Can I Get a (GAAP) Witness?

The Rigas family founded the cable company Adelphia, a primary player in the corporate scandals of 2002. John Rigas was Adelphia's CEO, and his son, Timothy Rigas, was the CFO. During the trial, the prosecution presented facts indicating that, between mid-1999 and 2001, Adelphia fraudulently excluded from its consolidated financial statements over $2.3 billion in bank debt by methodically recording those liabilities on the books of other entities affiliated with the Rigas family but not consolidated with Adelphia's financial statements. The exclusion of those liabilities, the prosecution argued, violated GAAP and allowed the Rigases to mislead investors through SEC filings and other public statements. Moreover, the prosecution argued that the Rigases often created sham transactions backed by false documents to give the false appearance that Adelphia had actually repaid debts when, in truth, it had simply shifted them to the unconsolidated Rigas-controlled entities.

At trial, the government was able to secure convictions against the Rigases without using an accounting expert to explain the relevant portions of GAAP to the jury. The Rigases objected, and argued that this omission was reversible error because their charges were predicated on technical accounting matters, so the prosecution was required to support those charges with evidence from an accounting expert. Specifically, the Rigases argued that since Statement of Financial Accounting Standard No. 5 (Accounting for Contingencies) ('SFAS 5') governed whether the liabilities in question should have appeared on Adelphia's balance sheet, the government needed to call an expert to explain the requirements of SFAS 5.

The applicable Federal Rule of Evidence, 702, does not require parties to use experts to prove matters outside the so-called 'ken' of laypeople. In practice, however, most criminal courts require experts in matters that are deemed scientific and/or technical in nature, because they are outside the realm of most people's understanding. Thus, experts are routinely called, for example, in connection with medical, forensic and psychiatric issues.

Accounting issues are a different matter. The dearth of criminal accounting fraud cases and their fact-specific nature mean that few appellate courts have considered whether expert testimony in general is necessary to support a conviction. So the Rigases relied heavily on a legion of civil accounting cases that required parties to call accounting experts to explain technical accounting matters. These cases include class action lawsuits, SEC enforcement actions and accounting malpractice cases.

'Intolerable'

In their Supreme Court petition, the Rigases asserted that it is 'intolerable' for the civil standard to be inapplicable to criminal cases, where the burden of proof is higher. For example, in SEC v. Guenthner, 395 F. Supp.2d 835, 846 (D. Neb. 2005), the court held that 'establishing that an accounting practice or method is inconsistent with GAAP requires expert testimony.' Similarly, in Danis v. USN Comms., Inc., 121 F. Supp.2d 1183, 1192 (N.D. Ill. 2000), the court made it clear that violations of GAAP standards 'are established through expert testimony.' In addition, a number of commentators subscribe to the view that expert testimony is essential to establish either compliance or non-compliance with GAAP. Rossi, Expert Witnesses, at 381-82 (1991). Indeed, 'prosecutions depend upon the opinion testimony of these [accounting] experts on matters that strike at the very heart of the case, such as proper accounting procedures.' Naftalis, White Collar Crimes, at 275 (1980). The common theme is that because GAAP, is by its very nature, is just as technical and specialized as medical or forensic issues, an expert must assist the trier of fact in understanding how it is applied by the accounting profession.

Unfortunately for the Rigases, the court did not believe that the case was about technical GAAP issues. Rather, it saw the issue as whether Adelphia's financial statements, taken as a whole, were misleading through faulty disclosure, without regard to whether they technically were GAAP compliant. The court repeatedly stated that 'GAAP's requirements were not essential to the securities fraud alleged.' Instead, it relied on the long-held notion, put forth by Judge Friendly in United States v. Simon, 425 F.2d 796, 805-06 (2d Cir. 1969), that compliance with GAAP does not shield guilt in a securities fraud case. 'Even if [the Rigases] complied with GAAP,' the court wrote, 'a jury could have found, as the jury did here, that Defendants intentionally misled investors' because 'GAAP rules do not govern whether Adelphia's disclosures ' were false and fraudulent.'

United States v. Ebbers

The court relied heavily on the recent decision in United States v. Ebbers, 458 F.3d 110, 126 (2d Cir. 2006), another case involving SFAS 5, where the Second Circuit panel noted that 'GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.' Therefore, Ebbers held that the government is not required to 'prevail in a battle of expert witnesses over the application of individual GAAP rules.'

