USA v . Gagalis et a l . CR-04-126-PB 03/20/06

UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW HAMPSHIRE

United States of America

v. Case N o . 04-cr-126-01/06-PB Opinion N o .

Robert J. Gagalis, et a l .

MEMORANDUM AND ORDER

Defendants are charged with several counts of securities

fraud in connection with their roles as officers and employees of

Enterasys Network Systems, Inc. (“Enterasys”). Before me are

their motions to dismiss count five of the superseding

indictment, which charges the defendants with making false and

misleading statements to Enterasys’s outside auditors in 2001.

The government objects. For the reasons set forth below, I deny

defendants’ motions.

I. BACKGROUND

Count five of the superseding indictment, entitled

“Securities Fraud: False Statements to Auditors; Aiding and

Abetting,” charges that the defendants: [K]nowingly and willfully made, and caused to be made, materially false and misleading statements, and omitted to state or caused others to omit to state material facts, necessary to make the statements made not misleading, to Enterasys’ outside auditors, in connection with an examination of the financial statements, quarterly review, and the preparation and filing of a document and report required to be filed with the SEC. Specifically, the defendants: (a) concealed, and caused others to conceal, from Enterasys’ outside auditors, revenue associated with the GEMMS, Paraprotect and Worldlink transactions so as to hide the true substance of those transactions; (b) stated and caused others to state that the altered Letter of Agreement in the Ariel transaction was executed on or about August 3 1 , 2001, when, in fact, they knew it was not executed until on or about September 2 0 , 2001; (c) concealed and caused others to conceal the secret side letters in the Ariel and Tech Data transactions; and (d) falsely stated, and caused others to falsely state, in a management representation letter that: (i) the company had made available to its outside auditors all relevant records, including side letters; (ii) there had been no instances of fraud by any member of management and by employees who have significant roles in internal control; (iii) there had been no instances of fraud by others at Enterasys that could have a material effect on the company’s financial information; (iv) there had been no violations and no possible violations of laws or regulations the effects of which should be considered for disclosure in financial information; and (v) revenue recognized had been modified to the extent appropriate when a right of return or other significant future obligation existed.

All in violation of Title 1 5 , United States Code, Sections 78ff, Title 1 7 , Code of Federal Regulations, Section 240.13b2-2, and Title 1 8 , United States Code, Section 2 .

Superseding Indictment ¶ 104.

-2- Count five charges defendants with violating 15 U.S.C.

§ 78ff,

.13b2-2 (“Rule 13b2-2”) and

. 1 15 U.S.C. § 78ff(a) imposes criminal liability for willful

violations of the Securities Exchange Act of 1934 (“Exchange

Act”) or “any rule or regulation thereunder the violation of

which is made unlawful or the observance of which is required

under the terms of [the Act]”. At the time defendants’ alleged

conduct occurred, Rule 13b2-2 provided:

No director or officer of an issuer shall, directly or indirectly,

(a) Make or cause to be made a materially false or misleading statement, or

(b) Omit to state, or cause another person to omit to state, any material fact necessary in order to make statements made, in the light of the circumstances under which such statements were made, not misleading to an accountant in connection with (1) any audit or examination of the financial statements of the issuer required to be made pursuant to this subpart or (2) the preparation or filing of any document or report required to be filed with the Commission pursuant to this subpart or otherwise.

1

, the federal aiding and abetting statute, provides that anyone who “commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal.”

( a ) .

-3-

.13b2-2 (2003) (amended May 2 8 , 2003).

II. DISCUSSION

Defendants argue that count five should be dismissed

because: (1) the Securities Exchange Commission (“SEC”) lacked

the statutory authority to promulgate Rule 13b2-2, on which count

five is based; (2) Rule 13b2-2 could not have served as the basis

for a prosecution under 15 U.S.C. § 78ff in 2001, when defendants

allegedly violated the rule; and (3) 15 U.S.C. § 78m(b)(5)

prohibits the imposition of criminal liability for the conduct on

which count five is based. I address each argument in turn.

A. SEC’s authority to promulgate Rule 13b2-2

In order to address defendants’ argument that the SEC lacked

the statutory authority to promulgate Rule 13b2-2, I first

discuss the history of the Rule.

