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.

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.