Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Friday, August 3, 2012

Government Loses Two Securities Fraud Cases This Week

It has not been a good week for government enforcement of securities laws.    On Tuesday, a jury in a federal district court in Manhattan rejected the SEC’s allegations of wrongdoing against Brian Stoker, a former mid-level executive at Citigroup.  On Thursday, a federal appeals court in Washington D.C. threw out convictions of traders in the “squawk box” prosecution.(Download Usvmahaffy)  Many commentators lament the failure of government to clean up the mess of the financial crisis and bring wrongdoers to justice.   ProPublica’s  Jesse Eisinger sums it up, “As every frustrated American knows, no major banking executive has gone to prison or has been fined any significant amount in the aftermath of the financial crisis.”  So what went wrong this week?

First, SEC v. Brian Stoker (S.D.N.Y.).  In this case, a companion to the SEC’s enforcement action against Citigroup Global Markets (in which Judge Rakoff rejected the parties’ proposed settlement; that case is now on appeal to the Second Circuit), the SEC charged Stoker with negligence in connection with his role in creating CDOs that Citigroup sold to investors.  According to the SEC, Stoker knew, or at least should have known, that he was misleading investors by not disclosing that Citigroup helped select the underlying securities in the CDO and then bet against it.  The jury refused to find Stoker liable and also issued an unusual statement that the judge read aloud in the courtroom:

“This verdict should not deter the S.E.C. from investigating the financial industry, to review current regulations and modify existing regulations as necessary.”

So what does this mean?  Was the jury saying that the agency went after the wrong guy?  Stoker, the only individual defendant in the case, was portrayed by his attorney as a “scapegoat,” a relatively junior executive (albeit one who made $2.4 million at Citigroup in 2007, the year before he left) at Citigroup.  In contrast, the SEC’s attorney, in his closing to the jury, argued that “Citigroup stacked the deck and Brain Stoker dealt the cards.” 

Alternatively, was the jury saying that it had no sympathy for the sophisticated investors who purchased the CDOs?  The defense presented evidence that Citigroup’s marketing materials contained warnings about the riskiness of the investment and should have alerted the purchasers that Citigroup might bet against the security.  Maybe the jury thought that the agency should use its scarce resources to protect unsophisticated investors from fraud?

In any event, to this jury, this was the wrong case for the agency to pursue.

Second,  U.S. v. Mahaffy (2d Cir.)  The convictions of these defendants stems from charges that in the early 2000s traders at several brokerage firms  allowed employees of A.B. Watley, a day trading firm, to listen in on live feeds from “squawk boxes” to obtain information on clients’ pending block orders, so they could engage in “front running.”  This litigation has a long and tortuous past.  The first trial in 2007 resulted in acquittal on 38 counts, but the jury deadlocked on one count of conspiracy to commit securities fraud.  The government determined to retry the defendants on this count and ultimately obtained convictions based on conspiring to misappropriate confidential information.

Now, as securities law specialists know, a violation of securities law based on the misappropriation theory requires the government to establish that the misappropriated information was confidential.  The squawk boxes blared throughout the firm; hence, the key issue was proving that the firms treated information about block orders transmitted via the squawk boxes as confidential.  The government called representatives from each firm who testified that client order information was confidential and they did not permit employees to allow outsiders to listen to squawks.   On cross-examination, defense aggressively challenged the assertions that the information was treated as confidential.

After defendants were convicted and sentenced following the second trial, the SEC initiated an administrative proceeding against one of the defendants, in the course of which it disclosed thirty transcripts of depositions taken as early as December 2004.  Defendants argued that information contained in twelve of the transcripts was exculpatory and should have been turned over to them in the criminal proceedings pursuant to Brady v. Maryland.  Specifically, they argued that the information undermined testimony from government witnesses that the squawked information was treated as confidential.  The district court, while it criticized the government’s conduct, refused to set aside the conviction.

The Second Circuit, however, reached a different outcome and determined that the Brady violations undermined confidence in the jury verdict.  (It also found that the district court did not adequately instruct the jury on the scope of honest services fraud and also vacated that component as well.)  It found that, because of the centrality of the issue of confidentiality, the defendants should have been provided with the transcripts: “The withheld SEC testimony strongly suggests that the brokerage firms did not treat squawked block order information as confidential and that senior employees and management at the respective firms did not bar the transmission of squawks or take steps to maintain  exclusive control of pending block order information.”  The court also found that there was no doubt that the government knew, at the time of the first trial, that at least one transcript contained possible Brady material, because the SEC attorney who conducted the depositions was designated as special AUSA for this case, sat at the counsel table during the trial, and even called the Brady issue to the attention of the DOJ attorneys.

The court concludes its discussion of the Brady issue with a pointed question:  

“In light of the government's mishandling of material exculpatory and impeaching material, we wonder whether the government will choose to subject the defendants to yet a third trial.”

Unfortunately, Mahaffy is not the first case where prosecutors fail to live up to their professional responsibilities in their zeal to obtain convictions, either because they are convinced of the guilt of the defendants or because they can’t bear the thought of losing.

So a bad week for the government.  And we continue to wait for government actions that will seek to identify and hold accountable the movers and shakers that caused the financial crisis.

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