1. History of Rule 13(b)2-2

Beginning in 1973, as a result of the Watergate scandal,

the SEC began investigating the undisclosed use of corporate

funds for illegal domestic political contributions. See

Securities Exchange Act Release N o . 13185,

,

-4-

, at *2 (January 1 9 , 1977). On May 1 2 , 1976, the

SEC issued a report to Congress entitled “Report on Questionable

and Illegal Corporate Payments and Practices,” which included its

findings and recommendations for legislation to prevent further

abuses.

Before Congress acted on the SEC’s recommendations, the SEC

announced four proposed rules that would: (1) require registered

issuers to “maintain books and records accurately reflecting the

transactions and dispositions of assets of the issuer;” (2)

require such issuers to “maintain an adequate system of internal

accounting controls designed to provide reasonable assurance that

specified objectives are satisfied;” (3) “prohibit the

falsification of an issuer’s accounting records;” and (4)

“prohibit the officers, directors, or stockholders of an issuer

from making false, misleading or incomplete statements to an

accountant engaged in an examination of the issuer.”

at * 1 .

After the proposed rules were released for public comment

but before they were adopted, Congress enacted § 13(b)(2) of the

Exchange Act (codified at

(m)(b)(2)).2 The

2 Section 13(b)(2) of the Exchange Act was enacted as part of the Foreign Corrupt Practices Act (“FCPA”). See Pub. L . N o .

-5- original Senate bill ( S . 305) included all four of the SEC’s

proposed rules. H.R. Conf. Rep. N o . 95-831, at 10 (1977),

reprinted in 1977 U.S.C.C.A.N. 4120, 4123. The House amendments

to S . 305 struck all four provisions from the bill “because the

SEC had already published for comment rules designed to

accomplish similar objectives under its existing authority.”

The House subsequently agreed to include the first two proposed

rules (requiring issuers to maintain accurate records and an

internal accounting system) in § 13(b). The Senate acquiesced to

deletion of the other two proposed rules, noting that “[a]lthough

these provisions were supportive of the basic accounting

section,” the use of the word “knowingly” in the proposed

legislation raised issues presented by the Supreme Court’s

decision in Ernst & Ernst v . Hochfelder,

(1976).

H.R. Conf. Rep. N o . 95-831, at 1 0 . The House Conference Report

stated that “[i]n deleting the Senate provisions, the conferees

intend that no inference should be drawn with respect to any

95-213,

(1977). The statute provides, in relevant part, that every issuer shall “make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer” and “devise and maintain a system of internal accounting controls.” 15 U.S.C. § 78m(b)(2)(A)-(B).

-6- rulemaking authority the SEC may or may not have under the

securities laws.” Id. at 1 1 .

Subsequent to the enactment of § 13(b), the SEC released

revised versions of the third and fourth proposed rules. See

Securities Exchange Act Release N o . 15570,

,

(February 1 5 , 1979). In 1979, the SEC adopted the

regulations as Rules 13b2-1 (

.13b2-1), prohibiting

the falsification of books and records, and Rule 13b2-2 (

.13b2-2), prohibiting the making of false or

misleading statements to accountants. In doing s o , the SEC

stated that although the rules would be codified with other rules

promulgated under § 13 of the Exchange Act, it was not relying

exclusively on § 13 as the foundation for the rules. Release N o .

15570,

, at * 6 .

The conduct addressed by Rule 13b2-2 ultimately was

explicitly prohibited by statute when Congress passed the

Sarbanes-Oxley Act in 2002. See

(a).

2. Analysis

Defendants argue that the SEC exceeded its rulemaking

authority when it adopted Rule 13b2-2 because the conduct it

purported to regulate was not prohibited under the Exchange Act.

-7- They maintain that the Rule represents an attempt by the SEC to

implement proposed legislation that Congress “rejected” when it

enacted § 13(b). The government counters that the SEC had the

authority to promulgate Rule 13b2-2 pursuant to its general

rulemaking authority under § 23(a) of the Exchange Act. See

Release N o . 15570,

, at * 6 - 7 .

Section 23(a) gives the SEC the power to “make such rules

and regulations as may be necessary or appropriate to implement

the provisions” of the Exchange Act. 15 U.S.C. § 78w(a)(1).

