Apples and oranges: securities market losses should be treated differently for major white-collar criminal sentencing under the federal guidelines.

• Author: Esterhay, John D.

Table of Contents I. Introduction II. The Civil Damages Origins of Market Loss at Sentencing A. Securities Fraud in Private 10b-5 Actions B. Victim Loss C. Calculation Method D. Causation 1. Transaction Causation 2. Loss Causation E. Pre-Guidelines Market Loss in Sentencing III. The Federal Sentencing Guidelines and Evolution in Criminal Cases A. The Guidelines B. Federal Courts' Calculations of Loss IV. Current Problems with Securities Price Reduction as Loss A. Civil Causation Should Be the Bare Minimum for Criminal Sentencing 1. Basic's Fraud-on-the-Market Should Not Apply at Criminal Sentencing 2. Civil Doctrine Should Apply to Criminal Market Loss Calculations B. Market Loss Is Not Reasonably Foreseeable as Required by the Guidelines C. United States v. Booker V. A Workable Solution VI. Conclusion I. Introduction

On December 16, 2008, the United States District Court for the District of Connecticut sentenced Ronald E. Ferguson, CEO of Gen Re Corporation, on charges of conspiracy, securities fraud, and mail fraud for his role in orchestrating an illegal scheme that resulted in almost $600 million in market decline of AIG Corporation's stock price. (1) Despite the Federal Sentencing Guidelines (Guidelines) recommending life in prison (2) for these crimes, the court sentenced Ferguson for two years. (3) At sentencing, the court emphasized that Ferguson did not gain directly from this loss amount. (4) Instead, this amount resulted from later marketplace transactions. (5)

Ferguson's direct responsibility involves the issue of market loss, a unique type of victim loss that a court calculates for sentencing purposes, which consists of losses third-party shareholders suffer, normally after revelation of the fraud. (6) This Article will discuss how the victim loss amount influences the Guidelines for fraud under section 2B1.1 and how these Guidelines provide harsh imprisonment terms when loss amounts reach the hundreds of millions of dollars. such dollar amounts are common when employing market loss. When the fraud becomes public knowledge, the price of a security listed on an efficient market quickly will incorporate the new information, causing a sharp decrease in the security's price. (7) Because defendant responsibility is unclear with market loss, judges often are hesitant to apply severe Guideline sentences to such defendants, (8) as was the case with Ferguson. such hesitance creates disparities between judges who apply the Guidelines, and those judges who do not. This Article will examine these problems and how they result from a failure to differentiate market loss from direct loss.

Part II analyzes the history of market loss, a calculation of loss that arose as a damage calculation in private plaintiff civil securities fraud actions. This Part describes the evolving theory of loss causation in order to understand the foundation for market loss at criminal sentencing. This Part also explains how market loss might have been used in sentencing before the Guidelines.

After the codification of the Guidelines, victim loss became the official driving factor in fraud sentencing. Thus, Part III examines the loss table and how a large loss finding leads to a long prison term recommendation. Because the court must calculate victim loss to adhere to the Guidelines, courts determine market loss in a manner similar to previous civil securities fraud cases. Part III also analyzes the subsequent developments in federal court.

Part IV argues that market loss is inappropriate for criminal sentencing in its current form, because it differs from direct victim loss due to weaker causation. A defendant might be civilly liable for market loss, but he is not responsible for that loss in the way that criminal sentencing should require. Loss causation, even if sufficient in civil cases, should be afforded special treatment for sentencing purposes.

Part V presents a solution in which market loss punishes the defendant less severely than direct loss because of the weaker causal link. Adopting a parallel loss table for market loss can accomplish this differentiation. Such an amendment to the Guidelines would help solve the problems this Article identifies.

