SEC’s Single-Minded Focus on Fraud Theory Results in Loss on Appeal

On May 19, 2014, in SEC v. O’Meally, No. 13-1116, the United States Court of Appeals for the Second Circuit overturned a jury verdict in a “market timing” case finding violations of sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933.  The case is noteworthy as an example of a common flaw in SEC enforcement actions: overreaching in its charges because of a failure to recognize that not all cases involve fraud.  A copy of the O’Meally opinion can be found here.

The case involved so-called “market timing,” which was a common practice in the late 90s and early 2000s in which investors would arbitrage price differentials between mutual fund valuations and stock market prices.  Because the net asset value of a mutual fund is determined based on the stock prices of its portfolio investments at the close of daily market trading on the U.S. East Coast, but market information continues to flow in after that time, investors could have an opportunity for short-term mutual fund investments based on stale prices.  Many mutual funds barred such trading, especially after the practice became well-known and a target of law enforcement and private litigation, but also sometimes made exceptions to their rules.  It was argued that this kind of short-term trading activity hurts long-term mutual fund investors, for example by increasing overall costs and requiring that funds maintain larger reserves for redemptions.  But there was nothing inherently unlawful about market timing trades – they were merely a form of trading arbitrage.  However, the trades could be unlawful if they were accomplished through misrepresentations, which sometimes occurred to avoid fund rules barring such trades.

In 2006, Prudential Securities paid $600 million to a number of government agencies or regulators – the Department of Justice, the SEC, the New York Stock Exchange, the NASD, the New York state attorney general, and several state securities agencies – to settle potential claims based on market timing, as reflected here.

Frederick O’Meally was a broker at Prudential Securities who made money for his customers in market timing trades (and became one of Prudential’s top traders).  The SEC sued four such brokers based on market timing activities, and three others settled.  O’Meally went to trial.  The SEC’s theory at trial was that O’Meally engaged in fraud because he knew about the fund rules he was violating, and used methods to disguise that his trading activity was market timing.  The evidence at trial showed that mutual funds applied their restrictions on market timing trades inconsistently, sometimes permitting trades based on negotiations with Prudential or based on the large amount of business Prudential did with them.  Other people at Prudential knew about O’Meally’s trading activity, including his supervisors, the compliance department, and the legal department.  In fact, “Prudential’s legal and compliance departments approved O’Meally’s trading practices on more than one occasion….”

It appears that the evidence was decidedly mixed.  O’Meally contended he acted “in good faith” because he received these internal approvals, noted that mutual funds often permitted market timing trades, and had valid customer-based rationales for the trading methods the SEC argued were intended to deceive the funds.  The testimony from Prudential witnesses, and even the mutual funds involved, lent some support to this contention.

The SEC charged both fraud and non-fraud violations.  The non-fraud violations required only proof  of negligence, not scienter (knowing fraud or reckless misconduct).  But instead of hedging its bets and introducing evidence that O’Meally at a minimum acted negligently, it went “all in” on its fraud charges, presenting essentially no evidence on negligence.  To prove negligence, the SEC would have had to show that O’Meally breached an accepted “standard of care” with regard to these trades, but it never even tried to do so.  As the court noted: “The only evidence adduced was of deliberate acts that were carefully executed, profitable and legal.  The SEC did not propose how O’Meally’s conduct might have been sloppy or ill-calculated.  Negligence was not referenced in the opening or closing arguments.”

The jury rejected the claims of fraud (either by deliberate or reckless conduct) as to trades with all of the 60 mutual funds involved, apparently accepting O’Meally’s good faith defense.  But it went on to find that as to six of those funds, O’Meally violated two provisions, sections 17(a)(2) and 17(a)(3) of the 1933 Act, by acting negligently.

The Second Circuit reversed the judgment as to sections 17(a)(2) and (a)(3) because the SEC presented no evidence to support a negligence finding.  Given the standard that would apply to overturn a jury verdict – that even with all inferences drawn in the SEC’s favor there was no evidence upon which a reasonable juror could find negligence – the result reflects poor tactical judgments by the SEC.  The SEC chose not to introduce any evidence of a standard of care that governed O’Meally’s conduct under which he should have known that repeatedly violating fund rules was not permitted.  That normally would be done through an expert witness who would give his or her opinion that the conduct was at least negligent, and the SEC has plenty of access to experts who could provide that type of testimony.  But it failed to do so.

If this were just a “one off” failing, it would hardly be worthy of mention.  Lawyers make tactical mistakes all the time.  But it was not.  The SEC habitually obsesses on fraud charges in its enforcement actions, and often neglects to present evidence or argument on charges that require a lesser state of mind.  That is because the SEC enforcement staff views fraud as the charge with the most firepower and media impact.  Especially after having “convinced” other defendants to give up and accept a settlement that charged (but did not prove) fraud, the enforcement lawyers are loathe to accepting a jury verdict showing a lesser degree of culpability.  But the cases that go to trial are often the  ones that present the most difficult facts, and therefore are often the ones in which the ability to prove fraud is seriously in doubt.  Instead of pursuing an approach that might succeed at proving lesser violations, the SEC’s lawyers often go “all in” on the fraud theory, even where, as here, there is substantial contrary evidence.  The result here is that after years of litigation (the alleged violations occurred in 2000-2003), the SEC left all of its chips on the table.

Straight Arrow

May 19, 2014

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2 thoughts on “SEC’s Single-Minded Focus on Fraud Theory Results in Loss on Appeal

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