Serpent on the Rock (36 page)

The huge investigations of Wall Street insider trading and market manipulations consumed the working days of almost every top official in the SEC enforcement division. With so much manpower delegated to pursuing the high-profile lawbreakers, few aggressive inquiries were made into whether Prudential-Bache was following the terms of the 1986 settlement. It would be seven years later, after the Boesky and Drexel investigations were finished, before the government finally learned that Pru-Bache had ignored the strict compliance requirements of its settlement and engaged in a series of even more serious violations.

Even as the SEC and prosecutors were striking fear all over Wall Street, one of America's top brokerage firms was a renegade.

CHAPTER 11

SOON AFTER DAYBREAK, a phalanx of hunters checked their shotguns as they waited near the main lodge at Longleaf Plantation. The men, many wearing bright orange baseball caps emblazoned with the Longleaf name, had just finished a hearty breakfast at the commercial hunting reserve near Lumberton, Mississippi. In a few minutes, professional guides would drive them by Jeep to their designated courses. There the hunters would begin their daylong pursuit of fattened, pen-raised bobwhite quail. The morning sky was clear on this day in January 1985. A light rain that fell during the night gave the brisk air an especially crisp scent. It was the perfect weather for Longleaf's classic hunt, a blend of Old South traditions and European courtliness.

John Graham, the head of Graham Resources, walked past the crowd of hunters as he carried his bags to his car. A slender, round-faced man with well-groomed dark hair, Graham was a familiar face at Longleaf. A born hunter, Graham began visiting the reserve in the late 1970s and had loved it from the start. To him, it was the perfect mix of outdoors and elegance. After a day's hunt, the evenings at Longleaf featured sumptuous dinners of roast quail in wine sauce and southern cuisine, served by tuxedo-clad waiters.

It was a lifestyle Graham craved, one he enjoyed even more since becoming the most important general partner working with the Direct Investment Group. In just a year and a half, Graham had raised more than $170 million from 15,477 investors for the Prudential-Bache Energy Income partnerships. Now he often hobnobbed with his new friends at Pru-Bache and had personally introduced them to Longleaf. Darr himself had become an avid hunter since being taught to shoot by Tony Rice, Graham's chief financial officer. Now Darr, as well as Pittman, Joseph DeFur, and other Prudential-Bache executives, could truly appreciate what Longleaf had to offer. The trips were expensive, costing more than $250 per person for the day; an overnight stay added about another $200 per person to the bill. But none of the Prudential-Bache executives paid a dime. Instead, after each trip, Longleaf shipped the huge bill to Graham Resources' headquarters in Louisiana, where the cost was passed along to the energy income partnerships. Investors were picking up the tab for the newest hobby at the Direct Investment Group.

Graham walked to the back of his car, popped open the trunk, and threw in his bags. Before he could turn around, Mark Files, a senior vice-president at Graham Resources, sidled up alongside him and tossed his bags into the trunk as well. The men had just finished a wonderful two-day hunt at Longleaf. They had bagged near the limit on quail and were ready to head home. Files, an owlish-looking version of Graham himself, had agreed to share a car ride home with his boss so that they could have a private talk. They needed to discuss some problems facing the energy income partnerships. Problems that investors didn't know about.

In a matter of minutes, Files and Graham were on their way. They both knew this would be a serious conversation. The partnerships hadn't been producing enough cash to keep distributions high. All the assurances investors received about the safety and high returns of the partnerships had been just so much false advertising. If investors found out how poorly the deals were faring, sales of new partnerships would flounder. Without new sales, the fat fees that Graham Resources and Prudential-Bache received from the deals would level off. So Graham Resources had quietly advanced more than $2 million to the partnerships, which was used for expenses and distributions, making it appear as if investors were receiving hefty returns.

The men turned south on Interstate 59 as they talked about what the distribution rate should be for the recently completed quarter for the first energy income partnership, called P-1. Files suggested that they arrange for a 15 percent distribution. Graham agreed. Fifteen percent sounded reasonable to him.

Still, distributions that high might require another cash advance from Graham Resources. All these advances were starting to concern him, Graham said. The subsidies were getting too large. Even though the subsidies had a long-term benefit to the oil company, they tied up an enormous amount of its capital. So Graham had another idea.