Lessons for the Future

Rigas offers some lessons for defense counsel in future accounting fraud prosecutions. Because its underlying premise is that the criminal case revolves primarily around disclosure, counsel's objective should be to focus attention on the interrelationship between underlying technical GAAP matters and the ultimate disclosure made in the financial statements. Perhaps defense counsel should call its own expert witness to cast doubt on the prosecution's thesis, create reasonable doubt, and force the government to call a rebuttal expert, thereby inviting the jury to focus on the complexity of the matter and on whose expert is more convincing.

The Rigases, at their trial, did not call an expert to discuss SFAS 5 or any other pronouncement of GAAP. This was unfortunate, because there are many pronouncements in GAAP, including SFAS 5, which provide guidance on appropriate financial statement disclosure. In those instances, a GAAP expert probably would be required to show either compliance or non-compliance with the relevant standard. It is important to note, however, that GAAP addresses only the financial statements and associated footnote disclosures. GAAP does not apply to other areas of a company's annual report, such as the 'Management's Discussion and Analysis' section, the 'Risk Factors' section, or the 'Executive Compensation' section. Thus, even if GAAP addresses disclosure as it relates to specific financial statements, the overall annual report may still be found misleading.

Conclusion

In future criminal accounting fraud cases, counsel must be aware that faulty company reports can be found fraudulent when taken as a whole even if the financial sections technically comply with GAAP. In such cases, the government will not be required to call an expert because a layperson can readily understand whether the disclosures were intentionally misleading. When a criminal case hinges on whether GAAP was correctly applied, however, expert testimony should be required. Unfortunately for John and Timothy Rigas, the Second Circuit did not think that Adelphia presented such a case.

Christopher M. Cutler, a partner with McGuireWoods LLP based in Washington, DC, was formerly with the Public Company Accounting Oversight Board's Division of Enforcement and Investigations and the SEC's Division of Enforcement.

John and Timothy Rigas ('the Rigases') were convicted in 2004 by a federal jury for their roles in looting millions of dollars from Adelphia Communications Co. and for failing to disclose billions of dollars in company liabilities on Adelphia's financial statements. In their appeal to the Second Circuit, the Rigases argued that because their convictions were predicated on Adelphia's accounting for liabilities in its financial statements, the prosecution was required to call an accounting expert to explain the technical aspects of applicable Generally Accepted Accounting Principles (GAAP). They contend that the failure to do so rendered the jury's verdict reversible.

The Second Circuit recently affirmed all but one of the counts of convictions. U.S v. Rigas , 490 F.3d 208 (2007), holding that the prosecution was not required to call a GAAP expert because compliance with GAAP was not essential to the securities fraud alleged. Instead, the Second Circuit held that the essence of the offense was a failure to disclose material information, and that a lay jury properly could find that the Rigases intentionally misled investors through insufficient or misleading financial-statement disclosures, even if Adelphia's statements were technically GAAP compliant. The Rigases have filed a petition for a writ of certiorari to the Supreme Court.

The Adelphia Fraud

The Rigas family founded the cable company Adelphia, a primary player in the corporate scandals of 2002. John Rigas was Adelphia's CEO, and his son, Timothy Rigas, was the CFO. During the trial, the prosecution presented facts indicating that, between mid-1999 and 2001, Adelphia fraudulently excluded from its consolidated financial statements over $2.3 billion in bank debt by methodically recording those liabilities on the books of other entities affiliated with the Rigas family but not consolidated with Adelphia's financial statements. The exclusion of those liabilities, the prosecution argued, violated GAAP and allowed the Rigases to mislead investors through SEC filings and other public statements. Moreover, the prosecution argued that the Rigases often created sham transactions backed by false documents to give the false appearance that Adelphia had actually repaid debts when, in truth, it had simply shifted them to the unconsolidated Rigas-controlled entities.

At trial, the government was able to secure convictions against the Rigases without using an accounting expert to explain the relevant portions of GAAP to the jury. The Rigases objected, and argued that this omission was reversible error because their charges were predicated on technical accounting matters, so the prosecution was required to support those charges with evidence from an accounting expert. Specifically, the Rigases argued that since Statement of Financial Accounting Standard No. 5 (Accounting for Contingencies) ('SFAS 5') governed whether the liabilities in question should have appeared on Adelphia's balance sheet, the government needed to call an expert to explain the requirements of SFAS 5.

The applicable Federal Rule of Evidence, 702, does not require parties to use experts to prove matters outside the so-called 'ken' of laypeople. In practice, however, most criminal courts require experts in matters that are deemed scientific and/or technical in nature, because they are outside the realm of most people's understanding. Thus, experts are routinely called, for example, in connection with medical, forensic and psychiatric issues.

