Business Law Chapter 5 Homework About four months after Skilling's departure

84

Chapter 5

Ethics and Business

Decision Making

Case 5.1

C.A.5 (Tex.),2009.

U.S. v. Skilling

554 F.3d 529, Fed. Sec. L. Rep. P 95,037

United States Court of Appeals,

Fifth Circuit.

UNITED STATES of America, Plaintiff-Appellee,

v.

Jeffrey K. SKILLING, Defendant-Appellant.

No. 06-20885.

Jan. 6, 2009.

CHAPTER 5: ETHICS AND BUSINESS DECISION MAKING 85

Chief Operating Officer and joined the Board of Directors. In February 2001, he became Enron’s CEO, and on August 14, 2001,

A. Conspiracy and Securities Fraud

Several of Skilling’s convictions stem from allegations of conspiracy and securities fraud. The government presented evidence*535

that Skilling engaged in fraud in several of Enron’s business endeavors. As an international, multi-billion dollar enterprise, Enron

had elaborate financial dealings. At the time of its bankruptcy, the company was comprised of four major businesses: Wholesale,

which bought and sold energy; Transportation and Distribution, which owned energy networks; Retail, or Enron Energy Services

expectations for EES’s profitability after its initial start-up period, EES did not meet these expectations. As of the fall of 2000,

various utilities in California owed Enron substantial fees, which Enron had already booked as profits under its “mark–to-market

accounting.”FN1 The utilities, however, were suffering heavy financial losses and stopped paying these fees. Under general

accounting rules, Enron should have recorded a loss of hundreds of millions of dollars based on the failure of the utilities to pay the

fees, but Skilling and his co-conspirators tried to hide the harm by transferring the losses to Wholesale so that EES would continue

to show promise, at least on paper.

FN1. This means that Enron immediately recognized income, discounted to present value, based on projected future

earnings.

The government claims that Skilling hid EES’s other problems as well. For example, in early 2001, EES employees allegedly

realized that Enron was not properly valuing EES’s contracts and that, again because of Enron’s use of mark-to-market accounting,

FN2. The government claims that, in addition to being hidden, these non-core earnings were suspect in other ways. Many

of them came from the sale of a portion of Enron’s fiber optic network, commonly referred to as “dark fiber,” to LJM2, a

86 CASE PRINTOUTS TO ACCOMPANY BUSINESS LAW

pseudo-third party that Fastow controlled. Allegedly, EBS also improperly hedged its investment in Avici, an internet

company, in a Raptor Special Purpose Entity (“Raptor”). As discussed below, the Raptors arguably were instruments of

“fairly small” amount of EBS’s earnings, which the government alleges was not actually the case.FN3

FN3. Koenig pleaded guilty to securities fraud for this statement, among others.

Three days later, Skilling spoke at Enron’s annual analysts conference, claiming that EES and EBS, like Enron’s other major

businesses, had “sustainable high earnings power.” Skilling argues that this statement was merely harmless puffery. At the

conference, he also reasserted that Wholesale was “not a trading business. We are a logistics company.”

On March 23, 2001, Enron held a special conference call with analysts. Enron’s stock price had been declining, and investors

revenues.

On July 17, 2001, Skilling told investors that EES “had an outstanding second quarter” and was “firmly on track to achieve” its

earnings targets. That quarter alone, EES lost hundreds of millions of dollars. Skilling reiterated that the EES reorganization was

based on a concern for management efficiency, while the government contends that the only purpose of the EES reorganization

was to hide EES’s losses.

*538 Skilling allegedly took a similar unwarranted action at the end of the second quarter of 2000. At that time, the consensus

estimate was 32¢ per share. A draft earnings report showed that Enron was going to announce earnings that met the estimate.

Skilling, however, wanted to beat the consensus estimate by reporting 34¢ per share. To do that, he allegedly told Wholesale to

increase its earnings by $7 million, and then by an additional $7 million. Wholesale acquiesced both times, reopening its books and

adding $14 million from a reserve account that it had set aside to cover potential liabilities. The government claims that Enron did

create an entity to help Enron more easily meet market expectations. The impetus for creating LJM was the $200 million that Enron

had received from an investment in a company called Rhythms Net. Enron wanted to book that money, but it was possible that the

value of the investment would drop, meaning that the asset’s expected value would have to be reduced. By transferring the asset

to a pseudo third-party, however, Enron could hedge its investment without needing to pay market rates for this hedging service.

