During the recent trial of former Tyco CEO Dennis Kozlowski, I noted here and here that the cross-examination of Mr. Kozlowski did not go well for the defense.
Consistent with that theme, this Wall Street Journal ($) article reports today that Mr. Kozlowski — who essentially was convicted of embezzling excess compensation from Tyco — wrote this letter several years ago to a Houston assistant district attorney in which he requests that the prosecutor seek the maximum prison term for a former executive of a Tyco unit who had been found guilty in a Houston state court for — you guessed it — embezzlement.
In his letter, Mr. Kozlowski wrote that the former Tyco unit executive’s crime “cannot be condoned in any manner” and that “not only did he steal from the stockholders … but he breached the fiduciary duty placed in him.” In advocating the “maximum term,” Mr. Kozlowski noted that the court needed to send a message that “wrongdoing of this nature against society is considered a grave matter.”
The former Tyco unit executive got 20 years, although he was paroled after four.

U.S. District Judge Karon O. Bowdre today appointed an alternate juror to replace a male juror suffering from “recurring health problems” during jury deliberations in the corporate-fraud trial of former HealthSouth Corp. CEO Richard M. Scrushy (a previous post on the trial is here). With that move, the judge proceeded to instruct the jury that it would have to start over in its deliberations toward a verdict on the 36 criminal counts against Mr. Scrushy.
This development probably went over about as well as the proverbial turd in the punchbowl with the Scrushy jurors, who have been deliberating on the case since May 19 after enduring a trial that began on January 25.
The 36 counts against Mr. Scrushy include conspiracy, fraud, false statements and one count of false certification under the Sarbanes-Oxley Act. Mr. Scrushy used the “honest idiot” defense during the trial, contending that the finance executives at the company who engineered the fraud hid it from him.

Two columns in today’s Wall Street Journal address one of the too little-discussed effects of this post-Enron era’s criminalization of business — that is, the chilling of beneficial risk-taking.

In his weekly WSJ ($) column, Alan Murray examines the motives of former AIG chairman and CEO Maurice “Hank” Greenberg to arrange the structured finance “finite risk” insurance transation that is at the heart of Eliot Spitzer’s lawsuit and public allegations that Mr. Greenberg engaged in fraud while at AIG.

According to Mr. Spitzer’s theory of the case, the deal allegedly involved a phony, risk-free swap of insurance assets that allowed AIG to boost short-term reserves and assuage the concerns of analysts, who had been fretting that AIG was drawing down its loss reserves to boost profits. In return, the company paid Berkshire Hathaway’s General Reinsurance Corp. unit a fee of $5 million.

Mr. Murray’s column dismisses Mr. Spitzer’s contention that Mr. Greenberg’s arrangement of the questionable transaction was motivated purely by the Mr. Greenberg’s greed in propping up the value of his extensive AIG equity holdings. Rather, Mr. Murray focuses more on Mr. Greenberg’s obsession with short-term results over taking a longer term view of AIG’s financial health.

However, the more interesting question is whether it makes any sense for the government to criminalize taking the risk of financial transactions that may push the edge of the envelope of applicable accounting rules, but that may nevertheless lead to preservation or creation of wealth for equity owners?

Despite the government’s bludgeoning of various AIG and General Re executives into plea deals and the AIG’s board acquiescence to Mr. Spitzer and other governmental investigators, it still has not been proven that the transaction in question in AIG’s case was even accounted for improperly, much less illegal. Should not the government wait to address possible criminality (and its corresponding negative effect on value) until at least the underlying transaction has been proven to be violative of applicable accounting rules?

Meanwhile, in his WSJ ($) column, Holman Jenkins examines how the government’s criminalization of structured finance transactions almost scuttled a market that has turned out to be perfectly legitimate and hugely beneficial for consumers of life insurance — i.e., the business of buying and selling “used” life insurance policies where the buyer of the unwanted insurance policies (such as AIG) buys a life insurance policy from a seller, keeps up the premiums until the seller of the policy dies, and then collects the death benefit. As a result, owners of life insurance now have a legitimate market in which they can liquify their life insurance policy before the insured’s death.

Whether you consider that market ghoulish or not, the market serves a legitimate financial demand of owners of life insurance policies. Nevertheless, as Mr. Jenkins reports, part of Mr. Spitzer’s lawsuit against AIG attempts to penalize the company for its accounting of its investment in that market, and discovery in the lawsuit has already revealed that Mr. Greenberg wrote in a memo that adverse public relations emanating from an investment in the market may outweigh its financial benefit for AIG.

