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“Intent to Harm” Not Required for Criminal Conviction Pursuant to Investment Advisers Act of 1940

In United States v. Tagliaferri, 15-536 (May 4, 2016) (Leval, Pooler, Wesley), the Court issued a per curiam order affirming Defendant’s conviction for violations of the Investment Advisors Act of 1940, 15 U.S.C. § 80b-6 (the “1940 Act”), entered by the United States District Court for the Southern District of New York (Abrams, J.).  In the underlying appeal, the Defendant raised several challenges to his conviction by a jury for violations of the 1940 Act, as well as securities fraud, wire fraud, and violations of the Travel Act.

In today’s precedential opinion, the Court addresses only the significant issue of whether a criminal conviction under the 1940 Act requires proof of “intent to harm”—and concludes that such proof is not required.  As such, a conviction may be sustained with proof of only “intent to deceive.”

Last year, the Court held that “intent to harm” is also not required for a conviction under section 10(b) of the Securities and Exchange Act of 1934. See United States v. Litvak, 808 F.3d 160 (2d Cir. 2015).

The Court addresses Defendant’s remaining challenges in a summary order, which is available here.

Tagliaferri’s Conduct and the 1940 Act

Tagliaferri’s conviction stemmed from his role as the founder and principal asset manager of an investment advisory firm that he formed in Connecticut in 1983, and then relocated to the U.S. Virgin Islands in 2006.  At the time of relocation, the firm had around $252 million in assets and 115 client accounts.  Tagliaferri was found to have engaged in three basic forms of misconduct, starting in 2007:  (1) investing some of his client’s assets in companies that paid him “fees” in return, without disclosing to his clients these “kickback” arrangements; (2) executing securities trades between client accounts, without disclosing these “cross-trades” as required by the firm’s compliance policy, and sometimes collecting fees in the process; and (3) mischaracterizing a $5 million investment as a “loan,” generating fake “sub-notes” for clients, and using fees from his “cross-trades” to pay any clients that demanded payment on the fake notes.

Section 206 of the 1940 Act, codified at 15 U.S.C. § 80-6b, makes it unlawful for “any investment adviser by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly,” to:  (1) “employ any device, scheme, or artifice to defraud any client or prospective client”; (2) “engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client”; (3) “knowingly … sell any security to or purchase any security from a client” while “acting as principal for his own account” or “as broker for a person other than such client” without disclosing such capacity to and obtaining consent for the transaction from his client; and (4) “engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.”  This provision is enforceable both through civil SEC proceedings, see id. § 80b-9, and—for any “willfull[] violat[ion]”—though criminal prosecution, see id. § 80b-17.

Trial Court Proceedings

Tagliaferri’s main defense at trial—which gave rise the legal question at issue on this appeal—was that he never intended to harm his clients through this conduct.  While acknowledging that his kick-back and cross-trade fees posed conflicts that should have been disclosed, he claimed that the underlying trades were nonetheless executed in good faith and in the best interests of his clients.  Likewise, he admitted the impropriety of his fake loan and “sub-note” scheme, but maintained that he thought it would all work out and his clients would not be harmed.

At trial, the district court declined to instruct the jury that a conviction under section 206 of the 1940 Act required proof of “intent to harm.”  The court also instructed the jury that while “good faith” is a defense to this charge, “a belief by the defendant, if such belief existed, that ultimately everything would work out so that no investors would lose any money or that particular investments would ultimately be financially advantageous for clients does not necessarily constitute good faith.”   The jury thereafter convicted Tagliaferri on this count, among others.

Tagliaferri’s Appeal of 1940 Act Conviction

On appeal, Tagliaferri challenged this conviction, and the underlying jury instructions, on the basis that the fraud component of this criminal charge requires the government to prove not just “intent to deceive” but also “intent to harm.”

Tagliaferri pointed to common law fraud cases requiring both forms of “intent” in order to establish “intent to defraud,” as well as cases applying this common law fraud requirement to criminal prosecutions for mail and wire fraud.  Tagliaferri asserted that section 206 of the 1940 Act, when asserted using the criminal enforcement art of the Act, likewise incorporates this common law requirement.  The Court disagreed.

