The Definition of Fraud

Considering how important the offense of fraud is to white collar crime, you might expect the definition of fraud to be pretty clear by now. But a recent interesting case out of the 11th Circuit highlights the ongoing occasional uncertainty about what constitutes criminal fraud. It also highlights the risks of going to a bar with a stranger – but I digress.

Fraud is at the heart of much of white collar criminal law. White collar crimes, by definition, typically involve taking a victim’s money or property through some kind of deception rather than by force or violence. That same concept – wrongfully obtaining property of another through a trick or scheme – is also the essence of fraud. Any litany of the most common white collar offenses will include many with “fraud” in their title: mail and wire fraud, health care fraud, insurance fraud, securities fraud, real estate fraud, bank fraud, credit card fraud, and so on.

But fraud itself is not defined anywhere in the criminal code. As one federal judge helpfully observed: “The law does not define fraud, it needs no definition. It is as old as falsehood and as versatile as human ingenuity.” But of course we do need a definition, because human ingenuity also cooks up a lot of schemes that may be shady but are not criminal. Criminal law requires us to draw lines between conduct that actually amounts to fraud and conduct that may be merely dishonest or unethical — and sometimes those lines can be quite blurry.

Crimes such as robbery or homicide generally have pretty straightforward parameters. There may be defenses or mitigating factors in any particular case, but the facts that will establish the elements of the offense are usually relatively clear. If someone sticks a gun in your face and takes your wallet, there’s not much doubt there has been a robbery. If you come home to find your front door broken and all your valuables missing, there has been a burglary. But as I discussed in my last post, white collar crimes frequently involve more gray areas. The ancient crime of fraud is no exception.

In the absence of a statutory definition, the parameters of criminal fraud have been explored over the years in judicial decisions, with courts suggesting various formulations. The Supreme Court has said that to defraud typically means to deprive someone of property “by dishonest methods or schemes,” and typically involves “the deprivation of something of value by trick, deceit, chicane, or overreaching.” Another common formulation characterizes fraud as conduct that violates the sense of “moral uprightness, of fundamental honesty, fair play and right dealing in the general and business life of members of society.”

The trick, of course, is that not everyone will always agree on what constitutes “fair play and right dealing,” and mere “dishonesty” is generally not a crime. As I frequently remind my students, there is a lot of sleazy, rotten, immoral stuff that goes on in the world that is not criminal. White collar criminal law frequently involves trying to figure out the distinction.

Charles Ponzi: when it comes to the definition of fraud, the Ponzi scheme is a classic example

Charles Ponzi

The Textbook Example: The Ponzi Scheme

The textbook example of a fraud is the Ponzi scheme, named for its most famous practitioner, Charles Ponzi. In the 1920s Ponzi came up with an scam involving purported trading in International Reply Coupons (IRCs). IRCs were certificates that could be purchased in one country, enclosed in an international letter, and then be redeemed by the recipient in another country for the postage necessary to send a reply. Ponzi claimed that he could double investors’ money in just a few months by buying and selling large quantities of IRCs and taking advantage of differences in international postage rates and currency exchange rates. Early investors received substantial “returns” on their investment; word quickly spread and the money poured in.

In truth, of course, Ponzi was not investing in IRCs at all and was simply keeping the money. If any investors wanted to withdraw some of their funds, he would pay them off using money he had taken in from other investors – a central characteristic of what we now call a Ponzi scheme. Most investors, seeing the impressive returns they were supposedly earning, were happy to keep their money with Ponzi and to send even more. People mortgaged their homes and sent Ponzi their life savings. He made millions within the space of a few months. But ultimately the scheme collapsed, the investors were wiped out, and Ponzi was indicted and sent to prison.

Nearly a century later, Bernard Madoff was convicted for the largest single investment fraud in history, costing his investors billions of dollars. His New York company, Bernard L. Madoff Investment Securities, LLC, was simply one giant Ponzi scheme that he ran for decades. The classics never grow old.