But as Mr. Jenkins points out, Mr. Spitzer’s assault on AIG’s involvement in the market risks damaging a market that is valuable for ordinary citizens and actually a market that government should be encouraging:

Gone are the days when insurance companies were the sole market for policyholders who wanted something to show for decades of paying premiums without having to die first.

Once, these policies might have been allowed to lapse or returned to the company for a minuscule “surrender” payment. But — here’s the peculiar calculation — where the covered person has suffered a health reverse that reduces his or her life expectancy, the real economic value of the death benefit may be far greater than the surrender value, even after the premiums that would have to be paid until he or she finally dies.

Now that institutional investors are buying and selling hundreds of policies at a time, vanished is the specter of an investor seeking to hasten his payoff with a blunt object. Pricing will improve too, as securitization takes advantage of the law of large numbers to remove much of the risk from mortality estimates.

The new securities are expected to appeal particularly to pension funds, always looking for ways to match the maturities of their investments with the timing of their payouts. Thus the recycling of life insurance by older Americans will become, twice over, a way for them to finance their own retirements.

Indeed, Mr. Spitzer’s assault on the “used” life insurance policy market is taking place at the same time as he is hammering the sub-prime mortgage market, another market that benefits ordinary citizens.

Thus, in the wake of the morality plays of Mr. Spitzer and governmental prosecutions involving structured finance transactions that the prosecutors either mischaracterize or do not understand, legitimate and productive business transactions are unfairly and incorrectly portrayed as complex business frauds. The misguided nature of the government and the Enron bankruptcy examiner’s criminalization of many of Enron’s valid structured finance transactions has already been well-chronicled by University of Chicago structured finance expert Christopher Culp and others in the recent books, Corporate Aftershock (Cato 2003) and Risk Transfer (Wiley 2004).

Mr. Spitzer and his minions are eminently capable of misusing the power of the state to deprive citizens of other valuable markets when what they really ought to be doing is encouraging the type of risk-taking that creates valuable markets for citizens such as the one that Mr. Jenkins describes.

This Wall Street Journal ($) article picks up on the theme of this post from late last year — i.e., that the government’s regulation of accounting firms through criminalization of their services is contributing to the shortage of accounting firms that have sufficient resources to provide the specialized services that big companies need:

Intel Corp. is one of the many big companies now bumping up against the limitations. After using Ernst & Young LLP as its auditor for more than three decades, the semiconductor maker considered switching recently for a fresh look at its financials. But it stuck with Ernst after receiving proposals from the other Big Four firms: Deloitte & Touche LLP, KPMG and PricewaterhouseCoopers LLP. That is because federal regulations bar the three other firms from serving as Intel’s independent auditor unless they give up valuation, computer-software and other work they do for Intel.
Worries about the shrinking number of top-tier auditing firms began mounting with the collapse of Arthur Andersen LLP in 2002, after its conviction for obstruction of justice tied to its audits of Enron Corp. (The conviction was reversed last month by the Supreme Court.) The Sarbanes-Oxley corporate-governance act, passed by Congress in response to the accounting scandals at Enron and elsewhere, has complicated the situation, as well, by forbidding auditors from providing certain nonaudit-related services to audit clients. The restrictions, aimed at enhancing the independence of auditors, have led some companies to distribute nonaudit work to the other Big Four firms. But that puts these companies in a bind if they want to switch auditors.

Meanwhile, KPMG is learning that playing nice with the Justice Department may not be all that it’s cracked up to be. As noted here last week, the threat of an indictment has KPMG pursuing a settlement of the government’s criminal investigation into its promotion of tax shelters under a deferred-prosecution agreement. As a part of that effort, KPMG issued a well-publicized admission of wrongdoing and public apology last week regarding its involvement in the tax shelters.
However, as a result KPMG’s public admission, this NY Times article reports KPMG is now a sitting duck for damages in the myriad of civil lawsuits involving the tax shelters and even unrelated accounting issues, and that KPMG’s co-defendants in the tax shelter civil cases are furious over the financial implications to them of KPMG’s public admission of wrongdoing.
All of this is having a devastating effect on KPMG financially. KPMG reported earlier this year that it had revenue of $4.1 billion last fiscal year, but that “practice protection costs” — i.e., insurance, legal fees and litigation settlements — were running at the staggering amount of more than $400 million annually, or more than 10 percent of the firm’s revenue.
Thus, the cost of avoiding an indictment might just cause KPMG to meltdown anyway. At very least, the cost of cooperation will cause substantial financial damage to the firm, resulting in job loss and less competition for audit services for big companies. And let me get this right — this is a “business-friendly” Republican Administration pursuing these policies?

