Ideoblog

More on the hedge fund acquittal

I said yesterday that I would be posting more on the acquittal of the Bear Stearns hedge fund managers, but John Carney says it for me:

[W]hen taken in context, the evidence provided actually indicated that the men were engaged in an active and ongoing analysis of the shape of the market. They were evaluating different pieces of evidence from the market, some of which seemed to show that the market for mortgages was falling apart and some of which indicated that the markets were temporarily dislocated due to an investor panic over the popping of the real estate bubble.

We want fund managers to feel free to express doubt about their strategies, to openly debate new evidence. This case threatened to have a chilling effect on internal debates over fund strategies.  Hopefully this acquittal will restore the confidence in fund managers that juries will not jump to the conclusion that the private expression of doubt equals fraud if it is not disclosed to investors.

Unfortunately, our view on this may be too optimistic. The very threat of prosecution may be a deterrent enough for many, even if they think they would be acquitted in the end. The chilling effect of this misguided prosecution may not have been totally extinguished by today's acquittal.

This point extends beyond what managers are saying to what they're doing. Criminal law does not mix with ordinary business operations. We have to decide whether we like the comforting spectacle of "fat cats" being hauled before the bar when times turn bad more than encouraging risk-taking to promote the creation of wealth.

A win for the Bear Stearns defendants

The jury completely rejected the government's misbegotten prosecution of the Bear Stearns hedge fund managers. 

I expect to have more to say later about this case. 

The Bear Stearns hedge fund prosecution: spin or fraud?

The WSJ reports on the trial of former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin, who, while desperately trying to keep their hedge funds from going under, supposedly misled investors about the funds' health. Interestingly, these are the only Wall Street executives being criminally tried for conduct connected with the meltdown.

Tannin said in an April 2007 conference call that he was "comfortable" with the funds' performance, though he had recently told Cioffi that if a report they had about the funds was "ANYWHERE CLOSE to accurate, I think we should close the funds now." Cioffi said during the call that investors had requested a "couple of million" dollars of redemptions, though one investor said it wanted to take out its whole $57 million investment. Cioffi is being charged with insider trading for an undisclosed withdrawal of his money from the fund and for lying about how much money had invested in it.

Here's what I said before the charges were filed:

[T]his scenario was shades of Enron – the swift collapse of a trust-based business. Here the "truth" may be particularly elusive. What in retrospect seems to be appropriate pessimism might have caused an unnecessary bank run. This sort of case is suited for a civil fraud claim, but not a criminal case. Note, too, that the sophisticated hedge fund investors were a far cry from the public investors and employees imperiled in Enron.

Of course what's really happening here is that the hedge fund managers are taking the fall for the collapse of Bear, and the even broader reverberations from that, including the controversial merger, the bailout and the credit markets' woes.

As with Enron, the public is screaming for action.  When in doubt, throw somebody in jail. The public will eventually calm down, by which time the now impoverished defendants will be in jail or being exonerated on appeal.

Beyond the politics there is the gross unfairness of the corporate crime lottery. Wrongful misrepresentations of this sort usually land you in a civil case. But if you stumble into a national disaster you end up in jail.

The hedge fund managers also had the bad luck of their chosen line of work, as distinguished, say, from being corporate executives. Remember that Bear's Alan Schwartz said on the eve of the collapse "we don't see any pressure on our liquidity, let alone a liquidity crisis." He's lucky that he didn't head up a hedge fund, or that he wasn't Lay or Skilling. As I've often said, Steve Jobs was a beneficiary of this sort of calculus in the backdating fuss.

Anyway, get ready for another misguided high-profile corporate criminal prosecution.

I can't say the managers behaved perfectly here. Possibly they should be subject to civil fraud. But singling these guys out for criminal liability under these circumstances is unfair. Perhaps even worse, imposing criminal liability for spin could encourage misleadingly pessimistic disclosures that end up hurting rather than helping investors.

This trial indicates that we still haven't learned our lessons from the aftermath of Enron.

Update: Dan Slater discusses the risks to the prosecution of treating this case like another Enron.

Judge Chin to the Second Circuit?

So the NYT is reporting, per the WSJ Law Blog.

According to Sen. Schumer, Judge Chin has "steadily applied the law."

I haven't closely observed Judge Chin's career, but I did report on one case that doesn't justify that praise.

I will also note, for what it's worth, that Judge Chin follows in the footsteps of another federal trial judge, Kimba Wood, who was elevated (at least temporarily) after handing down a nice long sentence to a financial criminal (in Chin's case, 150 years for Madoff; in Wood's case, ten years for Mike Milken).

