The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

By the time you read this blog post, you undoubtedly will have seen one of the stories in the mainstream media reporting on the February 25, 2013 decision of Southern District Court Jed Rakoff ordering former Goldman Sachs director Rajat Gupta to repay most of the legal fees the company incurred in connection with the government’s investigation and prosecution of Gupta. In case you didn’t see the stories, you can find them, for example, here and here.

There are a number of interesting things about Judge Rakoff’s order, many of which garnered little attention in the mainstream media reports.

By way of background, readers may want to recall that Gupta was convicted in June 2012 of leaking boardroom secrets to Raj Rajaratnam, who relied on the leaked non-public information in making highly profitable securities trades. Gupta was sentenced in October 2012. Gupta is appealing his conviction.

Judge Rakoff did not enter the order ordering Gupta to repay Goldman in a separate proceeding. Rather, Judge Rakoff entered the order in connection with the criminal proceeding against Gupta, and in particular as part of his (Rakoff’s) deferred determination of restitution in connection with Gupta’s sentencing. Goldman had specially appeared in Gupta’s criminal case to seek restitution of the $6.9 million in fees it paid to the Sullivan & Cromwell law firm in connection with the criminal case and related matters. (Goldman later withdrew a request for restitution of Gupta’s salary and for restitution of legal fees incurred in connection with a Section 16(b) short-swing profits proceeding against Gupta, which would explain why the amount Rakoff awarded was below the restitution amount Goldman had originally requested.)

Goldman sought restitution under the Mandatory Victims Restitutions Act, which mandates restitution in a criminal case where an identifiable victim has suffered a pecuniary loss. Under the Act, the restitution may include “necessary” expenses incurred during participation in the investigation or prosecution of the offense. Under Second Circuit authority, necessary other expenses may include attorneys’ fees, provided that the court finds by a preponderance of the evidence that the expenses were necessary and were incurred in connection with the investigation or prosecution of the offense, and that they were incurred by victims of the offense.

Goldman submitted 542 pages of its counsel’s billing records, relating to a range of related matters, not just Gupta’s criminal proceedings alone. Gupta had argued that the restitution, if any, should be limited to fees incurred in his prosecution. But Judge Rakoff interpreted the relief to which Goldman is entitled under the Act broadly. Judge Rakoff said that “this Court has no difficulty in concluding, by a preponderance of the evidence, that nearly all of the expenses Goldman Sachs here claims were the necessary, direct, and foreseeable result of the investigation and prosecution of Gupta’s offense.” 

Among other things, Rakoff included expenses incurred during Goldman Sachs’s internal investigation into Gupta’s conduct; the fees Goldman incurred to attend post-verdict proceedings in Gupta’s case; the fees the company incurred in the parallel SEC case against Gupta; and the fees the company incurred in connection with Rajaratnam’s criminal prosecution.

It is important to highlight the fact that in ordering Gupta to repay Goldman for the fees it incurred, Rakoff was interpreting and applying the Mandatory Victims Restitution Act. Rakoff’s order did not involve or relate to any interpretation or application of Gupta’s rights for advancement of indemnification of his attorney’s fees under Goldman’s by-laws or under applicable state law. I emphasize this fact because, following Gupta’s conviction, there has been discussion in the press of Goldman’s rights (if any) to seek recoupment from Gupta under applicable principles governing advancement or indemnification.

It remains an interesting question whether or not Goldman might have had the right (or would have had the right if Gupta’s conviction is affirmed) to seek to establish in a separate civil proceeding that it had a right of recoupment. But Goldman was not relying on its recoupment rights and Judge Rakoff did not order Gupta to pay Goldman in reliance upon principles of advancement or indemnification. Rather, he was applying the Mandatory Victims Restitution Act.

The fact that Rakoff was applying the Act is also important in connection with the question of what the ruling might mean in other cases. The ruling is only going to be relevant in other cases where a corporate official has been criminally convicted and where there is an identifiable victim that has suffered a pecuniary loss. Absent a conviction, there would be no grounds for restitution. A company seeking restitution of attorneys’ fees and other expenses would have to meet the Act’s other requirements as well. (It should be noted that Goldman is not the only company to have sought restitution of attorneys' fees from a former official convicted of a criminal offense; as discussed here, Morgan Stanley is seeking in a separate proceeding to recover millions it paid to and on behalf of Joseph Skowron, a former hedge fund manager for the company who plead guilty to insider trading.)

Although it does not appear to have been relevant in Gupta’s case, it is interesting to consider what subrogation rights a D&O insurer might have under the Act in the event of a criminal conviction. To the extent that the attorneys’ fees had been paid by an insurer, the insurer might take the position that it is subrogated to any victims’ restitution rights to which the company is entitled under the Act. Whether the insurer would be as successful casting itself as the victim in that situation is an issue the carrier would have to address.

