THE CRIMINALIZATION OF SECURITIES ENFORCEMENT AND OVERREACHING
Attorney General Eric Holder, in remarks at the Western Regional Financial Fraud Enforcement Task Force Summit on December 10, 2010, emphasized the need to continue to “make use of the full range of parallel criminal and civil enforcement resources to combat financial fraud . . .” The use of parallel civil and criminal law enforcement investigations into financial and other types of securities fraud has been on the rise in the post-Enron era. The recent formation under executive order of the Financial Fraud Enforcement Task Force (here) has accelerated this trend.
There is no doubt that parallel proceedings can enhance the government’s enforcement activities. They can also provide a potential defendant with opportunities such as a coordinated resolution of multiple investigations.
At the same time, the increasing coordination of civil and criminal enforcement authorities has accelerated the criminalization of securities enforcement. That can result in overreaching and a misuse of the criminal law. This became apparent in the option backdating cases. There, the first civil enforcement actions by the SEC in the area were brought simultaneous with the first criminal prosecutions. As a result, in some instances, such as the Broadcom cases, there was prosecutorial overreaching which ended with cases being dismissed because of government misconduct (here).
The risk of overreaching is not limited to new, novel areas however. It also exists in traditional cases such as those based on financial fraud. The recent ruling of the Ninth Circuit in U.S. v. Goyal, No. 08-10436 (9th Cir. Dec. 10, 2010) is a classic example of overreaching, substituting arguments for evidence in an effort to reach a result.
Mr. Goyal was the chief financial officer of NAI, formerly known as McAfee, from 1997 to 2001. He was indicted for securities fraud, making false statements to the SEC and lying to the auditors. In essence, all of the charges centered on the accounting treatment used to recognize revenue on the sale of the company’s products. The company sold product using what were called “buy-in” deals under which it offered customers incentives at the end of the quarter to help make its numbers. “Sell-in” accounting was used. Under this approach the company recognized revenue when the product was shipped. GAAP permits this approach if the company makes a reasonable estimate of the amount of future rebates, discounts or returns to reduce recognized revenue.
Alternatively, the company could have used “sell-through” accounting. Under this approach, the revenue is recognized later when the distributor sells the product to a reseller. It does not require a reserve.
Here, the government argued that “sell-through” accounting should have been used which would have lowered revenue. It also would have resulted in the company missing its quarterly sales and revenue goals. Essentially, the government argued that NAI violated GAAP by using sell-in rather than sell-through accounting. In making this argument, not only did the government fail to challenge the reserves used by the company, it also did not prove materiality. Thus, even before any question of compliance with GAAP could be considered, the Court concluded that the securities fraud charges must fail. While the government tried to argue that a stipulation on materiality could substitute for proof, the Court rejected the theory. The stipulation was over broad, the Court concluded. Without proof of materiality the convictions for securities fraud had to be overturned. The Court also reversed the convictions for making false statements and lying to the auditors for lack of proof.
Chief Judge Kozinski, in a concurring opinion, addressed the overreaching problem noting that both the government and the defendant lose in such instances: “This case has consumed an inordinate amount of taxpayer resources, and has no doubt devastated the defendant’s personal and professional life. The defendant’s former employer also paid a price, footing a multimillion dollar bill for the defense. And, in the end, the government couldn’t prove that the defendant engaged in any criminal conduct. . . . This is not the way criminal law is supposed to work. Civil law often covers conduct that falls in a gray area of arguable legality. But criminal law should clearly separate conduct that is criminal from conduct that is legal. . . . This is not only because of the dire consequences of conviction . . . but also because criminal law represents the community’s sense of the type of behavior that merits the moral condemnation of society . . . When prosecutors have to stretch the law or the evidence to secure a conviction, as they did here, it can hardly be said that such moral judgment is warranted.” (emphasis original).
Parallel proceedings can indeed have efficiencies for both the government and those involved. At the same time, the resulting increase in the criminalization of securities enforcement has significant potential for abuse which can harm, everyone as the prosecution of Mr. Goyal illustrates.