“We have no desire to preclude any enforcement actions,” Schechter interjected. Perhaps, the Prudential Securities lawyers suggested, the firm would send a letter to the judge assuring him that it would waive the standard from the Baldwin-United case. If that was done, perhaps Klein would withdraw his letter, Schechter said.
“I'm willing to discuss this,” Klein said. “But I meant what I said in that letter.”
Bell continued to press Klein to change his mind, without success. Then the floor was turned over to Schechter.
“I want everyone here to understand Prudential Securities,” Schechter said. “We want to put this matter behind us. We're not a bad firm, we're not a corrupt firm. We had some serious problems in the past with these partnerships. But it wasn't a firmwide problem. It was a problem with certain brokers.”
The explanation got Schechter nowhere. All of the regulators had seen enough information, particularly involving the Graham deals, to know that the problems emanated from New York. Besides, one of the regulators said, the responsibility for what happened could not be sloughed off onto the sales force even if the brokers were responsible. The senior executives in New York were still in charge of supervising those brokers. One way or the other, New York obviously had a problem.
“The people who were responsible are no longer at the firm,” Schechter said.
Everyone in the room knew that Schechter was referring to Jim Darr and George Ball.
“Why did they leave?” one of the regulators asked.
“Because the decision was made to put this problem behind us.”
“Well, that's fine, put it behind you,” said Saxon, the Florida commissioner. “But you're going to have to make people whole to do that.”
The firm had been doing precisely that, Schechter said. All told, the settlements or proposed settlements from the firm exceeded $180 million. And the total cost of dealing with the partnership problem, when legal fees were included, reached $300 million.
The regulators listened silently. Several were uncomfortable with Schechter's numbers. Some quick arithmetic told them that the highly criticized class-action settlements made up most of what had been paid to investors. Worse, the firm's legal fees were almost as high as the cost of its settlements. Some regulators concluded that Schechter's own numbers showed that the firm was throwing massive legal resources into fighting the claims of investors who refused to accept the cheap class-action settlements.
The meeting came to an amicable end, with agreements that the firm would voluntarily provide documents to the task force. As everyone headed for the exits, Nancy Smith approached Muller with a question she thought better to ask in private.
“Why aren't you guys going after Darr?” she asked. “You've been pretty derogatory about him and willing to lay blame on him. Why not go after him?”
“After all this is over, we probably will,” Muller replied. “But right now, we both have our hands on the grenade, and if either Darr or the firm lets go, we both blow up.”
Judge Livaudais's courtroom in downtown New Orleans was packed with lawyers. It was February 9, 1993, the second day of hearings on the fairness of the class-action settlement involving the energy income partnerships. Edward Grossmann, the lead class-action lawyer, and the Davis, Polk lawyers for Prudential Securities had been the chief architects of the settlement. Over two days, they presented witnesses who proclaimed the deal's high quality.
A range of plaintiffs' lawyers had spent the entire hearing attacking the settlement as inadequate and the result of too little digging by Grossmann. Not a single sworn deposition had been taken in the case, they said. How could Grossmann know the value of the case without having questioned witnesses under oath? On top of that, the plaintiffs' lawyers argued that aggressive efforts should be made to sell the partnerships' oil reserves for the benefit of investors rather than just turning them over to a new public company run by Graham. As evidence of the settlement's inadequacy, the lawyers stressed that close to twelve thousand investors had already rejected itâa huge number for a class action. And hanging over the proceedings like a sword was the protest from Klein and the other state regulators.
Grossmann, a heavyset man with an aggressive personality, approached the podium and looked up at the judge. He was ready to present his closing arguments. A lot was at stake; his law firm stood to make millions if the deal was approved.
“This settlement has met with an unusual assault and unprecedented critical press coverage,” Grossmann said. “But it has been received with overwhelming approval by the class. All told, 125,000 of the 137,000 investors approved.”
The statement reflected the twisted logic of class-action lawyers. No investor had approved the settlement. Instead, 125,000 investors had, for whatever reason, not sent in letters asking to opt out of the deal. The number of investors who had received the settlement notification, read it, understood it, realized that they had to write the court to refuse the deal, and knew that they had to write three separate letters to do so was almost certainly negligible. But in Grossmann's argument, even investors whose notification forms had been mailed to the wrong address had “approved” the settlement by not responding.
“It is irrefutable that 125,000 people believe that this is the best way to resolve their claims,” Grossmann said. “If it is not approved, it is not clear that they will get any recovery of any kind.”
Grossmann turned to the issue of the state regulators and the concerns raised by Klein's letter. He did little to hide his contempt for their unwanted intrusion.
“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 materialâan 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.
“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.