Serpent on the Rock

by Kurt Eichenwald

  Levine tore into his assignment with zeal. Working with public filings and contacting people in the industry, he found the competition in the public market and what products they were selling. By the time he finished his analysis, he had assembled a huge matrix of the sale and performance of every public tax shelter available. There seemed to be enormous room for growth. Levine thought that Bache could do great business by selling more public deals.

  But Levine’s increasing excitement about the prospects for the business was being offset by a growing distaste for Darr. The more he got to know him, the more Levine thought that his initial impression of Darr had been off base. For some reason, Darr seemed to delight in publicly humiliating the people who worked for him, usually by picking their weakest point. Even though Pittman and Proscia were Darr’s biggest supporters, he would belittle them at department meetings by saying that they were lucky he existed because they would never be able to find another good job on Wall Street. Sometimes, when it was time for the meetings to break for lunch, Darr would start shaking all over, crudely mimicking a low-blood-sugar attack. Then he would announce that a marketer who was known to have diabetes needed to eat.

  With due diligence executives like Levine, Darr’s attempts at humiliation in business discussions were more veiled. He would ask technical questions about particular deals that were virtually impossible to answer, such as obscure financial data that might be buried in a footnote of an offering memorandum. If the executive stumbled in answering, Darr would aggressively pursue follow-up questions, sometimes to the point where the executive could no longer speak. Once the executive left the room, Darr would burst into peals of laughter. “I really had him going that time,” Darr said, laughing after one particularly ghastly encounter.

  D’Elisa had taken a liking to Levine and couldn’t stand it when Darr played his games with him. So he quietly found out what questions Darr was planning to ask. Then, before the interrogation began, he took Levine aside and slipped him the answers. By doing so, D’Elisa figured, he wasn’t harming Levine’s education; he was just robbing Darr of some cruel pleasure.

  Levine’s understanding of Darr was solidified in the fall of 1981 at one of the department’s quarterly meetings in New York. A number of Bache’s general partners attended, making presentations about future projects. Levine sat with his colleagues from around the country in an auditorium at the Gold Street headquarters. Darr sat in the back of the room, occasionally interrupting with his own observations.

  Suddenly, a movement in the aisle attracted Levine’s attention. It was Darr, signaling that he wanted Levine to come out of the row. Levine stood and pushed past his colleagues. He knew what this was about: It was time for the quarterly bonuses. During these meetings, Darr loved taking people aside, one at a time, to deliver bonus checks. Levine was curious to find out how much he would be making.

  He reached the end of the row, and Darr escorted him toward the back with an envelope in his hand. They stopped as they reached the back wall, and Darr turned to look at Levine.

  “David, you’re a sharp guy,” Darr said. “And you’ll have a choice, very soon, to either stay here and have a tremendous amount of power, or join another firm where you could earn a lot more money.”

  Levine felt somewhat uncomfortable. He had expected to hear something about his performance. Darr’s line of conversation seemed out of context.

  “So, that’s the choice, money or power,” Darr continued as he handed Levine his bonus of about $4,000. “For me the answer has been easy. That’s why I stay here. I like power.”

  For what he wanted, Darr was in the right job at the right time. A new administration in Washington was pushing historic revisions in the country’s fiscal policies, changes that would alter the American economy. And in an unintended ripple effect, they would transform Jim Darr into one of the most powerful people in the retail brokerage business.

  It dawned foggy and damp on August 13, 1981, in California’s scenic Santa Ynez Mountains. By late morning, troops of reporters and photographers took the white-knuckle drive up the winding road to the mountaintop. They gathered in front of the stucco house, built in 1872, that was now part of President Reagan’s Rancho del Cielo. For weeks, the news media had been wagging a collective finger at Reagan for vacationing during the entire month of August. There was much going on in the world—the airtraffic controllers’ strike and Moscow’s criticisms of the new administration’s Soviet policies. But on this day, the reporters awaited Reagan’s arrival for a historic ceremony. He was about to sign into law the package of tax and budget reductions that had come to symbolize his administration. It was the defining moment in the eight-month-old Reagan presidency.

  The Reagan bill, called the Economic Recovery Tax Act, promised to cut personal income-tax rates by 25 percent over three years and sharply cut business taxes to encourage new investment in plants, equipment, and real estate. After presenting the plan less than a month into his administration, Reagan, as well as his supporters, expressed confidence that the proposal would effectively kill the burgeoning tax shelter industry. On its face, the argument seemed to make sense. After all, shelters were largely a response to high tax rates, and the Reagan plan was expected to cut personal income-tax rates by an average of 25 percent over three years. But there was a critical flaw in their argument: Rather than kill the shelter business, the Reagan bill would spur their growth by making them more attractive investments.

  The heart of his business tax-cut plan was a program known by the acronym ACRS, which stood for Accelerated Cost Recovery System. Under that proposal, assets such as real estate and equipment could be depreciated far faster than they had been in the past. Essentially, where the tax code once declared that a building would run itself down in twenty-five years, giving investors depreciation deductions throughout the entire period, under ACRS the time was reduced to fifteen years. That made investments in real estate and other depreciable assets far more attractive. It sharply boosted the amount of deduction bang an individual could get for each investment buck. Never had there been any legislation so significant to the growth of the tax shelter industry.

