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.

A second opinion in U.S. v. Stein, S1 05 Crim. 0888 (LAK) (S.D.N.Y. July 25, 2006) (“Stein II”), again concludes that the government’s actions in seeking the cooperation of KPMG with its investigation of the firm’s tax shelter practices violates the Constitution. In Stein II, the court finds that statements made by two former KPMG partners were coerced in violation of the Fifth Amendment and, therefore, must be suppressed. The ruling is based on the Thompson Memorandum and facts developed at an evidentiary hearing which demonstrate that KPMG, at the behest of the government, forced employees to waive their Fifth Amendment rights so the firm could “cooperate” and avoid a criminal prosecution. Stein I also concluded that actions taken by KPMG in an attempt to meet the Thompson Memorandum standards of cooperation violated the constitution (as discussed here in previous blog postings).

Stein I and II suggest that the government – both the SEC and DOJ – should reform their standards for assessing “cooperation.” Whether Judge Kaplan’s rulings are sustained on appeal or not is beside the point. Some may argue that the government has the right to set whatever standards it wants to assess cooperation. Such a position, however, ignores the inherently coercive position in which issuers find themselves when faced with a potential enforcement investigation and action. Most, if not all, issuers are compelled to “do whatever it takes” to avoid prosecution or at least mitigate the effects of a potential action. Entities know all to well the devastating effects a criminal or civil action can cause. Accordingly, often issuers react to government pressure by firing executives, waiving privilege and perhaps even cutting off payment of legal fees to garner “cooperative” status.

Unfortunately the current standards – perhaps as administered, rather than literally written – are misdirected. First, waiving privilege should generally not be necessary. Indeed, a policy built on waivers will eventually undercut the ability of a company to obtain quality legal advice, which is the reason the privilege exists. Nevertheless, the SEC has repeatedly sought to have Congress and the courts make privileged material available to them, largely to no avail. All of these actions which tend to erode the privilege are unnecessary because companies need not waive privilege to give “just the facts” to the government.

Frequently, the privilege debate devolves to a question of whether interview notes created during internal investigations will be turned over. The SEC seems to believe that these notes contain “more truth” than the subsequently prepared interview memoranda. Regardless of the accuracy of this supposition (or perhaps paranoia), production of internal investigation notes are unnecessary. In most cases, the SEC staff should be able to assess if it has the pertinent facts from reviewing non-privileged material. If in some exceptional case there is a compelling need for attorney work-product, the staff can surely raise the issue with the company’s lawyers and demonstrate the compelling need.

Similarly, the question of “who got fired” frequently poised by government investigators is little more than overreaching. Whether the company has taken steps to prevent a reoccurrence is the key. The retention or termination of employees is a matter between the company and the employee; and more important is a state law question reserved for the states under the savings clauses in the federal securities laws. Congress and the courts have given the SEC very limited authority in this area in the form of requesting an officer/director bar under limited circumstances. To the extent the government believes an employee is guilty, simply put they should institute whatever law enforcement action they deem appropriate and afford the employee proper due process.

Finally, the government has no business inquiring about the payment of legal fees. Again, this is a traditional state law issue typically covered in state corporation codes and company by laws. It has nothing to do with the federal securities laws. While it may be tempting for government investigators to try and ease their burden in any subsequent enforcement action by cutting off the ability of persons to fight the case, such conduct is clearly inappropriate.

In sum, the government should reassess its practices in implementing its standards for corporation cooperation. New standards should focus on what government needs to effectively enforce the law, which fall within two distinct categories: obtaining the pertinent facts and prevention of future violations