U.S. Supreme Court Reviewing Important Fraud-related Cases

John Marshall, chief justice of the United States from 1801 to 1835, would have been proud to exercise judicial review over upcoming fraud-related cases. Never one to back down from a fight, Marshall, in a case all political science and law students know [Marbury v. Madison (1803)] established the U.S. Supreme Court’s right to exercise judicial review and, if need be, declare laws passed by U.S. Congress unconstitutional. 

The supremacy clause of the U.S. Constitution (Article VI, Clause 2) established that the “Constitution, and the laws of United States ... shall be the supreme law of the land ... and the judges in every state shall be bound thereby ...” However, our founding fathers didn’t address the federal question whether “The judicial power of the United States is extended to all cases arising under the Constitution,” according to Marbury. The Marbury case provided Marshall an opportunity to declare that the Supreme Court had the authority to review the constitutionality of actions taken by the legislative and executive branches of the government. In essence, the Supreme Court has the final “judicial review” over congressional legislative actions. 

The legacy that Marshall gave us soon will be exercised by the current chief justice, John Roberts, along with fellow Supreme Court members, who heard oral arguments in early December of 2009 in three fraud-related cases. One case deals with the constitutionality of a provision in the Sarbanes-Oxley Act of 2002 (SOX), and two cases address the constitutionality of the honest services statute.

SOX UNDER the MICROSCOPE, AGAIN 

SOX created the Public Company Accounting Oversight Board (PCAOB) whose purpose is “to oversee the audit of public companies … in order to protect the interests of investors …” and “to establish … by rule, auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports... .” (Section 101 of SOX)  

What might be SOX’s Pearl Harbor, the case of Free Enterprise Fund v. Public Company Accounting Oversight Board (08-861), was argued before the Supreme Court on Dec. 7, 2009. In this case, Free Enterprise Fund, a nonprofit public interest organization, and a Nevada accounting firm sued the PCAOB seeking an order that SOX violates the U.S. Constitution. The principal questions at issue are whether the creation of the PCAOB violates the Constitution’s 1) separation of powers principles and/or 2) appointment’s clause. 

Here’s a summary of the issues before the Supreme Court: 

The first question addresses whether SOX violates the Constitution’s separation of power doctrine by the manner in which members of the PCAOB are selected and removed. The separation of powers doctrine refers to the division of powers among the legislative, executive, and judicial branches of government as defined by the first three articles of the U.S. Constitution. It prohibits one branch from exercising powers constitutionally assigned to another branch. 

The Free Enterprise Fund contends that SOX violates constitutional requirements on separation of powers because it vests members of the PCAOB with executive functions but doesn’t give the president any power to appoint or remove those members, thus depriving the president of any authority to supervise or control the PCAOB. 

The second question addresses whether the PCAOB’s appointment structure violates the appointments clause of the Constitution, which provides that the president must appoint “principal officers,” but that heads of departments may appoint “inferior officers.” A primary question is whether the PCAOB members qualify as principal officers or inferior officers. The Free Enterprise group contends that, under the appointment clause, if the members of the PCAOB are deemed “principal officers,” then the president should appoint them, which he currently doesn’t. But if the members are deemed to be inferior officers, then the head of the SEC – rather than the SEC commissioners acting collectively – should appoint the members.  

Here are the actual questions before the Supreme Court: 

1. Whether SOX violates the Constitution’s separation of powers doctrine by vesting members of the PCAOB with executive power while stripping the president of all authority to appoint or remove those members or otherwise supervise or control their exercise of that power, or whether, as the court of appeals held, the act is constitutional because Congress can restrict the President’s removal authority in any way it “deems best for the public interest.” 

2. Whether, under the appointments clause, PCAOB members are “inferior officers” directed and supervised by the SEC, where the SEC lacks any authority to supervise those members personally, to remove the members for any policy-related reason or to influence the members’ key investigative functions, merely because the SEC may review some of the members’ work product.  

3. If PCAOB members are inferior officers, whether the act’s provision for their appointment by the SEC violates the appointments clause either because the SEC isn’t a “department” under Freytag v. Commissioner, 501 U.S. 868 (1991), or because the five commissioners, acting collectively, aren’t the “head” of the SEC. 

The case could either be seen as a challenge by businesses to avoid the perceived added costs now incurred for audits of financial statements and internal controls or a valid constitutional challenge to the expansion of government into the public sector.  

The court will rule on the PCAOB’s constitutionality (and by inference that of SOX) in the spring of 2010.

HONEST SERVICES STATUTE 

Less than 24 hours after the oral arguments in Free Enterprise Fund, the Supreme Court heard oral arguments in Black v. United States [08-876] and Weyhrauch v. United States [08-1196], two of the three fraud cases dealing with the honest services statute currently before the court. The third case, Skilling v. United States [08-1394], was scheduled for March 1.  

The first case involved newspaper magnate Conrad Black, who controlled Hollinger International Inc. In 2007, Black was found guilty of directing funds for personal benefit due Hollinger. He was convicted of mail fraud and obstruction of justice. In his appeal, Black argued that his actions didn’t financially harm the company and can’t be considered honest services fraud. 

In the second case, Bruce Weyhrauch, a former member of the Alaska House, was charged with several crimes including honest services fraud. According to the indictment, Weyhrauch helped advance an oil service company’s causes in exchange for the promise of future legal work. Weyhrauch contends that he isn’t guilty of honest services fraud because he hadn’t the duty to disclose the job solicitation. 

The third case involved Jeffrey Skilling, the former chief executive officer of Enron Corporation. In 2006, he was convicted of multiple federal felony charges relating to Enron’s financial collapse. Skilling contends that the government should have had to prove that his actions arose from his intent to achieve private gain at Enron’s expense. 

