Tipper Gored

United States v. Gansman, No. 10–0731-cr (2d Cir. September 9, 2011) (Cabranes, Chin, CJJ, Keenan, DJ)

From 2005 to 2007, James Gansman, an attorney at Ernst and Young, was having an affair with one Donna Murdoch. Perhaps as part of their “pillow talk,” Gansman - the “tipper” - would pass Murdoch material, non-public information, on which Murdoch - the “tippee” - traded profitably. Gansman was ultimately prosecuted for securities fraud under the “misappropriation” theory - as described by the Supreme Court, this occurs when a defendant misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.Liability can attach even if the defendant does not trade on it himself.

Gansman, whose defense was that he did not intend to commit securities fraud, sought a jury instruction under SEC Rule 10b5-2, asking the court to instruct that Gansman shared information with Murdoch as part of a relationship of trust and confidence in which they had a pattern of sharing personal confidences - the aforementioned “pillow talk” - such that Gansman reasonably expected that Murdoch would keep the confidences to herself and not trade on them.

The district court gave a version of the charge that was only slightly different in wording contained in Gansman’s request. The court instructed that Gansman contended that he did not provide Murdoch with insider information with the understanding that she would use it to buy and sell securities, because he shared the information with her as part of a relationship in which they shared work and personal confidences.

Both sides took issue with this in the circuit. Gansman complained that the district court should have used his own wording, but the circuit held that the charge adequately conveyed his theory of defense - many facts in the record contradicted that theory, however - and that the charge was not error.

More importantly, the court rejected the government’s argument that the charge should not have been given at all. In prosecuting a “tipper” under the misappropriation theory of insider trading, the government must prove as an element of the offense that the tipper conveyed material non-public information to his “tippee” with the understanding that it would be used for securities trading. Otherwise, at least where the tippee owes a duty of trust or confidence to the tipper, and the tipper conveys confidential information without intending that the tippee trade on it, only the tippee is liable on a misappropriation theory. And here, it was “perfectly appropriate” for Gansman to defend against the charge by arguing that his relationship with Murdoch exemplified those circumstances. Indeed, there have been cases where a tipper was not liable even though the tippee was. If the jury here had agreed with this theory - it did not, of course, - Gansman would have been acquitted.

PC World

Here are two per curiams in white collar cases, decided on the same day.

First, in United States v. Lauerson, No. 09-0255-cr (2d Cir. June 7, 2011) (McLaughlin, Pooler, Sack, CJJ) (per curiam), the circuit agreed that the district court lacked the authority to waive the delinquency and default penalties arising from the defendant’s falling behind on his restitution payments. The relevant statute, 18 U.S.C. § 361, permits courts to, in some circumstances, modify or remit the restitution order itself, but does not permit waiver of those penalties.

And, in United States v. Wolfson, No. 10-2786-cr (2d Cir. June 7, 2011) (Kearse, Pooler, Lynch, CJJ), the court found no error in the jury instructions at a“pump and dump” securities fraud trial. The scheme operated by having corrupt stock brokers selling overvalued stocks, for which they were rewarded with “exorbitant” commissions that they either failed to disclose at all or lied about. Wolfson argued that the brokers had no duty to disclose their commission, and thus that it was error for the district court to give a fiduciary duty instruction. But the circuit noted that, while there is no “general” fiduciary duty inherent in the ordinary broker/customer relationship, there is a “relationship of trust and confidence.” A properly instructed jury “may find that stock brokers have a duty to disclose material commissions to their customers, and can convict brokers who breach that duty.”

Lies My Broker Told Me

United States v. Kelley, No. 06-5536-cr (2d Cir. January 5, 2009) (per curiam)

Kevin Kelley, a stock broker, was convicted of securities and wire fraud based on his fraudulent activities with respect to four separate securities. For each of them he would either (1) purchase stocks for his clients without their authorization (2) do so without disclosing his own interest in the company or (3) misappropriate client funds for his own use. Kelley subsequently deceived his clients about the value of their investments by sending them false account statements.

Over his objection, those account statements were admitted into evidence on the securities fraud counts. On appeal, he pursued that claim, again without success. Kelley’s specific argument was that under 15 U.S.C. § 78j - section 10(b) of the Securities Exchange Act of 1934 - it is a crime to “employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance.” His point was that since the deception must be made “in connection with” the purchase or sale of the stock, statements like those at issue here, which he created and disseminated up to four years later, did not fall under the statute.

The court agreed with Kelley in principle, but not in application. The 10(b) violations here arose from Kelley’s broader scheme to induce his clients to buy the stocks, or his use of client funds to buy them without authorization, and not from the statements themselves. Rather, the statements were properly introduced at trial as evidence of Kelley’s intent to defraud and of the scope of his scheme. They also showed that his actions were not “simple mistakes but were instead part of a large, intentional scheme to defraud.”

The court disposed of Kelley’s other arguments in a summary order bearing the same docket number, in which there is one holding of note. The trial court permitted the government to introduce into evidence tax returns of one of the companies involved in the scheme as a “statement by the party’s agent or servant” under Fed.R.Evid. 801(d)(2)(D). On appeal, while the court rejected a Crawford argument with respect to those returns, it agreed that it was error - albeit harmless - to admit an unsigned tax form under this rule.

