Serpent on the Rock (26 page)

Pittman, who played absolutely no role in putting the deal together originally, raised his arm from the audience to accept Darr's praise.

The meeting broke up, and Chanin wandered over toward Marron, looking a little disturbed.

“Boy, Dennis,” he said. “You just got screwed.”

Three executives from Graham Resources walked into a cocktail party at a hotel near Fort Lauderdale, Florida. They were scheduled to meet a group of thirty Prudential-Bache brokers and managers who were attending a sales conference in the late summer of 1983. It was Graham Resources' first opportunity to size up the types of people who would be selling the new Energy Income Fund.

The Graham executives—Rich Gilman, Paul Grattarola, and Rusty Renaudin—fanned out in the massive marble room. They walked among the Prudential-Bache brokers and managers, who were busily munching on shrimp hors d'oeuvres and downing free drinks. Waiters in white gloves walked through the crowd, whisking away the empty plates and glasses that the brokers scattered about the room.

James Parker, the Direct Investment Group's chief marketer for Florida, introduced the Graham executives to as many brokers as he could. After about half an hour, the crowd moved to a conference room. There the Graham executives were scheduled to make a presentation describing the new energy income partnership.

Before leaving Louisiana, the three executives had plotted how to handle this group from Prudential-Bache. This, they decided, would be the best opportunity to get some intelligence on the firm's brokers and managers. Graham had done business with Merrill Lynch in the past and knew the high level of training that those brokers received. Renaudin and Grattarola, both regional marketers for Graham, were former Merrill Lynch stockbrokers and felt they understood the sales staff's mentality.

The best pitch, the group had decided, was to treat the Prudential-Bache brokers as if they were from Merrill Lynch. That meant making a sophisticated marketing presentation about the way the Energy Income Fund worked and how it might perform. This would not be like hocking shoes; instead, Graham would provide an educational lecture that would help the brokers understand the product and see where it might fit with their clients' investing needs. If the presentation went over the heads of the crowd, then Graham, in coordination with Prudential's marketing team, could dumb it down a little the next time.

The task of making the presentation at the Florida meeting was given to Gilman. As all the brokers and managers found their places, Gilman sat down at the head table, reviewing his notes. Finally he was introduced and stood up before the assembled group.

“I'm here today to introduce you to an exciting new product that will provide your clients with a unique way to participate in the oil and gas industry,” Gilman began. “It is called the Prudential-Bache Energy Income Fund.”

As planned, Gilman launched into a sophisticated description of how the partnerships worked. Although the presentation was technical, it was not financially complex. He described how the partnerships would use investor money to buy oil in the ground, then pump it and sell it. The cash from sales—minus expenses—would be returned to the investors in distributions. Included in each distribution was the original cash used to buy oil plus the profit from its sale. It was like investing in a car for $1,000, souping it up, and selling it for $1,500—the money received included $500 in profit and $1,000 in original investment.

Finally Gilman explained that determining the value of the oil in the ground was somewhat complex. Although a reserve was purchased all at once, it would be pumped out over decades, with the price of oil always changing. He described how values are assigned to the reserves, using the parlance of the industry, mentioning the “present value” of the reserves and the “internal rate of return” of the partnership.

Gilman paused and looked up. A sea of blank, uncomprehending eyes looked back at him. The brokers and managers had absolutely no idea what he was talking about. Nor did anyone look like they much cared.

A hand went up, and Gilman pointed toward the man. “Do you have a question?”

“Yeah,” the Prudential-Bache broker said. “What are you guys going to pay in commissions?”

As complex as the Energy Income Fund was to understand, the first thing that the brokers cared about was how much money was in it for them.

For the next few minutes, Gilman fielded question after question about the commission structure of the partnerships, from how much would be paid overall to how much would end up in the brokers' pockets.

Grattarola sat back in disgust.
Great
, he thought.
We've got a bunch of guys
here interested in just three things: commissions, commissions, and commissions
.

Eventually, the brokers started asking some questions about the oil business. But the queries were either pointless or so idiotic that Gilman seemed to have trouble keeping a straight face.

“Is oil going to $100 a barrel?” The Graham executives did not know.

“Well, how long do you think it would take for it to go that high?” Again, they said they did not know if it ever would.

