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what now appears routine, a leading investment bank
in the US has been indicted for fraud. On Monday May
16th, 2005, a Florida jury ruled that Morgan Stanley
had acted in bad faith and defrauded erstwhile corporate
raider and beleaguered financier Ronald O. Perelman
in 1998. In the first instance it required Morgan Stanley
to pay Perelman $604 million in compensation. Two days
later, the jury ordered Morgan Stanley to pay a further
$850 million in punitive damages. This took the total
awarded to Perelman to $1.45 billion. For Morgan Stanley,
the punitive damage payments far exceeded a recent fine
the firm had paid as part of the Wall Street settlement
over conflicted research, which was a mere $125 million.
However Morgan Stanley is not financially threatened
having earned $4.5 billion last year and already put
aside $360 million for the case.
The case is interesting for a number of reasons. First,
critics of Morgan Stanley's current top management argue
that the award was partly the result of the arrogance
of Morgan Stanley's defense which turned the judge and
then the jury against it. The facts of the case are
straight forward. In 1998, in a deal brokered by Morgan
Stanley, Perelman sold his 82 per cent stake in Coleman,
a manufacturer of camping gear, to Sunbeam, a consumer
appliances manufacturer, for 14 million shares of Sunbeam
and cash.
At that time Sunbeam was being run by Albert J. Dunlap,
who had a reputation as a specialist at turning around
ailing firms, and was nicknamed Chainsaw Al, because
of his willingness to fire workers to cut costs as part
of the revival. He had come to Sunbeam after having
turned around Scott Paper during 1994 and 1995. And
by 1998, he seemed to have achieved the same at Sunbeam,
where profits and share values had risen sharply.
It was at this time that Perelman, no small or benign
financier himself, chose to buy into Sunbeam shares
by merging Coleman with Sunbeam in a stock and cash
deal. Some insiders to the world of finance concur with
Sunbeam that in that deal Perelman had been paid a higher
price for Coleman than its finances warranted. But,
possibly expecting to gain even more by holding Sunbeam
shares, Perelman did not encash that gain by selling
Sunbeam stock.
Morgan Stanley was closely involved in the transaction,
having advised Sunbeam and approached Perelman to seal
the deal. But that was not all. It helped Sunbeam to
raise $750 million dollars to finance the cash component
of the transaction and meet other costs. This it did
by underwriting the high-yield, below investment grade
''junk bonds'' and the bank loans that helped finance
the Coleman acquisition. Morgan Stanley, reportedly,
had planned to pass on some of these loans which devolved
on it as underwriter to other institutions at a later
date, but it was not able to do so in full.
The issue at hand is that a few months after the Coleman
deal it became clear that Sunbeam's profit record that
lead to rising share values, was the result of a manipulation
of the accounts rather than an actual turn around. The
Sunbeam board chose to relieve Chainsaw Al of his position
and in 2001 Sunbeam collapsed and filed for bankruptcy
protection. In the event, the prices of the company's
share collapsed and Perelman's Sunbeam shares became
worthless. Morgan Stanley too lost $300 million because
of the portfolio of Sunbeam debt that it had not managed
to offload. Needless to say, among those who lost in
the deal must have been a large number of smaller investors,
who must have directly and indirectly bought into Sunbeam
when its share prices were rising.
The matter would have been put to rest if everybody
involved-Perelman, Morgan Stanley and the smaller investors-agreed
that they had made a wrong judgement about Dunlap and
Sunbeam and accepted the they suffered on that account.
Unfortunately for Morgan Stanley, while the smaller
investors did do so, Perelman did not. And what is more,
instead of holding Alfred Dunlap responsible for his
losses he chose to target Morgan Stanley. Perelman sued
Morgan Stanley in 2003, claiming that it had misled
him when the deal was being negotiated by talking up
Sunbeam's performance and prospects and that it had
concealed from him evidence of a worsening of Sunbeam
finances because of the $33 million Morgan Stanley would
earn as an advisor to Sunbeam and from underwriting
Sunbeam's bond offering.
However, at that time, there were two reasons to believe
that Perelman would not have been able to persuade the
jury to vote in his favour. First, it was difficult
to believe that Perelman would have made his investment
in Sunbeam and held on to the shares purely on the basis
of Morgan Stanley's marketing hype. Perelman's past
track record hardly identified him as a gullible small
investor. Rather, he had a reputation as a sharp deal-maker
and corporate raider with his own share of suspect transactions.
Most famously, he gained control of cosmetics major
Revlon in a $1.8 billion hostile takeover in 1995. Though
Revlon has suffered losses and lost market share to
firms like L'Oreal and Proctor and Gamble, Perelman
had held on and there are signs recently of a possible
return to profitability that would improve share prices
and enhance Perelman's paper wealth.
In the past Perleman has benefited from the sale to
Citgroup for $8.8 billion of his 30 per cent stake in
Golden State Bancorp, a savings and loan; the acquisition
in 2003 of Allied Security, a major provider of security
guards; and an acquisition last year of a 70 per cent
stake in the manufacturer of the Humvee military vehicle
for more than $900 million.
But it has not been success all the way. Perleman's
reputation was damaged, for example, by a series of
losses, beginning with the bankruptcy of Marvel Entertainment.