Backdating prosecution bites the dust

It's ironic, as the WSJ Law Blog notes, that on a day that the WSJ chose to revisit backdating with a story implying that not enough is being done about it (see my earlier post), the key backdating prosecution of Greg Reyes, former Brocade CEO, the case that was the veritable criminal law poster child of backdating, the vindication of the WSJ's Pulitzer-hounding on this subject, has been reversed.

I've been covering this case, e.g. here and here, as part of my effort to highlight the ambiguities inherent in prosecuting backdating, and therefore why these cases are inappropriate for criminal treatment.

Although the case could have gone down on a number of grounds, e.g., materiality, the court chose to focus on the prosecutorial misconduct of "culpably" misrepresenting the state of the evidence during closing argument.

As the Ninth Circuit opinion emphasizes, this was no minor technicality:

At trial, an issue as to Reyes' criminal state of mind was whether Reyes knew the corporate records falsely stated the company's financial condition by under-reporting the company's expenses. Reyes' defense was that he thought the transactions were properly accounted for, in reliance on the Finance Department's expertise to comply with accounting principles and SEC regulations. The government, however, argued that the Finance Department was unaware of the backdating, and thus powerless to get the accounting right. A key question therefore became whether the Finance Department knew that the backdating scheme was taking place.

And this is a central problem with backdating cases generally: should the CEOs, unschooled in accounting technicalities, be held criminally responsible for the way compensation was set forth on the company's books? This is why, for example, it has been so difficult to distinguish Reyes from Steve Jobs, who unlike Reyes benefited from the Apple backdating. Why should the CEO be held criminally responsible for the way the company's experts were handling the accounting?

Well, there was lots of evidence that responsible people in the Brocade Finance Department did know. Yet, as the court said

the prosecutor asserted to the jury in closing that the entire Finance Department did not know about the backdating, and further that the government's theory of the case was that "finance did not know anything." "Our theory is that those people didn't know anything . . . . Elizabeth Moore says finance didn't know. Did you need everybody in the finance department to come and tell you that they didn't know?" The government even displayed for the jury a diagram explaining the prosecutor's position that the Finance Department did not know of the backdating. The prosecutor asked the jury to assume other employees of the Finance Department would testify that they did not know about Reyes' backdating procedure when the prosecutor knew they did. * * *

The record demonstrates that the prosecution argued to the jury material facts that the prosecution knew were false, or at the very least had strong reason to doubt.* *

Moreover, these facts were critical:

Although the government's case was relatively strong, the jury took seven days to deliberate, and the case was complex and technical. Moreover, the prosecutor's statements were particularly prejudicial given that Reyes' defense rested on his delegating his responsibilities to others and reliance on them. At the end there was considerable focus on the issue of what the Finance Department knew. The prosecutor's false statements went directly to this issue. Moreover, the statements were made during closing arguments, both orally and visually, and closing statements from the prosecution "matter a great deal." * * * Deliberate false statements by those privileged to represent the United States harm the trial process and the integrity of our prosecutorial system. We do not lightly tolerate a prosecutor asserting as a fact to the jury something known to be untrue or, at the very least, that the prosecution had very strong reason to doubt. * * *There is no reason to tolerate such misconduct here.

The court nevertheless refused to dismiss the indictment. Now the government has to decide whether to spend millions more to retry this case. Doing so would be incredibly irresponsible. How could the government justify a retrial of a case that, in the court's view, rested so fundamentally on the prosecutor's lie to the jury?

This case illustrates not only a central legal ambiguity in backdating cases, but the extent to which corporate crime cases have been marred by excessive prosecutorial zeal. This botched case crowns the illegitimacy of the whole fiasco of criminalizing backdating.

Update: Business Week's Peter Burrows, whose coverage of this case has been on target from the beginning, has similar sentiments.

The impending moment of truth in the Skilling prosecution

Tom Kirkendall, as usual, has the details.

For starters, he has more on the widely reported cert petition for a hearing on the toxic venue and honest services issues.

But even more interesting, he notes that Skilling and the prosecution are jointly moving to delay Skilling's motion for a new trial based on prosecutorial misconduct.  

Tom asks:

So, what is going on here? Could it be that Skilling's team has discovered even more exculpatory evidence that the Task Force failed to disclose to the Skilling defense prior to the trial? Could it be that the government's current lawyers -- who were not members of the now disbanded Task Force and who have little incentive to cover for their predecessors -- are now finding themselves dealing with a serious failure of the Task Force members to comply with rules requiring the disclosure of exculpatory evidence to the defense in Skilling's case?

He concludes by wondering whether the climax of Skilling will be comparable to that in the Stevens trial.

Criminalizing prosecutorial agency costs

It was about three years ago, while the Enron trial was ongoing, that Judge Lewis Kaplan first said he was “bothered” by government conduct pressuring KPMG into not paying individual defendants’ defense costs. Judge Kaplan later dismissed those charges on 6th amendment grounds, and the Second Circuit affirmed.  Then the Enron-related Nigerian Barge prosecution was overturned by the 5th Circuit.

