Should the two managers at the Bear Stearns hedge funds have been indicted?

The funds were highly invested in CDOs--mortgages, in other words.  The indictment indicates that the two defendants were aware that problems in the CDO market were affecting the funds in March 2007.  But of course concerns over CDOs and subprime mortgages were already rife in the markets.  As the indictment noted, a major investor in the fund announced in April 2007 that it intended to redeem its entire $57 million investment.  Similarly, part of the allegations in the indictment are that the defendants understated the level of redemptions by other investors.  In other words, without any disclosure from the funds, the investor was presumably concerned enough about the investments in the fund to eliminate its position.  All of this suggests that the market had considerable information and concern on the investment content of the funds.

Similarly, the alleged fraud lasted, according to the indictment, only about three months, during a period of turmoil in the market and apparent turmoil within the funds.  Discussions of closing the funds only occurred in late April 2007.  In other words, had Tannin and Cioffi announced then that they were shutting down the funds, they would have done so only about a month before the funds actually closed. 

Finally, it is not clear from the indictment that investors would have saved anything had the funds shut down even sooner.  The assets in the funds were apparently illiquid and probably worthless before June.  Had the funds shut down in late April or early May, most investors would still have lost their investment.  The only real difference is that the funds would not have processed withdrawals in May and not accepted any new investments during the month. 

The indictment makes considerable hay out of the fact that Cioffi withdrew $2 million.  It makes far less out of the fact that he left in the fund $4 million, an investment presumably lost.

None of this discussion is meant to excuse the behavior of the two managers.  It sounds from the indictment as if they had serious problems internally and understated them to the market.  The broader question, however, is whether this behavior should be ciminalized.  It shouldn't, is the short answer.  Unlike Enron, this was not a fraud of massive proportions.  Unlike Enron, the funds went into bankruptcy not because of a fraudulent conspiracy but because of bad investments.  Unlike Enron, this was a short term event during a period of turmoil.  Moreover, those investors that lost funds appear sophisticated and likely aware of the problems in the subprime market.

In this case, civil penalties are enough.  The careers of Tannin and Cioffi in the securities business are essentially over.  The SEC can bankrupt them by taking away the rest of their net worth.  And, as noted, Cioffi has already lost $4 million.  Jail, however, is not the answer.  Moreover, the criminal action will not address the broader, more significant issue.  Why were these hedge funds almost entirely unsupervised by management at Bear Stearns?  While the indictment makes a great deal out of the failure of the two defendants to reveal the true state of affairs to management at Bear Stearns, this was not a subtle matter.  Bear Stearns had two hedge funds highly invested in CDOs and other debt instruments.  Yet somehow management apparently never inquired or looked into the condition of the funds, sitting back and waiting for their managers to report any problems. 

This should be a matter left to the Securities and Exchange Commission and private investors.  It should entail an examination of the behavior not only of Tannin and Cioffi but also management at Bear Stearns.  It should not be left to criminal authorities.

It is a tough time to be a hedge fund.  For one thing, the economy is not cooperating and solid returns are hard to come by.  For another, the term "hedge" fund has become pejorative, a term that stands for short term investors who elevate their profit making goals over all other interests.  They have been demonized by the SEC and are not well liked by at least some on the Delaware courts. 

But the news only got worse with the indictment of two portfolio managers, Ralph Cioffi and Matthew Tannin, from hedge funds operated by Bear Stearns.  The SEC filed civil charges as well.

They managed two funds, the High Grade Structured Credit Strategies Master Fund and the the High Grade Structured Credit Strategies Enhanced Master Fund, both formed under the laws of the Cayman Islands but operated out of New York.  The Enhanced Fund invested primarily in collateralized debt obligations (CDOs), instruments backed up by debt obligations, particularly mortgages. 

The indictment alleges that by March 2007 Cioffi and Tannin believed that the funds were at risk of collapse.  They covered up this "bleak state" in order to protect their compensation and reputation.  The indictment quoted internal communications indicating concerns with the funds, including some from emails.  During the same time period, Cioffi began reducing his own investment in the Enhanced Fund, pulling $2 of the $6 million out.  At the same time, the mangers were discussing their "awesome opportunities" and "great possibilities for the coming months" when discussing the funds with the public. 

