White Collar Crime Prof Blog

Noisy Withdrawal

A lawyer suddenly withdraws his appearance and "disaffirms prior oral and written representations."  This is referred to as a "noisy withdrawal."  The setting here, which is important, is an SEC matter - thus triggering Sarbanes-Oxley (SOX).  The experts seem to find that he acted correctly (see here and here). Christine Hurt of Conglomerate Blog provides an in-depth analysis of Rule 205.3 of the Securities Exchange Act (see here). And it should be noted that the "noisy withdrawal" concept was controversial from its inception.  (See letter by 79 law firms here).   

The real issue here is not whether the attorney acted correctly in withdrawing his representation of client Stanford.  Rather, the issue that needs to now be examined, in context, is whether this is a good rule to have.  Is it good to have attorneys withdraw from client representation in these types of situations, and is it good to have them announce it to the world? In the long run will we have better compliance with the law having the attorney withdraw, or will noisy withdrawals result in criminality being kept undercover?  And which way will best protect the public?

(esp)

The New SEC Enforcement Manual

The cite to the new SEC Enforcement Manual is here.  Commentary down the road. 

(esp)(w/ a hat tip to Stephanie Martz and Tiffany M. Joslyn of NACDL)

Ninth Circuit Reverses Stringer

The defense suffered a major loss today as a result of a reversal by the Ninth Circuit Court of Appeals. In United States v. Stringer, the district court had dismissed indictments concluding "that the government had engaged in deceitful conduct, in violation of defendants' due process rights, by simultaneously pursuing civil and criminal investigations of defendants' alleged falsification of the financial records of their high-tech camera sales company." The lower court had also stated that "should there be a criminal trial, all evidence provided by the individual defendants in response to Securities and Exchange (SEC) subpoenas should be suppressed." 

In a short 22 pages the Ninth Circuit penned an opinion that completely reverses this position. Circuit Judge Schroeder stated:

"We vacate the dismissal of the indictments because in a standard form it sent to the defendants, the government fully disclosed the possibility that information received in the course of the civil investigation could be used for criminal proceedings. There was no deceit; rather, at most, there was a government decision not to conduct the criminal investigation openly, a decision we hold the government was free to make. There is nothing improper about the government undertaking simultaneous criminal and civil investigations, and nothing in the government’s actual conduct of those investigations amounted to deceit or an affirmative misrepresentation justifying the rare sanction of dismissal of criminal charges or suppression of evidence received in the course of the investigations.

We also reverse the order excluding evidence received from the conflicted attorney. We do so because the government advised the attorney of the existence of a potential conflict and did not interfere with the attorney-client relationship."

The Decision - Download Stringer.pdf

(esp)

Can Information From Hacking Be The Basis Of A Securities Violation?

The second circuit has a fascinating securities case that has old laws meeting new technology. And the question will be whether the text of the statute ought to be stretched beyond its language to reach new forms of criminality -although in this particular case the criminality is merely alleged. (See Floyd Norris NYTimes story here)  Or is the legislature the more appropriate place to reform the law?

Basically, a Ukrainian trader allegedly hacked into a financial database and finding a forthcoming negative report, it is argued that he traded on the inside information.  The problem is that no fiduciary relationship exists to find that this conduct constitutes a section 10(b) violation. The district court judge in the Southern District of New York found no violation and the case proceeded to the Second Circuit with the government arguing otherwise.  Hon. Naomi Reice Buchwald, writing the thoughtful district court opinion, states in part:

"...the barrier to issuing a preliminary injunction at this stage in the proceedings is that the alleged 'hacking and trading' -- while illegal under any number of federal and/or state criminal statutes -- does not amount to a violation of section 10(b) of the Exchange Act under existing case law.   For as the SEC even acknowledges, in the 74 years since Congress passed the Exchange Act, no federal court has ever held that that the theft of material non-public information by a corporate outsider and subsequent trading on that information violates section 10(b)."

In the meantime, the SEC is trying to have the Second Circuit continue to freeze the trading account proceeds while the appeal is pending.  Representing the accused here is Charles A. Ross. The decision and arguments can be found accompanying the NYTimes story here.

(esp)

Insurance Executives Convicted

Five former insurance company executives, four from General Re and one from American International Group, were convicted of conspiracy, securities fraud, false statements to the SEC, and mail fraud in connection with a "finite insurance" contract used to make AIG's reserves look stronger than they were.  The defendants include the former CEO of General Re, Robert Ferguson, the company's former CFO, senior vice president, and long-time assistant general counsel in addition to a vice president from AIG.  The case revolved around reinsurance transactions in 2000 and 2001 that helped AIG report an increase in its insurance loss reserves, something that analysts had been critical about, negatively affecting the stock price.  According to prosecutors, the contracts were a sham transaction because no real risk passed to General Re, so AIG's accounting for it as a reinsurance agreement was improper.

An interesting twist in the case was the government's identification of former AIG CEO Maurice Greenberg as an unindicted co-conspirator, although he has never been charged with any crime.  Naming such a well-known executive as a member of the conspiracy may have been a means to undermine the defendants' "empty chair" defense that sought to blame the problems with the transactioin on Greenberg.  He was forced out of his position as CEO by then-New York Attorney General (and now Governor) Eliot Spitzer, who demanded Greenberg's termination on the threat of criminal prosecution of the company, an almost sure death sentence for an insurer.  General Re is a wholly-owned subsidiary of Berkshire Hathaway, whose CEO is Warren Buffett, once named as a potential witness in the case but never called by either side.

