Tenth Circuit Reverses Joe Nacchio's Sentence

Update 8/1: I'm glad to see that Law Prof Ellen Podgor, who specializes in White Collar Crime and really knows her stuff, agrees with me that this is a very technical opinion. She also comments:

What concerns me is the level of economic and mathematical skills needed by counsel and the courts to handle these cases. Clearly experts exist who understand the figures being presented, and have the ability to offer their schooled explanations to the court. But counsel and the court still need more than a basic understanding of economics to properly represent and sentence someone accused of insider trading.


Original Post 7/31

The Tenth Circuit today reversed the 72 month sentence imposed on former Qwest CEO Joe Nacchio for his insider trading conviction, holding the trial court had improperly calculated his sentencing guidelines. The matter will now go back to the trial court for re-sentencing. The opinion is here.


Law Prof Doug Berman at Sentencing Law and Policy provides his thoughts on the policy implications of the decision. I, of course, wanted to get to the bottom line and learn what new sentence Nacchio will get. Not so easy.

It's a very technical opinion that focuses on the method for calculating the amount of loss in insider trading cases. Essentially, it rejects the use of a "net profit" approach because it does not take into account extrinsic market factors that may have contributed to an increase in the stock's value. It adopts a "disgorgement" approach instead.

Under the government’s prosecution theory, the market would have viewed the inside information in a negative light, and disclosure of that information would have detrimentally impacted the value of Qwest stock. Therefore, the nondisclosure of the information allowed the stock to maintain an artificially high value and allowed Mr. Nacchio to benefit from that value when he traded in the stock. It is that illicit, artificially high value that should be reflected in the gain calculation, not the underlying value of the stock.

The facts:

Mr. Nacchio ultimately was convicted on nineteen counts of insider trading covering the trades that he had made from April 26, 2001, to May 29, 2001; he was acquitted of twenty-three counts covering earlier trades. The district court sentenced Mr. Nacchio to seventy-two months’ imprisonment on each count, to run concurrently, and two years of supervised release on each count, also to run concurrently. The district court additionally assessed a $19 million fine and ordered him to forfeit approximately $52 million.

...The parties do not dispute that: Mr. Nacchio’s gross proceeds from the relevant stock sales were $52,007,545.47; the cost of exercising the options was $7,315,000.00; the brokerage commissions and fees paid were $60,081.09; and the taxes paid were $16,078,147.81.

The Government's theory:

The government argued to the district court that Mr. Nacchio’s “gain resulting from the offense” pursuant to § 2F1.2(b)(1) was at least $44.6 million, i.e., the net profit Mr. Nacchio received from his stock sales during the April-May 2001 time period. That figure would equate to a 17-level increase to Mr. Nacchio’s base offense level and a Guidelines range sentence of 70-87 months. U.S.S.G. § 2F1.1(b)(1)®.

Nacchio argued (through calculations made by his excluded expert Dr. Fischel) that the maximum amount of loss was $1.8 million (i.e., 3.52 percent of $52,007,549), which would translate to a 12-level increase under § 2F1.1(b)(1)(M) and a Guidelines range of 41-51 months. The court arrived at its own figure of $28 million net profit, representing the gross proceeds minus the cost to purchase the shares. This resulted in a 16 point increase to the base offense level.

Together with a 2-level increase due to Mr. Nacchio’s abuse of a position of trust under U.S.S.G. § 3B1.3, the district court determined that the total offense level was 26, resulting in an applicable Guidelines range of 63 to 78 months. The district court imposed a sentence of 72 months’ imprisonment for each count, to be served concurrently.

The Tenth Circuit reversed the trial court's method of calculation of loss.

On the other hand, it is axiomatic that a critical objective of federal sentencing is the imposition of punishment on the defendant that reflects his or her culpability for the criminal offense (rather than for the unrelated gyrations of the market).

Contrary to the district court’s net-profit approach, a disgorgement approach is entirely consonant with central principles of federal sentencing policy in that it endeavors to hold the defendant accountable for the portion of the increased value of the stock that is related to his or her criminally culpable conduct. Consequently, it militates against the creation of unwarranted sentencing disparities among similarly situated defendants.

Federal sentencing is individualized sentencing: the sentencing court seeks to craft a sentence that fully reflects a particular defendant’s criminally culpable conduct, including the harm caused by it, and the defendant’s personal circumstances.

However, if the impact of unrelated twists and turns of the market is ignored in the sentencing calculus then an insider trading defendant is likely to suffer a sentence that is detached from his or her individual criminal conduct and circumstances.16 And this detachment can have a profound, detrimental impact on another objective of federal sentencing—the elimination of unwarranted disparities between similarly situated defendants.

In a footnote, the court explains:

Crimes like bank robbery and drug trafficking are thoroughly permeated with illegality. In contrast, the act of trading in securities—in itself—is entirely lawful. As relevant here, what makes the act illegal is trading while in possession of material, nonpublic information. Consequently, a whole host of factors can contribute to the gains or losses that a defendant incurs from trading in stock that have nothing to do with the criminal dimensions of his or her activity—factors that relate simply to the ordinary economics and psychology of the marketplace.

