This this NY Times article reported last week that nine executives from a several food supply companies have been charged with crimes for their part in a revenue pumping scheme at U.S. Foodservice, a subsidiary of the Dutch company Royal Ahold N.V.. All the executives are accused of participating in a scheme to inflate U.S. Foodservice’s profits by confirming to the company’s auditors that the company was owed millions of dollars more in rebates than was actually the case. According to the article, most of the executives are expected to plead guilty.
The U.S. Foodservice case reflects a growing trend in white collar criminal prosecutions — i.e., employees of a company doing business with a target company being accused of participating with the target company’s employees in an accounting scheme to inflate the target company’s profits. The same approach was taken in the recent Enron-related Nigerian Barge case, in which four Merrill Lynch executives were convicted of participating in an accounting fraud with various Enron sharpies.
On the surface, the cases appear to be similar. The U.S. Foodservice prosecution appears to involve blatantly fraudulent conduct in which vendor representatives falsified documents so that U.S. Foodservice auditors would be misled regarding the true amount of the company’s revenues. The documents were clearly false because the vendors had no legal obligation to provide the rebates set forth in the documents. Based on the false documents, the U.S. Foodservice’s auditors booked illusory revenue that inflated profits.
Similarly, the Nigerian Barge case also involved an oral side deal that was not disclosed to Enron’s auditors. As a result, the government successfully contended at trial that Enron was able to take advantage of the accounting benefit of selling the three Nigerian energy production barges to Merrill Lynch even though it secretly remained obligated to repurchase the barges. But for non-disclosure of the oral side deal, Enron would have had to book lower than expected earnings, which would have resulted in lower stock price, lower compensation to the executives involved, etc.
Thus, the two cases appear to have much in common — false documents, undisclosed side deals, and false disclosures to auditors. But the nuances reflect significant differences between the cases, and those differences point to the dangers of criminalizing common business transactions, particularly in the anti-business environment fueled by anti-Enron animus.
Unlike the apparent false documents in the U.S. Foodservice case, there was a real question during the Nigerian Barge trial whether the contract under which Enron sold the barges to Merrill Lynch was true or false. This is particularly important because the written contract included a standard provision that specifically provided that any prior oral agreements between the parties — which would include the oral side deal in which Enron agreed to repurchase the barges — were superceded by the written contract that included no such obligation. Thus, if the written contract was enforceable, then Merrill Lynch could not have required Enron to repurchase the barges. If Merrill could not have enforced the oral side deal, Merrill was truly at risk with regard to the transaction, and Enron’s accounting for the transaction was at least arguably correct. If that’s the case, then what’s the crime?
Undaunted, the Nigerian Barge prosecution trotted a few former Enron executives who had previously copped pleas to the witness stand to testify regarding the existence of the oral side deal and to opine that Merrill was not truly at risk with regard to its acquisition of the barges. The prosecution put on no evidence that the written contract was unenforceable. Rather, the prosecution focused the jury on the horrors of Enron and the bad judgment that a couple of the Merrill Lynch defendants had used in investing personally with former Enron CFO Andrew Fastow in a special purpose entity that ultimately ended up with the barges. Finally, the prosecution case was buttressed by U.S. District Judge Ewing Werlein‘s questionable decision to exclude a key defense expert, who would have opined that Merrill Lynch was truly at risk in regard to the barge transaction because the written contact rendered unenforceable the oral side deal for Enron to repurchase the barges.
In the end, the jury in the Nigerian Barge trial convicted five of six of the defendants, including all four of the former Merrill Lynch executives. Interestingly, the Enron in-house accountant — who was the only defendant in the case who ratified the supposedly faulty accounting of the underlying transaction to Enron’s auditors — was acquitted. The trial court’s ruling that excluded the defense expert testimony regarding Merrill’s risk in the underlying transaction will be one of the central issues on the appeal of the convictions.
Thus, few would quibble with the proposition that clear fraudulent conduct should be vigorously prosecuted. But such clear cases of criminal fraud should not be confused with ones that are based more on playing to the jury’s anti-business bias than proving the fraudulent nature of the underlying transaction. The difference is that the type of conduct that apparently occurred in regard to U.S. Foodservice would surely be prosecuted regardless of what companies were involved. However, it is highly unlikely that the defendants involved in the Nigerian Barge case would have ever been prosecuted had any company other than Enron been involved in the underlying transaction.
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