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Authors: Kurt Eichenwald

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BOOK: Serpent on the Rock
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The cost of the fraud, in financial and human terms, was so large it surpasses imagination. More than $8 billion worth of risky partnerships packaged by Pru-Bache collapsed after they had been falsely sold as safe and secure. Even after the partnerships lost most of their value, investors had no idea what had happened. Every month, on millions of account statements, Prudential-Bache lied about the true worth of the partnership portfolios, showing them as never having lost a penny in value. And so the damage spread unchecked for more than a decade, like a low-grade fever building slowly toward a fatal disease.

In the end, no single brokerage firm, banker, or trader destroyed the financial security of more people than Prudential-Bache. The losses from the celebrated insider-trading and junk-bond scandals of the 1980s add up to only a small fraction of the damage suffered by investors from the betrayals at Pru-Bache. And yet the hue and outcry that swept the country over the harm inflicted on powerful corporations and institutions by those scandals went unheard for years in the partnership debacle; for too long, the financially unsophisticated victims of Prudential-Bache's crimes did not have powerful lawyers fighting for them or the financial firepower to make their voices heard in Washington. They suffered alone, their scars unseen or ignored for years.

The crime was finally visible when, by the thousands, the firm's clients faced the prospect of losing their homes, their retirements, their children's education. Some investors who carefully pinched pennies for decades wound up in bankruptcy. Scores of Prudential-Bache brokers saw their careers, their health, and their lives fall apart, often because they unwittingly repeated the firm's lies about the investments. Still other brokers, caught up in the greedy revelry of the firm, violated securities laws and common sense by concentrating the portfolios of elderly retirees in the high-commission investments.

The fraud, beginning in the early 1980s, brought in more than a billion dollars in profits to the firm, through the fees and commissions paid by the partnership sales. At the center of the scandal was the Direct Investment Group, the little-known department that propelled Prudential-Bache to the forefront of the partnership business. For executives at the senior reaches of the firm, the flow of cash from the department's business became personal piggy banks, financing profligate corporate spending, regal lifestyles, and even sexual conquest. Limousines, wild parties, and expensive overseas junkets became the order of the day, paid for out of clients' investment dollars.

Overseeing this money machine was a small group of executives who cut corners or ignored problems as they promoted the firm and built personal empires. Alone, none of these men could have created the disaster that emerged from Prudential-Bache; together, their weaknesses and desires combined to push the firm inexorably toward scandal. At the head of the partnership department was James J. Darr, a hard-charging executive who took over in 1979 after his scrupulous predecessor was fired for refusing to sell deals of questionable quality. Darr transformed the department into an organization overwhelmed by charges of corruption.

But the executives who were supposed to watch Darr and rein in rule-breakers simply celebrated the department's financial success, with little attention to how the business was being done. At the top were George L. Ball, a celebrated wunderkind of Wall Street who, as president of E. F. Hutton & Co., oversaw a separate and fatal scandal for that firm before abandoning it to take over as chairman of Prudential-Bache; Loren Schechter, the firm's general counsel and chief law enforcer, who for years failed to notice the evidence of wrongdoing in his midst; and Robert Sherman, the head of retail at the firm, whose taste for liquor, eye for women, and desire for power became ingredients in decisions he made as Darr's supervisor.

The inside story of this massive fraud begins in the dawn of the 1980s at Bache & Company, a struggling third-tier brokerage already mired in scandal. In 1981, the firm was reborn and elevated to a newfound public esteem when it was purchased by Prudential, the respected insurance company. But as Bache's image improved, many of its shoddy practices worsened. By the end, the firm experienced a chain of scandals with connections like an archipelago, visible only beneath the surface. It is only in hindsight that each of those scandals can be seen as warnings—tragically missed, though sounded repeatedly over more than fourteen years—about the terrible secrets at Prudential-Bache Securities.

