Two recent white-collar cases are examples of a phenomenon that one tends to find when the defense is able to emerge victorious: a case with some core facts that simply do not fit the pattern of wrongdoing expected in the popular conception. The phenomenon is that of the case that trails behind, and that is missing the characteristics that ultimately matter most: the tail, not the dog.
One such case has received a great deal of media attention, largely because it represents the end of the Southern District of New York U.S. Attorney’s winning streak in insider trading cases: the prosecution of Raj Rajaratam’s brother, known as Rengan. The government indicted Rengan years after it had acquired the relevant evidence in the course of pursuing his brother, and very shortly before the expiration of the statute of limitations. To the extent that the government initially recognized that pursuing a criminal case against Rengan was a low priority, there were good reasons. He was not a significant player, having had limited success as a trader struggling in the shadow of his brother, a founder of the hedge fund firm Galleon Group LLC. The government’s wiretap evidence against Rengan was limited and inconclusive.
After indictment, the government’s evidence began to buckle under the weight of its allegations. Prior to trial, following defense motions pointing out inconsistencies in their charging theories, prosecutors dismissed four counts of alleged insider trading based on trades in the stock of Clearwire Corp. that occurred in Galleon accounts. At the conclusion of the government’s case at trial, the Court granted defense motions to dismiss the remaining substantive counts of insider trading, based on Clearwire trades that occurred in Rengan’s personal account. Review of the transcript of the argument on the latter motions reveals a circumstance unusual in criminal insider trading prosecutions – the defense was able to point to substantial evidence that Rengan’s actual trading pattern in Clearwire did not support the claim that he received inside information about Clearwire from his alleged source, his brother Raj. The evidence was undisputed, based on Rengan’s and Raj’s trades, that Raj did not share with Rengan all of the inside information Raj had received on Clearwire (and on other stocks). The brothers’ trading patterns in Clearwire did not match, and most critically, the evidence showed that Rengan was shorting Clearwire at a time when inside information Raj received indicated that Clearwire’s price would rise. Indeed, Rengan lost money on his Clearwire trades.
While there was a good deal more to the Rengan acquittal than this, including some outstanding work from defense counsel, the core facts described above suggest why the government may have been initially hesitant to pursue criminal charges. It was the kind of case that does not fit the pattern of trading seen in the government’s other, successful insider trading prosecutions, and that does not fit what a fact finder expects to see in such a case.
The other recent decision, which has attracted a good deal less attention than the Rengan Rajaratnam prosecution, is SEC v. Ginder (O’Meally), a May 2014 Second Circuit opinion reversing a finding of liability for a former Prudential securities broker, O’Meally, for facilitating a form of mutual fund trading known as market-timing. The case hearkens back to an earlier era, a decade ago, when then-New York Attorney General Eliot Spitzer was making his name pursuing alleged misconduct on Wall Street, including alleged abuses in the mutual fund industry. Market timing is a form of arbitrage that exploits brief differences in prices between mutual fund shares, which are valued once a day, and the component stocks that make up the mutual funds. Although market timing is not illegal, because it involves frequent short term trading, market timing was seen as disadvantaging long-term investors by increasing the fund’s transaction costs and decreasing the fund’s liquidity. Accordingly, many mutual funds tried to limit or eliminate the practice. In the early 2000’s, then-Attorney General Spitzer, and thereafter the SEC, aggressively pursued those who used allegedly deceptive practices to avoid mutual funds’ restrictions against market timing.
The SEC brought an enforcement proceeding against O’Meally and other Prudential brokers alleging that they engaged in intentional fraud by utilizing different “financial advisor numbers” when mutual funds blocked trading in the numbers they ordinarily used. The evidence at trial showed that the mutual funds were highly inconsistent in enforcing purported bans against market-timing, in many cases permitting it under varying circumstances. The evidence also showed that those who oversaw O’Meally’s activities at Prudential – his supervisors, the compliance department, and the legal department — approved of his practices, and that the firm invested in a computer program to make market timing more efficient.
The jury rejected all charges against O’Meally predicated on intentional misconduct, finding liability only based on a negligence theory under section 17(a)(2)-(3) of the Securities Act, and only for his trading in six out of sixty mutual funds at issue. At trial, the SEC had spent virtually no effort arguing a negligence theory, focusing all of its energy in claiming intentional misconduct. On appeal, the Second Circuit ruled that the evidence was insufficient to support the negligence verdict, because there was no evidence that O’Meally violated a general standard of care in the securities industry (as to which the SEC adduced no proof through expert testimony at trial), nor evidence that he acted unreasonably by disobeying instructions from Prudential. The court found that there was no evidence regarding how O’Meally’s conduct could have been “sloppy or ill-calculated” – the only evidence was “of deliberate acts that were carefully executed, profitable and legal,” and approved by Prudential’s legal and compliance teams. There was thus no legitimate basis for a reasonable juror to find negligence.
Besides representing another instance of fine work by defense counsel, the O’Meally decision illustrates some basic flaws that were inherent in many of the market timing enforcement proceedings of a decade ago that were settled rather than litigated. The decision also demonstrates the problem when the SEC seeks to rely on a “fallback” theory of negligence in a contested enforcement proceeding. Enforcement proceedings are rightly typically reserved for serious, intentional misconduct. When the SEC pursues conduct that lacks those elements, and winds up having to try to salvage a case by relying on lesser forms of alleged misconduct that do not fit the expected pattern, it runs the risk of missing the mark entirely – of losing track of the dog for focusing on the tail.