Taking Stock

United States v. Elgindy, No. 06-4081-cr (2d Cir. December 17, 2008) (Sack, Katzmann, CJJ, Rakoff, DJ)

Defendants Elgindy and Royer were convicted of securities fraud-based racketeering counts, as well as related extortion charges relating to a complex stock manipulation scheme. On appeal they challenged, inter alia, venue and the district court’s jury instructions on the securities fraud counts. The circuit affirmed.

The Scheme

In 1998, Elgindy started Pacific Equity, a company that provided information for stock investors. It had a publicly available website that published negative information about publicly traded stocks, while a subscriber-only site profited from this information by advising its subscribers to short-sell those same stocks. In 2000, Elgindy began receiving misappropriated negative law enforcement information about certain stocks from Royer, who was then an FBI agent. Elgindy would pass on this information to his subscribers and instruct them to short the stock before he made the information public. Then he would release the information to the public through his other website, and instruct his subscribers to release it through other public means, so that they could profit from the resulting drop in the stock’s price. In addition, Elgindy himself traded on and profited from the misappropriated information. Eventually, Royer left the FBI and began working directly for Elgindy. He continued to provide misappropriated information, however, using other law enforcement officers as his sources.

The defendants also used this set-up to commit extortion. At one point, they learned that a company’s CEO had been convicted of a drug felony that had been expunged. Elgindy described the CEO as a “three time felon” on the subscriber web site, and told him that he would not leave him alone unless the CEO gave him a discounted block of stock.

Venue

The defendants challenged the sufficiency of the evidence of Eastern District venue. Since they were charged with multiple counts, venue had to be in a district where all of the counts could be tried. Here, that standard was satisfied.

The there was Eastern District venue on the securities fraud counts because seven of the subscribers to Elgindy’s private website were located in that district, Elgindy sent hundreds of email messages to those subscribers containing Royer’s misappropriated information, and trades in the affected stocks were made by other investors residing in the Eastern District. While there was no “direct evidence” that Elgindy’s Eastern District subscribers themselves traded on the information, that was “of no moment.” Venue need only be proved by a preponderance, and “the jury could reasonably infer that it was more likely than not that one or more of these subscribers traded in the applicable securities.” Moreover, it was reasonable for the jury to find that Elgindy’s subscribers followed his instructions to disseminate information, which impacted the purchase of those stocks by non-subscribers who lived in the Eastern District.

These activities satisfied the “substantial contacts” test, which looks at the “site of the defendant’s acts, the elements and nature of the crime, the locus of the effect of the criminal conduct, and the suitability of the [venue] for accurate factfinding.”

These same Eastern District contacts also satisfied the racketeering and conspiracy counts.

As for the extortion counts, venue lay in the Eastern District for the similar reasons. Disseminating the fact that the CEO was a “three time felon” put downward pressure on the company’s stock, which in turn provided Elgindy with the ammunition to extort the CEO into giving stock Elgindy. Moreover, at least one of Elgindy’s Eastern District subscribers played an active role in those events.

The Securities Fraud Instructions

The defendants were convicted of securities fraud on two theories: that they unlawfully traded on material confidential information, and that they engaged in market manipulation.

For the first theory, they argued that the law enforcement information that Royer obtained was not “nonpublic,” since much of it was also publicly available. They claimed that it was error for the court to instruct the jury that “the fact that information may be found publicly if one knows where to look does not make the information ‘public’ for securities trading purposes unless it is readily available, broadly disseminated, or the like.”

The court found no error in this instruction. Borrowing from a Supreme Court case interpreting the Freedom of Information Act, it held that “[t]he law enforcement reports that Royer misappropriated were not themselves public in any practical sense, even if some of the sources from which they were compiled could be accessed by the public. Moreover, the manner in which law enforcement information was combined in the reports was itself nonpublic and helped inform its relevance for trading purposes.” The court did note, somewhat cryptically, however, that, “While the trial court’s instruction here given might not be universally appropriate, in the factual context of this case it correctly stated the relevant principles the jury needed to apply.”

As for market manipulation, the district court instructed the jury that the essence of the manipulation was “the deception of investors into believing that prices at which they purchase and sell securities are determined by the natural interplay of supply and demand,” and thus that “any conduct” that is “designed to deceive or defraud investors” by affecting the price of securities is prohibited. The defendants claimed that this was error because it permitted a conviction without a finding that the defendants “disseminated false information to the marketplace.”

But the relevant statute prohibits the use of “any manipulative or deceptive device or contrivance,” which the court held “extends to manipulation of all kinds, whether by making false statements or otherwise.” Here, the defendant “sought to artificially affect the prices of various securities by directing ... subscribers to trade and disclose the negative information at times and in manners orchestrated by the defendants that were dictated not by market forces, but by defendants’ desire to manipulate the market for their own benefit.” This conduct “squarely meets the ordinary meaning of ‘manipulation.’”