At its base, this is a cautionary tale about an abuse of the investor faith that is an essential building block of the American economy. That faith has created great industries, from the dawn of the railroad to the age of computers, by allowing huge pools of money to be channeled from individual investors to growing businesses. It has touched almost every American home, helping working people achieve financial independence or reach goals only dreamed of by their parents. At its essence, it is what allows billions of dollars of securities to trade each day based on nothing more than a voice on the telephone. By taking advantage of that faith, Prudential-Bache cracked the foundation of the marketplace. It robbed us of our ability to believe. It betrayed us all.

PART ONE

BEGINNINGS

CHAPTER 1

SOMEBODY AT BACHE & COMPANY was out to get them. The lieutenants in the firm's tax shelter department just knew it. They recognized all the old tricks—the sudden audits of expense statements, the false whispers about misconduct, the unrealistic sales expectations. Probably, they guessed, this was the revenge of that skirt chaser, Bob Sherman. But their boss, Stephen Blank, disregarded the signs. A political war was under way, and Blank would not even arm himself.

It was the spring of 1979, and a quiet power struggle at Bache was coming to a head. Blank, a handsome, dark-haired thirty-three-year-old, won some dangerous enemies at the firm during his six years running the tax shelter department. His tough standards in selecting deals for Bache had stepped on the toes of the executives whose pet projects he rejected. When certain of his decision, Blank refused to yield in his judgment—he often told colleagues that reputations in the business were built not on the successful deals that were sold but on the flops that weren't.

Still, Blank surprised even some admirers when he refused to sell a real estate deal brought in by Sherman, who as the cohead of retail sales stood higher on the Bache corporate ladder. Sherman was a tough, demanding executive who did not like to be turned down. For Blank, the refusal was a fatal move, one that helped set in motion a series of decisions that reshaped the firm forever.

STEVE BLANK wound up running the tax shelter division at Bache almost by default. A former high school teacher, he backed his way onto Wall Street in 1970 as a consultant helping brokerage firms manage their paperwork. The timing was perfect—the back offices of brokerages were being crushed by the huge volume of paper they needed to move each day in a booming market. When the back-office problems started clearing up, Blank took a job at Bache sprucing up its training programs.

Two years later, in 1973, Blank's big opportunity arrived. The executive who ran Bache's tiny tax shelter department abruptly resigned, and the firm launched a desperate search for a successor. Blank quickly emerged as the top candidate. He seemed the only one likely to have instant credibility with the sales force—he had already forged strong relationships with brokers and managers from his work in the training program. Until a permanent replacement could be found, Bache turned the business over to Blank. He was twenty-seven years old.

The selection of such a young and relatively inexperienced manager to run a division of a major brokerage firm was met mostly with shrugs. At the time, the tax shelter business was something of an unwanted stepchild on Wall Street. The shelters, also known as limited partnerships or direct investments, raised pools of capital from individuals to invest in business favored by the tax code. Many of those preferences were built in by Congress to encourage investments in certain industries, such as construction and oil exploration. Over years of backroom deals, Congress also granted favorable tax treatment to an array of businesses of less economic value, such as horse breeding, movie production, and even Bible publishing. Any of those businesses could be used in a tax shelter.

The risks of tax shelters were large, since investors sank huge amounts of cash into a single asset. If a big tenant pulled out of an office building owned by a shelter, for example, investors in that deal could well lose their money. But with high risk came the potential for high returns. The shelters usually allowed investors to defer paying or even reduce their taxes. But the shelters also provided income—such as the rents from an apartment building—and the potential of earning a profit when the asset was eventually sold.

The high risks and tax-based rewards attracted only a small cadre of the wealthiest and most sophisticated clients—the people in a high income-tax bracket. With such a specialized and limited clientele, interest among stockbrokers in tax shelters remained fairly low in the early 1970s.

Besides, the obscure real estate and oil deals left Wall Street's stock and bond brokers uneasy. Except to the experts, different pieces of real estate, or different oil wells, all looked pretty much alike. So investors had to trust Wall Street to sift through the available deals and offer the tax shelters with the highest likelihood of eventually producing a capital gain. That meant both the best properties and, equally as important, the most competent and reliable general partner to manage the shelter.