A sentencing approach that ignores this distinguishing aspect of the insider trading context would be at odds with the individualized sentencing objective of federal sentencing and the related concern pertaining to unwarranted sentencing disparities. In effectuating these aspects of federal sentencing policy in the insider trader context, sentencing courts must proceed with great care to ensure that the gain attributed to a defendant actually stems from the criminal dimensions of his or her stock trading.

On the disgorgement approach:

Therefore, from a policy perspective, it makes sense to adopt a sentencing approach that is focused on a defendant’s criminally culpable conduct and has the effect of excising—even if not completely —unrelated market forces from the sentencing calculus, thereby narrowing the zone of unpredictability in sentencing.

Such is the disgorgement approach we adopt here: it takes into consideration the fact that stocks have inherent value (quite apart from criminally fraudulent conduct) and seeks to exclude that unrelated value from the computation of a defendant’s punishment, and it sets a logical, temporal cutoff point for assessing the gain of the illegal conduct, i.e., the point when the information is disclosed and absorbed by the market.

So, how will the district court proceed?

Once the focus is properly centered upon the gain resulting from Mr. Nacchio’s insider trading offense (i.e., upon the increase in value realized due to the criminal dimensions of his stock trading), then the district court will have considerable discretion to consider a number of variables in arriving at an appropriate gain figure. We do not establish an exact formula here for arriving at that figure.

On the forfeiture issue, the Court said:

Therefore, we hold that under the specific facts of this case, Mr. Nacchio’s acts of insider trading involved lawful goods sold in an illegal manner. Thus, § 981(a)(2)(B) should be applied to calculate Mr. Nacchio’s forfeiture amount; the proceeds subject to forfeiture are subject to deduction of direct costs.27 Because the district court applied the wrong legal framework, we will reverse.

How much lower will Nacchio's sentence be?

Mr. Nacchio’s gain should be calculated in a manner that is more narrowly focused on producing a figure that reflects, in at least approximate terms, the proceeds related to his criminally culpable conduct (i.e., trading on material, nonpublic information).

...We further determine that it was incumbent upon the district court to adopt a realistic, economic approach (1) that would take into account that Mr. Nacchio’s offense did not inhere in his sale of the shares itself, but in the deception intertwined with the sales due to his possession of insider knowledge, and (2) that consequently would endeavor to compute his gain for sentencing purposes based upon the gain resulting from that deception.

How is the court supposed to figure that out? By using a civil disgorgement remedy. Anyone want to take a guess as to what it will be? And will the court agree to consider Dr. Fischel's calculations? That would be ironic, considering the trial court refused to allow him to present his opinion at trial that Nacchio didn't commit insider trading at all.

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    Look at it this way (none / 0) (#1)
    by Steve M on Fri Jul 31, 2009 at 01:00:03 PM EST
    In the civil context, let's assume a company engages in accounting fraud that has the effect of overstating its profits.  So the stock trades at X dollars a share, but if the public knew the real state of the company's finances, the stock price would obviously be something less than X.

    How much less?  The way we measure it is pretty simple.  At some point, the fraud comes to light, often by the company announcing a restatement of its past earnings.  When that bad news gets disclosed, the stock drops by some amount - let's say $10 per share.  So now we know that before the fraud was disclosed, the stock price was "artificially inflated" by $10 per share.

    Of course, many things can affect the price of a stock.  But if bad news like this gets announced on a Monday, and the stock drops $10 on Tuesday - or even over the next few days - we can pretty much assume that the price drop was due to disclosure of the bad news.  In the civil context, the burden pretty much gets shifted to the defendants to argue that part of the stock drop occurred for unrelated reasons.

    Switching to the Nacchio case, then, the proper measure of damages is the difference between what Naccio actually received for the stock and what he would have received if he had obeyed the law and held onto the stock until the nonpublic information was ultimately disclosed.  So if disclosure of that information ultimately caused the stock to drop by $10 per share, then Nacchio's profits from the insider trading are the $10 per share that he should have ended up losing together with the rest of the shareholders.

    Requiring Nacchio to disgorge the entire amount that he received from the stock sale, and basing his sentence on that total amount, is ridiculous because some of that amount is based on the intrinsic value of the stock and has nothing to do with the nonpublic information.  If the stock is trading at $80/share, and disclosure of the nonpublic information causes it to fall to $70/share, how much were your "ill-gotten gains?"  Obviously, it's the difference between $70 and $80 - the amount you got by trading in advance of the bad news - not the difference between $0 and $80!  If he had obeyed the law and held onto the stock until the nonpublic information was made public, he still would have owned stock worth $70/share - not $0/share.