Near the end, they called on a broker who was eagerly waving his hand. “Is it true that the oil is in huge underground lakes?” Grattarola took that question. After pausing for a minute to catch his breath, he answered. No, it was not true.

The meeting drew to a close, and a number of branch managers walked to the front of the room. Several of them looked extremely angry. One short, overweight manager pushed himself into the Graham executives' faces.

“What the hell were you people talking about?” the manager demanded angrily. “Present values? Internal rates of return? We don't want to hear any of this fancy stuff. You just talk about yield. How much money would somebody who put $10,000 in an oil partnership get each year?”

The Graham executives could not believe what they were hearing. Yield was the return on investment—for most retail clients, it usually referred to the amount of fixed interest they were paid on a bond. Even in the sloppy parlance of Wall Street, telling investors that the partnership's cash distributions were a yield would not only be misleading, it would be fraudulent. Perhaps part of the money—the difference between the costs of purchasing and selling the oil—might be referred to loosely as “yield.” But as Gilman had just explained, the distributions also included a return of the original capital that was used to buy the oil in the first place. Describing the distributions as “yield” would be like telling bank customers that all cash withdrawals from their own accounts were interest payments. It was simply false.

“Calling this ‘yield' does not tell the whole story,” Gilman answered. “It would be very misleading.”

“Well, then it's too damn complicated,” the manager replied. “If you guys can't break this down and make it simple, then nobody at this firm is going to sell it. Let me tell you, if your sales pitch is longer than three minutes, then I don't want you talking to my brokers. They've got better things to do.”

After a few more tense minutes, the meeting broke up. The three Graham executives hustled out of the room. They were supposed to drive a rental car to the airport, where they were scheduled to fly to another meeting of Prudential-Bache brokers. But they decided to take a limousine. They needed the driving time to start preparing a much slower, less sophisticated presentation. They hired a car and piled into the back.

“Well,” Gilman said. “What do you think?”

“I think we're in deep shit, guys,” Grattarola said. “These are the dumbest bastards I've ever run into. We've got managers who don't understand and are a bunch of hustlers. We've got brokers who are stupid and not well trained.”

Renaudin agreed. “These guys don't know their ass from a hole in the ground.”

The three discussed whether it was possible that the ignorance they were seeing was just in Florida, or if it was throughout the firm.

“I'll tell you, we don't need sales material for this bunch,” Grattarola said. “We're going to need educational material. We've got to keep it real simple for these guys and go back to the very, very basic stuff.”

Some questions were raised about whether educational material alone would help the brokers sell the partnerships. But Grattarola was insistent.

“These guys don't understand investments,” he said. “They don't understand the terminology of the Street. And they sure as hell don't understand oil and gas. We could end up with some serious compliance problems.”

All of them knew what Grattarola was saying. These brokers could easily fall out of compliance with the securities laws requiring them to accurately describe investments to their clients. How could they be accurate if they didn't understand what they were selling?

Getting the brokers educated was the top priority. Otherwise, they might start breaking the law.

“Today I want to tell you about an investment opportunity with potential high cash flow, a superior structure, a unique sharing arrangement, and low risk.”

By the late summer of 1983, hundreds of Prudential-Bache brokers across the country heard those words in the opening seconds of the first marketing video for the Energy Income Fund. The video, put together by the Direct Investment Group, began with a shot of Ron Gwozdz, the department's first product manager for the energy partnerships. As he recited the opening line, he walked to an office door and grabbed a hard hat. He threw open the door, and the scene dissolved to an oil field setting. For the next few minutes, Gwozdz talked about the experience of Prudential Insurance and Graham Resources in the oil business. He introduced John Graham, who discussed how low oil prices made the timing for the investment perfect.

“Ron, I've never seen a better time to buy products in the ground at distressed prices,” Graham said.

Graham dismissed the idea that there might be a long-term glut of oil and natural gas. “That's somewhat misleading,” he said. “This should not be the case.”

When Grattarola saw the video, he thought it was a disaster. It didn't explain the partnerships—if anything, it oversimplified them. It made them seem safer than they actually were. It didn't discuss the risks. It didn't raise any of the important compliance issues. It offered none of the education that was so critically needed. But few people in the senior ranks of Graham or the Direct Investment Group seemed to care. The video was simple. It would get the partnerships sold.

