United States v. Gluk

• Decision Date: 04 August 2016
• Docket Number: No. 14-51012,14-51012
• Citation: 831 F.3d 608
• Parties: United States of America, Plaintiff-Appellee, v. Michael Gluk; Michael Baker, Defendants-Appellants.
• Court: U.S. Court of Appeals — Fifth Circuit

831 F.3d 608

United States of America, Plaintiff-Appellee,

v.Michael Gluk; Michael Baker, Defendants-Appellants.

No. 14-51012

United States Court of Appeals, Fifth Circuit.

August 4, 2016

John Michael Pellettieri, Esq., Ellen R. Meltzer, Esq., U.S. Department of Justice, Washington, DC, Joseph H. Gay, Jr., U.S. Attorney's Office, San Antonio, TX, for Plaintiff-Appellee.

Elliot H. Scherker, Brigid F. Cech Samole, Jay A. Yagoda, Miami, FL, David W. Klaudt, Jason Scott Lewis, Dallas, TX, Greenberg Traurig, L.L.P., for Defendant-Appellant Michael Gluk.

Dennis P. Riordan, Riordan & Horgan, San Francisco, CA, Martha Ann Boersch, Esq., Oakland, CA, Theodore David Sampsell-Jones, William Mitchell College of Law, Minneapolis, MN, for Defendant-Appellant Michael Baker.

Before JOLLY and JONES, Circuit Judges, and MILLS, District Judge.^*

ON PETITION FOR REHEARING

E. GRADY JOLLY, Circuit Judge:

The petition for panel rehearing is GRANTED, the original panel opinion (presently available at 811 F.3d 738 (5th Cir.2016) ) is hereby withdrawn, and this opinion is substituted therefor.¹

Michael Baker and Michael Gluk appeal their convictions for securities fraud. Because we agree with their evidentiary challenges, we vacate their convictions and remand for a new trial.²

I.

Michael Baker and Michael Gluk were, respectively, the CEO and CFO of ArthroCare, a medical device company. Under their tenure (and, allegedly, with their knowledge) ArthroCare practiced “channel stuffing” with a related entity, DiscoCare.

“Channel stuffing” is a fraudulent scheme companies sometimes attempt, in an effort to smooth out uneven earnings—typically to meet Wall Street earnings expectations. Specifically, a company that anticipates missing its earnings goals will agree to sell products to a coconspirator. The company will book those sales as revenue for the current quarter, increasing reported earnings. In the following quarter, the coconspirator returns the products, decreasing the company's reported earnings in that quarter. Effectively, the company fraudulently “borrows” earnings from the future quarter to meet earnings expectations in the present. Thus, in the second quarter, the company must have enough genuine revenue to make up for the “borrowed” earnings and to meet that quarter's earnings expectations. If the company does not meet expectations in the second quarter, it might “borrow” ever-larger amounts of money from future quarters, until the amounts become so large that they can no longer be hidden and the fraud is revealed.

ArthroCare carried out exactly this fraud, with DiscoCare playing the role of coconspirator. Over several years, ArthroCare fraudulently “borrowed” around $26 million from DiscoCare. This “borrowing” occurred by directing DiscoCare to buy products from ArthroCare on credit, with the agreement that ArthroCare would be paid only when DiscoCare could sell those products. Although this can be a legitimate sales strategy, it was fraudulent here because DiscoCare purchased medical devices that it knew it could not sell reasonably soon for the sole purpose of propping up ArthroCare's quarterly earnings. This fraud was carried out under the day-to-day supervision of John Raffle, the Vice President of Strategic Business Units, and of David Applegate, another DiscoCare executive.

DiscoCare's business model (apart from the accounting fraud) was potentially wrongful, though no charges were brought. DiscoCare provided a medical device for which most insurers refused reimbursement. To sell its device, DiscoCare reached agreements with plaintiffs' attorneys in civil actions for personal injuries. These agreements resulted in the majority of DiscoCare's sales. Under this agreement, DiscoCare would treat clients of the attorneys. The plaintiffs' attorneys would then cite the expense of their clients' treatment as a reason for defendants to settle personal injury lawsuits. DiscoCare also allegedly illegally coached doctors on which billing codes to use, in an effort to increase insurance reimbursements. This practice allegedly went as far as instructing doctors to perform an unnecessary surgical incision to classify the treatment as a surgery. No charges were filed on any of this conduct.

