June 20, 2016

Calculation of Losses and Required Sentences in White-Collar Crimes – Are You Considering All Factors?

Introduction

Forensic accountants are routinely hired to assist in calculation of lost profits and economic damages in various types of litigation. One such engagement is assisting attorneys in calculating losses and/or reviewing such calculations to determine the length of sentence for a defendant in white-collar crime litigation. In most other matters, accountants have a free hand in determining the method appropriate to calculate damages incurred. However, Part 2B1.1 of the U.S. Sentencing Guidelines Manual provides certain parameters for accountants in calculating losses for the purpose of determining length of sentence for white-collar crime defendants. This article illustrates the use of a combination of damage theory and U.S. Sentencing Guidelines (Guidelines) to calculate losses related to white-collar crime and how changes to the Guidelines could change the approach to such calculations, thereby impacting a defendant’s length of sentence. This article does not address offenses involving taxation or corporate defendants.

Calculation of Losses

Conceptually, calculation of losses for sentencing in white-collar crimes is not substantially different from the calculation of losses in other types of litigation.

Part 2B1.1 paragraphs (a) and (b) of the Guidelines identifies the offense level of a defendant who is convicted of a “Basic Economic Offense” involving larceny, embezzlement, fraud, forgery, counterfeiting, and stolen and damaged property. The offense levels are largely predicated on the range and amounts of losses incurred by the victims of such crimes. This creates the need to engage accountants to assist the attorneys in calculating such losses incurred and/or examining the validity of such calculations as prepared by the prosecution. Paragraph 3 of the Application Notes to Part 2B1.1 provides parameters to accountants in calculating losses and the exclusions from and credits against such losses.

An initial consideration in the process is to understand the concept of the fraud and the methodology used to perpetrate it. Based on review of documents and case facts, the gain by the defendant or the loss created by the defendant’s activities is calculated. As indicated in paragraph 3(B) of the Application Notes, “The court shall use the gain that resulted from the offense as an alternative measure of loss only if there is a loss but it reasonably cannot be determined.” Although in most instances the gain realized by the defendant as a result of his or her offenses can be included in its entirety in our calculation, the victim’s loss might not necessarily be all-inclusive.

There are some additional steps required to calculate the victim’s loss as a result of the defendant’s offense. It is imperative to calculate the extent of loss that might have been incurred due to circumstances other than the defendant’s intention to defraud the victim. In one case, the defendants were charged for using fraudulent techniques to help prospective buyers of the homes developed by them qualify for specialized mortgage loan programs. Due to these fraudulent activities, the mortgagors defaulted on such loans, which resulted in lenders losing a substantial amount of their asset. The prosecution alleged that the loss in its entirety was a result of the defendants’ fraudulent behavior. However, the prosecution did not consider a key factor. During this same period, the economy and the real estate market went through a market downturn, leading to most, if not all, real estate markets experiencing a tremendous decline in property prices and a high unemployment rate. Additionally, the prosecution did not take into consideration factors such as divorce, bankruptcies, or major medical issues, which also led mortgagors to default on their loans. To accurately calculate the loss incurred as a result of the defendants’ activities, one must calculate the effect of any such factors and exclude them from calculation of loss incurred by the lender/victim.

Consideration should also be given to calculating mitigation of loss, if any. This concept is also illustrated in paragraph 3(E) of the Application Notes, which details the credits against the losses. Continuing with the above example, the value of any property that was foreclosed and/or subsequently sold should be calculated by the lender and credited against the losses calculated above.

An additional step, as described in paragraph 3(D) of the Application Notes, provides that the calculation of loss will not include interest, finance charges, late fees, etc. This is one of the few differences when calculating losses under the Guidelines versus losses in other types of litigation. In other lost profits and/or damages cases, an accountant will included interest, finance charges, late fees, and the agreed upon rate of return, especially if dictated by a contract between the parties.

The steps illustrated above focus on the need to calculate the victim’s loss as a direct result of the defendant’s activities. Such calculations assist attorneys in supporting their client’s position in sentencing.

The Effects of Changes to the Guidelines on Calculation of Losses

In April 2015, the United States Sentencing Commission voted to revise the Guidelines. The loss ranges within the table in Part 2B1.1, paragraph b(1) were intended to minimize disputes and related litigation over relatively small dollar fluctuations in the loss. That said, attention must be given to where an alleged loss is positioned within a “range.” The feasibility of effectively moving a loss from one range to another should be considered. Some significant changes that may impact offenses listed in the Application Notes to subsection 2B1.1 and the resulting economic loss are summarized below.

