed that even if the government could have overcome the hearsay objection, the statement would have been inadmissible under FRE 403 because its prejudicial effect outweighed its probative value. Indeed, because of the highly prejudicial nature of the testimony and the risk that the jury could have given it more credence since it came from USF’s general counsel, who was not a co-conspirator, the court concluded that the error was not harmless.
Willfulness Instruction
The Court, however, rejected the defense challenge to the district court’s instruction on willfulness. Acknowledging that insider trading is different (as noted earlier), the Court concluded that securities fraud charges like those at issue in Kaiser required merely that the defendant “had an awareness of the general wrongfulness of his conduct” and “do not require a showing that a defendant had awareness of the general unlawfulness of his conduct.” Here, the jury was charged that they had to find that Kaiser knew the statements were “false and fraudulent” and that he made those statements “with intent to create a deception,” and the government had to prove “the contrary of the idea of mistake or good faith.” If the jury found that Kaiser possessed such an intent, as it did, “it follows necessarily that it also concluded that there was “a realization on the defendant’s part that he was doing a wrongful act.”
Lawyers: Alexandra Shapiro (Macht, Shapiro, Arato & Isseries, LLP) and Richard Morvillo, Andrew Frey, Peter White, Charles Rothfeld, Daniel Brown and Michael Passaportis (Mayer Brown LLP) for defendant; AUSAs Daniel Chung, Daniel Braun.
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