The Martha Stewart insider trading saga finally ended on August 7. According to the SEC’s release, Ms. Stewart entered into a consent degree pursuant to which she is enjoined from future violations of the antifraud provisions, ordered to disgorge the losses avoided by her trading and required to pay prejudgment interest and a civil penalty equal to three times her avoided losses. Ms. Stewart is also barred for five years from serving as a director of a public company and is limited in the type of services she can render as and officer or employee of a public company. See Litigation Relapse No. 19794 (Aug. 7, 2006). http://sec.gov/litigation/litreleases/2006/lr19794.htm

The consent decree ends Ms. Stewart’s entanglement with the SEC just as her business activities seem to be on the rise. Presumably this is a good business decision for Ms. Stewart. At the same time, however, the settlement leaves important legal issues unresolved. The insider trading allegations in the complaint are on the fringes of the misappropriation theory upheld by the Supreme Court in U.S. v. O’Hagan, 521 U.S. 642 (1997). Presumably it was recognition of this fact that led the government to omit insider trading charges in the criminal case, although there is wide spread public perception that the criminal case was in fact based on insider trading.

The allegations in the civil complaint suggest reasons for omitting the insider trading claims. While, for example, the SEC complaint spent several paragraphs explaining the Merrill Lynch confidentiality policies allegedly breached by Mr. Bacanovic by telling Ms. Stewart that Imclone Chairman Sam Waskal and his daughter were attempting to sell all of the Imclone shares they held at Merrill Lynch, there is little information about her knowledge of Mr. Bacanovic’s duty and his breach other than Ms. Stewart’s receipt of a policy mass mailed to all clients outlining Merrill Lynch’s “Privacy Pledge.” Indeed, the allegations on this point appear flimsy, relying on a mailing months before the trades in question of a Pledge stating that brokers promised to keep “personal financial information” restricted. Likewise, whether the inside information was in fact material is far from clear based on the conclusory allegations in the complaint. Indeed, at one point after her stock sales the complaint claims that Ms. Stewart attempted but apparently failed to determine the significance of the information she had received. Further, the share price was declining at the time of her trade which raises further questions.

Finally, the SEC’s recitation that Ms. Stewart invoked her Fifth Amendment privilege during an interview after being informed she had a right to do so, presumably in an inappropriate effort to obtain an adverse inference or at least engender public skepticism toward Ms. Stewart, is heavy-handed and contrary to the spirit of the Fifth Amendment and the U.S. justice system. The resolution of the key insider trading questions presented by the case will have to await another day.

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When three former Merrill Lynch executives were convicted late last year of conspiracy and wire fraud based on a barge parking deal undertaken, according to the government, to help Enron meet its earnings expectations and thus falsify its financial statements and securities filings, it raised a question concerning the role of the professionals who typically participate in such deals. See blog entry for January 19, 2006.

 

The ruling on August 1 by the Fifth Circuit Court of Appeals reversing the conspiracy and wire fraud convictions of four former M L executives raises an even more significant question: Is the government being over zealous and improperly criminalizing conduct which should be dealt with in a legislative or regulatory context? See U.S. v. Brown, No. 05-20319, 2006 WL 2130525 (C.A. 5 August 1, 2006).

 

The majority opinion, authored by Judge Jolly, only hints at what is perhaps the real issue when it concludes that the conduct charged in the indictment does not constitute violations of the criminal law. The indictment charged conspiracy under 18 U.S.C. Section 371 to commit wire fraud in violation of Sections 1343 and 1346 and to falsify Enron’s books and records in violation of 15 U.S.C. Section 78m(b)(2), (b)(5) and 78ff, and 17 C.F.R. Section 240,13b2-1. Section 1343 is only concerned with “money or property,” not intangible rights. Section 1346, which expanded 1343, includes the right of an employer and the public to “honest services of employees and public officials.”

 

The problem is the language of 1346: In addition to being undefined, it is vague and does not give fair notice of what is criminal conduct. The courts have interpreted 1346, according to Judge Jolly, such that a breach of fiduciary duty can constitute fraud in certain instances, typically when bribery or self-dealing is involved. Here however, there is arguably no injury to Enron since the transaction was what it wanted to meet earnings estimates and there was no bribery or self-dealing or breach of duty by the ML executives and thus no criminal conduct.

 

Judge DeMoss, who joined the majority opinion, explains what is perhaps the real issue here: because the language of 1343 is vague and undefined it raises significant constitutional questions. In addition, the application of Section 1346 here is particularly problematic because in the past the word “services” has focused on an employer/employee relationship, which is not present here since the defendants worked for ML, not Enron.

Despite the conclusion that the activities concerning the barge deal as charged did not constitute criminal conduct, the court affirmed the perjury and obstruction convictions of former ML executive Brown which is based solely on his grand jury testimony about that deal. The majority – this time Judges Jolly and Reavley (who dissented from the ruling on the conspiracy and wire fraud convictions) joined to reject the defense argument that the two separate crimes charged should not both be based solely on Brown’s testimony in which he stated that in his opinion there was no side deal requiring a buy back of the barges by Enron – a position which is consistent with all the deal documents. Brown’s conviction for lying about a deal which turns out not to be criminal and obstructing a criminal investigation into conduct which does not constitute a criminal conspiracy or fraud was affirmed.

 

Clearly this ruling raises significant issues concerning the government’s use or perhaps misuse of the criminal law. It is one thing for the courts to interpret a criminal statute. But interpretation does not mean defining what conduct constitutes a crime. That is a job for congress. Similarly, the government should not be using criminal indictments to define what constitutes criminal conduct as was done here. At the same time it seems unfair to uphold perjury and obstruction charges based on Brown’s statement an opinion consistent with the deal documents that the barge deal did not have a side agreement.

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