Examples like Ponzi and Madoff are easy; no one doubts that their actions constituted fraud. They stole money from their investors by lying to them, harming their victims through a “dishonest method or scheme.” But some other cases are not so clear.

Suppose you walk into my electronics store wearing a Donald Trump t-shirt and a red “Make America Great Again” baseball cap. While you are looking at television sets, I point out a yuuge, 110-inch flat screen and say, “Guess what? This is actually the same kind of TV set that Donald Trump has in his private suite at Trump Tower!” Although it’s a perfectly good television set at a fair price, I actually have no idea whether Trump really owns it. If you buy the TV based on my statement, have you been defrauded?

Or suppose I’m a real estate agent showing you houses, and I tell you, “The houses in this neighborhood really hold their value. They should turn out to be great investments for the people who buy here.” In reality, I know the housing prices in the neighborhood have been declining and people are bailing out. If you buy, relying in part on my statements, have I defrauded you, even though you end up with a perfectly good, habitable house?

Or suppose I set up a website offering to sell $50,000 tickets on a private space flight to go visit the aliens who abducted Elvis. I get a few takers among rabid Elvis fans living near Graceland. If I abscond with their money is that a criminal fraud, even if no reasonable person could have possibly believed the offer was real? Or should the law say the victims should have known better and can simply sue me in civil court to get their money back? Does the answer change if the tickets were only $500? $5?

The Definition of Fraud

One well-known case exploring the parameters of criminal fraud is United States v. Regent Office Supply Co., decided by the U.S. Court of Appeals for the Second Circuit in New York in 1970. Regent sold office supplies through salesmen who solicited orders over the telephone. When they called a prospective customer, the salesmen would tell various lies about why they were calling; for example, they would falsely claim they had been referred by an officer of the customer, or that the salesmen had stationery they could offer at a good price because another customer had died. They used these false stories to “get their foot in the door;” to get past the receptionist who answered the phone and speak to someone who could actually place an order. Once talking to that person, however, there were no lies — the price and quality of the merchandise was honestly discussed, the products sold were perfectly good products at a fair price, and the products could be returned if the customer was not satisfied.

The government charged Regent with multiple counts of wire fraud, based on the phony stories told during the initial phone conversations. Prosecutors argued that the customers were deprived of the opportunity to bargain with all of the true facts before them. The agents deceived the customers about who they were and why they were calling, causing the customers to enter into the transactions under false pretenses. Were it not for the lies, the sales would not have taken place. The government argued that this amounted to a scheme to defraud. The trial judge agreed and found Regent guilty.

The Court of Appeals reversed the convictions. The court noted it did not condone the deceitful conduct, which it said was repugnant to “standards of business morality.” But simply because it was repugnant did not mean it was fraud. Although the customers may have been deceived, the court held, they were not defrauded.

The government’s position was that fraud could exist in a commercial transaction “even when the customer gets exactly what he expected and at the price he expected to pay.” The court was not willing to go so far. Fraud, the court said, requires that some actual injury to the victim be at least contemplated by the schemer, and that was missing here. The misrepresentations by the Regent salesmen did not go to the quality, adequacy, or price of the goods. When the deal was concluded the customers had gotten exactly what they expected.

To constitute fraud, the court held, it is not enough that there be some deception involved somewhere in the transaction. The deception must be coupled with a contemplated harm to the victim that relates to the very nature or heart of the bargain itself. Any intangible or psychological “injury” that may have resulted here from the customers being deceived about the reason for the sales call was not the kind of injury that would support a criminal fraud conviction. The sales tactics may have been sleazy and unethical, but they were not criminal.

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“Buy Me a Drink, Mister?”  United States v. Takhalov

This distinction between being defrauded and merely being deceived still rears its head in cases today. This past summer, the U.S. Court of Appeals for the 11th Circuit addressed it in United States v. Takhalov. The defendants in Takhalov were owners of several nightclubs in South Beach, Miami. The clubs hired Eastern European women to pose as tourists, locate visiting businessmen, and convince them to accompany the women into the bars owned by the defendants. The defendants did not deny this was taking place, nor did they deny that the women concealed their relationship with the clubs from the men – in fact, they argued this was a perfectly legitimate business model.

