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United States of America v. Sandra Hatfield and David H. Brooks

June 14, 2011

UNITED STATES OF AMERICA,
v.
SANDRA HATFIELD AND DAVID H. BROOKS, DEFENDANTS.



The opinion of the court was delivered by: Seybert, District Judge:

MEMORANDUM AND ORDER

Pending before the Court is the Government's motion to enter a preliminary order of forfeiture against Defendants David

H. Brooks and Sandra Hatfield. For the following reasons, the Court GRANTS this motion IN PART and DENIES this motion IN PART. However, the Court does not issue any specific forfeiture award at this time. Instead, it RESERVES JUDGMENT IN PART and hereby requests supplemental calculations and briefing consistent with this Order.

BACKGROUND

In October 2007, the Government charged Mr. Brooks and Ms. Hatfield with numerous crimes, including securities fraud, mail fraud, and wire fraud. In connection with this prosecution, the Court restrained numerous bank accounts as potentially subject to criminal forfeiture. The Court also issued seizure warrants directed at various pieces of personal property, including three automobiles, 6,007,099 shares of Point Blank Solutions, Inc., gold watches, designer pens, and a jewel-encrusted American flag belt buckle.

On September 14, 2010, the jury convicted Mr. Brooks on counts 1-11 and 15-17 of the Indictment, including all counts that alleged securities fraud, mail fraud, wire fraud, and/or conspiracy to commit those crimes. The jury convicted Ms. Hatfield on counts 1-3 and 12-16 of the Indictment, but acquitted her on counts 4-5. In so doing, the jury convicted Ms. Hatfield on all counts that alleged securities fraud, and conspiracy to commit securities, mail and wire fraud. But it acquitted her on the direct mail and wire fraud counts.

The parties agreed to waive their rights to a jury trial on forfeiture. So, in November 2010, the Court conducted protracted non-jury forfeiture proceedings. It then permitted the parties to submit lengthy post-hearing briefs, with reply submissions not coming in until April 14, 2011.

DISCUSSION I. Standard of Review

The Government seeks forfeiture under 18 U.S.C. § 981(a)(1)(C), which authorizes forfeiture of "[a]ny property . . . which constitutes or is derived from proceeds traceable to" many kinds of offenses, including securities fraud. 18 U.S.C. § 981(a)(1)(C). "Because criminal forfeiture is viewed as part of the sentencing process, the government need prove facts supporting forfeiture only by a preponderance of the evidence." United States v. Gaskin, 364 F.3d 438, 461 (2d Cir. 2004) (internal citations omitted).

"The calculation of forfeiture amounts is not an exact science." United States v. Treacy, 639 F.3d 32, 48 (2d Cir. 2011). Thus, "[t]he court need not establish the loss with precision but rather need only make a reasonable estimate of the loss, given the available information." Id. (internal citations and quotations omitted). And, consequently, the Court "is permitted to use general points of reference as a starting point for calculating the losses or gains from fraudulent transactions and may make reasonable extrapolations from the evidence established by a preponderance of the evidence at the sentencing proceeding." Id.

II. The Court's April 21, 2010 Order

The Government first argues that the Defendants must forfeit every penny of revenue stemming from their insider stock sales, and that the Court's April 21, 2010 decision erred in holding otherwise. In that decision, the Court held that only the "difference between the stock's inflated value, and what it would have sold for absent the fraud" is subject to forfeiture.

2010 WL 1685826 at *3, 2010 U.S. Dist. LEXIS 39618 at *10. For the following reasons, the Court's April 21, 2010 Order stands and the Government's argument is rejected.

A. The Government's Previous Reconsideration Motion

On June 30, 2010, the Government sought reconsideration of the April 21 Order. On August 3, 2010, the Court denied the Government's motion by Electronic Order. The Court promised to explain its reasoning in a written opinion, which it intended to complete shortly after the August 3 Electronic Order. Regretfully, the Court's demanding docket (including protracted proceedings in this case) prevented it from finishing this work. Nevertheless, to keep its promise, the Court explains its decision now.

i. Standard of Review

Although the federal and local rules of criminal procedure do not specifically provide for motions for reconsideration, courts in this Circuit have applied Local Civil Rule 6.3 in criminal cases. See, e.g., United States v. Aleynikov, 10-CR-96, 2011 WL 939754, at *10 (S.D.N.Y. Mar. 16, 2011); United States v. Yannotti, 457 F. Supp. 2d 385, 388-89 (S.D.N.Y. 2006).

