'Loss' in the Air Will Not Do

'Loss' under ' 2B1.1 of the U.S. Sentencing Guidelines is a pivotal sentencing issue in many federal fraud cases. In securities fraud, if the sentencing judge finds that the victims collectively suffered losses over $2.5 million, this alone can generate a sentence of five years in prison for a client with no criminal record. Over $400 million in losses can increase a sentence by almost two decades. However, sky-high loss enhancements are increasingly scrutinized in a post-Booker world. Drawing on civil securities law, recent decisions in several circuits endorse an approach holding a defendant responsible for only the portion of victims' losses that was proximately caused by the offense. Although stratospheric sentences in cases like WorldCom and Enron may not be past history, some courts' critical analyses bode well for future sentencings.

Arguing Loss at Sentencing Proceedings

As the Supreme Court noted in Gall v. United States, 128 S. Ct. 586, 596 (2007), a lower advisory Guideline means a lower 'starting point' or 'initial benchmark' for determining a sentence. In securities fraud cases, many factors often contribute to investors' losses. This creates opportunities for lower loss adjustments than those based on gross losses. This is particularly true in complex cases and in cases where events occurred during a volatile market, adverse economic conditions affected a stock's price, victims were sophisticated speculators, or a fraud involved multiple stocks or those with substantial residual value after the dust from a scheme settled ' in sum, where any extrinsic factors that contributed to victims' losses might be carved out to reduce loss for sentencing purposes.

Establishing that the government must prove loss by clear and convincing evidence is a good gateway for arguing loss. Some courts recognize that a heightened standard of proof may be required where an 'extremely disproportionate sentence results from the application of an enhancement,' United States v. Zolp, 479 F.3d 715, 718 (9^th Cir. 2007), or an enhancement amounts to the 'tail which wags the dog of the substantive offense.' United States v. Okai, 454 F.3d 848, 852 (8^th Cir.) (dicta), cert. denied, 127 S. Ct. 697 (2006). A four-level adjustment may trigger a higher burden, at least in some jurisdictions. The issue turns on the totality of the circumstances, if not the chancellor's foot. Some circuits pay lip service to the possibility of a higher burden, and others appear to reject the notion. But defense counsel should always give the argument a try.

In the typical case, an 'oversimplified ' measure of damages [is] proffered by the Government.' United States v. Olis, 429 F.3d 540, 547 (5th Cir. 2005). The Guidelines follow no 'economic reality principle' and provide no single universal method for loss calculation. See U.S. Sentencing Commission, Office of General Counsel, An Overview of Loss in USSG ' 2B1.1 (March, 2007), at 4 (http://www.ussc.gov/training/loss-March%202007.pdf). A 'fact-intensive and individualized ' inquiry' may be required for a court to make a reasonable estimate of loss. Zolp, 479 F.3d at 718.

'Market Capitalization'

The government often proposes a 'market capitalization' theory of loss, which compares a stock's value before and after a fraud is exposed. It does not account for extrinsic factors that contributed to victims' losses, or even establish that a client's wrongdoing had any particular relevance to victims' losses. For these reasons, the Second Circuit rejected the government's methodology in United States v. Rutkoske, 506 F.3d 170, 178 (2d Cir. 2007). The government's calculation also may overstate the losses of investors who purchased stock cheaply before a scheme hatched, or held a stock afterwards and recouped losses when its price rebounded.

In Rutkoske and Olis, the courts looked to civil law for guidance in calculating loss. There are a wealth of securities fraud decisions regarding damages, most of which reject exponential concepts of loss. Civil cases following the Supreme Court's decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (1995), may pave the way for improved loss computations because the Court held that a securities fraud plaintiff must plead and prove loss causation ' i.e., that there was a 'causal connection between the material misrepresentation and the loss' ' in order to prevail. Drawing on this, the Fifth Circuit concluded that 'there is no loss attributable to a misrepresentation unless and until the truth is subsequently revealed and the price of the stock accordingly declines and the portion of a price decline caused by other factors must be excluded from the loss calculation.' Olis, 429 F.3d at 546. This is key to more reasonable loss adjustments.

Looking to civil statutes like the Private Securities Litigation Reform Act of 1995, which provides for damages based on the difference between the price an investor paid and a stock's mean trading price during the 90 days following revelation of a scheme, also may be fruitful. Did the market have an extreme but short-lived reaction to the disclosure of a fraud?