While the case is primarily an accounting fraud prosecution, it is different from more typical cases of this type because the main defendants were not from the company whose accounting was improper.  Indeed, there was no claim that General Re's recording of the transaction was improper, only AIG's.  In that sense, General Re was an enabler of AIG, the type of enterprise liability rejected by the Supreme Court in the Stoneridge case for private securities fraud actions.  One rationale for rejecting that theory of liability in Stoneridge was the presence of the SEC and federal prosecutors to crack down on companies that aid others in violating the securities laws.  An AP story (here) discusses the verdict, which the defendants have vowed to appeal. (ph)

Adventures in Witness Recollection

Preparing your client for a hearing is a must for every attorney.  But offering to have your client's memory fade in exchange for favors is a major problem, as illustrated in a recent SEC case.  The SEC filed an administrative action (here) to bar an attorney licensed in New York from appearing before the Commission because of what he told the attorney for a brokerage firm and its president who were being investigated.  The attorney's client came to the SEC's attention as a potential witness, and so the attorney began dealing with the investigators seeking to arrange her testimony.  At the same time, the attorney also had some conversations with the brokerage firm's lawyer that were rather revealing.  How did the SEC learn what was said, you might ask?  Well, it seems that the brokerage firm's attorney taped the conversations, as summarized in the administrative filing:

During the taped conversations, Respondent requested that Blumer [the brokerage firm's president] arrange for a "severance package" (i.e., removing his client as the co-signer on two car leases with Blumer and paying her salary) for his client. In return for this severance package, Respondent indicated that his client might not cooperate with the Commission and/or that her recollection of the relevant events might "fade." In the last of these conversations, Blumer’s attorney asked Respondent "what package" his client wanted to "not cooperate." Respondent stated, "Get her off those leases and, you know, your salary, and you can even pay it out over a year." Blumer’s attorney then asked, "what will we get if they do that, she won't cooperate or she won't remember?" Respondent stated "probably both."

New York is a one-party consent state for taping telephone calls, so there's no problem on that front.  Can't you trust the attorney you're trying to extort in exchange for having your client's memory "fade" a little bit?  It seems not, and the New York attorney may find himself in a bit of hot water with the Bar authorities who tend to take a dim view of such conduct.  Whether the U.S. Attorney's Office takes an interest in a possible obstruction of justice case remains to be seen.  Be careful what you offer in exchange for favorable testimony, it can cost you your career. (ph)

Comverse Comes Clean on Kobi, and He Countclaims for $72 Million

Comverse Technology issued the final report (here) on its internal investigation of options backdating and earnings manipulation, blaming the misconduct squarely on its founder and former CEO, Kobi Alexander, and other senior executives.  In 2006, Alexander fled -- or chose to relocate -- to Namibia shortly before his indictment in the Eastern District of New York on conspiracy, securities fraud, and obstruction of justice charges.  According to the company's report:

In reviewing the Company's practices relating to option grants from 1991 through 2005, the Special Committee reviewed 39 separate grants of more than 82 million options to approximately 6,200 employees and consultants, as well as 22 grants of approximately 1.2 million options to eight non-employee directors of the Company. It found that between 1991 and 2001, almost 54 million stock options (issued via 29 grants to 5,386 grantees) were backdated to obtain advantageous exercise prices, with the knowledge and participation of the Company's former Chairman and Chief Executive Officer, Jacob "Kobi" Alexander ("Alexander"), the Company's former director and General Counsel, William Sorin ("Sorin") and, at times, the Company's former Executive Vice President and Chief Financial Officer, David Kreinberg ("Kreinberg"). 

Kreinberg and Sorin earlier entered guilty pleas and settled securities fraud cases filed by the SEC.  The accounting improprieties involved "cookie jar" reserves used to smooth out Comverse's earnings so that they appeared to be less volatile than they were, a major no-no in financial reporting.

Alexander has been living in Windhoek, Namibia's capital, for over eighteen months, and an extradition request by the United States has been repeatedly postponed by the Namibian courts at his request; the next one is scheduled to take place in March, although given past practices it too is likely to be delayed.  One would think Alexander would not want to pick a fight with his former employer in the United States, even after it filed a lawsuit against him in New York state court to recover for the damages he allegedly caused it through the options backdating and accounting problems.  Instead, however, he filed a counter-claim to Comverse's suit, seeking $72 million in severance pay and for options that he claims the company improperly canceled.  Given that the Super Bowl is almost upon us, perhaps this is the "best defense is a good offense" approach.

If one were trying to stay away from the United States, would you file a claim in a state court lawsuit that might subject you to the jurisdiction of an American court and require you to appear for a deposition?  New York's civil discovery provision, CPLR 3110, provides: "Where the deposition is to be taken within the state. A deposition within the state on notice shall be taken: 1. when the person to be examined is a party or an officer, director, member or employee of a party, within the county in which he resides or has an office for the regular transaction of business in person or where the action is pending . . . ."  A party can seek to have a deposition taken outside the state, but it requires a showing of "substantial hardship" in order to avoid appearing in New York. 

Is a federal indictment a "substantial hardship" that might be grounds for Alexander to avoid returning to New York?  I'm certainly not an expert in New York civil procedure, but the few cases I saw on the topic allowing depositions outside the state generally involved issues related to illness or infirmities, or where the person would appear at a time closer to the trial so initial discovery could be taken through written interrogatories or video deposition.  Somehow, I suspect a New York state Supreme Court judge is not going to view a claim that a party wishes to avoid being arrested on federal charges -- even when that person proclaims his innocence -- as meeting the requisite standard to avoid appearing for a deposition, particularly when a counter-claim has been filed.  Even if Alexander is deposed in Windhoek, don't be surprised if the federal prosecutors get ahold of the transcript to use in his trial -- if there ever is one, givenn how well his attorneys are delaying the extradition process in Namibia.  Comverse doesn't appear to harbor any warm feelings for its former CEO these days, so it will look to make the case against him almost as much as the U.S. Attorney's Office will.  A Reuters story (here) discusses Alexander's counterclaim. (ph)

Deferred Prosecution Agreement for Former Monster Worldwide CEO

Former Monster Worldwide CEO Andrew McKelvey entered into a deferred prosecution agreement with the U.S. Attorney's Office for the Southern District of New York (available below) related to options backdating at the company.  This is the second such deferral agreement involving an individual in a white collar crime case that I'm aware of, the other one involving former investment banker Frank Quattrone to settle obstruction of justice charges.  While the Department of Justice has entered into these agreements with corporations with increased regularity, they are uncommon for individuals, with both coming from the same office and each involving special circumstances.  For Quattrone, the government would have had to try him a third time, after the first proceeding ended with a hung jury and the conviction after the second trial reversed due to improper jury instructions -- and the case would be transferred to a new judge because of a perception of possible bias by the judge in the first two trials. 