Under this standard, a motion for reconsideration will generally be denied unless "the moving party can point to controlling decisions or data that the court overlooked - matters, in other words, that might reasonably be expected to alter the conclusion reached by the court." In re BDC 556 LLP, 330 F.3d 111, 123 (2d Cir. 2003) (citation omitted); Aleynikov, 2011 WL 939754 at *10. "Local Rule 6.3 is narrowly construed and strictly applied so as to avoid repetitive arguments on issues that have been considered fully by the court." Yannotti, 457 F. Supp. 2d at 389 (internal citations and quotations omitted).

ii. The Government's Statutory Argument

The Government's reconsideration motion principally argued that the Court "overlooked a number of cases that implicitly" favor its position. See Docket No. 1144 at 3. But, overwhelmingly, the Government cites to district courts, other circuits, and Second Circuit summary orders. See generally id. at 3-4. Thus, even if the Court agreed with the Government that these cases support its argument (and it does not), these authorities cannot justify reconsideration. For, as noted above, the moving party must point to "controlling decisions," to obtain reconsideration. In re BDC 556 LLP, 330 F.3d at 123. Decisions of other district court judges and sister circuits are not "controlling" authority. Similarly, the Second Circuit's own rules declare that its summary orders "do not have precedential effect." Second Circuit Local Rule 32.1.1(a).

The Government does cite a few published Second Circuit opinions. But these cases are either inapposite, or actually strengthen the Court's own reasoning. For the sake of completeness, the Court discusses each of these cited authorities below:

a. United States v. Awad, 598 F.3d 76 (2d Cir. 2010), applies forfeiture law in a narcotics case. It does not address how to calculate forfeiture in the context of insider stock sales. And it stands only for the non-controversial proposition that a defendant is subject to forfeiture "irrespective of his assets at the time of sentencing." Id. at 79. Nothing in the Court's April 21 Order held otherwise. b. United States v. Zvi, 168 F.3d 49, 56 (2d Cir. 1999), is equally inapposite. Indeed, it references forfeiture only insofar as it reverses a forfeiture judgment because the underlying money laundering counts were time barred. And, though the Government cites it for how it defines "proceeds" under the wire fraud statute, that definition actually supports the Court's April 21 ruling. Specifically, the Second Circuit concluded that monies obtained through gold sales that preceded the filing of a false insurance claim were the scheme's "proceeds." The Second Circuit reasoned that, because the defendants used the insurance money to "pay creditors and consignors," the "pre-robbery sale of gold represented the defendants' take from the scheme." Id. In effect then, the Second Circuit defined "proceeds" as the scheme's fraudulent profits. So to here: Defendants' "take" from their underlying securities frauds was the amount that these frauds inflated DHB's stock price -- not DHB's entire market value.

c. United States v. Lizza Industries, Inc., 775 F.2d 492, 498 (2d Cir. 1985), also augments the Court's April 21 holding. In this case, the Second Circuit held that RICO forfeiture depends upon "gross, rather than net profits." In so holding, the Second Circuit recognized that this method of calculation "leaves open a possibility that defendants will be forfeiting profits that they would have made outside of their criminal activities." Id. But, the Second Circuit held, "This should not cause us to scuttle the method of computing forfeiture" because forfeiture "is a punitive, not a restitutive, measure" and "does not require the prosecution to prove or the trial court to resolve complex computations, so as to ensure that a convicted racketeer is not deprived of a single farthing more than his criminal acts produced." Id.