  At noon, Reagan finally appeared, wearing faded jeans, a denim jacket, and cowboy boots. He grinned broadly, looking relaxed and tanned and projecting the image of a man enjoying victory. He sat down at a table as he apologized for the fog. Then, using twenty-four pens, Reagan signed the bill.

  “This is only the beginning,” he promised.

  From that instant, Wall Street’s shelter gurus were scrambling. They understood that the new law would greatly increase the already growing demand for tax shelters. The possibility of a real public market developing in shelters seemed all the more likely.

  Within days, before Wall Street barely got out of the gate, the tax shelter business got another boost. A second radical change was announced on August 18 in the staid and solemn pages of the Federal Register. A publication of the United States government, the Register carries all proposed regulation and regulatory changes, and it is hot reading among lawyers and lobbyists. On that August day, it carried a proposal from the Securities and Exchange Commission that was read widely across the financial world: The government securities regulator wanted to change the rules for selling unregistered securities like private partnerships.

  The proposal, known as Regulation D, reduced some of the restrictions on such sales. It eliminated the ceiling that restricted the sales of unregistered securities to just a hundred people, loosened the definitions of what kind of investors could participate in such offerings, and raised the dollar amount of securities that could be sold to such investors. The intent of the change was to make it easier for small businesses to sell stock to the public, opening up new ways to raise capital. But it also had a mammoth effect on private offerings in the tax shelter world—now such offerings could be bigger, broader, and sold to more people than ever before.

  By itself, Regulation D would have rapidly expanded the tax shelter
business on Wall Street. Combined with the Reagan tax changes, it served as a turbocharger. Almost any firm that wasn’t already in the business launched its own tax shelter division. Firms that already had them, from Hutton to Merrill to Bache, expanded their operations even faster.

  One of the biggest investment fiascoes in history had been set in motion.

  The deals at Bache were coming fast and furious. Whatever demand the tax shelter department had seen earlier paled to what happened after the tax act and Regulation D. No one could keep up with the work. Even with all the new hires, the department’s staff was still skeletal compared with the number of people it actually needed. David Levine was pulled off his project exploring the public marketplace to handle more real estate due diligence work with John D’Elisa. Ellen Schachter still helped Dennis Marron on energy deals, but was also assigned the job of putting together a brochure to explain the new tax bill to brokers. The more the salespeople understood about the changes in the law, the more likely they would be able to convince their clients to buy the next tax shelter.

  The department threw all the bodies that could be found into the effort. Schachter sought some support from Lauren McNenney, an office temp who helped copy documents and answer telephones. McNenney, who in 1981 was working the first of two summers as a temp in Bache’s tax shelter division, had no business background—she had last worked as a lifeguard at a day camp. She attended Barnard College, where she majored in English. But her writing skills gave her a big break: Schachter asked McNenney to help edit and proofread the tax bill brochure. Soon McNenney was allowed to write some material on her own.

  With the work piling up, McNenney was a godsend. People in the department turned to her more and more, gradually allowing her to pick up assignments that were slipping by the wayside for lack of manpower.

  The due diligence team was overwhelmed not just from the number of new deals they had to approve—they also had to keep tabs on the old deals that had already been sold. Darr had negotiated for Bache to be paid a monitoring fee from some tax shelters it sold in exchange for reviewing their financial performance. Supposedly, this was designed to make sure that the general partners managing the deals did things right and took care of their investors. It was a key selling point for Bache brokers: In sales pitches, they painted a picture of top Bache financiers in green eyeshades peering over the shoulders of the general partners, watching everything that was done. The image of financial professionals crunching numbers late into the night to make sure investors were protected was a persuasive marketing tool.

  But asset monitoring paid only a small fraction of the fees that Bache received from selling new deals. So the job of keeping an eye on the performance of the old shelters quickly became viewed as simply a headache, an obligation that slowed down the whole process of churning out deals without enough juice from fees to make up for the effort. The monitoring assignment became a hot potato, passed from executives to subordinates, and from them on down the line.

  By the summer of 1981, dozens of complex tax shelters from around the country were mailing records to New York every three months so that Bache could monitor their performance. Each day, the scores of financial documents were carried from the Bache mail room to the tax shelter department for sorting. Then financial statements from a number of Bache energy deals were delivered to the desk of Lauren McNenney. The responsibility for reviewing, analyzing, and logging that financial data had fallen on her shoulders.

  The monitoring process that Bache brokers bragged about to clients as an example of the firm’s new, rock-solid stability was largely in the hands of a part-time temp.

