Serpent on the Rock (41 page)

Davidson was apoplectic. The commitment to the German investors was written in
English
. It was signed by Harrison. This was Harrison's obligation. He had to make good on it. The stakes were too high.

Finally, after days of negotiation, Harrison agreed to Prudential-Bache's demands: He would accept the responsibility for repaying the Bessemer– Key West investors their money but would use loans from the firm to do so.

By early November 1986, Davidson was writing up the outlines of a deal between Harrison and Prudential-Bache. Under their agreement, Pru-Bache would loan Harrison about $1.9 million in exchange for two promissory notes from him. Interest payments on the notes would be due quarterly. As security, Harrison would take out a second mortgage on the Bessemer Shopping Center in Alabama, granted in favor of Prudential-Bache. Harrison would not be permitted to sell the Bessemer property, and all of the cash flow from it would be applied to paying the new mortgage interest.

Harrison accepted the terms. Under the highly restrictive agreement, he waived all his rights to the Bessemer property until he paid Prudential-Bache back the $1.9 million. The property effectively belonged to Pru-Bache.

The lawyers for Prudential-Bache felt comfortable that they had protected the firm's interests. But there was one big problem: Whenever a mortgage is created, it must be recorded for public files. If Pru-Bache did that, a public record would be created, one that would be accessible to every investor in the Harrison partnerships—as well as their lawyers. Recording the mortgage would be direct proof of Harrison's financial problems. It also could lead to the disclosure of the huge commitment Harrison made in 1980 to the Bessemer–Key West investors. More than $250 million in Harrison partnerships had been sold by the firm since then, and not one of the disclosure documents revealed the commitment to the Germans. Any investor who found out about it could sue.

Prudential-Bache sidestepped the problem, and the mortgage was never recorded. No public document was created. Investors would never be told of this financial crisis.

Prudential-Bache, as a firm, was now effectively a secret investor with Clifton Harrison. It would soon learn the grim reality of that position: Despite the written assurances, Harrison would soon renege on every term of the agreement. Within a few months, he skipped the first quarterly payment he owed on the loan. Soon he was declared in default.

Prudential-Bache lawyers threatened to take legal action against Harrison but never did so. They had outsmarted themselves and handed Harrison a weapon: If they sued, the firm would create a public document showing all of the information it had failed to disclose to investors. Harrison had them over a barrel.

Harrison's control of the situation was so complete that, later, when he sold the Bessemer property and pocketed the proceeds, Prudential-Bache didn't raise a single objection. Years later, when asked why Harrison had been allowed to walk away with millions of dollars of the firm's money, Loren Schechter offered an incredible explanation.

“It was an administrative oversight.”

“Mr. Harrison, would you raise your right hand and repeat after me, please.”

Harrison, seated at a conference table in his lawyer's office on East Fifty-second Street in Manhattan, raised his hand and swore to tell the truth. It was ten o'clock in the morning on March 23, 1987. The lawsuit brought by John McNulty, the angry investor in the Archives deal, had finally reached Harrison's doorstep. Charles Cox, McNulty's amiable but aggressive Minneapolis lawyer, was ready to start the deposition. It would be the first time that any investor with Harrison would be able to ask him questions under oath.

The stakes were enormous. Almost without fail, every deposition begins with a short questioning about the witness's background. Depending on the questions Cox asked, Harrison might be compelled to reveal the secret of his criminal background that he and Prudential-Bache had tried so long to keep hidden.

Cox reviewed some notes. After asking Harrison to state his name and place of residence, Cox started with an open-ended, catch-all question.

“I notice in the private placement memorandum your background is set out in some length,” Cox said. “Is there anything that you feel should be added to what's set out in there?”

His hands folded in front of him, Harrison looked at Cox placidly. “I don't recall what's set out in the memorandum.”

“Well, let's start this way, then,” Cox said, as he led into a series of questions about Harrison's early background. He asked about Harrison's education and his first job. Harrison said he had worked at a bank, which he left in 1966.

“After 1966 and the bank, what did you do?”

Harrison's eyes shifted over to his lawyer, then back to Cox. “Can I talk to my counsel?”

“Sure.” Cox shrugged.

Cox watched, puzzled, as Harrison conferred in whispers with his lawyer, Steven Kaplan. After a few moments, they finished, and Kaplan looked at Cox.

“Charlie,” Kaplan said, “Mr. Harrison will answer, you know, questions regarding his educational background and work experience, and that's what you're asking about.”

Cox didn't understand what was going on. “You say he won't?”

“He will.”

“All right.”

“Is that what you're asking about, you want to know the sequence of his education and what his work experience is?”

Cox's antennae went up. Kaplan wanted him to limit the scope of his questions. His lawyer's sense told him he was circling around something important. He wasn't about to agree to restrict his inquiry.

