Corporate Fraud Issues - justice.gov · On July 9, 2002, President Bush created the Corporate Fraud...

Corporate Fraud Issues

The Deputy Attorney General's Introductory Letter

The President's Corporate Fraud Task Force . . . . . . . . . . . . . . . . . . . 1By Andrew Hruska

Overview of the Federal Securities Laws . . . . . . . . . . . . . . . . . . . . . . . 5By Randall R. Lee and Andrew G. Petillon

Sarbanes-Oxley: Broader Statutes–Bigger Penalties . . . . . . . . . . . . 13By Tom Hanusik

Cooking the Books: Tricks of the Trade in Financial Fraud . . . . . . 19By Joseph W. St. Denis

Market Capitalization as the Measure of Loss in Corporate FraudProsecutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

By George S. Cardona and Gregory J. Weingart

Dispositions in Criminal Prosecutions of Business Organizations . . 33By Miriam Miquelon

May 2003

Volume 51

Number 3

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In This Issue

MAY 2003 UNITED STATES ATTORNEYS' BUL LET IN 1

The President's Corporate Fraud TaskForceAndrew Hruska Assistant United States Attorney,Eastern District of New YorkFormer Senior Counsel to the DeputyAttorney General Department of Justice

The problem of financial crime is neither newnor, unfortunately, surprising. Given the liberty ofour free market economy, the enormous wealththat American enterprise generates, and thetemptation to defraud others, there will always bea small minority of businesspeople who usecriminal means to obtain wealth that the vastmajority of their colleagues earn through sweatand toil. As Deputy Attorney General LarryThompson cautioned, "it is important not to tarwith too broad a brush the overwhelming majorityof corporations that operate morally andproductively in the best and highest interest oftheir shareholders and the country. Yet, . . . thebreadth and extent of these recent scandals dodemonstrate intolerable legal and ethicalmisdeeds that require a comprehensive response."Deputy Attorney General Larry D. Thompson, ADay with Justice (October 28, 2002) available athttp://www.usdoj.gov/dag/speech/2002/102802adaywithjustice.htm. The spate of fraud at some ofour largest corporations, revealed over the courseof the past year, has injured investor confidenceand compelled an efficient, coordinated responseby both the Department of Justice (Department)and our many allied law enforcement andregulatory agencies. The President has chargedthe Corporate Fraud Task Force with that mission.

On July 9, 2002, President Bush created theCorporate Fraud Task Force, under the leadershipof Deputy Attorney General Larry Thompson, tooversee and direct all aspects of the Department'smanifold efforts to investigate and prosecutecorporate fraud. EXEC. ORDER NO. 13,271, 67Fed. Reg. 46091 (2002), available at

http://www.usdoj.gov/dag/cftf/execorder.htm.The Executive Order also instructed the TaskForce to coordinate the response of the federallaw enforcement and regulatory community tothis challenge. As the President explained, "Thisbroad effort is sending a clear warning and a clearmessage to every dishonest corporate leader: Youwill be exposed and you will be punished. Noboardroom in America is above or beyond thelaw." President's message to Corporate FraudConference, 38 WEEKLY COMP. PRES. DOC. 1626(Sept. 26, 2002) available athttp://www.whitehouse.gov/news/releases/2002/09/20020926-10.html.

The President's July 9 order created a dualstructure with a Department group and an inter-agency group. The Department's core groupconsists of the Assistant Attorneys General for theCriminal and Tax Divisions, the Director of theFBI, and the United States Attorneys for theSouthern District of New York, the EasternDistrict of New York, the Eastern District ofPennsylvania, the Northern District of Illinois, theSouthern District of Texas, the Northern Districtof California, and the Central District ofCalifornia. These United States Attorneys werechosen as representatives of major businessdistricts across the country. Although corporatefraud matters are aggressively prosecutedthroughout the country, many times inconjunction with the Criminal or Tax Divisions,these U.S. Attorneys' offices represent the bulk ofthe Department's enforcement. In addition, theDeputy Attorney General has designated PrincipalAssociate Deputy Attorney General ChristopherWray and this author as staff to the Task Force.

The interagency group is composed of theSecretary of the Treasury, the Secretary of Labor,the Chairman of the Securities and ExchangeCommission (SEC), the Chairman of theCommodities Futures Trading Commission(CFTC), the Chairman of the Federal Energy

2 UNITED STATES ATTORNEYS' BUL LET IN MAY 2003

Regulatory Commission (FERC), the Chairman ofthe Federal Communications Commission (FCC),and the Chief Inspector of the United StatesPostal Inspection Service (USPIS). While GrandJury secrecy concerns bar the interagency groupfrom discussing certain operational matters, thegroup does consult on policy issues and serves asa forum for the discussion of pressing matters ofbroad application. Perhaps more importantly,members of the interagency group communicatefrequently outside of Task Force meetings onpolicy and, where appropriate, operational mattersas they arise.

The Corporate Fraud Task Force has led anextraordinarily successful campaign againstcorporate fraud both in the many investigationsand prosecutions it oversees and in the policyinitiatives it has promoted. The Task Forceconcentrates on marshaling the full resources ofthe Department, and our allied enforcementagencies, to bring prosecutions and launch civilactions as quickly as possible following thediscovery of wrongdoing by a business.

The Task Force has met in full session sixtimes since its inauguration and hosted a nationalconference in September 2002 that includedaddresses by the President, the Attorney General,the Deputy Attorney General, as well as remarksby all the Task Force members. That conferencedrew together virtually all of the United StatesAttorneys and Special Agents in Charge of theFBI, the agency and regional leadership of theSEC, CFTC, IRS, USPIS, FCC, and theenforcement section of the Labor Department. Inaddition, Task Force members have contributed toa comprehensive national training program toeducate AUSAs, FBI Special Agents, and ourcolleagues in allied Task Force agencies, in ournew approach, new tools, and reneweddetermination to combat corporate fraud.

One of the first challenges the CorporateFraud Task Force faced was to define the problemthat demands our concentration. Although manyforms of financial crime remain serious issuesthat properly command the attention of ourprosecutors, the Task Force resolved to focus onthree types of specific conduct at the heart of thecurrent spate of corporate fraud:

• falsification of financial information,including false accounting entries, bogustrades designed to inflate profits or hidelosses, and false transactions designed toevade regulatory oversight;

• self-dealing by corporate insiders, including:

(a) insider trading,

(b) kickbacks,

(c) misuse of corporate property for personalgain (e.g., embezzlement, self-dealingtransactions), or

(d) individual tax violations related to theself-dealing (e.g., failure to report forgivenloans, kickbacks or other income); and

• obstruction of justice designed to concealeither of these types of criminal conduct,particularly when that obstruction impedesthe regulatory inquiries of the SEC or otheragencies.

These types of crimes may occur in differentkinds of business organizations, includingpartnerships and sole proprietorships, as well ascorporations, and at many levels within theorganization. They may involve securities fromthe NYSE-listed stock to private debt instruments.Some cases arise in Fortune 100 companies, andsome from small entities unknown outside thelocality. All of these crimes can have seriousimpact both on the direct victims of the fraud, aswell as on the national confidence in the integrityof the economy.

The results of the Corporate Fraud TaskForce's determination are printed on the frontpages of the national press. In the past ninemonths, the Department, and most often our TaskForce colleagues from the SEC or CFTC, haveannounced charges in the investigationsconcerning corporate fraud at WorldCom, Enron,Adelphia Communications, HealthSouth, ArthurAndersen LLC, Tyco International, Imclone,Homestore.com, Qwest, Dynegy, AmericanTissue Inc., El Paso Corporation, MercuryFinance, Anicom, Commercial Financial Services,Kmart, Peregrine Systems, Symbol Technologies,and many other companies. Many of the press


releases for these charges are available athttp://www.usdoj.gov/dag/cftf/pubs.htm.Investigations continue concerning most of thesecompanies and many more. Overall, the CorporateFraud Task Force is overseeing more than 150corporate fraud investigations. Task Force staffand the Deputy Attorney General consultregularly with the prosecutors and investigatorsassigned to these matters to coordinate the overallscope and direction of the Department's effort tocombat corporate fraud and to best coordinatewith our Task Force colleagues outside theDepartment. These investigations have led tocharges against more than 200 individuals andalready resulted in more than 75 convictions. Inaddition, Task Force members have obtained thefreezing of tens of millions in assets and areseeking the forfeiture of billions. See, especially,the forfeiture allegations in the indictment arisingfrom the investigation of AdelphiaCommunications: United States v. John J. Rigas,Timothy J. Rigas, Michael J. Rigas, James R.Brown and Michael C. Mulcahey (S.D.N.Y2002), available athttp://10.173.2.12/usao/eousa/ole/tables/fraudsec/rigasind.wpd, and arising from the investigationinto Enron Corporation from the Complaint inSEC v. Andrew S. Fastow (S.D. Tex. 2002),available athttp://www.sec.gov/litigation/complaints/comp17762.htm.

While painstaking efforts are, and must be,made to be fair and thorough in our approach, theguiding principle of the Task Force is that we canno longer afford to wait years before addressingsignificant criminal conduct that threatens tocorrupt the sound foundation of the economy.This real-time enforcement has cut the time fromdiscovery to prosecution decisions from thetraditional two or three years down to months oreven weeks, as the recent Department and SECactions in WorldCom, Adelphia, and HealthSouthdemonstrate. Resisting the desire to plumb everyaspect of the criminal conduct to wrap up the"perfect case," Department and SEC attorneys andinvestigators focused on discrete conduct thatcould be immediately charged.

Using this aggressive approach, the TaskForce has addressed the need to broaden thetraditional scope of our investigations to includethe conduct of professionals, such as lawyers,accountants, and investment bankers, both withinand outside the corporation. Because it is notpossible for significant corporate fraud to persistwithout the complicity or deception of these keyprofessionals, the Task Force determined that it isimperative to make prosecutorial decisions abouteach of the professionals in contact with thefraudulent business practice under investigation.Sometimes, as in the Arthur Andersen matter, aprofessional firm itself can become so enmeshedin the fraud of its client that the entire entity maybe criminally liable.

It is particularly disturbing when attorneys,the guardians of the law, participate or acquiescein crimes. As the Deputy Attorney Generalobserved:

The attorney's role is to take an independentlook with some healthy skepticism at thecorporation's conduct–where it is right tokeep it right, and where it is not, to make itright. . . . [L]awyers have a responsibility totheir clients, to the profession and to thepublic to view such practices in the cold lightof reality with an eye toward how they maylook splayed out on the front page in theunforgiving glare of unfavorable publicattention.

Deputy Attorney General, Larry D. Thompson, ADay with Justice (October 28, 2002) available athttp://www.usdoj.gov/dag/speech/2002/102802adaywithjustice.htm. To add force to thisdetermination, the SEC has recently promulgateda set of attorney conduct rules that requiresattorneys to report fraud within a corporation andto take active measures to disassociate themselvesfrom such conduct. Implementation of Standardsof Professional Conduct for Attorneys, Securitiesand Exchange Commission, 17 C.F.R. Part 205[Release Nos. 33-8185; 34-47276; IC-25919; FileNo. S7-45-02] RIN 3235-AI72, available athttp://www.sec.gov/rules/final/33-8185.htm.

The Task Force supervised the process ofrevising the Principles of Federal Prosecution of


Business Organizations that led to the DeputyAttorney General's promulgation of the newprinciples in January 2003. As the DeputyAttorney General stated in his directive toDepartment prosecutors:

The main focus of the revisions is increasedemphasis on and scrutiny of the authenticityof a corporation's cooperation. Too oftenbusiness organizations, while purporting tocooperate with a Department investigation, infact take steps to impede the quick andeffective exposure of the complete scope ofwrongdoing under investigation. Therevisions make clear that such conduct shouldweigh in favor of a corporate prosecution.

Memorandum of Deputy Attorney General LarryD. Thompson to Heads of DepartmentComponents and United States Attorneys(January 20, 2003), available athttp://www.usdoj.gov/dag/cftf/corporateguidelines.htm. The revisions also reemphasizethe need to pursue individual as well asorganizational crime. In addition, while thewaiver of work product protection and attorney-client privilege by the corporation may bedesirable and may be a factor in determining theextent and authenticity of cooperation, theprinciples make plain that, "The Department doesnot . . . consider waiver of a corporation'sattorney-client and work product protection anabsolute requirement." (Emphasis added.)Memorandum of Deputy Attorney General LarryD. Thompson to Heads of DepartmentComponents and United States Attorneys(January 20, 2003), available athttp://www.usdoj.gov/dag/cftf/corporate_guidelines.htm.

The Task Force has also played a crucial rolein advocating the Department's position on theappropriate enhancement of fraud sentences tocorrespond to the dramatic increase in statutorymaxima enacted by the Sarbanes-Oxley Act.Sarbanes-Oxley Act of 2002, PUB. L. NO. 107-204, 116 Stat. 745 (2002), available athttp://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=107_cong_public_laws&docid=f:publ204.107.pdf. Congress increased statutory maximafrom five years to twenty years for mail and wire

fraud (18 U.S.C. §§ 1341, 1343) and the newlyenacted Title 18 Securities Fraud offense (18U.S.C. §1348) from ten years (under the Title 15offenses) to twenty-five years. Thus far, theUnited States Sentencing Commission has notmade commensurate changes in the Fraud LossTable of UNITED STATES SENTENCING

GUIDELINES MANUAL § 2B1.1. The Task Forcecontinues to coordinate the Department's effortsto address this problem through a variety ofapproaches, including sending an ex officioCommissioner to participate in the SentencingCommission's procedures.

The Corporate Fraud Task Force willcontinue to press ahead on both the investigativeand policy fronts. As the Attorney General statedin his address to the Corporate Fraud Task Force'snational conference:

We cannot–we will not–surrender freedomfor all to the tyranny of greed for the few. Justover a year ago, Americans were called todefend our freedom from assault from abroad.Today we are called to preserve our freedomfrom corruption from within. You are theanswerers of this call; you are the defendersof this freedom. I am grateful to you all foryour leadership, and I thank you for yoursacrifice and your steadfast commitment toreturning integrity to American marketsthrough justice . . . .