Today’s Classic Rock Note:  (Hat Tip to The Meta Picture.com)

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There has been widespread news coverage of the dramatic December 15, 2009 decision of Central District of California Judge Cormac Carney to throw out the options backdating related criminal charges against Broadcom co-founder Henry T. Nicholas III and CFO William Ruehle, based on prosecutorial misconduct.

But even though many of press accounts have reproduced some of Judge Carney's harshest words – particularly his statement that the government’s treatment of a third defendant, Henry Sameuli, was "shameful and contrary to American values of decency" – the excerpts do not come close to capturing the depth and breadth of the Judge’s condemnation of the prosecutor’s conduct.

The transcript of the December 15 hearing at which Judge Carney delivered his ruling can be found here. I strongly recommend taking a few minutes and reading the entire transcript (it is relatively short), because only a complete reading truly conveys the extent of Judge Carney’s censure.

His reproach of the prosecutors is comprehensive, extensive and scathing. Judge Carney dropped a bomb on the prosecution. Not by accident, as if he got a little angry and then got carried away. No. Judge Carney clearly and consciously intended to summon every molecule of the power of his position and marshalled every tool in the arsenal of language. Judge Carney's decision is a case-hardened, bunker-buster, heat -seeking bomb -- that hit the bulls-eye.  

Among other things, he cites the prosecutors for "intimidating and improperly influencing" witnesses, which "compromised the truth process and compromised the integrity of the trial"; for making improper leaks to the media; for improperly pressuring Broadcom to terminate Samueli; for obtaining an "inflammatory indictment" of Samueli; and crafting "an unconscionable plea agreement" with Samueli.

Assistant U.S. Attorney Andrew Stolper, the lead prosecutor in the case, received particularly sharp criticism. Among other things, Judge Carney said that "the lead prosecutor somehow forget that truth is never negotiable." Of the case against Ruehle, Judge Carney said that to submit it to the jury "would make a mockery of Mr. Ruehle’s constitutional right to compulsory process and a fair trial."

In addition to the sheer potency of Judge Carney’s rhetoric, there are several other interesting aspects to Judge Carney’s rulings, some of which have not been fully noted in press reports.

The first is that Judge Carney’s decision to dismiss the case against Nicholas came during Ruehle’s trial. Nicholas was to be tried separately later. There was not even a motion on behalf of Nicholas pending. Moreover, Judge Carney’s dismissal of the indictment of Nicholas came just days after Judge Carney dismissed Samueli’s prior guilty plea, following Samueli’s testimony at Ruehle’s trial. Judge Carney’s decisions to first dismiss Samueli’s guilty plea and then to dismiss the case against Nicholas shows the extent of the concerns that were raised in Judge Carney’s mind as Ruehle’s trial unfolded.

Second, Judge Carney not only dismissed the criminal cases, he dismissed the SEC’s options backdating related enforcement action without prejudice –again, even though that SEC enforcement action was not formally before Judge Carney at the time. Judge Carney allowed the SEC thirty days to file an amended complaint, but he did also "discourage" the SEC from proceeding further, since "the government’s misconduct has compromised the integrity and legitimacy of the case" and the evidence during Ruehle’s trial "established that the SEC will have great difficulty proving that the defendants acted with reckless scienter."

Judge Carney also ordered the government to show cause why the separate drug distribution-related indictment against Nicolas should not be dismissed, and scheduled a date in February 2010 for the matter to be heard. Among concerns Judge Carney noted about the drug indictment is "government’s threats to issue a grand jury subpoena to Dr. Nicolas’ 13-year old son and force the boy to testify against his father."

Third, as part of discouraging the SEC from refiling its complaint, Judge Carney raised fundamental questions that go to the heart of the entire options backdating brouhaha --immediately after he had said that the SEC will have difficulty proving scienter. He said:

The accounting standards and guidelines were not clear, and there was considerable debate in the high-tech industry as to the proper accounting treatment for stock option grants. Indeed, Apple and Microsoft were engaging in the exact same practices as those of Broadcom.

These remarks suggest that, in addition to all of Judge Carney’s other concerns about the prosecutor’s misconduct, he also has fundamental concerns about whether there could possibly have been a culpable state of mind in connection with backdating. His reference to the uncertainty of the applicable standards and extent of the practices (even Apple and Microsoft!) certainly seems to raise questions about whether any criminal prosecution or even enforcement action is appropriate, not just the one against the Broadcom defendants.

Judge Carney clearly is quite sure that there was something wrong with the prosecutor’s actions in prosecuting the case, but he doesn’t seem to be sure at all whether or not there is actually anything wrong with backdating itself. Could these two points be related? Hmmm...