The reason given for the DPA with McKelvey is that he is suffering from a terminal medical condition, so that it would be unlikely a trial could take place on the charges, and even if there was a conviction it would be unlikely to survive under the abatement doctrine applied in federal cases.  The DPA essentially requires McKelvey to obey the law for twelve months and restrict his travel.  He acknowledged his involvement in backdating options at Monster Worldwide from 1997 to 2003, and the company's former general counsel earlier entered a guilty plea to charges related to the backdating and was cooperating in the investigation.  A U.S. Attorney's Office press release (here) discusses the DPA, and the SEC also entered into a settlement with McKelvey that requires him to disgorge profits of $275,000 but does not impose a civil penalty due to his illness (see SEC Litigation Release here). 

The disposition in this case appears to be based on the unique situation of the defendant, and does not seem to signal a trend toward using DPAs to resolve cases involving individuals involved in corporate misconduct.  I suspect, however, that defense lawyers may try to push for such dispositions in the future for individual clients in addition to corporations, and it will be interesting to see if these agreements become more common. (ph)

Download mckelvey_deferred_prosecution_agreement.pdf

Reyes Receives 21-Month Sentence for Options Backdating

Former Brocade Communications CEO Gregory Reyes received a 21-month prison term from U.S. District Judge Charles Breyer for his convictions related to backdating options grants at the company.  I expected the Judge to impose a lower sentence, perhaps dropping all the way down to home confinement or a split sentence, but he said that this was a case about "honesty" and that ""[e]very time Gregory Reyes falsified documents over a three-year period, he was lying . . . Corporate fraud is not a victimless crime. If widespread, it can affect the overall economy, employment, and, as we've seen with Enron, people's life savings."  Once the dreaded "E" word is invoked, no mercy will be shown.  A San Francisco Chronicle story (here) discusses the sentencing.

While Reyes got the benefit of Judge Breyer's decision to find no provable loss from the backdating (see earlier post here), thus sparing him a sentence that could have easily exceeded ten years, he did feel the court's wrath when the Judge bumped up the sentence two levels under the Sentencing Guidelines for obstruction of justice.  The basis for that decision was a statement in an affidavit Reyes filed in support of his co-defendant Stephanie Jensen's severance motion.  Reyes' key statement was, "I told Ms. Jensen that the options grant dates were the dates that I made the granting decisions.  Options were priced at the fair market value on the grant dates."  The district court granted the motion, relying on Reyes' affidavit that in a joint trial this exculpatory evidence would not come out.  At his trial, however, Reyes' counsel conceded that the options were priced based on "look backs" -- the defense didn't dare call it backdating -- and not as described in the affidavit, which was sealed. 

Judge Breyer obviously was perturbed by the affidavit because it led him to conduct two trials rather than one, and he announced that the sentence would have been fifteen months rather than the twenty-one months he imposed because of the obstruction.  The Judge and Reyes' counsel did not get along all that well during trial, and I suspect Judge Breyer felt he had been played by the defense.  One wonders why counsel allowed Reyes to file an affidavit with that kind of statement when the trial strategy on the selection of the options prices was not entirely consistent with it.  It may be the defense did not really focus on what was in the affidavit, which was filed well before Reyes' trial, when it made the final trial preparations, or perhaps did not think the Judge would grant the severance so the affidavit would not be of any significance.  Regardless of the reason, Reyes is sure to challenge the obstruction determination, no doubt arguing that his statement was not untruthful and did not exclude the "look backs" his lawyer conceded at trial.  The enhancement resulted in a 40% increase in the prison time, so the decision to file the affidavit turned out to be a costly one, at least for Reyes.

Reyes will remain free on bond pending appeal, with Judge Breyer acknowledging that because this was the first options backdating case to go to trial there were novel legal issues involved.  It is unlikely Reyes will have to report to prison for at least a year, assuming the conviction is upheld.  The sentence certainly sends a message to other defendants charged in backdating cases that they are likely to face prison terms if convicted.  And, unlike the Reyes case, other prosecutions involve defendants who benefited from the backdating, so the loss (or gain) issue will not be resolved quite as favorably as it was in this case if there is a conviction. (ph)

Is There a Cop on the Securities Beat?

The Supreme Court's decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (see earlier post here) to reject "scheme liability" as a means to apply Rule 10b-5 to those who provide some assistance in a company's allegedly fraudulent scheme was hardly a surprise.  The tone for the Court's view of the scope of the private right of action for securities fraud was set in its earlier decision in Central Bank v. First Interstate Bank, 511 U.S. 164 (1994), which eliminated aiding and abetting liability and limited Rule 10b-5 actions to those who qualify as so-called "primary violators."  After Central Bank, third parties who assist a securities fraud, most importantly accountants and lawyers, cannot be sued unless they participated directly in the misstatement or omission, which effectively requires proof that they disseminated the false statements or omitted material information from a disclosure.  The Private Securities Litigation Reform Act (PSLRA), adopted the following year as part of the "Contract With America" agenda advanced by the newly-elected Republican majority in Congress, restored aiding and abetting liability in SEC actions but did not extend it to private suits.  As such, it was easy for the Supreme Court to reject "scheme liability" that was little more than a back-door way to impose liability on those who would not otherwise meet the requirements to be a primary violator. 

