Relentlessly avoiding addressing the real issue, this NY Times article speculates that the problem with Eliot Spitzer’s recent unsuccessful prosecution of Theodore C. Sihpol, III was not that he charged Mr. Sihpol in the first place, but that he should have charged all of Mr. Sihpol’s superiors, too.

In so speculating, the Times confirms that it still does not understand that the governmental policy of regulating business through criminalization of merely questionable business transactions is a slippery slope toward injustice that ultimately undermines the rule of law.

Take the case of William Fuhs. He is the former mid-level Merrill Lynch executive who was recently convicted and sentenced to over three years in prison as a result of his participation in the Enron-related Nigerian Barge case.

As has already been noted in regard to the conviction of Daniel Bayly — the former head of global investment banking at Merrill Lynch and one of Mr. Fuhs’ bosses — the government’s prosecution of the Merrill Lynch executives in regard to the Nigerian Barge transaction was dubious, at best. The resulting convictions are a plain miscarriage of justice.

As with its prosecution of Mr. Bayly, the government’s case against Mr. Fuhs strains credulity.

Of the four Merrill Lynch defendants in the Nigerian Barge case, Mr. Fuhs was the only one who was not a managing director of Merrill Lynch. Mr. Fuhs did not participate in the one telephone conference with former Enron CFO Andrew Fastow in which Mr. Fastow allegedly assured Mr. Bayly and other Merrill Lynch executives that Enron would find a buyer within six months of the interest that Merrill was buying in the barges.

In fact, Mr. Fuhs’ only role in regard to the transaction was the ministerial processing of the transaction after Merrill Lynch had agreed to buy the interest in the barges from Enron.

Incredibly, during the government’s case-in-chief in the Nigerian Barge trial, none of the government’s fact witnesses knew or interacted with Mr. Fuhs — indeed, the only government witness who had ever worked at Merrill had neither met, spoken to, nor even heard of Mr. Fuhs!

Mr. Fuhs never conferred with anyone at Arthur Andersen (Enron’s auditors) regarding the transaction and the deal was the only Enron transaction that Mr. Fuhs ever worked on.

In short, the government presented no witnesses or evidence during its case-in-chief that Mr. Fuhs — who is not an accountant — had any idea that Enron’s booking of a $12 million gain on the Nigerian Barge transaction was arguably improper, much less that he intended to promote Enron’s accounting of the transaction.

Nevertheless, while Mr. Sihpol walks away from the New York courthouse a free man, Mr. Fuhs — a young man with a wife and two young children — faces a shattered professional and family life and 37 months in federal prison.

As Professor Bainbridge noted in this TCS op-ed and Professor Ribstein has repeatedly observed, the contrasting results in the cases of Mr. Sihpol and Mr. Fuhs — not to speak of the sad case of Jamie Olis — confirms that the pursuit of justice in such cases has become a sort of lottery.

If the prosecution pursues a bit player such as Mr. Fuhs but can come up with something particularly distasteful to the jury — such as Merrill Lynch’s involvement with the corporate pariah, Enron — then it wins.

On the other hand, if the government slams a little guy such as Mr. Sihpol while not pursuing his dastardly superiors, then the government loses.

This is a radical abuse of our criminal justice system, and the carnage to the families of Martha Stewart, Mr. Bayly, Mr. Fuhs, Mr. Olis and others who are caught in this troubling spiral simply cannot be responsibly dismissed as a “trade-off” of an imperfect system.

But as great as my compassion is for members of those families, my even greater concern is for the principles of justice and respect for the rule of law upon which the success of our society is largely based.

If we lose those, then, 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 then?”

U.C.L.A. law professor Stephen Bainbridge is one of America’s leading experts in the area of corporate and securities law, and he has long been generous in sharing his expertise on those subjects and others on his popular ProfessorBainbride.com weblog. Professor Bainbridge is also a formidable writer who is particularly gifted in breaking down complex legal issues in a simple and straightforward manner.
In this TCS Central op-ed (his blog post on the article is here), Professor Bainbridge takes dead aim at the dubious governmental policy of criminalizing business interests through the prosecution of agency costs, which are essentially the costs of poor corporate governance. The entire op-ed is a must read, and here is the money quote:

[S]hareholders deserve protection from theft, but not from risk taking, even when the risk in question is how much to pay an executive. Unfortunately, it’s not clear that prosecutors know the difference — or even care.

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.