Bad, But Not Otherwise Criminal: A Review of the Honest Services Law and Guide for Management
By Josh Shilts CPA/CFF, CFE, Laurie Holtz, CPA &
In 1987 the federal mail and wire fraud statute was amended by the "honest services" provision which made self-dealing by public officials and private individuals acting in a fiduciary capacity punishable by fine or imprisonment of up to 20 years.2 Prior to the Supreme Courts’ recent ruling in Skilling v. United States,3 the "honest services" provision was broadly enforced against politicians, public company officers, and even employees, for acts ranging from undisclosed conflicts of interest and other breaches of fiduciary duties, to acts amorphously described as those lacking integrity.4 In other words, an "honest services" offense was used as a "catch all charge against allegedly corrupt behavior instead of sticking to the more precisely defined offenses of bribery and kickbacks."5 On June 24, 2010, however, the Skilling decision limited honest services offenses to bribes and kickbacks,6 adding clarity to what was once a very unclear federal offense.
Despite Skilling’s limitation of what constitutes a punishable "honest services" offense, management has the responsibility to identify and react appropriately to ensure that dishonest acts do not have a negative impact on the business of for profit or not for profit entities (e.g. local, state and federal government entities, charitable organizations, etc.). This article will provide a brief history of the honest services law and will discuss how management, rather than lawmakers, are in the best position to combat fraud and other dishonest acts. It will also address the steps management can take to reduce the risk of said acts. Whether criminal or not, fraudulent and dishonest acts can have disastrous impacts on an entity, and it is in management’s best interest to take an active role in preventing such acts from occurring.
The honest services law was spurred into existence by a 1987 Supreme Court decision, McNally v. United States, which limited the federal mail and wire fraud statute (18 U.S.C §1341 et. seq.) strictly to schemes to defraud victims of tangible property, including money.7 The honest services law is an addendum to 18 U.S.C §1341, which was enacted by the US Congress in 1988 in direct response to McNally’s limitation.8 This addendum to the statute broadened a federal prosecutor’s enforcement options to punish any perpetrators of a "scheme or artifice to deprive another of the intangible right of honest services."9 Given its vagueness, §1346 created a large platform for federal prosecutors to seek convictions against both public officials and private individuals.
The honest services law has been used by the government to prosecute local, state and federal officials, as well as private individuals. Public officials have been convicted under §1346 for a wide array of unethical conduct, including briberies and failures to disclose conflicts of interest, and other breaches of fiduciary duties resulting in personal gain.10 Prosecutions and convictions of private individuals under this statute best illustrates the formerly broad scope of §1346.11 Recent, notable prosecutions and convictions of private individuals and public officials under the honest services law include those of Jeffrey Skilling, Enron CEO, and Conrad Black, the newspaper mogul, as well as the roundup of approximately 40 politicians and government contractors in New Jersey in July 2009. Interestingly, it was Skilling’s appeal, which focused on the vagueness of the interpretations of the honest services law, to the US Supreme Court that led to the court’s recent limitation of §1346 in the Skilling decision.
Skilling’s attorney, Daniel Petrocelli of O’Melveny & Myers, has stated that the Supreme Court’s decision in Skilling will have "profound implications for every workplace in this country [because] [a]ll employees are now free from the risk of the government criminalizing behavior that does not clearly violate the laws."12 Mr. Petrocelli’s comments should alert management to two things. First, that the government’s leash on preventing fraudulent and dishonest behavior from affecting businesses has slackened under §1346 - thus, management should take on a greater role in precluding such behavior. Second, that management must communicate to employees the consequences of committing fraudulent and dishonest acts.
The subprime mortgage debacle involving dishonesty by mortgage brokers, financial institutions, appraisers and others who knowingly arranged financing for individuals with no credit, steady income or an ability to pay is a prime example how dishonest acts, and failure to recognize and curb their detrimental effects, can ruin a business and (in the case of subprime mortgages) an entire economy. Despite early warning signs, lawmakers did not recognize the potential effects of the subprime scandal. For example, a member of the House Financial Services Committee was quoted in October 2007 as saying: "I don't have any information that makes me think that [the failure of two banks is] a harbinger of more failures."13 House Financial Services Committee Chairman, Barney Frank, D-Mass., said he had "not seen any sign that we are on the verge of a bunch of bank failures."14 These comments demonstrate how dishonest acts that are not overtly fraudulent can go unnoticed and unchecked by the government before their devastating effects occur. Thus, management is in the better position to take into account the potential for any risks of dishonest acts, fraud included, that can affect their organization, because of management’s intimacy with, and knowledge of, the operations of their entity.
