Serpent on the Rock (37 page)

Rice opened the conversation by discussing the fact that all of the competitors with energy income partnerships seemed to be disappearing.

Perhaps, Rice said, the market was saying that energy income partnerships were a product of the past. The future seemed to be in so-called roll-ups, which take all the oil wells and other energy assets out of a group of limited partnerships and roll them up together into a single publicly traded company. Traditionally, roll-ups were disastrous for investors. But the general partners—in this case, Graham Resources and Prudential-Bache— received fat fees for assembling a roll-up.

Darr shook his head. “I don't like it,” he said. “A roll-up could kill the future sales of the income funds.”

One big problem was that investors had paid more than 15 percent of their initial capital to purchase these partnerships. If, a few years later, the partnerships were rolled up into a stock they could have purchased for a 3 percent commission, they would be livid. Plus, then the old partnerships would be gone. There would be no track record for brokers to refer to when they tried to sell new partnerships.

Then perhaps, Rice suggested, they could find a way just to roll up the oldest income partnerships. That way, the track record of the recently sold partnerships could still be used in the sales materials for new deals.

The twisted logic seemed to escape everyone in the room. Essentially, Rice was suggesting a deal that would likely cost the early investors much of their remaining capital.

The Direct Investment Group executives said that they would think about the idea.

Rice proceeded to the next topic: The partnerships needed to borrow some money.

“From time to time, there has been insufficient cash on hand for purposes such as developmental drilling costs, taxes, et cetera,” Rice said. “We've been advancing cash to the partnerships interest-free to meet those needs. But now we'd like to arrange for a loan from Citibank for that cash.”

Just as John Graham had instructed Mark Files in the car ride from Longleaf, the true purpose for the money was being camouflaged. But it was a flimsy explanation. It was like someone who spent money on a movie every night saying he needed to borrow cash to buy food. That loan was not financing the necessary food expense—instead, the money for food had been blown at the movies. In the same way, Graham was taking money away from necessary expenses, such as paying taxes, to make distributions. But the distributions were supposed to be the cash left over
after expenses
.

Bill Pittman looked quizzically at Rice. This sounded fishy to him.

“If the partnerships are borrowing money to meet present needs, doesn't that mean that the returns being paid to investors are inflated?” he asked.

Bull's-eye. Even Pittman, with his limited background in the energy industry, had seen through the ruse. But the moment just slipped away under Rice's smooth assurances.

“No, no, no,” Rice said. He could see how Pittman might think that, he said, but it wasn't so. The accounting treatment of the developmental drilling was different from the accounting for distributions, he said. On top of that, the loans were only for a few million, so the interest payments should not affect the returns. The money they were making from energy production was enough to support the distributions, he said.

“All right,” Darr said. “Under the circumstances, it seems reasonable to obtain the credit commitment from Citibank.”

The joviality left Rice's face and was replaced with an expression of gravity. “That leads us to the organization and offering expenses,” he said.

Rice said that the partnerships had about $1 million worth of O&O expenses that Graham Resources had simply absorbed. The only way to make up for it would be to boost sales with more aggressive marketing. But in the first few months of the year, sales had been dropping off. In the latest partnership, the money allocated for O&O was not even going to cover all of the legal and accounting costs.

“We were able to recover all of the O&O on the first energy income program,” Rice said. “But that's changed in the current program because of Prudential-Bache's one percent acquisition fee that's considered part of the O&O.”

Darr visibly stiffened. He had fought hard to get that extra money coming into his department. He wasn't about to give it up simply because it was creating financial trouble for the biggest general partner working with the Direct Investment Group.

Still, Rice said, sales had started picking up recently. “If sales remain strong, the problem is going to diminish,” he said.

The executives from the Direct Investment Group seemed to nod their heads almost in unison. Darr signaled he wasn't willing to budge on the 1 percent acquisition fee. John Graham, through Tony Rice, was making it clear that his company would not keep financing Darr's greed. The only way that Graham Resources and the Direct Investment Group could keep dipping into the pockets of Prudential-Bache clients would be to step up sales on the next group of partnerships.

