Federal White Collar Crime: The “Non-Imprisonment Defense” in White Collar Crime Cases

OVERVIEW

In United States v. Steven Fishoff, the court considered Section 32 of the Securities Exchange Act, which stipulates that a defendant who violates Securities and Exchange Commission (“SEC”) rule or regulation but proves he “had no knowledge of such rule or regulation” is not subject to imprisonment. The rule is intended to protect laypersons who commit technical violations. 

Issue: What is the burden on a defendant who wishes to use the Section 32—the “non-imprisonment defense?”

Short answer: The defendant can establish lack of knowledge and avoid imprisonment if he demonstrates, by a preponderance of the evidence, that he did not know the substance of the rule or regulation that he violated.

FACTS

Steven Fishoff (“Fishoff”) began trading securities in the early 1990s and by 2009 he started his own firm, Featherwood Capital, Inc (“Featherwood”), where he profited anywhere between $2 and $5 million per year. Fishoff did not have formal training in the securities markets, regulations, or compliance. Nor did he have a securities or other professional licenses. He operated the firm without any expert legal or regulatory advice. 

One of Fishoff’s strategies was short-selling a company’s stock in anticipation of the company making a secondary offering. Short-selling is the sale of a security that the seller has borrowed believing that the price will drop. The seller profits by buying back the stock at a lower price before returning it. A secondary offering is when a public company issues and sells new shares to raise money—thus diluting the value of existing shares and causing a price drop. 

Although secondary offerings are confidential, a company, through its underwriter, may contact potential buyers to assess interest. This may result in the salesperson providing confidential information such as the issuing company and the pricing and timing of the offering. The recipient of this information pursuant to the sales pitch is then considered “over the wall” or “OTW” and is barred per SEC’s Rule 10b-5-2 from trading the issuer’s securities or disclosing the information to anyone else before it is publicly announced.

Featherwood was accused of such criminal insider trading. It received confidential information about impending secondary offerings and would short-sell them. Two of Fishoff’s associates opened accounts at investment banking firms and cultivated relationships with bankers to receive solicitations to invest in secondary offerings. 

The case arose from the trading of stock in Synergy Pharmaceuticals, Inc. One of his associates at the investment bank was solicited to participate in Synergy’s confidentially marketed secondary offering. The associate called Fishoff a few minutes later. Featherwood started short-selling Synergy stock that same morning via Fishoff’s online trading account. When Synergy announced the second offering, Fishoff made between $1.5 and $3.5 million by short-selling Synergy stock.

PROCEDURAL HISTORY

In November 2015, Fishoff was charged in a five-count indictment including one count of conspiracy to commit securities fraud and four separate counts of securities fraud. He pled guilty to Count 4, securities fraud in violation of 15 U.S.C. §§ 78j(b) and 78ff, 17 C.F.R. § 240.10b-5 (Rule 10b-5) and 18 U.S.C. § 2.  Fishoff claimed that he had no knowledge of SEC Rule 10b5-2 and was entitled to the affirmative defense against imprisonment pursuant to Section 32 of the Securities Exchange Act. 

The District Court rejected the Section 32 affirmative defense and the Circuit Court affirmed.

HOLDING

The defendant who wishes to qualify for the non-imprisonment defense must  demonstrate, by a preponderance of the evidence, that he did not know the substance of the rule that he violated. It is immaterial that a defendant does not know the exact number of the rule or that he did not specifically intend to violate the rule. 

The Circuit Court rejected the Fishoff’s argument that he did not have knowledge of the SEC’s technical rules and that no layperson would know Rule 10b5-2. Fishoff was a full-time trader who made his living trading stocks—so he was not a layperson. Moreover, Fishoff and his associates exchanged information using code, which shows consciousness of guilt. Finally, the fact that he had no compliance personnel, despite advice from friends who were securities professional, demonstrates that Fishoff deliberately avoided such advice because he knew he was violating securities rules.