Fraud in sharp business practices

This paper examines the issue of criminalization of business dealings known as sharp business practices and brings out the issues involved, the existing precedents on the subject and future directions. It has generally been held that for to establish criminal charges in sharp business practices, courts require proof of a quid pro quo arrangement between the sources of information and the person trading on it.1 A high proof of evidence is required for establishing the criminal charge; a US court of appeal overturned the conviction in a case where it found that the evidence was insufficient to establish the knowledge of the available benefits.2
In specialised trades the issue of fraud has been reviewed by US courts, and currently the courts are of the opinion that in specialized transactions element of deceit does not exist. Recently, a US court of appeals has quashed the sentence awarded in such a case. Courts are reluctant to term sharp business practices involving sophisticated parties as fraudulent on grounds that these transactions do fall within the domain of breach of contract and do not constitute a criminal offence.3 A corporate officer's fiduciary duty when combined with a mail or wire communication is not sufficient to establish mail or wire fraud.4
Issues involved Interesting it would be to review the facts of HSBC executive case in which a criminal complaint stands lodged in the US Federal District Court5 in Brooklyn, New York. As per the facts available, the NY prosecutors have accused two former bank executives at HSBC6 of a conspiracy to defraud a company by deliberately buying pounds ahead of the customer's sterling purchase and by reselling it to the client at a higher price. It has been alleged that by doing so, traders made $3m in profits in their own trading book. The bank received $5m in fees. The bank executives are now being accused of 'wire fraud'7, 'front running'8 and 'trading ahead'.9
The prosecution of bank executives has raised a number of important questions of law, say for example, whether or not taking advantage of a client's decision to engage in a currency transaction by trading ahead10 of customer's larger order does constitute a fraudulent scheme? Did the act of ramping the price in bank controlled accounts due to less favourable exchange rate cause a loss to the bank's clients through the use of inside information which as is alleged provided an opportunity to bank executives to reap a nice profit? Another question is whether or not the narrated facts lead to commission of a wire fraud.
As per wire fraud statute, the prohibitions include:
i. Scheme or artifice to defraud another person of money or property ie a deliberate misrepresentation of facts or false promises that are likely to affect the decision of a party on other side of the deal. However, not all conduct that strikes a 'sharp dealing' or 'unethical conduct' can be termed a scheme or artifice to defraud.11
ii. False or fraudulent pretences, representations or promises.
iii. Such fraudulent information is transmitted or causes to be transmitted by means of wire etc;
The offenders in this case are also accused of committing:
i. The act of front running;12 and
ii. Inside trading13
Existing precedents The debate is over the act of fraud alleged to have been committed by the accused. What is an act of fraud has been elaborated by a United States Court of Appeals for Second Circuit in Manhattan;14 the court held that in absence of evidence of an act of misleading, defrauding, or deceiving one's clients, the charge of fraud cannot be established. It may also be noted that in various other cases the US Courts have explained the requirements to constitute an act of 'Fraud': These requirements include:
a. A deliberate misrepresentation of facts or making of false promises that are likely to affect the decision of a party on the other side of the deal.
b. Some form of deception and not just taking advantage from client's actions, [this element is necessary for establishing the violation of law].15 In fact a party may not misrepresent material facts about an asset during a negotiation to sell it.16
c. An act of communication by wire etc with the customer on the deal.17
d. Existence of a lie
Future directions The complaint in the present case alleges that all the elements necessary to constitute a fraud are present in the case. The prosecutors have alleged that:
i. The bank executives misled the company about the best way to execute the currency transaction and about the price increase at a specific time;
ii. The bank executive told a lie by stating that the increase in price was the result of a heavy buying by a Russian;
iii. The bank executives failed to disclose to the client that the bank was ramping the price of the pound;
iv. There was an element of 'joy' in the mutual communications of bank executives after the deal was over;
v. The executives told a lie by stating that the bank was 'taking action' regarding the issue of ramping the price of currency and failed to explain how bank's earlier trade affected the price;
vi. The said acts of bank executives dissembled to keep the customer form learning how HSBC was taking an advantageous position ahead of the expected large trade;
The moot points in this case are likely to be as follows:
i. Whether any of the statement described in the complaint adds up to a fraud or a misrepresentation?
ii. Were there misstatements about the price of the pound?
