This previous post highlighted the egregiously disingenuous approach that the Justice Department has taken on the market loss issue in order to promote an absurdly long prison sentence for former mid-level Dynegy executive, Jamie Olis.

Now, the Third Circuit in In re Merck & Co. Sec. Litig., 432 F.3d 261 (3rd Cir. 2005) addresses the same market loss issue that is involved in the Olis case and undresses the same superficial reasoning that the DOJ has used to support its dubious sentencing campaign against Olis (hat tip to Lyle Roberts for the link to the Merck decision).

In the Olis case, Project Alpha — the transaction on which Olis worked and was prosecuted — was disclosed to the investing public in a Wall Street Journal article in early April 2002 that criticized Dynegy’s accounting characterization of the transaction.

However, despite the WSJ’s criticism, Dynegy’s stock price did not decline.

Over three weeks later, Dynegy filed an 8-K with the SEC that formally disclosed the recharacterization of Project Alpha along with about a half-dozen other negative matters that were more significant than the disclosure on Project Alpha.

Dynegy’s stock price tumbled, and the Justice Department ultimately relied on the market loss resulting from that decline in promoting the draconian 24-year sentence of Olis under the then-mandatory federal sentencing guidelines.

In Merck, the Third Circuit addressed whether Merck’s failure to disclose certain accounting practices of a wholly-owned subsidiary was a material omission.

On April 17, 2002, in connection with the initial public offering of the subsidiary, Merck filed an S-1 with the SEC that disclosed for the first time that the subsidiary had recognized as revenue the co-payments that consumers had paid, but the S-1 did not disclose the total amount of co-payments recognized.

Immediately after the filing of the S-1, Merck’s stock price actually increased. Two months later, a Wall Street Journal article reported that the subsidiary had been recognizing the co-payments as revenue and estimated the total amount of this revenue in 2001 at over $4 billion. Merck’s stock price dropped two dollars immediately after that WSJ article.

On appeal, the Third Circuit (with a panel that included new Supreme Court Justice Alito) concluded that, in an efficient market, the materiality of disclosed information is measurable by the movement of the company’s stock price immediately following the disclosure.

Inasmuch as Merck’s stock price did not decline when the S-1 was filed on April 17, the Third Circuit concluded that the co-payment recognition information had an immaterial impact on Merck’s stock price.

In response to the plaintiffs’ argument that the true disclosure took place two weeks later when the Wall Street Journal article publicized the estimated amount of the co-payment recognition, the court concluded that the “minimal, arithmetic complexity of the calculation” that the WSJ reporter made “hardly undermines faith in an efficient market.” The court noted that this was especially true given how closely analysts followed a company such as Merck:

“[Plaintiff] is trying to have it both ways: the market understood all the good news that Merck said about its revenue but was not smart enough to understand the co-payment disclosure. An efficient market for good news is an efficient market for bad news. The Journal reporter simply did the math on June 21; the efficient market hypothesis suggests that the market made these basic calculations months earlier.”

Applying Merck to the Olis case, the efficient market for Dynegy stock understood the bad news about Project Alpha when it was disclosed on April 3rd and no market loss resulted from the news.

Thus, when Dynegy’s stock price dropped weeks later after the company’s disclosure of more bad news, the efficient market attributed that loss to the additional bad news items and not Project Alpha.

In short, the Merck decision is strong support for the position that the Justice Department has failed to establish any causation between Project Alpha and the astronomical market loss figures that the DOJ has used in advocating lengthy prison sentences for Olis.

The new Third Circuit decision in Merck is not the only recent appellate authority that contradicts the Justice Department’s market loss position in the Olis sentencing. Despite that, Jamie Olis remains in prison awaiting a re-sentencing hearing in which the government will almost assuredly seek a prison sentence longer than 15 years.

Here’s hoping that U.S. District Judge Sim Lake takes a page from his colleague Ewing Werlein’s sentencing book and rejects the Justice Department’s disingenuous market loss claims in the Olis case, and — in so doing — reins in a Justice Department that increasingly runs amok in its zeal to criminalize the unpopular business executive of the moment.