While the government may object to analogies to civil law, the floodgate is open, as reflected in Rutkoske, Olis, and rulings like that of the district court that sentenced Brocade Communications' CEO Gregory Reyes. See United States v. Reyes, et al., CR 06-556-CRB (N.D. Cal.) (Order Re: Sentencing Guidelines, at CR 737). A 'nuanced approach modeled upon loss causation principles,' Olis, 429 F.3d at 547, can greatly benefit clients. A 'market-adjusted' analysis reduces investors' losses by any decrease in the value of a security that resulted from factors unrelated to a fraud. If a scheme dovetailed with any material adverse market forces other than a client's wrongdoing, the requisite causal link may be difficult for the government to establish under Dura and its progeny.

Assessing the appropriate amount of market-adjustment 'inevitably cannot be an exact science,' and ordinarily expert analysis is necessary for a court 'to approximate the extent of loss caused by a defendant's fraud.' Rutkoske, 506 F.3d at 179-80. Disentangling losses attributable to a fraud from those caused by unrelated factors is both a strategic and quantitative exercise. Consider issues like the following:

• Should victims' losses be market-adjusted to reflect any overall drop in the particular market, such as the mortgage-backed securities crisis or the dot.com crash? Did comparable companies' share prices drop simultaneously?
• What about adjusting victims' losses to reflect any drop in stock price caused by factors like increased competition, adverse economic conditions, exchange rate fluctuations, or instability in domestic or international markets?
• Were victims' losses caused in part by wrongdoing not attributable to the client?
• Should loss figures be adjusted to reflect risks knowingly undertaken by savvy investors in speculative securities, so that a client is punished only for risks that buyers unwittingly assumed?
• Where an investor profited on some transactions involved in the scheme, should gains offset aggregate losses? What about profits gleaned after a scheme ended and the stock rebounded? Do such circumstances warrant a longer window for calculating loss?
• Should a client receive the benefit of the doubt where the facts support assessing loss in varying time periods?
• Is a client's personal gain a reasonable alternative when victims' losses cannot be fairly approximated?

More traditional arguments also may support lower loss adjustments. For example, was the client unaware of a scheme at its inception? Did a client quickly withdraw from the scheme, or take steps to mitigate the harm? Did a client intend for his or her customers to profit from unauthorized speculation?

The Guidelines specify that loss is the greater of 'intended' or 'actual' (known or reasonably foreseeable) pecuniary harm. When neither can be reasonably estimated, a defendant's personal gain from a fraudulent scheme may be an appropriate option. See USSG ' 2B1.1, comment, n. 3(B). Gain could be things like diverted funds, inflated trading profits, commissions, bonuses or kickbacks. This alternative is ideal where a client profited little, or ended up among the losers when a scheme went awry. It also is the only alternative yardstick prescribed by the Guidelines, and thus may be more palatable to courts that disfavor nuanced approaches to sentencing.

Creative government efforts to generate high loss adjustments have not received a warm welcome. For example, the Reyes court rejected prosecutors' suggestion that loss could be calculated by reference to the SEC fines that the issuer paid, or tax liabilities of victim employees which it assumed. Speculative loss calculations, such as victims' expectations of profit or the opportunity cost of their funds, do not fare well either. As the Fifth Circuit stated, the 'Government does not further the goals of sentencing uniformity or fairness when, as seems to be happening in these cases, the Government persistently adopts aggressive, inconsistent, and unsupportable theories of loss.' Olis, 429 F.3d at 547, n. 11.

Conclusion

Because of the severe impact of loss adjustments, it may be worthwhile to develop a methodology that anchors the enhancement to a client's conduct and tempers the Guidelines' unbridled concept of loss. It is unclear whether courts will increasingly disfavor draconian sentences in securities cases, or grow indifferent to the pleas of those who push speculative stocks on naive investors, orchestrate pump and dump or Ponzi schemes, roll the dice with investor funds, falsify corporate records, mislead regulators and the like. Recent decisions, however, provide the defense with some sentencing ammunition in these challenging cases.

Evan A. Jenness ([email protected]) is a criminal defense attorney and the principal of Law Offices of Evan A. Jenness, in Santa Monica, CA.

