The Fifth Circuit handed two corporate executives at a medical device company a big win recently.
I’ve posted in the past about the indictments and trial of two former executives at ArthroCare, Michael Gluk and Michael Baker. They were found guilty in June 2014 of securities fraud in connection with a groovily-named company, DiscoCare.
The Fifth Circuit granted the two Michaels a new trial based on errors in certain rulings about evidence at trial. This is an unusual outcome in a criminal case, primarily because the courts of appeal apply a fairly high “abuse of discretion” standard when they review evidentiary rulings.
It’s a real challenge to convince an appellate court that the trial court abused its discretion when it decided to admit or exclude individual pieces of evidence. In a complex white-collar case, it’s likewise a heavy burden to convince a court of appeal that the admission or exclusion of that evidence really made a difference and was not simply harmless.
Let’s take a look at what happened here.
Background of the Case
Mr. Baker is the former CEO and Mr. Gluk is the former CFO of ArthroCare. My original July 2013 post on the subject offered an overview of the case:
The alleged scheme was not very complicated. Between 2005 and 2008, the indictment alleges, Baker and Michael Gluk as well as other executives and employees inflated the earnings of ArthroCare. At the end of financial quarters, the company would purportedly send products to its distributors based not on how much the distributors had ordered but on how much the company would need to ship in order to meet analysts’ expectations. These “sham transactions,” as the indictment calls them, would be included as sales in the quarterly financial statements.
The indictment charges that these transactions resulted in tens of millions of dollars in fake sales and led to inflated public earnings. Mr. Baker and Mr. Gluk did not disclose this scheme to the public. Hence: securities fraud.
DiscoCare was the biggest distributor with whom ArthroCare allegedly conspired to perpetuate the fraud. As the Fifth Circuit explained, “[t]his fraud was carried out under the day-to-day supervision of John Raffle, the Vice President of Strategic Business Units, and of David Applegate, another DiscoCare executive.”
ArthroCare purchased DiscoCare for $25 million—a fairly high price given that DiscoCare did not have any employees at the time. Rumors of accounting improprieties circulated, and the fraud “began to unravel” before the board’s eyes.
The board commissioned an internal investigation by Latham & Watkins to figure out what happened and who was at fault. Around the same time, the SEC also conducted an investigation and issued a report.
Both the SEC’s and Latham’s reports indicated that Mr. Raffle and Mr. Applegate (the DiscoCare execs) had intentionally committed fraud and that they had misled Mr. Gluk and Mr. Baker (the ArthroCare execs) during the scheme.
These reports, of course, were quite helpful to Mr. Gluk and Mr. Baker’s defense of the case. If they were misled by Mr. Raffle and Mr. Applegate, then their conduct was not intentional. If their conduct was not intentional, then it was not fraud.
Mr. Applegate and Mr. Raffle pleaded guilty and agreed to cooperate with the government and to testify against Mr. Gluk and Mr. Baker.
Trial Judge Excludes SEC and Latham Reports and Admits “Salacious” Evidence
At the Baker/Gluk trial, however, the trial court refused to admit the SEC and Latham reports into evidence. It concluded that the reports were more prejudicial than probative. Under Rule 403, if the probative value of the evidence is outweighed by unfair prejudice, then it should be excluded.
(As an aside, it’s pretty amazing to see how common it is for the government to use this argument successfully.
The government successfully convinced the trial court judge here that this evidence essentially helped the defendants a little too much.
When a defendant tries to have evidence excluded on the basis that its unfair prejudice outweighs its probative value, I can almost guarantee the court’s response: “Counsel, all evidence is prejudicial. That’s why the government wants to introduce it.”
The trial court did admit a host of evidence about other bad acts by Mr. Gluk and Mr. Baker related to ArthroCare. None of this conduct was directly relevant to the case. In the Fifth Circuit’s words, the evidence was “salacious.” At trial, Mr. Gluk and Mr. Baker argued that this was improper character evidence under Rule 404.
The government loves irrelevant, salacious character evidence. It’s interesting. It’s memorable. It breaks up days of testimony about spreadsheets and accounting rules.
I’ll get into the details about the “salacious” evidence below.