The parties differed about what happened once the men were inside the club. According to the defendants, the men simply purchased food and alcohol and had drinks with their female companions. The government, on the other hand, contended that once inside the club other misconduct took place, including concealing the true prices of drinks and food, forging the men’s signatures on credit card receipts, and secretly adding vodka to the men’s beer so they would get drunk faster. The defendants claimed that if any of that was going on, they knew nothing about it.

The legal issue in the case was right out of Regent Office Supply. The government argued the jury could have convicted the defendants of fraud based simply on the lies the women told the men to lure them into the bar in the first place, regardless of what happened after the men got there. Had the men known the women were actually club employees rather than simply friendly strangers, they would not have entered the club. Any business conducted in the bar, therefore, took place under false pretenses and amounted to fraud.

The defendants, on the other hand, argued that if all the government proved was that the men were tricked into entering the bar, then the men would have been deceived but not defrauded. Although the women might have concealed their relationship with the club, once inside the club the men ordered food and drinks off the menu and got exactly what they expected to get at the price they expected to pay.

The Eleventh Circuit agreed with the defendants. The Court noted that the wire fraud statute “forbids only schemes to defraud, not schemes to do other wicked things, e.g. schemes to lie, trick, or otherwise deceive. The difference, of course, is that deceiving does not always involve harming another person; defrauding does.” A scheme to defraud, the court said, must involve misrepresentations that go to the nature of the bargain itself – usually lies that go to either the value or the characteristics of the goods in question. But if the defendant lies about something else, such as the reason he is willing to enter into the bargain at all, those lies will not amount to fraud — even if the victim would not have entered into the transaction otherwise. The victim in such a case is not injured in a way the law of fraud will recognize.

Just as in Regent, therefore, even if the “customers” in Takhalov were misled about the reason for beginning the transaction (entering the bar), once there, according to the defense, the men got exactly what they expected – food and cocktails with attractive women — at the price they expected to pay. Any misrepresentations that took place when the women concealed their relationship with the bar did not go to the heart of the bargain with the bar itself. The defense was entitled to have the jury instructed that if this was all the defendants did, they were not guilty of fraud. Because the jury instructions failed to make this clear, the court reversed the convictions.

Other Upcoming Issues in the Law of Fraud

As Takhalov demonstrates, the exact parameters of the offense of fraud continue to be litigated. In fact, in its first week of arguments this term, the U.S. Supreme Court is going to consider two cases involving different aspects of fraud. Shaw v. United States involves the proof required to establish bank fraud, and Salman v. United States, a case I wrote about here, will examine the elements of insider trading, a particular variety of securities fraud. I’ll have more about those cases in future posts, as the law of fraud continues to evolve.

Stay tuned – and stay out of South Beach nightclubs.

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White Collar Crime, Prosecutorial Discretion, and the Supreme Court

Does the Supreme Court still believe in prosecutorial discretion? A string of cases over the past few years has to make you wonder.

Prosecutorial discretion – the power to decide whether to bring criminal charges, who to charge, what crimes to charge, and how ultimately to resolve the case – is a fundamental component of the criminal justice system. The legislature enacts the laws but the executive branch enforces them, which includes making judgments about when and how to bring a criminal case.

On the macro level, this means setting national and local law enforcement priorities and making decisions about the deployment of finite prosecutorial resources. Different administrations at different times have declared areas such as health care fraud, narcotics, illegal immigration, or terrorism to be top priorities and have allocated resources accordingly. Such decisions necessarily mean other areas will not receive as much attention; a dollar spent fighting terrorism is a dollar that can’t be spent investigating mortgage fraud.