Paragraph 3(A)(ii): Definition of Intended Loss to Include Pecuniary Harm That the Defendant Purposefully Sought to Inflict. As illustrated above, losses unrelated to factors other than the actions of the defendant should not be included in loss calculations. The inclusion in the definition of intended loss of pecuniary harm that the defendant purposefully sought to inflict adds another step to calculating losses in these engagements. It is now necessary to understand the level of expertise of the defendant and compare it to the crime perpetrated to understand if the defendant recognized that his or her actions would result in the extent of the losses incurred.

As in a Ponzi scheme, the perpetrator might have started a fraud alone, but more individuals were hired as the scheme grew. Although an assistant hired to maintain client relationships on behalf of the defendant is aware that the defendant is not investing in the financial instruments that they are communicating to their clients, that same assistant might not have the aptitude or the understanding of these financial instruments and their implications on clients’ losses. Thus, although the assistant may have been complicit in the Ponzi scheme, the revisions in the Guidelines at paragraph 3(A)(ii) of the Application Notes do not enhance their offense level if they did not understand the extent of harm they were inflicting and therefore did not purposefully seek to inflict the same extent of harm as the defendant.

Similarly, if a defendant decides to con a person out of his or her assets without knowledge that such person was heavily indebted to a few friends and family members, paragraph 3(A)(ii) of the Application Notes does not assume that the defendant purposefully sought to inflict harm on these friends and family members. Calculating losses in this example would include the losses incurred by the person conned and not any damage to his or her friends and family members. This avoids double dipping in the same pool of lost funds.

Subsection 2B1.1(b)(10)(C): Consideration of Defendant’s Individual Conduct and Whether Sophisticated Means in Perpetrating the Offense Was Used. The revision now requires a demonstrated link between the individuals who participated in the offense and their use of sophisticated means to perpetrate the offense. Although presenting such linkage is a liability issue and must be addressed by the attorneys participating in the litigation, understanding the structure of the sophisticated means used and its role in the perpetration of the fraud by the defendant comes under the purview of an accountant.

In another case, one of the corporate officers of a hedge fund decided to set up corporate shells that he used to move client contributions out of the fund. He did so by creating fictitious and self-dealing contracts between the hedge fund and these corporate shells. Although the hedge fund accounting records showed that the funds were paid out for services rendered, they were in fact siphoned off to these corporate shells and ultimately benefitted the corporate officer who controlled them. This corporate officer used a manager in the accounting department to facilitate the fraud in return for a slice of the funds transferred. Although the manager is a participant in the fraud, subsection 2B1.1(b)(10)(C) of the revised Guidelines would hold only the corporate officer as using a sophisticated means to perpetrate the fraud.

We anticipate that going forward it will be imperative to demonstrate through loss calculations how a defendant or a group of defendants perpetrated the offense using a sophisticated means. However, there will also be incidents where it will not be possible to demonstrate that it was others, also a part of the scheme, who actually used the sophisticated means to perpetrate the offense and not the defendant.

Paragraph 3F(ix): Allows the Use of Any Method Appropriate and Practicable under the Circumstances to Calculate the Fraudulent Inflation and Deflation in Value of Securities and Commodities. One of the most significant changes to the Guidelines is at paragraph 3(F)(ix) of the Application Notes, which now allows usage of any method appropriate and practicable under the circumstances to calculate the fraudulent inflation and deflation in value of securities and commodities. This revision is in addition to the formula illustrated in the Guidelines.

The formula, as described in paragraph 3(F)(ix)(I), calculated the loss by the difference between the price of a security or commodity during the period of offense and the price in the 90-day period after the offense was disclosed to the market. It then multiplied this difference by the number of shares outstanding. Although an apparently sound methodology, it was flawed because it did not take into consideration the absence of the market auto correcting for the perpetrated offense.

Loss on each stock held should be calculated as the difference between what would have been the value of the security had there been no fraud and the value of the security directly as a result of the fraud.

The revision in this portion of the Guidelines at paragraph 3(F)(ix) also opens the door to accurately calculate the marketable value of stock using financial models, leading to a more accurate demonstration of the extent of damage caused by the defendant’s fraudulent activities.