Contrary to the Government's thinking, Lizza Industries does not endorse seizing a convicted Defendant's property willy-nilly, without proving that the Defendant obtained this property "as the result of the commission of the offense." 18 U.S.C. § 981(a)(2)(A). Instead, it views calculating a defendant's true ill-gotten gains as an ideal, but recognizes that this ideal might not always be obtainable or practical. 775 F.2d at 498 ("[c]onced[ing]" that its holding "leaves open a possibility" of the defendant forfeiting more than he illicitly earned). And it instructs district courts, when faced with imprecise measurements, to risk error in the Government's favor, reflecting forfeiture's punitive nature. Id. (no need to "ensure that a convicted racketeer is not deprived of a single farthing more than his criminal acts produced").

Consistent with Lizza Industries, the Court will not worry if this Order over-calculates Defendants' forfeiture liability by farthings. But the Court sees nothing in Lizza Industries to justify awarding the Government every farthing from the Defendants' stock sales, especially if most of that cash reflected the stock's bona fide value, not fraudulent appreciation "result[ing]" from "the commission of the offense."

18 U.S.C. § 981(a)(2)(A). iii. The Government's Eighth Amendment Argument

The Government also argues that the Court's April 21 opinion erred by conducting a "premature" Eighth Amendment analysis. The Government is wrong. The Court considered the Eighth Amendment as part of its statutory interpretation efforts. See 2010 WL 1685826 at *4; 2010 U.S. Dist. LEXIS 39618 at *11-12. This was not "premature"; it was required. For, when faced with dueling statutory interpretations, courts should construe a statute to avoid serious constitutional problems. Id. (citing U.S. v. Colavito, 19 F.3d 69, 71 (2d Cir. 1994)); Edward J. DeBartolo Corp. v. Florida Gulf Coast Bldg. and Const. Trades Council, 485 U.S. 568, 575, 108 S. Ct. 1392, 99 L. Ed. 2d 645 (1988) ("where an otherwise acceptable construction of a statute would raise serious constitutional problems, the Court will construe the statute to avoid such problems unless such construction is plainly contrary to the intent of Congress").

In any event, the Court's Eighth Amendment analysis was not dispositive. The Court found the Government's proposed interpretation "untenable" not just on constitutional grounds, but also as a matter of "statutory construction." 2010 WL 1685826 at *4; 2010 U.S. Dist. LEXIS 39618 at *13. Specifically, the Court noted that the Government's interpretation ignored § 981(a)(2)(A)'s language that limits forfeiture to property acquired "as the result of the commission of the offense."

Thus, the Government failed to meet the high burden necessary to support reconsideration. So the Court denied this motion.

B. United States v. Treacy

Setting aside whether reconsideration was appropriate last August, the Court must still consider whether intervening Second Circuit authority has impacted its analysis. In this regard, both parties point to the Second Circuit's recent decision in Treacy, referenced earlier in this opinion.

In Treacy, the Second Circuit addressed forfeiture in a securities fraud case arising from stock option backdating. The Government sought forfeiture under 18 U.S.C. § 981(a)(1)(C), the same statute it charges in the Indictment here. Compare Treacy, 639 F.3d at 40-41 with April 21 Order, 2010 WL 1685826 at *2; 2010 U.S. Dist. LEXIS 39618 at *6-7. But unlike here, in Treacy the Government did not claim that the defendant's securities fraud required him to forfeit 100% of the cash he generated when he exercised and then sold backdated options. Instead, the Government sought only the net profits the defendant earned because of the fraudulent conduct. The parties dispute, then, concerned the appropriate "measurement date" for valuing the stock options the defendant received. See id. at 41. The Second Circuit held that the district court committed "error" when it chose one measurement date, and remanded "for recalculation of the appropriate forfeiture." Id. at 44.

The Government argues, curiously, that Treacy does not "stand for the proposition that the Government may forfeit only the net profits, not the gross proceeds, of insider trading." Docket No. 1435 at 4. But, in this regard, the Government argues only that "for reasons wholly unrelated to this case, the government [in Treacy] took an extremely conservative approach to the forfeiture calculation" and thus did not ask the district court or the Second Circuit to interpret § 981(a)(1)(C) as requiring the forfeiture of a securities fraud's "gross proceeds." Id. at 5.