This Wall Street Journal ($) article examines the increasing criminalization of business in the post-Enron era, which has been a frequent topic on this blog. Although the article does a reasonably good job of summarizing the troubling trend, it comes up somewhat short on analyzing the key implications of the trend, such as the disincentive to take risks resulting from regulating business through criminalization and the degradation of the rule of law resulting from the government’s overly broad application of criminal laws in its quest to convict business interests. For more analysis in that regard, review this thread of blog posts over the past year and a half.
The money quote in the article come from Joseph Grundfest (earlier post here), the Stanford University business law professor and former SEC commissioner who is currently researching the implications of the government’s growing power to bludgeon business interests into cooperating with a criminal investigation even if those business interests do not believe that they have done anything wrong:

“It’s a lot like the scene in ‘The Godfather’ where Marlon Brando explains how he’s going to make an offer they can’t refuse.”

Along those same lines, this WSJ ($) article reviews the prison sentences that have been and are expected to be handed down in the latest string of criminal prosecutions of business executives, while this article examines the unusual arrangement in which the Newark, N.J. U.S. Attorney has inserted himself into the management of Bristol-Myers Squibb Co.. The company’s board agreed to the arrangement in order to stave off a large fine stemming from a criminal investigation into an alleged $2.5 billion fraud at the company.
American International Group Inc.’s board should get ready for the same type of arrangement with the Lord of Regulation. And don’t miss Professor Ribstein’s cogent analysis of the situation, in which he notes the big difference between prosecuting agency costs — such as sloppy corporate controls over executive compensation — and prosecuting a more clear-cut crime where the thief robs the victim at gunpoint.
By the way, Professor Ribstein’s point about the arbitrary nature of prosecuting agency costs is perhaps best reflected by the irony that the key prosecution witness against Messrs. Kozlowski and Swartz — Tyco outside counsel David Boies — is simultaneously defending Maurice “Hank” Greenberg against Mr. Spitzer’s criminal assault on AIG’s agency costs.
It does all get quite confusing, doesn’t it?

The morning brings several interesting obserations regarding yesterday’s guilty verdict in the trial of former Tyco International, Ltd. executives, L. Dennis Kozlowski and former Tyco finance chief Mark H. Swartz.
Over at Conglomerate, Professor Hurt (a former Houstonian, by the way) notes insightfully in this post that, on one hand, the case against Messrs. Kozlowski and Swartz differs from most other corporate crime prosecutions because of its relative simplicity, but that — on the other hand — such simplicity insures that no amount of regulation will ever prevent such actions from occurring again.
Meanwhile, over at the White Collar Crime Prof Blog, Professor Henning makes a key technical point about the way in which the prosecution handled the more recent prosecution after the first trial ended in a mistrial:

The government made its case in about 25% less time (13 weeks as opposed to 18 weeks in the first trial), and kept the accounting and reporting issues front-and-center. Going technical is usually a recipe for disaster (see the Enron Broadband Services prosecution for an example of mind-numbing detail), but in this case the Manhattan D.A.’s office concentrated on what was truly important.

Finally, in this remarkable analysis, Professor Ribstein questions the wisdom of unleashing the power of the state based upon the human frailties that drive most prosecutions of questionable business conduct:

Not merely envy (one’s discomfort at comparing oneself with another), or wanting to have what another person has, but disliking that person for having it and believing that his good fortune is undeserved. The resenter wants to lower the envied person to his level.
This is the common element in Tyco, Martha Stewart, Mike Milken and many other cases of this ilk, despite the facial dissimilarity of the offenses being tried.
Resentment is pernicious enough in itself because it seeks to degrade human achievement. But it’s worse when it leads to criminal prosecutions for what amount to agency costs — failure to get the requisite corporate approval for expenditures. The marginal criminality of these offenses is what leads to months of hugely expensive trials.
The supposed social payoff is deterrence. But the Kozlowskis of the world probably will keep doing this stuff while the legitimate sorts will be ever more afraid of taking chances. Not that the conduct in Tyco was particularly worth encouraging, but Mike Milken was a different case, in my view, and I don’t see much chance of politically ambitious prosecutors being able or willing to tell the difference.
So white collar prosecutions become a sort of lottery. If the prosecution can come up with something colorful, it wins, or maybe loses if it’s too colorful (Sardinia). These are not the elements of a rational criminal justice system.