By April, Tannin sent an email advising that the funds be closed.  He described the subprime market as "damn ugly" and that if their internal report on CDOs was accurate that the subprime market was "toast."  Despite the concerns, they reaffirmed to Bear Stearns management that the funds were in good shape.  They were likewise upbeat in a conference call with investors held on April 25, understating the number of anticipated redemptions. 

On June 7, the Enhanced Fund ceased redemptions; the High Grade Fund did the same on June 27.  The funds filed for bankruptcy later in the summer.  Their collapse largely heralded the beginning of the subprime crisis and raised concerns with the future of Bear Stearns, something that would contribute to the loss of confidence in the investment banking firm the following year and its acquisition by JP Morgan.

The indictment includes counts alleging disclosure violations and insider trading.  We will offer some thoughts on the indictment in the next post. 

The indictment is posted on the DU Corporate Governance web site. 

We have, to some degree, followed the claims arising out of the collapse of Refco. It is an example of a fraud uncovered in the post-SOX era, a consequence of a more active audit committee. Please refer to our previous posts for information on the topic.

The latest shoe to drop was the guilty plea, as reported inThe Wall Street Journal and Bloomberg.com, of Phillip R. Bennett, the former CEO of Refco, Inc. plead guilty to 20 criminal charges including bank and securities fraud, conspiracy, money laundering, and wire fraud. Bennett entered the guilty plea a month shy of the scheduled start of a criminal trial to determine his role in an 8-year accounting scheme that cost investors more than $2.4 billion.

Bennett, a British citizen, built Refco, Inc. into one of the biggest independent U.S. futures traders. Its August 2005 initial public offering (IPO) raised $583 million. Although the company appeared successful and attracted significant investment, Bennett and others actively engaged in nearly a decade of fraud to cover up poor financial performance.

Refco’s problems began when the company extended credit to customers who experienced significant trading losses during the Asian debt crisis of the late 1990s and were unable to make payments. To hide the shortfall from auditors and investors, Refco moved more than $1 billion in debt to Refco Group Holdings Inc. In return, the Bennett-controlled holding company gave the brokerage worthless IOUs which Refco characterized as a large receivable. Under Bennett’s direction, and with the help of the Vienna-based Bawag PSK Bank and unnamed customers, Refco was able to hide the fraud for years. Indictment, United States v. Bennett, No. 05-CR-1192 (S.D.N.Y. filed Nov. 10, 2005).

The carefully constructed house of cards finally toppled in October 2005. On October 10^th, Refco announced the discovery of a $430 million receivable owed it by a Bennett-controlled entity. Further, Refco stated that its 2002 through 2005 financial statements were unreliable. Bennett was arrested on October 12^th. On October 13^th, Refco announced that it lacked sufficient liquidity to continue operations and the New York Stock Exchange (NYSE) halted trading of the stock to evaluate the company’s suitability for continued listing and trading. Order Regarding Withdrawals, Unsecured Loans or Advances from Refco Securities, LLC and Refco Clearing, LLC, Exchange Act Release No. 52606 (Oct. 13, 2006).

Refco filed for Chapter 11 bankruptcy protection on October 17th and the NYSE formally suspended trading on October 18^th after concluding its evaluation. In the aftermath, the company’s stock fell from a post-IPO high of over $30 per share to 81 cents per share and resulted in market capitalization loss of more than $1 billion.

On November 18, 2005, the New York Stock Exchange filed an application with the SEC to delist the stock. The SEC granted the application effective November 30, 2005. Refco, Inc., Order Granting Application to Strike from Listing, File No. 1-32604 (Nov. 29, 2005).

Mr. Bennett will be sentenced for the criminal charges on May 20, 2008. If federal sentencing guidelines are followed, the former CEO may spend the rest of his life in jail. Though the criminal phase is drawing to a close, Bennett still faces civil lawsuits by investors. SEC counsel filed a complaint against Bennett in the U.S. District Court for the Southern District of New York on February 19, 2008.

The primary materials discussed in this post may be found on the DU Corporate Governance website.

On January 28, 2007 Carole Argo, former President and CFO of SafeNet, was sentenced to 6 months in jail and fined $1 million for her involvement in a backdating scheme. As wereported in November of last year, Ms. Argo plead guilty to one count of securities fraud admitting she “intentionally and systematically set out in a course of action to create opportunities for her and others to benefit financially through the backdating of stock option grants.”

