Edward Martinovich, Attorney at Law and Jay Mykytiuk, Attorney at Law
The collapse of Enron and the federal indictments of many of its executives and directors threw a spotlight on the murky world of securities regulations. Enron wasnt the biggest financial collapse of the decade, but it was arguably the most profound, touching off a criminal investigation that so far has resulted in 16 guilty pleas, and several high-profile criminal trials. Some of the crimes charged involved the illegal business practices that led to Enrons financial ruin. But Enrons top executives face criminal charges based, not on what they did to cause the companys collapse, but what they allegedly did with the knowledge that the company was collapsing.
The criminal charges against Enron executives are numerous, but the majority of them fall under the general umbrella of securities fraud. Securities fraud is an intentional misrepresentation made to investors that financially benefits the perpetrator. The Securities and Exchange Commission (SEC) is the agency charged with overseeing trade of stocks, bonds and other investments that change value with the stock market’s movements. Formed after the 1929 stock market crash to serve as a corporate watchdog, the SEC is responsible for prosecuting fraud and insider trading, as well as ensuring the accuracy of corporate financial disclosures. Most securities fraud prosecutions begin with an SEC investigation and a referral to the Department of Justice.
Amidst all of the various criminal charges and convictions that resulted from the Enron scandal, Enrons top two executives, Ken Lay and Jeffrey Skilling, both former CEOs, emerged as the poster boys for corporate malfeasance. Both Lay and Skilling are charged with two kinds of securities fraud. First, a corporation and its executives can commit securities fraud when they intentionally mislead the public, usually by failing to disclose information about the health of the corporation, or by deliberately misrepresenting its financial health. Second, those who have this information, fail to divulge it to the public, and then trade securities based on the knowledge, are guilty of insider trading. But the prosecutions of Lay and Skilling have demonstrated that securities fraud cases are often based on circumstantial evidence and therefore, can be difficult to prove.
Material omissions and misrepresentations are the subject of most securities fraud prosecutions. Every public company is required by securities regulations to maintain detailed financial records and to regularly report this information to the Securities and Exchange Commission (SEC). If these records are found to be false, this constitutes criminal securities fraud. In essence, the Enron defendants were charged with having knowledge that the financial health of Enron was failing rapidly, but making both public statements and filing financial disclosure forms that indicated just the opposite.
The second form of criminal securities fraud that Enron executives are charged with is known as insider trading. The most common variety of securities fraud, insider trading involves buying or selling securities based on knowledge that is not available to the general public. Whether you are a corporate insider or a private investor, any person who trades on non-public information is subject to insider trading criminal prosecution. In the three year period leading up to Enrons collapse, 28 Enron executives sold 21 million shares of Enron stock. Both Lay and Skilling are amongst that number.
There are several defenses to criminal securities fraud, and the cases against Lay and Skilling are far from open and shut. In order to convict a defendant of criminal securities fraud, the government must prove that the defendant acted with fraudulent intent. This means that the defendant intentionally committed the acts, or made the statements or omissions that led to violation of the law. Innocent mistake, negligence, or other innocent conduct, are viable defenses for criminal securities fraud defendants. Given the complex nature of the securities statutes, it is not a logical leap of faith to believe that they can be inadvertently violated. Both Lay and Skilling used versions of this defense at trial. Specifically, Lay argued that he had no knowledge of the true financial situation of Enron. He trusted his underlings to run the company, and this trust turned out to be misplaced. If true, Lays actions may certainly constitute negligence, but would not rise to the level of criminal fraud.
Proving insider trading can be equally as difficult. The law is not absolutely clear about the discretion of executives and directors in determining whether certain information is “material,” or relevant, to investors. It is actually a fairly common practice for executives to sell stock in advance of bad news. It happens at scores of blue-chip companies, none of which are currently facing criminal investigations.
The case against Skilling is that he was part of an effort to illegally deceive investors, and that he pocketed millions of dollars in stock-option gains while in possession of troubling, non-public information. But the problem with the governments case is that Skilling held on to a large percentage of his stock. In the two year period prior to his departure from Enron, Skilling always owned more than one million shares. Throughout that period, he exercised options and sold shares at about the same rate he acquired new ones. In addition, more than a year before the company went bankrupt, Skilling executed an automatic stock-sale plan, instructing his broker to sell 10,000 shares a week. Under Securities & Exchange Commission rules, this type of program serves as a defense against insider-trading charges for sales executed after it began.
Penalties for securities fraud and insider trading can be harsh. Securities fraud convictions carry a maximum fine of $5,000,000 and a maximum sentence of twenty years imprisonment for each count. Those convicted of insider trading may face up to a $1,100,000 fine and up to ten years imprisonment. If convicted on all criminal counts, Lay and Skilling could spend the rest of their lives in prison.
No matter how the Lay/Skilling trial turns out, the lessons of Enron have already been written. For corporate insiders and even casual investors, one of those lessons is that securities laws have teeth. Prosecuting securities fraud is a government priority and in this new climate, poor business performance may often trigger SEC investigations. Anything less than full disclosure of financial information will likely result in criminal charges, and fortuitously timed stock trades will raise red flags. The lessons from Enron are numerous, and learning some of the important ones may keep you out of court.
Tags: insider trading, securities fraud