Accounting issues are a different matter. The dearth of criminal accounting fraud cases and their fact-specific nature mean that few appellate courts have considered whether expert testimony in general is necessary to support a conviction. So the Rigases relied heavily on a legion of civil accounting cases that required parties to call accounting experts to explain technical accounting matters. These cases include class action lawsuits, SEC enforcement actions and accounting malpractice cases.

'Intolerable'

In their Supreme Court petition, the Rigases asserted that it is 'intolerable' for the civil standard to be inapplicable to criminal cases, where the burden of proof is higher. For example, in SEC v. Guenthner , 395 F. Supp.2d 835, 846 (D. Neb. 2005), the court held that 'establishing that an accounting practice or method is inconsistent with GAAP requires expert testimony.' Similarly, in Danis v. USN Comms., Inc. , 121 F. Supp.2d 1183, 1192 (N.D. Ill. 2000), the court made it clear that violations of GAAP standards 'are established through expert testimony.' In addition, a number of commentators subscribe to the view that expert testimony is essential to establish either compliance or non-compliance with GAAP. Rossi, Expert Witnesses, at 381-82 (1991). Indeed, 'prosecutions depend upon the opinion testimony of these [accounting] experts on matters that strike at the very heart of the case, such as proper accounting procedures.' Naftalis, White Collar Crimes, at 275 (1980). The common theme is that because GAAP, is by its very nature, is just as technical and specialized as medical or forensic issues, an expert must assist the trier of fact in understanding how it is applied by the accounting profession.

Unfortunately for the Rigases, the court did not believe that the case was about technical GAAP issues. Rather, it saw the issue as whether Adelphia's financial statements, taken as a whole, were misleading through faulty disclosure, without regard to whether they technically were GAAP compliant. The court repeatedly stated that 'GAAP's requirements were not essential to the securities fraud alleged.' Instead, it relied on the long-held notion, put forth by Judge Friendly in United States v. Simon , 425 F.2d 796, 805-06 (2d Cir. 1969), that compliance with GAAP does not shield guilt in a securities fraud case. 'Even if [the Rigases] complied with GAAP,' the court wrote, 'a jury could have found, as the jury did here, that Defendants intentionally misled investors' because 'GAAP rules do not govern whether Adelphia's disclosures ' were false and fraudulent.'

United States v. Ebbers

The court relied heavily on the recent decision in United States v. Ebbers , 458 F.3d 110, 126 (2d Cir. 2006), another case involving SFAS 5, where the Second Circuit panel noted that 'GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.' Therefore, Ebbers held that the government is not required to 'prevail in a battle of expert witnesses over the application of individual GAAP rules.'

Lessons for the Future

Rigas offers some lessons for defense counsel in future accounting fraud prosecutions. Because its underlying premise is that the criminal case revolves primarily around disclosure, counsel's objective should be to focus attention on the interrelationship between underlying technical GAAP matters and the ultimate disclosure made in the financial statements. Perhaps defense counsel should call its own expert witness to cast doubt on the prosecution's thesis, create reasonable doubt, and force the government to call a rebuttal expert, thereby inviting the jury to focus on the complexity of the matter and on whose expert is more convincing.

The Rigases, at their trial, did not call an expert to discuss SFAS 5 or any other pronouncement of GAAP. This was unfortunate, because there are many pronouncements in GAAP, including SFAS 5, which provide guidance on appropriate financial statement disclosure. In those instances, a GAAP expert probably would be required to show either compliance or non-compliance with the relevant standard. It is important to note, however, that GAAP addresses only the financial statements and associated footnote disclosures. GAAP does not apply to other areas of a company's annual report, such as the 'Management's Discussion and Analysis' section, the 'Risk Factors' section, or the 'Executive Compensation' section. Thus, even if GAAP addresses disclosure as it relates to specific financial statements, the overall annual report may still be found misleading.

Conclusion

In future criminal accounting fraud cases, counsel must be aware that faulty company reports can be found fraudulent when taken as a whole even if the financial sections technically comply with GAAP. In such cases, the government will not be required to call an expert because a layperson can readily understand whether the disclosures were intentionally misleading. When a criminal case hinges on whether GAAP was correctly applied, however, expert testimony should be required. Unfortunately for John and Timothy Rigas, the Second Circuit did not think that Adelphia presented such a case.

Christopher M. Cutler, a partner with McGuireWoods LLP based in Washington, DC, was formerly with the Public Company Accounting Oversight Board's Division of Enforcement and Investigations and the SEC's Division of Enforcement.