Ms. Argo’s guilty plea and sentence is in connection with two backdating grants which netted her and a former CEO of SafeNet over $2.5 million. Additionally, Ms. Argo received performance bonuses totaling $650,000, given to her, in large part, based upon corporate earning statements which did not include the backdated information.

Michael J. Garcia, U.S. Attorney for the Southern District of New York issued a release concerning Ms. Argo's sentencing. In the release Mr. Garcia stressed that Ms. Argo’s backdating, which occurred between 2000 and 2006, was part of a larger conspiracy to keep her activities secret from “Safenet’s shareholders and outside auditors, as well as securities analysts, the SEC, and members of the investing public.”

Gregory Reyes, the former CEO of Brockade, was sentenced Wednesday in connection with his conviction in a backdating case to 21 months in prison and ordered to pay a $15 million fine. We juxtapose the decision with the Supreme Court's opinion in Stoneridge. In that case, the Supreme Court gave as one of the reasons for not extending liability to vendors the fact that "[s]econdary actors are subject to criminal penalties." Stoneridge, at 15. It seems that the majority in Stoneridge are comfortable with the use of the criminal laws to sanction what might otherwise be left to the civil realm. I suspect that Gregory Reyes would take issue with the approach.

By the way, Reyes got six additional months because he stated in an affidavit attached to a motion to sever that he had not backdated. Later at trial he apparently admitted that he had, a discrepancy counsel contended was a result of "poor drafting." The judge was apparently not happy with the inconsistency, suggesting, according to one report, that it amounted to obstruction.

Primary materials on this case are posted on the DU Corporate Governance website.

George Will wrote an editorial over the weekend slamming John Edwards, using it as an opportunity to rale against  Milberg Weiss and Bill Lerach.  Will adds nothing to the preexisting discussion and provides incomplete, if not misleading, analysis.  He knows better.  In other words, his result oriented approach is a reflection of his own hubris and hypocrisy.

As is well known, some attorneys at Milberg Weiss apparently kicked back to plaintiffs a portion of the attorneys fees as an inducement to bring actions.  Will is right that at the time (and no longer true today), lead counsel was often determined by the first to file the suit, putting a premium on the race to the courthouse and providing benefits to those with a ready stable of plaintiffs.  Will then goes on to make the utterly inconsistent point that these suits were somehow invalid ("How do you convict a company of the crime of having the price of its stock fall? . . . Often you do not prove it, or even plan to.  Rather you threaten to be such a costly nuisance that the company pays you to go away."). 

Several observations are worth making.  First, if the lawyers at Milberg paid kickbacks to be the first to the courthouse, it is nonetheless clear that other firms would have brought these cases (why, otherwise, would they pay to be first?).  In other words, there is nothing about the kickback scheme that resulted in even a single additional case being brought.  Second, paying kickbacks to be first does not in any way suggest that the cases lacked merit.  If anything, it is the reverse.  Counsel would want to be first in the best cases.  Thus, to even suggest that somehow the kickback scheme resulted in meritless lawsuits is an unfortunate fiction and analytically indefensible.  An example of hubris, in short.  

Finally, we note that securities class actions brought before the PSLRA took on average around four years to resolve.  It required firms with deep pockets to pay all of the costs of litigation, with the payout only coming years later after considerable sunk costs.  In a race to the courthouse environment, firms that filed first were not necessarily the best representatives for shareholders.  They might lack the skill and resources to pursue the case adequately.  In other words, as a result of the kickback scheme, the attorneys at Milberg were able to circumvent the dysfunctional system that determined representation not upon the quality of counsel but upon the speed of arriving at the courthouse.  In the cases where counsel paid kickbacks, plaintiffs received the benefits of a firm with deep expertise and deep pockets. 

It doesn't make what Milberg and Lerach did right.  But violating legal requirements in making improper payments to plaintiffs is not at all the same as saying that companies were improperly sued or shareholders improperly disadvantaged.  Before George Will accuses others of hubris and hypocrisy, he should pay more attention to his own positions. 

Bill Lerach wrote a coruscating op-ed in the Washington Post making several good points about corporate greed. He rails that “[e]xecutive failure is consistently rewarded with giant payments -- or, really, payoffs -- to keep the parting sacrificial lamb quiet so that he or she won't bleat to the stockholders, lawyers and the media that the others at the top of the company (and in the boardroom) knew what was really going on.”