Anyway, I noted at that time three years ago:

The press likes to make big scandals out of bunches of stories of corporate misconduct. I wonder if it will do the same for government misconduct in prosecuting these cases.

Well, it is getting even more interesting.  The news around now is the crash-and-burn of the Stevens prosecution, which as I've said has more than a passing resemblance to the Enron prosecution.  The WSJ Law Blog reports about the Stevens case:

competition with other U.S. attorney’s offices may have pushed the unit to act in an overly aggressive manner. Thomas C. Green, a Washington defense lawyer who recently won the acquittal of Anibal Vilá said: “I think what happens is that they get caught up in the competition and there’s no experienced voice of reason who says we cannot do this, we should not do this, we must not do this. These two cases could not have happened if the vetting process was in place and operating as it should.”

And now the dismissal of a backdating criminal prosecution because the defendant was not warned explicitly enough that the company lawyers interviewing the defendant didn’t represent him. Here’s the latest on that. Not quite prosecutorial misconduct, but Judge Kaplan recognized the real problem in this situation, and the underlying source of it.

Could it be that there are agency costs in corporate prosecutions just as there are in corporations? Should these agency costs be criminalized too? Well, if agency costs in the context of competitive markets call for criminal prosecutions, doesn't it follow that prosecutors, who are armed with the power of the government, need even stronger deterrence?  Just a thought.

Update:  Tom Kirkendall has a lot more.

After Stevens, what about Skilling?

Well, at least Ted Stevens got some justice. The Justice Department moved to set aside his conviction because it "recently discovered" that prosecutors withheld from the defense its notes of an interview with a major witness that contradicted his later testimony. Seems there’s something called the Brady Rule that requires the government to turn those notes over. This was only part of the prosecutorial misconduct in this case.

Now let’s think back to another case – that of Jeff Skilling, who’s currently rotting in jail. In order to convict Skilling, prosecutors had to prove he knew of the fraud perpetrated by underlings, notably including one Andy Fastow. A key part of their case on this point was a so-called “global galactic” document that Fastow testified he went through with Skilling detailing illicit side deals.

Funny thing, though: this critical document, like something out of a spiritual, once was lost then it was found, in Fastow’s safe deposit box. At trial, as I discussed at the time, Skilling’s lawyer wondered if the document didn’t "show up when you were making your deal with the government?"

As for that deal with the government, Tom Kirkendall has noted that what was supposedly a ten-year sentence somehow mysteriously morphed into a six-year sentence (a fourth of the time Skilling got).  If you had already shown a tendency toward fraud, might you create a document to save yourself four years in jail?  What might a jury think about that? 

Then, whadyaknow, it turns out that the government had not turned over to the defense raw notes of an interview with Fastow in which, as I discussed at the time Fastow told the Task Force he “doesn’t think [he] discussed list w/ JS.” Shades of Stevens. 

As the defense argued:

This obviously exculpatory statement was not included in the Task Force’s “composite” Fastow 302s given to Skilling. Nor was it included in the “Fastow Binders” the Task Force assembled for the district court’s in camera review of the raw notes. It is not possible that this omission was inadvertent. Fastow’s statement is one of the most important pieces of evidence provided during all his countless hours of interviews. Moreover, in preparing both the composite 302s and Fastow binders, the Task Force extracted and included other—relatively inconsequential—statements from the same interview date and even the same page of notes.

How important was all this? Consider that Enron prosecutor John Hueston’s crowing in a law review article about his triumph in convicting Skilling and Lay despite obvious problems with his case:

In a trial involving allegations of earnings manipulation and disputes over the defendants' respective understandings of the application of often arcane accounting rules, proof of criminal intent was of critical importance. Assembling such evidence proved challenging, however, as both Skilling and Lay clearly relied on the advice of inside and outside counsel, as well as their auditors. For instance, although Skilling resigned from Enron for “personal reasons” after a mere six months as C.E.O. and only four months prior to the company's bankruptcy in December 2001, he later took steps seemingly inconsistent with alleged criminal intent. Prior to Enron's collapse, he offered to return to the company as its steward, and in the weeks prior to bankruptcy he took several steps toward engineering and personally financing a private buyout. As forcefully argued by his counsel at trial, what fraudster would seek to return to what he understood was a collapsing house of cards? 

Hueston knew he had a problem with Fastow, as he discussed in the article:

If the defense was successful in portraying Fastow as criminally independent of Skilling and Lay, and without credibility in describing the involvement of Skilling and others in the accounting side deals set forth in Fastow's handwriting in the Global Galactic document, the jury would surely discard his testimony by the time Glisan was called to the stand months later.