This NY Times article reports that Mel Weiss and Bill Lerach received good news and bad news earlier in the week regarding the longstanding criminal investigation against the two men and the Milberg Weiss Bershad & Schulman law firm over allegations of paying kickbacks in connection with class action lawsuits that the firm handled over the past decade.
The good news is that federal prosecutors have apparently informed Weiss and Lerach’s individual counsel that they will not seek an indictment against the two men.
The bad news is that the prosecutors still may go Arthur Andersen on the Milberg Weiss firm.
According to the Times article, two top Milberg Weiss partners — David Bershad and Steven Schulman — appear to be the main targets of the investigation. The heat on Milberg Weiss and its current and former partners was turned up last year when prosecutors indicted 78 year-old Seymour Lazar, a retired Southern California Palm Springs lawyer who was a plaintiff in at least 50 Milberg Weiss securities cases, with fraud and conspiracy. Prosecutors alleged that Lazar was involved in an alleged scheme with Milberg Weiss in which the firm secretly funneled him about $2.5 million for being the class representative in class action lawsuits that the firm handled. Lazar and Milberg Weiss contend that the payments were legal referral fees and deny that there was any effort to conceal them.
As noted in my previous posts on this matter, despite the irony that Weiss and Lerach are embroiled in a criminal investigation that is strikingly similar to the prosecution of agency costs that Weiss and Lerach profit from in connection with a good number of their class action securities fraud cases, I have great reservations about the government criminalizing the plaintiff’s lawyers’ conduct in these cases. Larry Ribstein shares those concerns, and notes with his usual keen insight:

To the extent that a goal of the case is to curtail securities class actions, this is not the way to do it. . . . Lerach and company are just products of the system that has been created by current law. Real reform requires changing the game, not just the players. How about this solution: getting rid of the ìfraud on the marketî theory?

Meanwhile, Bruce Carton has more on the ubiquitous Lerach in this second excerpt from Joseph C. Goulden’s new book, The Money Lawyers (previous excerpt here), which includes Lerach’s description of how his first meeting with Weiss transformed him from a boring Pittsburgh defense lawyer into an exciting plaintiff’s lawyer:

“Mel sat there like the complete master of the universe. He was barking orders right and left, saying which lawyer would do what, laying out the scenario for what would happen in court the next day. He was in complete charge, and all of us sat there saying, ‘Yes, Mel, you’re right, whatever you want. . . .’ Man, I was impressed. Mel was the smartest lawyer I had ever seen. I was used to dealing with the uptight, stuffy defense lawyers. Now I was definitely on the other side of the spectrum.”

The downtown Federal Detention Facility is not normally the destination of choice for U.K. bankers traveling to Houston, but it is looking increasingly as if that’s where three former U.K. bankers embroiled in a transaction devised by former Enron CFO Andy Fastow will be spending a considerable amount of time in the near future.
As this Forbes article reports, former NatWest bankers David Bermingham, Giles Darby and Gary Mulgrew lost their High Court appeal to avoid extradition to Houston to face charges that they bilked their former employer of $7.3 million in one of the schemes allegedly engineered by former Enron CFO Andrew Fastow and his right hand man, Michael Kopper (previous posts are here). After the High Court’s decision was announced, the three ex-bankers said that they intend to appeal to the House of Lords, the U.K.’s highest court.
The case is particularly interesting because NatWest — the institution that the Enron Task Force contends was bilked by the three former bankers — never sought to recover the allegedly bilked funds from the three men, never pursued criminal charges against them in England, and neither the Crown Prosecution Service, the Financial Services Authority nor the Serious Fraud Office in the UK found sufficient evidence to prosecute. Had a trial taken place in the U.K., the three men could not be extradited to the U.S. because of the principle of double jeopardy, but since no British trial has taken place, the British Home Secretary has granted the Enron Task Force’s request under the Extradition Act of 2003, which was passed to facilitate extradition of suspected terrorists to the U.S. Under that legislation, the Home Secretary can extradite British citizens without the U.S. authorities having to make a prima facie case — they need only set forth a statement of the facts that they hope to prove. Moreover, the Extradition Act is not recipricol — to extradite an American citizen from the U.S., the British still need to provide evidence that the American citizen has committed an extraditable offense.
Thus, if the bankers lose their appeal to the House of Lords and are extradited to Houston, they will be forced to prepare the defense of their case while imprisoned in Houston’s Federal Detention Facility. Meanwhile, their main accusers — Fastow and Kopper — remain living comfortably in River Oaks and Montrose.
Chalk it up as another example of the high price of asserting innocence.

During its four year existence, the Enron Task Force has always been better at bludgeoning plea bargains and villifying former executives in the media than actually obtaining convictions in court.

One of the former Enron executives who stood up to the Task Force is Sheila Kahanek, the former mid-level Enron accountant who was acquitted of fraud and conspiracy charges in the Task Force’s controversial Nigerian Barge prosecution. That case resulted in the questionable convictions of four former Merrill Lynch executives on charges that they assisted Enron in manipulating its finances in connection with a sale of an interest in some power-producing barges off the Nigerian coast.

