“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.”
“Prudential Securities has a lot of concerns about this criminal investigation,” protested Patrick Finley, the deputy general counsel. “We don’t believe there have been any violations of criminal law.”
Finley was sitting across from John Evans, the assistant attorney general in Arizona. Evans had been pursuing the criminal case against the firm for a year. It was June 14, and Finley was meeting with him at the offices of Prudential Securities’ lawyers in Phoenix. A number of other lawyers were in the room, including Dan Drake, the head of the general crime section of the federal prosecutor’s office there.
Evans had little doubt that the partnership mess at Prudential Securities was a major criminal fraud. Since bringing in the FBI the previous year, he had uncovered boxes of documents showing how the energy income partnerships had been sold. But the investigation had become too large for his office alone. The FBI said it would continue working on the case only if there was federal involvement. Evans was trying to interest the U.S. attorney in the case, and had invited Drake to the meeting to observe.
Finley’s presentation was almost old hat. It had been made repeatedly to law enforcement authorities throughout the country.
“We know there were serious problems with the activities of the Direct Investment Group,” Finley said. “But the people responsible are no longer at the firm. Now we’re dealing with those problems in the civil arena. We’re cooperating with all of those investigations the best we can.”
He added that the firm also intended to cooperate with the Arizona investigation.
Evans didn’t buy it. He had heard the complaints from regulators that the firm was not cooperating as it should. He had also spoken with plaintiffs’ lawyers throughout the country who told horror stories about abuses during litigation. He well knew that the firm would claim that certain documents requested in discovery did not exist—until the plaintiffs’ lawyer announced that the documents had already been obtained from other sources. Many of the plaintiffs’ lawyers felt compelled to request documents they already had to keep Prudential Securities honest.
Even worse were what looked like the firm’s deliberate misrepresentations. An Arizona lawyer told Evans about a case where the firm had claimed that a Prudential Securities document used as evidence by the plaintiffs was phony, only to produce the same document itself later in another case to prove a different point. When complaints were filed, the firm often tried to move the case to New York even if the client lived on the other side of the country. It went to the mat with almost any investor who insisted on full compensation.
With all those stories in mind, Evans was not about to take Finley at his word.
“Your statements about cooperation have not been borne out by the comments I have been getting from lawyers across the country,” he said. “What I have been told to expect from your company is strategic omission of documents.”
Evans leaned forward. “So let me tell you how I’m going to work this,” he said. “I’ve already obtained a large number of documents. Now, some of those documents are going to be covered by my subpoenas. If you don’t produce them the first time, I’ll make a more specific request. And if your company doesn’t produce them the second time, and I know they exist, then I have a pretty good obstruction-of-justice case. Let’s all remember that.”
The first subpoenas from federal prosecutors in the Southern District of New York went out in the early summer, signaling the start of the second criminal investigation of the partnership fraud.
At Prudential Securities, the new investigation came as a frightening shock. This was not an inquiry by some state. These prosecutors were looking into possible violations of federal securities laws. And they were good at it: The Southern District had taken on Michael Milken and Drexel Burnham—and won.
This time, the prosecu
tors started with an edge. First, they obtained all the information that had been released in the energy income class action. Then they took over the Arizona case from Evans, getting all the documents that he had found during his yearlong investigation.
The federal criminal investigation of Prudential Securities was far down the road from the moment it began.
The negotiations between the SEC enforcement staff and Prudential Securities picked up rapidly over the summer.
Gary Lynch and Arthur Mathews attended every session. Sometimes Loren Schechter appeared as well. A broad range of topics was on the table. With the Capt. Crab settlement having failed to push the firm to clean up its act, the enforcement staff demanded changes in the management structure. Under the setup the SEC wanted, the executives responsible for enforcing security law requirements would be specifically identified. If the firm failed to comply with the law again, those executives would be responsible.
Schechter objected to the proposal.
“The firm’s under new management,” he said. “They’re not responsible for what happened in the past. And new management perceives any requirement like that as a suggestion that they are not operating the firm in compliance with securities laws.”
It was the same argument Schechter had presented eight years before when he was negotiating the Capt. Crab settlement. That fact didn’t escape the attention of some of the SEC lawyers at the table.
“It may be new management, but it’s the same firm,” McLucas said.
Even as they haggled over those terms, the basic concept of how the settlement would work was taking shape. The firm would set up a compensation fund for all defrauded investors. Every partnership investor would be allowed to submit a claim to the fund, and each claim would be evaluated individually. For all of the partnerships, Prudential Securities would waive the right to argue that the statute of limitations had expired. Then a cash offer would be made to investors who had been defrauded. The whole process would be supervised by an independent administrator appointed by the SEC.
Numerous questions were still open. In particular, there was no agreement on the amount of money that should be in the fund.
In the opening negotiations, Lynch and Mathews had offered to have the firm pay $50 million, an amount the SEC dismissed as laughable. Over weeks of negotiation, the offer was doubled to $100 million, and then doubled again to $200 million.
The SEC negotiating team rejected the offers. They wanted the firm to pay a minimum in the range of $250 million. But that would be only the start. There would be no cap on the settlement. Instead, the final total would be determined by the damages suffered by investors. Prudential Securities would keep paying valid claims, regardless of the final cost.
“That’s nuts,” Arthur Mathews said when he heard the proposal. “This is a business. We can’t agree to an unfixed liability.”
McLucas held firm.
“Look, if we can’t reach an agreement on this and you guys hold out for something that’s ridiculous from our business analysis point of view, we’ll just have to litigate this case,” Mathews said.
“That’s your decision,” McLucas said. “But of course, if we litigate, in addition to litigating for the money, we’re going to litigate to pull the firm’s license. You know as well as I do that in the circumstances of this case, the firm couldn’t tolerate even the threat of that.”
