Securities Fraud and Sentencing Guidelines After Sarbanes-Oxley

In the legislative process that led to the adoption of Sarbanes-Oxley (SOX), legislators from both sides of the aisle vied with each other to establish their credentials for being tough on white-collar crime. The maximum penalties for mail fraud and wire fraud were increased from 5 to 20 years. Pub. L. No. 107-204 ' 903. The maximum penalty for willful violations of any provision of the Exchange Act or rule or regulation adopted thereunder the violation of which is unlawful was increased from 10 to 20 years. Pub. L. No. 107-204 ' 903. If this were not enough, a new crime relating to securities fraud in connection with the securities of public companies with a maximum penalty of 25 years was created. Pub. L. No. 107-204 ' 807 This does not exhaust the list, but should be sufficient to suggest that there are more than enough post-SOX criminal laws covering financial fraud to deter rational corporate officers and others to refrain from participating in financial crimes. The maximum statutory sentence, however, is less significant than other sentencing guideline factors in determining the range of sentence (minimum to maximum) within which the sentencing judge must impose a sentence. Defendant X, as we describe in greater detail below, an officer of a public company convicted of a willful violation of Rule 10b-5 resulting in a loss to more than 250 investors of $7-$20 million and a first time offender, under the Guidelines' Sentencing Table (below) has an offense level of 37 and faces a minimum term of 210 months (17.5 years) and a maximum sentence of 262 months (21 years and 10 months). Critical to determining the sentencing range is the Sentencing Table and what goes into it. See United States Sentencing Commission, Guidelines Manual (Nov. 2003) (available at http://www.ussc.gov/2003guid/2003guid.pdf), The Sentencing Table is as in effect as of Nov. 1, 2003 and incorporates amendments resulting from the provisions of the Sarbanes-Oxley Act discussed below.

About the Table

The table horizontally takes into account the defendant's Criminal History Category (prior offenses) and vertically the Offense Level stated as a number (ranging from 1 to 43) derived from various factors we discuss below reflecting in generic terms the seriousness of the offense. Where the two intersect determines in months the range of the minimum-maximum sentence. Thus, an Offense Level of 10 and a Category I criminal history (0-1 prior convictions) requires the sentencing judge to impose a sentence of not less than 6 months and a maximum of not more than 12 months. In contrast, an Offense Level of 27 and a Category I Criminal History would result in a sentencing range of 70-87 months. We stress the importance of the Offense Level on the assumption that corporate officers of public companies generally do not have prior convictions. The difference between the Offense Level of 10 and 27 under the above assumptions in terms of the minimum sentence is six months in the case of 10 and almost 6 years in the case of 27. There are also four zones (A-D) that are impacted by the Offense Level and Criminal History category but not in a straight line, which are relevant in determining whether probation, home detention, community service or some combination are or are not a sentencing alternative. For our immediate purpose, we note that only the A zone is eligible for probation without any imprisonment or substitute for imprisonment and that if in the D zone probation and none of the other alternatives not involving imprisonment is appropriate. It is also important to realize, that for federal crimes parole is not possible and that the maximum reduction of the sentence for good behavior is approximately 15%. See Guideline Manual (November 2003), at p. 9.

