Circle of Greed

by Patrick Dillon

  “For over 30 years, ever since accountants were required by law to certify the financial statements of publicly held firms, there has been very little questioning of the accountant’s role and of his performance,” Weiss explained publicly. “As a result, an unhealthy reliance developed between the auditor and the company paying his fee, leading to a situation where the accountant started to forget his real clients—the ones who rely on the financial statements.”*

  He had a working knowledge of the field he was critiquing. Before attending law school, Weiss had been an accounting student himself, albeit an uninspired one, at Baruch College in New York. He would reach the campus on the number five subway line that he’d board daily from his home in the Bronx. He was a city kid, a Yankee worshiper, a street stickballer, a verbal brawler. His father was an auditor, a green-eyeshade persona specializing in small businesses in the wholesale meat district. As a teen, Mel helped his father run through the figures posted in multiple columns on butcher paper “biff sheets.” Thousands of digits, in difficult-to-decipher handwriting, particular to the pen or pencil of the butcher who had done the tallying, would have to be tediously reconciled. Although it gave Mel an aversion to his father’s vocation, he retained a head for numbers.

  He went to law school at night, and after graduating, clerking in a venerable Manhattan law firm, and doing a stint in the army, Weiss worked for small offices handling personal injury cases, often before juries, and delved into real estate law and derivatives cases in which he represented shareholders who thought the companies they held stock in were not being run with their intentions in mind. By the time he met Lawrence Milberg in 1965, Weiss was confidently equipped and dexterous with the tools of his trade, including an aptitude for dissecting financial sheets prepared by corporate accountants. He would describe his role as “taking a knife and slicing into the belly of the corporation to find out what had gone on.”

  That’s what he had done with the U.S. Financial case, dissecting it as a self-contained real estate company that “left nothing to chance.” Now Weiss began issuing instructions, directing each of his fellow attorneys like a quarterback playing street football in the Bronx: “You go long to the hydrant; you button hook at the Buick …” as to their role before the federal panel the following day.

  Lerach remembered the thespian command in Weiss’s soft voice, the assurance with which he issued his orders, the clarity of his game plan, and the brute force of his intellect. Weiss took a breath, ready to hit the sweet spot that would be delivered before a judge and jury if it came to it. The fraud, he said, resided in the fact that “this company entered into transactions with its affiliates on the last day of every reporting period, thereby creating virtually all of the profit for the entire reporting period.” In other words, he pointed out, “U.S. Financial was advancing the money to buyers to make their down payments.” It was nothing but a churn of money with no economic substance, he concluded, except for thousands of investors who had millions drained from their pockets. Perhaps even more important, Weiss reminded the other attorneys, U.S. Financial’s accountants and banks were in on this scam. In fact, since U.S. Financial had all but scorched its own earth, the more fertile ground might well lay with the accountants Touche Ross, investment banking house Goldman Sachs, and its major commercial banker, Union Bank of California.

  “We must go after them equally aggressively,” Weiss said firmly, looking around the table and then cracking a smile. “They’ll make it seem as if we are committing an unpardonable sin by suing them.”

  Lerach was smitten. Mel Weiss could frame a complex fraud case completely—and yet compactly—with a skill Lerach had never before encountered. Weiss was field general and salesman at the same time. Each of the attorneys represented individual claimants, Weiss acknowledged: each appeared to qualify under the rules governing the period of time their class of plaintiffs suffered the losses. Yet they should be gratified that as lead plaintiffs’ counsel, his firm, Milberg Weiss, had the most experience and most success in class action matters. He already had damage experts to calculate how much the stock had been fraudulently inflated during the class period. He looked around the table at each of the lawyers and repeated to them the losses their clients claimed they’d suffered. As lead counsel, he would strive to return to each of them more than they had lost. He would have to control the case, perhaps with some assistance from one or two of those gathered in the room. But he would be in charge.

  No one argued.