'Loss' under ' 2B1.1 of the U.S. Sentencing Guidelines is a pivotal sentencing issue in many federal fraud cases. In securities fraud, if the sentencing judge finds that the victims collectively suffered losses over $2.5 million, this alone can generate a sentence of five years in prison for a client with no criminal record. Over $400 million in losses can increase a sentence by almost two decades. However, sky-high loss enhancements are increasingly scrutinized in a post-Booker world. Drawing on civil securities law, recent decisions in several circuits endorse an approach holding a defendant responsible for only the portion of victims' losses that was proximately caused by the offense. Although stratospheric sentences in cases like WorldCom and Enron may not be past history, some courts' critical analyses bode well for future sentencings.

Arguing Loss at Sentencing Proceedings

As the Supreme Court noted in Gall v. United States , 128 S. Ct. 586, 596 (2007), a lower advisory Guideline means a lower 'starting point' or 'initial benchmark' for determining a sentence. In securities fraud cases, many factors often contribute to investors' losses. This creates opportunities for lower loss adjustments than those based on gross losses. This is particularly true in complex cases and in cases where events occurred during a volatile market, adverse economic conditions affected a stock's price, victims were sophisticated speculators, or a fraud involved multiple stocks or those with substantial residual value after the dust from a scheme settled ' in sum, where any extrinsic factors that contributed to victims' losses might be carved out to reduce loss for sentencing purposes.

Establishing that the government must prove loss by clear and convincing evidence is a good gateway for arguing loss. Some courts recognize that a heightened standard of proof may be required where an 'extremely disproportionate sentence results from the application of an enhancement,' United States v. Zolp , 479 F.3d 715, 718 (9 th Cir. 2007), or an enhancement amounts to the 'tail which wags the dog of the substantive offense.' United States v. Okai , 454 F.3d 848, 852 (8 th Cir.) ( dicta ), cert . denied , 127 S. Ct. 697 (2006). A four-level adjustment may trigger a higher burden, at least in some jurisdictions. The issue turns on the totality of the circumstances, if not the chancellor's foot. Some circuits pay lip service to the possibility of a higher burden, and others appear to reject the notion. But defense counsel should always give the argument a try.

In the typical case, an 'oversimplified ' measure of damages [is] proffered by the Government.' United States v. Olis , 429 F.3d 540, 547 (5th Cir. 2005). The Guidelines follow no 'economic reality principle' and provide no single universal method for loss calculation. See U.S. Sentencing Commission, Office of General Counsel, An Overview of Loss in USSG ' 2B1.1 (March, 2007), at 4 (http://www.ussc.gov/training/loss-March%202007.pdf). A 'fact-intensive and individualized ' inquiry' may be required for a court to make a reasonable estimate of loss. Zolp, 479 F.3d at 718.

'Market Capitalization'

The government often proposes a 'market capitalization' theory of loss, which compares a stock's value before and after a fraud is exposed. It does not account for extrinsic factors that contributed to victims' losses, or even establish that a client's wrongdoing had any particular relevance to victims' losses. For these reasons, the Second Circuit rejected the government's methodology in United States v. Rutkoske , 506 F.3d 170, 178 (2d Cir. 2007). The government's calculation also may overstate the losses of investors who purchased stock cheaply before a scheme hatched, or held a stock afterwards and recouped losses when its price rebounded.

In Rutkoske and Olis, the courts looked to civil law for guidance in calculating loss. There are a wealth of securities fraud decisions regarding damages, most of which reject exponential concepts of loss. Civil cases following the Supreme Court's decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (1995), may pave the way for improved loss computations because the Court held that a securities fraud plaintiff must plead and prove loss causation ' i.e. , that there was a 'causal connection between the material misrepresentation and the loss' ' in order to prevail. Drawing on this, the Fifth Circuit concluded that 'there is no loss attributable to a misrepresentation unless and until the truth is subsequently revealed and the price of the stock accordingly declines and the portion of a price decline caused by other factors must be excluded from the loss calculation.' Olis, 429 F.3d at 546. This is key to more reasonable loss adjustments.

Looking to civil statutes like the Private Securities Litigation Reform Act of 1995, which provides for damages based on the difference between the price an investor paid and a stock's mean trading price during the 90 days following revelation of a scheme, also may be fruitful. Did the market have an extreme but short-lived reaction to the disclosure of a fraud?