Three Overlapping Provisions

SOX contains three overlapping provisions relating to sentencing guidelines premised on the notion that white-collar crime was not adequately punished. All three provisions required the U.S. Sentencing Commission 'to promulgate the guidelines or amendments provided for under this section as soon as practicable, and in any event not later than 180 days after the date of enactment of this Act.' On May 1, 2003, the U.S. Sentencing Commission to implement the SOX directive submitted to Congress amendments to the sentencing guidelines, which became effective on Nov. 1, 2003. Our discussion, unless otherwise indicated, is based on the amended guidelines pertaining to 'Theft, Embezzlement, Receipt of Stolen Property, Property Destruction, and Offenses Involving Fraud or Deceit,' and the related Sentencing Table. Guidelines Manual, ' 2B1.1 at p. 72; Ch.5 Pt. A, at p. 362. The factors that go into the Offense Level are critical in determining the sentencing range for the new style financial fraud defendants, who we assume have no prior criminal record. The base Offense Level is 7 for conviction of an offense involving fraud or deceit that has a statutory maximum prison sentence of 20 years or more; otherwise the base Offense Level is 6. Guidelines Manual, ' 2B1.1(a). Accordingly, increasing statutory maximums to 20 years does not make a significant difference by itself in this context. What largely determines the Offense Level is the amount of loss caused by the fraud or deceit offense. Staying in the relatively small area to illustrate a point ' a loss of less than $5000 no increase in the Offense Level; 2 is added to the Offense Level if the loss is more than $5000 and less than $10,000, and 4 is added if the loss is more than $10,000 and less than $30.000. Guidelines Manual, ' 2B1.1(b)(1). To be in the A Zone and eligible for probation and no imprisonment (ie, a sentence range of 0-6 months), the Category I offender under the Sentencing Table must have an Offense Level of 8 or less. Accordingly, one who is found or pleads guilty of one of the above offenses that provides for a statutory maximum of 20 years would be eligible for probation if the loss caused was less than $5000. If we assume, as is usually is the case in the event of a guilty plea, a reduction of 2 in the Offense Level for accepting responsibility (Guidelines Manual, ' 3E1.1(a)), probation would be possible if the loss is over $5000 but did not exceed $10,000 (7 plus 2 for over $5000 less 2 for accepting responsibility). On the other hand, a loss of over $10,000 but less than $30,000 adds 4 to the Offense Level bringing it up to 11 and a reduction of 2 for accepting responsibility leaves an Offense Level of 9 and a minimum sentence of 4 months. In contrast, if the offense of which the defendant is found or pleads guilty carries a maximum sentence of less than 20 years under the same circumstances it has a base Offense Level of 6, and the defendant who caused a loss of $10,000 but less than $30,000 would be eligible for probation. Accordingly, this is one instance in which the Sarbanes-Oxley increase of the maximum sentence increases the likelihood that securities fraud violations will result in some jail time. Given the additions to the Offense Level based on the amount of loss as discussed below, it is apparent that the impact of securities fraud on investors has more to do with the sentence than the statutory maximum sentence.

Offense Involving Fraud or Deceit

Under the guidelines, for an offense involving fraud or deceit the amount of loss caused adds to the Offense Level the following: (A) $5000 or less no increase; (B) More than $5000 add 2; (C) More than $10,000 add 4; (D) More than $30,000 add 6; (E) More than $70,000 add 8; (F) More than $120,000 add 10;(G) More than $200,000 add 12; (H) More than $400,000 add 14; (I) More than $1,000,000 add 16;(J) More than $2,500,000 add 18; (K) More than $7,000,000 add 20; (L) More than $20,000,000 add 22; (M) More than $50,000,000 add 24; (N) More than $100,000,000 add 26; (O) More than $200,000,000 add 28; (P) More than $400,000,000 add 30. Guidelines Manual, ' 2B1.1(b)(1). We discuss below the determination of loss, but a substantial accounting fraud is likely to result in a loss of at least $7 million, adding 20 to the base level of 7 and resulting under the Sentencing Table, other factors aside, a sentencing range of 70-87 months.

Other Factors

There are, however, other factors to take into account that are directly relevant to securities fraud and in part are an outgrowth of SOX. The Offense Level increases with the number of victims'10 or more, add 2; 50 or more add 4; 250 or more add 6. Guidelines Manual, ' 2B1.1(b)(2). That is almost an automatic increase of 6 for securities fraud. In addition, if the offense substantially endangered the solvency of a public company, 4 is added to the Offense Level. Guidelines Manual, ' 2B1.1(b)(12)(B). There is one consolation, however, that the two combined (number of victims and endangering solvency) cannot add more than 8, if that would take the Offense Level above 24. Guidelines Manual, ' 2B1.1(b)(12)(C)-(D). Finally, increase the level by 4 if the offense involves a violation of securities laws and the defendant was an officer or director of a public company (or a registered broker-dealer or investment adviser or person associated with a registered broker-dealer or investment adviser). Guidelines Manual, ' 2B1.1(b)(14)(A).