When the SEC originally proposed Rule 13b2-2, it stated that the

rule was “necessary or appropriate” to implement the “periodic

reporting requirements” of the Exchange Act, as well as sections

10(b), 14(a), 20(b) and 20(c). 3 Release N o . 13185,

, at * 7 - 8 . In particular, the SEC found that “[t]he

accountant’s examination of the issuer’s financial statements is

3 Section 10(b) prohibits the use of manipulative or deceptive devices in connection with the purchase or sale of a security. 15 U.S.C. § 78j(b). Section 14(a) governs proxy solicitations. Id. § 78n(a). Section 20(b) prohibits unlawful conduct performed through or by the means of another person. Id. § 78t(b). Section 20(c) makes it unlawful for a director or officer of an issuer to hinder, delay or obstruct without just cause the filing of any required document, information or report. Id. § 78t(c).

-8- one of the key safeguards to the reliability of the system of

financial disclosure; to the extent that individuals hamper or

frustrate the accountant’s work, the reliability of that system

is diluted.” Id. at * 8 . Later, when it adopted the final

version of Rule 13b2-2, the SEC also stated that the Rule would

“promote compliance with the requirement of new Section

13(b)(2)(B) that issuers devise and maintain a system of internal

accounting controls.” See Exchange Act Release N o . 15570,

,

, at *11 (February 1 5 , 1979).

The issue before me is thus whether the SEC correctly

concluded that it had the statutory authority to promulgate

regulations prohibiting issuers from making false or misleading

statements to auditors. My analysis of this issue is governed by

the two-step process announced in Chevron, U.S.A., Inc. v . NRDC,

3 7 , 842-43 (1984). See Nat’l Cable & Telecomms. Ass’n

v . Brand X Internet Servs., 125 S . C t . 2688, 2699 (U.S. 2005)

(applying Chevron to FCC’s authority under

(b) to

“prescribe such rules and regulations as may be necessary in the

public interest to carry out the provisions” of the

Communications Act of 1934); NLRB v . Beverly Enterprises-

Massachusetts, Inc.,

3 , 32 (1st Cir. 1999) (giving

-9- Chevron deference to regulations promulgated under Board’s

authority “to make such rules and regulations as may be necessary

to carry out the provisions of [the National Labor Relations

Act],”

5 6 ) .

Chevron first requires that I consider “whether the

statute’s plain terms ‘directly address the precise question at

issue.’” Nat’l Cable, 125 S . C t . at 2702 (quoting Chevron,

) (brackets omitted). If instead “the statute is

silent or ambiguous with respect to the specific issue,” the

question becomes “whether the agency’s answer is based on a

permissible construction of the statute.” Chevron,

. Where Congress has given “an express delegation of

authority to the agency to elucidate a specific provision of the

statute by regulation,” such regulations are “given controlling

weight unless they are arbitrary, capricious, or manifestly

contrary to the statute.” Id. at 843-44; see also United States

v . O’Hagan,

4 2 , 673 (1997).

Section 23(a) gives the SEC broad but ambiguous rulemaking

authority to adopt such regulations as are “necessary or

-10- appropriate” to implement the provisions of the Exchange Act. 4

Because this grant of authority is ambiguous, I must determine

whether the SEC’s promulgation of the Rule was based on a

permissible construction of the statute. In its May 1 2 , 1976

report, the SEC concluded that “[m]illions of dollars of funds

have been inaccurately recorded in corporate books and records. .

. . Such falsification of records has been known to corporate

employees and often to top management, but often has been

concealed from outside auditors and counsel and outside

directors.” Release N o . 15570,

, at * 2 . The SEC

determined that Rule 13b2-2 was “necessary or appropriate” to

implement the various disclosure provisions because “the

accountant’s examination or audit of the financial statements of

the issuer is a crucial element in safeguarding the reliability

4 Defendants argue that Hochfelder, a pre-Chevron case, stands for the proposition that the SEC does not have the power to regulate a broader range of conduct than that which is explicitly proscribed by statute. See Hochfelder,

. In Hochfelder, the Supreme Court held that Rule 10b-5 could not be construed to permit liability without proof of scienter because the language of § 10(b) and its legislative history demonstrated that Congress only intended to address intentional wrongdoing. Id. at 214. Unlike here, only the first step of the Chevron analysis was required in Hochfelder because § 10(b) unambiguously required proof of scienter.

