Ellen Podgor and Peter Henning do a great job of breaking down the issues and details of the Second Circuit’s decision in overturning the conviction of Frank Quattrone yesterday, so I’m attempting to step back and assess the big picture.

In so doing, one thing is becoming clear — Quattrone is the new poster boy for the enormous costs involved in the dubious governmental policy of attempting to regulate business fraud through criminalization of corporate agency costs.

As with the government’s case against Martha Stewart, the government did not prosecute Quattrone for alleged crimes related to his supposed mishandling of allocation of stock offerings during the technology boom. Rather, the government prosecuted him for allegedly attempting to cover up those purported crimes.

As a result, the prosecution’s case was built upon mostly email messages between Quattrone and his CSFB employer’s in-house counsel, all of which were innocuous in nature. Even the key email in the prosecution (as with Arthur Andersen, one relating to CSFB’s document retention policy) was one that Quattrone forwarded with the comment that he agreed with the email as he was hurriedly getting ready to leave his office for the day.

No one acted on Quattrone’s email and, within days of it, CSFB’s in-house counsel was advising him that it was “a big problem” because of the various ongoing investigations involving CSFB.

Of course, once CSFB settled and waived its corporate attorney-client privilege, that email became evidence in the prosecution against Quattrone. Thus, the jury was allowed to see evidence that a lawyer who appeared to be working in concert with Quattrone thought that his seemingly innocuous email was “a big problem.”

Talk about being put on the defensive from the start.

Meanwhile, the prosecution figured that its case against Quattrone was not sexy enough without more, so it presented evidence that Quattrone was allegedly involved in illegal activity that was not a part of the indictment (the Second Circuit ruled that it was error for the District Court to allow that into evidence) and that his motive for allegedly obstructing the investigations was so that could greedily preserve his huge CSFB compensation package (which the Second Circuit said was OK).

So, where does this leave us?

Well, it’s clear that the costs of the government’s criminalization of corporate agency costs are extraordinary. Based on Quattrone’s experience, no executive can rely any longer on the executive’s communications with company counsel remaining confidential or privileged. Thus, it would be far more prudent for an executive to say nothing to corporate counsel and to retain personal counsel immediately.

Better yet, the executive should forsee such problems and require as a part of the executive’s employment agreement that personal counsel be provided to the executive on the company’s dime. Good for the legal business, but not a prescription for reducing a company’s administrative costs or for facilitating open discourse regarding business or legal problems.

But should the executive even continue working for the employer after such investigations are commenced? Inasmuch as many of Quattrone’s actions that were used to prosecute him were performed in the normal course of interacting with others within CSFB regarding the status of the investigations, a powerful argument can be made that virtually anything that Quattrone did at that point — including simply sitting in his office and saying nothing — would have been used against him in the subsequent cover-up prosecution.

Indeed, even an immediate resignation would probably have been used by the prosecution as evidence of Quattrone’s culpability. Are we prepared to endure the cost attributable to companies losing key personnel simply because someone in government has elected to commence an investigation of those companies?

Thus, the lottery of regulating business fraud through criminalization of corporate agency costs is having huge and largely unevaluated costs. If the government pursues bit players such as William Fuhs or Daniel Bayly in the Enron-related Nigerian Barge case and can come up with something particularly distasteful to the jury — such as Merrill’s involvement with the corporate pariah Enron — then it wins and productive careers are destroyed.

On the other hand, even if the government oversteps with regard to a big fish such as Frank Quattrone, then the government may lose the battle, but it still wins the war because Quattrone is out of business.

This is not a rational deployment of our justice system, and the economic costs — not to mention the emotional carnage to the families of the executives who are caught in this troubling spiral — simply cannot be responsibly dismissed as a “trade-off” of an imperfect system.

Update: Don’t miss Christine Hurt’s clever analysis of Quattrone’s impact on the means for notification of a company’s document retention policy.