Let us add it up the Offense Level for Defendant X found guilty of a medium sized securities fraud involving violations of Rule 10b-5. Base Offense Level 7, plus 20 for loss between $7 million and $20 million, plus 6 for 250 or more victims, plus 4 as an officer or director of a public company ' 37 or a minimum sentence under the Sentencing Table of 210 months (17.5 years); maximum sentence of 262 months (21 years and 10 months), assuming a Category I Criminal History. The maximum exceeds the 20 year maximum sentence for a willful violation of the Exchange Act, but the typical indictment will include wire fraud, mail fraud, separate violations of sundry sections of the Exchange Act and the like up to 98 counts if you are Andrew Fastow. The several related counts will be grouped together to determine the Offense Level and sentences will run concurrently except when the Offense Level permits a maximum sentence that exceeds the maximum for an individual count. In the latter event, they will run consecutively to the extent necessary to permit the sentencing judge to impose the maximum if s/he determines the maximum indicated by the Offense Level and Criminal History category is appropriate. Guidelines Manual, ' 5G1.2(c)-(d). It could be worse, assuming a fraud with a mega impact and a loss of over $400 million, the Offense Level discussed above would be 47 and off the Sentencing Table chart, which only goes to 43 at which there is one sentence, life. There are adjustments and they can work both ways. Assuming the worse, the level can be increased by up to four levels for being the organizer or leader of an offense involving the participation of five or more persons or that was otherwise extensive. Guidelines Manual, ' 3B1.1(a). On the other hand, there can be a decrease of 4 levels if the defendant was a minimal participant. Guidelines Manual, ' 3B1.2(a).

Determination of the Amount of the Loss

Determination of the amount of loss in most instances of securities fraud will be the principal determinant of the Offense Level. A Commentary to the guideline relating to fraud and deceit, and other crimes with which fraud and deceit are grouped, specifically relates to the determination of the amount of loss resulting from these crimes, and given the different types of violations that can produce such losses the comment is varied in a number of respects. Guidelines Manual, ' 2B1.1, Commentary 3., Loss under (b)(1). The one general comment states that '[t]he court need only make a reasonable estimate of the loss.' Guidelines Manual, ' 2B1.1, Commentary 3(C), Estimation of Loss. Of the five specific factors listed for estimating loss, the most appropriate relevant to financial fraud appear to be the approximate number of victims multiplied by the average loss to each victim, and the reduction that resulted from the offense in the value of equity securities or other corporate assets.

The Commentary for determining the amount of loss also provides for credits against the loss, including 'the money returned to the victim(s), but only if returned 'before the offense was detected.' Guidelines Manual, ' 2B1.1, Commentary 3(E)(i), Credits against Loss. This suggests that court-ordered restitution is not to be taken into account. A Ponzi scheme is included among the special rules for determining loss, providing that a 'loss shall not be reduced by the money or the value of the property transferred to any individual investor in the scheme in excess of that investor's principal investment (ie, the gain to an individual investor in the scheme shall not be used to offset the loss to another individual investor in the scheme).' Guidelines Manual, ' 2B1.1, Commentary 3(F)(iv), Special Rules. It is fortunate that the guidelines require only a reasonable estimate of loss. There is a fair amount of case law determining the amount of loss under the guidelines in connection with financial fraud in the typical fraud on the market case, but no real agreement as to the appropriate methodology. There is much more extensive case law relating to the analogous, but, nonetheless, somewhat different issue of determining loss in securities fraud class actions. Courts in the context of determining the sentencing guidelines are likely to simplify the approach and, for example, based on expert testimony that may be conflicting determine the approximate number of shares purchased during the period the market was inflated by misrepresentations and continued to be held when the fraud was disclosed, which becomes the share multiplier. Under this simplified model, the assumption is made that purchasers who bought and sold during the period in which the stock was inflated and before disclosure of the fraud were not damaged as they paid an inflated price and sold at an inflated price. The court based on expert testimony determines the amount of inflation per share caused by the fraudulent activities of defendant and multiplied by the share multiplier that becomes the amount of the loss.

[IMGCAP(1)]

Harold S. Bloomenthal is Counsel to Holme, Roberts & Owen LLP, Denver. He is the author of 'Sarbanes-Oxley Act in Perspective, Securities Handbook, Securities and Federal Corporate Law Reports and Going Public Handbook,' co-author of 'Securities and Federal Corporate Law, Going Public and the Public Corporation,' and co-author and co-editor of 'International Capital Markets and Securities Regulation.' This article originally ran in The Corporate Compliance & Regulatory Newsletter, a sister publication.

