With several cases regarding “honest services” fraud pending before the U.S. Supreme Court, see The Supreme Court Takes a Hard Look at “Honest Services” Fraud, above, the Third Circuit became the latest circuit court of appeals to define the parameters of such fraud. On October 22, 2009, the Third Circuit reversed, in part, the convictions of two former executives of the Ben Franklin Technology Center (“BFTC”), a publicly funded, not-for-profit corporation, in Pittsburgh. The government alleged that the defendants had used public funds for their own benefit, violating both their fiduciary duties to BFTC and their contractual obligations to the U.S. Navy. Because there was no allegation that their violation of the Navy contract ran afoul of state law, the Third Circuit held that the superseding indictment had failed sufficiently to allege honest services fraud.
In the early 1980s, the Commonwealth of Pennsylvania created BFTC, along with other companies, to encourage the development and commercialization of new technology. The Commonwealth allocated funds to BFTC upon the condition that BFTC use them in conformity with its mission. In approximately 1995, BFTC entered into an agreement with the Navy to administer a project known as the National Network for Electro-Optics Manufacturing Technology (“NNEOMT”). Between 1994 and 1998, Lawrence McGeehan was the President and Chief Executive Officer of BFTC and Kathleen Haluska was its Vice President and Chief Operating Officer. Together, McGeehan and Haluska oversaw the daily operations of BFTC, including administration of NNEOMT funding.
A federal grand jury returned a superseding indictment against McGeehan and Haluska, alleging 22 counts of mail and wire fraud, in violation of 18 U.S.C. §§ 1341, 1343, 1346, and 2, and seven counts of fraud against the United States, in violation of 18 U.S.C. §§1031 and 2. Counts one through nine of the indictment (the “BFTC Counts”) alleged that McGeehan and Haluska devised a scheme to defraud BFTC of their honest services by misusing its funding for lavish travel and entertainment. Counts 10 through 22 (the “Navy Counts”) alleged that BFTC owed the Navy a duty of honest services, pursuant to its contract to administer NNEOMT, and that McGeehan and Haluska “devised a scheme and artifice to defraud the [Navy] of the intangible right of honest services owed to it by BFTC.” Counts 23 through 29 alleged that both defendants knowingly executed a scheme and artifice to defraud by causing BFTC to obtain money and property from the Navy.
In pretrial motions, McGeehan argued that the allegations in the BFTC Counts were insufficient to state an honest services fraud offense because there was no allegation that he either profited illegally from his conduct or violated state law. McGeehan also contended that the Navy Counts did not properly allege honest services fraud because he owed no fiduciary duty to the Navy. Haluska filed a similar motion, but with respect to the BFTC Counts, argued that honest services fraud only occurs when a fiduciary fails to disclose a conflict of interest, and there was no such claim here. The district court rejected these arguments. McGeehan was convicted of various counts at trial, and Haluska entered an unconditional guilty plea prior to verdict. Upon conviction, they each appealed the district court’s denial of their motions for dismissal of the honest services counts.
In McNally v. United States, 483 U.S. 350 (1987), the Supreme Court limited the reach of the federal mail fraud statute, 18 U.S.C. § 1341, to “the protection of property rights,” to avoid an unduly broad and ambiguous interpretation of its language. Specifically, McNally excluded from the statute schemes to defraud individuals or the government of the intangible right to honest services. In response to McNally, Congress enacted 18 U.S.C. § 1346, which provides that “the term ‘scheme or artifice to defraud’ includes a scheme or artifice to deprive another of the intangible right of honest services.”
The Third Circuit has reviewed three honest services fraud cases since McNally, each of which involved the “honest services” owed by public officials. The McGeehan court noted that “the key quandary in honest services fraud jurisprudence is identifying the source of the ‘honest services’ that are owed under the statute and the precise circumstances under which criminal liability can flow from the deprivation of those services.” The court noted that, in its prior decisions, it had suggested that a limiting principle was important to prevent “[t]he federalization under the criminal law of the law of contracts and other business transactions – quintessential matters for state regulation.” In fact, in a previous opinion, the Third Circuit had held that to be found guilty of honest services fraud a public official had to have violated a duty specifically established by state or federal law.
The court reasoned that as to the BFTC Counts, the allegations were sufficient to plead honest services fraud because the defendants owed BFTC a fiduciary duty “to operate BFTC in a fiscally responsible manner” and breached that duty, “causing BFTC to ‘suffer substantial financial harm.’” In short, the allegations were “sufficient to demonstrate that defendants owed a fiduciary duty to BFTC by virtue of their status as corporate officers, and that defendants were obligated to disclose any personal interests in matters over which they had decision-making power.”
As to the Navy Counts, the court held that the indictment failed sufficiently to allege honest services fraud. As the court explained, those counts “involve[d] the conduct of private individuals who allegedly caused one business entity to breach its contractual obligations to another business entity. Unlike the BFTC counts, the Navy [C]ounts [did] not involve services owed pursuant to a recognized fiduciary relationship such as the officer-corporation relationship, nor ha[d] the Government contended that any other state or federal law provided for the honest services allegedly owed by BFTC to the Navy.” The court reasoned that § 1346 requires the Government “allege more than the breach of non-fiduciary contractual duties in order to charge a private individual with honest services fraud”; specifically, the government must allege at least the violation of a state law. Because there was no such allegation here, but rather there were simply allegations of breach of BFTC’s contract with the Navy, the indictment was defective. In short, the Third Circuit held that a mere violation of the duty of good faith and fair dealing implicit in a contract was an insufficient basis for private-sector honest services fraud.
For the full text of the decision in United States v. McGeehan, click here.