  Fred Fiandaca, Prudential’s liaison to Bache, popped open the back door of the dark, chauffeur-driven sedan and clambered inside. In an instant, George McGough, the head of Bache corporate resources, slid in beside him. It was March 1982, and the two men had just finished a luncheon meeting. They were heading back to Bache to finish up some work. Fiandaca liked McGough—the two had been working closely for months trying to coordinate Bache’s purchasing operations with Prudential’s. The payoff had been enormous. The combined purchasing power allowed Bache to receive enormous discounts on merchandise—the savings it received on furniture alone had climbed from 25 percent off list price to as much as 60 percent.

  But Fiandaca knew the success in that one area was dwarfed by stumbling throughout the rest of the firm. Even though the merger had been completed almost nine months earlier, Bache’s missteps continued. The firm had embarrassed itself by proudly touting an agreement in principle to purchase Bateman Eichler Hill Richards Inc., a large West Coast securities firm, without first securing a large stake in the firm. The announcement signaled to the marketplace that Bateman Eichler was for sale, and two weeks later, a humiliated Bache announced that the deal was off. Kemper Insurance took advantage of Bache’s foolishness, rushed in with a better offer, and snapped the prize away.

  Bache even fumbled the mailings announcing the introduction of its first important new product since it had been acquired by Prudential. Known as the Command Account, the product combined money market accounts with checking and debit cards. It was supposed to be in direct competition with Merrill’s Cash Management Account, a product envied by senior Prudential executives. But the thousands of Bache announcements became simply another embarrassment. The mailings about the Command Account were sent to the wrong locations around the country. A prospective customer in Norwich, Connecticut, for example, received a letter telling him that if he wanted to open a Command Account, he should contact the nearest Bache branch—in Scottsdale, Arizona. The mailing made Bache look like a bunch of bumblers, which, to a degree, it was.

  As far as Fiandaca could tell, the only Bache department that was doing well was Darr’s tax shelter division. In that regard, Prudential executives knew they had been very lucky. They had wanted to get into the retail tax shelter business in a big way, but even they did not expect the impact that the Reagan tax bill and Regulation D would have on partnership sales.

  Still, that one department’s success was not enough to overcome Bache’s mediocrity. The firm’s total financial performance continued to be dismal. For 1981, it earned only about $5 million on more than $730 million in revenue. The first months of 1982 were even worse, with Bache stacking up millions in losses. Although some of that could be attributed to the lagging stock and bond markets, Bache’s performance was worse than that of any of its big competitors. After years of success, Prudential uncomfortably watched its name associated more and more with a firm that seemed to symbolize failure.

  Fiandaca never mentioned his concerns to McGough, but the Bache executive could tell that the time for Jacobs and Sherrill was running out. He saw the firm plow ahead, making important decisions without consulting Prudential. It seemed like once the Belzbergs were out of the picture, Jacobs settled back in the comfort of Bache’s bloated bureaucracy, seeking consensus and running the firm in its old, slipshod way. He felt like shaking Jacobs and telling him to wake up. Prudential was not going to be ignored.

  As Fiandaca and McGough rode through the crowded streets of Manhattan back to Bache, they chatted about their meeting and the most recent results from the purchasing program. McGough decided to find out what Fiandaca knew.

  “But I guess it’s not working so well on the higher levels,” McGough said.

  “Yeah, obviously not.”

  McGough paused for an instant. “How long do you think it will last?”

  “By summer,” Fiandaca said. “Harry just doesn’t understand what this is all about.”

  “So what’s going to happen?”

  “Knowing the way they do it,” Fiandaca said, “I think they will probably go out and try to get the best guy on the Street to run the firm.”

  McGough thought about that for an instant. A list like that couldn’t be too long. Wall Street is not a place overrun with good managers. The only two choices he could imagine were the chairman of Shearson Loeb Rhoades, whic
h had just been purchased by American Express, or else the president of E. F. Hutton, who had built up that firm’s huge retail force in a matter of years.

  “Well,” McGough said, “then it’s either going to be Sandy Weill or George Ball.”

  Inside the Bache cafeteria that warm June morning, some two hundred executives munched on toast and eggs as they waited in anticipation. It was the one-year anniversary of Bache’s merger with Prudential, and Jacobs had organized this special ceremonial breakfast to commemorate the day. Everyone wanted to be there—this was one of the few meetings attended not only by every senior member of the firm but by a phalanx of Prudential executives, including Bob Beck himself. Word started circulating days before that Jacobs had special plans for his presentation, which probably had something to do with the television monitors that had been set up around the cafeteria.

  By the time they had finished eating, Jacobs stood up. He was never much at public speaking, and this morning was no different. Working off his prepared text, he described what had happened to the firm since the merger. The lights dimmed and a video began, showing Bache employees working hard. Jacobs described the firm’s performance in glowing terms, from the number of people working to the new opportunities created by the Prudential merger. The tax shelter department was doing particularly well.

  Some executives shifted uncomfortably in their seats. They knew that these highlights were ignoring the truth about the disasters at Bache. Since the firm was no longer a public company, the numbers were not out, but most executives knew that Bache had lost close to $50 million in the first six months of the year. It was hardly a performance to celebrate.