Mathews agreed to present the proposal to the firm. But he clearly indicated that he would recommend strongly against it.
Mathews was true to his word. He argued vehemently to Simmons that the firm could not possibly accept an open-ended liability. With such a term, there was no telling how high the final cost might be.
“We’ve run all the numbers,” Simmons replied. “The cost for valid claims is going to be far less than $200 million. Even if it’s uncapped, that’s all we’ll have to pay.”
Mathews began arguing again, but Simmons wouldn’t bend.
“We have to get this thing behind us,” he said.
The lawyers were instructed to tell the SEC that Prudential Securities would accept the uncapped liability for the compensation fund.
Darr’s deposition in the energy income class action was scheduled for July. The plaintiffs’ lawyers filed a motion with Judge Livaudais asking that Prudential Securities be compelled to produce the Locke Purnell report. Without it, the lawyers argued, they could never properly interview Darr about the suspicious private dealings that had been described in Business Week two years before. Judge Livaudais agreed and ordered that the document be turned over.
Prudential Securities rapidly conceded. The months of fighting the SEC, the state regulators, and the NASD were pushed aside. Judge Livaudais was sitting on the case that involved $1.4 billion in potential liability. Schechter had no desire to anger him.
As soon as the decision was made, Schechter rewrote history. All of the battles were forgotten. He reacted as if, to get the Locke Purnell report, all anyone had to have done was ask.
“We’re happy to turn over the report,” Schechter told reporters. “There was nothing to hide.”
Schechter’s words destroyed any credibility he had left with the state regulators. All of them knew the statement was laughable. After all, when Schechter made the comment, the Idaho regulators had been putting the finishing touches on their suit against Prudential Securities, demanding the production of the Locke Purnell report. They had been planning to file it in a matter of days. Now they didn’t need to.
On Friday, July 16, a voice came across Prudential Securities’ internal communications system.
“Hello, everybody, this is Wick Simmons.”
It was a critical time for good news. The brokers were horribly demoralized. Every morning brought new headlines and new disclosures. Most of the working day was spent answering the questions of concerned clients. Cold-callers had to tell potential customers that the firm really wasn’t a bunch of crooks. Headhunters were calling top brokers, trying to persuade them to leave. Simmons had decided that he needed to do something. A talk with the brokers was his answer.
“I know that many of you are hearing questions about all these news articles that have been giving constant reminders about our mistakes in the eighties,” Simmons said. “So I’d like to bring out some points to be sure that everybody knows we are on track here.
“We’re at the final stages of what we hope will be an agreement in principle and then a detailed understanding of a global settlement, in which, under the SEC’s leadership, we wrap up all of our partnership-related and other regulatory problems.” It would be a settlement that would resolve problems with the SEC, the NASD, and many state regulators, he added.
“You should have confidence that we are extraordinarily close,” he said.
Simmons did not tell the brokers how much the settlement would cost the firm, but he said that Prudential Securities could afford it. “The settlement will certainly be a large one, but one that wouldn’t damage our firm, interrupt our business, or change in any way our ability to serve customers.”
Simmons’s statement to the troops was big news. Brokers called reporters to let them know what the boss had said. Press reports concluded that a deal was almost wrapped up. After all, the firm’s management would deliver such an upbeat message only if they were positive that a deal was at hand. Otherwise, if an agreement collapsed, the demoralizing impact on the sales force would be devastating. No manager would be foolish enough to do that.
The following Monday morning, a group of SEC lawyers gathered around a table in McLucas’s corner office. They reviewed the newspaper reports of Simmon’s comments to the brokers in disbelief. The anger in the room was almost palpable.
“What the hell is going on here?” McLucas said. “Why are these idiots talking about our settlement discussions in public?”
The SEC lawyers called the firm and demanded a copy of any tapes or transcripts of Simmons’s talk. When they finally heard the talk on tape, the SE
C lawyers became even angrier. McLucas and Newkirk, the associate director of enforcement, got Prudential Securities’ lawyers on the phone in a conference call.
“What are you people doing talking about a settlement before it’s ready to announce?” McLucas demanded. “That’s not an effective way to deal with us. It puts the deal at risk.”
The firm’s lawyers tried to explain, saying that the relentless publicity had been causing Prudential Securities to lose some of its best brokers. They felt as if they had to say something to stop the firm from hemorrhaging. After telling them to never do anything like that again, McLucas brought the conversation to a close.
Later that day, the SEC lawyers involved in the Prudential Securities case came into McLucas’s office to discuss what Simmons had done. Some laughed about it. His talk had been a blunder of gargantuan proportions. Now that Simmons had announced the settlement, he was going to have to make sure the deal happened. Whatever morale problems existed now would pale in comparison to what would happen if Simmons had to back-track. That shifted the strategic advantage to the SEC. Now the enforcement staff could be tougher in the negotiations. Prudential Securities would be desperate to settle.
In Boise, Wayne Klein shook his head as he read the newspaper articles about Simmons’s pep talk. He thought the message Simmons delivered was divorced from reality. The SEC and Prudential Securities might be close to working out their problems, but not once had the firm discussed settlement with the states. No numbers were on the table. No terms had been mentioned. Nothing .
Klein and the other members of the task force had been in constant contact with the SEC and knew they were close to a deal. Klein himself had even sat in on a few of their negotiating sessions. But apparently Simmons was assuming that the states were going to rubber-stamp any deal the firm reached with the federal regulators. Klein knew that wasn’t going to happen. He felt he had to get a message to the firm’s management that they were blowing it.
About two o’clock that afternoon, the department’s receptionist told Klein that Chuck Hawkins from Business Week was on the line. Klein thought about it for an instant. If ever there was an opportunity to fire a shot across the bow, this was it. He picked up the telephone.
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