A cocktail of events — including the economic downturn, financial scandals rooted in events that sometimes escaped the initial attention of regulators, and media-friendly criminal trials involving a mix of high-profile professionals and wiretap evidence that historically has been reserved for prosecuting more traditional criminal organizations — has helped fuel the stated desires of Congress and the executive branch to combat securities fraud more aggressively. One consequence of this phenomenon is that the U.S. Federal Sentencing Guidelines, which govern federal sentencing hearings, will soon set forth several new provisions that seek to “crack down” on securities-related offenses.

Each year, the U.S. Sentencing Commission promulgates amendments to the guidelines that become effective automatically, absent intervention by Congress. Consistent with directives issued to the commission via the Dodd-Frank Wall Street Reform and Consumer Protection Act, this year’s crop of amendments, set to take effect on November 1, include several revisions to the guidelines that govern sentences for convictions involving securities fraud and insider trading. The most important amendment, discussed immediately below, pertains to the definition of “actual loss” in securities cases, the critical starting point for determining a defendant’s advisory guidelines sentencing range. Other amendments, discussed further herein, share the goal of enhanced punishment but appear less likely to have much practical effect on sentencing outcomes in securities cases.

Actual Fraud Loss for Securities Fraud

This year’s guidelines amendments seek to standardize the calculation of actual financial loss — defined as the reasonably foreseeable pecuniary harm that resulted from the offense — in cases involving the fraudulent inflation or deflation in the value of a publically traded security or commodity. This amendment is important because the severity of the advisory guidelines range for fraud convictions, including securities fraud, is driven largely by the amount of monetary loss involved in the crime. For example, an actual loss of $100,000 typically translates to an initial advisory guidelines range of 18 to 24 months’ imprisonment (absent any enhancements or reductions), while a loss of over $1 million more than doubles this range to 46 to 57 months.

Given the significant impact that the loss calculation has on a defendant’s potential sentence, the commission was concerned that the varying and often complex methods used by federal courts to calculate actual loss in securities fraud cases were possibly contributing to unwarranted sentencing disparities. Thus, the commission is amending the fraud guideline, Section 2B1.1 (Theft, Property Destruction and Fraud), to create an application note setting forth a rebuttable presumption that actual loss is the difference between the average price of the security during the period that the fraud occurred and the average price of the security during the 90-day period after the fraud was disclosed to the market, multiplied by the number of outstanding shares. This methodology is known as the modified rescissory method.

A chief concern with calculating actual loss is that market forces unrelated to the fraud — like a sudden downturn in the market or poor quarterly earnings — can make it appear as if the fraud caused more harm than it actually did, thereby unfairly increasing a defendant’s advisory guidelines range. A purported advantage of the modified rescissory method is that it attempts to minimize the impact of these external market forces by averaging the post-fraud price across a relatively lengthy (90-day) swath of time, which in theory helps to dilute the effect of any day-to-day market volatility. Another advantage cited by some courts, as well as the Department of Justice, is that this loss formula is relatively easy to calculate using publically available trading data, which can obviate the need for extensive expert testimony and fact-finding.

Critics of the modified rescissory method, including the Federal Public and Community Defenders, urged the commission during the comment period to approve the market-adjusted method as adopted in both the Second and Fifth Circuits (and cited favorably in the Third Circuit). Like the modified rescissory method, the market-adjusted method calculates loss based on the securities’ change in value after the fraud. The critical difference is that the market-adjusted method specifically excludes any changes in value that were caused by external market forces unrelated to the fraud, such as a widespread market crash. It requires specific consideration of the impact of actual market factors, as opposed to the modified rescissory method’s reliance on an average post-fraud price over a seemingly arbitrary 90-day window. In practice, courts applying the market-adjusted method look to expert opinion as well as considerations of both the general market and any relevant market segment. In this way, advocates of the market-adjusted method believe that it more accurately captures the loss actually caused by the fraud, thereby resulting in a fairer sentence.

The commission’s amendment attempts to address these competing concerns by making the modified rescissory method a rebuttable presumption of actual loss, stating that “the court may consider, among other factors, the extent to which the [loss] amount so determined includes significant changes in value not resulting from the offense (e.g., changes caused by external market forces, such as changed economic circumstances, changed investor expectations, and new industry-specific or firm-specific facts, conditions, or events).” Thus, courts retain discretion to filter out external market conditions from a loss calculation to attain a more reasonable estimate.

It remains to be seen whether courts will now adhere strictly to the rebuttable presumption, or whether they will give the parties significant leeway to argue the impact of specific external factors. Nonetheless, the adoption of the modified rescissory method appears to invite a decrease in the incidence of reliance on evidence of external market factors. Some sentencing judges, now provided with a clear and simple rule endorsed by the guidelines, may be less inclined to credit extensive offers of proof and expert testimony regarding actual loss.

