Second Circuit Further Defines “Honest Services”
White Collar Criminal Practice, Internal Investigations & Government Enforcement Update
Date: February 20, 2014
In a recent and significant ruling addressing criminal fraud, the Second Circuit shed light on what constitutes “honest services” fraud after the Supreme Court’s decision in Skilling v. United States. In Skilling, the Supreme Court held that the government could no longer use the favored fraud theory unless it could establish the existence of a bribe or kickback. In its decision in United States v. DeMizio, the Second Circuit held that an individual defendant need not receive any direct payment to receive a kickback and consequently to be convicted of “honest services” fraud.
In Skilling, the government argued that Enron’s former chief executive officer conspired to commit “honest services” wire fraud by deceiving investors about Enron’s true financial performance while he, in turn, received increased salary and bonuses. On appeal, Skilling argued that his conviction should be vacated because the statute didn’t adequately define what conduct it prohibited, and it allowed prosecutors to arbitrarily determine what conduct was criminal. The Supreme Court agreed, holding that prosecuting individuals without establishing a link to bribery or a kickback scheme constituted a violation of due process. The question before the Second Circuit in DeMizio was whether payments made to the defendant’s relatives constituted such a bribe or kickback.
United States v. DeMizio
Darin DeMizio worked for Morgan Stanley in its stock loan department from 1991 through 2005. From 2001 to 2005 he was the head of its domestic stock loan desk, which is responsible for borrowing and lending stock that is necessary for short selling to take place. To transact a short sale, borrowing institutions utilize broker-dealer intermediaries to locate lending financial institutions. These broker-dealer intermediaries sometimes work with finders to help identify lenders.
DeMizio required firms doing business with Morgan Stanley to employ his family members or use finders affiliated with his family members. These family members did little to no work, but the firms added their names to documents recording the transactions with Morgan Stanley. As a result of this arrangement, the third parties increased their business with Morgan Stanley. DeMizio’s family members benefited because he caused his employer to overpay these firms for their services. The overage resulting from this premium compensated DeMizio’s family members as well as the firms. The government introduced evidence that payments to these firms amounted to $1.7 million.
In 2008 DeMizio was indicted for conspiring to commit securities fraud and honest services wire fraud, as well as making a false statement to the FBI. The “honest services” wire fraud provision, contained in 18 U.S.C. § 1346, provides that a scheme or artifice to defraud includes a scheme or artifice to deprive another of the intangible right of honest services. DeMizio argued at trial that his relatives had performed work in exchange for the money they were paid and, as a result, there were no kickbacks or bribes. Instead, he claimed that he had only steered business to these firms. He asked the district court to instruct the jurors that if his conduct did not involve kickbacks or bribes, then they must find harm to the employers of his family members in order to convict him. The district court declined and did not further define “honest services” in its instruction to the jury.
DeMizio was convicted and appealed to the Second Circuit. While the appeal was pending, the Supreme Court decided Skilling. The Second Circuit stayed and then dismissed DeMizio’s appeal without prejudice and remanded the case to the district court for consideration of its instruction to the jurors in light of Skilling. The district court upheld the initial conviction because the government had relied on a kickback theory during its case, and although its instruction did not reflect the holding in Skilling, the error was harmless because there was no alternative theory upon which the jury could have convicted.
DeMizio once again appealed and argued, among other points, that a kickback was only a kickback if his relatives actually performed no work, and that because he did not personally receive any payment, he could not be guilty of receiving a kickback.
The Second Circuit concluded that although a kickback is often paid directly to an employee who steers business to an entity and then shares in the profits, the fact that payment is made to another entity specified by the employee and in which the employee has an interest can constitute a kickback. Examples of such entities include spouses, family, friends, lovers or others loyal to the employee. As a secondary point, the court noted that there was evidence that DeMizio’s relatives would have needed his financial support if they had not received the benefit of the arrangement. Thus, it was reasonable to infer that DeMizio did personally benefit from the arrangement. Moreover, the court rejected DeMizio’s argument that there was no kickback if some work was performed, because such a scenario would allow wrongdoers to shield themselves by merely performing minimal work.
The Supreme Court’s Skilling decision does not appear to have narrowed the scope of the “honest services” fraud theory as much as some might have expected. It is clear from DeMizio that non-traditional kickbacks or bribes, such as payments directed by contractors to third-party entities in which a dishonest employee may have an interest, will fall within the ambit of the “honest services” fraud statute. In addition, “partial show” jobs may be considered a kickback to the dishonest employee, as well as traditional “no show” jobs. Drawing the line between an illegal kickback and doing a favor for a friend will not be easy. Employees must be certain to identify and disclose potential conflicts to their employers to avoid accusations not only of self-dealing, but also allegations of “honest services” fraud.
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