Throughout Prudential Securities, the proposed settlement was treated as a blessing. After the terms were disclosed, Richard Haughey, the manager of the firm's Rancho Bernardo, California, office, called a meeting of some of his top brokers. The branch had been consistently one of the biggest sellers of the energy income partnerships, and it looked like the settlement would bail it out of a lot of potential claims.
As he briefed some of his brokers on the settlement in early January 1993, Haughey smiled. “We're not supposed to give legal advice to clients,” he said. “But if your clients go into the energy income class-action settlement, they cannot sue Prudential, and they cannot sue you.”
Then Haughey winked at the assembled group of brokers.
James Barrett, one of the branch's biggest sellers of the energy income partnership, stood up and walked out of the meeting. He was incensed. For years after the problems with the partnerships became apparent, he had demanded to know what the firm was going to do for the defrauded clients. Now he knew. It was going to cheat them again.
Barrett headed into his office where his fiancée was waiting for him. As he was describing what had just happened in the meeting, Haughey knocked on his door.
“Jim, I don't like to see you looking so upset,” Haughey said. “What's the matter?”
Barrett spun around. “This settlement sounds like a damn screwing, and you know it.”
Haughey closed the door. “You know what happens in class-action lawsuits, don't you, Jim?” he asked.
“You tell me.”
“The only ones who make out in a settlement are the attorneys and the defendants,” Haughey said.
Barrett felt so angry his hands trembled. “Well, what about my clients?”
“The clients always get screwed in a class action, Jim,” Haughey said. “They always get screwed.”
After a few minutes, Haughey left. The broker sat down at his desk and stewed. He picked up the telephone, dialed the Direct Investment Group in New York, and asked for Jim Kelso, the head of the department. Once Kelso got on the line, Barrett started complaining about the horrible class-action settlement.
“Jim, it's out of our hands,” Kelso said. “You need to talk to the law department.”
Later that day, Barrett called Carlos Ricca in the law department. He mentioned several concerns he had about partnerships and then got to the settlement.
“What's going on with this settlement for $37 million?” Barrett asked. “Brokers in my office are saying that's like two cents on the dollar. How in the hell can we do this to our clients? I mean, I've got my brother in this crap, I've got my ex-wife in it, I've got myself in it. All my good clients who are my friends are in there. How can we do this to them?”
“It's all being done in New Orleans,” Ricca responded calmly. “It's out of our hands, you know.”
Barrett was sick of everybody saying it was out of their hands. His anger finally got the better of him.
“Fine, it's out of your hands, it's out of Kelso's hands, nobody is responsible for this bullshit,” Barrett said. “What would you do if I called
60 Minutes
or
Business Week
and told them what the hell was going on? Would that be in your hands?”
Ricca's voice stiffened. “I wouldn't do that if I were you.”
“Well, I guess you're not me, are you?” Barrett said.
Barrett was angry for the rest of the day. By January 6, two days later, he had calmed down. His statement about going to the media had been an idle threat. Instead, he just went back to work. He began his morning by preparing a mailing of two thousand invitations to an investment seminar. As Barrett was getting them ready, Haughey's secretary dropped by. Haughey wanted to see him.
Barrett walked into his manager's office and babbled for a few seconds about the mailing. Haughey looked on stone-faced.
“Jim, I can't have you do that mailing,” Haughey said finally. “I have to terminate you.”
Barrett gasped. “Why?”
“This has nothing to do with me,” Haughey said, holding up his hands. “I'm just following orders. This comes straight from the law department. Carlos Ricca called and said that we had to fire you. He said that you have an overconcentration of direct investments in your accounts.”
“Wait a minute,” Barrett said. “I haven't sold one of those things in a long time. Are you telling me they just noticed that I sold a lot of them?”
“Jim, I'm just doing what I was told. I have to terminate you for having an overconcentration of direct investments.”
Bullshit
, Barrett thought.
You have to fire me because Ricca thought I was going to blow the whistle
.