Market Jeopardy Enhancements

Beyond establishing a definition of actual loss, the commission promulgated several additional amendments at the urging of Dodd-Frank, many of which focus on increased punishment in securities fraud cases. Although the spirit of each of these additional amendments is clear — enhanced punishment — their likely practical effect is not so clear. Many of the following refinements are slight or arguably redundant in light of current sentencing practices.

One amendment seeks to enhance the advisory guidelines ranges of those whose criminal conduct has jeopardized either large or publically traded companies, or the market itself. Section 2B1.1(b)(15)(B) of the current guidelines already provides a four-level enhancement if the financial crime substantially jeopardized the safety and soundness of a financial institution or an organization that is publically traded or has 1,000 or more employees. Factors to consider when applying this enhancement include whether the entity became insolvent, whether it had to reduce the value of its employees’ retirement accounts and whether it had to substantially reduce its workforce. In a nod to the financial and political realities of the economic downturn, the commission has amended the application note for this provision to make clear that this enhancement still can apply notwithstanding the fact that the victim entity avoided any of these negative repercussions due to “government intervention, such as a bailout.”

Further, Section 2B1.1′s application note regarding upward departures from the advisory guidelines range now specifically states that courts may consider the “risk of a significant disruption of a national financial market” as a reason for increasing a defendant’s sentence beyond the otherwise recommended range. The commission’s commentary explains that this amendment responds to Dodd-Frank’s concern that financial crime sentences “account for the potential and actual harm to the public and the financial markets.” What exactly qualifies as such a significant risk is not defined. Although the tenor of this amendment obviously stresses the need for increased punishment in extraordinary cases, it does not appear likely to make much practical difference in the current federal sentencing regime, in which courts already have broad authority to vary upwards or downwards from the guidelines due to a variety of factors.

Insider Trading Amendments

Consistent with Dodd-Frank’s focus on Wall Street reform, the commission’s amendments also add a new offense characteristic, Section 2B1.4(b)(2), for defendants involved in “an organized scheme to engage in insider trading.” This offense characteristic applies to schemes that involve “considered, calculated, systematic, or repeated efforts to obtain and trade on inside information, as distinguished from fortuitous or opportunistic instances of insider trading.” A non-exhaustive list of factors that courts may consider in determining the existence of such a scheme includes the number of transactions involved, the dollar amount of the transactions, the number of securities involved, the duration of the offense, the number of participants, the extent of the efforts taken to obtain material nonpublic information and any efforts to conceal the offense.

Qualifying defendants receive a minimum offense level of 14, which translates to an advisory guidelines range of 15 to 21 months’ incarceration in the absence of any other adjustments, including acceptance of responsibility. The purpose of this amendment is to provide a floor offense level for certain defendants; it does not otherwise provide any additional offense level enhancements, such as by providing a two-level offense level increase for all qualifying defendants if their base offense level is already 14 or higher.

In practice, this amendment may have little if any impact on the punishment meted out in the type of organized, sophisticated schemes that it seeks to target. As noted, its purpose is to ensure a minimum punishment for defendants who display certain aggravating characteristics. However, under the traditional loss analysis, defendants involved in an insider trading scheme involving a loss of more than $30,000 are already subject to an offense level of 14 or higher. Thus, this amendment’s only impact will be on those defendants charged with insider trading schemes producing a relatively minor loss of $30,000 or less. These minor cases are presumably less likely to involve the type of “calculated, systematic, or repeated” conduct that is necessary for this offense characteristic to apply. Conversely, insider trading schemes that are truly “calculated, systematic, or repeated” in nature are likely to generate losses well above $30,000, and therefore already will involve an offense level of 14 or higher, regardless of this amendment.

Another amendment targets financial industry professionals who use their positions to facilitate illegal insider trades by adding an application note to the longstanding enhancement for a defendant’s role in the offense. Specifically, an application note to Section 2B1.4 will state that the two-level enhancement under Section 3B1.3 (titled “Abuse of Position of Trust or Use of Special Skill”) can apply to those who use their positions to facilitate or conceal insider trading violations. According to the amendment, the examples of professionals who might qualify for this enhancement include “a hedge fund professional who regularly participates in securities transactions or a lawyer who regularly provides professional assistance in securities.”

This amendment does not appear to alter current sentencing practices, because Section 3B1.3 already applied potentially to such professionals. Further, the new language clarifies that the enhancement “ordinarily would not apply to a position such as a clerical worker in an investment firm, because such a position ordinarily does not involve a special skill.” Arguably, this amendment may actually assist certain defendants, by making it clear that the enhancement does not reflexively apply whenever the defendant worked at a business dealing with securities. •

Peter D. Hardy and Matthew T. Newcomer are attorneys in the Philadelphia office of the law firm of Post & Schell, and are part of the firm’s white-collar defense, internal investigations and corporate compliance practice. Hardy is the author of Criminal Tax, Money Laundering, and Bank Secrecy Act Litigation, a legal treatise published by Bloomberg BNA.