In the legislative process that led to the adoption of Sarbanes-Oxley (SOX), legislators from both sides of the aisle vied with each other to establish their credentials for being tough on white-collar crime. The maximum penalties for mail fraud and wire fraud were increased from 5 to 20 years. Pub. L. No. 107-204 ' 903. The maximum penalty for willful violations of any provision of the Exchange Act or rule or regulation adopted thereunder the violation of which is unlawful was increased from 10 to 20 years. Pub. L. No. 107-204 ' 903. If this were not enough, a new crime relating to securities fraud in connection with the securities of public companies with a maximum penalty of 25 years was created. Pub. L. No. 107-204 ' 807 This does not exhaust the list, but should be sufficient to suggest that there are more than enough post-SOX criminal laws covering financial fraud to deter rational corporate officers and others to refrain from participating in financial crimes. The maximum statutory sentence, however, is less significant than other sentencing guideline factors in determining the range of sentence (minimum to maximum) within which the sentencing judge must impose a sentence. Defendant X, as we describe in greater detail below, an officer of a public company convicted of a willful violation of Rule 10b-5 resulting in a loss to more than 250 investors of $7-$20 million and a first time offender, under the Guidelines' Sentencing Table (below) has an offense level of 37 and faces a minimum term of 210 months (17.5 years) and a maximum sentence of 262 months (21 years and 10 months). Critical to determining the sentencing range is the Sentencing Table and what goes into it. See United States Sentencing Commission, Guidelines Manual (Nov. 2003) (available at http://www.ussc.gov/2003guid/2003guid.pdf), The Sentencing Table is as in effect as of Nov. 1, 2003 and incorporates amendments resulting from the provisions of the Sarbanes-Oxley Act discussed below.

About the Table

The table horizontally takes into account the defendant's Criminal History Category (prior offenses) and vertically the Offense Level stated as a number (ranging from 1 to 43) derived from various factors we discuss below reflecting in generic terms the seriousness of the offense. Where the two intersect determines in months the range of the minimum-maximum sentence. Thus, an Offense Level of 10 and a Category I criminal history (0-1 prior convictions) requires the sentencing judge to impose a sentence of not less than 6 months and a maximum of not more than 12 months. In contrast, an Offense Level of 27 and a Category I Criminal History would result in a sentencing range of 70-87 months. We stress the importance of the Offense Level on the assumption that corporate officers of public companies generally do not have prior convictions. The difference between the Offense Level of 10 and 27 under the above assumptions in terms of the minimum sentence is six months in the case of 10 and almost 6 years in the case of 27. There are also four zones (A-D) that are impacted by the Offense Level and Criminal History category but not in a straight line, which are relevant in determining whether probation, home detention, community service or some combination are or are not a sentencing alternative. For our immediate purpose, we note that only the A zone is eligible for probation without any imprisonment or substitute for imprisonment and that if in the D zone probation and none of the other alternatives not involving imprisonment is appropriate. It is also important to realize, that for federal crimes parole is not possible and that the maximum reduction of the sentence for good behavior is approximately 15%. See Guideline Manual (November 2003), at p. 9.