Attorney General John Ashcroft, "Enforcing theLaw, Restoring Trust, Defending Freedom,"Corporate Fraud Task Force Conference,(September 27, 2002), available athttp://www.usdoj.gov/ag/speeches/2002/092702agremarkscorporatefraudconference.htm. Thesupport of the entire U.S. Attorney community isnecessary for these efforts to continue with thegreat success we have all achieved to date.�


ABOUT THE AUTHOR

�Andrew Hruska is an Assistant United StatesAttorney in the Eastern District of New York. Hewas formerly the Senior Counsel to the DeputyAttorney General. He advised the DeputyAttorney General on a variety of matters,including Corporate Fraud, the work of thePresident's Corporate Fraud Task Force, whichthe Deputy Attorney General chairs, and whitecollar crime in general.

Mr. Hruska previously served as an AssistantDistrict Attorney in the Frauds Bureau of theManhattan District Attorney's Office where heprosecuted a wide range of financial crimes,including securities fraud, bank fraud andaccounting fraud. Prior to that, Mr. Hruska wasassociated with the New York law firm ofSullivan & Cromwell. a

Overview of the Federal SecuritiesLawsRandall R. LeeRegional Director, Pacific RegionU.S. Securities and Exchange Commission

Andrew G. PetillonBranch Chief, Pacific Regional OfficeU.S. Securities and Exchange Commission

I. Introduction

The "federal securities laws" consist of sixstatutes enacted by Congress from 1933 to 1940to protect investors and restore confidence in thestock market following the Great Crash of 1929.Today, in the wake of corporate fraud scandalsand investor uncertainty, the federal securitieslaws are as important as they were seventy yearsago. The United States Securities and ExchangeCommission (SEC) is the federal agency withprimary responsibility for regulating the securitiesmarkets and bringing civil enforcement actionsagainst securities violators. The federal securitieslaws also provide for criminal liability, and theDepartment of Justice (Department) andUnited States Attorneys' Offices (USAOs) aroundthe country have been increasingly active inworking with the SEC and bringing criminalactions against securities violators.

Recent legislation gives the SEC and criminalprosecutors unprecedented powers to enforce thefederal securities laws, which should result inadditional civil and criminal securities cases. Inlight of these developments, more AssistantUnited States Attorneys (AUSAs) and relatedcriminal law enforcement personnel are devotingtheir efforts to prosecuting securities violators.This article gives a brief overview of the federalregulation of securities and attempts to providesome tips on working with the SEC andprosecuting securities fraud.

II. The SEC

The SEC was established in 1934 toadminister and enforce the federal securities laws.The agency has about 3,100 employees who workin the headquarters in Washington, D.C., and infive regional and six district offices throughoutthe United States. The professional staff membersare mostly attorneys, accountants, and examiners,but also include economists, financial analysts,and others. The agency has five Commissioners,including a Chairman, who are appointed by thePresident. William Donaldson became the SEC'sChairman in February 2003, following formerChairmen Harvey Pitt and Arthur Levitt. The fiveCommissioners meet in public sessions toconsider and vote on proposed rules and policyissues that affect the securities markets. They also


meet in non-public sessions to consider and voteon whether to authorize enforcement actionsrecommended by the staff.

The SEC has four operating Divisions:Corporation Finance, which oversees thedisclosure requirements of public companies;Market Regulation, which oversees broker-dealerfirms, the stock exchanges, and other securitiesmarket participants; Investment Management,which oversees the $15 trillion moneymanagement industry of mutual funds andinvestment advisers; and Enforcement, the SEC'slargest division, which conducts investigations,recommends enforcement action whenappropriate, and prosecutes civil enforcementactions in federal court and before administrativelaw judges. The Enforcement Division worksclosely with federal, state, and local criminal lawenforcement agencies around the country whensecurities law violations warrant criminalprosecution.

The SEC has regional offices in Los Angeles,Denver, Chicago, New York, and Miami, anddistrict offices in San Francisco, Salt Lake City,Fort Worth, Boston, Philadelphia, and Atlanta.Each field office operates enforcement programswithin their geographic region, and cases areinvestigated and prosecuted by either a fieldoffice or by enforcement staff at headquarters inWashington, D.C. (commonly referred to as thehome office). The enforcement staff consists ofattorneys and accountants with extensiveexperience and expertise in investigatingsecurities violations of all types.

The field offices (as well as the home office)also operate inspection programs, in which staffaccountants, attorneys, and examiners conduct on-site examinations of regulated persons andentities–broker-dealers, transfer agents, clearingagencies, investment companies, investmentadvisers, and the self-regulatory organizations–toensure compliance with the securities laws. Whenan examination reveals potentially seriousviolations, the examination staff may refer thematter to the enforcement staff for furtherinvestigation. Therefore, AUSAs who handlecases involving misconduct by a regulated personor entity may work closely with the SEC's

examination staff, who can also be a usefulresource because of their in-depth knowledge ofthe regulated community.

We strongly encourage United StatesAttorneys and AUSAs to develop close andcooperative relationships with the SEC fieldoffice in your jurisdiction. That office is likely tobe your most fruitful source of securities fraudcases and can be a tremendous source ofexperience and expertise. The more the SEC andthe USAOs work cooperatively and coordinatetheir efforts, the more both agencies can leveragetheir scarce resources and bring swifter and moreeffective actions to prevent wrongdoing andprosecute the wrongdoers.

III. The six federal securities statutes andrelated rules

Six statutes comprise the federal securitieslaws: (1) the Securities Act of 1933; (2) theSecurities Exchange Act of 1934; (3) the PublicUtility Holding Company Act of 1935; (4) theTrust Indenture Act of 1939; (5) the InvestmentAdvisers Act of 1940; and (6) the InvestmentCompany Act of 1940. Each statute alsoauthorizes the SEC to adopt rules and regulations(which are a group of rules relating to the samesubject) to further define and interpret the specificstatutory provisions. For example, Section 10(b)is the general antifraud statute of the SecuritiesExchange Act of 1934. 15 U.S.C. § 78j(b). Usingits statutory authority, the SEC adopted Rule 10b-5, which sets forth conduct that the SEC considersto be fraudulent under Section 10(b). 17 C.F.R.§ 240.10b-5. The core philosophy throughout thesix statutes and related SEC rules and regulationsis to protect investors by requiring companies tomake full disclosure of all material facts about asecurity. A fact is material, and therefore must bedisclosed, if a reasonable investor would considerthe fact to be important to an investment decision.See Basic Inc. v. Levinson, 485 U.S. 224, 231-32(1988).

Each statute provides a basis for criminalprosecution for willful violations of any provisionof the statute or rules and regulations thereunder,and for any knowing and willful material falsestatements in any report or document filed with


the SEC. Thus, although most criminalprosecutions are brought under the antifraudprovisions of the securities laws, it is important toremember that any violation of the securitieslaws, rules, and regulations, can be the basis for acriminal action if the requisite mens rea ispresent. Below we provide a brief overview offour of the six statutes that are most commonlycharged in SEC civil enforcement actions andcriminal prosecutions.

IV. The Securities Act of 1933

The Securities Act of 1933 (commonlyreferred to as the Securities Act or the '33 Act)primarily regulates the offer and sale of securitiesby companies to the public. The statute seeks toprotect investors in securities offerings byrequiring companies to disclose adequateinformation to allow investors to make fullyinformed investment decisions about the security.

A key provision in achieving this goal isSection 5 of the Securities Act, which requiresthat every offer or sale of a security involvinginterstate commerce must either be registered orexempt from registration. 15 U.S.C. § 77e. Thismeans that every time a company wants to raisemoney by selling securities to the public, theoffering process must comply with the detailedregistration or exemption provisions of theSecurities Act and related rules. The SEC oftencharges Section 5 violations in cases involving thesale of unregistered stock by boiler rooms or bypublicly traded shell companies. Criminalprosecutions are occasionally brought underSection 5, which does not require a showing offraud. 15 U.S.C. §§ 77e, 77x. Because a Section 5violation requires proof that the registration orexemption provisions have not been compliedwith (and because evidence of fraud tends to bemore compelling to a jury), criminal Section 5charges are more commonly brought inconjunction with securities fraud charges. Thefollowing briefly describes some Securities Actissues and provisions that can arise in a criminalcase.

A. Is a security involved?

A threshold question applicable to all federalsecurities laws, but that frequently arises in thecontext of Securities Act registration issues, iswhether an investment opportunity involves asecurity. If no security is involved, the federalsecurities laws do not apply. Because the federalsecurities laws typically provide the greatestrange of civil and criminal sanctions forfraudulent investment activity, the SEC andUSAOs often expend significant effort indetermining whether conduct involves a security.For the same reason, sophisticated fraudperpetrators often attempt to structure theiractivities to try to avoid falling within the legaldefinition of a security.

A security is basically an intangible interest ina business. Each of the six securities statutes setsforth a detailed legal definition of a security,which is further defined by SEC rules andinterpretations and court decisions. Section 2(1)of the Securities Act defines a security to include"any note, stock, treasury stock, bond, debenture. . . [or] investment contract . . . ." 15 U.S.C.§ 77b(a)(1). There often will be no question that asecurity is involved if the investment is describedas a "stock" or "bond" and has the typicalcharacteristics of these common securities.However, when the name or characteristics of aninvestment program do not make it obvious that asecurity is involved, a factual and legal analysisof the investment must be made.

The most common catch-all definition of asecurity in the federal securities laws is the term"investment contract" in Section 2(1) of theSecurities Act. 15 U.S.C. § 77b(a)(1). This termwas first interpreted by the Supreme Court in SECv. W.J. Howey, 328 U.S. 293 (1946). In Howey,the Court held that the ostensible "sale" of orangegroves to investors, under a contractualarrangement in which the seller would useproceeds from the sale to manage the groves andreturn a portion of the profits to the buyer, was inreality an investment contract and therefore asecurity. The Court defined "investment contract"in Section 2(1) of the Securities Act as a"contract, transaction or scheme whereby a personinvests his money in a common enterprise and is


led to expect profits solely from the efforts of thepromoter or a third party." Id. at 301. This three-part "Howey test" is often used by the SEC to findthat certain investment programs (e.g., earthwormbreeding programs, pyramid sales, "prime bank"instruments, etc.) are, in fact, securities, and canbe regulated as such.

B. Registered offerings under the SecuritiesAct

If a business offers and sells its securities tothe public and cannot rely on any exemption fromregistration (as discussed below), the offer andsale must be registered and comply with theSecurities Act. Registration means that aregistration statement must be filed with the SEC.The registration statement must include aprospectus, which is a disclosure documentprovided to prospective investors. The registrationstatement must include detailed information aboutthe company and its management, includingaudited financial statements, as required by theSEC rules and forms.

The SEC may choose to review and commenton the registration statement, and the companycannot sell its securities to the public until theSEC has completed its review and indicated that ithas no further comments. The primary objectiveof the review process is to ensure that theregistration statement provides full and accuratedisclosure of significant information about thesecurities. A knowing and willful false statementin a registration statement may be subject tocriminal prosecution. 15 U.S.C. § 77x.

C. Exempt offerings under the Securities Act

Under narrowly defined circumstances setforth in the Securities Act and related rules,certain types of securities and transactions areexempt from the registration requirements (butnot the antifraud provisions) of the Securities Act.For example, certain securities issued by federal,state, or local governments, such as municipalbonds, are exempt from registration. Certainsecurities transactions, often called privateplacements, are also exempt from registration.Section 4(2) of the Securities Act provides thattransactions "not involving any public offering"are exempt from registration. 15 U.S.C. § 77d(2).

Because it was difficult to determine whattransactions qualified for an exemption under thebroad language of Section 4(2), the SEC adoptedRegulation D to be a safe harbor for conductingcertain transactions without registration. 17C.F.R. §§ 230.500-230.508.

Regulation D is a set of rules that generallyallows a company to offer and sell securitieswithout registration when the money to be raisedis limited ($1 million or less in one type ofRegulation D offering, and $5 million or less inanother) and/or when the offering is madeprimarily to institutions, individuals who meetcertain income or net worth requirements, andcorporate insiders. To qualify for an exemptionfrom registration under most provisions ofRegulation D, the securities may not be soldthrough any form of general solicitation oradvertising. Rule 502, 17 C.F.R. § 230.502(c).This means that if securities are being sold bycold-calling or over the Internet, for example,they generally will not qualify for an exemptionunder Regulation D. Many fraudsters who claimto be selling private placements run afoul of thesecurities laws in the first instance because of theprohibition on general solicitations.

D. Antifraud provision under the SecuritiesAct

Section 17(a) is the general antifraudprovision of the Securities Act. 15 U.S.C.§ 77q(a). The provision prohibits fraud by anyperson in the offer or sale of securities involvinginterstate commerce. Section 17(a) proscribesthree types of fraud: first, "to employ any device,scheme, or artifice to defraud"; second, "to obtainmoney or property by means of any untruestatement of a material fact or any omission tostate a material fact necessary in order to makethe statements made, in light of the circumstancesunder which they were made, not misleading";and third, "to engage in any transaction, practice,or course of business which operates or wouldoperate as a fraud or deceit upon the purchaser."This provision is applicable even if the underlyingsecurity or transaction is exempt fromregistration.


Criminal violations of Section 17(a) aretypically brought in a wide variety of cases,ranging from the sale of fraudulent investmentsthrough boiler rooms to accounting fraud cases inwhich securities are sold to the public bycompanies that have reported false financialinformation in their registration statements. 15U.S.C. §§ 77q(a), 77x.

V. The Securities Exchange Act of 1934

The Securities Exchange Act of 1934(commonly referred to as the Exchange Act or the'34 Act) regulates the trading markets, that is, thesecondary trading of securities by brokers and thepublic after the initial sale of the securities by acompany. This is in contrast with the SecuritiesAct, which regulates initial sales by a company tothe public. The Exchange Act is an extensive andcomplex statute that regulates the trading marketsin at least three ways: first, by requiring marketparticipants, such as broker-dealer firms, transferagents, stock exchanges, and Nasdaq, to registerwith and be regulated by the SEC; second, byimposing periodic disclosure obligations oncompanies with publicly-traded securities and oninsiders of these companies (officers, directors,large shareholders); and third, by providing strongprohibitions against fraudulent or manipulativeconduct that could harm the integrity of themarkets.

