Regular readers of this blog know that the federal government’s criminalization of business since Enron has been steadily encroaching on professionals who provide advice to business interests. First, it was Arthur Andersen, then the Merrill Lynch bankers in the Nigerian Barge case, and then KPMG.
Now, Nathan Koppel of the WSJ Law Blog reports that the Department of Justice has thrown down the criminal gauntlet on legal advisors by indicting former Refco, Inc outside counsel, Joseph P. Collins, the former head of Mayer, Brown & Platt’s derivatives section. A copy of the indictment is here and my previous posts on the Refco case are here.
The indictment crosses the Rubicon in terms of the govenment’s willingness to prosecute an outside lawyer for merely advising a client in regard to structuring transactions that are not intrinsically illegal, but it nevertheless raises more questions than it answers. As is typical of most business prosecutions over the past several years that criminalize questionable business judgment rather than clear white collar criminal acts such as embezzlement, the indictment of Collins is a jumble of conclusory allegations of fraud without any specific allegations of Collins’ fraudulent conduct.
Although inartfully drafted, the government’s indictment essentially alleges that Collins assisted former Refco CEO and controlling shareholder Phillip Bennett in using Refco’s credit to reduce indebtedness to Refco of an affiliate controlled by Bennett. That’s not a crime, but the government alleges that Collins committed a crime by aiding Bennett in misleading Refco auditors and investors in not telling them about the use of Refco’s credit to reduce the affiliate’s debt to Refco. In addition, the government alleges that Collins aided Bennett in covering up from investors the dilution of Bennett’s ownership interest in Refco to BAWAG, which is characterized as “a longtime Refco customer.” Again, the government hinges its criminal case against Collins on the alleged non-disclosure of that dilution.
What’s curious about all of this is that numerous lawyers, accountants and investment bankers scrutinized and presumably profited from Refco over the past several years in connection with various investments in the firm, including its well-publicized public offering that valued the company at $4 billion five months before it disintegrated into a bankruptcy case. Not only did none of these professionals uncover the alleged fraud, but none of them other than Collins has been targeted as a criminal. Moreover, as this earlier post asks, if Bennett and Collins were orchestrating a massive fraud at Refco, then why on earth did they take it public where discovery of the fraud would likely lead to far more draconian consequences than if Refco had remained private?
Oh well, I suppose that question will be sorted out eventually. An ominous sign for both Bennett and Collins is that former Refco Capital Markets vice-president, Santo C. Maggio, pled guilty yesterday in New York to two counts of securities fraud, one count of conspiracy and one count of wire fraud under a cooperation agreement with prosecutors. In the meantime, it looks as if Collins and Bennett are not in lockstep with regard to defending their criminal cases. The initial public comments of Collins’ attorney suggest that Collins will assert that he had been duped by Refco’s fraud. Although that position can’t be pleasing to the Bennett defense, it is certainly understandable from Collins and Mayer Brown’s standpoint. It appears that Mayer Brown is underwriting Collins’ defense and probably will continue to do so as long as Collins is taking the position that any failure of his legal counsel was the result of being duped or, at worst, negligence.
Maintaining that position would appear to be extremely important to Mayer Brown, which has had been having its own business problems over the past year or so (see here, here and here). If a jury finds that Collins was engaged in criminal fraud with regard to Refco, then such a finding would likely constitute grounds for any insurer or reinsurer of Mayer Brown to deny coverage for damage claims arising from Refco-related civil litigation against the firm, as well as any legal fees generated in the defense of such litigation. In that turns out to be the case, Mayer Brown’s resulting business problems may make the ones that the firm has been dealing with over the past year look like a piece of cake in comparison.
As always, Larry Ribstein and Peter Henning have insightful thoughts on various implications of the Collins indictment.

The illusory nature of the financial damages attributed to former Brocade CEO Greg Reyes’ backdating of stock options, the W$J’s Holman Jenkins — who has been the most lucid mainstream media voice condemning the witch hunt mentality that permeated the criminal prosecutions involving backdated stock options — pens this column on the Reyes sentencing, in which he concludes:

Punishment should fit the crime; dozens of executives have lost jobs over backdating; a few have been asked to disgorge money and sign regulatory settlements that don’t require acknowledgment of wrongdoing. Even the trial lawyers have been unable to make a meal out of this scandal, thanks to an absence of demonstrable shareholder harm.

