Appeal from the United States District Court for the Eastern District of Wisconsin. No. 77-Cr-158 -- John W. Reynolds, Judge.
Before Tone and Wood, Circuit Judges, and East, Senior District Judge.*fn*
Defendants were convicted of causing false entries to be made in the records of the bank of which they were officers and of causing false and misleading financial statements to be filed by an affiliated bank holding company, in violation of the False Banking Entry Act and the Securities Exchange Act of 1934, and of conspiring to do the same. More specifically, they were found to have failed to disclose the effect on the bank's income account of certain "overtrades," I. e., security transactions executed at prices in excess of the prevailing market prices. In this opinion, we consider only the sufficiency of the indictment and the evidence, leaving alleged trial errors to be dealt with in a contemporaneously filed unpublished order. We affirm the convictions on the conspiracy and securities law counts but reverse on the banking entry counts.
Erickson was chairman of the board of directors of both American Bankshares Corporation (Bankshares), a holding company, and one of its subsidiaries, American City Bank and Trust Company (the bank); he was also president of Bankshares. Wilson was one of the bank's vice presidents and head of its Investment Department. Securities in the Investment Department were held in either a trading account or a portfolio account.
In early 1973 the bank, under Wilson's direction, executed a series of federal security short sales with the expectation that the market would continue to fall. When this expectation was not realized, the short sales had to be covered. Instead of borrowing the securities needed for that purpose from a third party, Wilson caused the bank to borrow them from its own portfolio and later purchase identical securities to replace them. Wilson later caused the bank to sell these "replacement securities" in the series of year-end overtrades described more fully below.
In either July or August 1973, Ernst & Ernst, who until 1974 was Bankshares' independent auditor, gave Erickson and Wilson the apparently mistaken advice that because the "short sales" had been covered with the bank's own securities, they were completed transactions; consequently the bank, and therefore Bankshares, would have to recognize any losses incurred on those transactions.*fn1 This loss would have approximated $800,000, a substantial amount in light of the bank's profit of only about $1,000,000 the previous year. Wilson objected, stating that "what he had done was common practice in the industry, and that he would obtain letters from other banks to support his position." (Government Exhibit (G.Ex.) 44, p. 2.) Ernst & Ernst expressed its willingness to reconsider its position if Wilson could provide such letters. After trying unsuccessfully to obtain the letters, Wilson told Erickson that some of the "replacement securities" had already been sold and most of the rest could be sold above the current market price to avoid the substantial loss threatened by the position taken by Ernst & Ernst. (Ibid.)
With Erickson's approval, Wilson then engaged in a series of negotiated overtrades, whereby the bank sold most of the remaining "replacement securities" not at market prices but at inflated prices. The Quid pro quo for each of these sales was a concurrent agreement by the bank to buy from the purchaser of the "replacement securities" other securities of approximately equal value at approximately equally inflated prices. The manner in which these transactions were recorded, which avoided recognition of loss,*fn2 forms the basis of the indictment.
The bank recorded these transactions as if the purchases were unrelated to the sales and each side of the transaction had been an independent arms length sale and purchase. The premium received by the bank on the sale of securities was included in the sale price recorded, without reference to the agreement to pay a similar premium on the reciprocal purchase of other securities or the market value of the securities purchased. Similarly, the cost of the securities purchased by the bank was recorded at the inflated purchase price instead of their market value. Although even the inflated selling price was usually a little less than the carrying value of the securities sold, resulting in a recorded loss to the bank, that recorded loss was much less than it would have been if the price recorded had been the market value of either the securities sold or the securities purchased by the bank.
David Drought, the Ernst & Ernst audit supervisor assigned to the Bankshares' examination for the year ending December 31, 1973, was understandably curious as to why anyone would pay more for securities than the prevailing market price. In a memorandum summarizing a February 26, 1974 meeting with other Ernst & Ernst personnel he explained:
The Money Center (the bank's Investment Department) had accomplished its goal of disposing of the issues without substantial losses but the question remained as to how other brokers could buy the securities at such inflated prices without hurting themselves.
(The bank's) purchases of new and different issues prior to year-end and, in some cases, the identical issues after year-end from the same brokers, also at inflated prices provided the answer. This was the matter of concern in that the Bank appeared to have sold the securities without loss by manipulating prices and later replacing the securities or equivalents so as to put themselves back in the beginning position with substantial unrecorded depreciation on the issues.
(G.Ex. 40, p. 2.)*fn3 Wilson's explanation was that the bank was able to dispose of the replacement securities at prices above the market price because, for these particular securities, there was a "seller's market" and the market prices reflected only a "thin and insufficient market." (G.Ex. 11, p. 2.) Erickson later made similar representations to a partner at Arthur Andersen & Co. (G.Ex. 44, p. 2.), the accounting firm that succeeded Ernst & Ernst as Bankshores' independent auditor.
Ernst & Ernst certified Bankshares' consolidated financial statements for 1973 without requiring any adjustments or explanation concerning these transactions, apparently taking the position that the transactions were "in substance" repurchase agreements, and therefore no gain or loss need be recognized.*fn4 Arthur Andersen, disagreed, however, reasoning that since the bank had purchased securities different from those sold, the transactions could not be treated as repurchase agreements. Further, since the transactions were closed, the full loss resulting from the sale of the "replacement securities" had to be recognized. Recognition of the loss was accomplished by writing down the carrying value of the security acquired in each overtrade to its market value on the day of the acquisition and making a corresponding adjustment in the income account reducing income, or increasing loss, in the amount of the write-down.
Counts 3 through 8 of the indictment charge both defendants with violating the False Banking Entry Act, 18 U.S.C. § 1005,*fn5 by causing entries relating to the purchases to be made in the bank's records that were "inflated and false in light of the true market value" of the securities ...