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Honest Services Fraud in the Private Sector I-1 Honest Services Fraud in the Private Sector I-1 Honest Services Fraud in the Private Sector Raymond Banoun Catherine Razzano Rajal Patel Lex Urban1 Cadwalader, Wickersham & Taft LLP Washington, D.C. Honest services fraud, also known as the “in- standards and requirements for such a prosecution tangible rights” theory of mail and wire fraud, has against a public official have been better defined been the subject of controversy both before and than those involving persons in the private sector. after the Supreme Court’s decision in McNally v. This is understandable as the justification for ap- United States, 483 U.S. 350 (1987). Prior to Mc- plying section 1346 to public officials is evident; Nally, the mail and wire fraud statutes proscribed a violation of honest services by a public official schemes to defraud others of tangible property or through corruption or self-dealing that breaches financial interests, and of the intangible right to “the essence of the political contract.” See United honest services. In the 1970’s and early 1980’s, States v. Jain, 93 F.3d 436, 441 (8th Cir. 1996). prosecutors regularly relied on 18 U.S.C. §§1341 Although Congress may have intended to apply and 1343 to charge public officials or private sec- section 1346 to the private sector, its failure to tor employees for devising such schemes to com- specifically state that intent has left prosecutors mit fraud where either the U.S. mail or interstate with the discretion and ability to criminalize con- wires were used. The McNally decision ended duct in private industry that may not otherwise be this practice by holding that these statutory provi- illegal. The courts have also been unable to enun- sions were “limited in scope to the protection of ciate clear guidelines for what constitutes “honest property rights,” and did not extend to intangible services fraud” in the private sector. However, the rights. See McNally, 483 U.S. at 360. Supreme Court will have the opportunity to either In 1988, Congress, sought to reverse McNally determine the constitutionality of the law or to by enacting 18 U.S.C. §1346 which provided that, clarify its scope when it issues its rulings in Black for purposes of the mail and wire fraud statutes, v. United States, 129 S. Ct. 2379 (argued Dec. 8, “the term ‘scheme or artifice to defraud’ includes 2009) (No. 08-876) and Skilling v. United States, a scheme or artifice to deprive another of the in- 130 S. Ct. 393 (Oct. 13, 2009) (No. 08-1394).2 tangible right of honest services.” However, nei- ther this new provision nor the legislative history REQUI R EMENTS FO R ESTABLISHING AN HONEST defined the phrase “intangible right of honest ser- SE R VICES FR AUD V IOLATION vices,” or the type of conduct that the legislature intended to prohibit, thereby creating confusion Currently, the circuit courts are split regarding over the reach of section 1346. whether a breach of a fiduciary duty is required to As a result, section 1346 has been routinely convict an individual in the private sector of “hon- used to prosecute a wide variety of conduct by est services” fraud. However, all courts agree that both public officials and private individuals. The some duty must be breached in order to do so. I-2 Raymond Banoun, Catherine L. Razzano, Rajal Patel, Lex Urban Fiduciary Duty Required into a federal crime by the mere use of Although the wording of section 1346 is broad the mails or interstate phone system. and does not impose any requirement beyond Aware of that risk that federal criminal engaging in a “scheme or artifice to defraud an- liability could metastasize, we held in other of the intangible right of honest services,” [United States v.] Lemire that “not every several circuit courts have held that the law re- breach of fiduciary duty works a crimi- quires a breach of a fiduciary duty to sustain the nal fraud.” Lemire, 720 F.2d [1327,] at conviction of an individual in the private sec- 1335, quoting United States v. George, tor.3 Thus, technically, even mere dishonesty by 477 F.2d 508, 512 (7th Cir. 1973). Rath- an employee could become a federal crime if it er, “[t]here must be a failure to disclose were deemed a breach of an existing fiduciary something which in the knowledge or relationship. See United States v. Frost, 125 F.3d contemplation of the employee poses 346, 368 (6th Cir. 1997) (affirming the honest ser- an independent business risk to the em- vices fraud conviction of university professors for ployer.” Id. at 1337. permitting students to plagiarize material and, as a result, obtain advanced degrees). Some courts, Id. at 973. however, have instituted additional requirements to limit the application of the rule, including that Thus, “absent reasonably foreseeable econom- either the harm caused by the conduct was ac- ic harm, ‘[p]roof that the employer simply suffered tual or reasonably