U.S. v. Grabske
| Decision Date | 20 December 2002 |
| Docket Number | No. CR01-0324CRB.,CR01-0324CRB. |
| Citation | 260 F.Supp.2d 866 |
| Parties | UNITED STATES of America, Plaintiff, v. William GRABSKE, Defendant. |
| Court | U.S. District Court — Northern District of California |
Douglas R. Young, William P. Keane, Farella, Braun & Martel, San Francisco, CA, for Plaintiffs.
John H. Hemann, Assistant U.S. Attorney, U.S. Attorney's Office, San Francisco, CA, for Defendants.
SENTENCING OPINION RE: CALCULATION OF LOSS
Defendant William Grabske ("Mr.Grabske") was the Chief Executive Officer of Indus International, Inc. ("Indus"), a publicly traded software company. On May 29, 2002, Grabske was convicted of securities fraud and other related offenses in connection with the preparation of false financial statements which overstated Indus's revenue for the third quarter 1999.
The parties agree that under the United States Sentencing Guidelines ("the Guidelines"), the base offense level is six. See U.S.S.G. § 2Fl.l(a) (1998). They also agree that the offense level should be increased by two levels for more than minimal planning, see id. § 2F1.1(b)(2), and an additional two levels for Grabske's role in the offense. See id. § 3Bl.l(c). While they agree that the offense level must also be enhanced based on the amount of investor loss caused by Grabske's fraud, see id. § 2F1.1(b)(1), they vigorously disagree as to the amount of such loss and even the appropriate method for calculating it. Each party retained an expert to support its proposed method and critique the opposing expert's method. Nonetheless, the parties ultimately agreed on what the outcome of the sentencing should be, and have stipulated to two alternative methods for reaching that result. Thus, the Court must resolve one critical issue: how to calculate the loss caused by Mr. Grabske's securities fraud.
On October 28, 1999, Indus issued a press release announcing its third quarter 1999 financial results. Indus reported that it had met quarterly targets with revenues of $50.88 million and earnings of $3.52 million, or 10 cents per share on a diluted basis. Analysts estimated that fourth quarter revenue would be $52.3 million with earnings per share again at 10 cents. The next day Indus shares closed at slightly over $6.00. The financial report was false because Indus had improperly recognized over $2 million in revenue from two contracts with rights of cancellation and return. A couple of weeks later, Indus filed its Form 10Q with the Securities and Exchange Commission repeating the false financial information announced in the press release.
Over the next two months the price of Indus shares rose steadily. Then, on January 6, 2000, Indus announced that it would not meet analysts' expectations for the fourth quarter and instead, that earnings per share would be zero cents on revenue of approximately $43 million. The price of Indus shares fell from $11.69 to $8.94 on the next day of trading.
Three weeks later, on January 27, 2000, Indus announced a fourth quarter 1999 loss of .24 cents per share. Indus also announced that it would be restating its third quarter 1999 financials and that the restatement would result in a drop of earnings from 10 cents per share to one cent per share. The next day Indus shares dropped from $9.69 to $7.63 per share. Four days later, however, shares of Indus rebounded to a price close to the price before the January 27, 2000 announcement. Indus did not make any public statements that would have contributed to the rebound.
On March 20, 2000, Indus issued its revised third quarter 1999 financial statement to report earnings of three cents per share, rather than the one cent per share predicted in late January and the 10 cents per share announced in late October.
One method of calculating damages in civil securities fraud cases is the "out-ofpocket" rule. The out-of-pocket rule fixes recoverable damages as "the difference between the purchase price and the value of the stock at the date of purchase." Green v. Occidental Petroleum Corp., 541 F.2d 1335, 1344 (9th Cir.1976). Both parties' experts employ an out-of-pocket method and agree that loss should be determined by multiplying the number of shares purchased during the fraud and held beyond the fraud's disclosure by the price at which the shares would have traded but for the fraud. The parties have stipulated that the number of damaged shares is 2,742,963 but disagree as to the proper means for computing the value of the stock at the time of purchase.