In the last section of the opinion, the majority discounts the idea that denying "scheme liability" effectively makes Rule 10b-5, the primary anti-fraud provision of the federal securities laws, unenforceable.  The Court stated, "Secondary actors are subject to criminal penalties, and civil enforcement by the SEC.  The enforcement power is not toothless." (Italics added).  Is there a cop on the securities beat to ensure that fraudulent schemes do not occur?  If enforcement is to be entrusted largely to the government, then the answer may well be that there is a shortfall in policing the public securities markets.  As far as criminal enforcement is concerned, securities cases remain fairly uncommon, despite the rash of CEO prosecutions and insider trading cases seen the past few years.  Indeed, there has been a consistent clamor that federal prosecutors are "criminalizing ordinary business decisions" by using the criminal laws against corporate officers for conduct that is claimed to be at best a civil regulatory violation.  Securities fraud cases are difficult to win because of the problem of proving the requisite intent and the time-consuming nature of the investigations.  Criminal prosecution is a necessary weapon to police the capital markets, but is hardly the most effective -- or efficient -- tool because of the costs involved and the limited number of cases that can be pursued.

Surely, then, the SEC can keep the markets honest and safe for investors, can't it?  The answer there is a resounding "maybe, but not as much as you might think."  To start with, the Commission's budget in FY2007 was $882 million, and it has a total of about 3,500 employees spread across four divisions, eighteen functional offices, and eleven regional offices (see SEC 2007 Annual Report here).  That's not a lot of people, and it is not like all, or even most, of them are devoted to enforcing the securities laws.  In considering the size of the SEC's annual budget, consider what is being spent in Iraq to fight the war there.  In FY2007, according to Congressional Budget Office testimony (here), the government spent $113 billion, and since 2003 a total of $368 billion.  What is spent in three days in Iraq is about the SEC's total annual budget, and what has been spent to date on the war probably exceeds the total expenditure on financial regulation by the federal government over the last 100 years.  My point is not that one is more important than the other, but that an independent agency viewed as the primary enforcement mechanism for the capital markets operating with a comparatively puny budget and only a few thousand employees (who leave the agency at a clip of about 8.5% a year) is not exactly the toothy enforcer the Supreme Court may be envisioning.

The amount of capital available for investment in United States is staggering in comparison to the size of the SEC, and the securities markets are undergoing a significant transformation.  The public markets trade in the trillions of dollars daily, while mutual funds regulated by the SEC control over $10 trillion in assets.  Add to that the $14 trillion held by pension funds and an addition $1 trillion+ by hedge funds -- which always have the moniker "lightly regulated" placed in front of them -- and you have massive accumulations of capital that are invested in a wide range of markets subject to varying degrees of SEC oversight.  My colleague, Steven Davidoff, argues persuasively that the SEC has not responded to the development of new securities markets, for example those in derivatives, and that the individual investor focus of the law may be out dated.  His article, Paradigm Shift: Federal Securities Regulation in the New Millennium (available on SSRN here), asserts that "Congress and the SEC are politically unlikely to rework the entirety of securities regulation to reflect [the new capital markets paradigm].  That is, until a new scandal inevitably arises."  When the scandal comes, will the SEC be overwhelmed, so that enforcement may be viewed as "toothless"?

Stoneridge Investment Partners was a correct application of the law in light of Central Bank, and makes sense from an economic point of view because private litigation is hardly an efficient means to regulate the markets.  But the SEC may not be up to the task either, not because it is inept or bumbling, but because it is simply overwhelmed by the changes in the marketplace it is charged with regulating and underfunded in its monitoring role.  In that sense, then, Stoneridge Investment Partners may effectively insulate those who help other companies cut corners and skirt near the edge of the securities laws because there need not be any real fear of enforcement of the anti-fraud provisions, at least as to those who are not primary violators.  Private litigation is not a substitute for the "cop on the beat," but is may be misguided to assert that there is a cop out there when the agency given that job does not have the tools to regulate and enforce the law effectively.  One of the great strengths of the capital markets in the United States has been the strong enforcement mentality that gives it credibility, and it is fair to ask whether that view will continue. (ph)

Addendum - See also Robert Barnes & Carrie Johnson, Corporate Fraud Lawsuits Restricted.

Supreme Court Rules in Stoneridge Case

The Supreme Court ruled in the case of Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. et. al, and there were no surprises in this 5-3 decision (Breyer not participating). The Court finds that "the implied right of action does not reach the customer/supplier companies because the investors did not rely upon their statements or representations."  In the decision, the Court reaffirms its holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A..

This case again reminds us that private causes of action are different from criminal actions.The Court states:

"Secondary actors are subject to criminal penalties, see, e.g., 15 U. S. C. §78ff, and civil enforcement by the SEC, see, e.g., §78t(e). The enforcement power is not toothless. Since September 30, 2002, SEC enforcement actions have collected over $10 billion in disgorgement and penalties, much of it for distribution to injured investors. See SEC, 2007 Performance and Accountability Report, p. 26, http://www.sec.gov/about/secpar2007.shtml (as visited Jan. 2, 2008, and available in Clerk of Court’s case file).And in this case both parties agree that criminal penalties are a strong deterrent. See Brief for Respondents 48;Reply Brief for Petitioner 17. In addition some state securities laws permit state authorities to seek fines and restitution from aiders and abettors. See, e.g., Del. Code Ann., Tit. 6, §7325 (2005). All secondary actors, further-more, are not necessarily immune from private suit. The securities statutes provide an express private right of action against accountants and underwriters in certain circumstances, see 15 U. S. C. §77k, and the implied right of action in §10(b) continues to cover secondary actors who commit primary violations. Central Bank, supra, at 191. Here respondents were acting in concert with Charter in the ordinary course as suppliers and, as matters then evolved in the not so ordinary course, as customers. Unconventional as the arrangement was, it took place in the marketplace for goods and services, not in the investment sphere. Charter was free to do as it chose in preparing its books, conferring with its auditor, and preparing and then issuing its financial statements. In these circumstances the investors cannot be said to have relied upon any of respondents’ deceptive acts in the decision to purchase or sell securities; and as the requisite reliance cannot be shown, respondents have no liability to petitioner under the implied right of action. This conclusion is consistent with the narrow dimensions we must give to a right of action Congress did not authorize when it first enacted the statute and did not expand when it revisited the law."