Three Overlapping Provisions

SOX contains three overlapping provisions relating to sentencing guidelines premised on the notion that white-collar crime was not adequately punished. All three provisions required the U.S. Sentencing Commission 'to promulgate the guidelines or amendments provided for under this section as soon as practicable, and in any event not later than 180 days after the date of enactment of this Act.' On May 1, 2003, the U.S. Sentencing Commission to implement the SOX directive submitted to Congress amendments to the sentencing guidelines, which became effective on Nov. 1, 2003. Our discussion, unless otherwise indicated, is based on the amended guidelines pertaining to 'Theft, Embezzlement, Receipt of Stolen Property, Property Destruction, and Offenses Involving Fraud or Deceit,' and the related Sentencing Table. Guidelines Manual, ' 2B1.1 at p. 72; Ch.5 Pt. A, at p. 362. The factors that go into the Offense Level are critical in determining the sentencing range for the new style financial fraud defendants, who we assume have no prior criminal record. The base Offense Level is 7 for conviction of an offense involving fraud or deceit that has a statutory maximum prison sentence of 20 years or more; otherwise the base Offense Level is 6. Guidelines Manual, ' 2B1.1(a). Accordingly, increasing statutory maximums to 20 years does not make a significant difference by itself in this context. What largely determines the Offense Level is the amount of loss caused by the fraud or deceit offense. Staying in the relatively small area to illustrate a point ' a loss of less than $5000 no increase in the Offense Level; 2 is added to the Offense Level if the loss is more than $5000 and less than $10,000, and 4 is added if the loss is more than $10,000 and less than $30.000. Guidelines Manual, ' 2B1.1(b)(1). To be in the A Zone and eligible for probation and no imprisonment (ie, a sentence range of 0-6 months), the Category I offender under the Sentencing Table must have an Offense Level of 8 or less. Accordingly, one who is found or pleads guilty of one of the above offenses that provides for a statutory maximum of 20 years would be eligible for probation if the loss caused was less than $5000. If we assume, as is usually is the case in the event of a guilty plea, a reduction of 2 in the Offense Level for accepting responsibility (Guidelines Manual, ' 3E1.1(a)), probation would be possible if the loss is over $5000 but did not exceed $10,000 (7 plus 2 for over $5000 less 2 for accepting responsibility). On the other hand, a loss of over $10,000 but less than $30,000 adds 4 to the Offense Level bringing it up to 11 and a reduction of 2 for accepting responsibility leaves an Offense Level of 9 and a minimum sentence of 4 months. In contrast, if the offense of which the defendant is found or pleads guilty carries a maximum sentence of less than 20 years under the same circumstances it has a base Offense Level of 6, and the defendant who caused a loss of $10,000 but less than $30,000 would be eligible for probation. Accordingly, this is one instance in which the Sarbanes-Oxley increase of the maximum sentence increases the likelihood that securities fraud violations will result in some jail time. Given the additions to the Offense Level based on the amount of loss as discussed below, it is apparent that the impact of securities fraud on investors has more to do with the sentence than the statutory maximum sentence.

Offense Involving Fraud or Deceit

Under the guidelines, for an offense involving fraud or deceit the amount of loss caused adds to the Offense Level the following: (A) $5000 or less no increase; (B) More than $5000 add 2; (C) More than $10,000 add 4; (D) More than $30,000 add 6; (E) More than $70,000 add 8; (F) More than $120,000 add 10;(G) More than $200,000 add 12; (H) More than $400,000 add 14; (I) More than $1,000,000 add 16;(J) More than $2,500,000 add 18; (K) More than $7,000,000 add 20; (L) More than $20,000,000 add 22; (M) More than $50,000,000 add 24; (N) More than $100,000,000 add 26; (O) More than $200,000,000 add 28; (P) More than $400,000,000 add 30. Guidelines Manual, ' 2B1.1(b)(1). We discuss below the determination of loss, but a substantial accounting fraud is likely to result in a loss of at least $7 million, adding 20 to the base level of 7 and resulting under the Sentencing Table, other factors aside, a sentencing range of 70-87 months.

Other Factors

There are, however, other factors to take into account that are directly relevant to securities fraud and in part are an outgrowth of SOX. The Offense Level increases with the number of victims'10 or more, add 2; 50 or more add 4; 250 or more add 6. Guidelines Manual, ' 2B1.1(b)(2). That is almost an automatic increase of 6 for securities fraud. In addition, if the offense substantially endangered the solvency of a public company, 4 is added to the Offense Level. Guidelines Manual, ' 2B1.1(b)(12)(B). There is one consolation, however, that the two combined (number of victims and endangering solvency) cannot add more than 8, if that would take the Offense Level above 24. Guidelines Manual, ' 2B1.1(b)(12)(C)-(D). Finally, increase the level by 4 if the offense involves a violation of securities laws and the defendant was an officer or director of a public company (or a registered broker-dealer or investment adviser or person associated with a registered broker-dealer or investment adviser). Guidelines Manual, ' 2B1.1(b)(14)(A).