In this important U.S. News interview, Kahanek tells her compelling story about being falsely accused of a crime and the ordeal involved in defending herself with limited resources against a prosecution team that has no such limitations. The entire interview is a must-read, but Kahanek’s answers to the following questions about the government tactic of preventing exculpatory testimony from coming to light and the high price of asserting innocence are particularly interesting:

The defense attorneys for Lay and Skilling have complained that the prosecution is scaring witnesses away from testifying for their clients. Did this happen to you?

It was extremely rare if you could get someone to return a call, much less answer your questions. Prosecutors have absolute power in deciding whom to indict, regardless of what the law says concerning the not-so-grand jury. It is an unfortunate reality that most people will not risk their freedom for that of another, particularly if they have a spouse or children.

So weren’t you tempted to plead guilty and limit your losses?

Absolutely not. Dan [her defense attorney, Dan Cogdell] and I got that clear from the start. A plea deal was not an option. It wasn’t an option. I had to know I fought for what was right. I had to be able to look myself in the mirror and know that I never compromised myself or the truth. Every day I had to dig into myself and find the strength to fight another day. I have asked a number of people with children: Would you stand up and fight if it meant you might not see your kids for 24 years, when you can take a deal for five years? No one has said absolutely that they would fight it. Someone told me: “When you have children it is not about you anymore.”

Read the entire interview, and then give some thought to the plight of William Fuhs, the former mid-level Merrill Lynch executive who was convicted in the same trial in which Kahanek was acquitted and who had virtually the same level of involvement in the transaction that formed the basis of the prosecution as Kahanek (Fuhs was the ministerial scrivener of the transaction and had no involvement in either the structuring or the negotiation of the deal).

Fuhs — who is in his early 30’s with a wife and two young children — now sits in federal prison awaiting disposition of his appeal for merely having documented a legitimate transaction that the government criminalized because of matters in which Fuhs was not involved.

What our Justice Department has done to Kahanek, Fuhs and the other Merrill Lynch executives involved in the Nigerian Barge case — and how the government is handling the Lay-Skilling prosecution — is a radical abuse of our criminal justice system, and the extraordinary damage to the individuals and families involved cannot be responsibly dismissed as a trade-off of an imperfect system.

As we watch principles of justice and the rule of law trampled upon in such cases, contemplate whether — as Sir Thomas More asked Will Roper in A Man for All Seasons — “Do you really think you could stand upright in the winds [of abusive state power] that would blow” if the government were to set its sights on you?

Former Reliant Energy gas trader Jerry Futch — who was arrested and charged under particularly heavy-handed circumstances — has filed a motion to withdraw his prior plea deal with the Justice Department and a motion to dismiss his indictment on four counts of reporting false transaction data to publishers that produce indexes used to value natural gas contracts.

Futch’s surprising motions were the latest developments in a series of controversial criminal cases that the U.S. Attorney’s office for the Southern District of Texas has been pursuing against former traders of natural gas who worked for various Houston-based companies.

The case against Futch is one of about a dozen that the Justice Department has been pursuing in regard to alleged manipulation of natural gas trading indexes, which are used to value billions of dollars in gas contracts and derivatives.

Industry publications such as Inside FERC Gas Market Report use data from traders to calculate the index price of natural gas, which affects the level of profits that traders can generate.

In Futch’s case and in the related trader cases, it remains unclear in what context the allegedly false information was transmitted or whether the publication even used any false information. However, the government’s theory of criminal liability is that it needs only to prove that fake trades were reported to the publications and not that the trades were actually published or affected the markets.

Eleven other former traders have been charged in similar cases, eight of whom (including Futch) have pled guilty. Four others others are currently awaiting trial, including former Dynegy trader Michelle Valencia and former El Paso trader Greg Singleton.

Futch’s motions are particularly interesting in that they assert the argument that Reliant Energy and its Houston-based counsel, Baker & Botts, effectively threw Futch to the wolves in not making him aware that he was a target of the criminal investigation into the false data reporting and that his statements in a Commodities Futures Trading Commission civil investigation could be used against him in the criminal investigation.

As has become typical in this era of the vanishing attorney-client privilege, Reliant Energy entered into a cooperation agreement with the CFTC in November 2003 in which the company agreed to give the government broad access to its employees such as Futch. Although Reliant Energy and Baker & Botts contend that Futch was advised that his statements in the civil investigation could be used against him, Reliant Energy did not provide Futch with independent counsel during the investigation.

