In a sharp rebuke of the Eastern District U.S. Attorney’s Office for failing to disclose Brady materials, a federal appellate court has overturned the convictions of six brokers implicated in a scheme to allow day traders to eavesdrop on confidential communications.

The U.S. Court of Appeals for the Second Circuit said in United States v. Mahaffy, 09-5349, that the federal prosecutors deprived the defendants of a fair trial by failing to turn over transcripts that contradicted the testimony of key government witnesses. The panel noted that an attorney for the Securities and Exchange Commission who conducted pretrial depositions cautioned that at least some of the materials could be subject to mandatory disclosure under Brady v. Maryland, 373 U.S. 83 (1963).

“The government’s failures to comply with Brady were entirely preventable,” Judge Barrington Parker (See Profile) wrote for the circuit. “On multiple occasions, the prosecution team either actively decided not to disclose the SEC deposition transcripts or consciously avoided its responsibilities to comply with Brady.”

Parker said the government’s Brady violations “unfairly skewed” the case against defendants who were “forced to mount their defenses without the benefit of material exculpatory and impeaching sworn testimony.”

Additionally, he questioned whether the government should proceed with a third trial.

“In light of the government’s mishandling of material exculpatory and impeaching material, we wonder whether the government will choose to subject the defendants to yet a third trial,” Parker wrote in an opinion joined by Judges Richard Wesley (See Profile) and Joseph McLaughlin (See Profile).

Robert Nardoza, a spokesman for Eastern District U.S. Attorney Loretta Lynch, said the office is reviewing its options and declined further comment.

Yesterday’s 38-page opinion from an appeal argued in early March overturned the convictions of six brokers because of the Brady violation and remanded because the trial judge, Eastern District Judge John Gleeson (See Profile), “did not adequately instruct the jury that it had to find bribery in order to convict under an honest services fraud theory of conspiracy to commit securities fraud.”

The case centers on allegations that traders with Merrill Lynch, Smith Barney/Citigroup and Lehman Brothers provided confidential information to the day trading firm of A.B. Watley.

It was alleged that the traders let brokers at Watley listen in on internal communications by placing phone receivers up to their firm’s “squawk boxes,” which are used by firms to transmit trading information, including some information on client orders.

According to the indictment, Kenneth Mahaffy of Merill Lynch and later Smith Barney; Timothy O’Connell of Merrill Lynch; and David Ghysels of Lehman Brothers allowed Watley employees to eavesdrop on squawk box communications.

Watley was then able to buy or sell securities at a lower price than would have been available once the squawked orders were executed, the government alleged.

It also was claimed that Watley employees placed so-called “wash trades”—the simultaneous purchase and sale of securities at the same price and for no purpose other than to generate commissions—for Mahaffy, O’Connell and Ghysels. Those three, plus Watley employees Robert Malin, Linus Nwaigwe and Keevin Leonard, were indicted.

In 2007, the defendants were acquitted on 38 of 39 counts and the jury hung on the remaining count of conspiracy to commit securities fraud.

Two years later, a retrial was held, with honest services and property fraud as the linchpin of a conspiracy. The jury deadlocked, but after Gleeson delivered a supplemental charge the defendants were convicted.

After sentencing the SEC brought an administrative action against Mahaffy and, in connection with those proceedings, disclosed transcripts of 30 investigative depositions dating back to 2004. Several of the transcripts dealt with a critical issue in the case—whether the information shared with Watley was confidential.

With those transcripts in hand, the defendants moved for a new trial. Gleeson criticized the government for failing to disclose the information, but said reversal was not required because the jury would not have reached a different result if it had been aware of the depositions.

Host of Excuses’

The Second Circuit unanimously disagreed.

“For the government to secure convictions under its property fraud theory, it had to prove beyond a reasonable doubt that the brokerage firms had exclusive use of the squawked information, considered that information to be confidential, and that they treated it as such,” Parker wrote.

However, Parker said, several witnesses who testified before the SEC—including senior officials at Merrill, Smith Barney and Lehman—”squarely contradicted that picture” and said the squawks were not confidential and that there were no company policies against disseminating information transmitted over the boxes.

On appeal, the government advanced “a host of excuses as to why this testimony was not Brady material,” and noted that some of the information actually supported its theory. But the Second Circuit found it clear that the transcripts “contained substantial Brady material, much of which was easily identified as such.”

It noted that Sandeep Satwalekar, an SEC staff attorney who had conducted nearly all of the depositions, had warned prosecutors that at least one of the transcripts contained material that could fall under Brady. However, the circuit said, the prosecution team for the first trial declined to disclose the materials and the second trial team declined to revisit the issue.

“We conclude that the government’s failure to disclose portions of the transcripts violated Brady and that these Brady violations undermined confidence in the jury’s verdict,” the panel said.

The honest services issue arose on appeal in the context of Skilling v. United States, 130 S. Ct. 2896 (2010), where the U.S. Supreme Court held that the statute covers only schemes involving bribes or kickbacks. Skilling was decided after the Mahaffy trial.

During deliberations, the jury asked for a plain-English explanation of the statute and Gleeson described it as “a kind of anti kickback or anti bribery law.” The Second Circuit, however, said the “bare bones statement” was inadequate.

Andrew Frisch of Manhattan, who represents Mahaffy along with Jeremy Sporn, said he is “ecstatic” over the ruling and said the government should drop the case.

“The Department of Justice has been determined to find a way to prosecute people who work on Wall Street,” Frisch said in a statement. “The way to reform Wall Street is to address its real problems, not prosecute people who happen to work there for a benign practice historically condoned and encouraged by the industry.”

In an interview, Frisch said the SEC transcripts completely undercut the prosecution’s theory of honest services fraud by showing that the sharing of squawk box transmissions was not contrary to brokerage firm policies.

“The undisclosed testimony establishes that the brokerage firms were historically engaged in the conduct for which the defendants were prosecuted,” Frisch said. “It can’t be that you deny your employer honest services by doing what your employer has previously condoned.”

Also appearing were Donna Newman of Manhattan for Nwaigwe; Yuangchung Lee of Federal Defenders of New York for O’Connell; Susan Wolf of Hoffman Pollok in Manhattan and Matthew Brissenden of Garden City for Ghysels; Thomas Dunn of Manhattan and Mitchell Alan of Golub, Golub & Golub in Manhattan for Leonard; and Susan Kellman of Brooklyn for Malin.

Eastern District Assistant U.S. Attorney James McMahon argued for the prosecution; Hope Augustini argued for the Securities and Exchange Commission.