Deceptively Simple

United States v. Finnerty, No. 07-1104-cr (2d Cir. July 18, 2008) (Jacobs, Pooler, CJJ, Restani, J)

The New York Stock Exchange functions, essentially, as an auction market. Specialist firms are designated to facilitate the auction of a particular stock by processing the bids to buy and offers to sell it. Specialists also trade for their own firm’s accounts. “Interpositioning” occurs when the specialist interposes himself in the middle of public trades to make a profit for the firm. It is prohibited by NYSE rules.

Defendant Finnerty engaged in thousands of instances of interpositioning, making $4,500,000 in profit for the firm’s account, and thereby inflating his bonus. He was charged with, and convicted of, three counts of securities fraud. After trial, the district court granted his motion for a judgment of acquittal, holding that the government failed to prove that interpositioning was a “deceptive act” under securities law because the government did not “provide proof of customer expectations.” The government appealed, and the circuit affirmed.

Securities law prohibits any “manipulative or deceptive device or contrivance” in connection with the purchase or sale of securities. The government did not argue that there was any market manipulation here, arguing only that Finnerty’s actions were deceptive. It agreed that he made no misstatements, however, arguing that he engaged in “non-verbal deceptive conduct.” While conduct can be deceptive, it “irreducibly entails some act that gives the victim a false impression.”

Here, the government identified “no way in which Finnerty communicated anything to his customers, let alone anything false.” Rather, what he did was a “garden variety conversion.” Even if some customers might have understood that NYSE rules prohibit specialists from interpositioning and that those rules “amount to an assurance (by somebody) that interpositioning will not occur,” here there was no evidence that this understanding was “based on a statement or conduct by Finnerty.” Thus, he did not commit securities fraud.

Nor was his ability to take advantage of his position by itself deceptive; “not every instance of financial unfairness” constitutes securities fraud absent proof of manipulation, a false statement, a breach of duty to disclose, or deceptive communicative conduct. Finally, the evidence of consciousness of guilt could not overcome this problem. Finnerty clearly knew that he had violated an NYSE rule, and tried to cover it up. But this does not establish securities fraud, either.

Hollywood Accounting

United States v. Leonard, No. 05-5523-cr (2d Cir. June 11, 2008) (Kearse, Calabresi, Katzmann, CJJ)

In this case, the court concludes that interests in film production companies were “investment contracts,” and hence securities, under federal securities law. It also holds, however, that the district court erred in treating the entire cost of the securities as the loss amount under the guidelines.

Facts

The defendants ran sales offices that peddled interests in LLC’s formed to finance the production and distribution of motion pictures. Potential investors were solicited over the phone and, if they expressed an interest, would be sent offering materials, including brochures, operating agreements, and other such documents. Investors could purchase $10,000 “units” by completing and mailing back a subscription agreement.

The defendants’ sales offices would receive a commission of around 45% for each unit sold. This was the fraud - although the offering materials indicated that a commission would be paid, they did not accurately disclose the size. Read generously to the defendants, they seemed to indicate that no more than 20% of the unit price would go toward sales commissions.

The Sufficiency of the Evidence

The defendants’ first claim was that there was insufficient evidence that the investment units were “securities.” The definition of “security” covers many types of instruments. Here, the specific question was whether the units were “investment contracts.” An investment contract is one where the investor “is led to expect profits solely from the efforts of the promoter or a third party.” Here, the defendants argued that the investors were supposed to help manage the LLC’s, and hence never expected to profit “solely” from the efforts of others.

There is a difference between companies that seek “passive investors,” which fall under the securities laws, and those in which there is a reasonable expectation of significant investor control, which do not. But here, this distinction was complicated by the fact that the investment units were shares in LLC’s. According to the circuit, LLC’s, due to their hybrid nature, require a case-by-case analysis of the “economic realities” of the underlying transaction.

Here, the organizational documents describe an investment that, on its face, was not a security. Those documents were intended to create the impression that subscribers would play an active role in the management of the companies. In reality, however, the members of the LLC’s “played an extremely passive role in the management and operation of the companies.” They voted rarely, and only a small number of them served on any committees. Thus, according to the circuit, “the vast majority of investors in both companies did not actively participate in the venture, exercising almost no control.” For example, the trial evidence showed that the managerial rights mentioned in the subscription documents were illusory, because others made almost every significant decision about the making of the films before the fundraising was even complete. Moreover, the investors themselves had no experience in film production, and played no role in shaping the organizational agreements themselves, casting further doubt as to whether the members were truly expected to have significant control over the enterprise.

And that was enough for the jury to properly conclude, considering “substance over form,” that, “from the start,” there was no reasonable exception of investor control.

The Loss Calculation

At sentencing, the district court held the defendants accountable under for the entire cost of the securities they sold, on the theory that the investors would not have participated if they knew the true size of the sales commissions. The circuit deferred to the district court’s finding about the investors’ decision to participate, but held that this did not “in and of itself” mean that the securities they received were “entirely without value.”

Since the investors actually obtained an interest in a company engaged in producing and distributing a motion picture, the district court should have deducted from the purchase price the actual value of the instruments. The court notes that these were “illiquid securities for which there is no public market,” and thus that it will be quite difficult to value them. Nevertheless, the district court must make a “reasonable estimate” of this figure.