  The next day the attorneys appeared before the panel of federal judges who would decide the venue; several made their cases as to why they should be included in the class action and why it should be tried in New York and not San Diego. One of them, a young attorney from the venerable New York firm of Sullivan & Cromwell, representing Goldman Sachs, told the panel, “There is not a judge anywhere in San Diego sufficiently sophisticated enough to try this complex financial matter.” This reasoning did not win the day. The judges voted to send the case where the defendant company resided—San Diego. The day before, Mel Weiss had all but predicted that outcome, even while arguing for a change of venue to New York. In fact, everything that Weiss had foretold unfolded just as he had said it would. This fact was not lost on Lerach, who by the time he returned to Pittsburgh had a new idol and soon-to-be mentor.

  “I thought to myself, ‘Okay, now you’ve found the guy who’s going to show you what to do in life,’” Lerach recalled.

  Weiss also had his eye on the young attorney from Pittsburgh. The decision to try the U.S. Financial case in San Diego was the antecedent to creating a powerful East Coast—West Coast axis, eventually to be known as Milberg Weiss Lerach, that would become corporate America’s most feared, most hated, and by many accounts meanest law firm.

  PREDICTABLY, TOM FORT HAD a different reaction to Mel Weiss. Days later, back in Pittsburgh, Lerach was feeling almost giddy when he got off the elevator and strode toward his office at Reed Smith. On the way he passed Fort’s secretary, Jean Stiver, a secret Lerach confederate. She stopped Lerach, saying she had something to show him. It was a memo Fort had dictated for the partners following the Brown Palace meeting. It described the case and notified the other partners that Milberg Weiss would be the lead counsel against U.S. Financial and that the case would be tried in San Diego.

  Lerach’s eyes locked on the final passage, searing in its derision: “As for Melvyn Weiss, whom I can only describe as conducting himself as a 1930s Hollywood movie star …”

  Lerach chuckled and handed the memo back. “Doesn’t everybody want to be a movie star?” he said. “I’m going to California.”

  * Lerach has told the story of meeting Mel Weiss in Denver several times (although Weiss himself once told the New York Times that he believed they first met in San Diego).

  * The account here is drawn from four separate interviews the authors had with Lerach in mid-January 2008, as well as an account in the Times Lerach gave to Timothy L. O’Brien in 2004, and another he gave to Joseph C. Goulden in his 2005 book, The Money Lawyers. The versions are similar, although each contains details the others do not.

  4

  GOLDEN STATE

  The palm trees came into view first, and then, from the right side of the first-class cabin, Bill Lerach noticed the Spanish-Moor motif of Balboa Park’s museums and exhibition halls, its world-famous zoo, and its renowned botanical gardens, as the airliner descended into San Diego. An aspiring gardener, he made a mental note to visit. But that was a secondary consideration on this trip, his first ever, from Pittsburgh to the West Coast. At twenty-eight years old, on track to become the youngest partner at venerable Reed Smith, he would be working on the biggest case of his career.

  A minute later, on its final approach toward its landing at the downtown airport, Lindbergh Field, the plane seemed to be gliding just over the city itself, over a smattering of low-rise buildings with a newer, upstart high-rise here and there. Just beyond and drawing nearer, the long, narrow harbor
stretched out, shimmering in the still-bright December afternoon light. Berthed and anchored throughout the harbor were dozens of large gray naval vessels—tankers, destroyers, minesweepers, tenders, submarines, aircraft carriers—announcing to even the most uninformed visitor that San Diego was a company town, and the company was the U.S. Navy.

  By New Year’s Day 1975 the city’s innocence had receded into the past, not only because of disillusionment in military communities over the outcome of the Vietnam War, but also because of the shocking plunge from grace of a man who literally answered to the name “Mr. San Diego.” That was the name of a civic award given out each year, and C. Arnholt Smith had won it twice. A local newspaper opined that Smith was really “Mr. San Diego of the Century.”

  A high school dropout, Smith literally presided over the city’s economy. He owned the largest bank; he owned the largest hotel; he owned the San Diego Padres baseball team; he owned the state’s premier commuter airline; he owned a tuna fleet; he owned a shipbuilding business; he owned Yellow Cab operations in thirteen California cities; he owned the biggest shopping center in Southern California; he owned a diversified manufacturing organization; and he owned a lot of land. From his Westgate-California offices above San Diego, Smith could turn in any direction and look down on something he owned.

