Second Circuit Reverses SEC Market Timing Verdict

by Dorsey & Whitney LLP
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The Second Circuit reversed a jury verdict in favor of the SEC in a market timing case, concluding that there was no evidence to support it. Specifically, the Court found that the “SEC ultimately succumbs to its strategic choice at trial to pursue a theory of scienter or nothing. Its entire jury presentation was premised on the idea that [Defendant] O’Meally violated Section 17(a) through intentional conduct. The SEC’s summation relied solely on intent and recklessness; theories rejected by the jury. And as to negligence, the SEC never introduced testimony or any other evidence on the appropriate standard of care against which a jury could measure O’Meally’s conduct.” This was “fatal” to its case. SEC v. O’Meally, No.. 13-213 (2nd Cir. Decided May 19, 2014).

Frederick O’Meally was a broker employed at Prudential Securities from 1994 to 2003. For many of his clients he traded shares in mutual funds using market timing, a form of arbitrage. While the strategy entails numerous short-term trades in a fund’s shares which can disadvantage it by increasing costs and was prohibited by a number of funds, it is not illegal.

A number of funds served “block notices” on Mr. O’Meally. Those indicate that the broker has run afoul of the fund’s restrictions and preclude a specific account from trading. Mr. O’Meally persisted over the objections of the funds. He continued using new financial advisor or FA numbers and account numbers. From January 2001 through September 2003 he earned about $3.8 million from market timing for his clients.

The SEC filed an enforcement action alleging violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The complaint claimed that Mr. O’Meally failed to follow directives issued by the funds and his employer. Before the jury the SEC focused on scienter and reckless conduct.

Mr. O’Meally introduced evidence demonstrating that the policies established by the funds were “anything but clear due to their inconsistent application.” In some cases the policies were not followed. In others the fund negotiated with Prudential to allow market timing trades without the salesperson notifying those responsible for enforcement. Mr. O’Meally also demonstrated that there were legitimate reasons for having multiple FA numbers such as sharing business generation credit.

Prudential’s internal policy was to honor the demands of the funds in the narrowest sense. If a block notice was issued the firm interpreted it to apply only to the specific FA number, not others.

The jury returned a verdict finding that Mr. O’Mealy did not violate Exchange Act Section 10(b) or Securities Act Section 17(a)(1). It did find that he violated Securities Act Sections 17(a)(2) and (3) as to six of the sixty mutual funds claimed by the SEC. Mr. O’Meally was ordered to pay a penalty of $60,000, disgorgement of $444,836 in fees and prejudgment interest. The District Court denied his Rule 50 motion which argued the insufficiency of the evidence.

On appeal Mr. O’Meally challenged the denial of his Rule 50 motion. Such a motion can only be granted “’if there exists such a complete absence of evidence supporting the verdict that the jury’s findings could only have been the result of sheer surmise and conjecture, or the evidence in favor of the movant is so overwhelming that reasonable and fair minded [persons] could not arrive at a verdict against [it].’” Here, this is the case.

The Commission claims that Mr. O’Meally made false or misleading statements to the mutual funds by using alternate FA numbers and customer account numbers to conceal hiss trading from the mutual funds. The prospectuses and blocking notices are clear, according to the Commission.

The SEC’s argument, however, fails in view of the inconsistent application of those policies and notices. Prudential’s compliance department approved Mr. O’Meally’s trading practices on more than one occasion. The Prudential legal and compliance departments all approved of his practices.

While Mr. O’Meally contends that the SEC was required to offer expert testimony on the applicable standard, that depends on the circumstances. In this case expert testimony may not have been of assistance. Nevertheless, the SEC offered the jury no evidence on the applicable standard. Mr. O’Meally was left in a position of conflicting standards. No jury could have found that he was negligent under these circumstances.

Nor could the jury conclude that Mr. O’Meally unreasonably failed to obey his employer’s instructions. While the firm’s policy was to comply with the letters sent from the funds, it encouraged traders to read them in the narrowest sense. The SEC offered nothing to contradict these facts. Again, under these circumstances the jury could not have reasonably found Mr. O’Meally negligent. The verdict was reversed and remanded with instructions to dismiss the complaint.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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