The Government's position is, frankly, bizarre. A statute does not mean one thing as to one defendant, and an entirely different thing with respect to a less favored defendant. Central to Due Process is that courts must interpret the same statute "consistently," regardless of what the context is, or who is on trial. Leocal v. Ashcroft, 543 U.S. 1, 12 n. 8, 125 S. Ct. 377, 160 L. Ed. 2d 271 (2004). Indeed, as Judge Richard Posner has opined, "The rule of law means that judges" must "decide cases 'without respect of persons,' that is, without considering the social status, attractiveness, etc. of the parties or their lawyers."*fn1 Here, the Government argued before the Second Circuit that § 981(a)(1)(C) means one thing, and the Second Circuit adopted and applied that interpretation in a published order that binds this Court. The Government may not, necessarily, be estopped from challenging that interpretation in another case before the Second Circuit. See generally Nat'l Fed'n of Fed. Employees, Local 1309 v. Dep't of Int., 526 U.S. 86, 108, 119 S. Ct. 1003, 143 L. Ed. 2d 171 (1999) (administrative agencies not estopped from changing their interpretations of a statute, but affording revised interpretations less deference). But, for now, and in this lower Court, Treacy precludes the kind of indiscriminate seizure the Government desires.

Applying Treacy, the Court concludes that it commands the same standard the Court adopted in its April 21 Order. The only "difference" in Treacy's approach reflects the disparate facts between that case and this one: fraudulent price deflation at acquisition v. fraudulent price inflation at sale. Treacy, as an options backdating case, required the district court to properly calculate what the options' strike price would have been, absent the fraud. This case, on the other hand, arises from illegal insider sales. Thus, it requires the Court to calculate what Defendants' shares would have sold for, absent the fraud. Under both metrics, the Court must distinguish property that the Defendants fraudulently acquired from property that the Defendants would have acquired anyway, legitimately.

Thus, the Court finds that Treacy does not change its April 21 analysis.*fn2 So, as before, the Court finds that only the "difference between the stock's inflated value, and what it would have sold for absent the fraud" is subject to forfeiture. 2010 WL 1685826 at *3; 2010 U.S. Dist. LEXIS 39618 at *10.*fn3

III. What Should Be Included In Forfeiture?

A. Mr. Brooks' Liability for Inflated Inventory

The Indictment*fn4 alleged that DHB overvalued its

Interceptor Vest Inventory during the 2003 and 2004 fiscal years, spanning the calendar years 2003-2005. Indictment ¶ ¶ 25-27. The Indictment alleged that the overvalued inventory inflated earnings from $19.6 million to $26.2 million in 2003, and from $34.4 million to $48.2 million in 2004. Id. at ¶ 27. The Indictment similarly alleged that the overvaluation inflated gross profit margin from 21% to 28% in both fiscal years. Id. at ¶ 27. And the Indictment further alleged that a DHB employee (identified at trial as Travis Brooks) "repeatedly informed" Ms. Hatfield in November 2004 that the inventory was overvalued, but that Ms. Hatfield refused to take action. Id. at ¶ 25.

After considering the Defendants' Rule 29(a) motions, the Court agreed that the Government had sufficiently evidenced that DHB materially inflated the value of its Interceptor Vest Inventory. See 724 F. Supp. 2d at 327-328. However, the Court noted that the Government's opposition to Mr. Brooks' motion "point[ed] to no testimony indicating that Mr. Brooks had knowledge of the allegedly overvalued inventory before his 2004 trades," though substantial evidence linked Ms. Hatfield to this fraud. Id. at 328. Thus, after providing the Government with an opportunity to show cause, the Court acquitted Mr. Brooks "of the insider trading charges to the extent that those charges are predicated on DHB's allegedly overvalued inventory." 2010 WL 2838525 at *2; 2010 U.S. Dist. LEXIS 72297 at *5. The Court's Order did not, however, extend to the Indictment's conspiracy to commit securities fraud count.