In a result that was anticipated by this earlier post, the ever-observant Peter Lattman reports this afternoon that the Second Circuit Court of Appeals in this 61-page opinion has overturned the conviction of former Credit Suisse First Boston investment banker Frank Quattrone on witness tampering and obstruction of justice charges. The Second Circuit remanded the case to the District Court for yet another trial (this will be the third) and, in an unusual move, ordered that U.S. District Judge Richard Owen — the judge of Quattrone’s first two trials — be replaced for Quattrone’s third trial.
The Second Circuit’s opinion essentially concludes that there was sufficient evidence to convict Quattrone of the charges, but that the jury instructions that Judge Owen were fatally flawed. Here is the meat of the decision on that issue, which relies heavily on the U.S. Supreme Court’s reasoning in its Arthur Andersen decision:

Quattrone claims that both charges incorrectly explained the nexus requirement in that each allowed the jury to convict without finding that Quattrone knew that the relevant subpoena or document request called for documents he sought to destroy. Quattrone also argues forcefully that the second portion of that section of the charge, presented in the alternative, is error. He argues that the instruction allowed the jury to find a nexus as a matter of law merely if it found that Quattrone ìhad reason to believe [the documents] were within the scope of the grand juryís investigation.î

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The Free Enterprise Fund’s Mallory Factor observes in this WSJ ($) op-ed today that even notorious anti-business politicians such as House Democrat Nancy Pelosi and the Lord of Regulation are starting to question the over-reaction that is the Sarbanes-Oxley legislation.
Factor’s piece is a good summary of the core defects of SOX, but Larry Ribstein has provided the more thorough and thought-provoking commentary as he has been traveling the country this week talking about SOX. In preparing for a talk at Berkeley, Professor Ribstein sums up the superficial nature of the only line of defense that he has heard defending SOX:

I’ll be particularly interested to hear whether anybody has a cogent defense of SOX. All I’ve heard so far along these lines is this: “There was fraud; fraud is bad; SOX is against fraud; therefore SOX is good.” This seems to assume that we should favor legislation that purports to restrict fraud regardless of cost, and regardless of effectiveness. And even this has been mainly from journalists, accountants, regulators and legislators — i.e., those with a stake in the regulation. I’d really like to hear something more from disinterested parties.

Then, in regard to Peter Lattman’s post regarding revelations of more alleged fraud at Refco, Professor Ribstein notes that SOX did not prevent the Refco frauds from occurring:

Significantly, all this is after SOX, and occurred after Refco had gone through the intensive scrutiny involved in an IPO.
Some might say that the lesson from all this is the need for still more regulation. I’d be interested in hearing about the regulation that could have prevented the problems indicated above. Requiring certification of internal controls isn’t very effective when the fraud is by the certifying CEO, as may be the case here.
I would say, and have said, here and here, that the more realistic lesson is that no amount of regulation can prevent fraud by the most determined fraudsters. It can, though, catch law-abiding firms in a spiral of regulatory costs.

In this Aaron Lucchetti piece($), the Wall Street Journal continues its fine coverage (see Peter Lattman posts here, here and here) of the Lord of Regulation‘s ongoing lawsuit against Home Depot co-founder Kenneth Langone and former New York Stock Exchange chairman Richard Grasso over Grasso’s supposedly excessive NYSE compensation package and Langone’s support of it.
Lucchetti reports today that Spitzer and Langone are preparing for Langone’s deposition next week (wouldn’t you like to be a fly on the wall of that one), and notes that Spitzer’s already dubious case against Langone is now boiling down to whether Langone misled fellow NYSE directors by including a part of Grasso’s compensation plan in a footnote of a memo to directors rather than in the body of the memo:

“The footnote on this work sheet could be more clear, but I do believe the committee understood,” [former NYSE human-resources director Frank] Ashen said in the deposition regarding the $18 million in bonus payments. Those payments were made in a “Capital Accumulation Plan” that was established for several NYSE executives in addition to Mr. Grasso.
Mr. Spitzer’s complaint argues that the CAP awards never should have been put into a footnote but should have been included in the work sheet’s “total compensation” column. The complaint specifically cites the compensation work sheet for 1999, saying it doesn’t make clear that the CAP award for that year was paid in addition to the figure identified on the work sheet as Mr. Grasso’s total compensation. . .
Mr. Spitzer’s lawsuit calls for Mr. Langone to “make restitution” to the NYSE for the amount paid to Mr. Grasso that the suit alleges he didn’t properly disclose — in other words, the $18 million. Mr. Langone’s response, in a statement yesterday: “He hasn’t laid a glove on me.”

The trial of the Grasso-Langone case is currently scheduled for late October, so stay tuned. Larry Ribstein comments here on the corporate governance implications of the lawsuit.

Amidst a flurry of sealed pleadings and orders denying his attempt to withdraw his guilty plea, former Reliant Energy natural gas trader Jerry Futch was sentenced to almost five years in prison yesterday by U.S. District Judge David Hittner based on Futch’s guilty plea on charges that he provided false information on natural gas trades to publications that produce indexes used to value natural gas contracts.
Here is an earlier post on Futch’s case, which raises troubling questions regarding his employer and its counsel’s derogation of Futch’s self-incrimination and attorney-client privileges.

The ever-observant Ellen Podgor points us to this interesting Paul Wenske/Kansas City Star article that reports on the increasing role of advisors to indicted business executives providing advice on the preferred location for the executives to serve their prison sentence. According to the article, the following are the top five-preferred locations for serving a white collar prison sentence in the federal system:

Yankton, S.D. A stand-alone federal prison camp that is a converted college campus.
Englewood, Colo. Just outside Denver, it is a satellite camp to the federal correctional institution there.
Texarkana, Texas. Has drug and alcohol treatment and offers adult continuing education and correspondence courses.
Sheridan, Ore. In the heart of the south Yamhill River Valley near Portland. Offers college programs.
Pensacola, Fla. Inmates can work during the day at a nearby naval base.

John Hasnas is a professor of ethics and law at Georgetown University’s McDonough School of Business and is the author of the new book, Trapped: When Acting Ethically is Against the Law (Cato 2006), which is an adaptation of Hasnas’ article Ethics and the Problem of White Collar Crime.
In this superb Cato Institute op-ed (first published in the Wall Street Journal), Professor Hasnas addresses a common topic on this blog — the perverse effect that implementation of the Department of Justice’s Thompson Memo has had on companies serving up their employees as sacrificial lambs to avoid an Arthur Andersen-like meltdown:

Say you run a financial services firm that markets tax shelters to wealthy clients. Although the shelters are aggressive, you firmly believe they’re legal. Indeed, you have sent one of your tax partners to testify before Congress to that effect. The IRS hasn’t challenged the shelters in court, and no court has declared them to be illegal. Nevertheless, the Department of Justice has opened an investigation of your firm for tax fraud and indicted the partner who testified before Congress.
As a responsible executive, what should you do? Instruct corporate counsel to conduct an internal investigation to ensure that no law has been broken? Have the legal department begin to work on the corporation’s defense? Enter into a joint defense agreement with the partner under indictment? Advance the partner’s legal fees in accordance with the company’s policy of supporting employees sued for employment related actions?
Or should you have the corporation accept responsibility for tax fraud, officially declare that several of your tax partners engaged in unlawful conduct, refuse to enter into a joint defense agreement or advance the legal fees of any of these partners, fire those who refuse to cooperate with the government, waive the firm’s attorney-client and work product privileges, disclose all information that may incriminate your employees to the government, and agree to pay a several hundred million dollar fine?
[The latter approach], surprisingly, is the answer. Under current federal law and Department of Justice policy, it would be irresponsible management to attempt to defend the corporation or its employees.