The great flaw in the Reyes prosecution, which was the first of its kind, was the prosecution’s attempt to fulfill the media image of backdating, rather than focusing on the venial offense it was. The government has suggested Mr. Reyes should face 10-20 years. Judge Charles Breyer, in a recommendation recently unsealed, proposed 15-21 months. Some law bloggers think it not impossible Mr. Reyes will receive a suspended sentence.

Let’s hope so. Because unless we plan to send Steve Jobs and a hundred other executives to jail for backdating, it would be grossly disproportionate to inflict jail on Mr. Reyes.

Read the entire column. By the way, the Reyes sentencing has been postponed indefinitely.

Former Hollinger International chairman and CEO Conrad Black (previous posts here) was sentenced on Monday to six and a half years in prison as a result of his conviction on three counts of mail fraud and one count of obstruction of justice stemming from Black and his associates’ taking of $2.9 million in non-compete compensation from the sale of Hollinger assets that the prosecution contended should have gone to Hollinger. Lord Black was ordered to report to prison on March 3rd.
Given the severity of the trial penalty (see also here) in criminal cases against wealthy businesspeople these days, Black’s sentence could have turned out much worse under the circumstances (sentencing expert Doug Berman had set the over/under on Black’s sentence at 8 years). Let’s face it — the American criminal justice system is stacked against defendants such as Lord Black, Jeff Skilling, Jamie Olis or any number of other recently-convicted businesspersons who elect to protest their innocence at trial. The now common practice of the prosecution loading indictments with multiple charges for the same acts (and the judiciary’s reluctance to dismiss duplicative charges) virtually ensures that juries will throw a bone to the government and convict on at least some of the counts (Lord Black was acquitted on 9 of the 13 counts against him).
Meanwhile, it’s interesting to note the impact that all of this has had on Hollinger. The stock of Sun-Times Media — which is all of what is left of Hollinger — is down to about $1 a share, which is a quarter of the share price when the Black trial began and a fraction of its value during the time that Black ran the company. Black himself expressed “deep regret” during the sentencing hearing for the $1.2 billion in shareholder value that has been lost during the tenure of the company management team that succeeded Black’s team.
In a very real sense, the government destroyed Hollinger in order to make a statement in destroying Conrad Black. Sound familiar?