-11- of the information that is disclosed to the public pursuant to

the disclosure requirements of the Securities Exchange Act.” Id.

at * 1 2 . Likewise, the SEC found that the Rule would promote

compliance with new § 13(b) by acting as a “deterrent to the

falsification of corporate books, records and accounts and to the

making of false, misleading or incomplete statements . . . that

might conceal the falsification of such books and records.” Id.

at * 1 1 .

These conclusions are reasonable in light of the SEC’s

findings and the purpose and history of the Exchange Act. There

is nothing in the plain language of the statute that manifestly

contradicts the SEC’s determinations. The legislative history of

§ 13(b) does not suggest that Congress intended to prohibit

adoption of the Rule; indeed, the House Conference Report

explicitly stated that “no inference should be drawn with respect

to any rulemaking authority the SEC may or may not have” with

regard to the omitted rules. H.R. Conf. Rep. N o . 95-831, at 1 1 .

Contrary to defendants’ assertions,5 the fact that Congress chose

5 Defendants analogize this case to FCC v . ABC,

(1954), in which the FCC “attempt[ed] to do an end-run around Congress” by adopting regulations after Congress failed to act on its proposed legislation. Def. Mem. of Law in Support of Mot. to

-12- not to include all of the proposed rules in § 13(b) does not

compel the conclusion that it intended to limit the SEC’s

authority to regulate in this area. I thus conclude that the

SEC’s determination that Rule 13b2-2 was necessary or appropriate

to implement provisions of the Exchange Act is entitled to

deference under Chevron. See Ragsdale v . Wolverine World Wide,

Inc.,

1 , 86 (2002) (“The [agency’s] judgment that a

particular regulation fits within this statutory constraint must

be given considerable weight.”) Accordingly, dismissal of count

five is not warranted on this basis.

B. Criminal liability under 15 U.S.C. § 78ff

Defendants next argue that even if Rule 13b2-2 is valid,

they cannot be held criminally liable for violations of the Rule

under 15 U.S.C. § 78ff. Section 78ff provides that criminal

liability may be imposed on “[a]ny person who willfully violates

any provision of [the Exchange Act] . . . or any rule or

regulation thereunder the violation of which is made unlawful or

Dismiss at 1 4 . The Court found that the FCC’s interpretation of the Criminal Code “stretch[ed] the statute to the breaking point” and lacked support in decided judicial and administrative cases. ABC,

9 4 , 296. Such a conclusion is not warranted here.

-13- the observance of which is required under the terms of this

chapter.” 15 U.S.C. § 78ff(a) (emphasis added).

Defendants contend that the conduct proscribed by Rule 13b2-

2 cannot be punished under § 78ff because it was not “unlawful”

under the Exchange Act prior to passage of the Sarbanes-Oxley Act

in 2002. This argument misses the point. Section 78ff

criminally punishes the violation of rules that must be observed

under the Exchange Act. As I have explained, Rule 13b2 was a

valid exercise of the SEC’s authority to promulgate regulations

and thus it has the force and effect of law. See Chrysler Corp.

v . Brown,

8 1 , 295 (1979). Therefore, I conclude that a

willful violation of Rule 13b2-2 may result in criminal liability

under § 78ff(a).

C. 15 U.S.C. § 78m(b)

Finally, defendants argue that count five must be dismissed

pursuant to 15 U.S.C. § 78m(b)(5). The short answer to this

argument is that the provision defendants rely on applies only to

prosecutions under 15 U.S.C. § 78m(b)(2). Count 5 is based on

Rule 13b2-2 and § 78ff. Thus, defendants’ argument necessarily

fails.

-14- III. CONCLUSION

Defendants’ motions to dismiss count five of the indictment

(Doc. Nos. 1 2 1 , 149) are denied.

SO ORDERED.

/s/Paul Barbadoro Paul Barbadoro United States District Judge

March 2 0 , 2006

cc: William Morse, AUSA Peter Anderson, Esq. Christopher H.M. Carter, Esq. William Cintolo, Esq. Philip Cormier, Esq. Victor Dahar, Esq. Mark Dubnoff, Esq. Andrew Good, Esq. Cathy Green, Esq. John Kissinger, Esq. Michael Koenigk Esq. Richard McCarthy, Esq. Michelle Peirce, Esq. Karen Picket, Esq. Michael Ramsdell, Esq. James Rehnquist, Esq. Eva Saketkon, Esq. Bruce Singal, Esq. David Vicinanzo, Esq.

-15-