Serpent on the Rock

by Kurt Eichenwald

  “Nor should we rely on some state investigator cracking this open with some massive fraud finding that we don’t know of,” Grossmann said.

  The class action should not impede the state investigations, Grossmann said. “But we shouldn’t wait for them either. They’ve shown no evidence, and lots of rhetoric.”

  Finally Grossmann dismissed the possibility raised by plaintiffs’ lawyers of selling the oil reserves for the benefit of investors. The idea, he implied, was ridiculous. The only option, he said, was the roll-up.

  “There are no white knights out there to buy limited partnership assets,” he said. “I talked to Dillon, Read and Morgan Stanley, in addition to Wasserstein Perella. Each one of these Wall Street firms agreed that it wasn’t practical since it would require approval of all of the limited partnership investors.”

  Grossmann paused. “Nobody could do that.”

  Livaudais’s written opinion on the energy income class-action settlement was filed in the New Orleans Federal Court on February 19 at 3:40 in the afternoon. In eighteen pages, he made it clear that he hadn’t bought Grossmann’s arguments. Early on, he rejected the idea that the settlement’s wide approval was irrefutable.

  “There were some 12,000 opt-outs and a large number of silent voices,” Livaudais wrote. “The court does not feel that mere silence is acquiescence. It has a responsibility to those silent voices who will be affected by this litigation.”

  Livaudais noted the objections to the settlement by the Idaho regulators, with support from the other states. This, he wrote, had to be considered seriously.

  “Because there are state administrative and regulatory investigations in progress,” he wrote, “the wisest course and perhaps the most equitable may be to defer ruling to allow additional information to be amassed.”

  Livaudais wasn’t rejecting the settlement, but he also wasn’t approving it. The settlement was simply being stopped.

  The long shot from Idaho had hit the target.

  Klein read Livaudais’s order carefully. His enormous respect for the judge grew with each page. The energy income case had to be the largest one on Livaudais’s docket. Most judges simply approved class actions and cleared them away. Livaudais not only showed enormous guts, Klein thought, but a clear understanding of the stakes involved for 135,000 retail investors.

  The order also made Klein feel vindicated. For weeks, lawyers for Prudential Securities had kept up their criticism that the regulators were sticking their noses where they didn’t belong. Now Livaudais was saying that the regulators had been right.

  Klein finished reading the decision and hustled down the hallway to the copying machine. Minutes later, he was walking around the office with a broad smile on his face, handing out copies to his examiners.

  “Take a look at this,” Klein said as he handed a copy to Mary Hughes. “It’s amazing. The settlement didn’t go through.”

  In the politics of regulatory investigations, the balance of power had just shifted. The states now had the advantage over Prudential Securities.

  That spring, Gary Lynch delivered a demand from Prudential Securities to the SEC: Prove it. If the enforcement staff was so convinced that they had the evidence to support a case, then let the lawyers for Prudential Securities see it.

  The request was highly unusual, but in this case it seemed like a perfect idea. Thomas Newkirk, the SEC’s associate director of enforcement, thought that if the firm saw the evidence, it would be forced to settle. And settling quickly with the firm was the central goal in this case. The elderly investors who suffered horrendous losses needed the money a settlement would give them. The SEC lawyers wanted that done quickly, before too many of the investors died.

  Pat Conti and other lawyers working on the case were ordered to put together a notebook of the most damaging evidence, which could then be turned over to Lynch at Davis, Polk.

  The idea seemed strange to Conti. The evidence had been subpoenaed from Prudential Securities. All they were doing was handing the same material right back. The firm and its lawyers knew what the documents said. Why go through the exercise?

  “This is a waste of time,” Conti complained to Newkirk. “Why are we giving them back their own documents?”

  “They’re testing us,” Newkirk responded. “Just because they gave us boxes of documents doesn’t mean we found the juicy stuff.”