Indeed, this fundamental problem with the backdating allegations may explain why prosecutors have had so much trouble obtaining and retaining backdating convictions. Thus, for example, the conviction of former Brocade Communications CEO Gregory Reyes was overturned, again for prosecutorial misconduct (based on improper statements prosecutors made to the jury), and McAfee’s former general counsel, Kent Roberts, was acquitted.

It does sort of make you wonder whether Kobe Alexander might  now having second thoughts about his decision to flee to Namibia rather than face the criminal charges for alleged options backdating at Comverse.

Though the Broadcom criminal indictments have been dismissed and the SEC enforcement action has also been dismissed, possibly for good, an enormous amount of damage has been done. There is not only the terrible toll that the legal actions took on the lives of the individual criminal defendants. There is the almost unbelievable cost that all of these actions imposed on the company and its insurers.

As I noted in a prior post (here), Broadcom agreed, as part of the settlement of the options backdating-related shareholders’ derivative lawsuit, to settle its claims against its directors’ and officers’ liability insurers for $118 million, all of which represented a payment to the company in reimbursement of defense expenses incurred in connection with the various backdating-related legal proceedings. In the recitals to the insurance settlement, the parties stated that at point Broadcom’s cumulative legal expenses exceeded $130 million.

It is very hard not to conclude that entire sorry options backdating scandal has been an enormous waste, of time, talent and money.

There have been a number of interesting blog posts about Judge Carney’s dismissals of the Broadcom indictments, including items on the SEC Actions blog (here) and on the Ideoblog (here). The WSJ.com Law Blog has a post (here) comparing Judge Carney to Judge Rakoff.

Special thanks to Nancy Adams of the Mintz Levin firm for forwarding me a copy of the hearing transcript.

Even More Failed and Troubled Banks Next Year?: According to yesterday’s Wall Street Journal (here), the FDIC is looking to increase its budget by 35% next year and to add 1,600 new staffers, as the agency struggles to deal with the complications from the wave of failed and troubled banks. Among the reasons that agency Chairman Sheila Bair cited to justify moves is that the increases  "will ensure that we are prepared to handle an even larger number of bank failures next year, if that becomes necessary, and to provide regulatory oversight for an even larger number of troubled institutions"

The suggestion that the FDIC must be prepared for even more failed and troubled banks in 2010 is disturbing. There have already been 130 failed banks this year, and at the time of the FDIC’s last Quarterly Banking Profile, the FDIC reported that there were 552 Problem Institutions as of September 30, 2009, as noted here. Put simply, the FDIC thinks in order to be prepared for 2010, it has to be ready to deal with more than 130 additional bank failures next year and more than 552 troubled institutions.

Clearly, the banking industry’s problems are deep and continuing. The problems associated with failed and troubled banks are among the most significant concerns as we head into 2010.

Goodbye to All That: The blogosphere is losing one of its most talented and esteemed members. Yesterday, our friend, law-school compatriot and fellow blogger, Mark Herrmann, of the incomparable Drug and Device Law Blog, announced that he is retiring from blogging. Alas.

Herrmann, who has been a partner at Jones Day since before dinosaurs roamed the earth, is leaving Big Law to go be a client -- I mean , to become Vice President and Chief Counsel - Litigation at AON Corporation. As a result, Herrmann no longer thinks he will have as much time to write about legal issues surrounding medical drugs and devices -- go figure. 

Herrmann is moving on to do God's work, defending against unscrupulous types who would presume to sue insurance brokers. But as a result, the blogosphere is losing one of its most intelligent, cantankerous and amusing voices. Have no fear, his blogging partner (A blogging partner! What a concept! I should have thought of that!), Jim Beck, will be carrying on the fine tradition of the Drug and Device Law Blog.

Everyone here at The D&O Diary wishes Herrmann every success at AON. May the force be with you, Mark. Welcome the world of insurance brokerage, dude.

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Eastern cultures ascribe events to destiny, fate, or “karma.” But in our culture we demand to know who is to blame. The Zeitgeist of America’s blame culture apparently has decreed that Ralph Cioffi and Matthew Tannin, the former Bear Stearns fund managers, are to be the first level scapegoats for the subprime crisis. The “perp walk” to which they were subjected last week – why? Whatever happened to the presumption of innocence?—is now a standard component of the American blame ritual.

But a review of the charges against them does raise some concerns. Indeed, many observers have already questioned the proceedings.