At that moment, Barrett realized that, even if he bothered to tell any reporters what he knew, Prudential Securities would just dismiss it as the ravings of a disgruntled former employee. He stood up and walked out. It was his last day at the firm. Barrett left convinced that his clients would be tricked into joining the energy income settlement. But he didn't think there was anything he could do. If Prudential Securities fired him for making a hollow threat, Barrett felt sure that the firm would crush anyone it saw as a danger to the settlement. He feared that no one would be able to stop it.
Barrett had no way of knowing that a little-known securities regulator from Idaho was just getting ready to try.
CHAPTER 18
SCORES OF CASUALLY DRESSED state securities regulators milled about the Hibiscus Room at the Brazilian Court Hotel as they hunted for their seats. The meeting about trends in securities law enforcement was scheduled to begin any minute. It was the morning of January 11, 1993, the third day of the winter enforcement conference at the hotel in Palm Beach, Florida.
The group began to quiet down as William McDonald, a regulator from California and the chairman of that day's session, stepped up to the podium. He asked everyone to come to order quickly because they had a packed agenda. The first topic was Prudential Securities. The firm's partnership troubles had first been mentioned at last year's meeting. The number of state investigators had since grown rapidly.
“A number of states have approached me about complaints they have received regarding Prudential in the limited partnership area,” McDonald said. “Some states have already progressed far along in their own investigations.”
McDonald nodded toward Klein, who was leaning against a wall at the side of the room. “Wayne Klein from Idaho has been looking into this matter for some time. So, Wayne, could you give everyone a sense of what it is that you're finding, and where the investigation might be going?”
Klein spoke for a few minutes about his department's findings. He had expected that McDonald would ask him for a presentation. The previous day, Klein and Joseph Goldstein, a lawyer from the SEC enforcement division who was attending the conference, had spoken with McDonald about setting up a system to coordinate the different state investigations. That would help the SEC, which was receiving dozens of requests for information from regulators across the country, and could give the states more leverage in dealing with Prudential Securities. McDonald had agreed to get it done before the end of the conference.
After Klein finished his presentation, McDonald recognized Don Saxon, the Florida state securities regulator, and asked for details of his state's investigation of the firm. Saxon's presentation was followed by another from Matthew Neubert, a regulator from Arizona. All of the inquiries were treading on similar ground.
“All right,” McDonald said after several presentations. “As you can see, there are a number of states working on the Prudential matter that have expressed interest in getting information from the SEC. Now, the SEC has suggested that a coordinating group would be the best way to funnel information. Which states would be interested in participating?”
A flurry of hands went up. Saxon and Neubert, who had both obtained information from Bristow, Hackerman, were the first to be named. Then Nancy Smith from New Mexico joined up, followed by Lewis Brothers from Virginia.
The last hand was Klein's. He had hesitated for a moment, worried about whether working with the other states might slow his own investigation. But he put aside his doubts in the hopes of gaining access to more information from the SEC. McDonald immediately named Klein chairman of the group.
At 12:15 that same day, the newly formed Prudential Multi-State Task Force met for a buffet lunch at a circular table in the hotel's dining area. They were joined by several members of the SEC enforcement staff.
The regulators quickly established an agenda. They listed the questions Prudential Securities needed to answer and the documents they wanted the firm to turn over. They discussed how, if the partnership matter was going to be resolved, it should be as a global settlement involving both the states and the SEC. That would prevent Prudential Securities lawyers from playing the two sides off each other. The SEC lawyers agreed.
Klein was delighted. Apparently Richard Breeden, the commission's chairman, was no longer an obstacle to cooperation. Then again, Breeden was an appointee of George Bush. Bill Clinton had just won the presidency, so Breeden would be chairman for only another few weeks. Klein felt sure that had at least something to do with the new willingness of the SEC enforcement staff to work with the states.
Near the end of the luncheon, Nancy Smith, the New Mexico securities regulator, raised concerns about the energy income class-action settlement. Smith, a former aide to Congressman Ed Markey of Massachusetts, had investigated the types of partnership roll-ups involved in the settlement for congressional hearings a few years earlier. In her mind, roll-ups were little more than scams that enriched general partners at the expense of their investors.