But too often, these general partners, mostly real estate developers and oil wildcatters, impressed stockbrokers as a little too slick, maybe even sleazy. Some general partners sold shelters without knowing much about the business they were promoting—their fortunes were tied to the fat management fees they could charge, not to the growth of their deals. And the deals were complex, with few brokers having the knowledge to explain them properly to their clients. So tax shelters existed largely as a Wall Street footnote, a business that most firms had but did not particularly want.

Then came May 1, 1975. On that day, known ever since on Wall Street as May Day, the securities industry bowed to congressional pressure and abandoned fixed commissions on the sale of stocks and bonds. The competition so often championed by brokerage firms for other industries suddenly romped down Wall Street, setting off a major rate war. Commissions plummeted. No longer could brokerage firms subsidize bloated operations through fat commissions on securities trades. Firms unable to adjust collapsed by the dozens. The industry had to either dramatically cut back expenses or find new products with higher commissions that could be pumped through the sales force. Suddenly tax shelters, which could be sold for higher commissions than stocks and bonds, didn't look so unappealing.

Across Wall Street, firms like E. F. Hutton and Merrill Lynch rapidly built up financial firepower for the tax shelter business. At Bache, Blank had already started expanding slowly. In 1974, he hired Curtis Henry, a tough-talking Texan with a blunt style who had worked as a regional tax shelter marketer at Du Pont-Walston until that firm went under. Henry was given the job of finding and examining tax shelters that Bache could sell. At about the same time, Blank offered a full-time marketing job to David Hayes, a broker in Bache's Washington office who had worked with the department on a part-time basis for years.

With Henry and Hayes as his anchor, Blank aggressively expanded around the country. He hired James Ashworth in San Francisco to market the shelters to Bache brokers in that region of the country. He also brought on John D'Elisa in Smithtown, New York, to perform the close examination, or due diligence, to make sure the deals were good for investors. Legally, Bache had an obligation to its clients to ensure it sold only shelters with the highest potential to succeed. The department had to resist the temptation to sell easily available, lousy deals that could bring huge commissions to the firm but saddle clients with disastrous investments.

By 1978, Blank's temporary assignment had lasted five years. His department now housed twenty professionals and about ten administrative staffers working in the firm's cramped offices at 100 Gold Street in lower Manhattan.

Even with the constant expansion, the department had trouble keeping up with business. Demand for shelters exploded—with high inflation, clients wanted investments like real estate that would likely increase in value at least as fast as consumer prices rose. As more deals were sold, brokers realized the juicy fees available to anyone who could land the lucrative job of general partner.

Suddenly every Bache broker seemed to have a cousin or a friend or a neighbor who wanted to be a general partner in a tax shelter. Their proposals arrived in New York almost every day, some little more than handwritten scrawls on scraps of paper. The department uniformly tossed out those shaky deals, but brokers simply appealed to more senior executives in the firm. Even though the effort was rarely successful, the folks in tax shelters joked that Vince Lombardi, the famed football coach of the Green Bay Packers, didn't invent the power sweep—the end run had come out of Bache.

The biggest political battle over the sale of a shelter began that same year, 1978. One afternoon, Blank received a telephone call from Bob Sherman in San Francisco. Sherman, a hard-driving former stockbroker with an aggressive hunger for profits, ran Bache's retail business in the West and was calling with a pitch: The Robert A. McNeil Corporation was putting together a new partnership investing in California apartment buildings. A buddy of Sherman's who worked for McNeil told him of the deal, and Sherman had promised his friend that Bache would sell it. Now he wanted Blank and his team to give the deal the once-over and get it ready for marketing.

But the proposal left Blank uncomfortable. A number of similar tax shelters were already in the pipeline, and he did not want to offer the same kind of investment over and over. Deals needed sizzle to maintain brokers' attention, and nothing bored the sales force more than repetition. Beyond that, Blank had other concerns about the McNeil Corporation. The company was a polarizing force in the business—some thought it was the greatest, others thought it was the worst—and Blank did not want that kind of headache. As head of the department, he was responsible for accepting each deal, and he always wanted to be untroubled when he did.