On the micro level, prosecutorial discretion involves deciding whether to pursue criminal charges in a given case and what charges to pursue. Factors such as the nature of the offense, strength of the evidence, the nature and extent of any harm, adequacy of other potential remedies, any mitigating circumstances or remedial efforts by the accused, and prosecutorial resources and priorities all may come into play.

For federal prosecutors, policies governing how they should exercise this discretion are set forth in the U.S. Attorneys’ Manual, and in particular in the Principles of Federal Prosecution. The Principles contain detailed guidance concerning when to bring charges, what kind of charges to bring, and how to handle criminal cases, in order to “promote the reasoned exercise of prosecutorial discretion by attorneys for the government.” USAM 9-27.110.

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Prosecutorial Discretion and White Collar Crime

Prosecutorial discretion is particularly important in white collar crime. With non-white collar, or “street” crimes, the parameters of the offense tend to be more clearly defined and charging decisions often are more black and white. If there is a body on the street with nine bullets in it, you pretty clearly have a homicide. If authorities can identify who did it, that person will almost certainly be charged. The prosecutor is not likely to say, “Due to our limited resources and other priorities, we’ll take a pass on this one and let the victim’s family file a civil suit instead” – not if the prosecutor wants to keep her job, anyway.

But white collar crime is full of gray areas. White collar prosecutors deal with sometimes nebulous concepts such as “fraud” and “corruption,” and white collar statutes are written in notoriously broad and general terms. As a result, it often falls much more to the prosecutor to determine whether something is a crime at all and to decide what kind of conduct merits a prosecution.

For example, suppose a hedge fund goes belly-up, and the investors who lost their money claim they were misled about their investment. Was it fraud, or was it merely aggressive – maybe even sleazy – sales tactics followed by incompetence, mismanagement, or just bad luck? Unlike a homicide, robbery, or drug case, at the outset it may not be clear that a crime has been committed. A prosecutor might well conclude, “If I investigated this for two years, perhaps at the end I would have a provable criminal fraud case – but perhaps not. Given my resources and priorities, I’m going to focus on other cases and let the SEC and private plaintiffs pursue civil and administrative penalties in this one.”

Given these potential gray areas, what’s the best way to deter and prosecute white collar crime? Imagine two different regimes. In System #1, Congress drafts broad statutes that proscribe conduct such as fraud in general terms, in order to encompass as much potentially criminal conduct as possible. It is left to the Executive Branch, through prosecutors, to enforce those statutes and determine which cases to pursue – with that discretion tempered, of course, by the oversight of the courts.

In System #2, Congress tries to write very precise and detailed statutes that are as specific as possible in defining the prohibited conduct. Such white collar statutes would leave fewer gray areas and less room for prosecutorial discretion – in other words, they would be more like street crimes. The downside of such a system would be that it necessarily creates loopholes: the more precisely you define criminal concepts like fraud, the greater the opportunity for individuals engaged in what should be criminal conduct to skirt the law’s prohibitions.

Historically, white collar criminal law has been closer to System #1: broad statutes prohibit things like fraud or corruption, and prosecutors are entrusted to exercise their discretion to determine how to apply those laws. But in a series of decisions over the past few years, the Supreme Court has signaled it is becoming increasingly uncomfortable with such a system. These decisions have limited several significant white collar statutes, moving us closer to System #2 – although with laws narrowed by the Court rather than by Congress. In the process, the Court has removed discretion from the hands of prosecutors while also making it more difficult to prosecute some criminal conduct.

The Supreme Court Limits Prosecutorial Discretion

The first such case was Skilling v. United States in 2010. Skilling involved the proper interpretation of 18 U.S.C. § 1346, which prohibits schemes to deprive another of the “intangible right of honest services.” Honest services fraud, a species of mail and wire fraud, has been around for decades. Most cases of honest services fraud have involved relatively straightforward allegations of corruption such as bribery, kickbacks, and conflicts of interest.

