Risk & Compliance

Fraud Squad

Federal investigators are on a crusade to elevate corporate misdeeds to criminal offenses.
Alix StuartApril 1, 2003

U.S. Attorney Patrick Meehan hasn’t yet caught any companies engaging in the fraudulent accounting tactics that Enron used to boost revenues. But should one turn up in the Philadelphia jurisdiction where Meehan represents the Department of Justice, well, he wouldn’t be sorry.

“I’m not wishing that there be some major corporate scandal with Eastern Pennsylvania nexus,” says Meehan, an antiterrorism expert and member of the DoJ’s newly formed Corporate Fraud Task Force. “That doesn’t mean we aren’t very aggressively scrutinizing activity in our area.”

To that end, Meehan has been changing the way he does business. For one thing, he’s getting weekly, rather than ad hoc, updates on suspicious corporate activity from his white-collar-crime expert. More important, he’s teaming with other agencies, such as the Internal Revenue Service and the U.S. Postal Service, to pursue corporate cases that have potential criminal implications. Already, he and Arthur S. Gabinet, the Philadelphia-area head of the Securities and Exchange Commission, have planned staff cross-trainings and reviewed cases of mutual interest.

Meehan is hardly alone in tightening his scrutiny. While the 93 Presidentially appointed U.S. Attorneys who represent the DoJ nationwide have broad discretion in choosing cases, it’s hard for them to ignore the fact that their bosses have put revenue inflation and expense miscapitalization on a par with terrorism and drug pushing. “When financial transactions are fraudulent and balance sheets are falsified, the invisible hand that guides our markets is replaced by a greased palm,” said Attorney General John Ashcroft as he pressed charges against WorldCom executives last August. “Corporate executives who cheat investors, steal savings, and squander pensions will meet the judgment they fear and the punishment they deserve.”

Beyond the rhetoric, the federal government has taken unprecedented measures to strengthen its corporate fraud-fighting resources. Before last summer, there was no “home” for such cases within the DoJ, which relied on its various subdivisions, including the FBI, securities-fraud and white-collar-crime units, and local U.S. Attorneys, to handle them on an as-needed basis. Now the inter-agency Corporate Fraud Task Force, formed last July, is coordinating investigations into alleged misconduct at such major firms as Adelphia Communications Corp. and Qwest Communications International Inc., and equipping local staffs with the resources and expertise they need to hasten indictments. President Bush’s proposed budget, meanwhile, offers $24.5 million to the cause, some of which will be used to hire 88 new staff members in the U.S. Attorneys’ offices and 118 new workers at the FBI.

Add to these moves the public outrage at Enron and WorldCom officials, and no wonder prosecutors like Meehan feel compelled to jump on business-fraud cases. “Until now, most [U.S. Attorneys’] offices outside the major metropolitan centers haven’t had the resources or experience to take these cases on,” says John Falvey, a former assistant U.S. Attorney and now a white-collar defense attorney in Boston. “Thanks to the political climate, though, every office is now looking to make them.”

That means that executives — particularly finance executives — have become targets for prosecutors looking for a win with superiors. “Many of the [accounting] cases I’m involved in, and my colleagues say the same thing, would not have been the subject of criminal investigations a few years ago,” says Jan L. Handzlik, a partner at Kirkland & Ellis. Adds Thomas E. Dwyer Jr., a white-collar defense attorney at Dwyer & Collora in Boston, “Every office is looking for its own Enron.”

More Than Tough Talk

Of course, the DoJ has long talked tough about corporate fraud, and has brought action against executives at companies that created massive investor losses, such as Cendant and McKesson. Yet, while prosecutors have had the legal authority to bring criminal fraud charges since the 1930s, the agency has historically stuck to crimes that yield more tangible evidence, such as murder, kidnapping, or illegal arms possession.

