Generally Accepted Accounting Principles

Arguably, the most important piece of office equipment to a lawyer defending against accusations of financial crime in federal court is a calculator.  Not a fancy one, with sine, cosine and tangent, but your basic model, provided it’s got enough room on the screen for lots of zeroes.  That’s what we used to figure out what the government is talking about when it comes up with the bizarre and outrageous loss calculations tossed out to the judge at arraignment and again at sentence.

Bruce Karatz, former CEO of KB Homes,  found that out when he saw the government’s response to the calculations by his probation officer in the presentence investigation report.

On Wednesday [meaning today], the former chief executive is scheduled to be sentenced in Los Angeles federal court for his April conviction for fraud and making false statements in connection with an options-backdating scandal. Karatz, who the government alleges tried to make nearly $11 million from backdating, has denied wrongdoing and plans to appeal his conviction.

The U.S. Probation Office, an arm of the courts, has recommended that Judge Otis Wright give Karatz probation and eight months of home confinement. But the U.S. Attorney’s office wants a 6.5-year prison sentence.

A key issue in the case revolves around how much financial loss KB Home and its shareholders suffered. The Probation Office believes there was no loss. Prosecutors argue that the $11 million, representing gains Karatz made or hoped to make at KB Home’s expense, qualifies him for a multiyear prison term.

It’s unusual that the PSR rejected the government’s loss calculation, and this reflects either a great effort on the part of Karatz’s counsel or a particularly independent probation officer.  Calculating loss is required under the fraud table of the Sentencing Guidelines, but how one calculates loss is another matter.

The idea that the loss caused by fraudulent conduct be actual loss, the net amount of money gained as a direct result of the conduct, is archaic.  Actual loss is often tiny, even non-existent, in most cases, and that does the government no good at all.  The loss amount is used to determine the guidelines sentence, and by coming up with a loss in the multi-millions, if no billions, the government wields a huge club over the head of a defendant, forcing a choice when deciding to roll the dice and fight, of staring down decades in prison if the court adopts the government’s calculations.

The dispute is part of a growing debate over whether the sentencing system for white-collar crimes has come to rely too heavily on calculations of financial losses to fraud victims. Under the sentencing guidelines, legal experts say, an executive of a large public company convicted of a crime like securities fraud could be sentenced to life imprisonment on a first offense.

Pretty much anything a senior executive in a public company does will give rise to ramifications, to even the most unimaginative prosecutor, in the millions of dollars.  Spend $100 on a half decent lunch to befriend the decision-maker on a foreign contract, and bear the gazillion dollar consequences of the revenue derived from the contract over ten years, replete with assumptions of market hegemony.  Forget the cost of the meal.  Forget even the cost of performance of the contract, or market share.  Assume only revenue, with terms so favorable that your favorite deity would be asking for a job, and every person in the world signing up for your service, and then we’re talking loss.

It’s not that the government’s overzealous calculations necessarily turn judges’ heads.  Judges often have a far better grasp of the real loss than do prosecutors, who have little, if any, understanding of business, and whose flights of fancy can be ludicrous.

But some judges are balking. Last month in New York, U.S. Judge John Gleeson gave a convicted securities swindler five years even though the guidelines called for 17 to 22 years. “Here in the trenches where fraud sentences are actually imposed, there is a more nuanced reality,” he wrote.

But you can’t count on it, either.  Post-Enron, when Congress responded to public outcry and trebled the guideline sentences for corporate fraud because it got congressfolk elected, there were plenty of judges who felt the pain inflicted upon thousands of people by the greedy fraudsters.  Screwing with loss calculations was one way, an easy way, to jack up sentences to meet expectations that these criminals would suffer long and hard for what they did.  Some judges generally accept the government’s accounting.  It’s the new GAAP.

But not every financial and corporate crime meets the Enron and Madoff bar.  Many are trivial in themselves, often without any discernible harm to anyone, except through rhetorical gamesmanship and wild speculation.  Yet sentences equivalent to murder are in the offing.  I can’t tell you how many times I’ve heard a corporate executive mutter, “it’s not like I killed anybody.” 

The play for sympathy, ironically, is on the government’s side when it comes to loss calculations.  This is what they  had to say about Karatz:

The U.S. Attorney’s office here wants a 6.5-year prison sentence. In a filing, the prosecutors argue that confining Mr. Karatz in his “24-room Bel-Air mansion,” would suggest “a two-tiered criminal justice system, one for the affluent….and a second for ordinary citizens.”

