In Securities Fraud Case, Government Not Required to Prove Non-Compliance with GAAP

Last week another of the huge Enron era financial fraud cases moved closer to conclusion. The Second Circuit Court of Appeals affirmed the convictions of Timothy and John Rigas for what the court called “looting” the one time cable giant which had been founded by the family, Adelphia Communications. U.S. v. Timothy J. Rigas and John J. Rigas, Nos. 05-3577-cr(L), 053589-cr(CON)(2nd. Cir. May 24, 2007).

A key argument rejected by the court involved the application of generally accepted accounting principles (GAAP) in criminal securities fraud cases. The defendants argued that the government is required to prove that key accounting entries claimed to be part of a securities fraud not in accord with GAAP. This argument was coupled with a claim that the government must prove non-compliance through expert testimony.

The Court rejected these arguments as it has repeatedly done in the past. Specifically, the court reiterated its long held rule that “GAAP neither establishes nor shields guilt in a securities fraud case. . . Making GAAP compliance determinative of securities fraud charges would require jurors to ‘accept the accountants’ evaluation whether a given fact was material to overall fair presentation’–a proposition this Court . . [has previously rejected].” Compliance with GAAP may however demonstrate that a defendant acted in good faith.

The defendants attempted to circumvent the long established rule just recently reaffirmed in the unsuccessful appeal of former Worldcom CEO Bernie Ebbers by claiming that when a specific principle governs the accounting treatment involved, the government is required to prove non-compliance with it or at least offer expert testimony on the point. Here defendants argued that FAS 5 concerning loss contingencies was key. Although the district court noted that expert testimony might have been helpful to the jury, the Second Circuit rejected defendants’ argument. Rather, from the testimony of various fact witnesses offered by the government the court held that the jury could find that investors were misled by the transactions involving the defendants and Adelphia. Whether these transactions complied with GAAP is not the issue the court noted. The government, the court held, was only required to prove the elements of securities fraud, not non-compliance with GAAP.