But prosecutors in some cases stretched the boundaries of the theory, using honest services fraud to prosecute, for example, a university professor who helped students plagiarize work to obtain degrees to which they were not entitled; an IRS employee who improperly browsed through certain tax returns but did nothing with the information; state officials who awarded public sector jobs based on political patronage; and a state official who failed to disclose a potential conflict of interest when state law did not require disclosure. Some of these schemes seemed wrong or dishonest but were far from traditional criminal corruption. The confusion over what actually qualified as a deprivation of honest services led Justice Scalia to argue in 2009 that the law was in a state of “chaos.”

The Supreme Court finally attempted to bring some order out of this chaos in Skilling. The defendant, former Enron CEO Jeff Skilling, argued that the honest services statute should be struck down as unconstitutionally vague, but the Court disagreed. Instead, it limited the law to what it deemed the core of honest services fraud: cases involving bribery and kickbacks.

The holding in Skilling dramatically narrowed the scope of honest services fraud. This successfully removed prosecutors’ ability to use the theory in innovative ways to charge more unusual schemes. But the limitation also created safe harbors for certain conduct, such as self-dealing by elected officials, that is plainly corrupt but may no longer be charged as a violation of honest services.

In 2014, the Supreme Court decided Bond v. United States. (Although not really a white collar case, Bond is instructive as part of the same trend at the Court.) In Bond a jilted wife tried to injure her husband’s lover by sprinkling some caustic chemicals on her mailbox and doorknob. The chemicals caused only a slight skin irritation on the woman’s thumb that was easily treated with cold water. Federal prosecutors subsequently charged Bond using a felony statute that prohibits the use of chemical weapons and carries a penalty of “any term of years” in prison.

The Court ultimately held that the statute did not apply to Bond’s conduct. But an undercurrent of the case was the Court’s obvious concern over the government’s decision to apply a federal law aimed at preventing the horrors of chemical warfare to such a trivial incident. During oral argument, Justice Kennedy told the Solicitor General that it “seems unimaginable that you would bring this prosecution.” Justice Alito remarked, “If you told ordinary people that you were going to prosecute Ms. Bond for using a chemical weapon, they would be flabbergasted.”

This trend continued in 2015 with Yates v. United States. Yates was a commercial fisherman working in the Gulf of Mexico. A fish and wildlife officer boarded his boat to conduct a routine inspection and ended up citing him for having several dozen red grouper on board that were slightly smaller than the legal limit – a civil violation. The officer told Yates to keep the fish until he returned to port, where they would be seized and destroyed. Once the officer left his boat, however, Yates instructed a crew member to throw the undersized fish overboard and replace them with larger ones.

When this ultimately came to light, prosecutors charged Yates with three crimes including obstruction of justice under 18 U.S.C. § 1519, a twenty-year felony. That law prohibits the destruction of “tangible objects” in an effort to obstruct a federal investigation. Captain Yates argued before the Supreme Court that fish were not “tangible objects” within the meaning of this statute. The Court ultimately ruled in his favor, but only by adopting what I believe was an unnatural and strained interpretation of the law.

But Yates is actually more significant for what it revealed about the Court’s views on prosecutorial discretion and charging decisions. During oral argument, the Justices were clearly disturbed by the application of a twenty-year felony to this fish-dumping episode. Justice Scalia asked what kind of “mad prosecutor” would charge Yates with a twenty-year offense, and sarcastically suggested perhaps it was the same prosecutor who had charged Bond with a chemical weapons violation. Later in the oral argument Justice Kennedy remarked, “It seems to me that we should just not use the concept [prosecutorial discretion] or refer to the concept at all anymore.”

The Court’s skepticism about prosecutorial discretion surfaced again this past spring in McDonnell v. United States. In reversing the corruption convictions of the former Virginia governor, the Court adopted a narrow definition of “official act” for purposes of federal bribery law. At oral argument and in its opinion the Court imagined federal prosecutors targeting elected officials for simply attending a lunch where a supporter bought them a bottle of wine, or for attending a ballgame as the guest of homeowners who earlier had sought the official’s help.

