by T. GormanPosted on Posted in SECActions

The decision in U.S. v. Stein, S 1 05 Crim. 0888 (LAK) (S.D.N.Y.), this week dismissing the indictment against a number of the defendants in the KPMG tax shelter case only serves to underscore the need for Department of Justice (“DOJ”) and the Securities and Exchange Commission (“SEC”) to reform their standards on cooperation.  In another lengthy opinion, Judge Kaplan details the sad tale of how the government used the threat of prosecution to turn accounting giant KPMG into its pawn, stripping individuals of their right to counsel and a fair trial: “The government threatened to indict, and thus to destroy, the giant accounting firm, KPMG LLP (“KPMG”).  It coerced KPMG to limit and then cut off its payment of the legal fees of KPMG employees.  KPMG avoided indictment by yielding to government pressures.  Many of its personnel did not.  They now await trial, four of them deprived of counsel of their choice and most of the others unable to afford the defenses that they would have presented absent the government’s interference.”  The prosecutors in Stein, of course, deny that they pressured KPMG to strip individuals under their investigative eye of their rights and the company claimed its actions were voluntary.  The court found otherwise. 

In this post-Enron era, the fact of the matter is that the Stein story is replicated frequently, but perhaps in a more subtle fashion in DOJ criminal and SEC civil investigations.  To be sure, DOJ prosecutors and SEC enforcement officials typically do not direct a company under investigation to not pay legal fees.  Likewise prosecutors do not direct the company not to enter into joint defense agreements so that employees will have access to materials necessary for their defense.  And, of course prosecutors do not directly ask company officials to waive privilege or any other rights.  They do not have to.  The standards of prosecution, coupled with the potential consequences of the prosecution, do it for them. 

The DOJ and SEC standards for the prosecution of business organizations set forth in the Thompson and McNulty memos and the Seaboard Release, respectively, all have the same key loophole for the government:  they offer credit for cooperation if the company voluntarily waives its rights. How much credit and what actions must be taken is not defined.  The point is clear however:  More cooperation equals more credit.  What is more?  The list of choices includes the waiver of the attorney client privilege, waiver of work product protection, turning over privileged interview notes from an internal investigation, terminating employees the government might think are guilty, not paying legal fees and avoiding common interest or joint defense agreements under which materials are shared with current and former employees that may be necessary to their defense.  For those seeking to avoid prosecution, “more” all too often equals whatever it takes – that is, all of the above.

As in Stein, prosecutors typically label such acts “voluntary” and disclaim any coercion or improper actions.  Companies taking these steps echo this theme.  In Stein, the Court rejected these claims.  In daily practice, these claims are equally hollow. Yet, until the cooperation credit loop hole is closed this game of labeling actions taken under the coercive threat of prosecution as voluntary will continue.

The two bills pending in Congress will not resolve this matter.  Senate bill S. 186 and House bill H.R. 3013 are both designed to halt the erosion of fundamental rights that to often occurs in government criminal and civil prosecutions.  Both are based on legislative hearings which detail the abuses under the current standards.  Both propose welcome and necessary changes to the system.  Neither closes the cooperation credit loop hole, because both permit cooperation credit for the waiver of rights.  While it may seem appropriate to permit credit for waivers of rights by companies, in truth, the result is anything but appropriate.  There is nothing appropriate about law enforcement or company officials being implicated in the erosion of fundamental rights such as the right to counsel or the preparation of a defense, which is what happened in Stein.  Rather, the only appropriate course is to close the cooperation loop hole:  end cooperation credit for waivers of fundamental rights and end the kind of situations on which Stein is based.

by T. GormanPosted on Posted in SECActions

Last week, the SEC brought its latest case in the seemingly never-ending stock option backdating scandal.  In SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo. July 12, 2007), the agency charged the founder and former Chairman and CEO of Engineering Support, Michael F. Shanahan, Sr., and his son, a former board member at the company, with violations of the antifraud, proxy, and reporting provisions in connection with an option backdating scheme.  This is the most recent case to trickle out of the SEC of the reported 140 companies under investigation.  Two points make this case somewhat noteworthy.  First, the options involved immediately vested, according to the SEC complaint.  Thus, if the options were improperly backdated as the SEC claims the defendants immediately profited from the scheme.  Typically, option grants do not vest at least in part until some point in the future.  Under those circumstances, it is not always clear that backdating will result in a profit. Likewise, the huge numbers about how much people profited are somewhat questionable when the options do not vest immediately.  

Second, and perhaps of more importance, are the kind of claims brought here.  With dozens of companies still under investigation, the continuing question is what standards the agency will use in determining whether to bring enforcement actions.  The initial cases all involved aggravated fact patters with falsified documents, cover-ups, false claimants and similar activities.  While Shanahan involves claims of fraud based on what, if established, is intentional conduct, it lacks the kind of egregious conduct seen in many earlier cases.  To be sure, Shanahan contains allegations of false backdated options, large profits and false filings.  The claims however, are based on violating a stock option plan that directed options be priced at the market, allegations that various filings represented that the options were properly priced according to the plan and the failure to disclosure the fact that the options had been backdated.  If established by the SEC, this conduct of course violates the securities laws.  At the same time, it is clear that the case is based on allegations which materially differ from many of the earlier cases.  This may represent a significant evolving step in the scandal, signaling that the SEC is expanding it loop of liability.  

That loop may receive further definition later this week.  On Thursday, the Court in U.S. v. Reyes, the criminal trial involving the former Brocade CEO is due to rule on the defense’s Criminal Rule 29 motions for acquittal made at the conclusion of the government’s case-in-chief.  Whatever the ruling, it is significant that the Court delayed the decision on the motions for a significant period of time.  All too often courts, deny these motions from the bench following the oral argument.  In Reyes however, the Court significantly delayed ruling on the motions to consider the papers.  This action, at a minimum, suggests that there is a very significant question as to whether the government has established its case.  If granted, the ruling would be a huge blow to the government’s prosecution of options backdating cases.  Indeed, such a ruling could redefine the standards used by the government in evaluating cases, particularly in view of the repeated allegations of intentional conduct made by both government prosecutors and SEC officials when the cases involving Brocade were brought.  Even if the motions are denied in Reyes (as is typical), the long delay in ruling on them raises significant questions about the kinds of cases the government is selecting for prosecution.  As the scandal continues to evolve, the question of standards of prosecution and case selection will continue to be key not only for the dozens of companies and individuals still under investigation, but also others because of what it says about SEC and DOJ enforcement of the securities law.