The criminal case against former Cendant Corp. Chairman Walter Forbes has now lasted eight years. Yesterday, the second trial against Forbes on charges of securities fraud, conspiracy and two counts of lying to the Securities and Exchange Commission ended in a mistrial (NY Times article here) with the jury deadlocked after 27 days of deliberations. The first trial of Forbes in 2004 also ended in a deadlocked jury.
After running a company that merged with another to form Cendant in 1997, Forbes became Cendant’s chairman and heir apparent for the CEO position. But the accounting fraud came to light in 1998 and Cendant’s market cap plummeted by $14 billion in one day, which prompted the indictment against Forbes. Mounting a similar defense to that of former HealthSouth CEO Richard Scrushy, Forbes contended that subordinates betrayed him and then concealed the scheme. One of Forbes’ underlings — Cosmo Corigliano, the chief financial officer of Forbes’ company that was used to form Cendant — copped a plea on conspiracy and fraud charges and was the main government witness against Forbes during the trial.

In addition to maintaining the Wall Street Journal’s essential Law Blog, Peter Lattman continues to contribute interesting news articles for the WSJ, including this one from yesterday that he co-authored with Jesse Eisinger about something that is close to the heart of the Enron scandal — a company’s alleged use of special purpose entities to dump low-performing assets that would otherwise depress earnings if the company were to hold on to them (thus, the characterization of an SPE as a “nuclear waste dump”).
Public revelations of former Enron CFO Andy Fastow’s shenanigans with certain of Enron’s SPE’s in October, 2001 triggered the collapse of Enron into bankruptcy, and the same thing almost happened to Omnicon — the world’s largest ad holding company — back in June 2002. At that time, the WSJ reported that an Omnicon SPE called Seneca Investments appeared to have been used by Omnicom to avoid an earnings charge of about $90 million in connection with its reporting of $246 million of earnings for the first half of 2001. Given the nearness of similar disclosures relating to Enron and Enron’s subsequent December, 2001 bankruptcy, Omnicom’s stock price dropped like a rock before stabilizing at about half of its pre-SPE disclosure price. Nevertheless, the company was able to stem an Enronesque collapse into bankruptcy.

Continue reading →

The Woodlands is a dynamic suburban community on Houston’s far northside, but it’s not the type of place that one normally associates with business scandals.
However, late last week, it appears that The Woodlands had its own real business scandal. The revelations began unfolding on Thursday when Chicago Bridge & Iron — the Netherlands-based engineering company that maintains its worldwide administrative office in The Woodlands — filed an 8-K (i.e., the regulatory filing that advices the investing public of significant corporate events) that contained this agreement, under which CBI controller Tommy C. Rhodes will be paid a $1.8 million ìstay bonusî so long as he remains with the company until the end of June. However, the more interesting part of the deal is that Rhodes must ìwithdraw and dismiss or close any and all complaints he previously has filed against the company.î This follows an earlier 8-K from the company on October 31, 2005 that disclosed that a senior member of CB&Iís accounting department had alleged accounting improprieties and that, as a result, third quarter 2005 numbers would be delayed.
All of that was followed on Friday with this announcement in which the company disclosed the termination of Gerald M. Glenn as Chairman, President and Chief Executive Officer, and Robert B. Jordan as Executive Vice President and Chief Operating Officer. Then, on Saturday, the Chronicle reported that Messrs. Glenn and Jordan’s attorney was already taking the approach that a good offense is the best defense, asserting that the executives “are being targeted by a results-oriented process where the reputations of honest men have been unfairly called into question. These men are not going to hand over their good names for the sake of a misguided, biased and incomplete review.”
Meanwhile, the company announced that “all previous earnings guidance issued by the company for 2005 is no longer operative. When given, the guidance will be subject to closing the books of the company for 2005 and completion of the audit committee’s previously announced ongoing investigation.”
Not exactly Enronesque, but pretty juicy nonetheless for The Woodlands.

As discussed in more detail here earlier, the settlement between American International Group and regulators over business fraud charges may be consummated as early as later this week, according to this Wall Street Journal ($) article (NY Times article here).
The expected amount of the regulatory extortion, er, I mean, “settlement”: $1.6 billion.
9 Feb. 2006 Update: It’s a done deal. NY Times article on the settlement is here.

Now that title got your attention, didn’t it? ;^)

Selling stocks short receives a bad rap generally because it generates profits from misfortune — i.e., when the stock price goes down — which is counter-intuitive to how most folks believe that one should make money in investments (i.e., holding stocks long-term as they appreciate in value).