“I want you to arrange for bank lines of credit to those partnerships,” he said.

Files nodded.

“And you should camouflage, to the extent you can, the purpose of it,” Graham said.

Keeping the truth hidden was important. It was unlikely that investors in the partnerships would be happy to learn that the cash they were receiving was borrowed money. Particularly since the prospectus, as well as the sales material for the energy income partnerships, said that Graham would not borrow money to pay for distributions.

“All right, John,” Files said.

This was a tricky problem. Files could tell that Graham felt trapped by the advertised distributions the partnerships were supposed to have and wanted a better alternative than telling investors the truth about the partnerships' performance.

Graham said he didn't want to tell Prudential-Bache about the plans. In his estimation, it wasn't right to talk with the firm about the difference between the actual cash-flow distributions and the amount brokers were projecting in their sales pitches.

“And if they see through the borrowing plan,” Graham said, “we should just ask for their forgiveness, rather than their permission.”
¹¹

Graham seemed to be angry with Prudential-Bache, and, in his mind, with good reason. Even with all the money the Direct Investment Group was pouring into Graham Resources, relations between Darr and the oil company were tense. Darr insisted on piling huge fees for Pru-Bache onto the partnerships. He even demanded for Pru-Bache a piece of some fees Graham Resources charged. In recent months, Darr had tacked on a new one percent acquisition fee for Prudential-Bache. That money came out of the so-called organization and offering expenses, or O&O, that Graham charged for putting the partnership together and selling it. That fee went toward anything that was considered a cost of putting the deal together, no matter how loosely related it was. Even the multimillion-dollar trips to induce brokers to sell the energy income fund were counted against the O&O.

But Darr had taken so much money out of the O&O that it left Graham Resources without enough to cover those actual costs. With securities rules limiting the amount of investors' money that could be spent on costs, Graham itself was stuck with paying the rest of the bill out of its own pocket. Essentially, Graham Resources was paying the acquisition fee to Prudential-Bache, a fact that enraged John Graham. During their drive from Longleaf, his anger at Darr's piggishness boiled over.

“I want to get the one percent back on our O&O,” he said. He clearly thought he was getting screwed by Darr.

That almost sounds like an ultimatum
, Files thought. “I know it's a serious matter,” he said. It made no sense for Graham Resources to keep eating those expenses all on its own.

Graham suggested that if the Direct Investment Group wanted to take so much of the money allocated for those expenses, perhaps the energy company should negotiate turning the responsibility for paying all of the O&O over to Prudential-Bache. At least in that way, the brokerage firm would be carrying the risk for making up any losses.

Files didn't like the idea at all. After all, it wasn't just the Direct Investment Group that could push off some of its costs onto the partnerships as organization and offering expenses. Graham Resources could do it, too, charging some of its own overhead off as a partnership expense and bolstering the energy company's profitability.

The best way to recover the O&O was to push higher sales. That would mean more fees for Graham Resources from all the other fees it charged to the partnerships. Selling the energy income partnerships was becoming a volume business.

While they were on the subject of the Direct Investment Group, Files said he had something he wanted to mention: Darr was champing at the bit to go hunting again.

“I can sense that Jim Darr wants to visit Longleaf again this quail season,” Files said. He had already checked into a number of dates that would be available in February and March. But there would be some restrictions on the number of people who could come, and they would not be guaranteed their favorite lodge.

“If we have an interest in the turkey season, though, the dates are fairly open,” Files added. “But I'd judge that Darr wouldn't enjoy turkey hunting as much. There's little shooting and a great deal of waiting.” Darr was a guy who liked action. He had no patience for waiting.

The two men discussed one last possibility: bringing Darr out to Longleaf on a hunt with executives from Prudential Insurance and First City National Bank of Houston. But Files shook his head.

“I think it would be a mistake to bring Darr on that hunt,” he said. “We already have a number of kings to take care of there.”

Charles Dawson sauntered out of the Prudential-Bache branch in north Dallas and headed toward his brown Chrysler LeBaron. He was ready to drive back to his one-man branch in the tiny Texas town of Sulphur Springs, eighty miles east of Dallas. At six-four with gray hair and a friendly face, the forty-five-year-old Dawson looked like the country broker that he was. He was probably the only employee at Prudential-Bache who ran a dairy farm on the side. But on that day in April 1985, he was the firm's top salesman.