“How he got where he is,” Cox replied. He was keeping his options open.

Cox went back to the questioning and again asked what Harrison had done after leaving the bank in 1966. At first, Harrison said he attended Southern Methodist University in 1967. Cox raised an eyebrow. Harrison was skipping a period of time between the bank and college.

“Did you do anything in the interval?” Cox asked.

“I was a carpenter,” Harrison replied without flinching. He left out that he did his woodworking as a prison inmate.

“Was that your first real introduction to construction?”

“Unfortunately, I think, yes.”

Cox shrugged. He couldn't understand what all the fuss was about. “Good place to start, really,” he said.

“It was difficult being a carpenter.”

Cox looked back at his notes. There was something here, and he was missing it. He decided to try again. “Why did you leave the bank?”

“We had major disagreements.”

“By ‘we' you mean you and your—”

“Me and my direct supervisor.”

Cox asked a few questions about the supervisor and then decided he wasn't getting anywhere. He moved on to questions about Harrison's time at SMU. Cox asked no more questions about Harrison's life during the years he spent in prison.

His criminal background could continue to remain a secret. All it took was for Harrison to avoid telling the full truth while under oath. And all in front of a lawyer for Prudential-Bache.

Tillie Tillman was raging again at his branch manager, Dave Diestel.

“It's unbelievable the crap they've been piling onto us! Darr and that crowd should be shot!”

From the time Tillman had told his friend Diestel about Harrison's felony conviction, both men had been stunned. They talked about it constantly. Even now, in early 1987, neither could offer an explanation of how Darr and his team betrayed the trust of so many of their own brokers. Whatever their reasoning, it impressed them both as the most cynical of deceptions.

What Tillman had learned about Harrison had gotten around the firm quickly. With massive telecommunication systems, complete with thousands of telephones connecting the brokers, retail brokerages are tiny places. The details of a shouting match in a San Diego branch can be known within the hour in Bangor, Maine. Tillman was the first person to publicly roar about Harrison's criminal conviction. He didn't care who heard him—in fact, he hoped as many people as possible did.

Almost daily, another broker heard the news.
The firm had been representing a convicted felon
. Some brokers were anguished to learn the news.

But most other brokers felt lucky, as if they had sidestepped an oncoming train. Their clients had not been interested in the kind of pure tax shelters Harrison peddled, so they had stayed away from the deals. Instead, most of them had focused on selling partnerships with the potential for real economic returns, like the energy income deals. The brokers were sure that those deals were legitimate. They could see the high cash distributions their clients were receiving each quarter. So when they started to hear that Graham Resources was preparing a whole new type of partnership for sale, the brokers at Prudential-Bache awaited it eagerly.

CHAPTER 13

IN THE CONFERENCE ROOM just down the hall from his office, Darr was giving a pep talk. Executives from the Direct Investment Group, along with Tony Rice from Graham Resources, listened closely as Darr spoke. He sounded like a football coach before the biggest game of the year.

“We're going to clear the decks for this one and put all our muscle behind it,” Darr said. “We've never marketed a product this aggressively.”

The meeting on November 11, 1986, followed months of discussion about assembling a new type of partnership with Graham to take advantage of the horrific collapse in oil prices. All the talk was paying off. Pru-Bache was days from launching its latest product with Graham, a partnership called the Prudential-Bache Energy Growth Fund.

“The Energy Growth Fund is extremely important to Prudential-Bache,” Darr said. “Direct Investment due diligence is on the line.”

The idea behind the growth fund was simple. With the collapse of oil prices, banks throughout the Southwest were struggling with loans to energy companies that had been secured by oil reserves. The banks had written down the loans, assigning them a value that was a fraction of the original amount. Under the theory of Graham and the Direct Investment Group, a loan of $100 million, for example, was being carried by a bank at a value of $40 million. That meant that the growth fund could purchase half of that loan for $20 million. But the good part was that the loan was secured by oil reserves that were still worth $80 million. The growth fund could either receive huge profits when the borrower paid off the entire $100 million, or it could seize the $80 million worth of reserves if the borrower defaulted. Either way, it sounded like a no-lose deal.

On top of that, the new partnerships would be extremely lucrative for both Graham Resources and Prudential-Bache. The exorbitant fees charged to other partnerships would look downright tiny compared with those of the growth fund. Prudential-Bache and Graham would extract 15 percent of investors' capital up front. Then they would take another 15 percent of every partnership distribution. Whenever a client received back a dollar of the original cash, at least thirty cents would be missing.

Darr feared the growth fund would be so envied that Wall Street's premier firms, such as Goldman Sachs and Salomon Brothers, would rapidly put together their own copycat products. So he wanted the growth fund marketed as quickly as possible.