Subsection 2B1.1(b)(1): Requires Inflation Adjustment to the Ranges of Loss Used to Calculate the Offense Level. The inflation adjustment to the range of losses was revised for the first time since 2001. This adjustment was needed to accurately calculate offense levels of the defendants in line with the extent of the fraud perpetrated by them. Although the minimum range was increased by a mere $1,500, the maximum range saw an inflation increase of $150 million. Although this change will not bring about any difference in the methodology of calculation of losses, it will lead to equivalent length of sentence for the crime committed.

Subsection 2B1.1(b)(2): Allows Consideration of Substantial Financial Hardship of the Victim as a Result of the Offense as an Offense Enhancement Factor. The 2015 changes to the Guidelines at subsection 2B1.1(b)(2) included substantial financial hardship of the victims as an enhancement factor. Paragraph 4(F) of the Application Notes details the following circumstances in which the court considers a victim to have suffered from substantial financial hardship:

  1. becoming insolvent;
  2. filing for bankruptcy under title 11 of the U.S. Bankruptcy Code;
  3. suffering substantial loss of a retirement, education, or other savings or investment fund;
  4. making substantial changes to employment, such as postponing retirement plans;
  5. making substantial changes to living arrangements, such as relocating to a less expensive home; and
  6. suffering substantial harm in the ability to obtain credit.

Calculating individual loss is a simpler task than determining whether the loss was a result of the defendant’s actions. We are living in an economy of constant turmoil and numerous external factors that are continually affecting the value of our wealth. If a defendant perpetrates fraud for a period of time, the calculation of loss is not simply the difference between the values of an asset before the period of fraudulent behavior and after the fraudulent behavior was discovered. The value of an asset, during this period, can be affected by many other factors as described above. The calculation of an individual’s loss must be calculated as the difference between the value of an asset had the fraud never been committed and the value of asset as a result of the fraud. This calculation should be done for the period during which the fraud was perpetrated. This should filter out effects of other factors unrelated to the defendant’s activities on the value of the asset.

Thus, as a result of the revisions to the Guidelines as stated above, there would be no change in the process of calculating losses to the individual; however, it must be clearly demonstrated that the substantial financial hardship was a result of the particular defendant’s fraudulent activity.

Calculation of Gain to the Defendant

There are instances where the loss suffered is not conclusively determinable as a direct result of the fraud. As an alternative calculation, the court allows the calculation of gain to the defendant resulting from perpetration of the fraud (paragraph 3(B) of the Application Notes). Any increases in such gains resulting from external factors, such as growth in the value of the asset in the market, will also be included in gains related to fraudulent behavior. For example, if a broker steals funds from his or her clients’ portfolios and invests these funds in a personal portfolio in the market, any gains that resulted would also be part of the calculation. Conversely, any losses do not decrease the initial gain of funds from stealing from the broker’s clients. 

This concept is also supported in paragraph 3(F)(iv) of the Application Notes, which provides that in a Ponzi or other fraudulent investment scheme, any gain to an individual investor shall not be used to offset the loss to another individual investor in the scheme.

Conclusion

The above discussion of changes demonstrates that the focus of the Guidelines is shifting from merely punishing a defendant for perpetrating fraud to appropriately sentencing a defendant for the type, involvement, and graveness of the fraud. This may result in a smaller, or necessarily larger, length of sentence for the defendant.

The Guidelines are largely predicated on the amount of loss incurred by victims or, alternatively, the amount of gain realized by the perpetrator. Therefore, it is imperative that these calculations be prepared with the utmost accuracy and understanding of the fraud. Merely calculating the difference between the value of assets or net worth does not result in actual or intended loss suffered due to fraudulent offenses. In fact, such calculations may include mistakes, such as double counting of the amount of loss or impact on the victims. This results in erroneous calculations and sentences that could have an adverse impact on the sentences of the defendant. With the shift in the Guidelines to appropriately sentence the defendant for the type, involvement, and graveness of the fraud perpetrated, it is now critically important to create a direct link between the losses suffered/gains realized and the defendant’s fraudulent behavior.

Additional Resources

For other materials on this topic, please refer to the following. 

BLS Committee Newsletters 

White-Collar Crime Committee Newsletter
Spring 2016 

In the Know           

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