“This is an outrageous settlement,” Smith said. “It has such a small amount of money, then they throw in this roll-up. It's nonsense.”
The regulators also knew that the settlement could cause problems for their investigation. There were 120,000 investors in the energy income partnerships. Once their claims were resolvedâno matter how unfairlyâ those investors would be less likely to spend the time and energy to help the regulators build their case. Not only would the paltry settlement wipe out valid investor claims, but it would severely hamper any chance regulators had of getting money back for other investors.
“There's a deadline coming up soon,” Smith said. “The judge is going to hold a fairness hearing on the settlement's terms. And I think it's urgent that we get a letter to him and try to stop it.”
The state regulators agreed to write the federal judge in the case, Marcel Livaudais, and asked if the SEC would do the same. Goldstein from the SEC replied that was not likely. The commission had a policy against getting involved in private litigation.
As the meeting was about to break up, Klein mentioned that he had recently learned an interesting fact: The Brazilian Court, the hotel where the task force was formed and where its first strategy session was held, was part of the Prudential-Bache partnership debacle. The hotel had been syndicated in a deal sponsored by one of the firm's biggest general partners, Clifton Harrison. It was later seized by S&L regulators when it defaulted on a series of loans. Investors lost everything.
The birthplace of the task force was also the perfect symbol of its cause.
In late January, Pat Conti, a senior counsel with the SEC enforcement staff in Washington, read over Prudential Securities' five-page response to his most recent subpoena. Conti was in charge of investigation number HO-2636, titled “In the Matter of Prudential Securities.” When he started work on the case months before, Conti read through the documents that had been collected by the New York regional office in its original, aborted inquiry into the
Business Week
allegations. The material was useful, but Conti still thought a lot of important documents were not in the file. In particular, he wanted a copy of the three-volume Locke Purnell report.
A few weeks before, he had subpoenaed Prudential Securities seeking that report and any other documents relating to investigations of Darr. He had felt somewhat secure that the firm would turn over the material. In a recent lawsuit, an Alabama court rejected Prudential Securities' argument that the Locke Purnell report was a privileged communication from its lawyers. In essence, the court held that the firm had simply farmed out its legally required responsibilities to oversee its operations. Just because it hired a law firm to handle that job did not mean Prudential Securities could hide the information.
But in its letter responding to the subpoena, Prudential Securities was refusing to turn over the report to Conti. The letter came from Gary Lynch, the former head of enforcement for the SEC who had been in charge when the Capt. Crab case was brought. Lynch was now a lawyer at Davis, Polk and represented the firm.
The letter was blunt: Every document that Conti wanted was an attorney-client product and was exempt from disclosure. The judgment by the Alabama court had no bearing on the situation, Lynch wrote. After failing to reverse the ruling on appeal, Prudential Securities had settled the case on the condition that the former client support having the judgment vacated. The former client accepted, and the judgment was withdrawn. The report was never turned over. As a result, the Alabama decision no longer existed as a precedent. Just as in the McNulty case involving Clifton Harrison, the firm had paid to have an adverse ruling disappear.
Conti finished reading the letter and set it down. The firm was clearly going to fight this one hard. Conti still wanted the Locke Purnell report. But at that moment, he hadn't the faintest idea how he was going to get it.
Klein sat at a desk in the Idaho State Supreme Court's law library, looking for a legal precedent in volume 748 of the
Federal Supplement
. He had returned a few days before from the conference in Palm Beach and was spending every working day in the library, researching class actions. If he was going to write a letter asking Judge Livaudais not to accept the energy income settlement, he wanted his arguments as strong as a legal brief.
The letter to Livaudais had become something of an obsession for Klein from the moment Nancy Smith suggested it. To him, the stakes were enormous. The financial future of thousands of unsophisticated, frightened investors rode on what the judge decided. If nothing else, Klein wanted to be sure that Livaudais had as much information as possible.
