Sunday, August 12, 2007

Is Fraud O.K., if You Help Just a Little?

Published: August 10, 2007

Correction Appended

It takes a team to pull off a good corporate fraud. Of course, the manager is responsible, but what about the people — and the companies — who just helped out a little? It may be that they are the only ones with enough cash to pay billion-dollar judgments.

That is a major point at issue in the legal quagmire that is emerging at Refco, the bankrupt commodities brokerage firm. And it is an issue that the Supreme Court may well decide in its next term, in a decision that could terrify — or greatly relieve — those who simply cooperate in a fraud. And that, in turn, could make future frauds more or less easy to pull off.

Does a company have any obligation to avoid transactions it knows are intended to deceive creditors and investors? What about lawyers who help structure such transactions? If other executives or directors see red flags, but choose not to investigate them, can they be held responsible?

In the case to be heard by the Supreme Court, a cable television operator, Charter Communications, cooked up a deal to buy set-top cable boxes from Motorola and Scientific-Atlanta at premium prices — with the excess payments sent back to Charter in the form of advertising purchases. That allowed Charter to show revenue it desperately needed.

To an appeals court, Motorola and Scientific-Atlanta did no wrong — or at least not enough to count as being more than aiders and abettors of the fraud, and therefore subject to civil suits for damages. They were not the ones who told lies to investors. “Imposing such liability would introduce far-reaching duties and uncertainties for those engaged in day-to-day business dealings,” the court said.

At Refco, the company’s longtime chief executive, Phillip R. Bennett, has been accused of hiding hundreds of millions in losses from auditors and investors. He is said to have hidden it using fake transactions with cooperating companies.

It was not noticed when the Thomas H. Lee companies took control of Refco in a leveraged buyout in 2004, or when Refco went public in August 2005. But two months later a new employee figured it out and told the board’s audit committee. Refco collapsed into bankruptcy and was liquidated. Creditors lost hundreds of millions of dollars.

Now, the lawsuits are flying. The Lee companies sued Mayer, Brown, Rowe & Maw, which was Refco’s law firm, claiming it helped prepare the documents for the false transactions that covered up the fraud.

This week Refco’s trustee turned around and sued Mr. Lee and his company, claiming they would have discovered the fraud if they had done a decent job of due diligence before the leveraged buyout. It seems that Mr. Lee got a tip before the buyout, but rather than have his accountants check it out, he asked Mr. Bennett about it and then accepted his assurances that all was fine.

More defendants may yet appear. Among the candidates are Grant Thornton, Refco’s former auditor, and Ernst & Young, which did tax work for the company. The underwriters of its stock offering, led by Credit Suisse, Goldman Sachs and Bank of America, may also be sued, and Refco’s bankruptcy examiner has suggested suing Weil, Gotshal & Manges for not doing a good enough job when it represented the Lee companies in the buyout.

Weil, Gotshal is still representing Lee, and filed its suit against Mayer, Brown.

Looking at litigation like this, it is tempting to dismiss it as a search for deep pockets, and to agree with some courts that it such is a threat to normal business practices.

But those practices may deserve to be threatened. It is hard to imagine that Motorola did not understand something was fishy when a customer asked to pay extra for its product, and then get the money funneled back to it. As for Mayer, Brown, its lawyers told the Refco examiner that they had no idea why the fake transactions were being conducted, and deemed it to be none of their business. They had little recollection of the work they had done.

The ultimate liability of Mayer, Brown may hinge on the Supreme Court’s coming decision. If it agrees with some lower courts, it could say such conduct can get a company in trouble. Or it could agree with other lower courts who conclude that lawyers have no duty to speak, and therefore cannot be liable if they fail to point out a fraud.

There is no question that you will be in trouble if you get caught engineering a corporate fraud. But it may be O.K. if you just help out a little.

Correction: August 11, 2007

An article and headline in Business Day on Thursday about a suit involving the collapse of the commodities firm Refco, and the High & Low Finance column on Friday about the same subject, referred incorrectly to both the defendants and the plaintiff in the suit. As the article described, the suit was filed by the trustee of the Refco Liquidation Trust, which represents creditors of Refco. He is not the Refco bankruptcy trustee, as the headline said, nor is he the trustee of the company, as the first paragraph said.

The article and the column should have pointed out that the Thomas H. Lee Partners and partnerships run by that firm, which are defendants in the suit, are no longer controlled by Thomas H. Lee, who severed his ties with the firm in 2006. Mr. Lee is named as a defendant because of his role as a director of Refco, and the suit names several other former directors who were not identified in the article.

The article and column also misstated certain allegations in the lawsuit. The suit stated that representatives of the Lee companies, not Mr. Lee himself, had failed to thoroughly investigate allegations of irregularities before the Lee companies took control of Refco, and had failed to disclose their knowledge of problems at the company before it went public in 2005.


Anonymous said...

Considering trust is a critical part of the Private Equity equation, I would be real worried if I was Thomas H Lee right now. All this bad press can not be good for business.

The creditors sense blood in the water and look ready to strike with a strong case against those involved in the LBO.

Although the proverbial brown stuff has hit the fan, Thomas H. Lee's defense seems to be one of pointing his finger in the other direction. Considering the Examiner's report, I am not sure that strategy is such a good one.

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