On October 18, 2010, in connection with the upcoming forfeiture trial, the Court denied a motion from Mr. Brooks that, among other things, argued that he could not be ordered to forfeit assets obtained through the Interceptor Vest Inventory Scheme. See 2010 WL 4177159; 2010 U.S. Dist. LEXIS 111084. Although denying Mr. Brooks' motion, the Court expressed "concerns" regarding the Government's theory that it could use the Interceptor Vest Inventory Scheme to support forfeiture without proving, by a preponderance of the evidence, that Mr. Brooks knew about this scheme before he traded. 2010 WL 4177159 at *7; 2010 U.S. Dist. LEXIS 111084 at *20-21. Notwithstanding this Order, the Government adduced no evidence at the forfeiture trial that reflects Mr. Brooks' knowledge of the scheme.

The parties disagree about the scope of the Court's prior orders, which the Court acknowledges could have been clearer. Mr. Brooks argues that the Court's prior orders preclude a forfeiture awarded predicated, in part, on the Interceptor Vest Inventory scheme. The Government, conversely, alleges that Mr. Brooks has incurred forfeiture liability for the Interceptor Vest Inventory scheme because he entered into a conspiracy to commit securities fraud, and thus is liable for his co-conspirator's acts.

The Court agrees with the Government. A conspiracy's proceeds are subject to forfeiture. See United States v. Capoccia, 402 Fed. Appx. 639, 641 (2d Cir. 2010). And a defendant incurs forfeiture liability for the "proceeds of the entire conspiracy," including acts that the defendant was not personally responsible for. United States v. Sanchez, 2011 WL 1244216, at *3 (2d Cir. April 5, 2011); United States v. Stathakis, 04-CR-790, 2008 WL 413782, at *11 (E.D.N.Y. 2008). Here, Mr. Brooks was convicted of conspiring with Ms. Hatfield to commit securities fraud, including by conspiring with her to inflate DHB's gross profit margins. Thus, Mr. Brooks incurred forfeiture liability for Ms. Hatfield's acts within that conspiracy, regardless of what he personally might have known. Indeed, forfeiture is particularly appropriate in this case, because Mr. Brooks benefited when Ms. Hatfield's fraudulent overvaluations caused DHB's stock to rise.

B. The R&D Reclassification Scheme

The Indictment, prior to redaction, alleged that DHB fraudulently reclassified $22 million in cost of goods sold expenses as "research and development," thereby improperly inflating its gross profit margin. At trial, the parties agreed that DHB performed the reclassifications. But they disagreed about whether the reclassifications were fraudulent.

Defendants contended that, instead of being fraudulent, the reclassifications largely reflected their good-faith but imperfect efforts to account for R&D that DHB actually performed. In this regard, Defendants cited significant testimony, from the Government's own witnesses, establishing that: (1) DHB lacked internal controls sufficient to track R&D expenses; (2) in light of those non-existent internal controls, Ms. Hatfield instructed DHB's Chief Financial Officer, Dawn Schlegel, to reclassify a percentage of gross sales each month as R&D, with this percentage supposedly reflecting Ms. Hatfield's estimate of R&D that DHB actually performed (later a consistent 3% each month); and (3) DHB did a significant amount of R&D, which it did not otherwise account for in its financial statements because of these weak internal controls. In light of this evidence, the Court concluded that, although the Government had sufficiently evidenced a few fraudulent "acts," they did not provide the Court with sufficient evidence of the "larger fraudulent scheme" alleged in the Indictment. See 2010 WL 2710616, at *3; see also 724 F. Supp. at 326-27. Consequently, the Court struck the paragraph that quantified the fraudulent reclassifications as $22 million, concluding that the Government had not adduced evidence showing that this entire amount was fraudulent.

In its October 18th Order, the Court noted that Professor Harris' proposed testimony "incorporates assumptions regarding the proper R&D amount." 2010 WL 4177159 at *6; 2010 U.S. Dist. LEXIS 111084 at *19-20. The Court then instructed that "During the forfeiture phase, the Court will require the Government to submit evidence that supports those assumptions.

Absent evidence, the Court will not infer that the R&D reclassifications, in their entirety, reflected R&D that was never performed." Id.