It is important for the Court and Congress to distinguish the ability of private actors to bring actions under generic statutes.  Although prosecutors do not always act wisely in using their prosecutorial discretion, their oversight is important when there are criminal implications.  Civil litigants do not have the same ability to pick those cases that serve the public good as they represent individual clients.  Thus, it is important for Congress and the Court to place added restrictions on the use of these statutes when it involves civil litigants.

See also Scotus Blog here. 

(esp)

Fraud Without Loss in the Reyes Case

Former Brocade CEO Gregory Reyes got a dose of pretty good news from U.S. District Judge Charles Breyer about his upcoming sentencing for options backdating at the company.  In an opinion (available below) discussing various sentencing issues, Judge Breyer determined that the government did not propose any reasonable method for determining the loss from the backdating, and therefore he would not apply an enhancement under the Sentencing Guidelines for loss to increase the offense level.  The Judge did not find the loss was zero, which could be a more problematic conclusion, but instead found that the government's various proposed methods of calculating the loss were inadequate to fairly estimate the harm.  Complicating matters in this case, which may make it sui generis, is that Reyes did not personally profit from the backdating, at least not as charged in the indictment, so intended gain is not available.  The government argued that Reyes did profit from other the backdating of other options not charged in the case, but the court rejected that as not proven by the government.

One method proposed by the government was to look at the decline in Brocade's stock price on the day the company disclosed the improper accounting for the options, which triggered a loss of over $3 million.  Judge Breyer rejected that method, finding that it did not adequately measure any loss directly from the backdating but only how the market reacted on one particular day to a news event.  The Judge also rejected using a "recissory" method to estimate the value of the options as backdated because in fact they turned out to be worthless, due to the significant decline in Brocade's stock price when the tech bubble burst and all the options ended up under water.  Finally, he rejected using the amount of the SEC fine Brocade paid, which was $7 million, and the tax liability it assumed for covering the tax consequences of the backdating, which was over $3 million.  On the SEC fine, the court stated that this method had never been used before, and for such a significant enhancement he would not adopt a novel method of calculating the loss.  The amount of the loss is the primary driver of sentences under the Guidelines, and by finding no loss from the backdating, Reyes avoided a sentence that could have stretched past twenty years if a particularly high figure was calculated. 

Judge Breyer did enhance the sentence on two grounds: Reyes' role as an officer of a public company and as an organizer of the criminal conduct.  Together with the base offense level, the Guidelines sentencing range is 15-21 months, based on an Offense Level of 14.  Not a walk in the park for Reyes, for sure, but substantially less than what has been seen in other CEO prosecutions.

After the Supreme Court's recent decisions in Gall and Kimbrough granting district judges considerably more discretion in sentencing, I suspect Judge Breyer may depart from the Guidelines recommendation.  It would not surprise me if he gave Reyes a split sentence, perhaps the old "double nickel" of five months in prison and five of home confinement, and could even give a pure home confinement/probation sentence.  Prior to Gall, I would have expected prosecutors to appeal the district court's loss analysis.  But now that the standard of review is abuse-of-discretion, I doubt the Judge's analysis is so off base as to draw a reversal from the Ninth Circuit.  Reyes is sure to appeal the conviction, but I think the sentencing will be good news, at least to the extent one can ever say that being sentenced in federal court provides a measure of good news.

The court's loss determination is definitely good news for Stephanie Jensen, Brocade's former human resources manager who was also convicted in a separate trial on conspiracy and false SEC filings charges for the Brocade backdating.  Given that she is unlikely to qualify for the organizer enhancement like Reyes, and probably was not in a senior position to trigger the four-level enhancement for being an officer of a public company, her offense level would be 6, leading to a sentencing range of 0-6  months.  At that level, she would be eligible for probation, or home confinement at worst, a far better outcome for her than a term of imprisonment. (ph)

Download us_v_reyes_sentencing_guidelines_loss_opinion_nov_27_2007.pdf

An Interesting Twist in the Reyes Case

The prosecution of former Brocade Communications CEO Gregory Reyes has taken a new turn with the defense filing a motion for a new trial (available below) based on newly discovered evidence, specifically a witness who may not have been entirely truthful in her testimony.  Reyes was the first defendant convicted for fraud based on options backdating, and the company's former human resources manager, Stephanie Jensen, was just convicted on conspiracy and false statement charges. 

In preparation for Jensen's trial, the witness, who worked in Brocade's finance department, had been listed as a prosecution witness.  Right before a pretrial interview with prosecutors, her lawyer from Wilson Sonsini informed the prosecutors that she would assert her Fifth Amendment self-incrimination privilege, and the law firm withdrew from her representation.  The witness had been important to the government's case, with the brief noting that her testimony was cited more than twenty times in the prosecution's closing arguments.  Even more, the defense points out that the "Court, in its order denying the Rule 29 and Rule 33 motions, emphasized the importance of the fact that Ms. Moore did not know about the retroactive pricing of options, and articulated its belief that “the human resources department did not pass along information about the scheme to people in the finance department like Elizabeth Moore." 

In support of its motion, the defense filed affidavits from three individuals who assert that the witness believes her testimony was misconstrued by the prosecutors, and that she was not ignorant about the backdating.  It's not clear whether her testimony at Reyes' trial was diametrically opposed to what she is now stating, so she may not have committed perjury.  But the withdrawal of her counsel and assertion of the Fifth Amendment certainly give the defense fodder to seek a new trial. 

The U.S. Attorney's Office disclosed her assertion of the self-incrimination privilege to Reyes and Jensen as soon as they learned of it, sending an e-mail that stated:

Please be informed that we have been notified by George Niespolo, counsel to Elizabeth Moore, that Ms. Moore will assert her Fifth Amendment privilege if called to testify at the Jensen trial. Mr. Niespolo did not share with us the grounds for that assertion, and he declined to tell us whether he considered the information Brady material as to either Mr. Reyes or Ms. Jensen.  We asked Mr. Niespolo for further details, which he declined to provide except to add that the information was somehow related to her prior testimony.