Everyone knew what he had to do.

The image of an elderly couple, nearing retirement age, beamed out from the video screens set up in a conference room. A group of about thirty Prudential-Bache brokers watched silently. The couple stood in the doorway of their modest white house, happily receiving a letter from their mailman. It was, the video implied, another fat distribution check from their investment in the energy income partnerships. The image dissolved into a picture of a working oil well.

“Prudential-Bache Energy Income Partnerships II: A means to profit from the energy market both today and in the future,” a disembodied voice intoned as orchestra music swelled. “It's an investment we're proud to put our name on.”

The lights came up in the conference room. Pete Theo, a top marketer for Graham Resources, hung his jacket on a chair and strode in his shirt-sleeves to the front of the after-work crowd of brokers. They had gathered on an evening in late June 1985 to hear Theo's latest pitch about the energy income partnerships. The new marketing video was just the first part of Theo's sales effort.

Theo, a trim, broad-shouldered man with straight, dark hair and a narrow face, said he wanted to talk about a few features of the investments. He walked away from a podium to a nearby paper flip chart. Picking up a black marker, he wrote “SAFETY” in big, capital letters on the chart.

“How safe is the investment income?” Theo asked as a number of the assembled brokers wrote the word “safety” on their notepads.

Plenty safe, indeed, Theo said. A lot of oil companies borrowed heavily in the late 1970s, when energy prices were high, he said. Now they needed to raise cash and were selling their oil wells at rock-bottom prices to earn the money to pay down the loans. So, the energy income partnerships were buying those oil wells at distressed, fire-sale prices. This “loan payoff” theory was the latest rationale behind the energy income partnerships. It had never been used to justify the sales of the earlier partnerships.

“Next item: income,” Theo said, as he wrote the word on the flip chart. A number of brokers dutifully wrote that word in their notebooks.

He turned away from the flip chart, tapping the back of the marker on his hand. “Why are we buying these properties?” he asked. “What does it do for us?”

Theo turned back to the flip chart. “It produces substantial income by buying at the prices we're able to buy when these oil companies are forced to sell,” he said. “We can produce income in the fifteen to twenty percent range.”

In big numbers, Theo wrote “15–20%” on the flip chart. Some of the Prudential-Bache brokers copied these numbers onto their notepads.

“The first year, with the start-up costs and the lag time of making these acquisitions, the income will only be in the twelve to fourteen percent range,” Theo said. In smaller numbers, he wrote “12–14%” as the brokers copied it down.

Theo didn't mention that in more than two years of operation, the Prudential-Bache Energy Income partnerships had
never
produced an actual return in that range. The only way they even appeared to do so was through the return of investors' original capital and the advances from Graham.

“Now, at this point, let me jump down to tax benefits,” Theo said, writing the words “tax benefits” on the flip chart. “Even though we are only producing twelve to fourteen percent in the first year, the vast majority of this income is tax-free, and in subsequent years, you will see about one-third to one-half being tax-free.”

Some brokers nodded at the familiar refrain. The videotape had just mentioned all of the tax benefits reaped from investing in the energy income fund. They'd read in the sales material about how the tax code's oil depletion allowance sheltered as much as half of the partnership cash flow. It was a major selling point to investors, who were delighted to hear that they could receive such high returns on tax-free income.

But repetition never made it true. There was little, if any, tax benefit from investing in the energy income partnerships. In reality, as much as 50 percent of the distributions clients received in the early years was just a return of the original cash they invested. They owed no taxes on it because none of it was income. The sales point was a heinous and seductive lie.

By that time in Theo's speech, many of the brokers were convinced: Their customers could be paid a high return for purchasing a safe investment. But Theo topped it all off with the most persuasive bit of information in his whole presentation.