  Among the other beneficiaries of Smith’s influence was his friend and business colleague Robert H. Walter, the head of U.S. Financial Corp., whose developments were sometimes conjoined with Smith’s landholdings. Smith’s U.S. National Bank (USNB) was also one of Walter’s banks of choice. In 1973 USNB collapsed under the weight of $400 million in outstanding debt—mostly loans to companies he controlled—making it the biggest bank failure in U.S. history. Even earlier, the Justice Department and the Securities and Exchange Commission had turned their attention to Smith’s suspected self-dealings through his Westgate-California Corporation, which used his USNB as its moneylender and launderer. Forbes magazine’s description of C. Arnholt Smith as “perhaps the swindler of the century” turned out to be wishful thinking. Greater frauds, and greater scam artists, were in America’s future—and Mel Weiss and Bill Lerach would sue most of them.

  When Lerach landed in San Diego in December 1974, ready to do battle with lawyers representing banks and accounting firms that had aided U.S. Financial’s fraudulent empire, Smith was facing an indictment by a federal grand jury for embezzlement and fraudulently commingling funds in an arrangement that comptroller of the currency James E. Smith had termed “total fraud … self dealing run riot.”

  This irony delighted Lerach, who appreciated the nuances of greed, except for one fact. Smith and Westgate would have been as ripe for a private securities lawsuit as Walter, except that Smith’s bank was insolvent and so was his fraudulent corporation. “The bastard left nothing for the rest of us,” Lerach quipped.

  CLASS ACTION WAS A legal doctrine that crossed the Atlantic Ocean with the Pilgrims and was codified into federal jurisprudence as early as 1820; it was spelled out specifically by the U.S. Supreme Court as Rule 48 in 1842. The advent of the Great Depression unleashed a torrent of lawsuits against corporations, and in 1937 the high court codified that old rule into a new one, Federal Civil Rule 23.

  The stock market collapse and onset of the Depression had led to the near-crumpling of the nation’s banking system. A frightening 1,456 banks failed in 1932, and after Franklin Roosevelt’s landslide election that year, the pace only picked up. In Washington a consensus quickly developed that new legislation was needed, and fast, to rein in an unregulated banking system that Senator William Gibbs McAdoo of California said colorfully “does credit to a collection of imbeciles.” Congressional hearings were held hurriedly—and in Roosevelt’s First Hundred Days, Congress passed a sweeping measure called the Banking Act of 1933, popularly known then and forever more as Glass-Steagall, after its authors, Senator Carter Glass of Virginia and Congressman Henry B. Steagall of Alabama. Steagall’s passion was federal deposit insurance; Glass was obsessed with forbidding financial institutions from engaging in both commercial and investment banking. The compromise bill that bore their names accomplished both aims.

  Revelations unearthed during the 1932 congressional hearings into the banks’ relationship with Wall Street led to further reforms. The Truth in Securities Act of 1933, as it was initially called, required new securities to be registered in advance with the Federal Trade Commission and to be accompanied by detailed filings disclosing “every important essential element” of the stock being issued twenty days prior to the stock going up for sale. It also held underwriters and corporate officers responsible for the truthfulness of those representations—a provision that would lead to much litigation in the next half century. The following year the Securities Exchange Act of 1934 extended those provisions to all stocks sold publicly, not just new ones; required financial disclosure from officers of publicly held corporations; gave the Federal Reserve the power of regulating how much purchasers of new securities could rely on bank credit—thus setting the margin rate; and established the Securities and Exchange Commission (SEC) to oversee all this new regulation.