The Court began its analysis with SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), in which the Supreme Court acknowledged this common law fraud precedent but concluded that Congress “did not intend to require proof of intent to injure and actual injury to the client” when it gave the SEC authority to enjoin conduct that “operates ‘as a fraud or deceit’ upon a client,” pursuant to section 206(2).  Id. at 195.  The Supreme Court acknowledged, however, that the case before it was not “a criminal proceeding for ‘willfully’ violating the Act,” and cited to precedent for the rule that “penal statutes are to be construed strictly.”  The Supreme Court thus left open whether “intent to harm” might still be required for a criminal prosecution.  Resolving this question today, the Second Circuit rejected Tagliaferri’s claim that Capital Gains signaled that this additional element should in fact apply in the criminal context for any violation of section 206.

The Court explained that the strict construction of “penal statutes” applies only when statutory terms are ambiguous, and otherwise “does not imply criminal enforcement of a civil liability must add an additional essential element.”  Considering the text of section 206, along with the additional “willfully violates” element for criminal prosecution, the Court concluded that by its unambiguous text “intent to harm is not an element of a criminal conviction.”

The Court focused its analysis on subsections (2) and (4) of section 206, and held that “at minimum” these two subsections “do not incorporate the full requirements of fraudulent intent at common law.”  The Court observed that the language of subsection (2) was similar to a provision in the Securities Exchange Act of 1933 (the “1933 Act”) that prohibits conduct which “operates or would operate as a fraud or deceit.”  In Aaron v. SEC, 446 U.S. 680 (1980), the Supreme Court held that such language “focuses upon the effect of particular conduct on members of the investing public, rather than upon the culpability of the person responsible,” and therefore does not require intent. Id. at 697 (emphasis in original).  Applying this analysis to subsection (2) of the 1940 Act, the Court concluded that its terms likewise prohibited conduct which had the effect of being fraudulent or deceitful, and did not require proof of deliberate intent to cause harm.

Addressing subsection (4) of the 1940 Act, the Second Circuit explained that the Supreme Court has interpreted similar language in other securities laws to require either intent to defraud or intent to deceive.  Accordingly, “the reach of section 206(4) extends to practices motivated by intent to deceive, even if not intent to defraud”—and as such, “intent to harm” is not required.

The Court rejected Defendant’s claim that the “willfully violates” requirement of § 80b-17 for a criminal prosecution based on these provisions imports an “intent to harm” element.  According to the Court, a “willful[] violat[ion]” requires just intentional conduct with knowledge that it is wrongful.  Since the “wrongfulness of section 206 violations derives from their deceptiveness, proof that the defendant intended to deceive his clients suffices to establish the requisite mens rea for guilt.” (Emphasis added.)  Specific intent to cause harm through such conduct is not required.

The Court similarly noted in a footnote that while subsection (3) of the 1940 Act contains its own “knowingly” requirement, that subsection also does not require “intent to harm.”

The Court did not specifically address subsection (1), which proscribes a “device, scheme, or artifice to defraud.”  This language is similar to section 17(a)(1) of the 1933 Act, which (unlike the other two subsections of section 17(a)) the Supreme Court in Aaron held did require some form of knowledge and intent to defraud, even in a civil action. Aaron, 446 U.S. at 696.  The Second Circuit did not discuss what is necessary to establish such “intent to defraud” in the context of this specific subsection of section 206.

In Litvak, the Second Circuit recently held that the scienter requirement applicable to section 10(b) of the 1934 Act required “intent to deceive, manipulate or defraud,” and thus did not require “intent to harm.”  The Second Circuit there acknowledged that while it had interpreted “intent to defraud” to require proof of “contemplated harm” in the context of mail and wire fraud, it has also held that the burden of proof for criminal intent for securities fraud is lower than for mail and wire fraud. Litvak is not directly applicable, however, since (as the Court there recognized) the scienter requirement for section 10(b) is not restricted to “intent to defraud,” but extends to “intent to deceive” and “intent to manipulate.”

While the Second Circuit may have left open what is required to establish a criminal violation of section 206(1) of the 1940 Act, its decision today makes clear that the other three subsections capture a broad array of deceitful conduct without requiring proof of “intent to harm.”  This is broadly consistent with the approach taken by the federal courts in construing securities laws to be distinct in operation from common law fraud, and it maintains consistency between the 1940 Act charge here and charges under the 1934 Act.  The decision makes it harder for defendants to present a defense under the 1940 Act that they acted deceptively, but not with any intent to harm others.  This is a difficult defense to present even in the best circumstances because it requires significant concessions by the defense that may be difficult for the jury to reconcile with a “not guilty” verdict.

-By Jason Vitullo and Harry Sandick