On January 27, in United States v. Connolly, the U.S. Court of Appeals for the Second Circuit misstated and misapplied the law of fraud in reversing the criminal convictions of former Deutsche Bank traders Matthew Connolly and Gavin Black.  The court’s order of acquittals over the findings of a jury and following a diligently fair trial was especially unfortunate given how difficult it is for the government to prove criminal conduct in the trading divisions of large global financial institutions.

The Connolly case was one of numerous prosecutions in the United States and the United Kingdom that charged traders and others at some of the world’s largest financial institutions with manipulating Libor – then the leading, global benchmark interest rate – in order to guarantee their banks higher profits on interest rate derivative deals, and thus increased bonus compensation for themselves.  The cases have included some of the most compelling evidence of fraud ever surfaced in investigations of major banks.  The defendants in the various Libor cases effectively, and sometimes literally, called themselves crooks.  The Deutsche Bank case was no exception.  The Second Circuit nonetheless ruled that Connolly and Black were mistaken in thinking there was anything wrong with what they did because, according to the court, they did not “lie.”

To say that fraud requires a lie, and that this case did not involve lies, is to misunderstand both the evidence and the law.  To do this in the face of the findings of a jury that no one could contend was not properly instructed on the law is – and I say this as one, like so many, who holds the court in great esteem – to fail to measure up to the standards and traditions of the Second Circuit as the preeminent arbiter of misconduct in financial markets.

The jury found, and the court did not dispute, that Connolly and Black agreed with others at the bank to alter the bank’s submissions to the trade organization that calculated and published Libor, solely for the purpose of favoring positions on the bank’s derivatives trading books that were coming due for settlement.  The defendants knew that this was contrary to what the bank was supposed to do, which was to report an estimate of what it would cost the bank to borrow funds short-term from other financial institutions – and not to choose a number requested by in-house traders seeking to pad their deal profits.  The jury found, and the court did not dispute, that this apparently successful effort to manipulate Libor would have been material to a reasonable counterparty in an interest rate derivative trade and that the manipulation was not in fact disclosed to Deutsche Bank’s counterparties.

This prosecution was based on a straightforward theory of fraud.  The Second Circuit has stated time and again, in cases involving both the mail and wire fraud statutes and the securities fraud statutes, that the conduct element of fraud is not limited to expressly false representations.  Fraud, which at its core rests on the concept of deception, can be committed by actions and by literally true but misleading statements.  One could argue that a great many of the traders who manipulated Libor actually lied to their counterparties by representing that they would price deals off an objectively determined benchmark that they knew would not, come settlement time, be fairly determined.  But that argument was not necessary.  The miscreant Libor traders committed fraud by their conduct when they secretly tampered with the benchmark interest rate in a manner designed to dupe those on the other side of their transactions.

The evidence of intent, which is typically hardest to prove in these sorts of cases, was overwhelming and essentially undisputed.  No wonder the jury returned a verdict of guilty.  Prosecutors usually must argue by inference about opaque states of mind that, in this instance, were instead plain for all to see.  The Connolly case, like many of the Libor cases, was replete with records of communications in which traders and other bank personnel explicitly agreed to alter the bank’s submissions to the trade organization in directions and amounts that were chosen solely on the basis of what would pad the trading books, depending on what positions those books happened to reflect at one time or another.  Sometimes they chortled about what they were doing.

The court, however, found that these people were not engaged in fraud, even if they thought they were, because they did not literally lie.  Inter-bank, short-term cash loans in the London market were not routinely sought or extended.  In the absence of actual such deals on any given day, Deutsche Bank and other institutions had to estimate the likely cost of borrowing and exercise judgment in their rate submissions.  Since even the manipulated, book-motivated numbers Deutsche Bank submitted to the British Bankers’ Association (BBA) could have reflected the actual rate charged for an inter-bank loan, the court said, the rates were not false, there was no lying, and thus there was no fraud.

The court’s opinion reads, unintentionally no doubt, as if the judges were unaware of the Second Circuit’s repeated recognition of the empirical truth that conduct alone can be deceptive if it causes a victim to continue to deal while subject to a material misapprehension.  This principle is central to understanding how the court has handled frauds that deceive through the manipulation of regulatory schemes.  In 1969, in United States v. Simon, Judge Friendly explained why a trial judge correctly denied a request for a jury instruction that expert testimony about the defendant accountants’ compliance with GAAP would be a complete defense to a charge of securities fraud.  Compliance with the particulars of GAAP was relevant evidence of the defendants’ good faith, and thus could be considered on the element of intent, but the ultimate question for the jury was whether the defendants intended to mislead, regardless of whether they technically transgressed accounting rules.  The Second Circuit reiterated this point when it affirmed the conviction of WorldCom co-founder and CEO Bernard Ebbers, who similarly complained that he had been denied a jury instruction stating that he could not be guilty of fraud in the reporting of the company’s (severely misleading) financial results if the company’s filings had, according to his expert, technically complied with the terms of GAAP.

It is settled that manipulative disclosures can be a vehicle for a scheme to defraud, as for example when a company misleadingly shifts earnings between reporting periods or engages in hidden shifting of business-segment reporting to burnish profits or conceal losses – stratagems that have been the basis for many prosecutions, including important parts of the Enron and WorldCom cases.  The Connolly defendants lacked even the claim of an errant jury instruction as a basis for appeal.  They could not argue that their jury was not given every opportunity to consider the relevance of the BBA’s concededly vague and ineffective rules about Libor reporting to the question of their intent to commit fraud.  It is thus startling that the court nonetheless rejected the jury’s work, reversing the convictions on the simplistic rationale that the numbers Deutsche Bank provided to the BBA were not literally false under all hypothetical circumstances – as if these defendants had been prosecuted for perjury rather than fraud.

The panel’s mistake in Connolly is especially regrettable because en banc proceedings are rare in the Second Circuit, and a grant of certiorari in the Supreme Court is both unlikely and quite risky for the government, given the Court’s recent tendencies to favor large enterprises in business cases and to narrow liability in cases of interpreting federal criminal statutes.  We are left, therefore, with an adjudication that bolsters the common cynicism outside Second Circuit circles that “bankers” are effectively immune from criminal prosecution – in a matter that, as much as any in recent memory, should have stood as clear proof that such a view is wrong.

This post comes to us from Samuel Buell, the Bernard M. Fishman Professor of Law at Duke University School of Law and a former federal prosecutor.