What Prison Term Range will Nottingham Consider?

This entry is the first in the Nacchio Sentencing Series and answers the following question:

Question 1.  What is the range of prison terms Nottingham might consider using the Federal Sentencing Guidelines?

When Joe Nacchio returns to Denver on July 27^th for sentencing, what might he expect from Judge Nottingham? While the statute related to insider trading prescribes up to ten year prison term, Nottingham will consult the Federal Sentencing Guidelines for guidance. Under the current guidelines, Nacchio could expect a sentence in the range of approximately 10 to 12.5 years. These current guidelines ratcheted the range higher for acts committed after November 2001 and later after Sarbanes-Oxley was enacted. However, since the guidelines at the time of Nacchio’s trade will give him a lower range of two months shy of 6 years to 7 years and three months, Nottingham will apply the 1998 Federal Sentencing Guidelines.

I will go through the analysis that the court will also apply. To apply theFederal Sentencing Guidelines Table to determine the range of months Nacchio might serve, the court must determine the “level” related to the offense increased by aggravating factors (reduced by mitigating factors) as well as the adjustment for the amount of gain attributable to the guilty counts. This total “offense level” is compared to the criminal history of Nacchio to determine the range of months Nacchio might serve in prison.

The first step to determining the recommended range of punishment according to the FSG is to locate “the base offense level.” According to USSG §2F1.2(a) that level is “8.” Next, this base level is “increased by the number of levels from the table in §2F1.1 corresponding to the gain resulting from the offense.” (USSG §2F1.2(b)(1). This gain is the difference between Nacchio’s stock sales (Counts 19-42) resulting from the offense of insider trading and his cost in those shares.

Count	No. of Shares	Gross Proceeds	Cost	Gain
24	350,000	13,599,565.00	1,925,000	11,674,565.00
25	300,000	11,901,480.00	1,650,000	10,251,480.00
26	110,000	4,523,002.00	605,000	3,918,002.00
27	100,000	4,083,530.00	550,000	3,533,530.00
28	50,000	1,954,260.00	275,000	1,679,260.00
29	70,000	2,681,602.00	385,000	2,296,602.00
30	20,000	774,000.00	110,000	664,000.00
31	30,000	1,140,000.00	165,000	975,000.00
32	43,200	1,641,600.00	237,600	1,404,000.00
33	20,000	744,500.00	110,000	634,500.00
34	56,800	2,137,765.00	312,400	1,825,365.00
35	105,000	3,965,504.00	577,500	3,388,004.00
36	20,000	760,000.00	110,000	650,000.00
37	10,000	381,140.00	55,000	326,140.00
38	10,000	386,027.00	55,000	331,027.00
39	10,000	382,320.00	55,000	327,320.00
40	4,100	155,805.00	22,550	133,255.00
41	15,900	604,200.00	87,450	516,750.00
42	5,000	191,250.00	27,500	163,750.00
	1,330,000	52,007,550.00	7,315,000	44,692,550.00
		Gross Sales	Cost	Total Gain
			($5.50 a share)

Total Sales Prices     $ 52,007,550

Cost ($5.50 a share)        7,315,000

Gain                           $ 44,692,550

This gain on thetable in USSG §2F1.1 shows an increase to the base of “17.”

The guidelines also specify that if Nacchio abused his position of trust as CEO to commit the crime, an aggravating factor of 2 levels must be added. To recap to show a total offense level of “27,” see the table below. Note that since Nacchio has not taken responsibility for these offenses, this mitigating factor is not present and thus there is no reduction of 2 levels.

Levels          Basis

8           Insider trading base level

2           Aggravation for violation of position of trust

17         Adjustment: Gain on shares sold corresponding to the offense

27         Total Offense Level

The Sentencing Table assuming the lowest category of prior criminal history applies to Nacchi shows a range for Nottingham to consider at the 27 offense level is 70 to 87 months or approximately almost 6 to 7.25 years. The guidelines specify that the terms would usually run concurrently. Nottingham can depart from the guidelines upon a showing that the Federal Sentencing Guidelines do not adequately take into account the special circumstances of the Nacchio case.

