Sunday, September 24, 2006

Criminal Sentencing Perspective on Plaintiffs'-Style Damages Calculations

On September 22, 2006, Judge Sim Lake of the United States District Court in Houston re-sentenced former Dynegy tax executive and lawyer Jamie Olis to six years in prison for securities fraud, upon reconsideration after Olis's initial sentence of 24 years that had been reversed on appeal. (Press reports of the resentencing may be found here and here.) Both the history of Olis’s sentencing and Judge Lake’s September 22, 2006 sentencing memorandum (here) provide an interesting perspective on the plaintiffs’-style damages calculations that prosecutors urged the Court to use in determining Olis’s sentence.

Olis, along with two other Dynegy executives, Gene Foster and Helen Sharkey, was indicted for an alleged conspiracy to commit fraud; mail fraud; wire fraud; and securities fraud. The essential allegation was that the defendants had engaged in a scheme (“Project Alpha”) to distort Dynegy’s financial statements by disguising a $300 million loan as operating cash flow. Foster and Sharkey pled guilty to conspiracy and cooperated with the government. Olis’s case was tried to a jury in November 2003, and he was convicted on all counts.

Judge Lake originally sentenced Olis to 24 ¼ years in prison. Judge Lake based this sentence on the federal sentencing guidelines, which he viewed as mandatory, and his determination of the pecuniary loss that Dynegy shareholders suffered as a result of the fraud. Olis appealed his conviction and his sentence to the Fifth Circuit. While his appeal was pending, the U.S. Supreme Court issued a ruling that the federal sentencing guidelines are merely advisory and not mandatory. In October 2005, the Fifth Circuit affirmed Olis’s conviction, but vacated his sentence and remanded the case to Judge Lake. In remanding the case, the Fifth Circuit stated that it was unclear whether Judge Lake would have imposed the same sentence if the Judge had regarded the sentencing guidelines as advisory rather than mandatory. The Fifth Circuit also specifically held that Olis’s sentence “overstated” the shareholder loss caused by the fraud.

On resentencing, Judge Lake began his analysis by re-examining the question of the Dynegy shareholders’ “actual loss” from the fraud. (The pecuniary loss from the criminal conduct is a factor for courts to consider under the federal sentencing guidelines.) In making this determination, Judge Lake, following Fifth Circuit precedent, relied upon “applicable principles of recovery of civil damages for securities fraud.” In other words, even though the context was a criminal sentencing, Judge Lake relied upon principles of civil damages calculations, so his comments about those principles are relevant in both contexts.

In support of their argument that Dynegy’s shareholders loss from the fraud was in the range of from $161 million to $714 million, the prosecutors relied on the testimony of an economic expert, Frank Graves of the Brattle Group. Graves used an “events study” to determine the per-share inflationary effect to Dynegy’s share price as a result of Project Alpha. Graves then used two alternative models to estimate the number of shares that were damaged, the proportional trader model and the two-trader model. Using these assumptions, Graves estimated the range of shareholder damages from $161 million to $714 million. Olis’s attorneys, supported by a former SEC Commissioner and Stanford Law Professor Joseph Grundfest (who was acting pro bono on Olis’s behalf and who testified at Olis's two-day resentencing hearing), argued that Graves’s analysis failed to account for Dynegy’s numerous other negative announcements unrelated to Project Alpha and relied on numerous unproveable assumptions. (A copy the sentencing memorandum submitted on Olis's behalf, including Grundfest's written declaration, is bookmarked here.) After a lengthy review of the economic analyses, Judge Lake concluded that “it is not possible to estimate with any degree of reasonable certainty the actual loss to shareholders attributable to the corrective disclosures.”

Because Judge Lake could not determine the “actual loss” to shareholders, he instead looked to the “intended loss” of the defendants’ conduct. There had been trial testimony from one of the cooperating defendants that the defendants had intended that Project Alpha would avoid $79 million in federal taxes. Using this "intended loss" figure and taking into account a number of mitigating circumstances (including specifically the fact that Olis had not intended to profit personally from Project Alpha), Judge Lake resentenced Olis to 6 years’ imprisonment. Olis has already served two years and four months in prison, so he could be out of prison by May 2010, or earlier for good behavior.