The video ended with Gwozdz walking in an oil field, praising the partnership. “Prudential-Bache Energy Income Fund 1 is a limited partnership that is projected to give you high cash flow, appreciation, and low risk,” he said. He added that the partnership “has a projected return on investment of from 16 percent to 19 percent.”

By the fall of 1983, those marketing lines had been used to raise $26.7 million from 2,328 investors for the first Graham energy income partnership sold by Prudential-Bache. The investors all heard about the high returns and the low risks.

The largest criminal fraud to come out of the Direct Investment Group was under way.

CHAPTER 8

DAVID LEVINE WALKED ACROSS the lobby of the Drake Hotel toward a bank of pay telephones. After watching a long presentation at one of the department's quarterly meetings in late 1983, he needed to stretch his legs. He smiled as he saw Lauren McNenney just ahead. A few months earlier, McNenney had joined the department as a full-time analyst, following two summers working as a temp. She and Levine became fast friends who shared an admiration for each other and a distaste for the Direct Investment Group.

On this day, the two of them had something to celebrate: Levine had successfully killed a bad deal. Usually there were huge battles with Darr, as he tried to wheedle, cajole, or compel the due diligence team to approve the deals for sale. But earlier that week, when VMS, the Chicago real estate company, brought in a partnership syndication of an apartment building in Greenwich Village, Darr had not flinched when Levine rejected it. Levine argued that the deal's success relied on converting the property from a rental building into a cooperative. Although it might be profitable if the conversion worked, Levine thought it was far too risky. Besides, it was a small deal, and VMS had another firm lined up to sell it.

As Levine and McNenney chatted about his recent victory, Darr spotted them from across the lobby and strolled toward them. He signaled Levine that he wanted to talk.

“David,” Darr said, “I want you to call VMS about that Greenwich Village building. Bob Sherman needs an apartment in the city. I want you to have VMS get him one there.”

Levine stared at Darr, a look of incomprehension on his face. He couldn't believe that Darr wanted him to hit up a sponsor for an inside deal on an apartment. Darr asked what the rentals were in the building, and Levine rattled the prices he remembered off the top of his head.

“Yeah, that sounds about right,” Darr said. “Call them today.”

Darr strolled away, evidently confident that Levine would follow up on his instructions. For much of the day, Levine agonized about what to do. Finally, that afternoon he telephoned Mitchell Hochberg, a friend who worked at VMS, and relayed the request.

“David, come on,” Hochberg replied. “You're really putting me on the spot. I mean, you guys just rejected this deal, and now you want us to get you an
apartment
?”

Still, VMS came through and agreed to provide a nine-hundred-square-foot apartment for the use of the Prudential-Bache executive. About a week later, Levine received a telephone call from Bob Sherman, complimenting him on the job he had done.

“I really like the apartment,” Sherman said. “But there are a couple of things I want you to get done.” Sherman instructed Levine to have VMS redo the kitchen cabinets, install a new refrigerator, and perhaps put in a stall shower.
⁵

“Oh, and also,” Sherman said, “see if you can do anything about the rent.”

Disgusted, Levine hung up. He thought what Darr and Sherman were doing was completely unprofessional, not to mention unethical. He wasn't even sure if it was legal. A clever plaintiff's lawyer could certainly argue that the apartment was a form of compensation that needed to be disclosed to investors. But Levine was sure this little side deal with VMS would never find its way into the real estate company's prospectuses.

Levine wanted nothing more to do with it. He called Hochberg and told him that VMS needed to speak to Sherman. Then he stepped out of it. Later, he found McNenney, who had witnessed the original conversation with Darr, and told her what happened. She couldn't believe how open Darr and Sherman were about something that, in her mind, was clearly a corrupt act.

“If they don't think this is sleazy enough to hide from us,” McNenney said, “what else must be going on that we don't even know about?”

More than they could imagine.

William Petty, an executive vice-president with Watson & Taylor Investments in Dallas, was surprised when his secretary told him that Jim Darr from Prudential-Bache was on the line. It was an afternoon in the second week of November 1983, a few months after Watson & Taylor had sold its first public real estate limited partnership through Darr's department. Even though Petty frequently heard from the Direct Investment Group, usually it was Freddie Kotek in due diligence or one of the marketing people. Darr never called him.