A 24 room Bel-Air mansion (and no mention of the cost of his shower curtain)?  Well, clearly he should go to prison instead.  It’s not like he studied hard to get into good schools, worked hard to make his way up the corporate ladder.  Served well to achieve the position of CEO.  And was very well compensated along the way.  After all, it’s a crime in America to be successful.  Or so the government contends when it uses its very own version of GAAP to calculate loss under the guidelines.

13 comments on “Generally Accepted Accounting Principles

  1. Brian Gurwitz

    24-room Bel Air mansion? Impressive, though Orange County is only 30 miles away. And much nicer than LA County.

    Don’t knock class warfare in the courtroom. Embrace it.

    Perhaps loss calculations should be reduced by some factor based upon the amount of federal tax revenue attributable to the defendant in the 5 years preceding the offense.

    Prosecutors, judges, and probation officers should recognize that many of those white collar defendants are paying their salaries, paltry though they might be.

    I’m not saying that the criminal justice system should screw only the poor. That would be wrong. I’m merely arguing that the poor should be screwed worse.

  2. Nathan Burney

    Great post. I have never yet encountered a federal loss calculation that withstood elementary scrutiny. I’ve had success at sentencing pointing out how the feds did it wrong, and what the right answer ought to be (a great expert is worth his weight in gold here).

    It is appalling that so many of the people prosecuting financial crimes do not (or will not) understand basic corporate finance, how to calculate a discount rate, and the like.

  3. BadLawyer

    A two-tiered criminal justice system, just imagine! At least.

    A friend of mine, a retired organized crime-wanna be and pundit has long scoffed at all financial aggregations in state and federal court. Drugs are always claimed to have certain “street values,” thefts of goods are alleged to have “retail values,” that upon nay scrutiny are speculative at best. The surreality of the two-tiered criminal justice system is a marvelous and tragic thing to consider. Thanks for casting light on this aspect of it, Scott.

    Wow, no typos.

  4. SHG

    Discount rate?  I’m waiting for an AUSA to concede that loss is the net of revenue and expenses.  And don’t even get me started on valuing counterfeit goods as if they were the real thing sold at MSRP.

  5. Nathan Burney

    You’re right, they do tend to confuse gross revenue with net profit/loss. And very few are actually morons. Some are quite bright. Makes me wonder if there’s a special school they go to, to unlearn any valid accounting/finance stuff they might have picked up in school.

  6. Windypundit

    I’m not sure what your beef is with GAAP (Feds prosecuting people for having non-GAAP numbers in their financial statements?), but from what you say, there’s no way the feds’ loss calculations would pass a GAAP review. That is, no company would get away with using these kinds of calculations in their financial statements, would they?

  7. Dan

    The jab at the 24 room Bel-Air mansion is particularly ironic, or maybe even galling, when you consider that the AUSA who crafted those words, probably has their eye on their own 12 room starter mansion five minutes after this case ends and they walk back out the revolving door into the private sector.

  8. John

    QUOTE “I can’t tell you how many times I’ve heard a corporate executive mutter, “it’s not like I killed anybody.”

    When the company I worked at was driven into the ground on purpose for a takeover they killed people with their actions.

    Widows of retirees had to decide if they wanted to buy medicine, or eat, once their insurance was gone.

    One guy died of a heart condition because of the stress he was put under by their actions.

    That’s the irony, these criminals don’t even realize they are killing people with their greed.

  9. Tim

    I’d like to echo Scott’s comment above. Financial crime can have devastating effects on people, inevitably more vulnerable people. Alan Bond here in Australia defrauded billions of dollars and left thousands of ordinary people without savings. He got a couple of years in prison (which in itself was unusual) and is now back in business a multi-millionaire.

    Sounds like the situation might be a bit different in the US, but in Australia white-collar crime is ludicrously under-prosecuted and the penalties pathetic.

    Finally, your last comment about ‘it’s a crime to be successful’ bothers me. I’m hoping that you are objecting to the prosecution using Karatz’ wealth to argue he should go to jail *instead of* house arrest where house arrest is the appropriate penalty; I entirely agree that would be wrong. But it reads a bit like you think he should be spared punishment because he’s ‘worked hard’ and ‘served well’ in the job….at least until he defrauded his employer. Which I’m sure you would agree is bollocks.

  10. SHG

    Yes, Tim, I’m objecting to using success as a reason to imprison him.  Notably, the judge thought exactly the same.  Sorry if you read it differently, but I don’t see anything that would suggest otherwise.

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