As noted above, the Exchange Act providesthe SEC with broad authority over the stockexchanges and the National Association ofSecurities Dealers (NASD), which together areknown as self-regulatory organizations (SROs).An SRO is a member organization that createsand enforces rules for its members based on thefederal securities laws. Among other things,SROs discipline and sanction their members, andestablish rules to ensure market integrity andinvestor protection, all under the oversight of theSEC. SROs are the first-line regulators of broker-dealers (as compared to investment advisers andinvestment companies, which do not presentlyhave an SRO).

A. Reporting obligations of public companies

A company becomes "public" under theExchange Act by, among other things, selling

securities to the public under a registrationstatement, or having more than $10 million inassets and more than 500 shareholders. 15 U.S.C.§ 78l(g); 17 C.F.R. §§ 240.12g-1, 240.15d-1.Once a company becomes public, it must beginfiling periodic reports as required by theExchange Act and related SEC rules. 15 U.S.C.§ 78m(a); 17 C.F.R. §§ 240.13a-1, 240.13a-11,240.13a-13. The periodic reports requiredisclosures about the company, its management,and its financial condition.

Once the periodic reports are filed, they areavailable to the public through the SEC's onlinedatabase called EDGAR. The accuracy of thesereports is important because investors baseinvestment decisions on information in thereports. Most of the recent high profile corporateand accounting fraud scandals involvedallegations that the companies had misledinvestors by including inaccurate financial andother information in periodic reports.

When a public company files a periodicreport that is later discovered to be materiallyinaccurate, the company generally must file thereport again with restated (accurate) information.The SEC's enforcement staff looks carefully atthese restated periodic reports because they areevidence that a prior report was inaccurate andcan be an indication that fraud has occurred.

The three main periodic reports that publiccompanies must file are the annual report onForm 10-K, the quarterly report on Form 10-Q,and the current report on Form 8-K. The annualreport on Form 10-K must be filed within ninetydays after the end of a company's fiscal year. (In2004 and 2005, the filing deadline for the 10-Kwill be shortened to seventy-five and sixty days,respectively, after the end of the company's fiscalyear.) The Form 10-K report is generally the mostdetailed of the periodic reports. It provides acomprehensive description of the company'sbusiness activities, plans, management, andfinancial condition. The Form 10-K requiresfinancial statements audited by an independentpublic accountant. As noted above, knowing andwillful false statements in any periodic report aresubject to criminal prosecution. 15 U.S.C. § 78ff.


The quarterly report on Form 10-Q must befiled within forty-five days after the end of acompany's first three quarters. (In 2004 and 2005,the filing deadline for the 10-Q will be shortenedto forty and thirty-five days, respectively, after theend of the company's first three quarters.) TheForm 10-Q provides quarterly updates of thecompany's business activities and financialcondition and is typically much less detailed thanthe Form 10-K. The Form 10-Q requires financialstatements that must be reviewed by anindependent auditor, but do not need to beaudited.

The current report on Form 8-K must be filedwithin five or fifteen days after the occurrence ofcertain events. The Form 8-K provides disclosuresabout important events or changes during the lifeof a company, such as bankruptcy, a merger, amajor acquisition, a change in the company'sindependent auditor, or a director's resignation.Under proposed new rules, the filing deadline willbe reduced to two days after the triggering event,and the list of triggering events will besignificantly expanded. As with restated periodicreports, the SEC's enforcement staff lookscarefully at certain Form 8-K reports because theycan be an indication that fraud or other significantproblems at a company have occurred. Forexample, a change in the company's independentauditor could indicate a material accountingproblem.

In addition to the disclosure obligations ofpublic companies, officers, directors, and largeshareholders of public companies have their owndisclosure obligations. 15 U.S.C. § 78m(d), 78p;17 C.F.R. §§ 240-13d-1, 240.16a-2, 240.16a-3.For example, these public company insiders mustreport their beneficial ownership of the company'sstock in public SEC filings and update theinformation if they buy or sell additional shares.Insiders sometimes seek to conceal theirownership or control of a company from thepublic by failing to file, or filing false ormisleading SEC reports, regarding theirstockholdings. In such cases, criminal chargesmay be brought if prosecutors can demonstratethat the insiders acted knowingly and willfully. 15U.S.C. § 78ff.

B. Accounting obligations of public companies

The Exchange Act requires public companiesto keep accurate books and records and maintain asystem of internal controls to provide reasonableassurances that financial transactions are properlyrecorded. 15 U.S.C. 78m(b)(2)(A), 78m(b)(2)(B).Although simply the failure to have adequatebooks and records or internal controls is not abasis for criminal prosecution, prosecutors maybring criminal charges against persons whoknowingly circumvent or fail to implement asystem of internal controls, or knowingly falsifybooks and records. 15 U.S.C. §§ 78m(b)(5).

Rule 13b2-2 under the Exchange Actprovides that civil and criminal charges may alsobe brought against a director or officer whomakes a materially false or misleading statementto an auditor in connection with any audit orexamination of the financial statements of areporting company. 17 C.F.R. § 240.13b2; 15U.S.C. § 78ff.

Another accounting-related provision isSection 30A of the Exchange Act. 15 U.S.C.78dd-1. Adopted in 1977 as part of the ForeignCorrupt Practices Act, Section 30A prohibitspublic companies from making improperpayments to foreign officials for the purpose ofinfluencing their decisions. These paymentsconstitute accounting fraud when the transactionsare inaccurately reflected in the company'sfinancial statements to conceal the impropernature of the payments.

C. Antifraud provisions of the Exchange Act

Section 10(b) and Rule 10b-5 are the generalantifraud provisions of the Exchange Act. 15U.S.C. § 78j(b); 17 C.F.R. § 240-10b-5. Thesesections prohibit fraud by any person inconnection with the purchase or sale of securitiesinvolving interstate commerce (in contrast withthe "offer or sale" language in Section 17(a) ofthe Securities Act). The language of Section 10(b)and Rule 10b-5 essentially mirrors the languageof Section 17(a) of the Securities Act inproscribing the use of a device, scheme, or artificeto defraud; the making of an untrue statement of amaterial fact, or the omission of a material fact


that results in a misleading statement; and actswhich would operate as a fraud or deceit.

Section 10(b) and Rule 10b-5 are undoubtedlythe most commonly charged provisions in bothcivil and criminal securities fraud cases. 15U.S.C. §§ 78j(b), 78ff; 17 C.F.R. § 240-10b-5.Because of their breadth, violations of thoseprovisions are typically alleged in virtually everytype of case brought by the SEC, including casesinvolving accounting fraud and other falsefinancial reporting, offering frauds, insidertrading, market manipulation, andmisappropriations of funds by brokers.

D. Effects of the Sarbanes-Oxley Act

On July 30, 2002, legislation known as theSarbanes-Oxley Act of 2002 became law.Sarbanes-Oxley has had, and will continue tohave, profound effects on the federal securitieslaws and civil and criminal enforcement of thelaws. Among other things, the Act created a newPublic Company Accounting Oversight Board,added more rigorous disclosure requirements forpublic companies, established new corporategovernance requirements, imposed new rules ofconduct and professional responsibility onattorneys, and significantly strengthened thecriminal penalties for securities fraud. Sarbanes-Oxley also added new weapons to the SEC'senforcement arsenal, including authority to seekofficer and director bars in federal court andadministrative cease and desist proceedings undera new, lower standard, the ability to freeze certainextraordinary payments before bringing an action,and authority to seek penny stock bars in federalcourt.

Sarbanes-Oxley also contains severalprovisions that may make it easier to bringcriminal charges in certain securities fraud cases.First, the Act created a new criminal offense forsecurities fraud. Section 807 of the Act, codifiedat 18 U.S.C. § 1348, makes it a crime "to defraudany person in connection with any security. . . ."A person convicted under this new statute issubject to imprisonment for up to twenty-fiveyears. This new securities fraud statute is similarto existing mail and wire fraud statutes and maymake it easier for AUSAs to charge securities

fraud because the new statute is less technicalthan the reporting and accounting provisionsunder the Exchange Act.

Second, Sarbanes-Oxley added three newobstruction of justice crimes that eliminate someof the more restrictive provisions of the pre-Sarbanes-Oxley obstruction statutes. 18 U.S.C.§§ 1512, 1519, 1520.

Finally, Section 906 of Sarbanes-Oxley,codified at 18 U.S.C. § 1350, requires chiefexecutive officers (CEOs) and chief financialofficers (CFOs) of public companies to certifythat their corporation's financial statements, filedin periodic reports, are accurate and comply withSEC reporting requirements. 18 U.S.C. § 1350.This new provision provides criminal liability forthose who knowingly or willfully certify a reportthat does not comport with the requirements.

VI. The Investment Advisers Act of 1940 andInvestment Company Act of 1940

The last two federal securities statutes wereenacted in 1940 to regulate investment advisersand investment companies. Investment advisersare in the business of giving investment advice toothers for compensation. Investment advisershave a fiduciary duty to their clients and mustalways act in the best interests of their clients.

An investment company is an entity in thebusiness of buying and selling securities. Mutualfunds are the most common type of investmentcompany. Those who manage and controlinvestment companies also have fiduciary dutiesto investors. Congress enacted the two 1940 Actsto address the unique business and fiduciaryduties of investment advisers and investmentcompanies. Under the 1940 Acts, all nonexemptinvestment companies and investment advisersmust register with the SEC and submit to SECregulatory inspections at any time.

Section 206 of the Investment Advisers Act of1940 (the Advisers Act) is the general antifraudprovision applicable to investment advisers. 15U.S.C. § 80b-6. Section 206 prohibits any director indirect transaction that acts as a fraud ordeceit on any client or prospective client (incontrast with the antifraud provisions of the


Exchange Act, which require that the fraud be inconnection with the purchase or sale ofsecurities). Although there is no antifraudprovision applicable specifically to investmentcompanies, most investment companies sellsecurities under the Securities Act, have securitiestraded under the Exchange Act, and are managedby an investment adviser subject to the AdvisersAct, all of which have antifraud provisions. Anyfraud by an investment company, therefore, wouldlikely be actionable under one of the othersecurities statutes.

Criminal prosecutions under Section 206 ofthe Advisers Act may be brought in a wide rangeof cases where an investment adviser defrauds ordeceives its clients. 15 U.S.C. §§ 80b-6, 80b-17.Examples include cases in which the advisermisappropriates client funds, deceives clientsabout the value of their investments, places itsown interests above those of the clients (such asby allocating profitable trades to its own accountand losing trades to the clients' accounts, ascheme known as "cherry-picking"), or engages inother types of self-dealing.

VII. Overview of the SEC's enforcementauthority

While there are many similarities between themanner in which the SEC enforcement staff andAUSAs investigate potential securities lawviolations, there are certain key differences inboth procedure and substance. This sectionprovides a very brief summary of the SEC'senforcement authority.

The SEC enforcement staff conducts bothinformal and formal investigations. An informalinvestigation may entail interviewing witnesses,reviewing trading data and records that regulatedentities are required to keep and produce, andobtaining and reviewing documents that variousother third parties voluntarily produce. A formalinvestigation, which must be authorized by theCommission itself, gives the SEC staff theauthority to issue subpoenas to compel sworntestimony and the production of documents. TheSEC, however, does not present evidence to agrand jury, immunize witnesses, engage in covertinvestigative methods, or execute search warrants.

When the SEC staff is prepared to recommend anenforcement action, it presents a detailedmemorandum to the Commission setting forth theapplicable facts and legal analysis. TheCommission must authorize any enforcementaction.

Under the securities laws, the SEC can bringan enforcement action either in federal court orbefore an SEC administrative law judge. Whenthe SEC brings a federal court action, it may seekan injunction (i.e., a federal court orderprohibiting someone from violating specifiedprovisions of the federal securities laws).Violations of an injunction can be addressed byeither a civil or criminal contempt action. As partof an injunctive action, the SEC can also seekcivil money penalties, disgorgement of ill-gottengains received by the securities violator, and anorder barring someone from serving as an officeror director of a public company, eitherpermanently or for a fixed period. When the SECbrings a federal court action to halt an ongoingfraud, it often seeks emergency relief in the formof a temporary restraining order, an order freezingassets, and the appointment of a receiver.

The SEC can also bring an enforcementaction in an administrative proceeding before oneof the SEC's five administrative law judges. In anadministrative action, the SEC staff may seek tosuspend or revoke a person's registration as abroker-dealer or investment adviser, bar a personfrom association with the securities industry,suspend or prohibit attorneys and accountantsfrom appearing or practicing before the SEC,suspend or bar a person from serving as an officeror director of a public company, obtain civilmoney penalties and disgorgement in the case of aregulated person or entity, and obtain a cease anddesist order against future violations.

VIII. Resources

One good resource for learning more aboutthe SEC and the federal securities laws is the SECwebsite at www.sec.gov. Among other things, thewebsite provides a link to the six statutes andrelated rules that constitute the federal securitieslaws (under the subtitle "About the SEC");information on recent SEC enforcement actions


(Litigation); access to the annual, quarterly, andother periodic reports of public companies(Filings & Forms [EDGAR]); recent speeches bythe SEC Chairman, Commissioners, and staff(News & Public Statements); and telephonecontact information for SEC headquarters andregional and district offices (About the SEC –Concise Directory). Finally, we encourageAUSAs with questions about the federalsecurities laws to contact your SEC counterpartsin the regional and district offices and the homeoffice.

IX. Conclusion

For seventy years, the federal securities lawshave provided a comprehensive regulatoryscheme to oversee the securities industry andprovide civil and criminal remedies against thosewho violate the laws. While the SEC is theprimary overseer and regulator of the U.S.securities markets, only the Department andUSAOs can criminally prosecute those whoviolate the federal securities laws. It is essential,therefore, for AUSAs who handle securities casesto gain an understanding of the securities lawsand of the SEC's role, responsibilities, andoperations. At the same time, the SEC standsready and willing to share its expertise andexperience to assist you in our joint mission toenforce the federal securities laws.�

ABOUT THE AUTHORS:

�Randall R. Lee is the Regional Director of thePacific Region of the SEC. In that capacity, Mr.Lee oversees the SEC's enforcement andregulatory programs in nine Western statesthrough offices in Los Angeles and SanFrancisco. Before joining the SEC in December2001, Mr. Lee was an Assistant United StatesAttorney for the Central District of California forseven and one-half years, where he served as aDeputy Chief of the Major Frauds Section. Hepreviously practiced corporate and securities lawat Munger, Tolles & Olson in Los Angeles.