Probably that was the reason why none of them had bothered to find out whether the growth funds might actually work. Graham had held substantive discussions with only one bank, First City National Bank of Houston, which had been one of its primary lenders. On top of that, no one had performed anything but the most cursory due diligence.

So at this meeting three days before sales began, Darr demanded that someone put together some last-minute financial information on the growth fund. After all, the marketers couldn't sell the deal without some numbers to back up the theories.

“We've got no solid projections or case studies, and we're already working on the marketing guide,” he said. “The guide has to be available in six days. So let me tell you what we need for success here.”

Darr rattled off what he wanted the numbers to prove: First-year distributions would equal 15 to 20 percent, and investors would receive all their money back within five years. He seemed to have no basis for pulling those numbers out of the air, other than the fact that they sounded good.

In the end, the rushing proved to be unnecessary. Prudential-Bache had nothing to fear from Salomon Brothers and Goldman Sachs. Competitors don't copy failure. If anyone had checked before offering $500 million worth of growth funds to clients, they would have learned a very salient fact: The loans they wanted to purchase didn't exist for sale. They were figments of some marketer's imagination.

Tony Rice smiled as he briefed twenty Prudential-Bache branch managers about the energy growth fund. The crowd was getting pumped up. Ed Devereaux, a regional marketer for the Direct Investment Group, felt especially excited as he listened to the description of the growth fund. The product sounded brilliant. He was proud that his firm would be the first one on the market buying these discounted, overcollateralized loans.

As Rice made his presentation, Darr sat nearby, hanging on every word. At times, Darr would interrupt Rice, telling him to describe some complex element of the growth fund in simpler terms. Once he finished his presentation, Rice asked if anyone had any questions.

“Why would the banks give you guys this special opportunity to cherry-pick their loans?” a manager asked incredulously.

“Well, let me explain that to you,” Rice began. As he discussed the rules surrounding write-downs of loans and what that meant in banking, brokers exchanged furtive glances. What Rice was saying didn't make any sense.

Darr walked to the front of the room, saying he would take over the question himself. But even Darr's answer seemed to leave the manager puzzled. He asked another question about why the partnership worked the way it did. Darr scowled. He could barely contain his growing anger.

“Because that's the way it is,” Darr barked. “That's what happens. It's not your place to challenge the products we put together. We handle the due diligence on the deals, and you make sure they're sold.”

Darr moved on to other questions. Even with his belligerent attitude, the pointed questions kept coming. Finally Darr looked exasperated.

“Look,” he said, “if all you do is find fault, how are we gonna generate the revenue to keep you guys in business and pay your bonuses?”

The response fell on a silent crowd. Devereaux was no longer excited about the product. At that moment, he decided to avoid selling the growth fund as much as possible. The way Darr was acting, there had to be something wrong with it.

John Hutchison, a Prudential-Bache product manager for all Graham partnerships, looked over the sales material for the growth fund in late 1986 with a sense of delight. Hutchison was a veteran of the Direct Investment Group. He had already proved his skill handling the energy income partnerships. The growth fund looked like a breeze.

Hutchison was not the kind of person to invest his money recklessly. But the more he read about the growth fund, the more it seemed like a no-lose investment. Buying portions of these overcollateralized, discounted bank loans was perfect. He set down the sales material and took out his checkbook. He wanted to invest in this deal himself. Later he suggested to some of his colleagues, including Kathy Eastwick, a product manager and former compliance administrator, that they should invest their money in the growth fund, as well.

They had a lot of company. The Prudential-Bache Energy Growth Fund started to be sold on November 17, 1986. Within weeks, it was raising $1.2 million a day from clients. It was a total success.

“Harding's Highlights,” the partnership marketing material shipped out to all of the Prudential-Bache brokers in the Southwest, offered tips on the growth fund in early 1987. Linda Harding, a marketer in the region who wrote the material, seemed truly excited about this investment. She repeated the statements about how the fund would be purchasing overcollateralized, discounted loans from banks.

“It's like buying a bond at twenty-five cents on the dollar,” she wrote. But when this bond matured, she added, the investor would receive at least the whole dollar.

“This should be considered every bit as safe as the energy income fund, with tremendous upside potential!!!” she wrote.

In Florida, the reaction among brokers and managers to the growth fund concept was one of almost pure ecstasy. Jim Parker, the regional marketer for the Direct Investment Group in Florida, had never seen a partnership accepted by the field so quickly. For years, Parker had attempted in vain to persuade Ernie Higbee, the manager of the firm's branch in Gainesville, to sell a lot of partnerships. But as soon as Parker described the idea behind the growth fund, he could see Higbee's eyes light up.

“This could really be a home run for clients,” Higbee said excitedly.