As noted earlier here, the mainstream media-driven scandal over the fairly common practice of backdating stock options has been more about demonizing the unlucky businesspeople who engaged in the practice more than anything else. Inasmuch as there is nothing inherently illegal or damaging financially to granting backdated stock options, the real issue has always really been whether the company granting the backdated options disclosed them properly.
Unfortunately, the proper perspective toward that non-disclosure issue has been overwhelmed amidst the demonization of the backdating practice by mainstream media and avaricious prosecutors, many of whom did not bother to learn about how backdating options can be a legitimate tool to provide incentive to key employees. To this day, even many businesspeople and professionals who I talk with don’t understand backdated options. One can only imagine the level of confusion among the vast majority of American citizens who probably equate a backdated option with a backdated check.
The sad part about all this is that backdated stock options are really quite straightforward. Traditionally, management has provided key employees “at-the-money” options — that is, the option to buy stock at the price at which the shares are trading on the day the option is granted. Thus, if the share price goes up, then the key employee makes money. On the other hand, if the share price goes down, then the key employee makes nothing on the options.
But “at-the-money” options aren’t the only type of options. There can be “out-of-the-money” options or “in-the-money” options, and each type of option serves to provide a different type of incentive for key employees. If a key employee is granted out-of-the-money options, then a small increase in the share price won’t allow the employee to make any money on their options. Rather, it’s going to take a large increase in the share price for the employee to make money on the options. However, that large increase in share price can be very profitable for the employee — a grant of $100,000 in out-of-the-money options is much more valuable if there is a substantial increase in share price than a grant of $100,000 in at-the-money options would be under the same circumstance.
On the other hand, consider “in-the-money” options. These options continue to have value to the key employee even if the share price decreases slightly (because they are still “in-the-money”). But if the share price goes to hell in a handbasket, the options lose their value completely.
So, the different types of options provide management with flexibility in tailoring differing incentives depending on the circumstances that a company faces. A key employee with out-of-the-money options has incentive to take big risks because the only way that those options will become valuable is if the share price rises dramatically. On the other hand, a key employee with in-the-money options has little incentive to take big risks; rather, he wants to prevent the share price from falling because that’s the only way the options can lose their value.
Backdated options are simply a form of in-the-money option. Inasmuch as in-the-money options are a legitimate way to incentivize key employees, what’s the big deal about backdated options?
Well, there are different tax implications to these types of stock option grants, but whether there is any clear tax benefit from backdating options is far from clear. Heck, how many executives who were involved in backdating options based their decision on the tax implications of the grants? Probably not many. For years, accounting firms advised companies that, so long as the options were issued with formulaic pricing, then backdating the options was not a problem from a tax standpoint. Thus, for example, where companies granted options priced ìat the lowest trade date in the month granted,î accountants would routinely advise the companies that these were at-the-money options that need not be expensed.
Moreover, just because backdated options are in-the-money options doesn’t mean that the company or its shareholders are losing money. Options are not a zero-sum game where someone wins and someone loses. If management decides to sell the company’s stock for $50 when the market price is $100, then that does not mean that the company is losing money. So long as the shareholders know about management’s option program and that the company is going to be required at some point to sell a certain number of shares at $50, the shareholders aren’t losing money, either. The efficient market will price the dilution into the share price. This point was reinforced late last week when U.S. District Judge Charles R. Breyer of San Francisco concluded in the sentencing phase of the backdating criminal case against former Brocade CEO Gregory Reyes that the government had failed to “quantify any amount of loss that can be attributed to Reyesí conduct” (see related Roger Parloff post; Peter Henning also comments on the ruling here).
Which brings us around to the disclosure issue. Some of these backdated options were either not disclosed at all or were disclosed with a public statement such as “no gain to the options is possible without stock price appreciation, which will benefit all shareholders.” As can be seen from the above analysis, such a disclosure is wrong or at least misleading.
So, the question is what should be done about such a bad disclosure? Professor Ribstein took the lead early on in the blawgosphere by noting that criminalizing such conduct was akin to using a sledgehammer where surgical precision is needed. In this recent post examining the deal in which former UnitedHealth Group executive William McGuire agreed to return $620 million in compensation to settle backdating claims, Professor Ribstein contrasts McGuire’s deal with what happened to Brocade’s former human resources director Stephanie Jensen, who was found guilty of two criminal counts relating to backdating options even though she did not personally benefit from them. “In one [case,] the chief executive and main beneficiary likely will walk away with hundreds of millions of dollars,” notes Professor Ribstein. “In the other, an underling who didn’t profit from the offenses likely will go to jail.”
And the foregoing disparity doesn’t even address the Apple Rule as it relates to backdating stock options.
The reality is that criminalizing the practice of backdating stock options was a bad idea from the beginning, the equivalent of mob violence against unpopular businesspeople. The result is more of what Professor Ribstein has coined the “corporate crime lottery” where the winners pay a fine or fade the heat entirely while the losers go to jail. Professor Ribstein concludes his recent post in with the following observation:

[The McGuire and Jenson] cases are only the most recent examples of the lottery in action. Not much is gained from criminalizing this conduct over the many remedies, including the corporation’s own right of recovery, available for any wrongs that occurred (mostly inadequate disclosure). But much is lost from the odor of injustice that wafts over these disparate results.

And as Peter Henning reports, that odor of injustice may include the prosecution’s use of false testimony to convict Reyes.

Mary Flood notes that former Enron Task Force director Andrew Weissmann has been named in this Ethisphere article as one of the “100 Most Influential People in Business Ethics.”
They are kidding, right?. If it’s acceptable to promote business ethics through abuse of prosecutorial power, then Weissmann is your guy.

This Tom Fowler/Chronicle article (also see later report here) reports on the beginning of the latest in the series of criminal trials nicknamed “the trader cases” among the Houston defense bar involving Houston-based natural gas traders who allegedly manipulated natural gas trading indexes that are used to value billions of dollars in gas contracts and derivatives. The defendants are former El Paso Corp traders Jim Brooks, Wesley Walton and James Pat Phillips, who face 49 charges of conspiracy, false reporting and wire fraud. The trial of this particular trader case looks as if it will last about two months.