While not expressly suggesting that greedy CEOs be sent to jail, that seems to be his implicit message. Prof. Ribstein, blogged about the op-ed, rebutting this argument for criminalization arguing that “[t]he criminal justice system is wildly inappropriate to deal with this sort of case.” I am with Prof. Ribstein on this one. The problem is that Learch’s examples do not indicate that the actors were morally blameworthy, merely that they engaged in risky business actions. Meting out jail terms in such cases only serves as a temporary palliative for retributive urges. It is almost certain that those clamoring loudest for imprisoning risk-taking CEOs would be bringing down the rafters with their cheering had the risky bets paid off. A man cannot be made a hero one day and a criminal the next, based on the vagaries of the market.

Mr. Lerach is not alone in wanting criminal law punishments. This, almost obsessive, current focus on criminalizing conduct that was traditionally dealt with by other areas of the law is reflected in the fact, that of the approximately 3000 crimes in the federal statute books, almost half were created since 1970. Virtually every new legislation aimed at behavior modification is accompanied by claims about the need for criminalization upon the pretext that civil sanctions do not pack enough punch. This has serious ramifications insofar as it undermines the coercive power of the criminal law by diluting its expressive power. It also makes victims out of those (like Lerach) who do not deserve prison because their actions were not morally wrongful.

In a telling indictment of the system Lerach laments that “[t]he real frustration is that there's so little that can be done. Shareholders supposedly have access to the courts for a remedy, but they won't get far… The government -- forget it. The SEC, and even Congress, appears to be getting ready to cut back shareholder rights and court access even more.” Notwithstanding the system’s current flaws, the answer is not criminalization.

Lerach ends with a rather disingenuous claim: “I'm on my way to prison because, in my zeal to stand up against this kind of corporate greed over the years, I stepped over the line. It turns out that the legal system is a lot tougher on shareholder lawyers than it appears to be on Wall Street executives.” The enormous amounts that he made were at least as much of a motivation for his actions as any “zeal.” The unsavoury squabbling that lawyers engage in for class action booty in the name of shareholder activism is, sadly, yet another agency cost that comes with the territory.

Andrew Hayden, a student at the Sturm College of Law, has written a thoughtful post on this case.  Argo, the former president and CFO of SafeNet, agreed to plea to one criminal count in connection with backdating allegations.

In the category of criminalizing compensation practices, the indictment contains the usual allegations of backdating and the cover up of the practice, which ordinarily meant conforming all documents to the backdated date.  There are tantalizing hints throughout the indictment that illustrate the use of criminal punishment for what is really a civil offense. 

Argo, despite all of the allegations of covering up the practice, apparently was quite open about it.  When she was promoted to President and COO, she sent an email to the new CFO stating the following:

• Our past practice has been to aggregate options for performance awards or new hires in the quarter and pick the best price after the hire date.  We then send the unanimous consent to the comp committee and the options are approved.  I think this is a good practice because of the volatility of our stock price.  Who wants to have an option priced on your start date and then have the option underwater a month later when you are notified of the award price?

The memorandum indicates that the practice was not a secret within the company and was used as an ordinary business practice.  In other instances, she apparently informed the Compensation Committee of the Board about the practice.  As the indictment described in one instance:  

• The grant was dated October 8, 2002, but was not actually approved by the Compensation Committee until on or about October 24, 2002.  In an October 21, 2002 e-mail, ARGO told members of the Compensation Committee, "we will be able to issue options to [the Former CEO] as of October 8th 2002." 

In other instances, the Compensation Committee apparently approved the backdated options.  Moreover, to indicate the degree of secretiveness, the actual backdating was apparently referenced in the minutes to the meeting.  See Para. 59 ("Unlike prior grants, this grant was not approved by [unanimous written consent] but rather during a meeting of the Compensation Committee.  As a result, on the face of the meeting minutes it was clear that these grants had been backdated.  Member's of SafeNet's accounting department noticed the backdating and advised senior management . . . "). 