Given the loosening of enforcement options under §1346, and the lessons learned from the subprime mortgage debacle, it is up to management to evaluate and utilize resources such as forensic accountants to help prevent, detect and combat fraud and dishonest acts. Management’s sensitivity towards preventing and combating dishonest acts should be heightened because such acts can result in significant financial costs and negative exposure for an organization.
MarcumRachlin’s experienced professionals can help management identify the risks of fraudulent and dishonest acts and have the tools and resources to assist management in preventing and detecting such acts. Further, MarcumRachlin has the skills needed for aiding management in developing the appropriate controls to reduce the risk of fraudulent or dishonest acts from occurring.
Management must protect the assets and reputation of the organization for which they are responsible. It is also their responsibility to properly define what a dishonest service is to the organization as well as implement policies to define the consequences that go along with the dishonest service. The proper notification of an organization’s policy can be a strong deterrent to mitigate the risk of fraud and dishonest services.
The most effective and proven way to mitigate fraud or other "dishonest" acts is to implement risk mitigation solutions.15 Risk mitigation solutions can include internal control, internal audit, anti-fraud programs and continuous monitoring programs. An effective internal control program should rank risks to identify the significance and likely impact on the business. Continuous monitoring includes testing the operating effectiveness of internal controls and includes such activities as video surveillance, surprise cash counts, analytic review, surprise audits and a variety of other techniques. Proper development of an internal audit function can assist management in providing internal control, risk management and continuous monitoring techniques. Anti-Fraud programs consist of hotlines as well as procedures to investigate reported fraud and should be designed to assist management and internal counsel with appropriately addressing possible criminal or civil violations.
MarcumRachlin professionals are skilled at assisting for profit organizations and not for profits in implementing risk mitigation programs that are appropriately tailored for their entity. Further, MarcumRachlin’s Public Trust Group has assisted local, state and federal entities as well as for profit organizations and other not for profit entities in applying risk mitigation solutions. Drawing on this experience, MarcumRachlin’s Public Trust Group is well prepared to assist your organization in combating fraud and dishonesty both proactively with the establishment of appropriate risk mitigation solutions and through investigations when improper activity is suspected.
Management cannot rely solely on lawmakers, regulators or the courts to protect their organization from fraud. No criminal ever thought of the honest services law before they committed a theft or dishonest act. Implementing risk mitigation solutions and hiring the right professionals can significantly reduce the risk of fraud and assist the business in the recovery process in the event that fraud does occur.
118 U.S.C. §1341, et. seq.
2See 18 U.S.C. §1346.
32010 U.S. LEXIS 5259, at *105 (2010).
4See Frank C. Razzano & Kristin H. Jones, Prosecution of Private Corporate Conduct: The Uncertainty Surrounding Honest Services Fraud, 18 ABA BUSINESS LAW SECTION 3, Jan./Feb. 2009, http://www.abanet.org/buslaw/blt/
5See Jess Bravin, Justices Limit Fraud Law: Court Rules Prosecutors Overreached in Convictions of Enron’s Skilling, Others, THE WALL STREET JOURNAL, Jun. 25, 2010, http://online.wsj.com/article/
6See supra, note 2.
7See McNally v. United States, 483 U.S. 350, 360 (1987).
8Valerie D. Nixon, Our Intangible Right To 'Honest Services' by Public Officials, NORTH COUNTRY GAZETTE, Jun. 13, 2006, http://www.northcountrygazette.org/articles/061306HonestServices.html. See also Razzano & Jones, supra note 4.
918 U.S.C. §1346 (emphasis added).
10See Nixon, supra note 8.
11See Razzano & Jones, supra note 4 (indicating that convictions under §1346 have been secured or targeted against many types of private individuals including: corporate officers and directors for entering their company into contracts with entities in which they held an undisclosed interest; employees for accepting gratuities from suppliers selling products to their employer; attorneys for representing clients competing with another firm client in securing a contract; issuers of securities for paying brokers additional compensation for selling the issuers stock where the broker failed to disclose this compensation to their customers; and physicians who referred patients to facilities from which referral fees were received by the physicians).
12See Bravin, supra note 5.
13Joe Adler & Rob Blackwell, Subprime Hits Cited as a Second Bank Fails, AMERICAN BANKER, Oct. 5, 2007, http://188.8.131.52/article.html?id=20071004CBOUN1YG.
15For a more detailed discussion of the risk mitigation solutions that MarcumRachlin can provide, please refer to the unabridged version of this article.