But the worst damage came when he tried to recoup his
investment in Panavision, an ailing and debt-burdened
producer of movie cameras. He sought to sell Panavision
to another company he controlled, the licorice extractor
M & F Worldwide. Shareholders of M & F got wind
of the implications of the deal and filed a suit against
Perelman, who in a settlement in 2002 agreed to reverse
the transaction. Given this background it would have
been hard to convince the jury that Morgan Stanley was
solely responsible for Perleman's decision to sell his
Coleman stake to Sunbeam in a deal involving stock,
besides cash.
The second advantage that Morgan Stanley had was the
fact that it had lost $300 million on the deal, which
was much larger than the $33 million fee that it allegedly
was paid for completing the transaction. If Morgan Stanley
was in the know and was willfully concealing the facts,
why would it participate in a transaction that resulted
in a $300 million loss. Morgan Stanley was no gullible
investor either. In fact after the May 16 verdict the
company claimed that: ''Far from being part of the Sunbeam
fraud, Morgan Stanley was a victim of that fraud, losing
$300 million when Sunbeam collapsed.''
If despite these advantages that Morgan Stanley had,
the company has been charged to the tune of $1.45 billion,
it was because of the fact that it was not just unwilling
to settle out of court with Perelman for a smaller compensation,
but in fact took the court for granted. To start with,
it was lackadaisical in providing documents, including
e-mail messages, as part of the case. In June 2004 Morgan
Stanley had declared that it had provided all relevant
documents and e-mail messages required by the court,
only to discover when it was too late that there were
other documents it should have turned over to Perelman's
lawyers.
Judge Elizabeth T. Maass of Palm Beach Circuit Court
did not take kindly to this violation. In a surprising
move she issued an order reversing the burden of proof.
Based on her judgement that Morgan Stanley had ''deliberately
and contumaciously violated numerous discovery orders,''
she declared to the jurors that it was Morgan Stanley's
task to persuade them that the firm did no conspire
to commit fraud. Normally, it would have been the job
of Perelman lawyers to prove that fraud had been committed.
But judge Maass's ruling based on Morgan Stanley's ''obstructionist
behaviour'' implied that the jury can take for granted
that Morgan Stanley and Sunbeam acted in concert. Perelman
only needed to convince the jury that he acted on Morgan
Stanley's advice. Though this was a hurdle, the task
of persuading the jury had been rendered easier.
In fact, the task proved to be a walk through because
of a second instance of bungling on the part of Morgan
Stanley. When penalized for allegedly willfully withholding
evidence, Morgan Stanley decided to part ways with its
law firm Kirkland & Ellis, on the ground that it
was planning to file a civil malpractice suit against
its lawyers. While, the ostensible reason appeared to
be that Morgan Stanley was holding Kirkland & Ellis
responsible, few including the judge were convinced
of this. And when the new lawyer asked for continuance,
or additional time to prepare for trial, Judge Maass
demanded to know the actual reason why Kirkland &
Ellis had been discharged. Since Morgan Stanley was
unwilling to waive its client-attorney privilege and
reveal the reason for the split, judge Maass denied
the request to grant a continuance. ''How would you ever
test whether there truly was a potential malpractice
claim or it was simply a ruse to allow counsel to withdraw
and potentially get a continuance?'' she asked. If parting
ways with Kirkland & Ellis was Morgan Stanley's
way of buying time to decide whether to fight or settle,
its attempt had clearly failed. Even the accommodative
US elite seemes unwilling to stand this level of arrogance
that stemmed from Morgan Stanley's economic strength
that came not from profits in production but the opaque
world of finance.
The net result of all this was a speedily trial in which
Perelman won without much effort. Given the unusual
reversal-of -burden of proof ruling of the judge, there
is a possibility that the award would be reduced or
overturned on appeal. That makes it attractive to both
sides to settle out of court for a smaller sum. Morgan
Stanley can cut its losses while Perelman can ensure
gains, even if smaller. But the lesson is clear. There
were three big players who were party to a speculative
deal from which they expected to gain significantly-Alfred
Dunlap, Morgan Stanley and Ronald Perelman. When that
deal went awry Dunlap got away lightly-he lost his job,
had to make some settlement payments, but was never
investigated for fraud and charged. Perelman has now
made a significant gain. Morgan Stanley lost, but an
amount which its deep pockets can easily afford. As
for all the smaller players who may invested in Sunbeam
believing in the signals that the big players were directly
or indirectly sending out, they lost without even being
considered for a compensation since they were not part
of the case. In part, it is their participation and
their losses that go to shore up the gains of Dunlap
and Perelman.
The regularity with which such instances are being revealed
recently makes clear that US financial markets are not
competitive, transparent or well regulated. But it is
on the ground that US markets embody those characteristics
that the US example is being touted as the model that
developing countries like India should attempt to emulate
and approximate through a process of financial liberalization.
Given the size of the market here and the relative strength
of market players, it is likely that the damage of speculative
financial activity would even be greater. Past experience
of such damage had forced small investors out of the
market. But by skewing the structure of financial rates
of return and encouraging banks, insurance companies
and pension funds to enter that market, the government
still seeks to find platforms on which the small investor
can be enticed to return, so that the large players
can find new sources of gains even though they themselves
produce no surpluses.
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