In Business, How Cozy Is Too Cozy? : Roles of Technical Equities’ Broker, Bank and Auditor Questioned
In the fall of 1985, author and psychologist Charles Garfield told stockbroker Michael J. Doherty that he wanted to sell his 12,000 shares of stock in a San Jose firm called Technical Equities.
Garfield said he was concerned about the financial condition of the high-flying investment and management firm. He called its explanations for recent problems “shaky.”
According to court documents, Doherty tried to persuade Garfield not to sell. The stockbroker said the price was too low, and he praised Technical Equities as a solid company with strong management.
Less than six months later, Garfield’s unsold stock was worthless and Technical Equities had filed for bankruptcy protection. About 1,200 investors, including many famous athletes, suffered losses totaling $150 million.
And Doherty’s employer, the New York-based brokerage house of Bear, Stearns & Co., faced embarrassing questions about its relationship with Technical Equities and the San Jose firm’s charismatic chairman, Harry C. Stern.
Bear Stearns was not the only major institution mired in the collapse of Technical Equities. Also muddied were Los Angeles-based Security Pacific National Bank, the state’s second-largest bank and Technical Equities’ biggest unsecured lender, and KMG Main Hurdman, which audited the firm’s books for years and is now part of Peat Marwick Main, the world’s largest accounting company.
All three big institutions were accused of playing essential roles in creating the aura of prosperity for what one expert called in court records “a Ponzi scheme” in which new cash, inflated stock and negligent financial audits fed the illusion of a successful company.
When companies go bust, investors trying to recover money often set their sights on big institutions that worked with the company. Bankers, brokers, lawyers and accountants are becoming targets of lawsuits charging that they were too friendly with a big customer, overlooking problems in order to maintain a lucrative relationship.
The lawsuits revolve around a central question: How far must a bank, brokerage or accounting firm go in the name of prudence to check out the financial stability of a major customer?
In the case of Technical Equities, its investors claimed that the institutions did not go far enough.
Lawsuits accused Main Hurdman of ignoring adverse financial information in vouching for the firm’s fiscal health. The lawsuits maintained that the bank and the brokerage aided in the fraud through their cozy relationships with Technical Equities.
Last March, on the eve of a trial on the allegations, Bear Stearns, Security Pacific and Main Hurdman agreed to pay a total of more than $50 million to investors to settle the charges. The institutions admitted no wrongdoing in the settlements, and their lawyers contend that they were unaware of irregularities at Technical Equities.
The lawyers also defended the settlements as the best way to resolve issues that would have been enormously expensive to litigate and posed a risk that a jury would award the investors far more.
That is what happened to Stern and Herbert Barovsky, the former chief financial officer of Technical Equities. After a three-month trial ended last month, a Santa Clara County Superior Court jury ordered them to pay a state-record $147 million in punitive damages to the investors.
The jurors said a variety of schemes had been used to bilk the investors, ranging from charging them inflated prices for real estate to manipulating the price of the company’s stock.
After the trial, Stern and another former executive, John A. Lindberg, agreed to plead guilty to federal criminal charges and to cooperate in a continuing investigation into the fall of Technical Equities.
Joseph M. Burton, the assistant U.S. attorney heading the investigation, declined to specify potential targets of the inquiry. But he said “anyone involved” in the collapse would come under scrutiny.
Stern created the firm, known as TE, in 1969 and it grew into a mini-conglomerate that operated more than 60 limited partnerships, mostly in real estate, and owned several small manufacturing firms around the West.
Some of TE’s investors were famous athletes, such as former Dodger pitching great Don Drysdale and 19 members of the Los Angeles Raiders. Others were wealthy physicians. Some were elderly people.
All were lured by the promise of guaranteed returns, and many turned over control of their entire financial affairs to Technical Equities and a related consulting firm controlled by Stern, called Stern Management Associates.
They were also attracted by the image of Technical Equities as a firm with connections to blue chip institutions.
Pete Banaszak, a former Raider, testified at Stern’s trial that the involvement of Security Pacific and Bear Stearns made him think TE was in the “big leagues.” Albert Day, a former TE accountant and investor who later sued over money he lost, said in court papers that associating with the big institutions was “part of the image of being a first-class firm.”
The Broker
Michael Doherty was part of the image. He visited TE’s offices and was introduced at its annual shareholders meeting. Employees were encouraged to refer clients to Doherty, and his telephone number at Bear Stearns was in TE’s automatic dialing system.