Judge Lake’s rulings in Olis’s resentencing are significant in several respects. First, his reasoning and analysis carry important implications for Jeffrey Skilling, whom Judge Lake is scheduled to sentence on October 23, 2006. As discussed in detail on the White Collar Crime Prof blog (here), many of the mitigating factors that Judge Lake considered in Olis’s case are absent in Skilling’s, and Judge Lake’s remarks could be interpreted to suggest by implication that Skilling may face the prospect of a much more severe sentence. (The White Collar Crime Prof blog suggests that Skilling may face more than 20 years’ imprisonment and a fine of $400 million.)

Judge Lake’s rulings are also important for his analysis of the plaintiffs’-style damages calculation. The Judge explicitly relied on principles of civil case damages analysis in his attempt to calculate the Dynegy shareholders’ “actual loss.” The prosecution’s expert used analytic tools that plaintiffs’-style damages experts often use to estimate the purported loss of the shareholder class in civil securities fraud actions. So the fact that Judge Lake concluded that the prosecution had not established the actual loss with reasonable certainty, using these standard analytic tools, has potentially important implications for the credibility of these tools in civil cases.

To be sure, Judge Lake was very careful to note that his conclusion was based “on the facts of this case; it is not a conclusion that such estimates are never possible.” These are the words of a careful judge who is taking pains to try to limit the effects of his analysis to the case before him. But the reality is that the defense objections to the prosecutor’s experts analysis are equally applicable to the plaintiffs’ experts’ analysis used to calculate purported shareholder damages in many civil securities fraud cases. (Professor Grundfest's devastating critique, which is linked above, while keyed to the facts of the case, would apply at the theoretical level to the damages analyses in most civil securities cases.) And the bases for Judge Lake’s conclusion that the methodologies used did not produce a calculation of the shareholders' actual loss with reasonable certainty are equally applicable as well.

A variety of causes conspire to ensure that securities fraud lawsuits almost never go to trial. One consequence is that many of the standard tools in the plaintiff’s lawyers’ toolkit have rarely been subjected to judicial scrutiny. This is particularly true with respect to plaintiffs’-style damages calculations, which plaintiffs’ lawyers use to produce highly inflated estimates of purported shareholder damages. Plaintiffs’ lawyers use the calculations as a basis upon which to try to extract enormous settlements, with some effectiveness. (Indeed, the Dynegy/Project Alpha civil action settled for more than $474 million.) Yet both the damages calculations themselves and the calculations methodologies are largely untested by judicial scrutiny. Judge Lake’s ruling in the Olis resentencing suggests that were the plaintiffs’ style damages calculation more regularly subject to judicial scrutiny, many inflated damages estimates might not survive. Even though it is within the criminal context, Judge Lake’s opinion may provide some ammunition to use against the plaintiffs’-style damages calculation. Judge Lake’s reasoned opinion and the outcome of his analysis also suggest that scrutiny of the plaintiffs’-style damages calculation may be long overdue.

The D & O Diary is interested in its readers comments on the Olis resentencing and its possible implications, particulary those who may disagree with my views about the shareholder damages calculation.

A Note of Concern About Olis's Sentence: Even though Judge Lake significantly reduced Olis's sentence, Olis's sentence still stands in contrast to the lighter sentences that his co-defendants received. Gene Foster, who was Olis's boss, received a sentence of only 18 months, and the third defendant, Helen Sharkey received a sentence of only one month. It is hard to avoid the impression that the other two defendants received a lighter because they entered guilty pleas, but that prosecutors sought a heavier sentence for Olis because he insisted on going to trial. As Professor Ellen Podgor writes in the White Collar Crime Prof blog (here):


a question that definitely needs to be considered and addressed by Congress and the courts is whether the government should have this enormous prosecutorial power to leverage individuals against each other in order to obtain evidence for a prosecution on the individual who decides not to enter a plea. Is it within the bounds of the Constitution to punish individuals with higher sentences because they decide they want to use their constitutional right to a jury trial?
The September 25, 2006 issue of the Washington Post has an interesting and thoughtful article entitled "Cook the Books, Get Life in Prison: Is Justice Served?" (here, registration required) discussing the problem of calibrating sentences for white collar criminals


Hats Off to Joseph Grundfest: I have never had the honor of making Professor Grundfest’s acquaintance. I do know the high esteem in which he is held in the securities industry and the legal community generally. I can only imagine the demands on his time, and the opportunities he has to advance his own professional and monetary interests. The defense of a convicted white collar criminal is not a popular cause in the post-Enron, Sarbanes-Oxley world. The fact that he would take the time, burden and responsibility to become involved on a pro bono basis in Olis’s resentencing is truly impressive. Professor Grundfest, The D & O Diary salutes you.

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