A government witness who testifies in one trial and then decides to assert the Fifth Amendment in a second trial on the same transactions is certainly suspicious.  Whether Moore is truly a "key" witness remains to be seen, because the conviction of Jensen may provide a basis for prosecutors to argue that her testimony was not so important to the Reyes conviction that different, or even contrary, testimony from her would make a material difference. 

Reyes has not been sentenced yet, and the district court will need to straighten this out before getting to that point, if in fact the cases even reaches sentencing.  While "newly discovered evidence" claims can be brought on just about any ground, this one might gain some traction.  (ph)

Download us_v_reyes_new_trial_motion_dec_3_2007.pdf

Former Brocade HR Manager Found Guilty

The second defendant from Brocade Communications was found guilty by a jury in San Francisco on charges related to options backdating at the company.  Stephanie Jensen, the former human resources manager for the company, was convicted on one count of conspiracy and one count of filing false records with the SEC.  Jensen was charged with former Brocade CEO Gregory Reyes in 2006, and initially there were eight charges against her.  After the district court granted a severance motion, the government dismissed six counts, presenting a simpler case that focused on her work with Reyes to backdate options grants to a number of new hires at Brocade and the resulting false statements to the SEC because the backdated options were not properly accounted for in the financial statements.  According to an AP story (here), Jensen's primary defense was her lack of knowledge about the accounting for stock options.

Similar to the Reyes conviction, the government's case did not include evidence that Jensen benefited personally from the backdating, which is often a key component in such prosecutions.  The government relied in large part on the testimony of co-workers who raised questions about the backdating practices and Jensen's reassurances about who would be held responsible.

For a white collar crime case, this one was over almost before it began, with the trial lasting just a bit over one week.  The district court postponed the sentencing of Reyes until after Jensen's trial, so that should take place in the near future. (ph)

Backdating Plea

A press release of the Center District of California reports that "[a] former vice president of human resources at Broadcom Corporation has agreed to plead guilty to obstruction of justice in connection with a government investigation of options backdating at the Irvine-based technology company." The plea agreement was to a one count Information that "alleges that the [defendant] instructed a subordinate to delete an electronic mail that was evidence of option backdating by Broadcom senior executives and board members."  The agreement includes cooperation. 

One finds the typical language in the agreement that relates to a possible 5K1.1 motion by the government. The agreement states:

"d) At this time the USAO makes no agreement or representation as to whether any cooperation that defendant has provided or intends to provide constitutes substantial assistance. The decision whether defendant has provided substantial assistance rests solely within the discretion of the USAO.

e) The USAO's determination of whether defendant has provided substantial assistance will not depend in any way on whether the government prevails at any trial or court hearing in which defendant testifies.

Should the prosecution be allowed to determine whether there has been sufficient substantial assistance.  Even though one finds that it will not rest on someone being found guilty, it does place undue pressure on the cooperating witness to please the government.  One has to wonder whether the credibility of the evidence is compromised by the government influence over the witness's future.  Wouldn't it be better placed in the hands of the judiciary?

Press Release -

Download broadcom_tullos.151.pdf

Plea Agreement -

Download broadcom_tullos_plea_agreement.pdf

(esp)

Challenging the SEC Over the Denial of Attorney's Fees

One of the defendants in the SEC's civil lawsuit (amended complaint here) against a number of former Nortel Networks defendants for alleged accounting fraud has filed a motion to dismiss based on the claim that the Commission sought to improperly pressured the company to deny her the payment of attorney's fees.  The argument is reminiscent of the KPMG case, which is cited in the brief, in which the indictment of thirteen defendants was dismissed because of pressure from prosecutors on the accounting firm to deny attorney's fees to a number of former partners and employees later charged for their work on tax shelters.  A Globe & Mail article (here) discusses the filing, and notes the connection with the KPMG case.  Whether the two are the same is questionable because there are differences between the cases that may be crucial.

The motion by Mary Anne Poland (available below), a former assistant controller at Nortel, makes two interconnected arguments.  First, Nortel Networks cut off payment of her attorney's fees when the SEC indicated that it was looking at her as a possible defendant in an enforcement action.  Unlike the company's former CEO and CFO, also defendants in the suit, she does not have the deep pockets necessary to fight an SEC securities fraud case, which usually involves significant discovery and a long trial if it gets that far.  The motion states that Nortel's counsel, who was the former head of the Enforcement Division at the SEC, counseled the company to terminate the payment so that it could appear cooperative with the SEC in the case.  Nortel eventually settled the accounting case by paying a $35 million civil penalty. 

Poland's motion points to the company's cooperation as evidence of the Commission's involvement in the decision to terminate the attorney's fees.  The SEC's Litigation Release (here) announcing the settlement with Nortel states that "the Commission acknowledges Nortel's substantial remedial efforts and cooperation."  In addition, the motion notes that the SEC announced in another case -- involving telecom equipment manufacturer Lucent -- the Commission highlighted the company's cooperation that involved terminating attorney's fee payments for employees.  The argument is that the Commission, at least indirectly, caused Nortel to terminate Poland's attorney's fees.  Hence, the specter of the KPMG case, in which such governmental pressure led the firm to cut off the attorney's fees that eventually triggered the dismissal of the indictment. 

The problem for Poland is that the SEC's policy was not as explicit as the Thompson Memo that the defendants pointed to in the KPMG case as the basis for terminating the attorney's fees.  The motion leads off with the district court decision in United States v. Stein that found the violation of the defendant's rights based on the governmental pressure to deny attorney's fees.   While the SEC's policy certainly emphasizes a company's cooperation, it is not nearly as explicit at the Thompson Memo was on the attorney's fee issue -- a point changed in the current iteration of the Department of Justice's policy on charging corporation, the McNulty Memo.  It is not clear whether there is any direct evidence of pressure by the Commission staff on Nortel to cut off attorney's fees, and pointing to the company's lawyer as the source of that decision may be a crucial distinction from the KPMG case.  Moreover, unlike Stein, a criminal case, there is no Sixth Amendment right to counsel in a civil case, so that ground is unavailable to dismiss the complaint.