Federal prisoners must serve at least 85 percent of their stated sentences. Consequently, if Nottingham sentences Nacchio to 7 years which is on the high side of the maximum range, the minimum time Nacchio would have to serve is almost 6 years (or 71.4 months), based on the product of 85% of 7 years. From an historical perspective, parole was abolished in the federal system in 1987 as part of the reform that instituted the Federal Sentencing Guidelines.

Comments

[M. Hodak]

The "gain" component--by far the largest influence on sentencing, here--seems a bit arbitrary. I'm not sure what, exactly, is the basis for these "costs," but they plainly represent a historical cost fairly divorced from the opportunity cost of what the gain might have been in the absence of trading based on insider knowledge. In other words, if he had randomly sold his shares across the time period involved, he would have a gain much closer to the gain shown here than to this "cost." Economically, the random sale alternative seems a much more justifiable basis upon which to determine any "damage" he has done to his shareholders due to insider trading.

I'm aware that the people who drafted these guidelines might not have cared about the true economic basis for their penalties. But it seems to me that this basis for calculating gains would create a strong incentive on the part of executives to take cash instead of equity as compensation, which would hurt shareholder attempts to reduce agency costs. Or it might create an incentive to continually "roll" their shares so that any "cost" that might be imputed in possible insider trading allegations would be minimized, which would create uneven justice for different CEOs who happened to use this tactic versus those that didn't. What am I missing something here?

[Kevin O'Brien]

You make a great point that the "gain" component in the sentencing guidelines seems arbitrary. Actually, the guidelines on fraud usually focuses on the loss to the person defrauded. However, the guidelines state the following special rule for insider trading offenses: "Because the victims and their losses are difficult if not impossible to identify, the gain, i.e., the total increase in value realized through trading in securities by the defendant …, is employed instead of the victims’ losses." Obviously, the sentencing guidelines favor this measurement due to the ease in which it can be determined.

On your point that executives would be more likely to demand cash compensation rather than stock and thereby increasing the "agency cost" of the company because of this factor in the federal sentencing guidelines is excellent. In fact, Nacchio continuously lobbied Qwest to pay him in cash. The Qwest Board, however, refused and here are the reasons in my mind: (1) issuing stock does not adversely effect Qwest's cash flow; (2) cash compensation would adversely affect the net profit of the company for that time period; and (3) Qwest can only deduct up to a $1,000,000 in Nacchio's cash compensation under Section 162 of the Internal Revenue Code. Consequently, companies will always be very reluctant to grant a CEO's desire for cash compensation above $1,000,000 in favor of equity flavored compensation.

Your point that the "gain" factor in the guidelines will also "create uneven justice for different CEOs" is also valid. Yes, if a CEO appreciates his risk of an insider trading prosecution, he would sell his high cost shares during times that he is in possession of material nonpublic information. For example, Nacchio could have sold his $28 cost stock options stock rather than his $5.50 cost stock options during the time the jury found that he traded on material nonpublic information. This action would have substantially reduced the range of potential prison sentences for Joe Naccio. Having said this, I would doubt executives actually plan there company stock sales based upon a successful prosecution for insider trading. More likely, a tax advisor would always recommend selling high cost stock first to reduce currently the tax liability on the gain. However, Nacchio really wanted to exercise and sell first the $5.50 per share options/stock due to the higher gains he could realize for himself during the insider trading sales.

[M. Hodak]

Thanks for your response. I agree that few, if any executives would plan their stock sales to minimize their potential sentences for insider trading. I was just making the point that different executives using different trading strategies for whatever reasons could, if they get caught up in insider trading, end up with very different sentences for the same basic crime. It's like, "well if you turned left instead of right before hitting the other car, then five more years of jail..." That possibility should offend one's sense of justice enough for the courts to do something about it.