The jury ultimately convicted both Mr. Gluk and Mr. Baker. Surprisingly, the trial court ordered Mr. Baker held until sentencing, which I wrote about here.
Both Mr. Gluk and Mr. Baker moved for a new trial. They lost in the trial court and appealed on a number of issues. I’m going to focus on the evidentiary ones.
The SEC and Latham Reports Should Have Been Admitted
Mr. Baker and Mr. Gluk first argued that the trial court erred in excluding the Latham and SEC reports from evidence.
They explained that the reports would have provided the jury with useful guidance on a complex issue.
The government disagreed. On its position, the Fifth Circuit said that,
According to the government, Latham and the SEC were essentially fact-finding bodies, no more capable than the jury of determining whether Gluk and Baker had committed accounting fraud. The government worried that the “jury may have [incorrectly] believed that the SEC and Latham attorneys were better positioned to make factual findings” and thus been improperly influenced by the Latham and SEC reports.
It then described the executives’ position on the issue:
Gluk and Baker respond that Latham and the SEC indeed were better positioned to make factual findings and that professional findings would have been highly probative of the defendants’ culpability. Latham and the SEC are experts in understanding and evaluating financial fraud. The defendants point to multiple cases where the Fifth Circuit has held that administrative findings are admissible in subsequent criminal trials precisely because administrative expertise might aid the jury.
The court sided with the former executives. It relied on Fifth Circuit precedent, Smith v. Universal Services. In Smith, the court held that an EEOC report should be admitted because of its usefulness to the jury. Following this decision, the Fifth Circuit concluded:
We accordingly hold that the Latham and SEC reports are likely to have a proper and appropriate influence on a jury’s deliberations by providing it with expert assistance regarding the plausibility of expert testimony. The government acknowledges that the reports could have held significant weight to the jury. We agree, and thus conclude that the exclusion of these reports was not harmless error.
The “Salacious” Other Bad Acts Evidence Should Have Been Excluded
The jury did not just hear about DiscoCare’s “sham transactions” with ArthroCare. It also heard about other aspects of their business model, for which no charges were brought. The Fifth Circuit explained,
DiscoCare provided a medical device for which most insurers refused reimbursement. To sell its device, DiscoCare reached an agreement with plaintiffs’ attorneys; this agreement resulted in the majority of DiscoCare’s sales. Under this agreement, DiscoCare would treat clients of the attorneys. The plaintiffs’ attorneys would then cite the expense of their clients’ treatment as a reason for defendants to settle personal injury lawsuits. DiscoCare also allegedly illegally coached doctors on which billing codes to use, in an effort to increase insurance reimbursements. This practice allegedly went as far as instructing doctors to perform an unnecessary surgical incision to classify the treatment as a surgery.
It may not be prostitutes or drugs, but this kind of evidence counts as salacious in a white-collar case.
Mr. Baker and Mr. Gluk argued that because the case was bland, the government introduced the DiscoCare details to “spice it up” and outrage the jury, leading to their convictions.
The government contended that DiscoCare’s activities were relevant to the ArthroCare case because they showed why Mr. Baker and Mr. Gluk went to such extent to lie to investors and also showed how involved the two were in the fraudulent day-to-day operations.
The Fifth Circuit concluded that it may have been appropriate to admit some of this evidence, it was improper to admit all of it. In its words:
Allowing this breadth of testimony was error. The district court could have done more to police the line between proper and improper evidence; it should have been careful to prevent the government from dwelling on the salacious details of DiscoCare’s business practices that could not be charged to the defendants.
Important Evidentiary Wins
Both of these decisions were good ones, and the admission of the reports is a major win for future defendants in the same position.
Now, it may be rare that an internal investigation comes to a conclusion that no corporate executive did anything wrong, particularly in these post-Yates-Memo days. In the rare circumstance when it happens, though, a defendant should be permitted to take advantage of it.
Of course, it goes both ways. It seems likely that conclusions of wrongdoing in these types of reports will be admitted against a defendant.
But let’s take a win when we get one. Congrats to Mr. Baker and Mr. Gluk. If the government decides to try them again, I hope they prevail. Even better, I hope DOJ exercises its discretion not to try them again.