May 20 2008
Jail time for securities fraud defendants under the US Sentencing Guidelines is based principally on the amount of loss that resulted from an offence. A typical securities fraud case will involve a scheme either to ‘cook the books’ of a publicly traded company or to pump up the price and trading volume of a small stock for the benefit of a manipulator, who sells his or her own stock into the new market demand. The schemes cause investor losses when the fraud comes to light or the manipulation stops and the market plunges as a result.
While the Sentencing Guidelines calculations for securities fraud offences potentially include many factors, investor loss is the most important driver of higher sentences, accounting for as many as 30 out of a possible 43 offence level points (for offences resulting in more than $400 million in losses).(1) In recent years, courts outside the Second Circuit have increasingly imported proof standards from civil securities fraud cases into the criminal sentencing arena in ways that have increased the government’s burden in sentencing litigation.
In its recent decision in United States v Rutkoske(2) the Second Circuit has followed the Fifth and Ninth Circuits in applying existing loss causation standards from civil cases when testing the government’s proof of loss under the Sentencing Guidelines in certain securities fraud cases. How this change will play out in contested sentences and in plea bargaining is yet to be seen, but it is unlikely to favour the government.
In 2006 David Rutkoske was convicted in the Southern District of New York of manipulating the stock of NetBet, a start-up online gambling venture. Rutkoske owned a small stock brokerage firm and paid his brokers large, secret commissions to sell NetBet stock to their customers and thereby drive up its price. When Rutkoske’s brokerage firm had sold all of its NetBet stock into a market inflated by this scheme, Rutkoske stopped the manipulation and the share price plummeted. At sentencing, the district court calculated the investor losses according to a formula proposed by the government, which simply totalled the more than $12 million in losses that NetBet investors suffered during the period of the conspiracy, measured by: (i) calculating actual losses for those who sold during the manipulation period; and (ii) estimating actual losses for those who held through to the end of the manipulation by assuming that they received the market price on a date three months after the manipulation scheme ended. As the Second Circuit found, “[t]his method implicitly attributed the total amount of the decline in the value of NetBet shares to Rutkoske’s offence conduct”.
On appeal, Rutkoske argued that the district court should have determined which of the NetBet investor losses were caused by the manipulation scheme and which by other causes, relying on the Fifth Circuit’s decision in United States v Olis.(3) Olis was a securities fraud prosecution of the director of tax planning at Dynegy Corporation, Jamie Olis, for his role in a scheme to manufacture $300 million in revenue for the company. Olis’s 24-year prison term was based on the sentencing court’s finding that one investor (a pension fund) lost $105 million when Dynegy’s stock price declined after disclosure of the fraud. That sentence was vacated by the Fifth Circuit, which found that much of the $105 million loss was attributable to declines in Dynegy’s share price that were either before or significantly after the earnings restatement prompted by disclosure of Olis’s fraud. Therefore, the sentencing court had not “taken into account the impact of extrinsic factors on Dynegy’s stock price decline”.
In Rutkoske Judge Jon O Newman, writing for the Second Circuit, followed Olis in “look[ing] to principles governing recovery of damages in civil securities fraud cases for guidance in calculating the loss amount for a [Sentencing] Guidelines enhancement”. In particular, the court applied principles from the Supreme Court’s Dura Pharmaceuticals(4) ruling on pleading standards for loss causation in civil securities fraud suits, noting the requirement that in such suits a plaintiff must prove “that the misrepresentation caused the economic loss”. That includes ruling out other potential causes for the stock’s decline. Finding that the sentencing court in Rutkoske had failed to make any findings regarding how the investors’ losses were caused by the offence as opposed to “other factors relevant to the decline in NetBet shares”, the court remanded the case for recalculation of the sentence and restitution.
The government, relying on the guidelines’ admonition that a court “need only make a reasonable estimate of the loss”,(5) argued that the civil proof standards should not apply to loss calculation under the guidelines, but offered no further justification for limiting its burden at sentencing.(6) In rejecting that position, the court saw:
“no reason why considerations relevant to loss causation in a civil fraud case should not apply at least as strongly to a sentencing regime in which the amount of loss caused by a fraud is a critical determinant of the length of a defendant’s sentence.”