“In addition to this, I think it's worthy to take a look at who's buying,” Theo said. “Prudential Insurance is the biggest investor in this program.”

There was no better recommendation than that, many of the brokers thought. The people at Prudential Insurance were the best in the business. If they liked this deal, it had to be good.

Matthew Chanin, one of the top energy experts at Prudential Insurance, finished reviewing a letter from Graham Resources as he sat at his desk. Chanin was concerned. He didn't like what he was hearing about Graham's huge expenses. And now, in this letter from Al Dempsey dated July 2, 1985, Graham Resources was letting Chanin know that their large distributions seemed unsustainable.

Chanin wasn't alone in his discomfort. His colleague, Michael Resanovich, felt uneasy about the Direct Investment Group. The styles of Darr and the Prudential Insurance executives were just too different. Darr was more volume oriented than either Chanin or Resanovich had anticipated. No matter what the topic, Darr saw it through the prism of boosting sales. As far as Resanovich was concerned, the energy income partnerships were a smoldering problem that could flare up at any time. He thought Darr was a loose cannon who accepted weak due diligence.

Chanin knew Resanovich's concerns and shared some of them. The two men attempted to raise some red flags, but in truth, they could do little. They were midlevel executives at the giant insurance company. Darr was one of the most powerful executives at another firm that just happened to be owned by Prudential Insurance. If George Ball was happy with Darr, so be it.

Still, they could do everything in their power to rein in any excesses in the energy income partnerships. Now Graham Resources seemed to be in enough financial trouble to allow Chanin to impose some new, stricter terms on the way they did business.

The letter Chanin had just received from Al Dempsey presented the first opportunity to spell out those terms. The letter made clear that the partnerships were not making enough money to sustain 15 percent distributions. But Dempsey feared that if the distributions were cut, investors would not want to purchase the new partnerships as they were rolled out. Reality didn't make a good sales pitch.

So Dempsey had a suggestion: Deceive the investors.

“In an effort to allow us the forty-five to sixty days necessary to ‘condition' the marketplace for a decline in distributions with the least possible impact on our current marketing effort, we suggest maintaining the 15 percent distribution level,” he wrote.

By doing so, “I believe that the adverse impact on sales can be moderated and will result in a sustainable sales level over the balance of the year which proves profitable to all parties.” Except, of course, for the investors who were tricked by the phony track record into buying the next partnerships.

The option of telling the truth, Dempsey implied, would be disastrous to the profits for Prudential-Bache and Graham Resources.

“Reducing the second quarter distributions to the sustainable 12–12.5 percent level will, in my judgment, make future marketing of our programs at profitable levels impossible,” he wrote.

In a few days, a second request came from Graham through Tony Rice, asking for permission to borrow $5.7 million from the bank. After thinking about his options, Chanin decided to allow the loan. But only if Graham accepted certain conditions to improve partnership performance.

On July 16, Chanin dictated a memo to Tony Rice. Chanin said that he would allow the partnerships to borrow the $5.7 million. To make sure that sales stayed healthy, he also would permit them to continue paying the inflated 15 percent distributions by allowing Graham to advance cash to the partnerships for now.

But Chanin's agreement came with conditions. Graham Resources had to reduce the bloated administrative expenses that it was charging to the partnerships. Prudential regarded that expense reduction “as an issue of utmost importance,” Chanin wrote.

He was satisfied with the terms. If Graham Resouces cut expenses, fewer partnership revenues would be going toward maintaining the lifestyle of Graham executives. If he was successful, the energy income partnerships stood a much better chance of turning a profit.

Exactly one week after Matt Chanin dictated his memo, the new agreement seemed ready to fall apart. Rice and Mark Files had asked Dempsey to review the cash flow of all of the existing partnerships, called P-1 through P-6. He was instructed to determine if the additional cash that Graham Resources had agreed to advance the partnerships would be enough to maintain the bogus 15 percent distributions for the next half a year.