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The increasing criminalization of business took an interesting turn earlier this week when the Securities and Exchange Commission’s San Francisco office subpoenaed email and other documents from several journalists, including one who works at Dow Jones Newswires, another at MarketWatch.com, and even TheStreet.com and its co-founder, “Mad Money”‘s James Cramer, who, ironically, is a buddy of that subpoena-issuing machine, New York AG Eliot Spitzer. My younger son — a big fan of Cramer’s off-the-wall show — got a big kick out of Cramer rebelliously throwing the subpoena on the floor during his television show.
The subpoenas started flying after the online retailer Overstock.com accused a hedge fund and a stock-research firm of manipulating the media to drive down the price of its stock for the purpose of profiting through shorting Overstock.com stock (this tactic is described earlier here and here). It apparently meant little to the SEC Enforcement Division that the reporters were simply doing their job of tapping sources for information and then reporting that information to investors who make informed judgments in buying and selling stocks. Some of those sources may have even profited from shorting Overstock.com stock. Who knows and, frankly, who cares? So long as reporters are reporting what they learn and are not bribed to do so, they are simply doing their jobs and fulfilling their role in the complicated workings of efficient financial markets.
Then, in an extraordinary development, SEC Chairman Christopher Cox called off the SEC Enforcement Division dogs and issued a public rebuke of the division for failing to obtain his approval for issuing the subpoenas in the first place. Although I am occasionally critical of the media’s reporting on the increasing criminalization of business by various governmental entites, I viewed Cox’s action as a good thing and an indication that he was intent upon implementing responsible oversight of dubious regulatory initiatives that has been sadly lacking in the SEC and the Department of Justice in the post-Enron era.

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Donald Burwell, a former El Paso Corp. energy trader, pled guilty under a cooperation agreement with the Justice Department to federal charges Tuesday that he falsely reported natural gas trading data to a natural gas industry publication. Burwell faces a possible five-year prison sentence and a fine of $500,000, and his plea deal comes just two weeks after another of the dozen or so traders ensnared in the Justice Department’s prosecutions of natural gas traders filed a motion to withdraw his guilty plea. Earlier posts on Burwell’s case are here and here. The DOJ’s press release on the plea deal is here.
Given that he is unemployed and broke financially, Burwell’s plea deal is not surprising. The Justice Department has been alleging some astronomical market effect figures in these cases in order to threaten defendants with draconian prison sentences and, as we have seen in the sad case of Jamie Olis, the DOJ will follow through on the threat regardless of the law or the facts. At least one of the other trader cases similar to Burwell’s is scheduled for trial later this year.

In the law discussion equivalent of a high-caliber wrestling match, law professors Moin Yahya and Larry Ribstein square off in this Point of Law discussion over a subject addressed in this earlier post — the increasingly common practice of short-sellers and class action securities fraud plaintiffs’ attorneys banding together to drive the price of a company’s stock down, and then — after profiting from the short sale of the company’s stock — cashing in again on a class action lawsuit against the company.
Professor Yahya:

Plaintiffs are now given a double incentive to bring lawsuits ñ and God knows this is the last thing we need to be giving them. If this practice is legal, then plaintiffs and their lawyers can now profit by simply announcing a lawsuit. In the extreme, a lawyer can simply announce a suit, profit from the drop in price, and then withdraw the suit. Despite recent federal legislation aimed at managing class actions, many lawsuits can still be brought in state court, and in many states, the standards for what constitutes a frivolous suit are fairly low.

Professor Ribstein:

The better attack on dumping and suing is based, not on false assumptions or on incorrect statements of the law, but on the specific harms that we can show it causes. For example, one way to enhance the effect of the filing of a suit is to accompany it with false statements about the stock. This is already actionable under the federal securities laws. Also, a plaintiff who sells short the stock held by other class members is probably not an adequate class representative ñ his interests in prosecuting the suit are not aligned with the interests of the other class members.