The government claims that LJM became that pseudo third-party. Enron contributed $234 million of its own shares in seed money

FN4. Fastow purportedly explained to Enron’s Board of Directors that Causey and Skilling reviewed all Enron/LJM

FN5. The Board of Directors was nervous that the media would find out, a so–called “Wall Street Journal risk.” Many of

Enron’s managers objected as well, and Vince Kaminski, who was responsible for ensuring that Enron avoid taking

unnecessary risks, complained. His objection was this: if both Rhythms Net’s and Enron’s stock lost value, then LJM could

be undercapitalized, as the vast majority of its capital was Enron stock. Kaminski said that Skilling told him his group

“acted more like cops, preventing people from executing transactions instead of helping them.” After the LJM deal was

FN6. Around this time, LJM apparently was running out of capital, so Fastow raised nearly $400 million in capital and

formed LJM2, another third-party entity that could conduct deals with Enron. In the fall of 2000, Fastow confided in Skilling

that LJM2 was also stretched, and he proposed the creation of LJM3. The government claims that Skilling approved

LJM3, saying to put “as much juice” as possible into it. LJM3, however, was never organized. For simplicity, we refer to all

of these third-party entities throughout this opinion as “LJM,” except where we quote directly from the parties’ briefs or the

Merrill Lynch, apparently without even negotiating over price. Causey allegedly assured LJM that it would earn a guaranteed return

on the deal, meaning that there was no transfer of risk to LJM. In sum, the government asserts that the sale of the Nigerian barges

was not a true sale and that Enron improperly recognized earnings from the deal.

The third secret oral side deal involved the “Raptors,” which were special purpose entities (“SPE”) that would hedge assets for

Enron, meaning that if the assets decreased in value, a Raptor would cover the difference-at least on paper. The government

FN7. A “put” is an option contract that gives the holder the right to sell certain stock to the writer of the option at a

specified price up to a specified date.

FN8. The government alleges that by purchasing the “put,” Enron was betting that its own stock price would drop,

because the Raptor would have to pay Enron if the price of the stock dropped below a certain point. Skilling claims that

the “put” was merely a self-insurance mechanism.

To make this transaction work, however, Enron’s accountants had to sign off. Arthur Andersen, Enron’s external auditor, approved

the $41 million payment to LJM once it was described as a return “on” capital to LJM and not a return “of” capital. The auditors

allegedly kept nearly $500 million in losses off of Enron’s books in 2000.

The fourth “secret” side deal the government presented was “Global Galactic.” Global Galactic was not actually a single deal but

instead was the name that Fastow gave to the three-page handwritten list of his undocumented side deals with Enron. Fastow

claimed that he created the list to keep track of the various deals and to ensure that he was on the same page as Enron’s

management on the substance of these deals. Skilling asserts that he had no connection to the deals on this list.

actually contained known falsehoods, thus negating the validity of the audits. The assertedly false statements included claims that

the auditors had access to all financial records and that Enron had disclosed all related-party transactions.

When Skilling resigned from Enron in August 2001, Enron’s internal financial numbers were ghastly. On September 6, 2001,

Skilling allegedly called his broker and tried to sell 200,000 shares of Enron stock. The sale did not go through, however, because

the SEC still listed Skilling as an Enron “affiliate.” This designation meant that the broker had to disclose the sale to the SEC and

returned a superseding indictment charging Skilling, Lay, and Causey with various counts of conspiracy, securities fraud, wire

fraud, and insider trading. The indictment charged Skilling with one count of conspiracy to commit securities and wire fraud,

fourteen counts of securities fraud, four counts of wire fraud, six counts of making false representations to auditors, and ten counts

of insider trading. Several weeks before trial began, Causey pleaded guilty to one count of securities fraud, and the government

dropped four counts against Skilling that involved Causey. Skilling and Lay went to trial, and, at the close of its case, the

FN9. On July 5, 2006, Lay died, causing the court to vacate his conviction and dismiss his indictment.

United States v.

Lay,

456 F.Supp.2d 869, 870 (S.D.Tex.2006).

III. Honest-Services Fraud Allegation

On appeal, Skilling argues that we must reverse all of his convictions because the government used an invalid theory of “honest–

services fraud” to convict him. The jury convicted Skilling of one count of conspiracy. The indictment and the government’s theory

FN10. The Supreme Court recently ruled that, on collateral review, an error of this type is subject to harmless error

(1993)).

The honest-services statute provides that “the term ‘scheme or artifice to defraud’ includes a scheme or artifice to deprive another

of the intangible right of honest services.” 18 U.S.C. § 1346. That is, the statute defines the “scheme or artifice to defraud”

language found in the substantive mail and wire fraud statutes, 18 U.S.C. §§ 1341 and 1343, respectively, to include the

Id.

FN11.

See McNally v. United States,

483 U.S. 350, 355, 358, 107 S.Ct. 2875, 97 L.Ed.2d 292 (1987);

United States v.