This is not an attempt to justify Argo's behavior.  She apparently backdated and the company apparently misreported.  A breach of fiduciary duty or civil securities fraud certainly seems appropriate.  But given the business purpose (albeit misguided) and the openness of the practice, criminal prosecution seems excessive.  The phenomena is not entirely the fault of the Justice Department.  To the extent courts continue to use demand excusal to dismiss derivative claims involving backdating and high pleading standards to dismiss securities cases, criminal prosecution is the only remaining mechanism for ensuring some degree of accountability.

On July 25, 2007 an indictment was filed against Carole Argo, former President and CFO of SafeNet by the United States Attorney in the Southern District of New York. The two-count indictment accuses Ms. Argo of both securities fraud and conspiracy to commit securities fraud in connection with a stock options backdating scheme while serving as an executive for SafeNet. See Indictment, United States v. Argo, No. 07-CR-683 (S.D.N.Y. Oct. 5, 2007). Though, initially pleading not guilty, Ms. Argo changed her plea on October 5, 2007 to guilty to one count of securities fraud.

The US alleged Ms. Argo intentionally and systematically set out in a course of action to create opportunities for her and others to benefit financially through the backdating of stock option grants. The indictment listed eight instances where Ms. Argo, either for her own benefit or for the benefit of another, backdated certain stock option grants. Further, she did this as part of a conspiracy to hide her activity from the SafeNet board, investors, auditors, and the Securities and Exchange Commission.

Stock option grants give a recipient of such a grant the right to purchase stock in a company at a set price. Typically, the price of the stock option grant is the fair market value of that stock as of the date the option is granted. Backdating occurs when the grant date is changed so as to take advantage of a low in the price of the company stock.

The government claimed that Ms. Argo’s backdating and her attempts to hide the backdating had a two-fold effect. First, the government alleges, Ms. Argo’s backdating had the immediate effect of taking advantage of a low in the trading price of SafeNet. On one occasion, that Ms. Argo now admits to in her guilty plea, she backdated two grants, one for her and one for the former CEO of SafeNet. This backdating event netted the pair nearly $2.5 million. The second effect was that by hiding the backdating from the Safenet board of directors, Ms. Argo received performance bonuses totaling nearly $650,000. These bonuses where based upon the earnings performance of the company. The government argued that these earnings may not have been met had she reported the backdating.

It was reported in a press release issued this past week that Ms. Argo stated she “‘acted willfully and with the intent to defraud.’” Further, the release stated that Ms. Argo now faces a $5 million fine and 20 years in prison. Sentencing for Ms. Argo is scheduled for January 27, 2008. United States Attorney Southern District of New York’s Public Information Office, Former Chief Financial Officer of SafeNet, Inc. Pleads Guilty to Securities Fraud in Connection with Backdating of Stock Options, (October 5, 2007).

We have a post below on US v. Saltsman, a criminal indictment alleging a scheme to secretly issue "discounted PIPE shares" to two defendants via nominees.  Once the PIPEs were announced, the share prices of the relevant companies fell.  The shares issued in the PIPEs were used to cover short positons, allegedly earning the defendants $16 million in profit.  

Ordinarily, this would not be a topic of much interest to this Blog.  Of note, however, the indictment included Martin Weisberg, a partmer with Baker & McKenzie (but has since resigned).  The indictment mostly attributes to Weisberg the role of reviewer and scrivener, although there are allegations of false statements made to the SEC in response to comment letters.  In any event, as the post written by Vaughn Marshall indicates, the case against Weisberg is not entirely clear. 

On October 19, the Justice Department announced the indictment of six people for nineteen counts of securities fraud and money laundering. Four of the defendants are former officers and directors of Ramp Corporation and Xybernaut Corporation, including Martin Weisberg, a former partner at Baker & McKenzie law firm. The other two defendants are residents of Israel who were investors in the two companies.

The securities fraud charges are based on a number of PIPE transactions conducted by both companies with the Israeli investors. A description of PIPE transactions can be found in paragraph 16 of the indictment, and also here. The indictment alleges that the Israeli investors were secretly given discounts on their purchases of Ramp and Xybernaut shares in return for kickbacks to the other four defendants. The alleged scheme called for discounted shares to be sold to the investors through various shell corporations.

Disclosure of these transactions typically drives share price of the issuing company down as a result of the dilutive effect on the shares held by other investors. The government alleges that the Israeli investors “established large short positions in Xybernaut and Ramp stock prior to their receipt of the shares.” After the PIPEs were publicly announced and the market price of the two companies dropped, the investors used the shares obtained from the PIPEs to cover their short positions, thus reaping an alleged $16 million in profits.