�Andrew G. Petillon is an enforcement branchchief in the SEC's Pacific Regional Office (PRO)in Los Angeles, where he supervisesinvestigations of a wide range of securities lawviolations. He has been an SEC staff member forover seventeen years, as an enforcement staffattorney in the PRO, as an attorney in the PRO'sinvestment adviser and investment companyexamination program, and as an attorney in theSEC's Division of Corporation Finance inWashington, D.C.a

The SEC, as a matter of policy, disclaimsresponsibility for any private publication orstatement of any of its employees. The viewsexpressed herein are those of the authors and donot necessarily reflect the views of theCommission or any other staff members.

Sarbanes-Oxley: Broader Statutes–Bigger PenaltiesTom HanusikTrial Attorney, Fraud SectionU.S. Department of Justice

I. Introduction

The Sarbanes-Oxley Act of 2002 (the Act)became effective on July 30, 2002. PUB. L. NO.

107-204, 116 Stat. 745 (2002). The Act representsthe legislative response to the recent wave ofcorporate scandals that have plagued our capitalmarkets. This legislation supplies important newtools to federal prosecutors who enforce thenation's securities laws, while simultaneouslyincreasing the SEC's ability to punish corporate


officers and recoup ill-gotten gains. In addition,recent amendments to the UNITED STATES

SENTENCING GUIDELINES MANUAL (sentencingguidelines), adopted in response to the Act, makethe prospect of lengthy jail terms a reality forhigh-ranking corporate criminals.

The purpose of this article is to review threeaspects of the Act: (i) the new securities fraudcriminal provisions contained in 18 U.S.C.§§ 1348, 1349, and 1350; (ii) the recentamendments to the sentencing guidelines forcorporate criminals adopted in response to theAct; and (iii) the new regulatory powersconcerning corporate officers and directorsconferred on the Securities and ExchangeCommission (the SEC) by the Act. As explainedbelow, the Act changes the landscape forsecurities fraud investigations and prosecutionsby expanding the arsenal of weapons available toboth criminal and civil prosecutors. Thesechanges will make it easier for federal prosecutorsto bring securities fraud charges. Furthermore, theAct's increased penalty provisions andconcomitant amendments to the sentencingguidelines should serve as a significant deterrentto would-be corporate criminals.

II. New criminal securities fraud statutes

A. Securities fraud

The Act adds three new statutes to Title 18relevant to the federal criminal securities laws.The first, a general securities fraud statute,provides:

Whoever knowingly executes, or attemptsto execute, a scheme or artifice–

(1) to defraud any person in connectionwith any security of an issuer with a classof securities registered under section 12of the Securities Exchange Act of 1934(§ 15 U.S.C. 78l) or that is required to filereports under section 15(d) of theSecurities Exchange Act of 1934 (§ 15U.S.C. 78o(d)); or

(2) to obtain, by means of false orfraudulent pretenses, representations, orpromises, any money or property inconnection with the purchase or sale of

any security of an issuer with a class ofsecurities registered under section 12 ofthe Securities Exchange Act of 1934(§ 15 U.S.C. 78l) or that is required to filereports under section 15(d) of theSecurities Exchange Act of 1934 (§ 15U.S.C. 78o(d)); shall be fined under thistitle, or imprisoned not more than 25years, or both.

18 U.S.C. § 1348 (2002).

Aside from omitting the mailing and interstatewire requirements found in 18 U.S.C. §§ 1341and 1343 respectively, section 1348 goes a longway toward demystifying the formidable maze ofstatutes and regulations that constitute the Title15body of law under which securities fraudprosecutions are currently pursued. Practicallyspeaking, the new statute makes it easier to bringthese cases by omitting the willfulnessrequirement found in the criminal provisions ofthe Securities and Exchange Act of 1934 (the '34Act), 15 U.S.C. § 78a, et seq. (1996). Requiringthat securities fraud schemes be executedknowingly, rather than willfully, should makesecurities fraud charges more palatable to federalprosecutors who have extensive experiencecharging knowing violations in mail, wire, andbank fraud cases. In addition, eliminating thewillfulness requirement also removes apotentially confusing jury instruction. Althoughsection 1348 cites Title 15 for jurisdictionalpurposes, the bottom line is that it will apply tosecurities fraud in connection with the stock ofcompanies that trade on the New York andAmerican Stock Exchanges, as well as those thatare required to file periodic reports with the SEC.

Another benefit of section 1348(1) is that itomits the '34 Act requirement that the fraudscheme occur "in connection with the purchase orsale" of a security. Section 1348(1) requires onlythat the scheme occur in connection with asecurity. In light of the Supreme Court's decisionin SEC v. Zandford, which held that a schemewhich coincides with a purchase or sale of asecurity satisfies the "in connection with"requirement, this change may amount to adistinction without a difference. SEC v. Zandford,535 U.S. 813 (2002). Nonetheless, prosecutors


have one less hurdle to clear by eliminating thepurchase or sale requirement. The broaderlanguage of section 1348(1) will also encompass anumber of fraudulent and deceptive practices thatutilize pledges of securities and hedgingmechanisms, regardless of whether or not there isan actual purchase or sale of a security. Inaddition, by focusing on the scheme to defraudrather than some technical books and records orinternal control violations, section 1348(1) shouldenable federal prosecutors to stay focused, and getjuries focused, on the underlying fraud withoutbeing distracted by potential defenses to technicalviolations. Finally, for those cases wheredishonest means are used to deprive investors ofmoney and property in connection with securitiestransactions, section 1348(2) still retains thepurchase or sale language.

Section 1348 also increases the statutorymaximum for securities fraud to twenty-five yearsin jail. Prior to Sarbanes-Oxley, securities crimesprosecuted under Title 15 carried a statutorymaximum of ten years. Although Sarbanes-Oxleyincreased the Title 15 maximum to twenty years,section 1348 provides the longest potential jailterm for people convicted of securities fraud. 15U.S.C. § 78ff.

B. Attempts and conspiracies

Another new fraud provision in Title 18 is theattempt and conspiracy statute that is codified atsection 1349:

Any person who attempts or conspires tocommit any offense under this chaptershall be subject to the same penalties asthose prescribed for the offense, thecommission of which was the object ofthe attempt or conspiracy.

18 U.S.C. § 1349 (2002).

Section 1349 is important in three respects.First, it does not contain an overt act requirement.Thus, there is one less element of proof thanrequired by a conspiracy charge under 18 U.S.C.§ 371. Second, conspiracies charged under section1349 carry the maximum penalty for theunderlying substantive offense, rather than thefive-year maximum contained in section 371.

Notably, this applies to all conspiracies thatviolate Chapter 63 offenses. Thus, conspiraciescharged under section 1349 now carry a twentyyear term if they involve mail and wire fraud, athirty year term if they involve bank fraud oraffect a financial institution, and a twenty-fiveyear term if they involve securities fraud undersection 1348. Finally, section 1349 is important inthat it does not displace section 371 entirely.Thus, in cases where the facts and circumstanceswarrant a five year cap on exposure toincarceration, section 371 conspiracies to violateany fraud statute can still be charged. In addition,section 371 will have to be used when one of theobjects of the conspiracy is something other thana Chapter 63 offense, such as obstruction ofjustice.

C. False certifications of financial statements

The final new securities fraud provisionadded by Sarbanes-Oxley to Title 18 is found insection 1350 and addresses certifications offinancial statements by CEOs, CFOs, andequivalent officers:

(a) Certification of periodic financialreports. –Each periodic report containingfinancial statements filed by an issuerwith the Securities Exchange Commissionpursuant to section 13(a) or 15(d) of theSecurities Exchange Act of 1934 (§ 15U.S.C. 78m(a) or § 78o(d)) shall beaccompanied by a written statement bythe chief executive officer and chieffinancial officer (or equivalent thereof) ofthe issuer.

(b) Content. –The statement requiredunder subsection (a) shall certify that theperiodic report containing the financialstatements fully complies with therequirements of section 13(a) or 15(d) ofthe Securities Exchange Act and thatinformation contained in the periodicreport fairly presents, in all materialrespects, the financial condition andresults of operations of the issuer.

(c) Criminal penalties.– Whoever –


(1) certifies any statement as set forth insubsections (a) and (b) of this sectionknowing that the periodic reportaccompanying the statement does notcomport with all the requirements setforth in this section shall be fined notmore than $1,000,000 or imprisoned notmore than 10 years, or both; or

(2) willfully certifies any statement as setforth in subsections (a) and (b) of thissection knowing that the periodic reportaccompanying the statement does not

comport with all the requirements set forth in thissection shall be fined not more than $5,000,000,or imprisoned not more than 20 years, or both.

18 U.S.C. § 1350 (2002). Aside from explicitlyrequiring that CEOs, CFOs, and similar officerscertify the accuracy of financial statements ofpublicly traded companies, section 1350 isimportant in that it draws a distinction betweenknowing violations, which carry a $1,000,000 fineand ten year jail terms, and willful violations,which carry a $5,000,000 fine and twenty year jailterm.

Although it is difficult to practicallydemonstrate the legal ramifications of section1350's distinction between knowing violationsand willful violations, the Supreme Court heldthat "willful" has different meanings and "itsconstruction [is] often . . . influenced by itscontext." Ratzlaf v. United States, 510 U.S. 135,141 (1994). In the context of section 1350, it isclear that Congress intended to draw a distinctionbetween those who knowingly certify falsefinancials and those who willfully do so–adistinction that has a difference of up to ten yearsin jail. In practice, this distinction will fall almostentirely into the realm of prosecutorial discretion.Federal prosecutors using section 1350 will haveto exercise discretion when differentiatingbetween corporate officers who act knowinglyand willfully. That discretion should includeconsideration of the level of culpability andresponsibility of the putative defendant. Sinceboth provisions apply only to senior-levelofficers, the different exposure levels betweensections 1350(c)(1) and 1350(c)(2) providefederal prosecutors an opportunity to distinguish

between the corporate officer who knows that acompany's financial statements are misleading butnevertheless certifies them, and the corporateofficer who causes the financial statements to bemisleading and also certifies them.

III. Amendments to the United StatesSentencing Guidelines

The most significant practical change in howcorporate criminals will be treated underSarbanes-Oxley can be found in the recentamendments to the sentencing guidelines. WhenCongress passed Sarbanes-Oxley, it directed theUnited States Sentencing Commission to developmodifications to, inter alia, the fraud guidelineswithin 180 days of the Act's enactment. Inresponse, the United States SentencingCommission adopted a series of temporaryguideline modifications for fraud cases whichbecame effective January 25, 2003. See U.S.SENTENCING COMMISSION SUPPLEMENT TO THE

2002 GUIDELINES MANUAL.

The net effect of these amendments is that acorporate officer or director who is convicted ofsecurities fraud, in a case that has more than 250victims and that jeopardizes the solvency of theissuer, is exposed to eight additional points forsentencing guideline calculation purposes. Forexample, consider the CEO who is convicted ofsecurities fraud with a total loss to the company's300 investors of $500,000 in a case where thecompany filed for Chapter 11 bankruptcyprotection following revelations of themisconduct. As demonstrated in the followingchart, this corporate felon's exposure jumps froma 78-97 month range to a 188-235 month rangeunder the amended guidelines. Both of theseranges increase proportionately if furtheradjustments apply under U.S. SENTENCING

GUIDELINES MANUAL § 3B1.1 (2002) foraggravating role. Considering that $500,000losses in securities fraud cases are not infrequent,and that most public companies have well inexcess of 300 investors (i.e., potential victims),these guideline amendments will have asignificant impact on the ongoing effort to crackdown on corporate crime. Pursuant to anotheramendment found in the U.S. SENTENCING

GUIDELINES MANUAL § 2B1.1 (2002), courts


TableImpact of Sarbanes-Oxley on Sentencing

2002 Guidelines: Sarbanes-Oxley Amendments:

§ 2B1.1(a) base level 6 § 2B1.1(a) base level 6

§ 2B1.1(b) (1) loss +14 § 2B1.1(b) (1) loss +14

§ 2B1.1(b) (2)(B) >50 victims +4 § 2B1.1(b) (2)(C) >250 victims +6

§ 2B1.1(b) (8) sophisticated means +2 § 2B1.1(b) (8) sophisticated means +2

-- § 2B1.1(b)(12)(B) substantially endangerssolvency of (i) a public company, (ii) acompany with more than 1000 employeesor (iii) more than 100 victims

+4

§ 3B1.3 abuse of position of trust +2 § 2B1.1(b)(13) securities fraud byofficer/director

+4

Total Offense Level 28 Total Offense Level 36

Criminal History Category I = 78-97 months Criminal History Category I = 188-235 months

should consider "[t]he reduction that resultedfrom the offense in the value of equity securitiesor other corporation assets" when making lossdeterminations at sentencing. See U.S.SENTENCING COMMISSION SUPPLEMENT TO THE

2002 GUIDELINES MANUAL § 2B1.1., cmt. n.2(c)(iv) (2003).

The guideline amendment's first two-pointadjustment, or upgrade, applies in cases wherethere are more than 250 victims. Under the oldguidelines, cases with more than fifty victimswould result in a four-point upward adjustment tothe offense level. The amendments retain thisfour-point adjustment and add a new-six pointadjustment for cases with more than 250 victims,for a net increase of two points in cases with morethan 250 victims.

The next guideline amendment adds a specific

offense characteristic worth four points to theoffense level in cases where the crimesubstantially endangers the solvency of: (i) apublicly traded company; or (ii) a privatecompany with more than 1000 employees; or (iii)more than 100 victims. See U.S. SENTENCING

COMMISSION SUPPLEMENT TO TH E 2002GUIDELINES MANUAL § 2B1.1(b)(12)(B) (2003).This amendment expands the existing adjustmentfor crimes which jeopardize the solvency of banksand applies it to all large and/or publicly tradedcompanies. Notably, the nonexhaustive list offactors for courts to consider in determiningwhether financial solvency has been endangeredincludes: (i) whether the company has becomeinsolvent or suffered a substantial reduction in thevalue of its assets; (ii) whether the company hasfiled for bankruptcy; (iii) whether the company'sstock or retirement accounts have experienced a


substantial reduction in value; (iv) whether thecompany has substantially reduced its workforce;(v) whether the company has substantiallyreduced pension benefits; and (vi) whether tradingin the company's stock has been halted and/or thestock has been de-listed. U.S. SENTENCING

COMMISSION SUPPLEMENT TO TH E 2002GUIDELINES MANUAL § 2B1.1(b)(12)(B), cmt. n.10(B)(ii) (2003 ).