While the government may object to analogies to civil law, the floodgate is open, as reflected in Rutkoske, Olis, and rulings like that of the district court that sentenced Brocade Communications' CEO Gregory Reyes. See United States v. Reyes, et al., CR 06-556-CRB (N.D. Cal.) (Order Re: Sentencing Guidelines, at CR 737). A 'nuanced approach modeled upon loss causation principles,' Olis, 429 F.3d at 547, can greatly benefit clients. A 'market-adjusted' analysis reduces investors' losses by any decrease in the value of a security that resulted from factors unrelated to a fraud. If a scheme dovetailed with any material adverse market forces other than a client's wrongdoing, the requisite causal link may be difficult for the government to establish under Dura and its progeny.

Assessing the appropriate amount of market-adjustment 'inevitably cannot be an exact science,' and ordinarily expert analysis is necessary for a court 'to approximate the extent of loss caused by a defendant's fraud.' Rutkoske, 506 F.3d at 179-80. Disentangling losses attributable to a fraud from those caused by unrelated factors is both a strategic and quantitative exercise. Consider issues like the following:

• Should victims' losses be market-adjusted to reflect any overall drop in the particular market, such as the mortgage-backed securities crisis or the dot.com crash? Did comparable companies' share prices drop simultaneously?
• What about adjusting victims' losses to reflect any drop in stock price caused by factors like increased competition, adverse economic conditions, exchange rate fluctuations, or instability in domestic or international markets?
• Were victims' losses caused in part by wrongdoing not attributable to the client?
• Should loss figures be adjusted to reflect risks knowingly undertaken by savvy investors in speculative securities, so that a client is punished only for risks that buyers unwittingly assumed?
• Where an investor profited on some transactions involved in the scheme, should gains offset aggregate losses? What about profits gleaned after a scheme ended and the stock rebounded? Do such circumstances warrant a longer window for calculating loss?
• Should a client receive the benefit of the doubt where the facts support assessing loss in varying time periods?
• Is a client's personal gain a reasonable alternative when victims' losses cannot be fairly approximated?

More traditional arguments also may support lower loss adjustments. For example, was the client unaware of a scheme at its inception? Did a client quickly withdraw from the scheme, or take steps to mitigate the harm? Did a client intend for his or her customers to profit from unauthorized speculation?

The Guidelines specify that loss is the greater of 'intended' or 'actual' (known or reasonably foreseeable) pecuniary harm. When neither can be reasonably estimated, a defendant's personal gain from a fraudulent scheme may be an appropriate option. See USSG ' 2B1.1, comment, n. 3(B). Gain could be things like diverted funds, inflated trading profits, commissions, bonuses or kickbacks. This alternative is ideal where a client profited little, or ended up among the losers when a scheme went awry. It also is the only alternative yardstick prescribed by the Guidelines, and thus may be more palatable to courts that disfavor nuanced approaches to sentencing.

Creative government efforts to generate high loss adjustments have not received a warm welcome. For example, the Reyes court rejected prosecutors' suggestion that loss could be calculated by reference to the SEC fines that the issuer paid, or tax liabilities of victim employees which it assumed. Speculative loss calculations, such as victims' expectations of profit or the opportunity cost of their funds, do not fare well either. As the Fifth Circuit stated, the 'Government does not further the goals of sentencing uniformity or fairness when, as seems to be happening in these cases, the Government persistently adopts aggressive, inconsistent, and unsupportable theories of loss.' Olis, 429 F.3d at 547, n. 11.

Conclusion

Because of the severe impact of loss adjustments, it may be worthwhile to develop a methodology that anchors the enhancement to a client's conduct and tempers the Guidelines' unbridled concept of loss. It is unclear whether courts will increasingly disfavor draconian sentences in securities cases, or grow indifferent to the pleas of those who push speculative stocks on naive investors, orchestrate pump and dump or Ponzi schemes, roll the dice with investor funds, falsify corporate records, mislead regulators and the like. Recent decisions, however, provide the defense with some sentencing ammunition in these challenging cases.

Evan A. Jenness ([email protected]) is a criminal defense attorney and the principal of Law Offices of Evan A. Jenness, in Santa Monica, CA.