For a week, Klein did his research in the law library. Then, at night, he crafted legal arguments on his laptop computer. During his usual family time with his wife and three children, Klein sat alone in a room at his home, perfecting his letter. Sometimes, when his children seemed to really miss him, he carried his laptop into the family room and typed while they played or watched television.
On January 22, the twelve-page bombshell was ready. The letter, which would be placed in the court's public file, disclosed for the first time the existence of the state task force. In careful detail, it described the inadequacies of the class-action settlement. It said the notices of the settlement that had been sent to investors did not disclose all relevant information, including a number of the government investigations. Finally it argued that the settlement could impede the regulators' ability to do anything about any violations they found.
The letter ended with several recommendations, including that Livaudais refuse to approve the settlement or postpone approval until the regulators finished their investigation.
Klein sent the letter by overnight mail to New Orleans. He wasn't confident it would have any effect. At best, he figured, the chances that it would were no better than one in four.
The telephone call from Loren Schechter reached Klein four days later. It was the first time Schechter had called the Idaho Securities Bureau during its two-year investigation.
“I hear you sent a letter about the settlement to Judge Livaudais,” Schechter said.
“If you don't have a copy, I'd be happy to send you one,” Klein said.
Schechter thanked him, but said he could get a copy himself. “I'd be happy to get together with you and talk about it.”
“I'd been thinking about just that,” Klein replied. “Let me check with the other members of the task force and get back to you about possibly setting up a time.”
Klein hung up, delighted at the turn of events. For the first time, Prudential Securities was reacting swiftly to regulators and offering assistance. It boded well for the chances of cooperation in the task force investigation.
The receptionist told Klein that a judge was on the telephone. She took a swing at pronouncing the name, but it didn't sound like anyone Klein had ever heard of before.
He picked up the telephone. “This is Wayne Klein,” he said.
“Mr. Klein, this is Judge Marcel Livaudais from New Orleans.”
For an instant, Klein was shocked. But he had no doubt that the deep bass voice with the lilting New Orleans accent belonged to Livaudais himself.
“Yes, Judge Livaudais.”
“I've been out of town and just got back today,” Livaudais said. “I've read your letter and wanted to thank you for writing it.”
“Well, Your Honor, I just wanted to get some information to you that you could have while considering your opinion,” Klein said. “I hope it will be helpful.”
The two men spoke for another few moments, then Livaudais thanked Klein again and said good-bye.
Klein felt almost a sense of awe as he looked out the window of his second-floor office, gazing at the church next door. For an instant, he closed his eyes.
Maybe
, he thought,
there's a chance this might work after all
.
The Klein letter was the central topic at a meeting on February 1, 1993, between the task force and lawyers for Prudential Securities. The letter had been something of a watershedânow approval of the biggest partnership settlement suddenly did not seem assured. It upended the firm's entire legal strategy. Schechter had told senior executives that the best way to handle the partnership problems was to settle all of the class actions first, then deal with the regulators. The fewer clients with claims against the firm, the easier it would be to settle with the states and the SEC. The firm desperately wanted Klein to take his letter back. The threat to Schechter's strategy was getting bigger each day, as other regulators from around the country wrote Livaudais to support Klein's conclusions.
The meeting between the firm and the task force was held at a hotel in Washington, D.C. All of the task force members were there. A number of lawyers attended representing Prudential, including Schechter; Scott Muller, a lawyer from Davis, Polk who was handling the Graham cases; and Dan Bell, a former North Carolina securities commissioner who had been hired to deal with the state regulators. Bell was given the role of discussing Klein's letter.
“This lawsuit is a private action, involving the parties and Judge Livaudais,” Bell said. “State regulation has no role here. It's not your place. You shouldn't be involved in private litigation.”
Klein disagreed. He mentioned a class-action suit from years before involving the sale of securities in the bankrupt Baldwin-United Corp. A court held that the brokers who sold those securities were not liable to regulators for any more than was paid to settle the class action. If the state regulators didn't act now, their investigations could be scuttled.