Finally, the Sentencing Commission added anew offense characteristic worth four points foroffenses involving violations of the securitieslaws that are committed by officers and/ordirectors of publicly traded companies. U.S.SENTENCING COMMISSION SUPPLEMENT TO THE

2002 GUIDELINES MANUAL § 2B1.1(b)(13)(2003). Since this is a specific offensecharacteristic, the net effect for sentencingpurposes will be two additional points since thetwo-point adjustment for abuse of trust found inU.S. SENTENCING GUIDELINES MANUAL § 3B1.1(2002) will be mooted. U.S. SENTENCING

COMMISSION SUPPLEMENT TO TH E 2002GUIDELINES MANUAL § 2B1.1(b)(12)(B), cmt. n.11(C) (2003). However, this adjustment applies toall securities laws violations, including theaforementioned Title 18 statutes and the Title 15violations of the SEC's rules and regulations. U.S.SENTENCING COMMISSION SUPPLEMENT TO THE

2002 GUIDELINES MANUAL § 2B1.1(b)(12)(B),cmt. n. 11(B) (2003). In addition, this adjustmentwill apply to an officer or director convictedunder a general fraud statute whose conduct alsoviolates the securities laws. Id. Thus, federalprosecutors should keep this adjustment in mindwhen negotiating plea agreements that containguidelines stipulations since it can be used in mailand wire fraud cases and should be easier to proveat sentencing where the lower preponderance ofthe evidence standard applies.

IV. New SEC enforcement powers

In addition to the new criminal provisionsdiscussed above, the Act also provides significantnew enforcement powers to the SEC–three ofwhich are discussed herein. These new powershave the potential to significantly impact thedirection and progress of a parallel SEC civilinvestigation, which can, in turn, influence the

pace and direction of a criminal case. The SEC'snew powers fall into three areas: (i) lowerstandards for officer and director bars (O&Dbars); (ii) the ability to request a freeze ofextraordinary payments to officers and directorsin certain circumstances; and (iii) new forfeiturepowers in situations where earnings restatementsresult from misconduct.

Before the Act the SEC had the power topetition federal district courts to get officers anddirectors barred from serving in such capacitieswhen they commit fraud violations under eitherSection 17(a)(1) of the Securities Act or Section10(b) of the Exchange Act. The Act enhances theSEC's ability to seek O&D bars in two importantrespects. First, the SEC can now seek O&D barsin administrative proceedings, which means theadministrative law judges who have specificexpertise in securities fraud cases will be makingthese determinations. 15 U.S.C. §§ 77h-1, 78u-3.Second, the standard for an O&D bar has beenlowered by the Act from "substantially unfit" to"unfit." 15 U.S.C. §§ 77t(e), 78u(d)(2). While theprecise parameters of this new standard have notyet been litigated, it is clear that Congress hasreduced the standard for an O&D bar.

The Act also enhances the SEC's power topreserve a company's assets for the benefit ofdefrauded shareholders. Under section 1103 ofthe Act, the SEC can, in certain circumstances,petition federal courts to freeze extraordinarypayments to any director, officer, partner,controlling person, agent, or employee of acompany during an investigation. 15 U.S.C.§ 78u-3(c). The initial freeze order lasts for forty-five days and can be extended another forty-fivedays for good cause shown, or until the resolutionof a case if the SEC files charges. Id.

Another enhancement of the SEC'senforcement powers is provided by Section 304 ofthe Act and applies in situations where a companyrestates financial results due to "materialnoncompliance" resulting from "misconduct." 15U.S.C. § 7243. In these situations, whichgenerally occur when a company restatesfinancial results because of "accountingirregularities", the SEC can force the company'sCEO and CFO to forfeit bonuses, as well as


profits from trading in the company's stock, thatthey received within twelve months of the filingthat is being restated. Id. Notably, there is norequirement that the CEO and/or CFO be shownto have engaged in the misconduct at issue inorder for the SEC to enforce this new power. Id.

While the SEC's new powers are not availableto criminal prosecutors, the reality is that mostsecurities fraud investigations proceed on parallelcriminal and civil tracks, with a large amount ofcooperation between the SEC and Department ofJustice. Thus, an understanding of the SEC'spowers will assist the cooperative lawenforcement effort, especially when decisions arebeing made concerning attempts to freeze andforfeit fraud proceeds.

V. Conclusion

Sarbanes-Oxley has the potential tosignificantly enhance the federal prosecutor'sefforts to combat corporate crime. Broaderstatutes like section 1348, which focuses on thescheme to defraud, go a long way towarddemystifying an otherwise daunting maze ofsecurities fraud statutes and regulations. Increasedpenalties in the statutes, and concomitant offensecharacteristic adjustments in the guidelines,should help deter illegal conduct and inducecooperation after illegal conduct occurs. Inaddition, new enforcement powers at the SEC willenhance the effectiveness of parallelinvestigations between civil and criminalauthorities. Taken together, these changesrepresent important steps in the effort to protectour capital markets and restore investorconfidence, by cracking down on corporatefraud.�

ABOUT THE AUTHOR

�Tom Hanusik is a Trial Attorney with theFraud Section of the Criminal Division and amember of the Enron Task Force. Prior to joiningthe Department, he was Senior Counsel in theSEC’s Division of Enforcement.a

Cooking the Books: Tricks of theTrade in Financial FraudJoseph W. St. DenisAssistant Chief Accountant United States Securities and ExchangeCommission, Division of Enforcement

I. Introduction

In December 2001, Enron declaredbankruptcy as the many aspects of that scandalwere beginning to come to light. In the Report ofthe Powers Committee and a series of televisedcongressional hearings throughout the spring and

summer of last year, the mind-bogglingcomplexity of the Enron debacle was revealed toan incredulous and outraged public. As the Enronstory unfolded, other formerly high-flying largecapitalization public companies seemed to becollapsing under accounting scandals on adisturbingly regular basis.

High-profile corporate collapses during thelast eighteen months have caused the public, andmany in government and the financial servicesindustry, to question the soundness of the


financial reporting system. Generally acceptedaccounting principles (GAAP), the principleswhich govern accountants in the preparation offinancial statements, and generally acceptedauditing standards (GAAS), which provide aframework for the conduct of audits, are underfire for their apparent failure to detect and preventfraud. Some commentators have opined thatEnron's allegedly fraudulent financial statements,for example, would have been in conformity withGAAP had certain related-party disclosures beenmore complete, or had an independent investor'sownership of a special purpose entity (SPE) beena few tenths of a percentage point higher. Asrecently as February 24, 2003, NEW YORK TIMES

reporter Kurt Eichenwald told a nationaltelevision audience that "Enron complied with theletter of the law" in its financial reporting. SeeKudlow and Kramer (MSNBC televisionbroadcast, February 24, 2003).

These assertions seem somewhatdisconnected from real world events, given thepace and scale of criminal indictments and civilenforcement actions in the Enron matter andothers. One possible explanation for this is thatthe conclusions drawn by some commentatorsseem to be based on the assumption that GAAP isa system of binary rules that provides a clear "yesor no" answer to any conceivable question arisingin the preparation of financial statements, and thatGAAS is essentially a compliance checklist.Nothing could be further from the truth. Thepresumption that GAAP and GAAS are purelyrules-based systems is a questionable place tobegin an assessment of the financial reportingsystem or a financial fraud investigation. In fact,although there are certain "bright line" rules, theyare intended to provide minimum standards, notto function as hard and fast rules. In fact, GAAPand GAAS are essentially principles-basedsystems that require thousands of judgments to bemade by human beings in the preparation andaudit of financial statements, and the twoprocesses are inseparable in providing relevantand reliable financial information to investors.

This suggests three topical areas of interestfor prosecutors:

• GAAP and GAAS, being principles-based,must reflect the economic substance oftransactions rather than their form; therefore,a defendant's use of a technical "rules"defense is not necessarily insurmountable incases where there have been materiallymisstated financial statements.

• The audit process, being integral to financialreporting, is unlikely to exist in a free-floatingstate apart from or oblivious to fraud;therefore, large-scale financial fraud oftenrequires the participation and cooperation ofthose parties who hold an interest. These"stakeholders" to financial fraud can includeboards of directors, auditors, attorneys,customers, and suppliers, as well asmanagement. Although this article dealsprimarily with the auditor's responsibility, other actors are often involved.

• Certain recurring fact patterns haveestablished themselves over the years asdominant themes in financial fraud and thesepatterns can be expected to appear in thefuture.

II. Substance vs. form

In the post-Enron environment, the idea that acompany can manipulate GAAP such that it doesnot engage in bright-line rule violations, but stillpresents materially misleading financialstatements to its investors, has gained broadacceptance. Some prosecutors may feel this is anovel charging theory, but from an accountant'sviewpoint, it is a return to the profession's roots.Form over substance arguments, while popular inthe media and with the defense bar, do not cutmuch ice with the SEC or other law enforcementauthorities these days. As far as the accountingand auditing profession is concerned, theargument was settled long ago.

In fact, the greatest advantage of the currentsystem to financial statement users is its emphasison substance over form. The accounting literatureis replete with references to the importance of thisconcept. A couple of brief examples of thisinclude the following:

• "Substance over form is an idea that also hasits proponents, but it is not included because


it would be redundant. The quality ofreliability and, in particular, ofrepresentational faithfulness leaves no roomfor accounting representations thatsubordinate substance to form." QUALITATIVE

CHARACTERISTICS OF ACCOUNTING

INFORMATION, Statement of FinancialAccounting Concepts No. 2 ¶ 160 (FinancialAccounting Standards Bd. 1980). ["Con 2"].

• "Generally accepted accounting principlesrecognize the importance of reportingtransactions and events in accordance withtheir substance. The auditor should considerwhether the substance of transactions orevents differs materially from their form."THE MEANING OF 'PRESENT FAIRLY IN

CONFORMITY WITH GENERALLY ACCEPTED

ACCOUNT PRINCIPLES', Statement on AuditingStandards No. 69, AU § 411.06 (AmericanInst. of Certified Pub. Accountants 1992).["SAS 69"].

• "Because of developments such as newlegislation or the evolution of a new type ofbusiness transaction, there sometimes are noestablished accounting principles forreporting a specific transaction or event. Inthose instances, it might be possible to reportthe event or transaction on the basis of itssubstance by selecting an accountingprinciple that appears appropriate whenapplied in a manner similar to the applicationof an established principle to an analogoustransaction or event." Id.

• With respect to related party transactions: "Inaddition, the auditor should be aware that thesubstance of a particular transaction could besignificantly different from its form and thatfinancial statements should recognize thesubstance of particular transactions ratherthan merely their legal form." RELATED

PARTIES, Statement on Auditing StandardsNo. 45, AU § 334.02 (American Inst. ofCertified Pub. Accountants 1983). ["SAS45"].

Starting from the perspective that financialstatements should fairly present the economicsubstance of a company's activities, consider ahypothetical situation in which a clever

accountant, attorney, or MBA, creates a set offinancial statements that technically comply withevery specific rule in the GAAP literature, but arenot fairly presented and, therefore, not inconformity with GAAP. If investigators andprosecutors begin this case looking for bright-linerule violations, they will be met at every turn withan explanation of how each transaction compliedwith the letter of the law. Instead of starting aninvestigation looking for specific, tangible ruleviolations, prosecutors should seek to understandhow the tools of financial fraud were employed inan overall scheme to enrich management andothers. Consider how other parties to the fraud(auditors, customers, banks, etc.) may haveparticipated or cooperated and what they stood togain. Remember that cooperation can be active (acustomer signs a false accounts receivableconfirmation) or passive (auditors willfully ignorered flags or employ tortured logic to explain theunexplainable).

III. The audit process

The audit process includes more than thework performed by the auditing firm; it involvesthe whole corporate governanceinfrastructure–board of directors, auditcommittee, internal audit (if applicable), and anyother compliance-related activities. The auditcommittee of the board of directors is ultimatelyresponsible for the integrity of the audit process.However, there are specific standards withinGAAS that compel auditors to assert themselvesin situations where there are warning signs offinancial fraud, in order to fulfill their legal andethical obligations. Some in the auditingprofession claim that audits are not designed todetect fraud. It is true that audits are not designedto detect activities such as embezzlement, forgery,and counterfeiting. However, in examining someof the major frauds of the recent past, it isapparent that the audit process was adequate todetect many of these schemes, and in many casesit did. The American Institute of Certified PublicAccountants occasionally publishes statisticsindicating that a small percentage of frauds aredetected in the audit process. This seems at oddswith the experience of the Securities andExchange Commission (SEC) staff, which is thatauditors were often aware at some level that fraud


was being perpetrated, but failed to take theproper steps to investigate and report it. If afinancial fraud scheme, like those discussedbelow, is addressed by an auditing standard andyet continues undeterred, the prosecutor shouldask why the auditors failed to act. Was itincompetence or inexperience? Were the auditorsprotecting a lucrative fee arrangement, or werecompromised decisions made in the past toadvance their careers?

GAAS and the securities laws requireauditors to assess the risk of fraud and respond tored flags. Among the risk factors for financialreporting fraud cited in the auditing literature isthe presence of:

• A significant portion of management'scompensation represented by bonuses, stockoptions, or other incentives, the value ofwhich is contingent upon the entity achievingunduly aggressive targets for operatingresults, financial position, or cash flow;

• An excessive interest by management inmaintaining or increasing the entity's stockprice or earnings trend through the use ofunusually aggressive accounting practices;

• Domination of management by a singleperson or small group without compensatingcontrols such as effective oversight by theboard of directors or audit committee;

• Management setting unduly aggressivefinancial targets and expectations foroperating personnel;

• Management displaying a significantdisregard for regulatory authority;

• Domineering management behavior in dealingwith the auditor, especially involving attemptsto influence the scope of the auditor's work;

• Inability to generate cash flows fromoperations while reporting earnings andearnings growth;

• Significant, unusual, or highly complextransactions, especially those close to yearend, that pose difficult "substance over form"questions.