“Yeah, hi, Bill,” Darr said, sounding somewhat frustrated. “I'm looking for George.”

Immediately, the call made sense. Darr had developed a close relationship with George Watson, a named principal in the real estate company, and the two men spoke frequently. Watson, a thin, bald man with a quiet demeanor and a toothy grin, seemed to consider keeping Darr on his good side to be a central part of the job. Often he told Petty to take care of selling the deals, and Watson would take care of Darr. But on this day, Watson was not in the office. Darr had only asked for Petty as a second choice.

“George isn't in,” Petty said. “Is there anything I can do for you?”

“Yeah, tell me where I should send my $20,000 check.”

Petty paused for an instant. “Jim, I'm sorry, I don't know what you're talking about.”

“You know,” Darr replied. “For that land deal, over there on Stemmons Freeway.”

Petty sat back in his chair. He had never heard of the deal. “Jim, I'm sorry, I still don't know what you mean. Let me talk to George and I'll have him get back to you.”

He hung up the phone, perplexed. What was Darr doing investing in some land deal with Watson & Taylor? The company made huge profits buying and selling land in its private deals with its own money. Petty could not imagine that Darr was being allowed to invest in those lucrative private deals, too. He made a mental note to speak with Watson as soon as possible.

Later that day, after Watson returned, Petty walked down the hallway to his boss's wood-paneled office. “George, Jim Darr called about sending a check on a land deal,” he said. “I didn't know anything about it. What should I tell him?”

Watson looked up from his desk and smiled. “I'll take care of that, Bill,” he said in his smooth Texas twang. “Don't pay any further attention to it.”

A couple of days later, Watson came to Petty's office and knocked on the door. He said he wanted to talk to Petty about an investment.

“I've got this land deal that's a laydown,” Watson said. Petty perked up his ears. He knew that Watson used that word only when he had found something that was really good.

“Well, what is it?”

“It's over on Stemmons Freeway,” Watson said. “It's a done deal.”

Petty looked at Watson, confused. “What do you mean?”

“The land has already been sold,” Watson said.

Already been sold
. Petty could not believe his good fortune. In Texas in the early 1980s, the land business was wild, with developers and speculators making millions of dollars from buying and selling properties like stocks. It was possible to sell some land, with the final transfer of ownership simply awaiting zoning changes or other delays. From what Watson said, Petty figured that was the situation here—although the closing had not yet taken place, Watson had a buyer and a profit already sewed up. Now he was selling participations in the guaranteed profit. Watson's offer to let him buy a piece of this property was like a gift, Petty thought. For every dollar he could invest, he would receive a proportionate share of whatever profits Watson had locked in. The more money he could invest, the more money he would make.

“Gee, how much can I put in?”

“Well, $5,000,” Watson said.

That didn't sound like much. “You sure there's not any more available?” Petty asked. He was feeling a trifle greedy. If he could have put everything he owned in this investment, he probably would have.

“No, just $5,000.”

“All right,” Petty said. Before he could reach for his checkbook, a thought crossed his mind. This was the second time in just a few days he had heard about a Watson land deal over on Stemmons. “Is this the deal Darr called about?” he asked.

“Yes, it is,” Watson said.
⁶

So Darr is putting in $20,000, and I'm restricted to $5,000
, Petty thought. Watson was right—he
did
take care of Darr. When Petty later saw the list of investors in the deal, which was called Lombardi Number Three, he realized that the only other people from Watson & Taylor allowed to invest were two executives who would see the transaction's paperwork. Petty was sure the only reason he had been offered a stake was that he had heard about Darr's involvement.

The Lombardi deal proved a big winner. Within a matter of months, the payback on the deal came out, with Darr netting about $45,000. Petty did not know it, but this was Darr's second investment with a Watson & Taylor deal. George Watson had offered Darr the first opportunity in February, on almost the exact same day that the prospectus was filed with the Securities and Exchange Commission for the first Watson & Taylor public partnership sold through the Direct Investment Group. That deal, which was not disclosed in any of the public partnership's filings, netted Darr a profit of $46,258 in less than one month.

