Ninth Circuit holds that securities brokers pumping house stocks for higher commissions committed fraud in failing to disclose those commissions to clients
Rothschild LLP
Alain Leibman
USA
July 29 2010
Defending a securities fraud prosecution brought under 15 USC § 78j and Rule 10b-5 on the theory of undisclosed material information can be enormously challenging because the standard for judging whether particular information would have been material to a reasonable investor is so elastic and unpredictable. Just how immaterial the supposedly “material” information may be was underscored recently by the Ninth Circuit.
The case of United States v. Laurienti, 2010 WL 2266986 (9th Cir., June 8, 2010), concerned the securities fraud prosecution of the owners, senior managers and brokers of a defunct broker-dealer called Hampton Porter. The indictment alleged that Hampton Porter made a practice of selling blocks of stock provided to it by issuers through a “pump and dump” scheme. Its brokers were incentivized to sell these house stocks through greatly enhanced commissions, and only retained those commissions if they could discourage clients from selling out of their positions in the house stocks. By stoking buying activity in these stocks, the shares’ prices rose artificially and dramatically, and then the broker-dealer and others would dump their shares of those stocks to realize the gains. Clients of the firm were not informed, of course, about the brokers’ increased commissions on the house stocks, as compared to their commissions on all other stocks. Naturally, former clients testified at trial that if they had known of the house stocks’ commission rates, they would not have purchased those stocks. There was also evidence at trial of high-pressure sales tactics and unauthorized transactions in certain accounts, but no evidence of any misrepresentations or undisclosed information about the issuing companies, their performance, or the intrinsic value of the stocks.
The owners and managers pled guilty, leaving several brokers to go to trial; they were convicted. On appeal, the brokers maintained that there was no legal obligation to disclose their commissions, so they could not have committed securities fraud by failing to make the disclosure, and there was no other evidence of fraudulent statements or omissions.
Initially, the court of appeals opinion suggested, with an almost imperceptible wistfulness, that if the government had proceeded solely on a conspiracy to commit securities fraud theory, then the appeal would have been more easily resolved in its favor. In that scenario, the evidence of undisclosed commissions, “even if not independently criminal conduct,” would have amounted to circumstantial evidence of the brokers’ agreement to join the conspiracy of the owners and managers, and the conspiracy proof would have been complete against the brokers with no evidence at all of their committing actual acts of fraud. However, the opinion notes almost ruefully, the government did offer the failure to disclose bonuses not just on the conspiracy charge “but also as an independent violation of Rule 10b-5,” leaving the court no alternative but to decide the precise question: is it illegal to fail to disclose increased commission rates?
Reaching first the existence of a duty to disclose, the court held that in the presence of a relationship of trust and confidence between broker and client, Rule 10b-5 imposes on the broker an obligation to disclose all facts material to the relationship, citing Chiarella v. United States, 445 U.S. 222 (1980) (which concerned subsections (a) and (c) of Rule 10b-5, involving respectively, employing a device or scheme to defraud and engaging in a practice which operates to defraud, and which required disclosure of material facts if there was a relationship of trust). In dictum, the Laurienti court extended the obligation to disclose to subsection (b) of Rule 10b-5 (omitting material facts necessary to render other statements not misleading), even when there is not a relationship of trust. Although the jury instructions here were errant in failing to require the essential element of a trust relationship, the Ninth Circuit held that the broker defendants had waived their objections to the error.
Turning to the issue of the materiality of the commissions, the appeals court rejected the argument that the enhanced commission rates were immaterial as a matter of law, since, it held, a reasonable investor would consider them important. However, the court hastened to add, not all compensation arrangements are material and de minimis variations among different commission rates would indeed be immaterial.
Finally, the brokers argued that even if enhanced commissions are now to be deemed material, they had no way of anticipating that holding and so had no warning of the bounds of the criminal law. The court had two curt responses: (a) its holding was not unforeseeable in light of Chiarella; and (b) the failure to disclose is not illegal unless accompanied by an intent to defraud. A perfectly appropriate defense counsel response to the second point would be to firmly grasp one’s head with both hands and shake slowly from side to side, since the court’s guidance hardly illuminates the path between criminal and non-criminal conduct and leaves that demarcation entirely to the government’s charging decisions. |