While the loss causation standard adopted in Rutkoske is not new, it is clear from this and other recent cases that federal prosecutors in the Second Circuit have not been proving loss causation at sentencing. Therefore, the burdens imposed by the new standard have not yet played out in practice in this circuit.
The ruling in Rutkoske raises questions about sentencing practice.
Scope of loss causation analysis
First, how broadly will the courts construe the realm where detailed proof of loss causation is required? Olis noted that where a defendant:
“promoted worthless stock in worthless companies, measuring the loss as the entire amount raised by the scheme is neither surprising nor complex, and is fully consistent with civil loss causation.”(7)
That is because where there was no value to the stock before or after the scheme, all money lost through investment in the stock is the result of the fraud.
At the other extreme, in United States v Ebbers - the prosecution of the former chief executive officer of Worldcom - the Second Circuit recognized that where a fraud scheme’s directly caused losses are clearly so large as to swamp the Sentencing Guidelines loss range, no fine-tuned loss causation analysis is needed.(8)
However, neither of these categories covers many cases. For instance, Rutkoske required loss causation analysis despite the defendant’s brokerage firm handling the vast majority (between 72% and 90%) of the volume of NetBet stock during the manipulation period, which, when coupled with the evidence of broker bribery and other high-pressure sales tactics, could easily support a finding that the public market for NetBet stock was wholly engulfed in a manipulation scheme - and therefore that all loss was attributable to the fraud. The Ninth Circuit has determined that a company was not a ‘sham operation’ within the meaning of the Olis exception based simply on evidence that (i) it was in fact incorporated, and (ii) it occupied real estate. The court therefore required the government to prove loss causation.(9) Meanwhile, in Ebbers and Rutkoske, the Second Circuit repeatedly emphasized the narrowness of those situations where no loss analysis is required, stating that:
“[C]ases might arise where share price drops so quickly and so extensively immediately upon disclosure of a fraud that the difference between pre and post-disclosure share prices is a reasonable estimate of loss caused by the fraud. Even there, however, a coincidentally precipitous decline in shares of comparable companies would merit consideration.”(10)
Therefore, the loss causation principles will affect virtually all securities cases going forward. In particular, they will affect nearly all of the options backdating cases and any subprime cases that may be brought, since those typically involve companies that survived revelation of the fraud.
The government’s burden
Second, what level of proof will be required at sentencing on the question of loss causation? While the Rutkoske opinion noted the guidelines’ provision for a “reasonable estimate” of loss, it nevertheless observed that:
“[n]ormally, expert opinion and some consideration of the market in general and relevant segments in particular will enable a sentencing judge to approximate the extent of loss caused by a defendant’s fraud.”
In practice, this will likely mean that in any contested sentencing the government will need to present expert testimony aimed at separating out the effects on a particular stock of broader market forces and the effects of manipulative conduct or disclosures of a fraud scheme. This is not necessarily an easy burden for the government to bear.
First, there are the problems innate to the question of unpacking the ‘cause’ of a particular drop in share price, especially one that may have occurred over weeks or months as news of problems within a company leaked out. By its nature, this is fertile ground for disagreements among experts and uncertainty by courts. For instance, on remand in Olis, the government hired an expert who submitted an elaborate analysis of the loss caused by the Dynegy fraud, only to have the sentencing court rule that “it is not possible to estimate with reasonable certainty the actual loss” attributable to Olis’s conduct.(11)
Second, there is the practical issue of resources. Sophisticated economic analyses cost money; although the government can and will hire experts for big cases, there is reason to doubt that the Department of Justice has the budget to hire loss experts for all of its securities fraud cases. One potential result, therefore, is an increased government willingness to compromise on issues related to the guidelines in order to avoid a contested sentencing hearing that it cannot afford and may not win.(12)
The Rutkoske decision also raises questions about what other rulings may lie ahead if the courts continue to give parallel treatment to civil damages actions and criminal sentencing in securities cases. For instance, in addition to loss causation, two further principal limitations on the scope of civil securities fraud liability are transaction causation and the buyer/seller standing rule.(13) Transaction causation is simply reliance: did the plaintiff rely on the alleged misrepresentation? The buyer/seller rule requires that a plaintiff have bought or sold the security at issue in order to recover damages, and is designed to avoid the proof issues that would arise if, for example, courts allowed plaintiffs to claim damages for purchases or sales they would have made had the defendants told the truth.
