Ideoblog

The real backdating scandal

As I wrote yesterday, the Broadcom backdating prosecution has been dismissed because the prosecutor had made the case what the judge called a "mockery of justice." A key problem was the prosecutor's intimidating defense witnesses from testifying.

In August, Greg Reyes' backdating prosecution – the key conviction that ultimately triggered the Broadcom prosecution – was reversed on appeal. As I discussed then, the prosecutor 'culpably' misrepresented the state of the evidence concerning what Brocade's finance department knew about the backdating, which was critical to whether Reyes' state of mind.

Holman Jenkins writes in today's WSJ that he suspects the Broadcom court was willing to condemn the prosecutorial behavior "because it was in the service of a prosecution that fundamentally never deserved to be brought. . . .[M]ost backdating cases amount to companies trying to behave rationally amid irrational accounting rules, rather than the media's standard trope of businessmen a-lyin' and a-stealin'."

And now for the punch line. Despite Reyes' reversal, the court refused to dismiss the indictment, and the government had to decide whether to retry him. I opined in the post linked above that

[d]oing 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.

Well, the prosecutors in fact did decide to retry Reyes.

As Jenkins says, "[w]hy a U.S. attorney in San Francisco would want to try Mr. Reyes again is a mystery to us, but maybe it's time for an investigation of backdating investigations."

Jenkins ends his column by making a point that I have also made in numerous posts:

We can't close without mentioning the exemplary diligence and enterprise with which, way back when, certain reporters and editors uncovered the backdating phenomenon, and then the intellectual sluggishness with which they analyzed it.

They found an interesting story (one that fit well under the current interest in behavioral economics) and then got it fundamentally wrong by insisting on shoving it into a procrustean off-the-shelf narrative of executive "greed."

Indeed, for want of a single paragraph explaining why backdating could be (in the words of a recent academic paper) a case of optimum contracting between companies and employees, we might have avoided the waste and injustice of these misguided backdating prosecutions

So the press whipped the public into a frenzy over the backdating so-called scandal. The WSJ collected its Pulitzer for the story, but then relegated the important question of whether it involved a crime to the editorial page, not least Holman Jenkins. Responding to the public's misguided rage, prosecutors found themselves involved in criminal trials with no crimes. So they responded the way corporate executives sometimes do when they need earnings but have none – they cheated.

To summarize: The real backdating scandal is not the one that has been generally reported. It is, instead, the woeful inadequacy of mainstream business reporting compounded by prosecutorial misconduct.

Skilling’s SCOTUS brief

Tom Kirkendall, who has covered this case much better than the mainstream media, has a full report, with the brief itself.

On the honest services issue, the brief convincingly argues that Section 1346 unconstitutionally fails adequately to define the conduct it prescribes.

As the brief argues, it's important to keep in mind that the government does not accuse Skilling of stealing money from Enron. Rather, the government argues that he simply made a bad business judgment – he had Enron take on too much risk. In other words, Skilling argues,

making a bad decision or doing a poor job in running a business is a crime. Almost nothing else need be said in explaining why the Skilling appeal is of paramount importance to the protection of taking risk and creating wealth in the American business community.

This goes to the heart of the problem with "honest services" – criminalizing agency costs.

Tom also discusses Skilling's dramatic arguments for why the trial shouldn't have been held in Houston.

For earlier posts on the Skilling trial and appeal, many of which refer to Tom's more complete coverage, type Skilling into my Blogbar on the upper right hand corner.

Honest services and criminalizing agency costs

This blog has dealt almost from the beginning with the problems of criminalizing conduct by corporate agents that formerly would have been dealt with civilly via fiduciary duties and other remedies. One my earliest posts discussed the sad case of Jamie Olis, an ordinary mid-level tax planner who found himself facing a Soviet-style 24-year sentence.

Well, the tide has been clearly turning against these government outrages. Among other things, Olis's sentence was since reduced and he is now out of jail.

And now the criminal statute that helped send many so-called corporate criminals to jail, including most notoriously Jeff Skilling, is under attack in the Supreme Court, and reportedly isn't holding up very well. The Law Blog has a good summary of Tuesday's oral argument, with links. Among other things, LB reports:

At oral arguments on Tuesday, the justices' questions suggested they didn't think the honest-services law was drafted so that that the line between criminal conduct and lawful activity is adequately clear.

In one example, Justice Stephen Breyer imagined an employee distracting his supervisor with small talk "so the boss will leave the room so that the worker can continue to read the Racing Form."

"Explain it to me how your test does not make this statute potentially criminalizing 100 million workers in the United States," Justice Breyer continued.

That discussion gets to what I think the central problem is here: distinguishing between ordinary agency costs, which are pervasive in firms, and which firms have a wide range of contractual devices to deal with, and the agency costs that should trigger jail time.

As I said in Perils of Criminalizing Agency Costs:

The criminal law is not particularly well suited to make the sort of fine distinctions these cases require. Letting some of these people off while others spend their lives in jail creates a wide perception of injustice. Sending all of them to jail dissipates the moral force of the criminal law. Moreover. . . giving prosecutors such broad discretion as to which agents to charge creates opportunities for prosecutorial misconduct whose effects may be even worse than anything the corporate agents did. And . . . this line-drawing puts heavy demands on fact-finders unschooled in business.

The Law Blog says that if the Supreme Court is struck down,

Expect defendants convicted under the law to rush the courthouse door. Striking down the honest-services crime would trigger "an earthquake within the criminal justice community," said David Seide, a former federal prosecutor now with Curtis Mallet-Prevost Colt & Mosle LLP in Washington. Defendants convicted under the statute "will be able to say their convictions need to be reversed," he said.

The government agents responsible for this excess and the ensuing "earthquake" will never be held to account. But hopefully the lesson will be learned.

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.