foreseeable, that the omission only the loss of the loyalty and fidelity of the [em- or misrepresentation involved was material, or ployee] is insufficient to convict.’” United States that the conduct was neither approved, nor sanc- v. Sun-Diamond, 138 F.3d at 973 (citing United tioned, by the employer. States v. Frost, 125 F.3d at 368). The court added that it is insufficient to cite the criminal law pre- Actual or Reasonably Foreseeable Harm sumption that one intends the “natural and fore- The First and Sixth Circuits have held that it seeable consequences of his voluntary actions,” must have been reasonably foreseeable that the as that argument would defeat the requirement of employer, or person to whom the fiduciary duty intent. Id. at 974. Nonetheless, the court found was owed, would suffer economic harm as a re- that, in that instance, it was reasonably foresee- sult of the employee’s conduct. See, e.g., United able that if the scheme had become known, the States v. Martin, 228 F.3d at 17; United States v. law firm would have suffered considerable losses Frost, 125 F.3d at 368-69. as a result of negative publicity and affirmed the The District of Columbia Circuit has required conviction of Sun-Diamond despite the lack of ac- that the defendant reasonably foresaw that eco- tual harm. Id. at 974. nomic harm could have resulted from his breach The Seventh Circuit, however, went further to of fiduciary duty. United States v. Sun-Diamond, require that the fiduciary duty be breached at 138 F.3d 961, 973 (D.C. Cir 1998). In Sun-Dia- the “expense of the person to whom that duty mond, an employee convinced a partner at one is owed.” United States v. Hausmann, 345 F.3d of its law firms to funnel illegal contributions to 952, 956 (7th Cir. 2003). In other words, it must a political candidate through various surreptitious be established that the victim experienced some means. Id. at 969-70. The court warned that: actual harm. In that case, Hausmann, a Milwau- kee-based personal injury lawyer, referred clients to a chiropractor for services that were paid from In the private sector context, § 1346 insurance settlement proceeds. The chiropractor poses special risks. Every material act kicked back twenty percent of the fees he col- of dishonesty by an employee deprives lected to third parties, including a marketing firm, the employer of that worker’s ‘honest charities, and other business entities in which services,’ yet not every act is converted Hausmann held an interest. Id. at 954. The court Honest Services Fraud in the Private Sector I-3 affirmed Hausmann’s conviction because he used Exception Where Employer Approved or Sanc- his fiduciary relationship “for [personal] gain at tioned the Conduct the expense of the party to whom the duty was The Fifth Circuit has also required that an em- owed.” Id. at 956. The court reasoned that, ab- ployer neither have approved nor sanctioned the sent Hausmann’s fraud, his clients could have re- conduct that is alleged to have violated section ceived the value of the kickbacks as a discount 1346. In United States v. Brown, 459 F.3d 509 (5th and, thus, suffered economic harm, despite the Cir. 2006), in order to meet corporate earnings tar- fact that they were charged competitive fees by gets, Enron employees transferred leases of Nige- the chiropractor. Id. at 957. rian barges to Merrill Lynch with the understand- ing that the latter would be able to return them to Materiality Enron or transfer them to another party without Some courts have also required that the mis- suffering any adverse financial consequence. The representation made or the information that was Fifth Circuit reversed the employees’ convictions, withheld be material in nature. The Second Cir- distinguishing the case from Gray because En- cuit found that information is material if it either ron’s Chief Financial Officer had sanctioned the led, or was capable of leading, a reasonable employees’ conduct as part of a known corporate employer to change its conduct. United States goal, whereas the basketball coaches in Gray had v. Rybicki, 354 F.3d 124, 145 (2d Cir. 2003)(en acted without the university’s knowledge. The banc).4 This requirement is broader than the rea- court ruled that the conduct is beyond the scope sonably foreseeable harm test as it is not limited of section 1346 when (1) an employer aligns an to economic or pecuniary damage. Id. at 146. employee’s interests with a specified corporate In United States v. Gray, 96 F.3d 769 (5th Cir. goal, (2) the employee perceives his pursuit of that 1996), the Fifth Circuit applied this same ma- goal to benefit both himself and the company, and teriality test to uphold the conviction of Baylor (3) the employee’s conduct is consistent with that University basketball coaches who devised and perception, that conduct is beyond the scope of executed a scheme to academically qualify stu- section 1346.
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