Weisberg's alleged role in the scheme raises some interesting issues. First, many of the allegations are that he reviewed various filings that contained false disclosure. Thus, Paragraph 59c notes that Ramp filed a 10-K "reviewed by the defendant MARTIN WEISBERG" that failed to disclose a $50,000 gift or the role of certain defendants "in the change in Ramp's Board." The change in the board apparently referred to allegations in paragraph 33 that two of the defendants threatened to withdraw a PIPE transaction unless, among other things, three directors of Ramp resigned and two directors of their choosing were added to the board. Thus, the 10-K prepared by one attorney but reviewed by Weisberg "omitted any mention of SALTSMAN or EITAN's role in the change in Ramp's board of directors."

Other allegations in the indictment included claims that Weisberg made false statements to the SEC in response to a comment letter on a registration statement and that he failed to disclose certain payments received in his capacity as a director. As the indictment noted:

• "The 'Compensation of Directors' section of the 2003 Form 10-K state, in substance and in part, that Xybernaut's directors, including WEISBERG, were paid $1,000 per board meeting and received options to purchase 10,000 Xybernaut shares annually. The 2003 Form 10-K materially omitted any reference to the hundreds of thousands of dollars that WEISBERG and STEVEN NEWMAN received in exchange for causing Xybernaut to enter into the PIPE transactions with the Nominee Entities. These omissions rendered the disclosures made materially false and misleading."

There is not enough information in the indictment to truly assess the case against Weisberg. It is clear that much of what he did was typical of any securities attorney. Moreover, some of the allegedly false disclosure may have involved judgment calls that, in hindsight, were wrong but not criminal. Thus, the indictment notes that three directors resigned because of pressure from Saltsman and Eitan. The company said nothing about this in the Form 10-K. On the other hand, the SEC only expressly requires disclosure of the reasons for a director's resignation where there is a "disagreement with the registrant." See Item 5.02 of Form 8-K. Weisberg, to the extent he knew about the reasons for the change, may have viewed the information as immaterial. After all, it did not involve a change in control. Quite the contrary. The defendants only ended up with two representatives out of five on the board.

Moreover, the annual report did state that "we reduced the total number of directors on our Board of Directors from six to five pursuant to our By-laws, which permits our Board to set the number of directors from time to time. This change was made to avoid the possibility of a deadlocked Board with an evenly split vote." The indictment characterizes this as a false statement. In fact, it may well have been the reason why the board was changed from six directors to five. Moreover, with the defendants obtaining two slots, the change prevented the defendants from having the ability to deadlock the board. As a result, the statement may well be accurate.

The indictment can be found on the DU Corporate Governance website.

A post on the appeal of Jeffery Skilling has taken some time to develop, primarily because of the need to digest a 242-page tome filed to support his arguments for reversal.  The tome can be found at the DU Corporate Governance web site. 

In many ways, Skilling’s conviction exemplifies the worst consequences of blurring the line between bad business decisions and criminal conduct, overzealous prosecution, and the ready resort to mob justice. The government’s case against Skilling was based on a conspiracy to deceive investors about the true performance of Enron’s businesses by cooking the books to increase reported earnings, reduce reported losses, maintain an investment-grade credit rating, and improve the price of Enron’s stock. In doing so, Skilling allegedly breached his fiduciary duty of “honest services.” The shocking truth is that Skilling’s conviction is founded on no evidence as to when, how, or why the conspiracy was hatched, or anything beyond self-serving testimony from Fastow that proved that he committed any crime. The conviction chillingly demonstrates the need to clarify the “honest services” theory if it is to serve any function in distinguishing risky business behavior from criminal behavior.

In US v. Brown, 459 F.3d 509 (5th Cir. 2006), the government’s “honest services” theory was rejected by the court in similar circumstances, and there is no reason why Skilling’s appeal should not be successful, at least in part. In Brown, Enron and Merrill Lynch employees were alleged to have engaged in a conspiracy to defraud Enron and its shareholders by “parking” the now infamous “Nigerian barges” with Merrill Lynch for six months to artificially boost Enron’s earnings. It was alleged that Merrill paid $7 million to acquire equity in the barges to help Enron post $12 million in earnings to meet its forecasts. The state’s case was that this was a sham transaction because Enron executives orally promised Merrill a flat fee of $250,000 and a guaranteed 15% annual rate of return for the six months that it was required to hold the asset. Further, the government alleged that the transaction was in the nature of a lease rather than a sale because Enron executives promised it would buyback Merrill’s interest if no third party could be found.

