Helping Yourself While Serving Two Masters: Do Specialists Violate Rule 10B-5 When They Interposition?
Asudulayev, Roman, Fordham Urban Law Journal
The decision of the Second Circuit in United States v. Finnerty (Finnerty III) was the culmination of a number of District Court decisions that found that specialists on the New York Stock Exchange (NYSE) could not be held liable for fraud under Rule 10b-5 for interpositioning, whereby they put themselves between buy and sell limit orders, in violation of NYSE rules, and profited on the spread. Finnerty III and its District Court sibling decisions were wrongly decided. Specialists presented a uniquely thorny issue of agency law to the Federal Courts in New York. This issue was under-analyzed by the Federal Prosecutors and left the courts without a coherent theory of fiduciary duty for specialists. This Note will demonstrate that there is a fiduciary relationship between specialists and their public customers and will untangle that relationship to show that it prohibits interpositioning and that interpositioning was fraud under Rule 10b-5.
Introduction I. The Legal Background of Interpositioning and Some Economics A. Specialists B. Interpositioning C. Rule 10b-5 and Fraud D. Some Possible Analogies to Interpositioning 1. Trading Ahead 2. Insider Trading E. The Fiduciary Duties of Specialists 1. Establishing Fiduciary Duty 2. Fiduciary Duties F. Economic Terminology and a Dose of Legal Realism: Arbitrage and Rent II. The Conflict: The Courts' and the Government's Analyses of Interpositioning and Fraud A. The Logic of the Courts B. The Counter-Argument III. Who's Right? A. Economic Analysis for Legal Realism B. Mistakes in the Law and a Fact: Fiduciary Duty, Fraud, and Rule 10b-5 C. And All of the Analogies: Insider Trading and Trading Ahead D. Of Missing Steps and Synthesis Conclusion
With increasing public furor over the actions of various financial institutions, (1) it is easy to forget that apparent fraud in finance can create tricky legal issues. In 2005, federal prosecutors charged fifteen broker-dealers on the New York Stock Exchange, called "specialists," (2) with fraudulent trading. (3) The gist of the charge was that the specialists took advantage of trade requests that clients had sent to them. (4) Although specialists are allowed to trade on their own accounts, "when a buy order comes in at a higher price than a sell order, the specialist's duty is to match the customers rather than profit from the spread." (5) The practice of profiting from the spread is called "interpositioning." (6) Between 2005 and 2008, the Federal Prosecutor for the Southern District of New York began fifteen prosecutions. (7) All fifteen failed ignominiously (8): seven were dropped voluntarily; two ended in acquittal; (9) two guilty pleas were set aside; the government dropped a case against a fugitive; (10) two had their convictions overturned by the Second Circuit Court of Appeals; (11) and one individual, David Finnerty, had his conviction set aside by the District Court, and the Second Circuit upheld the decision. (12) Apparently, the government is quite unaccustomed to losing cases, (13) fifteen especially. How did this fiasco occur?
This Note will shed light on the operation of the NYSE, discuss the prosecutions, and explore the difficult legal questions they presented--questions that arguably have been left unanswered. Part I of this Note introduces the reader to the NYSE and its specialists, explains interpositioning, discusses the background law that relates to specialists--SEC Rule 10b-5, (14) fraud, and fiduciary duty--and explains some economic terminology that will later help put the role of specialists and interpositioning into perspective, and to consider this area of law from a more Legal Realist perspective.
Part II of this Note will discuss the logic used by the courts in their ultimate rejection of the allegation of fraud against specialists for interpositioning: the courts did not receive a strong argument that specialists were fiduciaries of their clients, meaning that mere theft by the specialists without any express promises to the contrary could not be considered fraud. …