Higbee was so enthralled with the idea that he agreed to make a presentation on the growth fund at an upcoming seminar for all of the brokers and managers in Prudential-Bache's Southeast region. The executives all gathered on the morning of February 7, 1987, at the Sheraton Premier hotel in Tysons Corner, Virginia. As Higbee gave his presentation, his excitement about the growth fund's potential seemed to infect the crowd.

“I put up $20 million and I've got $80 million in proven, producing reserves” as collateral, he said. “I'm number one in the pecking order in this loan. I get the first $20 million no matter what.”

Higbee broke into a huge smile. “Now, where's the risk?” he asked the crowd.

With what they were planning to do, Higbee said, investors could expect three to five times their money back in just five to seven years.

Of course, the prospectus said no such thing. In fact, little of what was in the sales material was broadcast in those terms in the public filing. Instead, it warned that the investment was extremely risky. But Higbee assured the brokers that the prospectus was largely worthless.

“Read the prospectus and chuck it,” he said. “There are so many caveats that you can't make a simple presentation.”

Charles Patterson, a senior officer with First City National Bank of Houston, pored through documents analyzing some of the loans that his bank had just sold to the Prudential-Bache Energy Growth Fund. He looked down the sheets of engineering reports and financial data that estimated the value of the loans.

And then Patterson smiled.

Ten million dollars
, he thought. For reasons he could not understand, Graham had agreed to pay $10 million more for the loans than First City thought they were worth. In an open bid, the bank never could have received the $57 million Graham Resources was willing to pay out of its growth fund. Whatever the rationale, Patterson didn't much care. First City had been struggling with serious problems stemming from too many bad loans. For a change, Patterson had some good news to report to the bank's board. Better still, he could tell them that Graham wanted to buy more loans for the growth fund as soon as possible.

Patterson didn't know it, but he was looking at the evidence of one of the most blatant deceptions ever to emerge out of the Direct Investment Group. He had never heard the false promises the firm had made about how the growth fund would buy discounted loans secured by oil reserves worth four times the investment. And he never could have suspected such commitments existed, because none of the loans purchased by the growth fund was anything like that. Many of them had no discount at all. The only one with a significant discount was secured by oil reserves worth only slightly more than the purchase price. Graham Resources appeared to be doing nothing more than just taking problem loans off the books of its onetime bankers.

Had anyone from Prudential-Bache or Graham Resources asked Patterson before the marketing of the growth fund started, he might have told them that their idea made no sense. If a bank had a loan on its books like the one described in the growth fund sales material, it wouldn't be sold. Banks aren't in the business of generating losses.

But, at least for their investors, the energy growth funds were. With 15 percent fees for investing and another 15 percent for distributions, the investments in loans that carried no discount were guaranteed to be losers. That didn't stop Graham Resources and the Direct Investment Group from characterizing huge losses for investors in the first growth fund as enormous gains. After all, the second growth fund partnership was ready for sale almost immediately. To help sales, the first growth fund needed the appearance of strong performance. Even though the fund had not made a penny, it distributed money anyway through a complex deception that simultaneously fattened the pockets of Graham Resources and Prudential-Bache.

First, the fund took $4.7 million of customer money. Fifteen percent, or $700,000, came off the top for fees to Graham Resources and Pru-Bache. With the remaining $4 million, they purchased a participation in a loan to a company called HRB Rig. The loan had no discount—the $4 million participation had an original value of $4 million. It was as if the growth fund had lent the money to HRB itself.

The beauty of the investment was that HRB owed a payment of about $4 million in just weeks. When the cash arrived, the growth fund had money that could be distributed to investors. But first, Graham and Pru-Bache took out about $600,000 to cover the 15 percent back-end fee. The remaining $3.5 million was distributed to investors.

It was the perfect deception. In weeks, Prudential-Bache and Graham Resources had shunted investor cash through a number of companies, converting $4.7 million into $3.5 million. Graham and Pru-Bache pocketed the $1.2 million difference.

When they received their bogus distribution, investors were not told they had just suffered a $1.2 million loss. Instead, their brokers held up the distribution as evidence of the growth fund's success. After all, it was already showing double-digit returns.

Within days, that lie would spread to every broker in the firm.

The summer 1987 edition of
Energy Digest
, a newsletter for Prudential-Bache all about the energy partnerships, featured a cover photograph of a fish.

“There were no scales on your eyes last fall,” the caption announced on the cover. “Thanks to you, this is the one that didn't get away.”

Inside, the first page featured a picture of brokers standing on a ship, holding huge fish in the air, along with a sign proclaiming “Growth Fund: 17% annual distributions.”

A huge portion of that distribution came from the secret $4 million shuffle of cash in the HRB Rig loan that had actually produced a $1.2 million loss. Nothing was said of that.

“Congratulations to all of you for helping to make the growth fund such an enormous success!” the newsletter said. It also added that the high returns meant brokers could sell even more of the next growth fund, called G-2.