The court was unsympathetic to the government’s claims because the facts did not show that the defendants had acted at the expense of the company, or had engaged in bribery and self-dealing. Rather, their actions were to the benefit of Enron. According to the majority, “…where an employer intentionally aligns the interests of the employee with a specified corporate goal, where the employee perceives his pursuit of that goal as mutually benefiting him and his employer, and where the employee’s conduct is consistent with that perception of the mutual interest, such conduct is beyond the reach of the honest-services theory of fraud as it has hitherto been applied.” The test for a deprivation of “honest services” case, as the court held in Rybicki, is that the defendant is secretly acting for his own interest while purporting to act for the employer. This is consistent with the Seventh Circuit’s ruling in United States v. Bloom.

There is no evidence that Skilling engaged in bribery or self dealing. Nor did he act secretly for his own benefit at the expense of Enron. There was no deprivation of “honest services” because, if anything, Skilling’s interests were too closely aligned with Enron’s. Unless the causal link between Enron’s ultimate collapse, and Skilling’s alleged actions are conclusively established, there was no harm caused by Skilling’s alleged “crimes.” In fact, the immediate consequences of Skilling’s actions were that Enron and its shareholders benefited. The application of the “honest services” theory in cases where bad business decisions caused financial losses dangerously corrodes the very basis of criminal liability by conflating moral wrongfulness with risk taking. It must be clarified if it has to serve the intended purpose.

The case against Skilling is in part a consquence of the weakening civil standards for liability.  With Delaware law making a sham of fiduciary obligations, civil remedies are in decline.  The truth is that Skilling's behavior should have been resolved in a civil courtroom, turning on whether he fulfilled his obligations to shareholders.  But absent a state court system willing to sanction management for mismanagment in appropriate cases, criminal courts are seen as the location of last resort and often the only place where some kind of punishment can be meted out. 

Enron may have collapsed in 2001 but the litigation is never ending.

On September 7, Former Enron CEO Jeff Skilling filed the opening brief in the appeal of his criminal conviction with the 5th Circuit Court of Appeals. The 239 page brief creates “four distinct categories of legal error that produced Skilling’s erroneous convictions:” (1) erroneous theory of fraud; (2) erroneous jury instructions; (3) community prejudice and truncated voir dire; and (4) prosecutorial misconduct.

In the first category, Skilling argues that the prosecution based its case upon a theory of “honest services” fraud; where a corporate executive can be liable for defrauding his employer even where the executive’s actions are intended to benefit the employer. According to Skilling, the 5th Circuit rejected this theory following his conviction in the case US v. Brown, 459 F.3d 509 (5^th Cir. 2006).

Skilling asserts that many of the instructions to the jury were made in error. In finding guilty knowledge on the part of Skilling, the jury was instructed that it could infer a culpable mental state if it also found he had intentionally made himself ignorant of actions taking place at Enron that he strongly suspected to be criminal. According to Skilling, this “deliberate ignorance” instruction is strongly disfavored in the 5th Circuit.

The jury instructions regarding the materiality of statements made by Skilling are also being attacked. He argues that the trial court applied an inappropriate standard under the securities laws by instructing jurors that they need only find his statements were “important.” Skilling also points out that many similar statements were dismissed by the very same district court judge in a civil case connected to the collapse of Enron’s water business. He goes on to state, “That a jury was allowed to convict Skilling criminally for statements for which he could not be held liable civilly not only reveals the instructional error requiring reversal, but underscores the profound unfairness of this entire case.”

He also argues that the trial court erred by allowing testimony from Andrew Fastow, former Enron CFO, that described “secret oral side deals” between himself and Skilling, while not instructing the jury on how they were to find whether or not these agreements in fact existed.

The last assignment of error relating to jury instructions is that Skilling was not allowed an instruction that explained his good faith reliance upon the advice of Enron’s lawyers and accountants, which Skilling claims, was central to his defense. Instead, he argues, the trial judge instructed the jury that Skilling was only entitled to rely on the advice of his personal lawyers and accountants.