Doherty joined Bear Stearns in San Francisco in 1979. As part of a drive in the office to drum up new business, he arranged for Bear Stearns to become the “market maker” in TE stock.
That means that Bear Stearns would maintain bid and offer prices in TE’s stock on the over-the-counter market and that buyers and sellers would go through the trading desk at Bear Stearns’ New York office. For nearly four years, Bear Stearns was in the highly unusual position of being the only market maker for TE stock.
During questioning by attorneys in pretrial sessions called depositions, Doherty said becoming a market maker was based strictly on how much business the deal would generate. He said no consideration was given to whether it was a good or bad company.
And Doherty said TE generated more business for him than any other company. From 1981 to 1985, 20% to 25% of his income came from trades in TE stock. He made $40,000 in commissions on TE trades in 1984 and a similar amount in 1985.
Doherty said the 200 to 300 clients who bought and sold the stock were all referred to him by TE. “I really didn’t understand what TE did,” Doherty said. “I was just an order clerk taking orders from these people.”
The distinction is important because a brokerage house is under additional responsibility if it recommends a stock to a customer, rather than simply taking an order. Bear Stearns’ lawyers maintained that the firm and Doherty were under no obligation to explore TE’s financial condition because they did not solicit the trades.
The investor lawsuits, however, maintain that there was no way that Bear Stearns could not have known something funny was going on at TE in 1985 because of Doherty’s close relationship to the firm.
Could Panic Investors
Throughout 1985, TE was suffering severe cash-flow problems as a soft real estate market damaged already weak investments. It doubled its borrowing from Security Pacific and sought to raise $10 million in new corporate debt. The debt issue’s success depended on maintaining a strong stock.
In addition, TE and its officials frequently referred to its stock price as a “barometer” of its success, and a big drop could panic investors and add to the woes. Because trading in the stock averaged only 2,000 shares a week, any big sale could push the price down dramatically.
But some big shareholders were concerned about the company’s health or were disappointed that the stock had gone flat after several years of consistent growth. They wanted to sell their stock.
In several instances described in court records, investors contacted Doherty intending to sell but were put off. Doherty routinely contacted Stern, who in turn tried to talk the investors out of selling.
A lawyer for Bear Stearns said Doherty was often unable to sell TE at the price investors wanted and that he contacted Stern in an effort to line up buyers. The lawsuits claimed that he was working with Stern to keep the stock price up.
For four to six weeks in the fall of 1985, Doherty bought chunks of TE stock within 10 minutes of the close of trading on the OTC market. The pattern eventually caught the eye of Bear Stearns officials in New York, who ordered an in-house inquiry, according to court records.
Questions were also raised at Bear Sterns about the purchase of 16,700 shares of TE stock by Doherty on behalf of a retired physician named William Graham during 1985, as the stock was dropping. The shares were bought through a margin account, which meant that Bear Stearns had loaned Graham’s account part of the purchase price.
Wouldn’t Repay Loan
Doherty said in court records that he bought the stock without talking to Graham. He said the purchase orders came from Linda Penny, a secretary to Stern, and that he understood that Graham had granted power of attorney to Stern’s firm.
When the stock plummeted from $21 to less than $2, Graham refused to repay the money that Bear Stearns had loaned his account for the margin purchases. Faced with paying the money himself under Bear Stearns policies, Doherty went to Stern’s office to get a copy of the power of attorney.
It was Jan. 24, 1986, and Stern, a week away from bankruptcy and scrambling to keep his company afloat, kept Doherty waiting five hours before telling him that he had lost the document. Doherty telephoned a Bear Stearns lawyer and got instructions on how to create a new power of attorney form, according to his deposition.
That night Doherty went to a San Francisco hospital, where Graham was awaiting surgery, and tried unsuccessfully to persuade him to sign a retroactive form. He returned the next day but was thwarted when a nurse said Graham was unconscious in the recovery room. Graham eventually signed the form but still refused to pay Bear Stearns for its loss.
Last week, Doherty’s attorney, A. C. Johnston, said Doherty had done nothing wrong and still works at Bear Stearns. A spokeswoman in New York said the firm had no comment.
Bear Stearns paid $10.8 million to investors to settle the lawsuits.