“[Accounting] cases are not easy to prosecute, since they have to prove that an executive knew or should have known about the fraud in order to indict,” says John K. Markey, a partner with Mintz Levin Cohn Ferris Glovsky and Popeo PC and a former assistant U.S. Attorney. That’s a higher burden of proof than SEC investigators typically require for civil cases, which are contingent on proving only that a filing contained incorrect information. Given the volume of resources required for the DoJ to build such cases, most prosecutors have found it worthwhile to take on corporations in only the most egregious or clear-cut instances.

Thanks to recent legislative changes, however, lawyers see a future in which many common accounting snafus, including restatements, could put executives at risk for jail time. “With the new Sarbanes-Oxley requirement to have strong internal controls and officer certification of financial statements, the bar has been lowered on the ‘knew or should have known’ standard,” says Markey. “The presumption will be that the CFO must have known if something has gone wrong.”

Just how fierce this chase will be and how long it will last is anyone’s guess. At press time, the DoJ had opened more than 150 investigations into allegations of corporate fraud. The FBI alone claims to have opened more than 50 major corporate-fraud investigations since initiating the Enron investigation in December 2001. And if the geographic scope of the investigations and the speed with which prosecutors are bringing indictments are any indication, there is good reason for many more companies to be concerned.

The U.S. Attorney’s Office in St. Louis, Missouri, for example, best known for prosecuting drug pushers and counterfeiters, is now investigating Charter Communications Inc. for alleged accounting fraud. Kmart Corp.’s management decisions are being probed by the Eastern District of Michigan. And the indictments against four former Qwest executives for allegedly booking revenue that should have been deferred were issued from the Colorado U.S. Attorney’s Office, which credited the Task Force’s oversight with speeding up the investigation.

At the same time, the Task Force is also helping offices clear out backlogs of older cases and deploying resources to take on smaller cases. In December, the U.S. Attorney’s Office in Tulsa completed a four-year investigation into now-defunct Commercial Financial Services Inc., thanks to additional staff from the DoJ’s Washington, D.C., office. In several districts, including the Southern District of New York and the Central District of California, a number of formerly unknown executives have been indicted for frauds involving relatively small amounts of money. U.S. Technologies Inc. chairman and CEO C. Gregory Earls, for one, is facing up to 50 years in jail and $3 million in fines for bilking investors out of $13.8 million.

In addition, at the Task Force’s urging, DoJ officials have demonstrated a newfound willingness to bring partial cases and add charges later. That helps explain why Enron executives have been charged in such a piecemeal fashion, starting last August with Michael Kopper and continuing most recently with two accounting managers involved with the company’s Braveheart scheme. That strategy also lends logic to why Kmart managers were charged with prematurely booking $42 million of vendor allowances as revenue in February, when the company’s own investigation turned up some $92 million in such improper allocations.

A Task Force Approach

The biggest weapon the Task Force has in combating fraud, however, may be the closer ties it is forging with other agencies. The group of 17, formed by President Bush last July and headed by Deputy Attorney General Larry D. Thompson, includes seven U.S. Attorneys, like Meehan, from major metropolitan areas, plus FBI head Robert Mueller, SEC chairman William H. Donaldson, and Labor Secretary Elaine L. Chao, among others. As an interagency team, the Task Force’s criminal authorities have easier access to corporate cases, as well as the topical expertise the Task Force needs to prosecute.

The group meets whenever necessary to discuss ways to leverage resources. “If you’re all sitting around a table, it’s much easier to get that tag-team help,” says U.S. Attorney for the Central District of California Debra W. Yang, whose district led the nation with charges against 483 white-collar defendants last year. She says her manpower temporarily tripled on one recent case after she mentioned it to Mueller.

Such cooperation between the SEC and the DoJ has long been a factor in several regions known for high-profile corporate-fraud cases, but the Task Force is broadening and deepening that relationship. Besides working with Donaldson and Stephen Cutler, the SEC’s head of enforcement in Washington, D.C., the DoJ has been tapping regional SEC officials with unprecedented frequency and eagerness. “I feel like a prom queen, I’ve been pinned by so many U.S. Attorneys who want to work with me,” says Harold F. Degenhardt, SEC district administrator in Fort Worth, referring to the six DoJ pins that have graced his lapel as a result of recent meetings with prosecutors.