Nor is it rational to base corporate criminal prosecutions on the timing of going bust.

Following on the heels of this earlier post, this NY Times article reports on the lawsuits that the Office of the Comptroller of the Currency and the Clearing House Association filed on Thursday in Manhatten U.S. District Court to enjoin the Lord of Regulation from using his subpoena power to obtain nonpublic credit score and loan information from national banks such as HSBC Holdings, J. P. Morgan and Wells Fargo. Here is an earlier post on Mr. Spitzer’s latest attempt to injure a productive part of the national economy, this time the sub-prime mortgage market.
Not pleased with competition in the regulation market that infringes on his demagogic ways, Mr. Spitzer commented as follows about the lawsuits:

“While such a move was expected from the banks, it is shameful that a federal regulator would join in an effort to shield the banks from scrutiny by state regulators.”

To which I wish the Comptroller of the Currency would respond:

“While we understand that Mr. Spitzer enjoys undertaking investigations that will provide publicity for his political purposes, we do not expect him to undertake investigations into areas that are the province of federal regulation and that will harm the ability of low-income families to climb the ladder to prosperity through home ownership.”

This post from mid-May noted former Merrill Lynch executive Daniel Bayly‘s motion to the Fifth Circuit Court of Appeals requesting that he remain free during the appeal of his conviction and sentence in the Enron-related Nigerian Barge case. Subsequently, the Fifth Circuit summarily denied Mr. Bayly’s motion in a one page order.
However, the May 31st Anderson decision of the U.S. Supreme Court has prompted the Bayly appellate team to file this compelling motion requesting that the Fifth Circuit reconsider its denial of Mr. Bayly’s motion for release pending appeal. The money section:

The fundamental errors in this case begin with the government’s novel and unduly creative use of an “honest services” thoery in connection with the wire fraud statute. See 18 U.S.C. 1343, 1346. As Bayly’s motion for release shows, the honest services charge in this case permitted a criminal conviction for conduct — the accelerated booking of gain — that was undertaken primarily on behalf of the alleged victim (Enron), which knew every aspect of the transaction, and not for the self-interest of the alleged conspirators (see Bayly motion at 16-20). No court ever has sanctioned such a broad application of the honset services statute — especially where, as here, no bribe or gratuity was provided to, nor were there any undisclosed conflicts of interest as to, the employees of the purtative victim (Id. at 19-20). As in Andersen, the Enron Task Force in this case secured a conviction through application of an entirely unprecedented theory in a hotly-contested area of the law. . . The government does not dispute that, if our view of the limits of Section 1346 prevails, all three counts of conviction must be set aside. (footnote omitted).

The motion goes on to address other grounds for reversal of Mr. Bayly’s conviction, particularly the trial court’s granting of the Enron Task Force’s objection to a jury instruction that the defense proposed on a key defense theory in the case — i.e., that the Enron promise to Merrill Lynch to arrange a sale of the interest in the barges within six months to a third party — as opposed to an Enron promise to repurchase the interest within that time frame — did not undermine Enron’s accounting of the transaction and, thus, did not constitute the basis of a crime. Inasmuch as Enron ultimately arranged for such a sale to a third party as opposed to buying back the interest in the barges from Merrill itself, the lack of a jury instruction on that issue appears to be another solid basis for reversal of Mr. Bayly’s conviction.
But read the entire motion, which is only eight pages. It is a masterful example of appellate advocacy and brevity that persuasively outlines the major injustice of the convictions of the Merrill Lynch executives in the Nigerian Barge case. Mr. Bayly worked on this relatively small transaction for less than two hours in the ordinary course of one of his business days. He is now facing two and a half years away from his family during the autumn of his life because of the government’s broad application of criminal statutes to cover what is not even clearly questionable business conduct, much less clear criminal conduct.
The Fifth Circuit’s Anderson decision is not a highlight of that body’s judicial decision-making, as the U.S. Supreme Court’s decision in the case reflects. Here’s hoping that the Fifth Circuit sits up and takes notice before yet another grave injustice takes place in the case of Daniel Bayly.