Stop the Music – 3rd Circuit Slams DOJ’s “Musical Chairs” in Securities Fraud Prosecution

SEC Rule 10b-5 is one of the main securities fraud laws. It says you can’t mislead people in connection with the purchase or sale of a security. You can’t make an untrue statement of a material fact. And you can’t fail to state a fact, when without that fact the statements you just made would be misleading.

That seems simple enough. But federal prosecutors in New Jersey seem to be having a hard time figuring out what that means.

In June 2005, the feds in New Jersey indicted Frederick Schiff, the CFO of Bristol-Myers Squibb, for failing to disclose material facts to investors. Allegedly, Bristol-Myers (a drug company) was paying wholesalers to order more drugs than they really needed, so Bristol-Myers could report higher sales numbers and inflate its stock value. Schiff allegedly didn’t tell investors about it during conference calls and in SEC filings. (See the indictment here and the DOJ’s press release here.) That indictment got thrown out for a grand jury leak, so they got a second one in May 2006, and finally a third one in April 2007 that dropped allegations of accounting violations.

With respect to the omissions, the government kept changing its tune. First, they said the company had a duty to correct misleading statements of others, based on a “general fiduciary duty.” The district court helpfully pointed out that there is no such duty in the law. So then the feds said there was a statutory duty under SEC regs S-K, which might actually have worked, but then they changed their mind and put on the record that they weren’t pursuing that theory. There was a “theory of duty based on falsity of reported sales and earnings,” which the District Court said wouldn’t fly. Then they tried to say the stuff left out of filings is a material omission that is misleading if you include the earlier analyst calls in the context (calling it “all of a piece”). The district court ruled that, no, there is no affirmative duty under either the “falsity” or the “all of a piece” theory. “It defies logic,” the court ruled, “to charge as a crime that an utterance in an analyst call must have other words written in a later SEC filing in order to make the utterance in the prior phone call ‘not misleading.’” Thanks for playing. The feds appealed.

In a unanimous decision today (opinion here), the Third Circuit slammed the DOJ for constantly changing its theory of the case, for playing “musical chairs” with its theory of how Schiff’s conduct counted as an unlawful omission under Rule 10b-5.

More importantly, the Circuit said the DOJ’s ultimate theory of liability here — that Schiff had a “general fiduciary” duty as a “high corporate executive” to disclose the inventory issue — was simply overbroad. “This argument reaches too far.”

This is a big setback for the feds, who now are left with a much narrower indictment than they started out with. Schiff already got severance from his codefendant (a huge win for the defense, in itself), and evidence about a stock drop on the day of disclosure was already precluded. All that remains, really, is an allegation that Schiff affirmatively misled analysts about the inventory stuffing during conference calls back in 2001.

It is an excellent precedent, however, for other cases where the prosecution’s theory of liability keeps “morphing” all the way up to the eve of trial. This has been a bone of contention of ours for years, so it’s gratifying to see this ruling. Prosecutors cannot argue in the alternative. Their position is that these facts actually happened — they cannot ask a jury to say it’s maybe these facts or maybe those facts. They can’t say maybe it violates the law if you look at it this way, or maybe if you look at it another way. And yet it happens.

When that happens, it means the prosecutor is both sloppy and intellectually dishonest. They’ve brought a case without first deciding whether it can even be proven at trial — because they haven’t determined yet their theory of why there’s liability here — which is unethical in our book. A prosecutor should never file charges in the first place until he has first decided that the case can be proven at trial. A prosecutor who needs time to investigate after filing charges, or who keeps changing his mind about why there’s liability, has abused his position.

That happens all the time, unfortunately, in lesser prosecutors’ offices. (Note to self: Write a post contrasting practices of the good offices with the crap ones.) It’s disappointing when it happens in amateurland, but it’s appalling when it the feds do it. So here’s a big cheer for the Third Circuit for shutting this one down.