Neither reliance nor a particular victim’s securities purchase or sale is an element of a criminal securities fraud offence under US Securities and Exchange Commission Rule 10b-5, but one can argue that either or both should be required for loss calculation under the guidelines.(14) Adding either would further restrict the scope of loss calculation and would require increasingly detailed proof from the government during sentencing litigation.
Although the Second Circuit has not ruled on either issue, in two recent decisions it has sent conflicting messages. On the one hand, the court has recently suggested that both reliance and buyer/seller standing (as well as loss causation) are required for a valid restitution order in a securities fraud case. In United States v Reifler, which involved a failed ‘pump and dump’ manipulation scheme, the court suggested but did not hold that in order to satisfy the Mandatory Victim Restitution Act, restitution could not be ordered for victims in a securities fraud prosecution who could not meet all the requirements applicable to civil damages claims under Rule 10b-5.(15)
On the other hand, while discussing loss calculation under the guidelines, the Second Circuit wrote in Ebbers that an “investor who buys securities before an extended fraud begins, and holds them during the period of the fraud” is a victim just as much as those who purchase in reliance on fraudulent misstatements, because “[t]he securities laws are intended to allow investors to buy, sell or hold based on accurate information”.(16) Such a view eliminates both reliance and buyer/seller standing from Sentencing Guidelines loss calculation, and includes losses incurred by those who bought before a fraud scheme began and held until after it was over, but did not sell. The court observed that although quantification of holder losses is difficult, “some estimate must be made for [Sentencing] Guidelines purposes, or perpetrators of fraud would get a windfall”.
The observations in Ebbers and Reifler point in different directions in the loss calculation and restitution arenas, but as they are not holdings, there is room for argument on both sides about how far established civil standards should govern in the criminal sentencing realm.
In the meantime, the loss causation analysis required by the Second Circuit since Rutkoske should apply to all but a few securities prosecutions and will heighten the government’s burden, both legal and practical, in bringing to bear the sentencing leverage embedded in the guidelines.
For further information on this topic please contact David Esseks or Brian De Haan at Allen & Overy by telephone (+1 212 610 6300) or by fax (+1 212 610 6399) or by email (email@example.com or firstname.lastname@example.org).
(11) United States v Olis, WL 305525 (SD Tex February 7 2006). The Olis court then found that Olis intended to cause a loss of at least $79 million in taxes denied to the United States, arrived at a guideline range of 12.5 to 15.5 years and imposed a non-guideline sentence of six years.
(12) For example, in an accounting fraud prosecution in the Southern District of New York of an official at Royal Dutch Ahold, the government originally sought a sentence based on the total market capitalization loss of $6 billion upon disclosure of the fraud. However, a defence expert's analysis attributed the vast bulk of the share price decline to issues other than the fraud in which the defendant was involved. In response, the government put forth no expert of its own to rebut the defence analysis and instead conceded that it could not identify the loss attributable to the fraud. As an alternative, the government advocated using the defendant's gain from the offence as a proxy for loss. (May 16 2006 letter, AUSA to Judge Thomas P Griesa, United States v Mark Kaiser, 04 Cr 733 (SDNY); sentencing transcript, May 17 2006, United States v Mark Kaiser, 04 Cr 733 (SDNY).) The resulting seven-year sentence, while significant, was far lower than the life sentence dictated by the advisory guidelines under the government's original loss analysis. In many cases where the initial loss estimates are much smaller (eg, in many options backdating schemes), the application of Rutkoske's loss causation principles may even mean the difference between jail and probation.
(14) For example, the arguments include that: (i) reliance is a necessary element of causation for the losses truly to have "resulted from the offence" within the meaning of the guidelines; and (ii) in the criminal arena, as in the civil, the courts should not speculate about losses from imaginary transactions.
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