The second related claim is that while Poland did not have counsel, the SEC sought and obtained two tolling agreements that allowed the investigation to continue beyond the five year limitations period.  The motion argues that the denial of attorney's fees was related to these requests because the Commission took advantage of Poland's position of acting without legal advice.  She claims that the SEC staff pressured her to agree to the tolling, once even saying that an FBI agent might join the interview.  Because there is no Sixth Amendment claim, the argument is that the government violated Poland's due process rights.  That was one basis for the Stein decision, but the due process concerns in criminal cases are different from those in a civil case.  Poland could have refused to sign the tolling agreement, or could have hired counsel with her own resources to advise on that issue.  Moreover, she is now represented again by lawyers.  Unlike a criminal case, the SEC cannot seek a prison term, so the decision to sign the tolling agreement may be viewed by the courts as less significant under the Due Process Clause.

The motion relies largely on the overtones of the governmental policy that was castigated in the KPMG case and has led to significant criticism of the Department of Justice on Capitol Hill.  The connection, however, between Nortel's decision to cut off the attorney's fees and any particular pressure from the SEC is less clear in this case.  The fact that a company decides to terminate the payment of fees, even if it is based on the hope that it will curry favor with the SEC, does not necessarily mean the Commission acted improperly.  Whether the dismissal motion gains any traction remains to be seen, but the damage from the government's actions in the KPMG case show how widely felt its effects will be for other cases and agencies. (ph -- thanks to YH for passing along the information)

Download sec_v_dunn_motion_to_dismiss_poland_nov_2007.pdf

Getting Ready for the Sentencing in US v. Black

Both sides filed their objections to the presentence report (PSR) in the prosecution of Lord Conrad Black and three other former Hollinger International executives -- Peter Atkinson, John Boultbee, and Mark Kipnis -- mail fraud charges in connection with non-compete payments.  Lord Black was also convicted for obstruction of justice related to his removal of boxes of documents from his Toronto office while the SEC was investigating the company, a conviction that may have a significant effect on the final sentence imposed.  While the PSR is not made public, the objections filed by both sides are, and we can get a pretty good idea of what the Probation Office is recommending, and where U.S. District Court Judge Amy St. Eve may end up in the sentencing.  Each of the filings is available below.

Two key points in the calculation under the Federal Sentencing Guidelines is the amount of the loss and which version of the Guidelines will be applied.  The former is the primary driver of the sentence, and the choice of which edition will be used can effectively increase the sentence by up to three times.  For Atkinson, Boultbee, and Kipnis, the PSR recommends the 2000 version (here) in effect at the time of the primary transaction for which they were convicted.  For Black, the recommendation is to use the current version of the Guidelines (here) because his obstruction of justice took place in 2005, and so the more recent version should apply -- there is no significant difference between the 2005 and 2007 editions, so the current one works just as well.  Black objects to the use of the more recent version, while the government objects to applying the 2000 version to the other three defendants, arguing that all should be subject to sentencing under the 2007 Guidelines. 

On the loss issue, the PSR calculates the amount at $5.5 million, based on the dollar figures involved in the transaction that formed the basis for the convictions of all four defendants.  Needless to say, each side objects to the loss calculation.  The defendants argue that the amount should be limited to their individual gain from the diversion of funds through the non-compete agreement, not the total, and even seek a lower figure, such as Atkinson's recommendation of $15,000 as the loss to Hollinger.  Meanwhile, the government has proposed a $32.15 million figure based on relevant, i.e. acquitted, conduct connected to other diversions charged in the case.  While Judge St. Eve could opt to use the higher or lower amounts, I suspect she will adopt the PSR calculation because it reflects the total amount in the transaction on which the jury convicted and does not give the defendants a discount for what they didn't take directly. 

Using the $5.5 million figure illustrates the difference between the potential sentence depending on which version of the Guidelines applies.  Under the 2000 version, the loss amount would increase the sentence by 14 offense levels, on top of the base offense level of 6.  Adding in potential enhancements for more than minimal planning and abuse of a position of trust brings the offense level to 24.  The sentence under the Guidelines would be 51-63 months, a bit over four years, and if the Judge grants a minor role adjustment to a defendant then the sentence could drop into the 37-46 months range.  Using the 2007 Guidelines, on the other hand, starts with a base offense level of 7, then the increase for a $5.5 million loss would be 18.  Under the Sarbanes-Oxley Act, the conviction of a corporate executive, such as the CEO, triggers an additional four-level enhancement, and add to that Black's obstruction of justice which can add another two levels.  He would be looking at a sentence of 108-135 months, and it could easily jump to 151-188 months if other enhancements are applied -- more than ten years. 

The selection of the applicable version of the Guidelines probably will be among the first issues Judge St. Eve decides at the sentencing, and the year chosen will give an early indication about whether she will impose a substantial term of imprisonment on the defendants.  Each of the defendants argues that the Guidelines calculation overstates the severity of the offense, a position I doubt the Judge will accept.  They also argue for a below-Guidelines sentence based on personal factors related to the defendants.  As we've come to expect in corporate executive cases, the defendants -- especially Black -- have had a number of letters written on their behalf urging Judge St. Eve to go lightly on the sentence.  Black's brief also devotes a lot of space to recounting his personal background to show what a good individual he is.  That argument might not strike a cord with the court, given that at one point during the trial the Judge told Black's counsel to rein in his client because of Black's somewhat intemperate comments to the press. 

Of course, the sentencing is just the final stop in the district court before the case leaves for the Seventh Circuit.  It will be interesting to see what issues each defendant advances in their briefs, and the oral argument is sure to be grueling given the number of lawyers who will be addressing the court. (ph)

Download us_v_black_atkinson_sentencing_memorandum_nov_27_2007.pdf

Download us_v_black_boultbee_sentencing_memorandum_nov_27_2007.pdf

Download us_v_black_kipnis_sentencing_memorandum_nov_27_2007.pdf

Download us_v_black_sentencing_memorandum_nov_27_2007.pdf

Download us_v_black_government_objections_to_psr_nov_27_2007.pdf

The SEC Starts Winding Down the Options Backdating Investigations

The flood of options backdating investigations seems to be receding, with the SEC closing cases without filing civil charges.  An article in The Recorder (on Law.com here) reports that the investigation of VeriSign has concluded without any further action.  The company's 8-K (here) states, "The staff of the Securities and Exchange Commission (“SEC”) has formally notified the Company that the SEC’s investigation concerning the Company’s historical stock option granting practices has been terminated and that no enforcement action was recommended to the SEC."  The company took a $160 million accounting charge related to the options, and its CEO and CFO both resigned.  The notification to VeriSign comes on top of other recent case closings involving backdating at high-tech firms Electronic Arts, Linear Technology, Nvidia, PMC-Sierra. and Zoran Corp. 