    Makes Sense (none / 0) (#2)
    by squeaky on Fri Jul 31, 2009 at 02:06:05 PM EST
    While this method will get them (none / 0) (#9)
    by coast on Mon Oct 05, 2009 at 12:46:33 PM EST
    closer to a more equitable answer, it still has issues.  A defendant will naturally want that difference to be as little as possible.  Looking at the drop in the price on the day of the annoucement is too simplistic.  The most obvious arguement for a defendant to use is that a good portion of that $10 decline (from your example) is due to programmed selling.  Do you look at just the decline that day or over a period of time as more information is released and its digested by the market?  While I agree with the premise, I think that it opens up even more doors.

    Also (none / 0) (#3)
    by squeaky on Fri Jul 31, 2009 at 02:08:05 PM EST
    They should calculate in the fact that Nacchio did not sell out his clients to the federal government's illegal wiretapping and datamining program.

    It is absurd to base anything on stock prices (none / 0) (#4)
    by SomewhatChunky on Fri Jul 31, 2009 at 02:38:35 PM EST
    It is absurd to calculate any sentence or damages based upon some "prediction" of what a stock should have or would have been worth.  Such laws are obviously written by people who have no experience trading or in the financial markets.

    Stocks go up an down because that's what people are willing to buy or sell them for at a given point in time.  That's it.  Trying to ascertain the "why" part is an interesting, but ultimately futile exercise in pure speculation.  To put people in jail or fine them based upon speculation is absurd.  These are terrible laws.

    Nobody "knows" what causes a security to change price.  But lots of people have opinions.    The contents of the daily financial press exists to sell papers, not to impart certainty.   It's a well known fact that Wall Street's best financial analysts get it right about as often as reporters throwing darts at the stock pages.  Index funds do better than actively managed funds because they have lower costs -- there is no inherent ability to apply knowledge to the art of security selection.  It makes no sense to debate that here - even active management advocates admit that if there is any edge, it is very small.  And these are highly paid financial professionals doing their best.  Anyone think a bunch of people in a courtroom are going to do it any better?

    While it is easy to make the case that the release of non-public information will affect the price of the stock, how it did so and what part of the price move should be attributed to that information is unknowable.    Any price effect might be $x in 5 minutes and 1/2X or 2X in one day.  What time frame is relevant?

    In the above example, I could make a case that the stock should or could go up because the  "black cloud" of uncertainty has been lifted from the company's future.  What if it had?

    Stock price movement is also affected by the "mood" in the financial markets at the time which seems an absurd way to sentence/fine someone for actions that happened along time ago.

    A stock could drop $10 because an institution decides to sell a large block and overwhelms the market with supply.  This could have been planned for months and have nothing to do with anything else.

    I could go on and on.  Sentencing/fines should not be reduced to a formula when the formula is based upon garbage.  Accuracy often has little to do with correctness.  There has to be a better way.

    This exact case aside (none / 0) (#5)
    by jimakaPPJ on Fri Jul 31, 2009 at 03:21:20 PM EST
    Isn't the issue punishment because the inside trader has harmed the whole market, and our capital formation engine, by bringing into question the transparency of the market???

    Yes but (none / 0) (#6)
    by Steve M on Fri Jul 31, 2009 at 03:35:47 PM EST
    the amount is still relevant to sentencing, and of course the size of the restitution order depends entirely on how much his ill-gotten profits were.  That doesn't mean it's not a serious crime even if the amount of the loss turns out to be rather small.  But you get a longer sentence if you're Bernie Madoff.

    I once observed the sentencing in a criminal case where the defendant, a former candidate for Mayor of Detroit (just imagine!) had been convicted of tax fraud.  You get a lighter sentence if you can show the actual amount you cheated the IRS out of wasn't very much.  And he brought in this accounting expert who wasn't even a CPA (couldn't find a CPA to endorse these bogus theories) and he was doing all this BS like "ok, so he shouldn't have taken this fraudulent deduction, so let's assume he recaptures it in the following year when he just happens to have a negative income for the year - gee, no loss at all!"  The judge was very unimpressed.


    Oh I understand that size counts (none / 0) (#7)
    by jimakaPPJ on Fri Jul 31, 2009 at 04:39:18 PM EST
    I just try and keep away from the Nach because I had too many friends who were really, really, really hurt by all that went on there.

    Reading Between the Lines (none / 0) (#8)
    by mountainsteve on Sat Aug 01, 2009 at 04:10:22 PM EST
    This opinion is less about the sentence than a reaffirmation of the panel's opinion on the merits of the appeal which was reversed en banc. They are sending a subtle message to the Supreme Court that cert. should be granted.

    The issue in the sentencing eerily parallels the issue on the merits. The relative weight of the the inside information in calculating the gain in essence mirrors the question of the extent to which that same information was "material" for purposes of determining whether the stock sales amounted to criminal activity. It is deliciously ironic that Judge Nottingham allowed Professor Fischel to testify at sentenceing after excluding his testimony at trial (therby gutting the materiality defense) for failure to establish his qualifications and then this panel relied on his testimony in fashioning its sentencing opinion.