A number of commentators have observed that Cioffi and Tannin’s alleged misrepresentations were no different than those of many others on Wall Street. Indeed, both Bloomberg’s Caroline Baum (here) and Professor Peter Henning of the White Collar Crime Prof blog (here) see little difference between Cioffi and Tannin’s statements about the Bear funds and the remarks of Bear Stearn’s CEO Alan Scwartz two days before the company’s collapse that “our liquidity position has not changed.” Professor Ribstein, on his Ideoblog (here), suggests that the difference between Cioffi and Tannin on the one hand, and Schwarz on the other, is that Cioffi and Tannin made the mistake of being hedge fund managers rather than corporate executives (“the bad luck of their chosen line of work”)

Some commentators even question the culpability of the two individuals’ alleged misrepresentations. As Professor Henning notes:

A false hope that the hedge funds would pull through, no matter how misguided, can be a defense to a fraud charge. Showing that Cioffi and Tannin were of two minds, or conflicted about where the market was headed, does not mean that the statements to investors were part of a fraudulent scheme.

Professor Henning goes on to observe:

As a Wall Street case, the charges seem a bit thin to me. Hedge fund managers are essentially salesmen, touting their wares in much the same way that the man in the used car lot has a great deal for you….The fact that Wall Street salesmen talked out of both sides of their mouths is nothing new.

Professor Henning also questions the significance of Cioffi’s withdrawl of $2 million from one of the funds, noting that “withdrawing your own money is not the type of theft one expects to see in a fraud case.”

In a Wall Street Journal op-ed piece today (here), former prosecutor Robert Mintz suggests that the duo’s biggest mistake was failing first – “these two were among the first to see their funds implode and that, perhaps more than any other reason, is why they now find themselves facing the prospect of significant jail time.”

These observations are all interesting and might (perhaps under different circumstances) suggest that the government could face an uphill battle. However, the circumstances demand a burnt offering and that is why Cioffi and Tannin were dragged into the public square. A burnt offering we shall have.

There is one additional element of the indictment that has not received as much attention that may be worth noting here. That is, as discussed in the U.S. Attorney’s June 19, 2008 press release (here), one element of the indictment relates to a possible cover up. The press release states that, after the SEC had requested the production of documents and materials in Summer 2007, Tannin’s “tablet computer” and Cioff’s “notebook” apparently “went missing."

One of the ineradicable lessons from the Watergate era is that the evasion will get you even if the underlying conduct does not. (Just ask Martha Stewart.) If the government can show that the defendants did inappropriately dispose of their technological devices as part of an evasion, the cover-up charges could loom a great deal larger.

And while the commentators may question the criminal indictment, they recognize that the alleged misconduct might support civil liability. Indeed, Professor Ribstein acknowledges that while “not a criminal case,” this “sort of case is suited for a civil fraud claim.” It has been somewhat overshadowed by the criminal indictment, but the SEC did in fact file a civil enforcement proceeding against Cioffi and Tannin at the same time as the indictment.

The SEC enforcement action (as described in the SEC’s June 19, 2008 Litigation Release, here), contains additional allegations against the two, including for example, that they “misrepresented the funds’ deteriorating condition and the level of investor redemption requests in order to bring in new money and keep existing investors and institutional counterparties from withdrawing money.” Among other things, the SEC alleges that Cioffi and Tannin “misrepresented their funds’ investment in subprime mortgage-backed securities.” It is alleged that the funds’ monthly performance summaries described the exposure as from 6 to 8 percent, when it supposedly later emerged that the “total subprime exposure – direct and indirect—was approximately 60 percent.”

The SEC seeks “permanent injunctive relief, disgorgement of all illegal profits plus prejudgment interest, and the imposition of civil monetary penalties.” But as serious as are these proposed sanctions, they still pale by comparison to the threat of incarceration the individuals face as a result of the criminal indictment.

As the U.S. Attorney’s press release states, “if convicted of securities fraud, Cioffi and Tannin face maximum sentences of 20 years imprisonment. If convicted of conspiracy, they each face a maximum sentence of five years.”

All of which leads to the final question. As Robert Mintz asked in his Journal op-ed piece today, “are we attempting to criminalize conduct primarily based upon the fact that we now know that the investing decisions led to a bad end?”

UPDATE: Professor Jay Brown has a paritcularly good post today on these same themes on his Race to the Bottom blog (here). Among other things, Professor Brown says that "this matter should be left to the Securities and Exchange Commission and the private investors...It should not be left to the criminal authorities."

Just the Thing: Even more American than the instinct to blame is the propensity for someone to try and profit off of another’s misfortune. And in that spirit, readers may be interested to know that a Ralph Cioffi signed Bear Stearns Hedge Fund Christmas Card is available (here) on eBay. As of the time of this blog post, the current bid was $81.

Sometimes I feel like the entire world is nothing more than abstraction of the old comic strip, The Strange World of Mr. Mum.

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