The most common method of shorting a stock is to borrow stock, sell it, and then cover the loan of the stock in the market by purchasing the stock later at a lower price. Other approaches to shorting involve buying a put option that holds the right to sell the stock for the next 30 to 60 days at current market prices, writing a call option granting another the right to buy a stock from you for the next 30 to 60 days at current prices, selling a stock future promising to deliver a stock 30 to 60 days in the future, or taking the selling position in a stock swap.

The issues relating to short selling arose in the news again this week as the prosecution in the Lay-Skilling trial played the tape of Jeff Skilling’s infamous “asshole” comment in response to a short-seller’s questions during an April, 2001 analyst conference call. Chronicle business columnist Loren Steffy followed that up with this timely column (related blog post here) in which he correctly points out that — despite such negative aspersions — the practice of short selling provides a valuable market purpose. Indeed, I suspect that Skilling would actually agree with Steffy that short selling is an important part of well-structured securities markets and that his “asshole” comment was not a condemnation of short-selling per se, but rather, a reaction to the short-seller’s improper attempt to profit from creating a false impression about Enron.

Skilling’s comment and Steffy’s column were then followed by this interesting Wall Street Journal op-ed in which Moin A. Yahya condemns the 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. I don’t agree entirely with Professor Yahya’s position in that regard (more on that later), but the professor does provide some highly interesting background into the genesis of the sad case of Jamie Olis:

A few years ago, a Houston-based energy company called Dynegy was experiencing financial difficulties and resorted to some questionable financing activities in what was known as “Project Alpha.” An employee named Ted Beatty learned about the project and informed a friend, who happened to work at a short-selling hedge fund. The fund subsequently took a short position against Dynegy’s stock. Later Mr. Beatty resigned and contributed to a Wall Street Journal article that highlighted the problems with Project Alpha. Much to the hedge fund’s surprise, however, the Dynegy stock price actually rose.

The hedge fund asked Mr. Beatty to help spread the bad news about Project Alpha, and hired a prominent plaintiff’s lawyer to assist him. The fund kept its role secret while Mr. Beatty and the lawyer kept working to lower Dynegy’s stock price. Mr. Beatty contacted various media outlets, government agencies, a credit rating agency and the local SEC office. The SEC announced an informal inquiry, which finally lowered the stock price. The lawyer’s firm launched a shareholder suit against Dynegy for its fraudulent practices. The hedge fund netted around $150 million from the fall in the price of Dynegy stock.

Project Alpha, of course, is the series of transactions upon which Olis’ conviction and over-the-top 24-year prison sentence are based.

As to Professor Yahya’s condemnation of the practice of “dumping and suing,” Larry Ribstein believes that he has missed the proper analytical framework for addressing the perceived abuses of the practice:

If a plaintiff or his lawyer (with the plaintiffís permission, so no misappropriation) is short-selling based on the true information that a suit is forthcoming I donít see how this is illegal under current law ñ itís not fraud without a duty to disclose, and itís probably not illegal insider trading or manipulation.

Yahyaís WSJ oped persists in his blanket claim of illegality despite this fairly elementary principle of securities law. As a result, he allows his polemic against the practice to obscure some real, and more important, issues.

To begin with, there is actually something to be said for using the markets to compensate people who bring in new information, such as the information underlying a lawsuit. Yahya calls this double-compensating class action lawyers. But the question is whether the fee the lawyer receives provides a socially optimal incentive to sue.

Now I can already hear the howls: how could I possibly be suggesting that securities class action lawyers are under-compensated? Well, Iím not saying that. Iím only positing the correct analytical approach. Assuming over-compensation is an incorrect way to analyze this issue. . . .

[C]onsider that a rule broadly characterizing undisclosed material information (in this case, about the intent to sue) as fraud could seriously extend the reach of the fraud laws. We have to remember that a rule intended to “catch” the people we don’t like could end up “catching” those we do.

I know that trial lawyers aren’t cool in some circles. But let’s make sure the weapons we fashion against them don’t circle back on the rest of us.

Read Professor Ribstein’s entire piece. Although Professor Yahya’s identification of the dumping and suing practice is interesting, Professor Ribstein is correct that more regulation is not the answer to controlling the perceived abuses that may arise from the practice.

Meanwhile, Jamie Olis remains in prison awaiting re-sentencing, a pawn of dynamic forces in the securities markets and the criminal justice system that are far stronger than any man could — or should ever have to — defend himself against.