Hueston then detailed how he skillfully set traps for the prosecution in his direct of Fastow. But he knew about the vulnerability on the authenticity of the Global Galactic agreement. Consider footnote 71:

Anticipating that the defense in its cross examination of Fastow might suggest that the Global Galactic agreement was fictional, we exercised our right to withhold Loehr's Jencks Act statements until the conclusion of Fastow's testimony. See 18 U.S.C. 3500 et seq. These statements revealed Loehr's ability to corroborate key aspects of Fastow's testimony about the document. For all other case-in-chief witnesses, prosecutors provided statements in advance of the time frame set forth in the act.

Yeah – but what about those raw notes of the Fastow interview?

Skilling's lawyer argued in the brief linked above:

By depriving Skilling of key exculpatory evidence that Fastow conveyed in his interviews, the Task Force was able to skew the proof and convince the jury to accept Fastow’s word over Skilling’s. As the Task Force later told Fastow’s sentencing judge and recounted in a law review article, Fastow’s testimony and credibility were the cornerstones to convicting Skilling.* * *

Tom Kirkendall adds:

The initial Fastow statements set out in the Skillling brief were not only not as damning as Fastow's trial testimony, they were irreconcilable with that trial testimony and described completely legal activity, even by Fastow. Consequently, had the Enron Task Force not been able to to pry Fastow off his original story, the core of the Task Force's case against Skilling and Lay would have have contradicted by Fastow, who was Skilling's main accuser at trial. And the fact that the DOJ did not disclose to the Skilling defense team how Fastow's incriminating testimony evolved over time from his exculpatory initial statements while Fastow and the Task Force were negotiating a dubious plea deal is beyond reprehensible. What is the DOJ going to say now, that they didn't disclose the exculpatory earlier statements to Skilling's defense team because Fastow was protecting Skilling in these initial meetings? Yeah, right.

Kirkendall, who has been on top of this case from the beginning, providing perspective the mainstream press has almost totally missed, says:

So, because of prosecutorial misconduct, the Justice Department decides to move for dismissal of the political corruption case against former Alaska senator Ted Stevens * * * Meanwhile, Jeff Skilling, who created billions of dollars in wealth and thousands of jobs by revolutionizing risk management of natural gas prices for producers and industrial consumers, sits in a Colorado prison cell under the weight of a barbaric 24-year prison sentence. Skilling's conviction involved even more egregious prosecutorial misconduct than the Stevens case. The criminal case against Skilling was materially weaker than the case against Stevens, too. It is a sad reflection of the current state of American rule of law that the DOJ readily concedes prosecutorial misconduct against a legislator, but ignores it in a shaky case against a businessperson who created many jobs and great wealth

A real criminal stands in the dock

Yesterday the world got to see a real corporate criminal.  Bernie Madoff deliberately used his control over money to ruin, directly or indirectly, thousands of lives.  He did this through a so-called "business" that was essentially never legitimate.

Madoff wasn't somebody who devoted his life to building a business and then watched it go up in flames (Skilling, Lay).  Madoff didn't fail to account for his pay properly.  Madoff wasn't some underling caught up in the corporate hierarchy who paid dearly for refusing to admit to a crime he believed he did not commit (Olis).  Madoff lied to and stole from everybody who trusted him for an entire generation. 

Yet it's likely that Madoff will receive a sentence not strikingly different from some of those just mentioned. It's too bad Madoff's guilt has been blurred by all those others who have shared the dock with him.

Sorkin on Madoff's bail

Andrew Ross Sorkin, writing in the NYT about the Madoff bail decision, opines:

Welcome to the two-tiered system of justice: one for the super-rich, the other for the rest of us. Judge Ellis’s explanation is not very satisfying.

For a more balanced view, here’s the WSJ Law Blog quoting law prof Peter Henning:

“The whole idea behind bail is to ensure that the defendant appears and also to impose conditions that will protect the community. I think the magistrate judge was on pretty solid ground, as much as it drives everyone nuts. We have this darn thing called due process. And the judge followed the law.”

Indeed, the magistrate was clearly correct. The Law Blog provides some helpful guidance to a decision that non-law-trained people may find objectionable or counter-intuitive. By contrast, Sorkin’s piece plays to the Madoff-hysteria of the masses – the same ones who like to read Ben Stein and Gretchen Morgenson.

I hasten to add that if Madoff is guilty as charged I’d have no problem seeing him rot in jail. But even as a businessman he’s still entitled to the protection of the law.

Now one might want to argue that we should revise the law so it doesn’t “reward” rich accused by allowing them to buy themselves out of jail pending trial. But then maybe we shouldn’t subject the rich or formerly rich to extra punishment, such as the corporate crime lottery discussed in my recent post.

In any event, these were not issues for the magistrate, whose job was to apply the law as it stands. A non-tabloid would help its readers understand that.