  From the start, the SEC was outgunned. Moreover, there were methods to beat the system that had gone unanticipated by Congress. One of them came to light the following decade. In 1942 reports came flooding into SEC headquarters* that companies were defrauding investors by withholding good news instead of bad news. Milton Victor Freeman, assistant solicitor for the commission, was informed by SEC regulators in the Boston regional office of a problem in a Holyoke, Massachusetts, firm called American Tissue Mills. Company executives spread rumors that American Tissue was in poor shape—it was actually going gangbusters—then bought up the stock when worried investors began to divest themselves of their shares. Meanwhile an SEC attorney named Mayer U. Newfield had noticed reports of similar activity in other regional offices. In May 1942 Newfield went to Freeman, and the two lawyers hashed over the problem.

  Freeman informed Newfield that a section of the 1934 Act, Section 10b, covered fraud in the purchase as well as the sale of securities—and authorized the commission to adopt rules and regulations prohibiting such behavior.

  “Why don’t we just take Section Seventeen under the ’33 Act, and insert the word ‘purchase,’” Freeman suggested.

  “Great,” replied Newfield. “That clearly covers the manipulations we are talking about.”

  And so they did. On May 16, 1942, in a session that took less than ten minutes, the change was made. Four of the five commissioners were present at the meeting, none of whom objected.

  “Well, gentlemen,” remarked Sumner T. Pike, one of two Republicans on the commission, “we are all against fraud, aren’t we?”* In a 1996 letter to Freeman—at the height of the passions in Congress running against Bill Lerach and Mel Weiss over their aggressive methods—Newfield offered his view that the “sole purpose” in adopting the rule was to give the staff of the SEC clear lines of authority and a new enforcement tool for rooting out fraud with regard to the purchase of securities. “No one dreamed at that time of the avalanche of fraud litigation which followed,” he said.

  Perhaps that was true within the confines of the SEC. But in passing the 1933 Securities Act, Congress clearly had private litigation in mind as a way of reining in crooked corporate executives. No less a legal thinker than Yale law professor and future Supreme Court justice William O. Douglas noted this legislative intent in a 1933 piece he coauthored for Yale’s law review.

  “The civil liabilities imposed by the Act are not only compensatory in nature, but also in terrorem (to frighten),” wrote Douglas and Harvard Business School professor George E. Bates. “They have been set high to guarantee that the risk of their invocation will be effective in assuring that the ‘truth about securities’ will be told.”

  Four decades later Mel Weiss persuaded his older partner and mentor Larry Milberg that the updating of Rule 23 in 1966—a step taken to open the courts to victims o
f racial discrimination—had also increased access to legal redress for disenfranchised investors, including those with claims too small or too costly to pursue individually. By coalescing hundreds, even thousands, of such claims by victims with common grievances and representing them all with just a few named claimants, they could initiate class action lawsuits the way civil rights attorneys had fought for the rights of multitudinous victims. What they were doing, and doing consciously, was emulating a famous case that had changed the law and American society. That case was Brown v. Board of Education. The case of record ended up as the one involving the school board in Topeka, Kansas, but NAACP lawyers had conjoined separate school desegregation cases from five states into one.

  What’s more, under a new theory called “fraud on the market” that had been given birth by legal academics—and quickly embraced, applied to Rule 10b-5, and put into practice in class action securities lawsuits by Mel Weiss—these plaintiffs need not have actually seen or relied on misleading statements to bring the lawsuits. If the plaintiffs’ attorney could prove that they relied on the public assumption that the market price of a stock reflected the market’s response to all the available public information about a company, when, in fact, a fraud had been perpetrated by cooking the books or releasing information that was untrue, a serious securities fraud case would exist. In addition, Weiss postulated that if other parties contributed to this fraud either by endorsing it in their accounting analyses or by helping concoct complex business deals that aided the fraud, those companies—the accountants, investment banks, vendors, even lawyers—could be equally culpable.

  There were hurdles. The first was conjuring up the clients to begin with; a second was informing others in the prospective class about a legal action on their behalf. This took time and money, both of which would have to come from those filing the claim. Weiss saw a pathway through the obstacle course. By taking cases on contingency (meaning deriving their fee from only the settlement or judgment, and even fronting the court costs), their firm, Milberg Weiss, would relieve their clients of financial pressure and help convince them to become plaintiffs.