Let us add it up the Offense Level for Defendant X found guilty of a medium sized securities fraud involving violations of Rule 10b-5. Base Offense Level 7, plus 20 for loss between $7 million and $20 million, plus 6 for 250 or more victims, plus 4 as an officer or director of a public company ' 37 or a minimum sentence under the Sentencing Table of 210 months (17.5 years); maximum sentence of 262 months (21 years and 10 months), assuming a Category I Criminal History. The maximum exceeds the 20 year maximum sentence for a willful violation of the Exchange Act, but the typical indictment will include wire fraud, mail fraud, separate violations of sundry sections of the Exchange Act and the like up to 98 counts if you are Andrew Fastow. The several related counts will be grouped together to determine the Offense Level and sentences will run concurrently except when the Offense Level permits a maximum sentence that exceeds the maximum for an individual count. In the latter event, they will run consecutively to the extent necessary to permit the sentencing judge to impose the maximum if s/he determines the maximum indicated by the Offense Level and Criminal History category is appropriate. Guidelines Manual, ' 5G1.2(c)-(d). It could be worse, assuming a fraud with a mega impact and a loss of over $400 million, the Offense Level discussed above would be 47 and off the Sentencing Table chart, which only goes to 43 at which there is one sentence, life. There are adjustments and they can work both ways. Assuming the worse, the level can be increased by up to four levels for being the organizer or leader of an offense involving the participation of five or more persons or that was otherwise extensive. Guidelines Manual, ' 3B1.1(a). On the other hand, there can be a decrease of 4 levels if the defendant was a minimal participant. Guidelines Manual, ' 3B1.2(a).

Determination of the Amount of the Loss

Determination of the amount of loss in most instances of securities fraud will be the principal determinant of the Offense Level. A Commentary to the guideline relating to fraud and deceit, and other crimes with which fraud and deceit are grouped, specifically relates to the determination of the amount of loss resulting from these crimes, and given the different types of violations that can produce such losses the comment is varied in a number of respects. Guidelines Manual, ' 2B1.1, Commentary 3., Loss under (b)(1). The one general comment states that '[t]he court need only make a reasonable estimate of the loss.' Guidelines Manual, ' 2B1.1, Commentary 3(C), Estimation of Loss. Of the five specific factors listed for estimating loss, the most appropriate relevant to financial fraud appear to be the approximate number of victims multiplied by the average loss to each victim, and the reduction that resulted from the offense in the value of equity securities or other corporate assets.

The Commentary for determining the amount of loss also provides for credits against the loss, including 'the money returned to the victim(s), but only if returned 'before the offense was detected.' Guidelines Manual, ' 2B1.1, Commentary 3(E)(i), Credits against Loss. This suggests that court-ordered restitution is not to be taken into account. A Ponzi scheme is included among the special rules for determining loss, providing that a 'loss shall not be reduced by the money or the value of the property transferred to any individual investor in the scheme in excess of that investor's principal investment (ie, the gain to an individual investor in the scheme shall not be used to offset the loss to another individual investor in the scheme).' Guidelines Manual, ' 2B1.1, Commentary 3(F)(iv), Special Rules. It is fortunate that the guidelines require only a reasonable estimate of loss. There is a fair amount of case law determining the amount of loss under the guidelines in connection with financial fraud in the typical fraud on the market case, but no real agreement as to the appropriate methodology. There is much more extensive case law relating to the analogous, but, nonetheless, somewhat different issue of determining loss in securities fraud class actions. Courts in the context of determining the sentencing guidelines are likely to simplify the approach and, for example, based on expert testimony that may be conflicting determine the approximate number of shares purchased during the period the market was inflated by misrepresentations and continued to be held when the fraud was disclosed, which becomes the share multiplier. Under this simplified model, the assumption is made that purchasers who bought and sold during the period in which the stock was inflated and before disclosure of the fraud were not damaged as they paid an inflated price and sold at an inflated price. The court based on expert testimony determines the amount of inflation per share caused by the fraudulent activities of defendant and multiplied by the share multiplier that becomes the amount of the loss.

[IMGCAP(1)]

Harold S. Bloomenthal is Counsel to Holme, Roberts & Owen LLP, Denver. He is the author of 'Sarbanes-Oxley Act in Perspective, Securities Handbook, Securities and Federal Corporate Law Reports and Going Public Handbook,' co-author of 'Securities and Federal Corporate Law, Going Public and the Public Corporation,' and co-author and co-editor of 'International Capital Markets and Securities Regulation.' This article originally ran in The Corporate Compliance & Regulatory Newsletter, a sister publication.