Minutes earlier, Dawson had dropped off orders for $1.4 million worth of energy income partnerships with the Dallas branch's wire operator. It was the largest amount of the partnership ever sold by one broker on a single day. Then, without a word, Dawson turned around and headed out on his way back to Sulphur Springs.

Dawson pulled his car out of the Pru-Bache parking lot and drove south on Central Expressway. He should have been feeling delighted. After all, with an 8 percent commission, he had just grossed more than $110,000. But he was too worried to celebrate. He hadn't sold an energy partnership for two years, ever since the bad experience he'd had while working at a small regional brokerage. An energy partnership he sold at that firm had been a disaster. His clients lost most of their money.

When he arrived in Dallas earlier that week, he had raised his concerns about the Graham partnerships to Charles Grose, the branch manager. But Grose just waved his worries away.

“Look, this is Prudential-Bache,” Grose had said. “This whole program is being looked over by Prudential Insurance itself. You can't ask for better.”

Dawson's car approached the twin gold towers that stood alongside Central Expressway. They were the first of a cluster of glass structures built in Dallas in recent years. A huge construction boom, driven by easy cash from S&Ls and limited partnerships, had pushed up prices to astronomical levels throughout much of Texas.

He turned on the air conditioner. It didn't work too well in the used car he drove, but at least it was something. Dawson came to Dallas every so often. Some of his biggest clients lived there, and somehow they felt better doing business with a broker from Sulphur Springs than with one from the Dallas branch. All that week, he had been going to their homes, one at a time, to present the latest energy income fund. Sitting at their kitchen tables, he told his clients about the advantages spelled out in the sales material. Even though the material said that the investors could expect returns in the range of 15 to 20 percent, Dawson undersold those figures, telling his clients that they might receive returns in the range of 13 to 15 percent. Dawson didn't like his clients to be overoptimistic.

Most important in his sales pitch was Prudential Insurance itself. Repeatedly Dawson stressed that the Rock was investing its own money in the energy income partnerships. That was good enough for his clients: One invested $800,000 in the partnership, and three others purchased $200,000 of it.

Dawson drove past Fair Park, home of the Texas State Fair. As he finally hooked up with Interstate 30, he was feeling a bit better. He thought again about how Prudential Insurance invested in the deal itself. There couldn't be anything to worry about.

Tony Rice walked into the conference room in the offices of the Direct Investment Group. The room was full of a bustling crowd of executives. Rice, the chief financial officer of Graham Resources, had an expression of relaxed friendliness on his face. To a large degree, it was a front. He didn't particularly like Darr, and had it not been for their business relationship, their country club chats and hunting trips never would have happened. For sure, Rice would not have always paid for their activities by sending the bills to the partnerships. But for this meeting on May 30, 1985, he needed to be at his most charming. That was the only way he could hammer out a truce between Graham Resources and Darr.

Rice, as always, was dressed impeccably in a well-cut European pin-striped suit with elegant cuff links. His clothing looked all the more fashionable compared with that of the rumpled man accompanying him. Alfred Dempsey, a heavyset Graham executive, was not much concerned with sartorial splendor. Someone just walking into the room would not likely guess that Dempsey was the man responsible for overseeing Graham Resources' marketing, legal, and financial planning.

On the other side of the table were the Direct Investment Group's top executives, including Darr, Pittman, and Proscia. They were joined by Joe DeFur, a product manager for the energy income partnerships; Tony Hertl, an accountant hired by Darr two years earlier to handle the finances for all of the Prudential-Bache co–general partners, such as Prudential-Bache Energy Production; and Jim Sweeney, who was there to take notes on the meeting.

The executives swapped a few jokes, complete with affected laughter. But the pretense didn't cover the thick tension in the air. Everyone knew what they were there for: John Graham was demanding that his company receive more money to pay for the organization and offering expenses, as well as for other costs. Darr, in turn, wanted to keep his hands on as much of the cash as possible. The dispute had reached a stalemate and was starting to threaten the men's relationship.