Even with what little Petty knew, Darr's financial ties with Watson bothered him. Darr was accepting rich investment opportunities from Watson at the same time he was judging the general partner's deals for public investors. It all seemed too ugly, too smarmy. But Petty could understand why Watson would want to keep the Prudential-Bache executive happy. At that point, almost no one was more important to George Watson's financial future than Jim Darr.

A fourth-generation Texan, Watson had come from a long line of wealthy Texas real estate men. At the age of sixteen, he was infected by his family's real estate bug following his success at selling some of his grandmother's land for $1.5 million. After receiving his business degree from the University of Texas in 1965, he dabbled some more in real estate but went through some tough times. Then, in 1974, he teamed up with Austin Starke Taylor III, a serious man known to everyone as Tracy. A former insurance agent, Taylor brought something to the business: connections in politics and business. His father, a wealthy cotton exporter and real estate investor, was a premier player on the Dallas axis of politics and business, and would be elected mayor during the 1980s. Through his father, Taylor had access to people who could make zoning changes or decide highway routes. Those were the sorts of decisions that could inflate the value of a land investment overnight.

Watson & Taylor expanded rapidly in its early years. Through a series of different entities, grouped under the name “the Watson & Taylor Companies,” the two men assembled and managed real estate properties both for the company's account and for outside investors. They were particularly attracted to deals involving mini-warehouses, a niche of the business that had less glamour—and far less risk—than developing office towers. In the late 1970s, their track record attracted the attention of Steve Blank's tax shelter department. Soon Watson & Taylor was selling real estate limited partnerships through Bache. The deals were not huge moneymakers for Bache, but they were solid performers.

By 1983, Watson & Taylor had been successful enough with earlier deals to sell its first big public partnership through Prudential-Bache. It took a little more than thirty days for the firm's brokers to sell the entire $14.4 million deal to 1,961 clients.

Better still for the Direct Investment Group, Watson agreed to allow a subsidiary of the brokerage, called Prudential-Bache Properties, to share the role of general partner. On top of the huge 8 percent commissions it received for selling the deal, the firm received a percentage of the cash flow from the partnership. And a chunk of that money went to select executives in the Direct Investment Group, including Darr.

Even as Watson & Taylor were raising millions thanks to Darr's ability to tap the huge network of retail brokers, the economics of Texas real estate were vastly changing. In 1982, Congress and the Reagan administration deregulated the multibillion-dollar savings and loan industry, allowing the institutions to invest directly in assets such as real estate. Suddenly huge thrift deposits were searching out real estate investments, helping to drive the prices of properties sky-high. Developers around the country immediately struck up deals with S&Ls or bought them outright for the purpose of using the deposits to finance real estate projects.

George Watson and Tracy Taylor forged a business relationship with a savings and loan just months after Prudential-Bache sold their first public partnership. Their effort began in 1982 when Taylor met Howard Wiechern, the chairman of First South, a small S&L in Pine Bluff, Arkansas. On a sweltering Saturday afternoon, Taylor flew to Pine Bluff to discuss a proposed land development project with Wiechern. The two men spoke about the background of Watson & Taylor, as well as about its recent business and future prospects.

“The Texas market is hot,” Taylor said. “There will be lots of opportunities to make money.”

Wiechern seemed suitably impressed. He listened as Taylor proposed that, if First South financed Watson & Taylor's developments, the company would share 25 percent of the profit. Wiechern shook his head.

“No, the way we do deals here in Arkansas is we're fifty-fifty partners,” he said. “We put up the money and you put up the work and find the projects and make them happen.”

After some negotiations, the men struck a deal. By May 1983, the floodgates had opened. That month, without approval from its lending committee, First South loaned Watson & Taylor $20 million. Over the next few weeks, First South loaned millions more to Watson & Taylor so that the company could pay the interest on other loans. Later, Wiechern and First South's president, Rod Reed, would backdate documents to make the loan appear properly approved and legitimate. The First South loans came so fast and steadily that by August 1983, three months after its first transaction with Watson & Taylor, Wiechern's thrift went in violation of federal regulations that restrict the amount of money that could be loaned to a single borrower. First South would remain in violation of those rules for years.