iii. Whether anything actually deceived the company which was important for its dealings?18
Even in cases where insider trading is alleged, the requirement for such an offence includes something tangible and concrete. And there must be proof of a quid pro quo arrangement between the source of the information and the person trading on it.19
It may be noted that in an alleged fraud case an appeals court found insufficient evidence to convict an accused where the available evidence did fail to prove a planned knowledge of the accused about the benefit gained; and since the pre knowledge is a requirement for establishing a criminal violation; hence in absence of such evidence the court concluded that the offence of fraud does not stand established.20
This interesting debate which challenges SEC's attempt to criminalize sharp business practices and to bring the culprits within the domain of fraud is likely to the settled by the US Supreme Court when it decides a pending case namely, Salman v. United States, which is likely to be heard in October 2016.21
Conclusion The present trend of the judicial precedent is tilted towards the requirement of presence of planned scheme to deceive, pre knowledge of benefits or personal gains to be reaped and the character necessary to show benefit through insider trading. It is thus required to find something tangible to establish mens rea or criminal intent of the accused. It is evident from existing precedents in financial services sector that the courts are of the view that contractual obligations be treated as falling outside the scope of criminal liability. The existing standards laid down by courts in this regard treat financial services sector as an outcome of contractual obligations and away from criminal liability unless and until proved so with the support of clear evidence.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates Karachi)
1. Dirks v. Sec 463 US 646 [1983]
2. US v. Newman Nos.13-1837-cr (L), 13-1917 [2014]
3. In United States v. Weimert No 3:14-cr-0002,-JDP-1 decided April 3, 2016 the seventh circuit in Chicago held that lies told by a bank officer to both side during negotiations for selling a property investment could not be the basis for wire fraud conviction. The court found insufficient evidence of fraudulent intent at the time of sales.
4. US v. Kwiat 817 F.2d 440 [7th Cir. 1987].
5. See, Petter J. Henning, 'Finding the Fraud in the HSBC Currency Trading Case, The New York Times, July 25, 2016".
6. HSBC itself is not accused of any wrongdoing.
7. See 18 US code § 1343, whoever, having devised or intending to devise any scheme or artifice to defraud, or for obtaining money or property by means of false or fraudulent pretences, representations, or promises, transmits or causes to be transmitted by means of wire, radio, or television communication in interstate or foreign commerce, any writings, signs, signals, pictures, or sounds for the purpose of executing such scheme or artifice, shall be fined under this title or imprisoned not more than 20 years, or both. However, the law does not cover all behaviour which strays from the ideal, [See US v. Colton, 231, F.3d 901].
8. Someone with advance knowledge of a specific market order in shares, bonds or currency from a client steps in ahead and buys for their own account. When the client's usually much larger order is executed it drives up the prices, the private purchase is sold at ramping prices leading to a profit. Front-running thus occurs when a firm trades ahead of a customer's large order that is likely to move the market, profiting off the inside knowledge of the impending change in the price. As per rules issued by Financial Industry Regulatory Authority, the act of front running is prohibited.
9. Trading ahead occurs when a specialist trades from his proprietary account before executing trades for public customers.
10. See Finra Rule 10 b-5 which is the primary antifraud provision in cases relating to securities, and protects persons who are deceived in securities transactions to make sure that buyers of securities get what they think they are getting.
11. [US v. Colton, 231 F.3d 890 (4th Cir 2000)]
12. Because the trading is not necessarily deceptive, even though it breaks the rules for brokerage firm
13. In order to prove inside trading there must be the existence of a fiduciary duty
14. See United States v. Finnerty 474 F. Supp 2d 530 [S.D.N.Y. 2007]; the principal issue considered in this case was whether the conduct of the trader of inter positioning amounted to deception within the meaning of federal securities law.
15. Not just taking advantage of clients even if it costs them money.
16. For example, a seller or his agent may not falsely tell potential buyers or investors that a piece of property has no history of environmental problems if soil and groundwater contamination on the property was disallowed the year before. The buyer would be led to purchase a property worth far less than she was led to believe, given the looming remediation cost. The information not revealed would be material to the price buyers of security are willing to pay, See United States v. Morris 80 F. 3d 1151 [7th Cir. 1996].
17. Though the bank was not obliged to disclose the escalating costs
18. HSBC'S own review of the transaction found no violation of its code of conduct and this fact would be used by the accused to argue that they did not commit a crime.
19. Dirks v. SECP
20. Id. n2
21. Peter J. Henning, "Supreme Court may redefine insider trading law", The New York Times August 03, 2016.