Institutional factors bearing on criminal charging decisions in complex regulatory environments.

• Author: Bove, Emil J., III

In April 2005, federal prosecutors brought novel securities fraud charges against fifteen former traders, known as "specialists, "from the New York Stock Exchange (NYSE). The indictment alleged that the specialists abused their positions on the NYSE floor between 1999 and 2003, resulting in $19 million in harm to investors. Prior to these charges, the specialists' trading practices had already been reviewed and sanctioned by Congress, the Securities and Exchange Commission (SEC), and the NYSE. Indeed, many of the traders had already been dismissed from the NYSE. Despite some limited early success, very few of these prosecutions ended in convictions.

This Article focuses on the framework established by the constitutional allocation of power to the main institutions of the criminal justice system: prosecutors, juries, legislatures, and courts. It applies this framework to the cases against the specialists, examining their history, regulation, indictment, and legal defenses. By doing so, it seeks, first, to shift the discussion of criminal charging decisions toward an inquiry that focuses more on the institutions involved in the process and, second, to add precision to the questions of when and whether it is worthwhile to call on the institutions of the criminal justice system.

The cases against the specialists provide an example of the potential utility of this framework and the degree of care necessary in making a criminal charging decision. Although many factors bear on prosecutorial discretion besides regulatory enhancement, hindsight regarding these cases cautions that charging decisions in complex environments involving multiple layers of overlapping regulation can be exceedingly delicate.

INTRODUCTION I. SETTING THE SPECIALISTS' SCENE: WHAT HAPPENED AND TO WHOM? A. The Settlements: SEC, NYSE & The Specialist Firms B. Punishing Individual Specialists C. Congressional Hearings D. The Criminal Charges II. THE LANDSCAPE: THE PRELIMINARY QUESTIONS OF How AND WHY? A. The Specialists' Task B. Specialists' Functions and Obligations C. Trading Ahead and Interpositioning D. NYSE Regulation, Inc. and the NASD Merger III. EFFICACY OF THE JURY TRIAL A. Juror Comprehension: Factual Complexity and Legal Instructions B. Strategic Trial Presentations 1. Simplification 2. "Piling On" C. Jurors as Securities Regulators? IV. GETTING IN THE COURTHOUSE: POTENTIAL PRETRIAL DEFENSES A. The Rule of Lenity B. Fair Notice: Novel Theories of Fraud C. "Minor Violations" V. CRIMINAL CHARGES AS SUPPLEMENTS TO THE REGULATORY ENVIRONMENT A. The Regulatory Environment: Multiple "Pyramids" B. Criminal Charges: Benefit or Burden? 1. Criminal "Prohibitions" in Complex Environments 2. Assessing the Specialists' Utility CONCLUSION INTRODUCTION

In April 2005, federal prosecutors brought criminal charges against fifteen former traders on the New York Stock Exchange (NYSE). These were "securities fraud charges in an area where criminal charges had never been brought," (1) against a class of traders, known as "specialists," that operates at the core of the U.S. capital markets. Where possible, the specialists were supposed to match buyers and sellers seeking to make trades on the exchange. Regulators, however, had uncovered instances where specialists violated NYSE rules by trading with investors using funds and stocks from their own banks' accounts instead of simply arranging trades at best-available prices between willing buyers and sellers.

The indictment alleged that the specialists abused their positions on the NYSE floor between 1999 and 2003 to effectuate these types of trades, resulting in $19 million in harm to investors. (2) Prior to the criminal charges, the specialists' practices had already been reviewed and sanctioned by Congress, the Securities and Exchange Commission (SEC), and the NYSE itself. Despite the fact that the specialists had already been banned from the stock exchange floor by the NYSE, the U.S Attorney declared: "We've excised a large tumor from the stock exchange. (3)

The government had some limited early success with the cases against the specialists, securing two guilty pleas and three trial convictions. But courts and juries slowly began to find weaknesses in the cases. Two juries acquitted. Shortly thereafter, charges against three other specialists were dropped. In November 2006, the U.S. Attorney's Office dropped the remaining charges. The final symbolic blow came in February 2007 when, following a jury's guilty verdict, the judge entered post-verdict judgment of acquittal on the grounds that the trial evidence was insufficient as a matter of law to prove securities fraud. (4)