The narrow definition of “official act,” the Court concluded, was necessary to prevent politically-motivated prosecutions and the criminalization of routine political courtesies. But critics of the Court’s decision – including me – argue that the result is to shield a great deal of corrupt conduct that is precisely what the law of bribery aims to prevent.

The Future of Prosecutorial Discretion

In these recent cases, when faced with the interpretation of white collar crimes such as bribery, honest services fraud, and obstruction of justice, the Court’s approach has been to interpret the statutes narrowly and consequently to remove charging discretion from federal prosecutors. A moment during the Yates oral argument is particularly illuminating. The Justices asked Assistant Solicitor General Roman Martinez what guidance prosecutors followed when deciding what kind of charges to bring, and that led to this exchange:

MR.MARTINEZ:  Your Honor, the ­. . . my understanding of the U.S. Attorney’s Manual is that the general guidance that’s given is that the prosecutor should charge ­­once the decision is made to bring a criminal prosecution, the prosecutor should charge the ­­the offense that’s the most severe under the law. That’s not a hard and fast rule, but that’s kind of the default principle.  In this case that was Section 1519.

JUSTICE SCALIA:  Well, if that’s going to be the Justice Department’s position, then we’re going to have to be much more careful about how extensive statutes are.  I mean, if you’re saying we’re always going to prosecute the most severe, I’m going to be very careful about how severe I make statutes.

MR. MARTINEZ:  Your Honor, that’s ­­. . .

JUSTICE SCALIA:  Or ­­how much coverage I give to severe statutes.

MR. MARTINEZ:  That’s ­­– that’s not what we were saying.  I think we’re not always going to prosecute every case, and obviously we’re going to exercise our discretion. . . .

As Martinez attempted to point out, the real-world exercise of prosecutorial discretion is far more nuanced than Justice Scalia suggested. It’s true that the Principles of Federal Prosecution provide as a general rule – as they have for decades – that once a decision to bring charges is made a prosecutor generally should charge “the most serious offense that is consistent with the nature of the defendant’s conduct, and that is likely to result in a sustainable conviction.” USAM 9-27.300. But the Principles also recognize the need for prosecutors to consider the nature and circumstances of a particular case, the purpose of criminal law, and law enforcement priorities. What charges are “consistent with the nature of the defendant’s conduct” is also a matter of judgment and discretion. And of course considerable discretion also is involved earlier in the process, when deciding whether to bring charges at all.

But this exchange suggests the Court may believe it needs to interpret criminal statutes more narrowly because it cannot always trust prosecutors to exercise sound judgment when enforcing broadly-written statutes. As Justice Kennedy suggested during the Yates argument, it may be that the Court no longer thinks of prosecutorial discretion as a viable concept.

Of course, some critics of federal prosecutors will welcome this development and suggest it is long overdue. And some will point out that, for prosecutors, this may be considered a self-inflicted wound. The charging decisions in cases like Yates and Bond in particular may be what led the Justices openly to question whether prosecutors should continue to be entrusted with the same degree of discretion.

But it would be unfortunate if the Justices truly come to believe they cannot rely on prosecutors to exercise sound judgment in charging decisions. One can always argue about the merits of particular cases, but overall our system of broadly-written statutes enforced by the sound exercise of prosecutorial discretion has worked pretty well. If the Court continues to chip away at those statutes due to concerns about controlling prosecutors, it will continue to create safe harbors for some conduct that is clearly criminal.

It’s particularly inappropriate for the Court to limit these statutes based on hypotheticals that have no basis in reality, as it did in McDonnell. When we start seeing widespread prosecutions of politicians for accepting legal campaign contributions and attending Rotary Club breakfasts, then maybe we can talk about the need to curb prosecutorial discretion. But simply because we can imagine a parade of horribles based on the broad terms of a white collar statute does not mean that prosecutors are actually marching in that parade.

At the McDonnell oral argument, Justice Breyer noted that narrowing the definition of bribery might mean that a certain amount of corrupt conduct will go unpunished. Unfortunately, for now that appears to be a risk the Court is willing to take.

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