2. The Civil Damages Origins of Market Loss at Sentencing

   Before the adoption of the Guidelines, courts were not required to precisely define loss for criminal sentencing. Consequently, courts first developed the theory of market loss for civil securities fraud cases and later applied it to sentencing. While courts now use market loss in any type of fraud case, the history of civil securities fraud continues to resonate in criminal sentencing. (9)

   1. Securities Fraud in Private 10b-5 Actions

      In response to the 1929 stock market crash and subsequent Great Depression, Congress enacted the Securities Act of 1933 ('33 Act) and the Securities Exchange Act of 1934 ('34 Act). Section 10(b) of the '34 Act authorized securities fraud enforcement pursuant to the Securities and Exchange Commission (SEC) Rule 10b-5, which states:

      It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

      (a) To employ any device, scheme, or artifice to defraud,

      (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

      (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. (10)

      Rule 10b-5 authorizes three enforcement mechanisms: "(1) criminal enforcement via prosecution by the U.S. Department of Justice (DOJ), (2) civil enforcement actions by the SEC, and (3) civil enforcement by private parties." (11) While criminal prosecution was an option from the beginning, (12) neither Rule 10b-5 nor any statute contemplated civil enforcement by private parties. (13)

      After the SEC advocated for a private cause of action in an amicus brief, (14) courts began endorsing this right in 1946. (15) In 1971, the U.S. Supreme Court affirmed private 10b-5 enforcement. (16) In the first few decades of securities lawsuits, private remedies were successful, (17) mitigating the necessity for criminal prosecution. (18) Additional procedural hurdles including a lack of resources in federal regulatory agencies like the SEC, complexity and difficulty of proof in major fraud cases combined with the lack of federal prosecutor security fraud expertise, the requirement for coordination and cooperation between the SEC and DOJ, and the SEC's focus on civil actions further limited the incidence of criminal enforcement. (19) Therefore, criminal securities fraud prosecutions did not begin to flourish until the civil doctrine was established.

   2. Victim Loss

      When private plaintiffs began filing securities fraud 10b-5 actions, courts had to develop a theory for calculating damages. The first question was whether damages should consist of loss to the plaintiff or gain to the defendant. (20) While many frauds result in the defendant taking exactly what the plaintiff lost, (21) in securities fraud, these amounts often diverge (22) due to the attenuated nature of loss in a widely-held security. Courts decided that victim loss was the more appropriate figure for damages. (23) Private plaintiff civil cases use victim loss as the amount for damages, because such claims arise as a remedy for losses the plaintiffs sustained. (24) Secondly, from a practical standpoint, "causation is already built into civil securities fraud cases as a ... factor the plaintiff must prove in order to show liability." (25) Neither of these characteristics hold true for criminal cases. Yet, courts adopted the civil remedy approach when first confronted with damages in criminal cases (26) after the Guidelines endorsed victim loss as well. (27)

   3. Calculation Method

      With market loss established as the benchmark for damages, civil courts were tasked with creating a method for calculating the loss in Rule 10b-5 cases. Many possible methods for calculating market loss exist, the advantages and disadvantages of which are beyond the scope of this Article. (28) In early securities cases, courts could not reach consensus on the calculation method, (29) but courts began to gravitate toward the "out-of-pocket" calculation method (30) because of its simplicity and its consistency with the common law understanding of damages. (31) Ultimately, Congress enacted the 1995 Private Securities Litigation Reform Act (PSLRA), (32) mandating that courts use the rescissory method, which attempts to make the "victim whole by restoring that person to the position he was in before the fraudulent transaction occurred,"33 in private 10b-5 civil actions. (34) By that point, courts were applying multiple competing theories of civil damage calculations, and because the PSLRA does not concern loss calculations at sentencing, (35) any of these theories --or even other new ones--could be available in the criminal context.

   4. Causation

      Once courts had settled on market loss and had created suitable calculative theories, the crucial issue of causation remained. In a private securities fraud action under Rule 10b-5, any stock purchaser or seller is a potential victim of the defendant's fraud when the defendant's actions have illegally manipulated the security's price during a period of time including the victim's transaction. (36) For a widely-held security, this activity can result in countless victims, and each victim is a potential plaintiff. (37) As a result, courts needed a way to differentiate instances where the defendant's fraud caused the plaintiff's loss from instances where opportunistic holders of the security were trying to profit through litigation arising from the...