Sanctions

There was a decision by the Second Circuit Court of Appeals Wednesday, Sept. 2, that may be heartening to long/short equity funds, short dedicated, etc. The question it helps answer is: "When might market makers and hedge funds receive compensatory damages from lawyers for the parties who bring lawsuits against them on claims such as 'naked short selling'?"

A lawyer who has become something of a short-sellers' nemesis, Wes Christian, has been sanctioned on connection with a lawsuit he filed against Knight Capital, the market maker, along with a collection of hedge funds and individual traders. He represented issuer ATSI, and alleged stock manipulation by Knight Cap and the others.

The district court dismissed the complaint with prejudice in February 2005. Defendants then moved for rule 11 sanctions against the attorneys involved. The district court agreed and imposed sanctions in March 2008 on the ground that the attorneys "lacked any reasonable factual basis" for bringing the suit. Crucial to the precedential significance of this is: the district court imposed sanctions of close to $70,000 without making a specific finding of bad faith.

On appeal to the 2d Circuit, the issue was whether sanctions against a lawyer in such a matter should be applied by a subjective or an objective standard, i.e. whether a finding of bad faith was required.

The court answered that question in favor of an objective standard, upholding the imposition of sanctions, although remanding for reconsideration of the amount.