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From Securities Regulation Daily, September 11, 2014

Duane Reade book-cooker’s restitution fight goes on

By Anne Sherry, J.D.

Duane Reade and its then-owner, Oak Hill, cannot recover everything they paid to the two law firms that uncovered and investigated fraud by former Duane Reade CEO Anthony Cuti. Although restitution is available under the Victim and Witness Protection Act (VWPA), the Second Circuit remanded to the district court to sort out which expenses were “necessary to the investigation or prosecution” of the government’s successful criminal case against Cuti (U.S. v. Cuti, September 11, 2014, Pooler, R.).

Background. To prepare for an impending arbitration claim by Cuti for post-termination benefits, Duane Reade undertook an internal investigation that uncovered two fraud schemes by Cuti and former CFO William Tennant. These results became the basis for counterclaims and affirmative defenses in the arbitration and also led to a government investigation into Duane Reade’s finances. Oak Hill agreed to pay 65 percent of fees and expenses incurred by the Paul, Weiss law firm, which represented Duane Reade in the arbitration. Cooley Godward Kronish LLP, as independent counsel to Duane Reade’s audit committee, investigated the credit rebilling and real-estate income concession schemes.

Following the jury’s guilty verdict, Oak Hill and Duane Reade jointly submitted an impact statement seeking approximately $53 million in restitution, most of which was requested to compensate Oak Hill’s claimed overpayment for Duane Reade in light of Cuti’s fraud. This portion was denied, but the district court eventually ordered Cuti to pay over $6 million in restitution to Duane Reade first, before paying restitution to Oak Hill as a “non-victim.” Cuti appealed this order to the Second Circuit.

Eligibility for restitution. The appeals court dispensed with Cuti’s first two restitution arguments: that Oak Hill was not eligible for restitution because it was not a victim of his fraud, and that Oak Hill should not have been reimbursed for paying its employees’ legal fees. Restitution is permitted where a third party has directly paid an expense incurred by the victim, and the district court’s decision that the legal fees were necessary and constituted an actual loss was soundly within its discretion.

“Necessary” expenses. More complicated was the question of whether expenses incurred by Paul, Weiss in the course of its work on the arbitration that uncovered Cuti’s fraud, and those incurred by Cooley’s internal investigations, constituted “necessary” expenses “related to the offense” within the meaning of VWPA Section 36663(b)(4). In United States v. Maynard, the Second Circuit had reasoned that expenses recoverable under the Mandatory Victim Restitution Act (MVRA) are those that the victim was required to incur to advance the investigation or prosecution of the offense. The VWPA’s restitution provisions being almost identical to those of the MVRA, and the same rationale applying to both, the court extended its reasoning under Maynard to the VWPA.

This did not end the court’s inquiry, however, because the case did not involve a straightforward “internal investigation paid for by the victim”: the internal investigation was motivated by Duane Reade’s need to defend itself in Cuti’s arbitration proceeding, and the company retained two separate law firms to handle the internal investigation and to assist with the government’s. Under Maynard, the expenses of an internal investigation are subject to restitution if the investigation’s purpose is to uncover or investigate fraud “when faced with evidence, indicia, or a grounded suspicion of internal misconduct,” but an investigation commenced for another reason is not “a means calculated to achieve the protection of a corporation’s ongoing operations and reputation” for restitution purposes.

The record on appeal gave no indication of when, if ever, Duane Reade had Paul, Weiss shift its focus from a defense to an investigation premised on a “grounded suspicion of internal misconduct.” Furthermore, the entire expenses of both the Cooley and Paul, Weiss investigations, premised on the same underlying findings and conduct, could not have been “necessary” to the government’s case under the VWPA.

At a minimum, Paul, Weiss’s expenses from meeting with the government, turning over its findings, and cooperating with the government are necessary expenses. The appeals court remanded to the district court to determine whether the government proved that some or any of the firms’ other expenses were “necessary to the investigation or prosecution” of the criminal case against Cuti, with instructions to consider whether the firms’ claimed expenditures were redundant or duplicative as well as whether the fact of two firms working in tandem created additional administrative costs.

The case is No. 13-2042-cr.

Attorneys: Michael Alexander Levy, U.S. Attorney’s Office, for the USA.

Companies: Duane Reade Inc.; Oak Hill Capital Partners L.P.

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