Posted on Tuesday, December 14, 2010
Recent columns on DealBook by Andrew Ross Sorkin and Jesse Eisinger asked why federal prosecutors have not brought any significant cases against senior corporate executives related to the financial meltdown. A partial answer to the question can be found in a decision issued on Friday by the United States Court of Appeals for the Ninth Circuit that reversed the conviction of a financial executive accused of accounting fraud for lack of evidence of any intent to defraud or mislead.
It is easy to assert that there ought to be prosecutions of corporate chieftains — “show trials” like the Soviet Union used to stage — because of the enormous losses sustained from the meltdown. Actually proving criminal charges is much more difficult, however, if the government has only sketchy evidence of an executive’s involvement in questionable decisions and the applicable legal standards are vague, at best.
The appeals court overturned the conviction of Prabhat Goyal, the former chief financial officer of Network Associates, on 15 counts of securities fraud, making false filings with the Securities and Exchange Commission and making false statements to the company’s auditors. The court concluded that the government simply failed to produce evidence to back up its claims that he intentionally inflated revenue and misled the accountants.
When an appellate court reverses a conviction, it usually allows the government an opportunity to retry the case, like when the problem is a faulty jury instruction as occurred in the trial of Enron’s former chief executive, Jeffrey K. Skilling, or there were prosecutorial misstatements about the evidence like the prosecution of Brocade Communications’ former chief executive, Gregory L. Reyes. In Mr. Goyal’s case, the appeals court ordered the entry of a judgment of acquittal because it concluded no rational jury could have convicted him based on the evidence presented, a fairly uncommon outcome.
The prosecution revolved around the recognition of revenue from Network Associates’ sales of computer security products to a distributor through what is called “sell-in” accounting rather than the “sell-through” method. Leaving aside the accounting minutiae, prosecutors asserted that Mr. Goyal chose “sell-in” accounting as a means to overstate revenue from the sales and did not disclose complete information to the company’s auditors about agreements with the distributor that could affect the amount of revenue generated from the transactions.
The line between aggressive accounting and fraud is a thin one, involving the application of unclear rules that require judgment calls that may turn out to be incorrect in hindsight. While Mr. Goyal was responsible as the chief financial officer for adopting an accounting method that likely enhanced Network Associates’ revenue, the problem with the securities fraud theory was that prosecutors did not introduce evidence that the “sell-in” method was improper under Generally Accepted Accounting Principles. And even if it was, the court pointed out lack of evidence that that this accounting method had a “material” impact on Network Associates’ revenue, which must be shown to prove fraud.
A more significant problem for prosecutors was the absence of concrete proof that Mr. Goyal intended to defraud or that he sought to mislead the auditors. The Court of Appeals for the Ninth Circuit found that the “government’s failure to offer any evidence supporting even an inference of willful and knowing deception undermines its case.”
The court rejected the proposition that an executive’s knowledge of accounting and desire to meet corporate revenue targets can be sufficient to establish the intent to commit a crime. The court stated, “If simply understanding accounting rules or optimizing a company’s performance were enough to establish scienter, then any action by a company’s chief financial officer that a juror could conclude in hindsight was false or misleading could subject him to fraud liability without regard to intent to deceive. That cannot be.”
The court further explained that an executive’s compensation tied to the company’s performance does not prove fraud, stating that such “a general financial incentive merely reinforces Goyal’s preexisting duty to maximize NAI’s performance, and his seeking to meet expectations cannot be inherently probative of fraud.”
Don’t be surprised to see the court’s statements about the limitations on corporate expertise and financial incentives as proof of intent quoted with regularity by defense lawyers for corporate executives being investigated for their conduct related to the financial meltdown. The opinion makes the point that just being at the scene of financial problems alone is not enough to show criminal intent.
If the Justice Department decides to try to hold senior corporate executives responsible for suspected financial chicanery or misleading statements that contributed to the financial meltdown, the charges are likely to be similar to those brought against Mr. Goyal, requiring proof of intent to defraud and to mislead investors, auditors, or the S.E.C.
The intent element of the crime is usually a matter of piecing together different tidbits of evidence, such as e-mails, internal memorandums, public statements and the recollection of participants who attended meetings. Connecting all those dots is not an easy task, as prosecutors learned in the case against two former Bear Stearns hedge fund managers when e-mails proved to be at best equivocal evidence of their intent to mislead investors, resulting in an acquittal on all counts.
The collapse of Lehman Brothers raises issues about whether prosecutors could show criminal conduct by its executives. The bankruptcy examiner’s report highlighted the firm’s use of the so-called “Repo 105” transactions to make its balance sheet look healthier than it was each quarter, which could be the basis for criminal charges. But the appeals court opinion highlights how great the challenge would be to establish a Lehman executive’s knowledge of improper accounting or the falsity of statements because just arguing that a chief executive or chief financial officer had to be aware of the impact of the transactions would not be enough to prove the case.
The same problems with proving a criminal case apply to other companies brought down during the financial crisis, like Fannie Mae, Freddie Mac and American International Group. Many of the decisions that led to these companies’ downfall were at least arguably judgment calls made with no intent to defraud, short-sighted as they might have been. Disclosures to regulators and auditors, and public statements to shareholders, are rarely couched in definitive terms, so proving that a statement was in fact false can be difficult, and then showing knowledge of its falsity even more daunting.
In a concurring opinion in the Goyal case, Chief Judge Alex Kozinski bemoaned the use of the criminal law for this type of conduct, stating that this prosecution was “one of a string of recent cases in which courts have found that federal prosecutors overreached by trying to stretch criminal law beyond its proper bounds.”
Despite the public’s desire to see some corporate executives sent to jail for their role in the financial meltdown, the courts will hold the government to the requirement of proof beyond a reasonable doubt and not simply allow the cry for retribution to lead to convictions based on high compensation and presiding over a company that sustained significant losses.
By PETER J. HENNING NYT