The Commission appears to be clearing out its investigative docket, likely closing the weaker cases while it prepares the stronger ones for some type of enforcement action.  Don't be surprised to see some new filings in the new year as the SEC moves beyond options backdating and faces new areas of concern arising from the subprime meltdown, especially disclosure issues related to the multi-billion write-downs of CDOs by leading financial companies. 

Over on the criminal side, there haven't been any significant new cases since the conviction of former Brocade CEO Gregory Reyes in August 2007, and it may be that the criminal pipeline is also shrinking.  Options backdating looks like it may be on its way to becoming yesterday's news. (ph)

Second Brocade Options Backdating Prosecution Slims Down

The prosecution of former Brocade HR vice president Stephanie Jensen for options backdating seems to be on the South Beach diet.  Prosecutors disclosed they planned to drop four charges from the original indictment, after earlier dismissing two others, so that she will only face two counts at trial.  Earlier, the company's CEO, Gregory Reyes, was convicted on ten counts related to his role in the backdating, including securities fraud and conspiracy.  Jensen was indicted along with Reyes in August 2006, but U.S. District Court Judge Charles Breyer granted her severance motion, and trial is set to begin with jury selection on November 19. 

In its Pretrial Conference Memorandum (available below), the government disclosed that it planned to drop three counts of making a false filing with the SEC and one count of securities fraud.  It earlier dismissed two mail fraud counts that included a right of honest services component, no doubt to avoid a defense argument relying on the Fifth Circuit's decision in U.S. v. Brown rejecting the application of the right of honest services theory when the defendant believes she is assisting the company.  The remaining charges are conspiracy and falsification of Brocade's books and records.  The latter charge is the narrowest in the original indictment, requiring no intent to defraud or mislead, only an intent that the corporate books be inaccurate.

In its memorandum, the federal prosecutors outlined their basic theory for Jensen's liability: "Jensen oversaw and directed the process by which the earlier date was selected, presented to Reyes, and recorded in the company’s corporate records. She also oversaw and directed the process by which other personnel records were falsified. Reyes signed committee minutes falsely stating that the decision to grant options had been made on the earlier date when the price was lower."

Whether the pared down case succeeds remains to be seen.  The severance allows Jensen to claim that she acted on Reyes' orders and that he was responsible for the proper recording of the options grants -- an "empty chair" defense.  She can also argue that she was unaware that the backdating was not properly recorded in Brocade's books and records -- an ignorance defense.  Unlike the CEO of a company, who can be expected to understand the requirements for SEC financial reporting, a lack of knowledge claim from a lower-level executive may have a greater chance of succeeding.  The conviction of Reyes for the same conduct certainly is not helpful to the defense, but the cases may play out differently so prior performance is not an indication of future returns, as the mutual fund companies like to warn.

With the government's case-in-chief set to start on November 26, Reyes' sentencing originally scheduled for that day will be postponed until after the conclusion of the second case.  The Jensen trial may take as long as two weeks, although the government claims it may complete its case-in-chief in three or four days.  Remember the rule of thumb whenever a litigator gives an estimate for how long it will take to put on a case: multiply by two. (ph)

Download us_v_jensen_pretrial_memo_oct_31_2007.pdf

ABA Second Annual Securities Fraud Institute - 23 Corporate Counsel Convictions

The opening session of the Second Annual Securities Fraud Institute provided "trends and expectations in securities fraud enforcement cases and criminal prosecutions" to a near filled large room.  Moderator Tom Hanusik asked questions to Professor James Cox (Duke), Alice Fisher (DOJ), Hon. Michael G. Oxley (a father of SOX), and Linda Chatman Thomsen (SEC). 

The opening question to Mike Oxley was - is SOX working? The former legislator discussed how SOX was passed in response to the public outcry of corporate scandals, with a purpose to restore investor confidence. He said that the Powers Report gave them the road-map to craft the legislation.  And although he was very supportive of the legislation he crafted, he did state that there were "things I would have done differently."  He did not elaborate on these items.  But later in the program he did state that it is hard to imagine another Enron or Worldcom taking place.

Alice S. Fisher,  Assistant Attorney General who heads the Criminal Division of DOJ, was quick to say that SOX is a "great law" and "we love it."  She noted the better compliance programs and the real "robust programs" coming after the legislation. In speaking about new tools provided to DOJ, she said that last year it was 313 convictions, but with the new tools it is 672 convictions.  She said that new tools "really changed behavior."

Linda Chatman Thomsen, Director of Enforcement at the SEC, also remarked on the new tools provided. She noted that four times they had used the freezing of extraordinary payments prior to an action being brought. She said that this helps in keep employees from pulling money from the company.

Fair Funds, a topic that will also be covered by a later panel in this program, was also discussed by Ms. Thomsen.  She said they had collected 9 billion dollars and noted that they were getting better at distributing these funds.  Hon. Mike Oxley noted that this provision was not in the House or Senate version, but that it came out of conference.

Professor James Cox, Duke Law School, provided commentary on several points including issues related to globalization.

The most shocking number heard by this blogger came from Alice Fisher who said that the Corporate Fraud Task Force had 23 convictions of corporate counsel.

Many other items were discussed at this opening panel, but it will be interesting to hear what defense counsel has to say about all of this as the program progresses. The ABA site for this program can be found here.

(esp) (w/ disclosure that she is later speaker at this conference)