Caveat vendor

Morgan Stanley

May 19th 2005 NEW YORK
From The Economist print edition

A Florida court wallops one of Wall Street's top investment banks

COULD the headlines get any worse for Morgan Stanley? Already facing an attempt by dissident former managers to unseat its chief executive, on May 16th the investment bank was ordered by a Florida court to pay $604m for defrauding Ronald Perelman, one of America's smartest and richest investors. Mr Perelman contended that Morgan Stanley had misled him in 1998 when he agreed to accept shares in its client, a second-rate appliance manufacturer named Sunbeam, in exchange for his controlling interest in Coleman, a supplier of camping equipment.
And yes, things could get worse. On May 18th, after no more than a brief deliberation, the jury decided to award Mr Perelman another $850m, this time in punitive damages.

Morgan Stanley says that it is planning to appeal and that it was “not permitted to defend itself on the merits.” Quite so. In a pre-trial ruling on March 3rd, the judge, Elizabeth Maass (sitting in the Florida district where Sunbeam had been based), had instructed the jury that the bank had conspired with Sunbeam to defraud Mr Perelman; the only questions were the extent to which he had relied on the misleading information and the size of the resulting loss. That left Morgan Stanley unable to argue that it was not a party to fraud but itself a victim of it: witness its own $300m loss on the deal.

The jury was thus spared one of the sorriest business stories of the past decade. Sunbeam had long been a disaster when it decided in 1996 to bring in the executive hero of the moment, “Chainsaw Al” Dunlap, who had managed profitably to gut and sell Scott Paper, a troubled papermaker, before celebrating his methods in a self-congratulatory book, “Mean Business”. His tenure at Sunbeam resembled a caricature of capitalism. It began with lots of firings and an overstatement of losses. Reserves were built up and then released, augmented by fraudulent sales; that created the illusion of a fast turnaround and boosted the share price before, inevitably, the charade became apparent. In 2002, Mr Dunlap settled charges with the Securities and Exchange Commission by paying a fine and agreeing that he would never again be an officer or director of a public company.

Mr Dunlap's fast work at Scott endeared him to few employees, but made him sought after by bankers. Morgan Stanley was just one of many firms wanting his business. In Mr Perelman, Morgan Stanley found a buyer who seemed well equipped to cope with the Chainsaw Als of this world, having acquired an intimate familiarity with the challenges of managing suspect firms. He still controls Revlon, an ever-struggling cosmetics company, and had a controversial stint atop Marvel Entertainment, a publisher of comic books, that earned him a fortune even as it left the company bankrupt. Earlier in the 1990s, Mr Perelman had benefited hugely from the government-sponsored bail-out of the savings-and-loan industry.

Further, Mr Perelman, like any other billionaire, could afford the finest financial and legal advice that money can buy. And, if that were not enough, Coleman had overlapping distributors with Sunbeam. He was in an excellent position to ignore whatever blather Morgan Stanley had to say in favour of his own investigation into Sunbeam's recovery.

Yet none of this was ever brought before the jury, because of something that turned out to be critical to Morgan Stanley's defence. It had consistently failed to turn over internal e-mails. As the bank had done in other investigations, it blamed the omissions on computer errors and the like. This time, however, in Mr Perelman it faced an adversary who was implacable, well represented and determined to extract more than a token settlement; past opponents, mainly regulators, have been more easily satisfied.

Worse still for the bank, it faced a judge who found its delays and evasive answers to requests intolerable. “Many of these failings were done knowingly, deliberately and in bad faith,” concluded Judge Maass, in her critical pre-trial ruling. “A reasonable juror could conclude that evidence of Morgan Stanley & Co's misconduct demonstrates its consciousness of guilt.”

That ruling, and the thought that lots of embarrassing dotcom-era e-mails might come to light, will warm the heart of many a plaintiff lawyer. And an odd twist to the Sunbeam case is worth a moment's meditation—not for Morgan Stanley specifically, but for the whole financial industry. According to Mr Perelman's allegations, the company's problems came to light only because of the demands of its auditor: Arthur Andersen, an accounting firm once renowned for its probity. How easily can reputations crumble to dust.

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