  The notebook was finished in a few days. In it were marketing materials about the safety of the VMS Mortgage Investment Fund and the energy growth fund. It also included sales literature advising brokers to stress safety and guarantees to friendly clients, regardless of the partnerships.

  When Newkirk finished reviewing the notebook, he had no doubt: The case could not be defended. Prudential Securities could try to fight the commission, but at the end of the day they would lose. No one who saw the evidence could think anything different. Newkirk ordered the notebook boxed up and shipped over to Lynch.

  About a week later, the enforcement staff met with Prudential Securities’ lawyers in the SEC’s fourth-floor conference room. The lawyers representing the firm were Gary Lynch and Arthur Mathews, the Washington lawyer who had represented the firm in the Capt. Crab case. Across from them was William McLucas, who had succeeded Lynch as the SEC enforcement chief, Newkirk, and Pat Conti.

  Lynch and Mathews opened up the discussion. Despite everything they had just seen in the notebook, they clung to the firm’s line.

  “There was nothing systemic here,” Lynch said.

  “What we had were some isolated cases of bad brokers,” Mathews added.

  McLucas broke in. “We don’t see it that way at all. It’s clear that what happened was centrally directed. And we’re prepared to establish that if we need to.”

  It was the last time anyone from Prudential Securities argued the “rogue broker” theory to the SEC. Instead, settlement negotiations soon began in earnest.

  The Prudential Securities investigation was taking its toll on the resources of the Idaho Securities Bureau. Other cases were at a standstill. The bureau had spent close to $50,000 hiring experts to help sort through financial material—an enormous sum of money for a single investigation. And there was no end in sight. Without a larger budget, Klein might not be able to see the investigation through.

  In March, Klein went to see his boss, Belton Patty. A soft-spoken man with a deep baritone voice, Patty had spent much of his life as a banker in Idaho until Governor Cecil Andrus named him head of the Department of Finance. Patty was a good boss, who believed in letting his people pursue whatever leads they felt were important. All he asked was that he be kept up to date on big cases and consulted on important decisions.

  For two years, Klein had been briefing Patty on the Prudential Securities case, and the story seemed to grow more amazing each time. By the end of Klein’s briefing in March, Patty felt sickened by what he heard.

  “This isn’t the kind of conduct I’d expect from a national brokerage firm,” Patty said. “It’s offensive. If all this is true, then Prudential is no better than a penny-stock firm.”

  Klein then explained the problem with resources. To finish up the investigation, they would need more money. They didn’t have enough lawyers. They might have to bring in an outside firm.

  Patty held up his hand. “I’ll take care of it, Wayne.”

  The timing was a little problematic. Because the Idaho state legislature was about to finish its session, it was a terrible time to try to change an agency’s appropriation. Patty decided he needed help so he called Governor Andrus to arrange a meeting.

  A few days later, in Andrus’s office, Patty described the problem. “I’ve got a serious-sized securities case that might require more money than I had in my appropriation,” he said. “I wanted to see if we could do something about that.”

  Andrus asked no questions. He knew nothing of the details of the case. He didn’t even know it involved Prudential. But he trusted the judgment of his appointees.

&
nbsp; “Don’t worry,” Andrus said. “If you need more money, I’ll get it for you.”

  With those words, the only threat to the Idaho investigation was gone.

  The bid for the energy income partnerships came out of nowhere.

  A group called GBK Acquisition Corp. filed a hostile tender offer on March 22 for thirty-one of the thirty-five partnerships. Livaudais’s refusal to rule on the class-action settlement had, in the parlance of Wall Street, put the energy income partnerships in play. Now they were on the block to the highest bidder.

  The $173.5 million bid from GBK, a company controlled by George Kaiser, a wealthy oilman from Tulsa, Oklahoma, was quickly criticized on Wall Street as far too low. But it brought other investors out of the woodwork. Soon a bidding war emerged. In less than eight weeks, Parker & Parsley Petroleum of Midland, Texas, agreed to purchase all of the partnerships for $448.3 million. All of that money, more than twelve times the amount of cash that had been in the class-action settlement, would go straight to the partnership investors.

