752 F.3d 569
2d Cir.2014Background
- Frederick O’Meally, a Prudential broker (1994–2003), used lawful market-timing trades on behalf of hedge-fund clients and earned about $3.8 million from January 2001–September 2003.
- Many mutual funds and Prudential issued “block notices” or policies intended to restrict market timing; some funds and Prudential nonetheless granted exceptions or applied restrictions inconsistently.
- O’Meally continued trading after some blocks by using alternative financial-advisor (FA) numbers and account numbers; Prudential’s compliance, legal team, and supervisors approved his practices and the firm invested in systems to support them.
- The SEC sued O’Meally under Sections 17(a), 10(b), and Rule 10b-5, alleging deceptive conduct and intentional concealment; the SEC’s trial presentation focused on scienter (intent or recklessness).
- The jury found no intentional or reckless misconduct under Section 17(a) or Rule 10b-5/10(b), but found negligent violations of Sections 17(a)(2) and (a)(3) as to six funds; the district court sustained the verdict on a negligence theory (failure to read/heed supervisory emails) and ordered disgorgement, a penalty, and prejudgment interest.
- On appeal, the Second Circuit reviewed whether the evidence was sufficient to support negligence liability under Sections 17(a)(2)-(3) and reversed, concluding the SEC failed to prove a breach of any applicable standard of care given the inconsistent fund practices and Prudential’s approvals.
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Whether evidence sufficed to prove negligence under Sec. 17(a)(2)-(3) | SEC: O’Meally negligently concealed trades by using alternate FA/account numbers and ignored fund/employer directives | O’Meally: Funds applied rules inconsistently; Prudential approved practices; no evidence of breach of any standard of care or expert proof required | Reversed — evidence insufficient to support negligence verdict |
| Whether expert testimony was required to establish negligence standard of care | SEC: No categorical requirement; pleadings and jury charge permitted negligence theory | O’Meally: Complex industry practices required expert proof of standard; SEC offered none | Held that expert testimony would have been needed or, at minimum, absence of any proof of breach made negligence speculative |
| Whether employer-instruction theory supported liability | SEC: Omitted directives and emails showed O’Meally failed to follow Prudential’s/block notices | O’Meally: Prudential construed block notices narrowly; supervisors, compliance, and legal approved his conduct | Court held employer-instruction theory unsupported; Prudential’s practices undercut claim of unreasonable conduct |
| Whether fund-prohibition theory supported liability | SEC: Prospectuses and block notices forbade market timing; using alternate IDs was deceptive | O’Meally: Funds routinely made exceptions; some allowed timing; inconsistent enforcement made it reasonable to proceed | Court held fund-prohibition theory unsupported because inconsistent fund behavior and approvals made negligence implausible |
Key Cases Cited
- SEC v. Ficken, 546 F.3d 45 (1st Cir. 2008) (describing market timing and block notices)
- Kircher v. Putnam Funds Trust, 547 U.S. 633 (U.S. 2006) (defining market-timing concept in mutual-fund context)
- In re Mutual Funds Inv. Litig., 529 F.3d 207 (4th Cir. 2008) (effects of short-term trading on funds and NAV)
- SEC v. Gann, 565 F.3d 932 (5th Cir. 2009) (procedures and effects of fund block notices)
- Aaron v. SEC, 446 U.S. 680 (U.S. 1980) (scienter not required for Sections 17(a)(2)-(3))
- SEC v. Dain Rauscher, Inc., 254 F.3d 852 (9th Cir. 2001) (negligence suffices under Section 17(a))
- Finkel v. Stratton Corp., 962 F.2d 169 (2d Cir. 1992) (negligence standard under securities statutes)
- Tepperwien v. Entergy Nuclear Operations, Inc., 663 F.3d 556 (2d Cir. 2011) (standard for granting judgment as a matter of law)