At the conclusion of the assessment, auditorsare required to design appropriate procedures toaddress the risks. If auditors discover that there ispossible material fraud, they are required to reportit to senior management and the audit committee.See CONSIDERATION OF FRAUD IN A FINANCIAL

STATEMENT AUDIT , Statement on AuditingStandards No. 82, AU § 316.17 (AmericanInstitute of Certified Public Accountants 1997)["SAS 82"]. Further, the securities laws compelauditors to report possible material fraud to theaudit committee, which is then required to advisethe SEC. See Securities Exchange Act, 15 U.S.C.78b § 10A(b)1.

IV. There are a thousand ways to cook thebooks, but only a few basic ingredients

To employ a culinary metaphor, there is apractically unlimited variety of recipes forfinancial fraud, but they all contain the same basicingredients. Howard Schillit has referred to theseas "shenanigans," and they include recordingbogus revenue, boosting income with one-timegains, and failure to record or disclose allliabilities. See HOWARD SCHILLIT, FINANCIAL

SHENANIGANS AT X, (McGraw Hill. 1st ed. 1993).An earlier article, David L. Anderson & JosephW. St. Denis, Investigating Accounting Frauds,USA Bulletin March 2002, at 3 includes a morecomplete discussion of these basic tools offinancial fraud. All of the patterns in publiccompany financial reporting fraud employ somecombination of these basic tools. Following aresome examples of common patterns.

A. Earnings management

The term earnings management refers to theintentional manipulation of a company's revenuesand/or expenses through the use of accruals orreserve accounts. This involves some combinationof shifting current expenses to future periods,shifting current income to future periods, andshifting future expenses to the current period.Some common examples of the accounts used arereserves for litigation, bad debts, returnedproduct, and environmental remediation. Earningsmanagement can also occur through manipulationof unearned revenue accounts and, one of thelargest areas of past abuse, restructuring reserves.In the case of restructuring reserves, large reserve


increases are characterized as "one-time charges"and then later released to supplement reportedincome from operations. Improper manipulationof these accounts takes place because theirbalances are based on estimates, an area in whichGAAP is perceived by many to be vague.

Accounting for reserves, known in theaccounting literature as "loss contingencies," iscontrolled by ACCOUNTING FOR CONTINGENCIES,Statement of Financial Accounting Standards No.5 (Financial Accounting Standards Bd. 1975)[SFAS 5]. SFAS 5 states that in order for a losscontingency to be accrued, it must be probablethat the loss has occurred at the date of thefinancial statements, and the amount of the lossmust be reasonably estimable. See SFAS 5 ¶8.SFAS 5 says nothing about how to make ordocument estimates. Too often this has led to theconclusion that the lack of guidance in this area ofthe accounting literature meant that accountingestimates could be whatever was wanted orneeded, and that the documentation could consistof a few stray thoughts or a conversation in thehallway. This approach is too easily manipulatedand should never survive the audit process, yet itis disturbingly common.

Indeed, auditors are required by GAAS toobtain and document sufficient competentevidential matter to support their audit of thefinancial statements. See EVIDENTIAL MATTER,Statement on Auditing Standards No. 31, AU§ 326.01 (American Inst. of Certified Pub.Accountants 1980) [SAS 31]. With respect toestimates, this means that auditors are required toobtain an understanding of how managementdevelops estimates supporting reserve accountsand then apply one or more of the following tests:

• Review and test the process used bymanagement to develop the estimate;

• Develop an independent expectation of theestimate to corroborate the reasonableness ofmanagement's estimate;

• Review subsequent events or transactionsoccurring prior to the completion offieldwork.

See AUDITING ACCOUNTING ESTIMATES,Statement on Auditing Standards No. 57, AU

§ 342.10 (American Inst. of Pub. Accountants1989).

Additionally, the federal securities lawsrequire issuers to "make and keep books, records,and accounts, which in reasonable detail,accurately and fairly reflect the transactions anddispositions of the assets of the issuer." SecuritiesExchange Act of 1934 (Exchange Act); 15 U.S.C.78b § 13(b)(2)(a). The SEC has pulled togetherthe concepts of "probable and reasonablyestimable" from SFAS 5 and "reasonable detail"from the Exchange Act in recent enforcementactions involving improper estimates. In June of2002, the SEC found that Microsoft Corporation:

recorded and adjusted its reserve accounts inways not permitted under GAAP in itsquarterly and annual filings. To a materialextent, these reserve accounts lacked factuallysubstantiated bases, and were thereforeimproper. The limited and inadequatedocumentation that Microsoft created withrespect to these reserve accounts either didnot substantiate any permitted basis for theaccounts or indicated that the accounts wereimpermissible under GAAP.

In the Matter of Microsoft Corporation,Accounting and Auditing Enforcement Release[AAER] No. 1563 at 9 ["Microsoft Action"]. TheMicrosoft Action made clear the SEC's positionthat undocumented reserve accounts that cannotbe explained and audited at a reasonably detailedlevel are in violation of the federal securitieslaws. When unsupported reserves are used tomake a failing company appear successful, that isfraud.

Here are a couple of other points aboutreserves. First, GAAP does not allow the accrualof reserves for future losses, no matter what thelikelihood. A common example of this is where acompany knows with absolute certainty that itwill incur losses when a foreign governmentchanges a currency exchange rate. Although itmay be known with 100% certainty that thechange will be made and how much it will affectthe company's results, it has not happened yet andcannot be accrued until it is incurred. Second,judgments that are not reducible to paper cannotbe reasonably estimable. Experienced managers


often feel that their undocumented judgment orgut feeling is the most accurate way to estimatereserves. They may be right. However, gut-levelor purely intuitive estimates do not meet theGAAP standard of probable and reasonablyestimable and are, therefore, improper. Further,GAAP requires that methods of estimation mustbe consistent and any material change in themethod of calculation must be disclosed toinvestors. See QUALITATIVE CHARACTERISTICS OF

ACCOUNTING INFORMATION, Statement ofFinancial Accounting Concepts No. 2 (FinancialAccounting Standards Bd. 1980).

B. Cherry picking

Cherry picking involves the creativeapplication of boosting income with one-timegains and failing to record or disclose allliabilities. Wall Street investment banks and largeaccounting firms made billions of dollars duringthe last bull market selling structured financedevices to their clients. The world of structuredfinance is full of sophisticated vehicles such assynthetic leases, special-purpose entities, andunconsolidated subsidiaries. Most of theseconcepts come out of capital-intensive, regulatedindustries such as utilities, where they are used toincrease access to capital. Structured finance alsouses derivatives, such as options, futures, andinterest rate swaps, to spread risk. When properlyused, structured finance provides a valuable riskmanagement tool that can reduce costs andprovide stability. However, more recently thesedevices have become popular with companies ofdubious intent, Enron being the most notorious.

In the 1980s, before the proliferation ofstructured finance, the energy industry wasextremely innovative in the use of limitedpartnerships for tax avoidance. Oil and gascompanies, in particular, set up hundreds andsometimes thousands of layered limitedpartnerships in a shell-game to disguiseownership and take advantage of tax loopholes. Inthe 1990s, companies like Enron combinedstructure finance with limited partnerships toallow them to present a highly engineered andextremely flattering view to investors. Enron hadover 2,500 subsidiaries. Through a myriad oflegal agreements, Enron arranged its assets,

liabilities, and income streams, such that debt andlosses were placed in unconsolidated subsidiaries,and gains and income were placed in consolidatedsubsidiaries. For example, Enron used mark-to-mark accounting to generate income on energysupply contracts in its consolidated wholesaledivision, while losses on its merchant investmentportfolio were siphoned into the unconsolidated(off-balance sheet) Raptor structure. See WilliamPowers, Jr., Chair, Report of Investigation by theSpecial Comm. of the Bd. of Directors (Feb. 1,2001) (Powers Report). Therefore, Enron'sfinancial statements presented only part of thepicture. This is the essence of a cherry pickingstrategy.

Some of the more mundane schemes of cherrypicking involve simply failing to properly classifyand disclose bank loans. The last few years haveseen an increase in the use of receivablesfactoring. This is a transfer of amounts due to acompany to a bank or other third party, inexchange for cash. If the transaction is properlyexecuted, i.e. the receivable is proper and thetransferee assumes all of the risks associated withcollection, the receivable can be removed fromthe balance sheet, and the cash received from thepurchaser can be included in the cash flows fromthe operations section of the statement of cashflows. However, if there is any guarantee by thecompany selling the receivable that it willrepurchase or otherwise "make whole" thepurchaser, it should be presented on the balancesheet as a loan, and the receivable should remainon the books. See ACCOUNTING FOR TRANSFERS

AND SERVICING OF FINANCIAL ASSETS AND

EXTINGUISHMENTS OF LIABILITIES, Statement ofFinancial Accounting Standards No. 140,(Financial Accounting Standards Bd. 2000).Moreover, the statement of cash flows shouldpresent the proceeds in the cash flows from thefinancing activities section.

A good example of just such a scheme is thatof Peregrine Systems, Inc. ("Peregrine"). TheSEC filed a complaint against Peregrine's treasurymanager on November 25, 2002, alleging"Peregrine management engaged in a myriad ofdeceptive sales and accounting practices to createthe illusion of growth, including secretly addingmaterial sales contingencies to what appeared on


their face to be binding contracts." See Securitiesand Exchange Commission v. Ilse Cappel, C.A.,No. 02 CV 2310 JM (LSP) (S.D. Cal. November25, 2002). Peregrine allegedly sold some of thesecontingent receivables to banks in order to reduceits day sales outstanding (DSO), an importantfinancial metric for analysts, and agreed tocompensate the banks for any amounts that werenot collectible. Effectively, Peregrine retained allof the risks associated with collecting thereceivables. When the receivables were sold,Peregrine removed them from the accountsreceivable line on its balance sheet, reducingDSO. Further, Peregrine did not recognize aliability for the amount received from the banks.In November of 2002, Peregrine's treasurymanager pled guilty to bank fraud.

Auditors are almost always complicit in acherry picking strategy because such schemesusually involve aggressive interpretations ofGAAP, along with lack of disclosure. This, morethan any other pattern, relies on form oversubstance. Although one would hope this ischanging, companies found in recent years thatthey could often convince their auditors to accepta highly liberal, self-serving interpretation ofGAAP for each individual transaction. Naturally,these transactions often accumulated into anunfair portrayal in the financial statements. Insuch cases, prosecutors should pay particularlyclose attention to the auditor's fraud riskassessment and compliance with SAS 82.

C. Channel stuffing

Channel stuffing refers to the practice ofpushing inventory into the "channel," whichgenerally consists of a network of distributors orresellers. By itself, channel stuffing is notnecessarily fraudulent. In fact, there arecircumstances in which loading up resellers withinventory makes good business sense. Forexample, when a company introduces a newproduct, it may be perfectly reasonable to floodthe channel in order to make certain that there isplenty of inventory on the shelves in the event theproduct is popular with consumers. An exampleof this strategy was Microsoft's launch ofWindows 95 in August of 1995. Microsoft knewit had a potential blockbuster, so it flooded the

channel with more inventory than it thought itcould possibly sell. On the night before therelease, customers lined up outside of storesaround the country to get their hands on a copy.Microsoft's strategy was a response to the risk thatthey had underestimated demand and would loserevenue due to stock-outs.

However, when channel stuffing is used toimproperly inflate a company's reported revenue,that is improper. One of the most common typesof fraudulent channel stuffing occurs whenrevenue is recognized on a consignment sale. Aconsignment sale takes place when a seller placesa product at a seller's location and collects whenthe reseller sells the product. In other words, thesale of the good from the seller to the reseller iscontingent on resale to an end customer. GAAPprohibits recognition of revenue in the presenceof a resale contingency. See REVENUE

RECOGNITION WHEN RIGHT OF RETURN EXISTS,Statement of Financial Accounting Standards No.48, ¶ 6b. (Financial Accounting Standards Bd.1981). The consignment nature of the sale isgenerally hidden in a side agreement, but it issurprising how often the language of the contractindicates that there is a resale contingency. Forexample, without stating outright that payment iscontingent on resale, there might be a cancellationclause that allows the reseller an out if they areunable to move the merchandise. Anotherexample is a contractual right to bill-back theseller for unsold goods, i.e. a round-trip. The SEChas brought numerous channel stuffing cases inrecent years, including Critical Path (AAER1539), Informix (AAER 1215), and North Face(AAER 1713). More details can be found on theSEC's web site at www.sec.gov.

Improper channel stuffing can take placewithout the auditor's direct knowledge as it ofteninvolves conspiracy with customers to providefalse audit confirmations. Where customersprovide such fraudulent evidence, it is hard tofault the auditor, since ostensibly independent,third-party confirmation is considered to be thehighest quality audit evidence. See SAS 31.However, consignment sales often create acollection problem, and the auditor has aresponsibility to follow up. For example, if acompany sells a block of software licenses to a


reseller on consignment, but obtains a fraudulentconfirmation from the customer stating that thereis no resale contingency, presumably theassociated receivable will remain uncollecteduntil the licenses are sold through to end users.After some period of time without collection, theauditor should become highly skeptical of therepresentations made at the time the sale wasbooked and consider whether the company'sfinancial statements should be restated, regardlessof whether the transaction was confirmed. SeeTHE CONFIRMATION PROCESS, Statement ofAuditing Standards No. 67, AU § 330 (AmericanInst. of Certified Pub. Accountants 1992).

D. Topsiders

This is one of the simplest and most blatantforms of fraud–making unsupported entries to acompany's books. In June of 2002, the SEC filed acivil complaint against WorldCom alleging thatthe company had improperly capitalized billionsof dollars in ordinary operating expenses. Thiscaused WorldCom to appear to be a profitablecompany, when in fact it was losing money. Thealleged fraud was accomplished through topsidejournal entries to reclassify line costs (fees paidby WorldCom to third-party telecommunicationnetwork providers for access rights) to capitalexpenditures. See Securities and ExchangeCommission v. WorldCom, Civil Action No. 02-CV-04963 (JSR November 5, 2002).