  It was the final piece of evidence that the rationale for the proposed class-action settlement had been absurd. After all, the bidding started just forty-one days after Grossmann, the class-action lawyer, proclaimed in New Orleans that such a sale could never occur.

  On March 29, sixteen lawyers arrived at a New Orleans law firm to attend the first deposition in the energy income class action. Livaudais’s decision had compelled the class-action lawyers to finally begin taking sworn statements of executives from Prudential and Graham. The first witness was Matthew Chanin from Prudential Insurance, the executive who had been most involved in the company’s decisions on the energy partnerships.

  Most of the lawyers knew each other from the lawsuit. But seated among the crowd was a woman none of the others had seen before. All of the lawyers introduced themselves for the record. Finally it was the unknown woman’s turn.

  “Marilyn Scanlan,” she said. “Representing the state of Idaho.”

  Klein, who had received a notice from the New Orleans court telling him of the Chanin deposition, had assigned Scanlan to watch and take notes. She was the only regulator in the room.

  Klein had good reason to want one of his examiners there. At the beginning of the case, the lawyers from Prudential Securities and Graham Resources had demanded a court order to keep all records and documents confidential, ostensibly to protect corporate secrets. Judge Livaudais had complied, restricting access to thousands of documents.

  While the regulators eventually could get hold of those documents, at times Prudential Securities seemed to drag its feet in producing them. Plus, Graham Resources had no offices in Idaho and was largely beyond Klein’s reach. If the Idaho investigators heard the testimony personally, there would be no need for a fight to obtain copies.

  As soon as Scanlan identified herself, Graham tried to tie her hands. Phillip Wittman, a lawyer for the oil company, said that he wanted her to state for the record that she accepted the terms of the court’s protective order. Under that rule, Scanlan could use the information only for the class action and not in the state investigation. She refused.

  “I have some statutory considerations here,” she said. “I don’t know that I can be bound voluntarily by an order like this. I think what I’ll propose to do is check with my office.”

  “You’re not really bound voluntarily,” said Lawrence Sucharow, one of the class-action lawyers. “It’s an order of the court, and you can only participate within the scope of that order.”

  “Well, I think we certainly have the same power to get the same information without any kind of restriction,” Scanlan replied. “So it seems to me that this is a lot of rigmarole. I don’t know that the state of Idaho has to abide by this, so let me see how my office wants me to proceed.”

  Scanlan stood and left the room. Klein had discussed this possibility in advance. They had decided that if the lawyers gave her any problems, she would contact Judge Livaudais’s chambers immediately. She walked to a pay telephone, called the judge’s clerk, and explained the situation. After Livaudais came on the line, Scanlan told him of the problem.

  “Who’s objecting to you being there?” he asked.

  “I think Prudential and Graham and maybe some others.”

  “Go back in there and ask who’s objecting.”

  “All right, just a minute.”

  Scanlan walked back into the deposition room. Chanin was in the middle of answering one of Sucharow’s questions.

  “Excuse me,” Scanlan said. “May I interrupt for a moment?”

  “Do you want to go off the record?” Sucharow asked.

  “No, I would prefer to stay on the record,” Scanlan said. She asked which of the lawyers in the room would object to her attending the deposition if she did not plan on complying with the confidentiality order.

  “I would, representing Graham defendants,” Wittman said.

  A number of the class-action lawyers said they would not object. They actually wanted the evidence to be public. Then the floor was turned over to Frank Massengale, one of Prudential Securities’ lawyers. Massengale said that the regulators could not simply ignore the court order.

  “So you would not object to my attendance without complying with the order?” Scanlan asked.

  “Certainly by agreeing to your presence, we wouldn’t waive our position to seek a contempt charge or other remedy if you violate the order,” Massengale said. “We believe the order applies to you.”