The third major category described by Skilling asserts that the jury pool was tainted by the wide sweeping impact of Enron’s collapse on the Houston community, and that a change of venue should have been granted. In addition, Skilling argues that any chance of finding an impartial jury was lost during an unreasonably short voir dire which only lasted “five hours and screened only 46 jurors -only eight jurors more than the minimum necessary to empanel a jury after the parties had exercised their peremptory strikes.” (emphasis original)

In the final category of “legal errors” Skilling accuses the prosecution of a veritable laundry list of misconduct, including; withholding exculpatory evidence, coercing and threatening witnesses, securing unlawful plea agreements, and destroying crucial documents. Lastly, Skilling attacks the twenty four year sentence handed down by the trial court, pointing out that it is “six years longer than the average federal sentence for murder.”

Check back for continuing coverage of this case. Skilling’s brief can be found on the DU Corporate Governance website.

As we have discussed, Gregory Reyes, the former CEO of Brockade, was convicted in early August of 10 counts in a backdating case. One of the critical issues in the case concerned the materiality of any misstatements. Often, the misstatements associated with backdating result in only a modest amount of change to the financial statements.

The materiality issue was recently addressed in the order denying a motion for acquittal and issued on August 27. A copy is posted on the DU Corporate Governance web site. The trial judge conceded that "stock option expenses do not say very much about the potential for a company to make money, which is what investors care about most." Nonetheless, "[i]t does not follow from this evidence, however, that investors necessarily consider stock option expenses immaterial." Instead, as the court concluded:

• "Regardless of whether or how a company granted options, it is likely that many investors still would be interested in buying shares of that company for the simple reason that it is wildly profitable. This does not mean that investors necessarily consider the stock options program immaterial. In other words, although investors consider some information more important than non-cash compensation expenses, it does not follow that they consider stock options expenses unimportant."

So why then was the information important to a reasonable investor? Because the behavior suggested that management was not acting in the best interest of shareholders. "[I]nvestors would have cared that Brocade was concealing in-the-money grants, which were perceived by investment professionals as a 'a giveaway of shares' that failed to align the interests of shareholders and employees." Moreover, materiality received some support from a “statistically significant drop” in share prices following announcement of an investigation into stock options. The information "permitted an inference that investors bought and sold shares of Brocade based on the company’s non-cash compensation expenses."

This case, therefore, resembles the old qualitative materiality cases. The court is essentially concluding that the inappropriate behavior essentially called into question the quality of the company's management. The reinvigoration of the qualitative materiality doctrine may well be one of the most significant consequences of the federal involvement in the backdating scandal.

Having said that, the Supreme Court's decision in Dura Pharm., Inc. v. Broudo, 544 U.S. 336 (2005) makes it clear that private parties must present evidence of causal loss to sustain a claim under Rule 10b-5. In the case of matters of managerial integrity, at least in private actions, plaintiffs would need to show that shareholders were harmed presumably through a fall in share prices.

Yesterday, we posted on the relationship between lax standards under Delaware law for compensation decisions and the collateral consequence that penalties are imposed at the federal level, often through the use of criminal provisions.  The Reyes case is an example.  There are others.  The Corporate Fraud Task Force for the DOJ issued a five year report.  The report noted the following number of people subjected to criminal penalties over the five year period (five years coinciding with the Enron/Worldcom scandals and the five year anniversary of SOX):

As the report noted, the Task Force obtained 1,236 total corporate fraud convictions.  Some of these were for backdating, some for insider trading.  But even those that involved securities fraud in the form of false disclosure to the public no doubt typically contained allegations that the insiders benefited from the misstatements in the form of increased compensation, whether bonuses or options.  In other words, the DOJ is involved in the criminalization of compensation practices. 

Is this heavy handed?  Maybe.  But it arises in part because Delaware law resolutely refuses to impose meaningful supervisory obligations on directors in the area of compensation.  Where these practices subject to greater oversight and board involvement, one wonders whether the level of perceived abuse would be so high and whether the federal government would need to use criminal sanctions so resolutely to create the deterrence necessary to prevent recurrence. 

Lax standards at the state level have resulted in a considerable level of preemption, as Sarbanes-Oxely demonstrates.  The lax standards have also likely resulted in increased criminal prosecutions of management.  Tougher standards at state law would make both less likely.