A basic auditing procedure is designed todetect improper topside entries. It is known in theprofession as "tying-out" the financial statements.This is where an auditor (usually aninexperienced auditor under the close supervisionof more senior personnel) traces the amounts inthe financial statements and related notes to theunderlying audited accounting records. If topsideentries have been made, they will be flushed outwhen the auditor attempts to tie the financialstatements back to the underlying books andrecords. In fact, this is a procedure that is requiredby GAAS, which states that the audit workingpapers "should be sufficient to show that theaccounting records agree or reconcile with thefinancial statements." See WORKING PAPERS,Statement of Auditing Standards No. 41, AU

339.06 (American Inst. of Certified Pub.Accountants 1982).

V. Conclusion

Accounting information, along with full andfair disclosure, should provide an accuratereflection of the economic substance of reportedtransactions. A system of specific, universallyapplicable rules that would provide such areflection in all or nearly all cases is notattainable nor is it desirable, as the cost ofcompliance would be prohibitive. It is alsoundesirable for another, more compelling reason:it would emphasize form over substance. Such asystem, if it did exist, would encourage pooreconomic outcomes because it would reward thefinancial engineer at the expense of theentrepreneur. The fall of Enron and its auditor,Arthur Andersen, provided useful insights into therisks inherent in such a rules-based system.�

ABOUT THE AUTHOR

�Joseph W. St. Denis is an Assistant ChiefAccountant in the United States Securities andExchange Commission's Division of Enforcement.Mr. St. Denis joined the Staff in 1998 afterworking as an auditor with Coopers & Lybrandand as a Chief Financial Officer and controller inthe high tech industry. Mr. St. Denis is a licensedCertified Public Accountant in Colorado.a

The Securities and Exchange Commission, as amatter of policy, disclaims any responsibility forany private publication or speech by its membersor staff. The views expressed herein are those ofthe author and do not necessarily reflect theviews of the Commission or the author'scolleagues on the staff of the Commission.


Market Capitalization as the Measureof Loss in Corporate FraudProsecutionsGeorge S. CardonaChief Assistant United States AttorneyCentral District of California

Gregory J. WeingartAssistant United States AttorneyChief, Major Frauds SectionCentral District of California

Congratulations! You've navigated your waythrough complex business deals and opaqueaccounting literature, marshaled your facts, andconvicted a defendant in a corporate accountingfraud case. Your reward is an equally dauntingchallenge–attempting to answer the question ofwhat exactly is the loss caused by the defendant'sconduct for purposes of calculating the sentenceunder the Sentencing Guidelines.

When the fraud victimizes a financialinstitution (for example, the manipulation ofaccounts receivable to draw down on credit lines),loss can be calculated in a fairly traditionalmanner by looking at how much the financialinstitutions actually lost. However, manycorporate fraud cases, particularly those involvingpublicly traded companies, are premised onwrongdoing that results in a fraud on the market,(for example, a public exchange such as the NewYork Stock Exchange or Nasdaq). While alternatemeans such as the offender's gain (for example,insider trading profits made during the fraud)exist by which to calculate loss, measuring theloss caused to persons in the market is mostappropriately done by comparing the differencebetween how the market priced the stock based onthe fraudulent information with how the marketwould have priced the stock had the market hadthe correct information.

Frauds on the market typically take one oftwo forms, with distinctly different patterns in theeffect on stock price. In the first type of case, thedefendants conceal information that, if known,would decrease the stock price. An examplewould be where corporate officers of apharmaceutical company conceal the FDA'sissuance of a nonapproval letter for a drug onwhich the company has pinned significant hopes.Were this information known, investors wouldlikely discount the future revenues of thecompany and bid down the company's shares. Theeffect of the fraud is typically to maintain thecurrent stock price or, to be more specific, tomaintain movement in the stock price consistentwith market trends. When the correct informationis ultimately discovered, be it through thecorporation restating its prior guidance or actualearnings, the revelation of an SEC investigation,the filing of a civil securities actions, or the filingof criminal charges, it produces a sharpdownward spike in stock price followed by alesser rebound to what remains a significantlylower stock price. (Diagram A is an example ofthe stock price pattern typically resulting fromthis type of fraud.) Alternatively, where theconcealed information renders the companyessentially worthless, the discovery of the fraudmay lead to a sharp downward spike in stockprice followed by a cessation in trading and theliquidation of the company.

The second type of case involves thedissemination of false information that inflatesthe stock price. An example would be a "pumpand dump" scheme, where an individual who hasrecently purchased or had issued to himself somesignificant number of shares in a company(generally one with a low price per share)generates an intentionally false rumor that thecompany has had a significant success (the


pump). For example, the pump could be that it isthe target of a takeover by a larger company, orhas developed a phenomenal new product withthe expectation of selling his shares once themarket has peaked based on the false information(the dump). The effect of the fraud is a significantupward spike in stock price, with the ultimatediscovery that the information was false (whetheras the result of the dump or otherwise) resultingin a sharp downward spike and rebound to theoriginal lower stock value. (Diagram B is anexample of the stock price pattern typicallyresulting from this type of fraud.) Alternatively,where the company was in dire straits at the timeof the false pump, the discovery of the fraud maylead to a sharp downward spike in stock pricefollowed by a cessation in trading and theliquidation of the company.

Other cases may represent a combination ofthese two types of fraud. An example would be acompany that fraudulently inflates revenues byengaging in "round trip" transactions, that is, salesto other companies that are contingent on a quidpro quo that the payments from those companieswill be returned to them, either directly or throughintermediaries, for the purchase of their products.The concealment of the "round trip" nature ofthese transactions may serve not only to concealthe company's actual losses, but also to inflate itsrevenues above what would be expected in theabsence of those losses. The effect of the fraudtypically is a more muted upward spike in stockprice (or alternatively, a more muted downwardslide if the company's market sector as a whole isdeclining), with the ultimate discovery of theconcealed fraud resulting in a sharp downwardspike and rebound to a price significantly belowwhat was the original lower stock price. (DiagramC is an example of the stock price patterntypically resulting from this type of fraud.)Alternatively, where the "round trip" transactionsserved to conceal the nonviability of thecompany, the discovery of the fraud may lead to asharp downward spike in stock price followed bya cessation in trading and the liquidation of thecompany.

In any of these cases, determining thesentence will turn largely on the determination of

loss, as loss will almost always be the singlebiggest upward adjustment to the defendant'soffense level. In this regard, the guidelinesthemselves provide only limited guidance.Assuming that the issue is the actual loss, theguidelines require the court to make a "reasonableestimate" of the "monetary" harm that thedefendant "knew or, under the circumstances,reasonably should have known, was a potentialresult of the offense." U.S. SENTENCING

GUIDELINES MANUAL § 2B1.1, cmt. n. 2(A)(i),(iii), (iv) & 2(C) (2002). Beyond this, the onlyhelpful guidance is that in making this"reasonable estimate," the court should take intoaccount "[t]he approximate number of victimsmultiplied by the average loss to each victim."U.S. SENTENCING GUIDELINES MANUAL § 2B1.1,cmt. n. 2(C)(iii) (2002).

The victims in a fraud on the market are theinvestors in that market, the shareholders. Whatthe guidelines suggest, therefore, is that the loss iscorrectly determined by aggregating the lossessuffered by these individual shareholders. Theseshareholders typically fall into two groups: thosewho owned shares prior to the fraud and eithertook or failed to take action with respect to theirshares as a result of the fraud, and those who didnot own shares prior to the fraud and purchasedshares as a result of the fraud. The change in"market capitalization" resulting from the fraudprovides a quick and reasonable estimate of thelosses suffered by both groups of victims. Themarket capitalization of a company on any givendate is the price per share of the stock multipliedby the total number of outstanding shares.Estimating loss using market capitalization entailstaking the difference between the marketcapitalization immediately prior to the fraud andthe market capitalization immediately (or shortly)after the revelation of the fraud.

In calculating damages in civil securitiesfraud cases, this general approach seems wellaccepted. Courts have adopted the fraud-on-the-market theory, with the consequence that in civilactions, as in criminal prosecutions, there is noneed to demonstrate the existence or scope of anindividual victim's reliance on the fraudulentconduct. The result is "the well-settled general


principle that damages in a securities fraud caseare measured by the difference between the priceat which a stock sold and the price at which thestock would have sold absent the allegedmisrepresentations or omissions." In re ExecutiveTelecard Securities Litigation, 979 F. Supp. 1021,1025 (S.D.N.Y. 1997); see also Affiliated UteCitizens v. United States, 406 U.S. 128, 153-55(1972); Flamm v. Eberstadt, 814 F.2d 1169,1179-80 (7th Cir. 1987); Blackie v. Barrack, 524F.2d 891, 908-09 (9th Cir. 1975). Moreover,courts have accepted the efficient markethypothesis under which the price of a securitywill accurately reflect all publicly availableinformation. See Basic v. Levenson, 485 U.S. 224,246 (1988); Flamm, 814 F.2d at 1179. Thus, incivil cases, courts have agreed that the differencebetween market price at the time of purchase andmarket price after the revelation of the fraud canbe used as a measure of damages. See ExecutiveTelecard, 979 F. Supp. at 1028 ("In the absence ofother influences, the price of a fraudulentlyinflated security and its 'true' value shouldconverge on or shortly after the date the fraud ormisrepresentation is disclosed.") Indeed, the focusin civil cases is often the propriety of differingexpert opinions based on varying computermodels that seek to account for market trends andother nonfraud influences on the changes in shareprice. See, e.g., Id. at 1024 (taking stock priceafter revelation of fraud as baseline, expert "useda proprietary computerized model–which reflectsadjustments for such factors as inflation, float,volume, intra day trading, and short interest–todetermine that total class damages were $18.5million").

In contrast to the fairly well-developed bodyof law arising out of damage calculations in civilsecurities fraud matters, there is sparse authorityin the criminal law area. What law does exist,however, suggests that change in marketcapitalization of a company is the mostappropriate measure.

If the company whose shares are manipulatedis a total sham, such that the shares becomeworthless after the fraud, the calculation of lossunder the guidelines is fairly straightforward. Forexample, in United States v. Hedges, 175 F.3d

1312 (11th Cir. 1999), the defendant conspiredwith several other individuals to manipulate theprice of stock in a company called CascadeInternational. Cascade's business venturesgenerated almost no revenue, and the companywas operating at an enormous loss. In a typicalpump and dump scam, the conspirators bought upsubstantially all of Cascade's stock, and thendisseminated false information about Cascade'soperations and profitability. The stock price rosesubstantially based on the false information (thepump), and the conspirators secretly sold off theshares they owned before the fraudulent conductcame to light (the dump). When the fraud becameknown, the publicly held shares of Cascadeimmediately became worthless.

In calculating loss, the court noted that of theeighteen million Cascade shares outstanding, atthe time the fraud came to light thirteen millionshares traded at an average price of $4 per share,and the remaining five million traded at anaverage price of $5 per share. The total marketcapitalization of Cascade was thus $77 million, allof which was lost when the fraud was uncoveredand the shares became worthless. The Court alsoadded in $15 million which was lost by financialinstitutions who lent Cascade money based on thefalse financial information, and estimated the totalloss at $92 million.

When the shares of an otherwise legitimatecompany are inflated through accounting fraud,and the shares retain value after the fraudbecomes publicly known and is factored into theshare price, the calculation of loss becomes muchmore difficult. While numerous cases have beenprosecuted involving such conduct, there is littlecase law given that such cases are often resolvedby way of plea, and the parties negotiate whatthey believe to be the appropriate loss figure aspart of the plea agreement.

To date, only the Second and Eleventhcircuits have opined as to how loss should becalculated when the stock retains residual valueafter the fraud ends. Moreover, neither of theopinions definitively states the appropriatemethodology for calculating loss under theguidelines. In United States v. Moskowitz, 215F.3d 265 (2d Cir. 2000), the defendant also


engaged in a pump and dump. At sentencing, thegovernment introduced evidence estimating theloss from between $7.1 million to $18.3 millionbased on the decline in the company's share priceupon revelation of the fraud. A civil class actionplaintiff's expert estimated the loss toshareholders to be $30 million. The district courtfound the loss to be between $5 and $10 millionunder the former U.S. SENTENCING GUIDELINES

MANUAL § 2F1.1 (2000). In light of thecompeting figures, the Second Circuit opined thatbecause there was ample evidence that the losswas in fact higher than the district court found,the district court did not abuse its discretion incalculating loss.

In United States v. Snyder, 291 F.3d 1291(11th Cir. 2002), two defendants who worked atand held substantial stock options in a publiclytraded pharmaceutical company participated in ascheme to falsify and misrepresent data fromclinical trials of one of the company's drugs. Theprosecutors submitted an expert report calculatingthat shareholders lost over $34 million from thefraud. The defendants, on the other hand, arguedthat there was no actual loss because the price ofthe company's stock was higher after thedisclosure of the fraud than its average priceduring the life of the fraud. For many of thereasons noted at the beginning of this article, thedistrict court found it was not feasible to make areasonable estimate of the victims' losses, andinstead calculated loss based on the intended orpotential gain to the defendants. Id. at 1295. Inreversing and remanding, the Eleventh Circuitnoted that under the Sentencing Guidelines,substitution of defendant's gain is not thepreferred method because it ordinarilyunderestimates loss. See U.S.SENTENCING

GUIDELINES MANUAL § 2B1.1, cmt. n. 2(B)(2002); U.S.SENTENCING GUIDELINES MANUAL

§ 2F1.1, cmt. n. 9 (2000). Instead, the EleventhCircuit suggested that the district court focus onthe period between the false press release aboutthe clinical trial and the days immediatelyfollowing the announcement of the fraud todetermine the amount that each share's price wasfraudulently inflated. Id. at 1296 n.6. The panelfurther suggested that this per share loss then be

multiplied by the shares bought and sold duringthat time frame.

Picking up on the suggestion in the Hedgescourt, at least one district court judge has alsoadopted the market capitalization approach. InUnited States v. Bakhit, 218 F. Supp. 2d 1232(C.D. Cal. 2002), the defendant engaged invarious accounting frauds to falsely inflate hiscompany's revenue. These frauds predated thecompany's initial public offering (IPO) (thefinancial statements were manipulated to defraudthe company's lenders before the company wentpublic), and continued after the IPO. Incalculating loss, the district court first determinedthe average share price during the life of thefraud, and then subtracted the average sellingprice after disclosure of the fraud but before thenext "significant intervening cause" affecting thestock price. Id. at 1241. To calculate loss, thecourt then multiplied that difference between theaverage selling price during the fraud and theaverage selling price after the fraud times the totalnumber of shares outstanding (since all the shareswere sold during the life of the fraud).