Just over a year after that decision, regulators at all levels started to struggle to stem the tide of financial losses from turmoil within the credit markets. Congress is working to craft legislative solutions, (5) the Federal Reserve has called for broader regulatory authority to police the nation's banking channels, (6) and the SEC continues to both investigate lenders (7) and seek broader reform. (8) In January 2008, the Federal Bureau of Investigation (FBI), the Internal Revenue Service (IRS), and federal prosecutors in New York, Los Angeles, Philadelphia, Dallas, and Atlanta formed a task force to consider criminal charges against lenders in the mortgage industry. (9) Dubbed "Operation Malicious Mortgage," the Department of Justice and FBI brought 144 mortgage fraud cases against 406 defendants between March 1 and June 18, 2008. (10)

In June 2008, in one of the more high-profile prosecutions arising out of the lending crisis thus far, federal prosecutors charged former Bear Steams executives Ralph Cioffi and Matthew Tannin with nine counts of securities, mail, and wire fraud. (11) Prosecutors allege that the executives encouraged investors to leave money in the hedge funds they managed while, at the same time, the funds' value was declining and Cioffi was withdrawing some of his personal money from the accounts. (12)

In the wake of the indictment, the FBI argued that the prosecution of Cioffi and Tannin is "not about mismanagement of a hedge fund investment strategy." (13) Nonetheless, these criminal charges run the risk of hindering ongoing reform efforts and carefully calibrated regulatory structures that oversee these complicated financial arrangements. This Article examines some of these issues--and the challenges that lay ahead for the prosecutors in cases like United States v. Cioffi and Tannin--by looking back to the failed criminal prosecutions against the NYSE specialists.

When considering the use of the criminal sanction in complex regulatory environments such as these, prosecutorial discretion must be exercised carefully. Charging decisions should involve a careful assessment of the potential effect on other regulators' efforts, as well as consideration of how the institutional actors in the criminal system will address the issues raised by the charges. Although theoretical arguments regarding the potential overuse of criminal sanctions have been thoughtfully posed for over fifty years, (14) the framework for this Article is based on the constitutional allocation of power to the main institutions of the criminal justice system: legislatures, prosecutors, courts, and juries. (15) Shifting the discussion of criminal charging decisions toward an inquiry that focuses on the institutions involved in the process adds precision to the questions of when and whether benefits could result from calling on the actors in the criminal justice system.

Part I sets the scene by briefly describing the efforts of other regulators that investigated and sanctioned the specialist firms and their traders. Congress, NYSE, the SEC, and federal prosecutors all participated. Part II discusses the specialists' function and the regulatory environment on the NYSE floor, between roughly 2000 and 2005, in order to illustrate the threshold challenge prosecutors sometimes face in obtaining an understanding of a discrete and complex segment of the financial markets in order to supplement the efforts of other regulators with more specific experience in that area.

After discussing the background knowledge required to make an informed charging decision, Part III addresses whether, given the complexities of the potential defendants' environment, a jury would understand the case and reach a proper guilty verdict. Viewed broadly as an institutional actor in the overall criminal justice process, the interaction between a jury and novel criminal charges, such as those against the specialists, is a critical consideration. The discussion provides an overview of the various types of complexity in a criminal trial and some of the strategies prosecutors use in complex cases. These factors also illustrate the considerations that might militate against bringing such charges in the first place.

Part IV focuses on the courts as an institutional gatekeeper to the whole system. In order to do so, it examines another practical consideration that is considered before bringing criminal charges--the defendants' likely legal defenses. Examining the specialists' arguments regarding fair notice and lenity yields two insights. First, responding to these defenses serves as one of the final obstacles for a prosecutor before the merits of the charges can be considered by a judge or jury. Second, thinking about these defenses requires an examination of which institutional actor--Congress, courts, or prosecutors--should define the contours of fraud doctrine in the criminal law. The discussion brings to the forefront questions about the respective roles of the various institutional actors involved in the regulatory process.

Having considered some of the institutional challenges facing prosecutors, juries, and the courts, Part V focuses on comparing the effectiveness of criminal charges relative to other available regulatory efforts in a complex environment. Clearly there are...