David Nelson, director for the SEC’s Southeast region, agrees. “The receptiveness of the DoJ is higher down here now than at any time before,” he says. A cross-training program that puts one of his staff members in the Miami U.S. Attorney’s office full-time has already boosted the flow of SEC cases to the DoJ, he says, and he expects to see it increase thanks to the encouragement from Washington.

So far, neither Degenhardt nor Nelson has scored an indictment as a result of these partnerships. But the fruits of such collaboration can be seen in central California, where efforts between Yang’s office and the Los Angeles SEC branch office have produced four indictments and five guilty pleas against the corporate officers at four companies — Homestore.com, eConnect, Motorcar Parts & Accessories, and Newcom — since last July. “The old model, in which we finish our own investigation, bring our case, and then make a referral to the U.S. Attorney’s Office, often no longer applies,” says Randall R. Lee, director of the SEC’s Pacific region. Instead, “we’ll call criminal authorities immediately” when an SEC case seems to have criminal elements.

Lines of Cooperation

So what’s the best advice for companies and finance executives in dealing with this new united front? Lie down and roll over, say lawyers. “One of the few ways a company or an individual can gain any benefit with prosecutors is by cooperating with them,” says Handzlik.

In fact, the access a company is willing to give the government to its employees and to its information can actually determine whether or not charges are pressed against the entity, say prosecutors, as well as how high the fines should be. “When a company walks in and says, ‘Here are the books, and all witnesses are available,’” says Patrick Fitzgerald, U.S. Attorney for the Northern District of Illinois, “that’s a very important factor in deciding whether or not to charge them if we find a crime took place.”

Such conduct is what made Homestore.com, an online real-estate concern, such a model cooperator, say authorities. Although four of the company’s former executives, including two former CFOs, were charged for a scheme to buy revenues, “we did not charge the company, in large part because of its behavior,” says Yang. “When we started investigating, they turned over all their documents without trying to hide anything, and they made an effort to root out the cause of the problem by getting the officers out of there.” Safety-Kleen Corp. and Aurora Foods Inc. also managed to avoid corporate charges when their executives were indicted.

Cooperation is not risk free, however. First, it carries with it no guarantees of leniency. Arthur Andersen signed its own death warrant by admitting to authorities that its Houston office had destroyed documents, say many attorneys, based on the fact that it later sank on a single charge of obstruction of justice related to the shredding. A similar situation now appears possible at Credit Suisse First Boston, according to published reports, where company-produced E-mails now look likely to be the basis of charges against former investment banker Frank Quattrone.

Second, cooperation often means a company may turn against its executives, says E. Lawrence Barcella, who is representing Homestore.com co-founder and former CEO Stuart Wolff. So far Wolff has not been indicted, but he is under investigation by the DoJ. But that has been enough to deny Wolff access to records he might have used to build any future defense, says Barcella, “even though the company’s internal investigation did not show any wrongdoing on his part.”

Most seriously, by waiving its right to keep confidential information confidential, a company may end up seeing that information “fall into the hands of civil plaintiffs or other federal agencies,” says Handzlik. Columbia/HCA (now HCA Inc.), for example, made internal coding audits available to investigators looking at its billing practices. The firm claimed that it was not waiving its attorney-client privilege or work-product privilege when it set up a confidentiality agreement with the DoJ that ostensibly protected the information from leaking. Shortly after settling in 2000 for an $840 million fine, though, “innumerable” plaintiffs — private insurers and individuals — tried to acquire the documents to build their own cases. The U.S. Sixth Circuit Court of Appeals ruled in favor of those plaintiffs, upholding the prevailing view that “once a client waives the privilege to one party, the privilege is waived in toto,” according to its June 2002 decision.

The DOJ vs. the CFO

For executives caught in the DoJ’s crackdown, prosecutors have a slightly different yet equally powerful incentive to induce cooperation — lesser charges and less jail time. And given new federal sentencing guidelines, it often behooves executives to work with the DoJ up front.