ArthroCare subsequently purchased DiscoCare for $25 million, a price that far exceeded its true value (DiscoCare had no employees at the time). During this purchase, the fraud began to unravel, with media reports alleging accounting improprieties. To reassure investors, Gluk and Baker made several false statements during a series of conference calls. As evidence mounted, the audit committee of ArthroCare's board of directors commissioned an independent investigation by forensic accountants and the law firm Latham & Watkins. As a result of this investigation, the board determined that Raffle and Applegate had committed fraud and that Gluk and Baker had not adequately supervised them. The board restated earnings, resulting in a significant drop in the value of ArthroCare stock. The board fired Raffle and Applegate for their roles in the fraud. The board also fired Gluk, determining that he had been remiss in not detecting the fraud earlier. Finally, the board fired Baker, determining that he should have implemented better internal controls.

The SEC investigated ArthroCare (both informally and formally) to determine the extent of the fraud. During this investigation, Raffle and Applegate exercised their Fifth Amendment right against self-incrimination to decline to answer questions. After its investigation, the SEC sued ArthroCare, Raffle, and Applegate for securities fraud; it did not sue Gluk or Baker. It did file a “clawback” complaint against Gluk and Baker; this complaint stated that the SEC “does not allege that Baker and Gluk participated in the wrongful conduct” but instead determined that Raffle and Applegate “intentionally withheld” information from Gluk and ArthroCare.

The government subsequently brought criminal charges, initially only against Raffle and Applegate. Raffle and Applegate pled guilty and agreed to testify against Gluk and Baker; the government then indicted Gluk and Baker for the channel stuffing. At trial, Raffle and Applegate testified that Gluk and Baker knew of the fraud; Gluk and Baker testified that they did not. The key question for the jury was whether to believe Gluk and Baker or to believe the government.

The district court made several significant evidentiary rulings challenged on appeal. First, the defendants sought to introduce the Latham report, the SEC's clawback complaint against Baker and Gluk, and two memos regarding the SEC investigation that the SEC had prepared for the DOJ. As discussed in more detail below, these memos both summarized the SEC investigation. The 2010 SEC memo stated that “Raffle and Applegate ... misled [Gluk] about whether certain DiscoCare sales satisfied the company's revenue recognition criteria.... Raffle also misled the company and its external auditor about the true [fraudulent] reason for certain product exchanges by DiscoCare and another distributor.” The 2011 memo expanded on the contents of the earlier memo and provided a somewhat more detailed summary of the investigation; this memo stated that Raffle and Applegate “orchestrated a scheme to materially misstate ArthroCare's publicly reported revenue and earnings.”

According to Gluk and Baker, these documents would have corroborated their claim that they did not know of the fraud. Specifically, the documents would have shown that independent, neutral investigators determined that Raffle and Applegate—and not Gluk and Baker—had carried out and concealed the fraud. Because no other independent testimony corroborated the defendant's version of events, they argued that this evidence was essential to their defense. The district court disagreed, and excluded all these documents as more prejudicial than probative.

The district court's second important evidentiary ruling concerned evidence of uncharged misconduct. Specifically, the government sought to introduce testimony about the uncharged medical fraud that allegedly took place at DiscoCare. The district court allowed this testimony, over objection.

The jury returned a guilty verdict. At sentencing, the court determined that Baker must forfeit his net proceeds (a different amount than the proceeds directly traceable to the fraud, see note 11 below) from selling ArthroCare stock during the period of the fraud, an amount equal to $22,165,030.78. This appeal followed.

II.

Gluk and Baker argue that the district court's evidentiary rulings were incorrect in two ways: the rulings kept evidence out that should have been let in, and it let in evidence that should have been kept out. We agree on both counts, and accordingly reverse the defendants' convictions.

We review the district court's evidentiary rulings for abuse of discretion, subject to harmless error review. United States v. El – Mezain , 664 F.3d 467, 494 (5th Cir. 2011).

A.

We first consider the district court's exclusion of the SEC documents. First, were the documents hearsay? The parties agree that the SEC documents fit the definition of hearsay. See Fed. R. Evid. 801. The defendants, however, argue that the documents are nonetheless admissible for their truth because of the 803(8)(iii) hearsay exclusion. Rule 803(8) provides that “[a] record or statement of a public office [is admissible] if: (A) it sets out: ... (iii) in a civil case or against the government in a criminal case, factual findings from a legally authorized investigation; and (B) the opponent does not show that the source of information or other circumstances indicate a lack of trustworthiness.” Fed. R. Evid. 803 (emphasis added).³

The government responds that SEC documents did not set out “factual findings from a legally authorized investigation.” In support of this argument, the government cites Smith v. Isuzu Motors, Ltd. , 137 F.3d 859 (5th Cir. 1998). In Isuzu Motors, ...