  Scanlan left the room for the pay phone, where she spoke with the judge’s clerk, Peter Pierce. She explained the positions of Graham and Prudential Securities. As Pierce spoke with Livaudais in the background, Scanlan could hear that he was angered by the companies’ attempts to impede the investigation. In a few seconds, Pierce was back on the line.

  “The judge wants you to go back and tell everyone that he is revoking the confidentiality order,” Pierce said.

  Scanlan returned to the deposition and let everyone know what she had been told. The class-action lawyers thought it was hilarious. One said he wanted to start throwing incriminating documents out of the window. The lawyers for Prudential Securities and Graham Resources were apoplectic. They demanded that the other lawyers keep the information confidential, even without the order. Everyone refused.

  That afternoon, Livaudais vacated the confidentiality requirement. With the thousands of internal documents suddenly public, an avalanche of bad publicity hit the firm. Articles appeared in the Wall Street Journal describing how the documents showed that partnership distributions had been falsely inflated. The Los Angeles Times, relying heavily on the newly available documents, splashed a two-part, ten-thousand-word exposé about the energy income partnerships across the front page. Some of the Direct Investment Group’s darkest secrets were finally spilling into public view.

  The lawyers for Prudential Securities and Graham had overplayed their hand. The regulators from Idaho had outsmarted them again.

  An all-new front in Prudential Securities’ regulatory war opened up the day after Livaudais’s ruling. At 9:53 on the morning of March 30, Ronda Blair, a staff lawyer in the Fort Worth office of the SEC, faxed a two-page document to Prudential Securities’ Dallas branch. It was a subpoena, addressed to John Bluher, a lawyer there. The commission wanted records about Fred Storaska.

  The enforcement staff had been investigating problems at the Dallas branch for months. They had already obtained copies of managers’ memos describing how Storaska could not be controlled. Since then, the commission had met with Douglas Schulz, a former broker and arbitration consultant who represented a number of former Storaska clients. Schulz had conducted his own investigation, and gave the SEC documents he had obtained from former members of Storaska’s staff. With the subpoena, the enforcement staff was officially notifying Prudential Securities of formal investigation number MFW-586, titled “In the Matter of J. Frederic Storaska.”

  SEC inquiries of the firm were sprouting eve
rywhere. The Fort Worth office was investigating Storaska, the Washington, D.C., office was handling the partnership case, and the Atlanta office was looking into apparent violations at the firm’s branch offices in Atlanta and Chesterfield, Missouri. All told, nine branches were being investigated.

  Within the SEC, the multiple cases were dubbed “Capt. Crab II.” Despite the assurances from Schechter during the Capt. Crab settlement negotiations so many years before, Prudential Securities had failed to impose proper compliance procedures. The problems caused by the party atmosphere at the firm during the 1980s were all catching up to it at the same time.

  Patrick Finley, the deputy general counsel of Prudential Securities, finished reading a letter from Wayne Klein and reached for the telephone. Finley had assured Klein repeatedly that the firm intended to cooperate with his investigation. But now, in early April, Klein had written that he thought Prudential Securities was stonewalling.

  Klein wanted the Locke Purnell report. Prudential Securities was refusing, again arguing that the document was a privileged communication with lawyers. Klein shoved back, sending the firm a letter that asked if their refusal was a sign that they no longer wished to cooperate. To Finley, it sounded like a dangerous breakdown in relations with the Idaho regulator.

  Finley called Klein several times, but couldn’t reach him. Finally he dictated a letter, assuring Klein that the firm had every intent to continue cooperating. But, he said, that had nothing to do with the Locke Purnell report, which was privileged and would not be turned over.

  The letter arrived at the Idaho Securities Bureau a few days later. After reading it, Klein walked to the office of Mary Hughes, one of his investigators. He told her to drop everything else she was doing; he wanted her to review the rules of attorney-client privilege to determine whether the firm’s claim was valid.

  “What are we going to do if I find out that the firm’s position isn’t valid?” Hughes asked.