The Government has now done so. First, it has highlighted Gov. Ex. 4587, a document introduced at trial but not brought to the Court's attention during either the Rule 29(a) briefing process, or in response to the Court's Order to Show Cause. See Gov. Rep. Br. at 11; 2010 WL 4177159 at *6, n. 8; 2010 U.S. Dist. LEXIS 111084 at *18-19 n. 8. Considering this document together with the other evidence before it, the Court agrees that Ms. Hatfield used the R&D reclassifications to "back-into" a desired gross profit margin. Id.

Second, and more importantly, the Government has now introduced DHB's restated financials into evidence. See Gov. Ex. 5129. These restated financials set forth that DHB overstated R&D expenses by $10.4 million in 2003, and by $8.4 million in 2004. As such, the restated amounts exceed the reclassifications listed in the Indictment, which Professor Harris used to calculate DHB's "true" gross profit margin. (See Tr. 145, 148-49, 230-31). The Court agrees with the Government that DHB's own restated financials serve as persuasive evidence regarding what the Company actually spent on R&D. And, with those restated financials, Professor Harris' calculations actually underestimate the degree that the R&D errors inflated DHB's stock price.

Defendants do not seriously dispute that DHB's restated financials evidence what the Company actually spent on R&D. But, Defendants contend, because DHB's restatement accounted for both "intentional and unintentional" R&D inflation, the restatement did not quantify Defendants' fraud. (Brooks Reply Br. at 9). Thus, Defendants contend, the Government did not truly establish how much Defendants' fraud inflated R&D.

The Court is not persuaded. As to R&D, Defendants engaged in two separate and distinct frauds. First, the record reflects that the Defendants fraudulently reclassified some costs of goods sold expenses as R&D for the purposes of inflating DHB's gross profit margins. To the extent that these reclassifications inflated DHB's share price, they are clearly subject to forfeiture.

Second, although not charged in the Indictment, the trial evidence demonstrated that the Defendants: (1) knew that DHB possessed woefully inadequate internal controls to track R&D expenses; (2) in the absence of those controls, decided to account for R&D by reclassifying cost of goods expenses as R&D; (3) failed to publicly disclose either those inadequate internal controls, or their crude substitute mechanism for recording R&D; and (4) traded while possessing this material non-disclosed information. See 2010 WL 2816326, at *2 n. 2; 2010 WL 4177159, *2; see also October 18 Order, 2010 WL 4177159 at *6; 2010 U.S. Dist. LEXIS 111084 at *18 (holding that Government can obtain forfeiture of proceeds from "uncharged" schemes). And, by enabling DHB's "negligent" reclassification policy, this fraudulent scheme led directly to any "unintentional" R&D overstatement in late-2003 and 2004. See generally 18 U.S.C. § 981(a)(2)(A) (defining proceeds as "property of any kind obtained directly or indirectly, as the result of the commission of the offense") (emphasis supplied). Indeed, it is inconceivable that DHB could have continued, in late-2004, to recklessly "account" for R&D if it had publicly announced, more than a year before, that: "The Company has barely any internal controls, much less a well-functioning accounting system. So, rather than disclose R&D expenses as are actually incurred, the Company instead reports whatever number its chief executives feel like, based on their subjective 'guess' as to how much R&D the Company performed." Such a disclosure would, assuredly, have caused pressures (i.e., lawsuits, SEC investigations, proxy challenges) that would, in turn, have forced DHB to adopt better business practices.

In any event, DHB's restatement recorded actual 2003 R&D expenses of $0.4 million, indicating that DHB originally overstated these expenses by $10.4 million, and recorded actual 2004 R&D expenses of $1.3 million, indicating that it originally overstated these expenses by $8.4 million. But Professor Harris based his analysis on the substantially lower reclassifications identified in the Indictment: $7 million in 2003 (suggesting actual R&D expenses of $3.8 million) and $6 million in 2003 (suggesting actual R&D expenses of $2.7 million). Thus, Professor Harris' calculations effectively built-in an assumption that the Defendants "negligently," but not fraudulently, miscalculated R&D by 950% in 2003 and by 208% in 2004. And Professor Harris did not consider these "negligent" ...


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