Even those who support tough penalties for white-collar fraud were startled in March when Jamie Olis, a former midlevel tax expert at the energy firm Dynegy, was sentenced to more than 24 years in federal prison for his role in a relatively minor financial scandal. In a world where Enron's Andrew Fastow will serve only 10 years and some of Fastow's colleagues might walk, Olis' punishment seems bizarrely harsh and unfair. One reason for this is a flawed method for calculating sentences for financial crimes, especially fraud at a public company.
Olis' saga began in April 2001, when he, his boss Gene Foster, and a colleague named Helen Sharkey used an accounting gimmick called a "special purpose entity" to temporarily increase Dynegy's operating cash flow. Pre-Enron, the rules regarding the legal use of special purpose entities were fuzzy, but, for arcane reasons, the way Foster, Olis, and Sharkey used this one was declared illegal. Dynegy eventually restated its results, and, in June 2003, federal prosecutors indicted Foster, Olis, and Sharkey for conspiracy, securities fraud, mail fraud, and three counts of wire fraud. Foster and Sharkey pleaded guilty to a single count of conspiracy and likely will be sentenced to no more than five years—the statutory maximum for a single conspiracy conviction. Olis maintained his innocence and went to trial. Last November, he was convicted on all six counts.
Olis' sentence was long for two reasons. First, unlike his colleagues, he took the risk of trying to defend himself. As is often the case, prosecutors had piled on charges, perhaps to pressure the defendants to plead. Olis' conviction on multiple counts raised the statutory maximum sentence that could be imposed. (For sentencing purposes, it was irrelevant that Olis presumably could not have committed securities fraud without also committing mail fraud and wire fraud—false financial information and accounting opinions aren't disseminated via ESP.) Second, Olis fell afoul of recently updated rules in the federal sentencing guidelines for financial crimes.
As with other federal crimes, fraud sentences are calculated using a complex formula set forth by the United States Sentencing Commission in a tome called the Guidelines Manual. The Manual calls for adjusting sentences based on the severity of the fraud, with severity determined largely by the magnitude of financial losses and the number of victims.
For a defendant with no criminal history, for example, the "base level" guideline for a fraud conviction is zero to six months in prison. Judges then have to consider approximately 20 possible adjustments to this sentence, including:
- The amount of the "loss" attributable to the fraud
- The number of victims of the fraud
- Whether the fraud involved "special skills" or "sophisticated means"
- Whether the defendant worked in the investment business or as an officer or director of a public company
Of these factors, by far the most influential is the estimated loss. Under guideline revisions adopted in 2001 and 2003 in response to public outrage about corporate scandals, if a fraud by an investment adviser or the officer or director of a public company is estimated to have caused losses of less than $5,000—the lowest category—there is no increase in the sentence. Above $5,000, the sentence increases, stepping up through 15 categories to losses of "more than $400 million." All else being equal, for example, if the loss estimate is $1 million to $2.5 million, the guideline sentence jumps to 63 to 78 months, or five to seven years. If the loss is more than $400 million, the guideline is 292 to 365 months, or 24 to 30 years. If a $400 million fraud also affected more than 250 victims, moreover, the guideline calls for a life sentence.
In theory, this sounds reasonable: Steal more money or cause more losses, and you do more time. In the case of securities fraud, however, it can produce outcomes that are so arbitrary and harsh as to be absurd.
Judges have discretion to determine estimated losses, but the guidelines advise them to base the estimates on factors that, where appropriate, include "the reduction that resulted from the offense in the value of equity securities"—in other words, the amount the crime caused a company's stock to fall. This is where the trouble starts.
First, it is pleasant to think that we know what makes stocks go up or down, but in most cases, we don't. Stock prices are the product of thousands of buy-and-sell decisions based on dozens of factors, including liquidity, interest rates, market direction, technical indicators, industry and company performance, and the relative attractiveness of other securities or asset classes. To conclude that a fraud "resulted in" such-and-such a loss by analyzing the stock price, therefore, is a delusion (although the folks who wrote the sentencing guidelines aren't the only ones who suffer from it).
In Olis' case, Judge Sim Lake apparently based his loss estimate—more than $100 million—on the amount that a single Dynegy shareholder, the University of California, said it lost on its investment. The university representative who testified at the trial did not attribute the loss to the fraud or confine it to the fraud period, and the university was not the only Dynegy shareholder to lose money (on the contrary, in the week after the restatement, the aggregate drop in the company's value was about $6 billion). The loss estimate, therefore, could presumably have been much higher or lower, swinging Olis' sentence from less than 10 years to more than 30.
The second flaw in stock-based loss determination: In most cases, securities fraud results in losses for only one class of investor—those who bought the stock after the fraud occurred and sold after it was exposed. For investors who owned a stock prior to the fraud, meanwhile, the scheme may actually have resulted in gains. The week after Dynegy disclosed that it would restate its results, for example, its stock dropped about $15 per share. If we use this drop to estimate that the fraud contributed $15 of value per share (a major stretch, given that Dynegy also released other bad news that week), we might argue that Olis and his co-conspirators generated about $15 of value for every share sold while the fraud was in place (in aggregate, $11 to $13 billion). Some of these shares were probably sold to investors who held them until after the fraud was revealed; some of them probably weren't. The fraud, in short, may have been as much a boon for Dynegy shareholders as a punishment.
Third, and most important, basing an employee's prison term on the drop in stock value following the revelation of fraud can make it shockingly risky to work at a major public company. Per the updated sentencing guidelines, a fraud estimated to have caused more than $400 million in losses and affected more than 250 victims can now warrant life in prison. Those who work at behemoths like Microsoft and GE, therefore, might want to consider the following. Both companies have more than 250 shareholders (potential victims) and both are worth in the neighborhood of $300 billion. As a result, even a minor fraud—one judged to have caused only a tiny fluctuation in the stock price—could send a participant upriver forever. At Microsoft, for example, which has 11 billion shares outstanding, a fraud would have to be judged to have moved the stock price by only 4 cents to trigger life imprisonment. Employees won't be comforted to hear that, like Olis, each participant in a fraud can be held liable for the entire loss.