Those guidelines — introduced in 1987 — give minimum sentences that make it difficult for federal judges to shorten. In addition, recent revisions suggest even longer minimum sentences for crimes committed after January 25, 2003. For example, the minimum sentence for an obstruction-of-justice charge was boosted from 18 months to 24 months.

Prosecutors are eager to wield the new standards. “Our emphasis is to make sure we follow through not just on prosecuting but [also on] arguing for a particularly tough sentence,” says Fitzgerald. And that sentence will be made even tougher, thanks to a recent Task Force-inspired DoJ directive to assign white-collar convicts to standard prisons, rather than low-security facilities. “They clearly want to eliminate any perception that white-collar criminals get favorable treatment,” says James M. Becker, an attorney with Saul Ewing in Philadelphia.

But could the DoJ be going too far in eliminating that perception? Some experts say it is possible. “When the playing field is tilted so heavily in favor of enforcement officials and the members of juries are viewing executives as criminals, it’s much harder to get fair treatment,” says Handzlik. He says that in many cases he knows of, executives will “take the pragmatic way out and plead guilty,” even when their cases are considered defensible. “That means, in my view, the system is not working properly.”

Only time will tell if the DoJ’s new aggressiveness will root out any real rot in Corporate America or if it is simply a legal witch-hunt. In the meantime, however, most attorneys expect more CFOs to go to jail. “In a case involving falsified financial statements of a public company, executives are very much at risk for jail time, and that’s only going to get worse,” says Falvey. Already, 200 individuals have been charged in such cases, and guilty pleas or verdicts have been secured against 60. “In the white-collar defense world, you win the case preindictment,” says Markey. “Once they [the DoJ] indict, they are emotionally and institutionally committed to the conviction of the individual.”

Alix Nyberg is a staff writer at CFO.

Attention Grabbers

What’s sure to grab the Department of Justice’s interest these days? Good clues can be found in the March 2002 issue of the United States Attorneys’ Bulletin, which outlined four “brazen accounting frauds” — side agreements, swap transactions, backdating, and concealing debt or expenses through special-purpose entities, deferred expenses, or accelerated recognition of losses — that make for good criminal cases.

By all accounts, prosecutors are taking the advice to heart. A side agreement with American Greetings Corp. was the basis of indictments against former Kmart Corp. executives. Alleged manipulations that boosted revenue without actual sales are at the heart of the Homestore.com Inc. case, as well as investigations of many telecom companies. And investigations at WorldCom, among others, hinged on concealing operating expenses as capital expenses.

How long ago the fraudulent activity occurred, how many people were involved, and how much money was lost are also key factors in deciding whether to take a case, say DoJ officials. Still, any willful violation of an accounting law can be construed as a criminal case — a long-standing policy under U.S. law that the Sarbanes-Oxley Act only clarified. The government, however, can charge only on what it can prove was willful, which can be a tall order. That, in part, explains why the DoJ charged just four former Qwest Communications Inc. executives for a single revenue-boosting scheme in late February, while the SEC brought concurrent civil charges against eight for two separate schemes. It wasn’t that the second case — a deal in which Qwest executives (including former Global Business unit CFO Grant Graham) “bought” revenues from Genuity — couldn’t lead to criminal charges later. It’s just that the evidence needed to prove criminal intent takes longer to develop, say experts, because the standard of proof is higher.

Securing that evidence has led to a renewed emphasis on whistle-blowers and employee testimonies. “One common mistake in the prosecution of accounting-fraud cases is to focus on the paper to the exclusion of key witnesses,” the Bulletin article reads. It goes on to advise prosecutors to ” ‘flip’ lower-level participants like narcotics prosecutors would,” noting that cooperation can usually be induced by making noncooperators targets of the investigation.

To further that approach, the FBI has set up an agency-staffed hotline to “provide the general public with the opportunity to furnish information concerning suspected corporate- fraud matters directly to the FBI,” according to a press release. The FBI expects the hotline to generate four or five new corporate-fraud cases each month. —A.N.