He checked with his regional marketers and heard the same negative reaction: Curtis Henry had worked with McNeil after the Du Pont collapse and told Blank he was uneasy about the company. He was also concerned about loans it arranged from the partnerships to other McNeil entities. The loans may have been legal, Henry said, but they sure would be fodder for future lawsuits if the investment went south. Blank's position hardened, and he rejected the proposed deal.

Sherman couldn't believe it. He sent the same proposal back to Blank with instructions for him to look at it again. Blank stood firm. He had no tolerance for political gamesmanship; he wasn't about to let a deal he rejected get shoved down his throat. The marketing staff sensed a dangerous battle in the offing.

“Goddamned Sherman is trying to get me to sell this deal again,” Blank grumbled to them in a conference call. To resolve the dispute, he was turning the proposal over to an outside law firm, Kutak, Rock & Huie from Omaha. He would let it check out the matter and decide if Bache should be doing the deal.

At the San Francisco branch, Sherman fumed.
What kind of organization
was this that a senior executive couldn't get a perfectly good deal done?

Sherman directed the brunt of his anger at Jim Ashworth, the tax shelter coordinator for the West who occupied the adjoining office. Time and again, Sherman told Ashworth that he wanted the deal done. It was a good deal. What was the problem? he demanded. But the McNeil deal bothered Ashworth, too, and he said so. As Sherman seethed, Ashworth told him that he did not want to do business with McNeil.

A few weeks later, Kutak, Rock delivered its findings. The lawyers refused to tell anyone in the tax shelter department what they learned. Instead, they insisted on reporting their findings to John Curran, Bache's general counsel. Curran met in his office with the lawyers and listened. In about an hour, he emerged with a judgment: Bache would not be doing McNeil's new partnerships.

The McNeil deal was dead at Bache. The tax shelter boys had won. Sherman couldn't possibly reverse the firm's top lawyer. But they knew the battle was far from over. Their victory could transform the powerful Sherman into a dangerous enemy. The members of the department anxiously awaited any signs of trouble.

Jim Ashworth hefted a carry-on bag over his shoulder as he hustled through a terminal at the Phoenix airport. He was looking for a pay phone so that he could call the office. It was early 1979, and Ashworth had just arrived on a flight from San Francisco. As a regional marketer, he spent most of his time on the road, visiting brokers at Bache branches in the West. Over a meal or a drink, he would tell them about upcoming tax shelters. Phoenix was just supposed to be another stop on his busy travel schedule.

To a degree, Ashworth was glad to be getting away from the Bache branch in San Francisco for a while. Since the McNeil blowup, his relationship with Bob Sherman had been strained. Then, just the day before, the two men had bumped into each other at an out-of-town party. Sherman was with a woman who wasn't his wife. And from the look on Sherman's face, Ashworth knew the encounter was only going to cause more trouble.

Ashworth found a bank of pay phones and called to check his messages. Steve Blank had called several times, he was told. His boss wanted to talk to him immediately. Ashworth called him from the airport.

“Jim, you need to get on the next plane for New York,” Blank said.

“Why?”

“Take my word for it,” Blank replied. “You've got to be here.”

Still in the dark, Ashworth booked the next flight to New York. Had he wanted to, Blank could not have shed much light on what was going on—he had been told very little himself. All he knew was that Ashworth, one of his best people, was under investigation by the firm.

Ashworth arrived at the Bache Manhattan headquarters the next morning and was taken to a white, barren room near the firm's security department. Leo McGillicudey, the head of Bache security, came in and sat down. The meeting started off ugly, and quickly grew worse.

“Mr. Ashworth, you are under investigation,” McGillicudey announced. “We are accusing you of cheating Bache on expense account items. I want to tell you, this is a very serious matter. You could go to jail. Do you understand?”

Ashworth felt his heart sink. Like every other regional marketer, he submitted dozens of expense reports each year, with some $80,000 in annual charges from around the country. No one had ever questioned them before.

“Do you have financial problems?” McGillicudey asked.

“I don't have any financial problems,” Ashworth sputtered. “I didn't do anything wrong. Why do you think I did?”

BOOK: Serpent on the Rock
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