Economists often determine the amount of stock price inflation due to fraud through an "event study." An event study looks to how the price of the stock changed after the fraud was disclosed as evidence of the amount by which it was inflated prior to disclosure. In other words, the out-of-pocket loss is the amount paid for the stock less the amount for which the investor sold the stock after the fraud was disclosed. See In re Cendant Corp. Litigation, 264 F.3d 201, 242 n. 24 (3d Cir. 2001). Here, the date of disclosure was January 27, 2000; the next day the price of Indus shares fell by more than $2.00.
Here, however, government expert Michael Smith ("Smith") argues that an event study is not useful because the fraud disclosure was not clean; that is, other negative information about the company was released contemporaneously with the fraud disclosure. Specifically, on January 27, 2000 Indus announced that it would restate its third quarter 1999 financials because of the fraud and that Indus had suffered a fourth quarter loss. As investors are arguably more interested in the more recent information—the fourth quarter information—than restated old information, Smith contends that the drop in the price of Indus's shares the day after the January 27, 2000 disclosure cannot be attributed solely to the third quarter restatement. Smith rejects an event study for this reason.
Smith proposes an alternative method: the earnings response coefficient ("ERC") method. To calculate the ERC, Smith first identifies past Indus quarterly earnings forecasts and ensuing earnings announcements. Second, he determines if the announcements were clean, that is, whether they contained only earnings information and not other information that might affect the stock price. Third, he calculates the change in Indus stock price associated with each unexpectedly low (or high) earnings announcement. Finally, Smith "regresses" the Indus stock price changes on the unexpected earnings announcements to estimate the ERC. Once the ERC is estimated, it is multiplied by the percent difference between the fraudulently reported earnings and the earnings as they would have been absent the fraud.
Smith estimates Indus's ERC as .290; that is, a negative earnings surprise of 100 percent (for example expected earnings of 10 cents per share and actual earnings of zero cents) results in a 29 percent drop in stock price. He concludes that for the third quarter of 1999, Indus's earnings absent the fraud would have been six cents per share. Since analysts had forecasted third quarter earnings of ten cents per share, this represented a 40 percent surprise. Multiplying the 40 percent earnings surprise by .290 results in a 11 percent, or 70 cents per share, decline in stock price. Seventy cents per share times the stipulated number of affected shares equals a total loss amount of approximately $1.9 million.1
Defendant's expert, Allan Kleidon, purports to use an event study. He, like Smith, notes that the price of Indus shares fell by $2.06 the day after the announcement of the restatement, but that on the same day Indus announced a .24 cent per share loss for fourth quarter 1999. He then posits that an accounting restatement of the previous quarter's earnings provides no new information to the investing public; the public only cares about how the company is performing now and will perform in the future. He concludes, therefore, that the influence of the third quarter restatement on the $2.06 price drop was minimal.
To be sure, Kleidon does not claim that the fraud had no impact on the price of the stock. Rather, Kleidon concludes that since the third quarter restatement announced on January 27, 2000 reduced third quarter 1999 income per share by nine cents (from ten cents to one cent), the inflation due to the fraud is nine cents per share. He multiplies that figure by the stipulated number of harmed shares (2,742,963) for a total loss of approximately $247,000. He then reduces this number by one third because one third of the third quarter restatement was due to accounting mistakes rather than fraud. Accordingly, defendant submits that the amount of the loss was approximately $164,000.
The government initially submitted a sentencing memorandum arguing that, based on its $1.9 million loss figure, the sentencing range for Mr. Grabske is 41 to 51 months. It urged the Court to sentence Mr. Grabske to 51 months because such a sentence "would take into consideration the severity of the offense and the loss to Indus shareholders." Government Sentencing Memorandum at 1. Mr. Grabske, on the other hand, argued that the applicable guideline range is 24 to 30 months. After reviewing the parties' submissions, the Court advised the parties that it was not satisfied with either side's loss calculation and directed the parties to meet and confer to at least narrow their areas of disagreement.
The parties subsequently submitted a stipulation. While they still do not agree on either the amount of the loss or the method by which the loss should be calculated, they have concluded "that there is no established case law setting forth the proper method for determining loss in criminal securities fraud cases." They also now agree on the sentencing range that the Court should apply. Accordingly, the parties have stipulated that the government's...
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