2875. The disjunctive phrase in the mail-fraud statute did not indicate that there were two objects of the fraud; rather, the Court

CHAPTER 5: ETHICS AND BUSINESS DECISION MAKING 91

Cir.2003) (en banc). Thus, to determine what constituted “honest–services” fraud, we looked to our pre–

McNally

precedent and

then set forth the rule for this circuit.

Brumley,

116 F.3d at 733-34 (“We decide today that services must be owed under state law

and that the government must prove in a federal prosecution that they were in fact not delivered.”).

In

United States v. Gray,

96 F.3d 769 (5th Cir.1996), we considered the honest-services statute in the context of a private

Id.

at 774-75 (quoting

United States v. Ballard,

680 F.2d 352, 353 (5th Cir.1982) (per curiam) (on petition for rehearing)). We

Id.

at

775. In light of our conclusions, the coaches’ conspiracy to violate NCAA rules was a federal crime; that their intent was to help

rather than harm the university was of no consequence.

Id.

at 774-75.

In

United States v. Brown,

459 F.3d 509 (5th Cir.2006), we again addressed honest-services fraud and refined our jurisprudence.

FN12. The government tried two Enron employees and four Merrill Lynch employees.

Brown,

459 F.3d at 513-14. The

jury acquitted one Enron employee and convicted the other five defendants; only the Merrill Lynch employees appealed.

Id.

at 522. Importantly, we expounded upon our understanding of honest-services fraud by providing a crucial distinction from the

facts in

Gray:

Gray

is distinguishable both factually and legally.

Gray

is dissimilar to this case in part because the opinion recognizes nothing

(3) has higher-level management

sanction improper conduct to reach the goal,

then lower-level employees following their boss’s

direction are not liable for honest-services fraud. Thus, we reversed the convictions of the employees in

Brown

because they were

92 CASE PRINTOUTS TO ACCOMPANY BUSINESS LAW

acting both in the corporate interest and at the direction of their employer.

Id.

at 522. In essence,

Brown

created an exception for

honest-services fraud where an employer not only aligns its interests with the interests of its employees but also sanctions the

Skilling misconstrues our holding in

Brown,

however, because he fails to recognize the manner in which the court in

Brown

explicitly distinguished

Gray.

As we noted above,

Gray

and

Brown

present different facts; in

Gray,

the basketball coaches acted on

their own volition, without any direction from their supervisors, while in

Brown,

a lower-level Enron employee acted at the direction

of Fastow, who as a decisionmaker had the authority to tell his employee that Enron sanctioned the particular fraud in question.

See Gray,

96 F.3d at 775;

See also Va. Bankshares,

501 U.S. at 1093 (“[C]onclusory terms in a commercial context are reasonably

understood to rest on a factual basis that justifies them as accurate, the absence of which renders them misleading.”);

In

re Wells Fargo Sec. Litig.,

12 F.3d at 927 (“ ‘[A] complaint does allege an actionable misrepresentation if it alleges that a

2. Proposed Supplemental Instruction

[10] Skilling next asserts that the district court committed reversible error by denying his proposed supplemental instruction as

unnecessary. Although Skilling’s proposed instruction was more specific than the one the court gave, particularly with regard to

puffery, the instruction the court provided captured most of the substance of Skilling’s proposed supplement and adequately

explained “materiality” to the jury.

FN31. Notably, in his brief, Skilling fails to point to any statements purportedly rendered immaterial as facts already known

to the market.

FN32. The court addressed “forward–looking statements” in its instruction on falsity. The court instructed the jury that “a

statement predicting future events concerning Enron or its stock”-i.e. a forward-looking statement-can be considered

FN33. Although not a challenge to the jury instructions, Skilling also questions the materiality of the statements underlying

his convictions on securities fraud counts 23 and 24, regarding statements that he made at the January 25, 2001 analyst

conference and on the March 23, 2001 analyst call. He argues that the jury improperly convicted him for statements that

were “immaterial as a matter of law.” For the reasons stated in this subsection regarding the appropriateness of the jury

instructions on materiality, however, we find Skilling’s challenge to lack merit and reject his assignment of error.

FN34. Skilling reasons that he did not waive his objection because he submitted the side-deal instruction before two jury

instruction conferences that constituted an “ongoing dialogue concerning jury instructions.” Although correct at a high

level of generality, this argument misses the point. The ongoing dialogue to which Skilling refers involved the parties’

FN35. The district court’s four-paragraph good-faith reliance instruction stated,

Good faith is a complete defense to the charges of conspiracy, securities fraud, and wire fraud contained in the

indictment since good faith on the part of a defendant is inconsistent with intent to defraud or willfulness which is an

essential part of the charges. The burden of proof is not on the defendants to prove their good faith since they have no

FN36. The proposed instruction stated,

Reliance on the advice of attorneys-whether employed by Enron or working for outside law firms and hired by Enron-

may constitute good faith. To decide whether such reliance was in good faith, you may consider whether Mr. Skilling,

Mr. Lay, or Enron sought the advice of a competent attorney concerning the conduct at issue in this case, whether Mr.