The Banker
Another important figure in TE’s world was Harold E. Hayek, who was the loan officer in charge of its account at Security Pacific for several years before becoming manager of the bank’s main San Jose branch.
Technical Equities was the biggest customer at the branch. According to the lawsuits, half of the second floor at the branch was devoted to handling accounts related to Technical Equities. At Christmas, a runner from TE distributed wine to every employee in the branch.
Security Pacific highlighted its role in the growth of Technical Equities in a series of advertisements in national publications. The ads, saying “Let Us Take You to Tomorrow,” ran six months before TE’s collapse.
Security Pacific provided $18 million in unsecured loans to TE and its affiliates and an additional $1.5 million in loans to its clients and executives. The bank maintained accounts for at least 117 TE employees, investors, partnerships and related entities.
One TE investor told the San Jose Mercury News that during a visit to the firm he told an executive he needed a loan. The executive said Hayek was in the TE building and summoned the bank official. Hayek and the investor talked briefly. The next day, $200,000 was wired to the investor’s account from Security Pacific.
Because of the close relationship between the bank and TE, the lawsuits maintained, the bank not only knew of the poor financial condition of the firm but arranged loans to shore it up.
The bank’s attorneys said Security Pacific had no special knowledge of TE’s condition. They said the bank lost $15 million on its loans to Technical Equities and its affiliates. In addition, the bank agreed to pay $25 million to settle the investor lawsuits. Hayek, whose attorney said he had no comment, is no longer employed at Security Pacific. No one would say whether he quit or was fired.
“The bank,” said its attorneys in a court filing, “had been sucked into TE and paid the price for reliance on the glowing picture painted by the audited financials.”
The Accountants
Main Hurdman provided TE with a clean bill of health for many years, and the investors claimed that the firm should have noticed the problems brewing within the company.
In the aftermath of the TE collapse, the State Board of Accountancy opened an inquiry into the actions of Main Hurdman and four of its accountants who worked on the final audit of TE. It was believed to be the first time a state agency anywhere had tried to discipline a major accounting firm.
The accusations zeroed in on the final audit report, accusing Main Hurdman of gross negligence in issuing an Aug. 1, 1985, opinion that said the auditors had found no evidence of a “material weakness” at TE.
According to the accusations, the auditors did not pursue evidence of questionable fund transfers, ignored a substantial late penalty paid by TE on its 1984 federal taxes, and did not raise concerns about the adequacy of TE’s internal accounting procedures.
Dismissed Accusations
The accusations, which sought to revoke the licenses of the firm and the individual accountants, became public the day before Main Hurdman completed its merger with Peat Marwick.
Earlier this year, the state board’s staff presented its evidence in a 23-day hearing before an administrative law judge. Arrayed against the staff and John E. Barsell Jr., the assistant attorney general handling the case, were nine lawyers for the accountants and the firm.
On May 26, the judge issued an opinion in which he dismissed the accusations. The decision has been presented to the full regulatory board, which can adopt the judge’s ruling or decide to hear the case itself. A decision is expected soon.
Lawyers for the accounting firm settled the investor claims against Main Hurdman by agreeing to pay $17.9 million.
Allan Steyer, one of the attorneys who represented the investors, summed up the role of the brokerage, the bank and the accountants this way: “Ultimately, the most important thing that the institutions did was give legitimacy to Technical Equities and foster the image that it was a solid company. That image was an inherent part of Technical Equities’ pitch.”
A Tangled Web
Technical Equities
The mini-conglomerate founded 19 years ago in San Jose ran more than 60 limited partnerships and owned several small manufacturing firms. In court records, one expert called the firm’s operation “a Ponzi scheme” in which new cash, inflated stock and negligent financial audits fed the illusion of success.
Security Pacific
The state’s second-largest bank was Technical Equities’ biggest unsecured lender. Because of the close relationship between the bank and TE, lawsuits maintain, the bank not only knew of the poor financial condition of the firm but arranged loans to shore it up.
KMG Main Hurdman
The accounting firm audited TE’s books and provided it with a clean bill of health for many years. Investors claimed in lawsuits that the firm should have noticed the problems brewing within the company and accused it of ignoring adverse financial information.
Bear Stearns
The New York-based investment bank was the sole market maker in TE stock. In 1985, one of its brokers praised TE as a solid company with strong management while it was suffering severe cash-flow problems.
