Bosses Behind Bars - The Economist

Bosses behind bars

How wise and just is America’s new experiment with long jail sentences for perpetrators of large corporate frauds?

Sep 21, 2004

ON JUNE 28th, Martin Grass will begin an eight-year sentence for fraud. Until 1999, he was chief executive of Rite Aid, a pharmacy chain whose share price collapsed in 2000 after a $1.6 billion revision to earnings. Last year, Mr Grass pleaded guilty to fraud and agreed to co-operate with the prosecution of former colleagues. He will serve at least six years and 10 months. If that sounds surprisingly long for a country with a reputation for going easy on corporate crooks, consider the fate of Franklin Brown, Rite Aid’s ex-chief counsel: he cut no deal with prosecutors, went to trial and was convicted on ten counts. Mr Brown, who will be sentenced soon, faces up to 65 years in prison.

In the popular imagination, white-collar criminals spend a couple of years in a country-club jail and emerge, reborn, as earnest philanthropists—like, say, Michael Milken, who was convicted during America’s last big corporate crime wave, in the 1980s, and spent just two years in jail. Outside America, short custodial sentences remain the norm. The typical sentence for fraud in England is four years, and almost never more than ten. This week, for example, Carl Cushnie, founder of Versailles, a trade-finance group, was sentenced to just six years in jail for his part in what the judge called a “massive fraud” in “a grand and evil scheme”. In Germany, the maximum sentence for serious fraud is ten years, though most people get less.

Until recently, Americans treated their fraudsters with even more leniency than the Europeans. But changes to the federal sentencing guidelines in 2001 and 2003 have raised the stakes. The public is now seeing the first results of these changes. Executives found guilty of large, economically damaging frauds are likely to serve the sort of long jail sentences that America has, until now, mainly reserved for murderers, rapists and armed robbers. Since George Bush set up a Corporate Fraud Task Force in July 2002, the workload of the Department of Justice (DOJ) has soared. Federal prosecutors have charged some 700 defendants in around 300 cases of alleged fraud, including over 30 chief executives.

Life is real

Last month, Jamie Olis, a former mid-level finance executive at Dynegy, a Texan energy firm, began a 24-year jail sentence for his part in a scheme, called Project Alpha, that inflated Dynegy’s cash flow in 2001 by $300m. In September, the trial of seven former executives at Enron Broadband, a subsidiary of the fallen energy firm, is due to begin. If convicted, each might face the prospect of spending the rest of his life in prison. So could Jeffrey Skilling and Richard Causey, two ex-Enron executives.

In 2001, America’s federal Sentencing Commission decided to combine previously separate guidelines for fraud and theft. It did so by creating a new measure of “loss” to help set the severity of a sentence. The bigger the loss that the thief or fraudster caused, the longer the sentence. Mr Olis would probably have got a five-to-seven year sentence under the old regime, say lawyers. Financial loss is not taken into account in corporate crime sentencing in Britain or in continental Europe.

Congress then instructed the Commission, through the 2002 Sarbanes-Oxley Act, to further increase “significantly” the penalties for fraud. As a result, the maximum sentence possible under certain scenarios has more than quadrupled.

There was a broad consensus before 2001 that sentences for fraud in America were too short. One of the Commission’s main tasks is to “provide certainty and fairness in meeting the purposes of sentencing by avoiding unwarranted disparity among offenders with similar characteristics convicted of similar criminal conduct.” If theft and fraud are similar offences, went the argument, should not their punishment also be similar?

As the first long sentences are handed out, several problems have begun to emerge. One issue, raised by some commissioners in 2001, is whether fraud and theft really are equivalent crimes. Each involves loss. But while theft produces a corresponding gain, fraud may not. In public filings, David Gerger, a lawyer who is preparing to appeal Mr Olis’s sentence, claims that Mr Olis received no direct financial gain from his part in Project Alpha. He drew only a regular salary and a bonus, which did not rise substantially during the time he worked on Project Alpha.

A second problem is how to measure loss. Mr Olis’s judge decided that the loss caused was $100m—which, under the 2001 guidelines, quintupled his sentence. The judge arrived at this number after hearing testimony from an official at the University of California, who said that the university system’s employee-benefits fund lost $100m due to Dynegy’s falling share price at the time of Project Alpha. Mr Gerger argues that economists have failed to prove any link between a firm’s cash flow and share price, and that Dynegy’s shares fell for many of the same reasons that caused a 90% drop in the entire energy-trading industry’s shares in 2001-02.

Meanwhile, the longer sentences inspired by Sarbanes-Oxley are attracting criticism even from people who helped devise the 2001 guidelines. Frank Bowman of Indiana University, whose ideas helped to shape those guidelines, now says they are arguably “too tough”.

Crucially, long sentences for fraud give extra leverage to the DOJ in its use of plea bargains, in which defendants exchange their right to a trial for less severe prosecution, or shorter jail sentences. This certainly cuts court costs. Yet the DOJ’s extensive use of plea bargains (97% of all criminal convictions come from pleas) already generates fierce controversy in America. Longer sentences for fraud are reigniting heated debate. In January, Andrew Fastow, Enron’s former finance chief, pled guilty to fraud, and has since been sentenced to a ten-year term. As it negotiated that deal, the DOJ was also in plea-bargaining talks with Mr Fastow’s wife, Lea. Her deal involved much manoeuvring by the DOJ, aimed at applying leverage to Mr Fastow. Sentencing her last month to one year in prison for signing a false tax return—after objecting to an earlier plea bargain with prosecutors as too light—Justice David Hittner said that the DOJ’s behaviour “might be seen as a blatant manipulation of the federal justice system and is of great concern to this court.”

Other judges are registering their objections to the DOJ’s use of plea bargaining by refusing to hand out custodial sentences at all. This month, Malcolm McVay, a former chief financial officer at HealthSouth, became the latest ex-HealthSouth executive to avoid prison, instead getting six months of house arrest. After he agreed to plead guilty, prosecutors asked for five years in jail. Judges can hand out lighter sentences than required by the federal sentencing guidelines—so-called “downward departures”. But the Commission keeps a record of those judges who depart downwards, prompting fears that Congress, which must endorse all federal judicial nominations, may block the promotion of judges who do not toe the government’s line.

Mr Olis was convicted partly on the testimony of two former colleagues, one of them his boss, who approved his work on Project Alpha. Both pled guilty and each got a five-year sentence. “This case had a 19-year penalty for going to trial,” says Mr Gerger. “If our system is that harsh and rigid, then I fear that innocent people as well as guilty people will feel they have to give up their right to a trial.”

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