Serpent on the Rock (60 page)

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 everywhere. 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.

“Simple,” Klein said. “We'll sue them.”

That same week, on April 20, Prudential Securities sued the National Association of Securities Dealers, the industry's largest self-regulator. The suit demanded that the court overrule an NASD arbitrator's decision requiring the production of the Locke Purnell report to Boyd Page, the Atlanta securities lawyer. Page was representing Donald Smith, a former Storaska client who lost more than $1 million from partnership investments. The arbitrator had accepted Page's argument that the report was essential to prove the conflicts of interest in the partnership department.

The lawsuit against the NASD made news around the country. Not only was it highly unusual for a big brokerage firm to try to strong-arm a regulators group, it also flew in the face of the arbitration code. Under those rules, neither party in an arbitration is allowed to bring a lawsuit over any matters involved in the case until the arbitration is completed. But Prudential Securities just ignored that.

“We are simply looking to make a legal point and make sure we retain this attorney-client privilege,” William Ahearn, a spokesman for the firm, told reporters.

State regulators around the country didn't see the matter so simply. Prudential Securities, using millions of dollars in legal might, appeared to be engaged in a cover-up.

Even without the Locke Purnell report, the task force's effort to gather documents from the firm was in full swing. By midspring, Prudential Securities had turned over reams of paper, much of it marketing material and data printouts about investors and employees. Boxes of documents were delivered to Klein in Idaho, and he spent an entire Saturday on his own, dividing up the records for shipment to other states.

The boxes contained few of the due diligence records for the partnerships. The regulators went back and asked for those documents. In a few weeks, Prudential Securities produced a number of thin files. It hardly seemed like enough material to justify selling a car, much less billions of dollars in partnerships. The firm had to be holding back. The regulators demanded to see more.

It took several weeks for the truth to sink in with the task force: The skimpy due diligence files were all that existed. The firm had been selling partnerships without much bothering to find out if they would work.

At the same time, the task force decided it needed proof to counter Prudential Securities' unsupported claims that most partnerships had been sold properly. The overwhelming anecdotal evidence would not be enough in court. Nancy Smith of New Mexico volunteered to put together a questionnaire for tens of thousands of investors around the country. The responses would show how many of the clients were suitable partnership investors and how many of them had been misled.

In April, Smith heard that Jim Moriarty, who had worked with Bristow, Hackerman on the growth fund litigation, had used questionnaires with 5,800 clients. She decided to call him for some tips.

“We hear that you put together a questionnaire for your investors,” Smith said. “We're trying to do the same thing on a more national level and could use some advice.”

Moriarty said that he had hired an expert on statistics and polling from Rice University for help in writing the questionnaire. He suggested that the regulators hire him, too.

“We don't have the budget for that,” Smith said.

“Oh, call the guy,” Moriarty replied. “It's not much money. No more than five or ten thousand dollars.”

“We don't have that,” she said.

Moriarty thought for an instant. At that moment, he was particularly flush. He had just been paid a huge contingency fee for his work on the growth fund cases. The money had come straight out of Prudential Securities' pocket. He broke into a smile.

“How about if I pay for it?” he asked.

“That would be great.”

“Well, those boys just sent me some cash for suing them,” Moriarty said. “So I'll call this guy from Rice and put their own money back into the cause.”

Smith thanked Moriarty. But he just laughed.

“Hey, don't thank me,” he said. “I'm going to enjoy this. I love the idea of using Prudential's own money to screw 'em twice.”