Skilling or Mr. Lay reasonably believed that the attorney had received all the relevant facts available at the time,

FN37. In his reply brief, Skilling adds an argument that publicity

during

the trial also affected the jury. Skilling appears not

to have raised that contention as a distinct legal claim in his initial brief, and it is arguably waived.

See, e.g., Cinel v.

Connick,

15 F.3d 1338, 1345 (5th Cir.1994). We need not reach that question, however, because even after considering

the additional material, our opinion is no different.

Cir.1982),

abrogated in part on other grounds by Garrett v. United States,

471 U.S. 773, 105 S.Ct. 2407, 85 L.Ed.2d 764 (1985).

To satisfy this constitutional guarantee, veniremembers are not required to be wholly ignorant of a case’s facts; instead, “ ‘[i]t is

Id.

at 250. Importantly, “[t]his presumption is rebuttable … and the government may demonstrate from the

voir dire

that an impartial

FN38. Even if a defendant cannot meet the higher burden for finding presumed prejudice, it is possible for the defendant

to “raise[ ] a significant possibility of prejudice” such that the district court’s

voir dire

is subject to additional scrutiny.

Chagra,

669 F.2d at 250 (internal quotation marks omitted). But, “ ‘[b]ecause the obligation to impanel an impartial jury

FN39. The government questions whether Skilling has waived his Federal Rule of Criminal Procedure 21(a) venue

argument by failing to raise it in his opening brief. If he has, then we review his venue arguments only against the

minimum constitutional baseline, which he did raise, and not the standard of Rule 21, which would be more favorable to

FN40. A district court should usually hold a transfer motion in abeyance while conducting

voir dire

instead of dismissing it

at the outset.

See Williams,

523 F.2d at 1209 n. 10.

[16] There was sufficient inflammatory pretrial material to require a finding of presumed prejudice, especially in light of the

FN41. Skilling cites thousands of relevant local television features and hundreds of newspaper articles-many of them on

the front page-about himself and Enron.

FN42. For instance, there was this statement in a

Houston Chronicle

news story: “ ‘I’m livid, absolutely livid …. I have lost

my entire friggin’ retirement to these people. They have raped all of us.’ ” In the next line, the paper reported that “[f]ormer

Chairman Ken Lay received about $67 million in 2001, while former CEO Jeff Skilling got about $40 million, according to a

FN43. There was, however, a sports-related reason for the sports page to mention Enron, as the Houston Astros

renamed their stadium-previously called Enron Field-to Minute Maid Park.

FN45. In its ruling, the district court quoted from a

Chronicle

story that branded Skilling as the “Ultimate Enron defendant”

and detailed how, “[r]ather than lying low, … Skilling keeps making news” such as being “arrested after a drunken scuffle

in New York.” The story also said, after quoting Skilling as protesting that he had “nothing to hide,” that “[w]e”-presumably

FN46. There is a need to determine whether the reporting was “straightforward [and] unemotional” or a “long harangue

condemning [the defendant].”

Chagra,

669 F.2d at 251.

The district court seemed to overlook that the prejudice came from more than just pretrial media publicity, but also from the sheer

FN47. Skilling offered opinion polls suggesting that one in three Houston citizens “personally kn[e]w” someone harmed by

what happened at Enron. The district court rejected these polls, noting that “courts have commonly rejected such polls as

unpersuasive in favor of effective

voir dire

as a preferable way to ferret out any bias.” But that is the point: we evaluate the

quality of the

voir dire

because Skilling established a presumption of prejudice.

Precedent also cuts in favor of Skilling. Unsurprisingly (given the strictness of the test for presumed prejudice), there are more

FN48.

See Calley,

519 F.2d at 209 n. 45 (“There has been a greater willingness to uphold a trial court’s determination that

jurors were capable of rendering an impartial verdict where that conclusion was reached after deliberate, searching, and

thorough

voir dire.

”).

FN49. A district court has “broad discretion” in conducting

voir dire,

and

[t]he court’s discretion extends both to the decision whether to propound questions proffered by counsel and whether

jurors should be questioned collectively or individually out of the presence of other jurors. This broad discretion,

however, is limited by the requirements of due process, and the reviewing court must independently evaluate the voir

Cir.1978); (8) whether the attorneys had “the opportunity to recommend further inquiries,”

Chagra,

669 F.2d at 254;FN50 and (9)

whether the “judge [ ] himself inquired into the prospective [jurors’] exposure to publicity and ability to render a fair and impartial

verdict,”

Calley,

519 F.2d at 209.

FN50.