Defense attorneys have made a number ofarguments against using the market capitalizationapproach. The arguments generally fall into threecategories.

First, it has been argued that stock price is aninaccurate measure of the value of a company;thus the efficient market hypothesis should berejected. As the citations above indicate, however,civil courts have repeatedly accepted the efficientmarket hypothesis, under which stock price ispresumed to incorporate all publicly availableinformation.

Second, it has been argued that using changesin market capitalization as a measure of lossresults in arbitrary guideline calculations becauseit fails to account for irrational exuberance,irrational panic, and other psychological trendsthat might affect stock price in the relatively shortterm. Again, in a widely traded market, theefficient market hypothesis suggests that suchtrends will have limited impact. Moreover, to acertain extent, this can be addressed by adjustingthe period used to measure the change in market


capitalization, such as waiting for the completionof the typical bounce back from the sharp dropoccasioned by revealing the fraud. In the diagramsat the end of this article, this would mean usingthe differences between points A and C, ratherthan other points on the stock price curve.

Third, it has been argued that using changesin market capitalization fails to account for otherfactors that might also affect stock price duringthe period of a fraud, such as ordinary markettrends or outside events such as a worldwidechange in oil prices or the entry of a newcompetitor. In civil securities fraud cases, this isthe subject of expert testimony, with duelingeconomists often attributing differing portions ofthe change in stock price to varying externalfactors. An argument can be made, however, thatin the criminal context such precision isunnecessary. In civil cases, the goal is to return tothe plaintiffs exactly what they lost, no more andno less. In criminal cases, however, the court isattempting simply to establish a rough measure ofculpability. See Bakhit, 218 F. Supp. 2d at 1240(noting prudential concerns with relying tooheavily on expert testimony at sentencing). Notonly do the guidelines explicitly require only a"reasonable estimate" of loss, but they also permitthe court to adjust from that estimate by departingdownward should the court determine that it"substantially overstates the seriousness of theoffense." U.S. SENTENCING GUIDELINES MANUAL

§ 2B1.1, cmt. n. 15(B) (2002). Without any needfor expert testimony, the court, therefore, canadjust the loss determined by the marketcapitalization approach to reflect any injusticesresulting from that approach as the result of grossexternal factors.

To streamline cases and speed investigations,prosecutors in corporate fraud cases quite oftenselect only certain fraudulent transactions onwhich to indict, while foregoing othertransactions that formed the basis of a restatementor other event that cast into doubt earlierrepresentations about the company. In thosecases, trying to separate the effect on the stockprice of the transactions proven to be fraudulentfrom other suspect, but noncriminal, transactionscan become complex. In such circumstances,expert testimony to establish what portion of theloss was caused by the transactions proven to befraudulent may be unavoidable.�

ABOUT THE AUTHOR

�George S. Cardona is the Chief AssistantUnited States Attorney in Los Angeles.

�Gregory J. Weingart is Chief of the MajorFrauds Section in the U.S. Attorney’s Office inLos Angeles, which prosecutes corporate andsecurities fraud matters.a


Dispositions in Criminal Prosecutionsof Business OrganizationsMiriam MiquelonUnited States AttorneySouthern District of Illinois

In January of this year, the Deputy AttorneyGeneral (DAG) issued a memo entitled"Principles of Federal Prosecution of BusinessOrganizations" which clarified the Department ofJustice's policy considerations in prosecutingbusiness organizations. Specifically, the memotasked prosecutors to "assess the merits of seekingthe conviction of a business entity itself" in thecontext of prosecuting business crimes.Memorandum from Larry D. Thompson, DeputyAttorney General 1 (January 20, 2003). Thememo represents a considered approach indeciding whether an entity prosecution isappropriate, by balancing the harm to society as aresult of a particular business crime against thepotentially devastating effect on a corporation orpartnership when a criminal charge is broughtagainst it.

As prosecutions against accounting firmsescalate, some consideration should be given tothe impact on the firm as a whole, particularlysince most accounting firms are partnerships andnot corporations. The significance is apparentfrom the very form of the business organization.For example, the Southern District of Illinoisrecently prosecuted the accounting firm of BDOSeidman, LLP, a New York Limited LiabilityPartnership. BDO operates nationwide and is onthe top fifteen list of accounting firms nationally.The BDO St. Louis office operated relativelyindependently from its other partners. While thepartnership shared revenues and had commonmanagement policies, each office operated as itsown autonomous cost center. There was relativelylittle communication between the various partnersrelative to local operations and clientele exceptfor client conflict checks. Unfortunately, certainpartners in the St. Louis office helped one of their

more lucrative clients unlawfully convert annuityfunds held in trust for personal injury clients toacquire part of the National Tea grocery chain inSt. Louis. Not surprisingly, the businessman knewnothing about operating grocery stores, thebusiness failed, and the annuitants, most of whomwere paraplegics, widows, and orphans, were leftwith nothing. The losses to the victims werecatastrophic and in excess of $60 million.

But for the assistance of the accounting firmin issuing reckless opinion letters and less thanaccurate financial statements, the businessmancould not have succeeded. Indeed, there is noquestion that the accounting firm could haveblown the whistle and advised authorities longbefore the losses increased to such monumentalproportions. Under the first consideration of theDeputy Attorney General's memo–that the natureand seriousness of the offense, including the riskof harm to the public, be considered–there was noquestion that BDO had to be criminallyprosecuted.

At the same time, the investigation revealedthat the criminal conduct was confined to the St.Louis office, and when the conduct becameknown to management, the local office wasdisbanded by the remaining members of thepartnership. In the case of a partnership, asopposed to a corporation, there is no other entity,such as a subsidiary, that can step forward andenter a guilty plea in an attempt to minimize theinstitutional damage suffered by the businessorganization.

Consideration number seven of the memorequires the prosecutor to review the "collateralconsequences, including disproportionate harm toshareholders, pension holders and employees notproven personally culpable, and impact on thepublic arising from the prosecution." Larry D.Thompson Memorandum of January 20, 2003 at3. The institutional damage to an accounting


partnership, particularly one that serves largenational clients, is severe. Once the indictment isannounced, the clients jump ship in an effort toavoid the perception that anything could beimproper with their internal accounting practicesor agency filings. Other accounting firms alsotake advantage of their colleague's misfortune anduse the opportunity to shepherd the business totheir own firms. The bottom line is that a criminalprosecution may contribute to insolvency for thebusiness organization. Sometimes that collateralconsequence is warranted, as the example in thisarticle demonstrates. However, part of our job asprosecutors is to make that judgment call. Inmany respects that is a heavy burden. As a caveat,that burden can be shared by seeking advice andreview from the Fraud Section of the CriminalDivision at Main Justice.

In the BDO case, however, the victims wereso vulnerable and the amount of the fundsdiversion so great, that the balance easily tippedin favor of prosecution. However, a prosecutiontechnique was utilized that did tend to minimize,at least to some degree, the collateralconsequences to the "innocent partners." First, acriminal information was filed with the court. Atthe same time, BDO entered into a pretrialdiversion agreement which effectively suspendedthe prosecution of the crime during which timethe partnership could make restitution to victims,engage in appropriate remedial actions toimplement compliance programs, replacemanagement, and provide full cooperation in thecontinuing prosecution of culpable individuals.The pretrial diversion agreement was also filed asa public document with the court, along with astipulation of facts providing a factual basis for anadmission of guilt in the event that the agreementwas revoked and the government proceeded onthe information.

Other salient features of the agreementinclude provisions governing the waiver of theapplicable statute of limitations past theexpiration date of the pretrial diversion, a waiverof the attorney-client privilege where suchinformation is required to satisfy the cooperationprovisions of the agreement, and a formalresolution authorizing the entry of the pretrial

diversion agreement and the stipulation of facts.Of course, this subjects the business organizationto additional collateral consequences, includingrelated civil actions that can be filed by thevictims, unless the agreement specificallystructures the payment as restitution requiringeach victim to sign a release in order to receivetheir distributive share of the restitution.

From an evidentiary standpoint, there doesnot appear to be any reported decision ruling onthe admissibility of a pretrial diversion agreementat a subsequent trial of an employee or othercoconspirator. In an unrelated case, prosecutorssuccessfully argued that the agreement wasadmissible during trial on the theory that it wastantamount to a prior conviction as a criminalinformation and stipulation of facts were filed,and that the pretrial diversion agreement wassubstantially similar to a plea agreement. Thesefacts, however, were also considered in thecontext of the cross-examination of a corporaterepresentative by the defense during the trial ofthe chief operating officer, in an apparent attemptto mislead the jury regarding the trueconsequences to the corporation. The implicationof the cross-examination was that the corporationhad escaped the punishment that was now beingunfairly heaped upon the chief operating officer.In any case, the issue of admissibility at trialshould be raised pretrial through an appropriatemotion in limine.

The use of a pretrial diversion agreement mayalso be helpful when prosecuting a publiclytraded corporation. The decision requiresbalancing competing interests and policies. Whereupper management has effectively operated thecompany and/or increased profits through ascheme or artifice to defraud, management hasbreached its duty to provide loyal and faithfulservices to the shareholders. By putting thecontinued viability of the corporation at riskthrough the use of unlawful business practices asthe "way of doing business," the shareholders'investments are also seriously placed at risk. Onthe other hand, in an effort to protect the interestsof the shareholders, any prosecution of thecorporation could affect its continuing viability inthe marketplace and render it insolvent.


Additionally, it is important to distinguishbetween a corporation operated at the highestlevels of upper management through fraud, andone where lower-level managers, in discreteoperations, have engaged in fraudulent acts. Theformer may be seen as a pervasive corporatefraud, whereas the latter may be viewed as anemployee fraud that requires a tighter corporatecompliance program to avoid a repeat in thefuture. Again, the Deputy Attorney General'smemo requires the prosecutor to consider the"collateral consequences, includingdisproportionate harm to the shareholders,pension holders and employees not provenpersonally culpable, and the impact on the publicarising from the prosecution."

In a recent case prosecuted by the SouthernDistrict of Illinois against the Exide Corporation,the largest automotive battery manufacturer in theworld, Exide supplied defective DieHard batteriesto Sears, Roebuck and Co. Upper managementemployees of Exide used corporate money to paybribes to the Sears battery buyer. Ultimately,Exide was required to plead guilty to a felonycharge because the fraud pervaded the highestlevels of management. All three of the chiefexecutive officers, the CEO, president, and CFO,were prosecuted and found guilty. However,Sears was given the opportunity to enter into aformal pretrial diversion agreement, along withthe filing of a criminal information and stipulationof facts, because the fraudulent conduct wasconfined to a discrete operating division. The factthat the fraud is confined to a particular operationof the company may still militate in favor of afelony prosecution where the fraud resulted inlarge profits or other substantial benefits to thecompany. It is important to consider all of thesefactors in evaluating the fairest disposition in thecase. However, the DAG's memo also cautionsagainst prosecuting a corporation based uponstrict respondeat superior theory for the isolatedacts of rogue employees. At the same time,"[f]ewer individuals need to be involved for afinding of pervasiveness if those individualsexercised a relatively high degree of authority.Pervasiveness can occur either within anorganization as a whole or within a unit of an

organization." Larry D. Thompson Memorandumof January 20, 2003 at 5.

As a caveat, a pre-trial diversion agreementshould not be offered as a means by which acorporation can "buy its way out" of criminalliability. It is also not to be employed as a meansfor the corporation to exact immunity fromprosecution for corporate management or otheremployees who are culpable and should otherwisebe prosecuted. The collateral consequencesevaluation should control, along with a realisticassessment of the knowledge and participation ofupper management and whether the fraud was theway of doing business at the company.

In this regard, disproportionate harm to atarget corporation should also be considered. Forexample, some corporations have special licensesor government contracts that may be lost in theevent of a prosecution. These are economicpenalties that may be disproportionate whencompared with punishment meted out to similarlysituated corporations that do not have licenses orcontracts at risk. One technique that can beemployed to avoid disparity in corporatepunishments is to allow a subsidiary of the targetcorporation to be named in the charginginstrument so that the parent can continue tooperate competitively in the marketplace,particularly where insolvency would harm thepublic and/or the shareholders.

Corporate cooperation is one of the keyfactors in evaluating the usefulness of a pretrialdiversion agreement. It is imperative for theprosecutor to ensure that the cooperation iscomplete and truthful. It is entirely appropriate forthe prosecutor to demand the waiver of attorney-client privilege and work product protection bythe corporation, make employees and agentsavailable for debriefing, disclose the results ofinternal investigations, file appropriate certifiedfinancial statements, agree to government orthird-party audits, and take whatever other stepsare necessary to ensure that the full scope of thecorporate wrongdoing is disclosed.

The DAG memo further instructs that whenprosecutors are considering pretrial diversionagreements, reference should be made to the


USAM § 9-27.600-650. The USAM principlespermit a nonprosecution agreement in exchangefor cooperation when a corporation's "timelycooperation appears to be necessary to the publicinterest and other means of obtaining the desiredcooperation are unavailable or would not beeffective." In the case of national or multi-national corporations, multidistrict or globalagreements may also be necessary. See USAM§9-27.641.

The decision to utilize a pre-trial diversionagreement in the context of prosecuting abusiness entity has many dimensions. Referenceshould be made to the DAG memoranda referredto in this article, the USAM, and to the practicaladvantages and disadvantages to the case and tothe public. Prosecutors may also considercontacting the Fraud Section of the CriminalDivision at Main Justice for guidance andadvice.�

ABOUT THE AUTHOR

�Miriam F. Miquelon is currently serving as theUnited States Attorney for the Southern Districtof Illinois. Ms. Miquelon is also on the adjunctlaw faculty at Washington University School ofLaw where she teaches Litigation Ethics and TrialAdvocacy. While serving as an AUSA, Ms.Miquelon prosecuted white collar and publiccorruption cases. She was also detailed to theOffice of Special Counsel during the Wacoinvestigation.a


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Corporate Fraud Issues - justice.gov · On July 9, 2002, President Bush created the Corporate Fraud...

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Transcript of Corporate Fraud Issues - justice.gov · On July 9, 2002, President Bush created the Corporate Fraud...