These cases revolved around the federal honest services statute – an open-ended fraud law consisting of only 28 words that U.S. prosecutors often have used to indict and then obtain convictions for corruption and white-collar crimes. Those words, which are found in Title 18 of the United States Code § 1346, extend the mail fraud statute to any scheme designed to deprive another of honest services: “For the purposes of this chapter, the term ‘scheme or artifice to defraud’ includes a scheme or artifice to deprive another of the intangible right of honest services.” The chapter in the code excerpt is chapter 63: “Mail Order & Other Fraud Offenses.”  

During oral arguments for the Black and Weyhrauch cases, the Supreme Court justices were troubled with the statute’s vague language and questioned if the term “honest services” was clear enough to give a person of ordinary intelligence fair notice of what conduct is prohibited. To understand how we got into “the mush of language” as Justice Scalia put it during oral arguments in the Weyhrauch case [Page 41 of the Proceedings in Case 08-1196], we have to know a little history of the mail fraud statute, 18 U.S.C. § 1341.  

The initial federal mail fraud statute was enacted in 1872 as a way to discourage using the mail services in furtherance of any “scheme or artifice to defraud” someone of tangible property but was amended in 1909 by adding the words “or for obtaining money or property by means of false or fraudulent pretenses, representations, or promises” [Act of March 4, 1909, ch. 321, § 215, 35 Stat. 1130 (1909) (codified at 18 U.S.C. § 1341)].  

Over the years, prosecutors broadened their use of the mail fraud statute, and the courts expanded the scope of what was meant by “property” to include tangible property rights. The reason for the expansion zeal was simple: it was easy to get convictions when all a prosecutor had to show was: 1) a scheme to defraud, 2) the intent to defraud, and 3) the use of the mail as part of the crime. Also, an expansive definition permitted federal prosecutors to reach new forms of fraudulent activity until Congress could enact more particularized legislation. 

Former Chief Justice Warren Burger wrote that the mail fraud statute “has traditionally been used against fraudulent activity as a first line of defense. When a ‘new’ fraud develops – as constantly happens – the mail fraud statute becomes a stopgap device to deal on a temporary basis with the new phenomenon, until particularized legislation can be developed and passed to deal directly with the evil.” U.S. v. Maze, 414 U.S. 395, 405-06 (1974) (Burger, C.J., dissenting) 

Congress enacted the honest services statute in response to the Supreme Court’s attempt to curb prosecutors’ broadening use of the mail and wire fraud statutes in the case of McNally v. United States, 483 U.S. 350 (1987). In McNally, Charles J. McNally appealed the U.S. Court of Appeals for the Sixth Circuit’s decision to uphold his conviction for mail fraud under the theory that he and two other defendants had schemed from 1975 through 1978 to defraud citizens of property – their intangible rights to honest and impartial government. The three were indicted in 1983. On appeal, the Supreme Court reversed the convictions and ruled that “The mail fraud statute clearly protects property rights, but does not refer to the intangible right of the citizenry to good government” [483 U.S. 350, 356].  

Less than a year later, the U.S. Congress provided its rebuttal to the Supreme Court’s view by passing 18 U.S.C. § 1346, which added the language of “intangible right of honest services.” 

During oral arguments in the Black case, Michael Dreeben, deputy solicitor general in the U.S. Department of Justice, addressed vagueness concerns inherent in the phrase “honest services,” suggesting that Congress intended that Section 1346 incorporate the “intangible right of honest services” concept, which had acquired a precise meaning in pre-McNally cases.  

In response, Justice Ruth B.Ginsberg asked: How could the phrase have acquired a precise meaning when “the lower courts were massively confused?”  

Responding to the question, Dreeben tried to explain that the lower courts weren’t confused about the meaning of the language – “honest services” – because they all adopted “one thing: divided loyalties of an agent or a fiduciary.”  

This last statement prompted Justice Breyer to comment on the vagueness of the statute and its potential to criminalize mistakes or minor transgressions: 

“Now, as I hear that – I am exaggerating, possibly, but I think every agent has a duty of loyalty to provide loyal and honest services to the master, the master agent. Every worker is an agent of his master, the employer. So every instance in which a worker does not provide honest services to the employer, he has met your test. I think there are 300 – perhaps there are 150 million workers in the United States. I think possibly 140 of them would flunk your test.” 

At this point, the oral argument transcript includes the word: “laughter.” It’s never a good sign when there’s laughter during Supreme Court oral arguments. Breyer went further: “Explain to me, how your test does not make this statute potentially criminalizing 100 million workers in the United States or some tens of millions?”  

Breyer wanted to know if an employee reading a racing form and Justice Sotomayor wanted to know if an auditor going to a baseball game on April 14 instead of doing honest work were violations of the statute.  

Such comments by the Supreme Court Justices during oral arguments suggest that the justices have concerns that the honest services statute is unconstitutionally vague, which means that the court could overturn the convictions in the three cases. If two words out of 28 can cause three cases to reach the U.S. Supreme Court, just imagine what 1,279 pages in the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173) from the 111th Congress will generate in cases on the court docket.  

Thank heavens for John Marshall and his belief in judicial review. Faculty members: if you have a student coming into your office shopping around for an elective to take, you might want to suggest a constitutional law course. I have a feeling that there will be a lot of fraud cases brewing for judicial review. 

Richard Hurley, Ph.D., J.D., M.S., CPA, ACFE Educator Associate Member, is an associate professor in the University of Connecticut (Stamford) School of Business. 

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