As Energy Funds Stumbled, Companies Reaped Benefits : Wall Street: Critics say Pru-Bache, others profited as investors absorbed losses. Firms blame oil price drop.

Investors didn’t know it, but Prudential-Bache’s Energy Income Funds partnerships paid for Pru-Bache executive James J. Darr’s 10-day vacation to London in 1988.

Darr, his wife and daughter ran up $34,000 in expenses on that trip--including $15,000 in round-trip airfare on the Concorde, $11,500 for two luxury suites at the Berkeley Hotel and charges for a chauffeured car that sometimes exceeded $1,500 per day.

At the time, the partnerships were performing poorly; internal evidence was mounting that they never would yield anything near the high returns investors had been told to expect.

Still, Darr--along with other Prudential officials and senior executives of Graham Resources, the small Louisiana firm hired to manage the funds--continued to play hard as they marketed partnership units to thousands of retirees and other small investors.

For the 137,000 customers who poured over $1.44 billion into the Energy Income Funds by the time sales were halted in 1990, there was little cause for celebration. Far from receiving any profits, investors had gotten back only $650 million of their original investments at the end of last year.

That track record and problems with other partnerships marketed by Pru-Bache (now Prudential Securities) in the 1980s have landed Prudential at the center of one of the most wide-ranging investigations ever of a major Wall Street brokerage.

State and federal investigators are looking into allegations of deliberate misrepresentation to customers, fraud and the use of borrowed money to mask that the partnerships were performing well below expectations. Those charges and others are detailed in two class-action lawsuits through which investors are seeking more than $500 million in damages; Prudential is negotiating to settle the suits.

Records and interviews, meanwhile, show that Prudential Securities’ parent company, giant Prudential Insurance, played a central role in many Energy Income Funds decisions.

Prudential Securities, Prudential Insurance and Graham all deny any wrongdoing. They contend that the partnership program produced losses only because oil prices collapsed in 1986--and, unexpectedly, never recovered. The firms say investors were told of all the risks.

As head of Pru-Bache’s Direct Investment Group, the umbrella for the firms’ $6-billion limited partnership program, Darr had direct responsibility for seeing how investors’ money was spent.

His trip to London and Scotland was part of a $1.2-million junket organized to reward 100 Pru-Bache brokers for sales of Energy Income Fund units--one of at least five such foreign trips ultimately paid for by the partnerships as overhead expenses.

Though enforcement officials say perks of such magnitude probably violate industry rules, Darr defends his trip as a good business practice. Maintaining good relations with Graham was essential, he explained in an interview, because “they were our largest client.” Darr’s lawyer added that the $34,000 may have included expenses for others on the trip, although the records seem to indicate how much was spent on each executive.

Documents and interviews show that Pru-Bache brokers were bringing in hundreds of millions of dollars a year for Graham to invest in oil and gas properties. From the start, though, the results of Graham’s acquisitions had been disappointing. The Louisiana firm overpaid for many properties, overestimated oil and gas reserves and based profit assumptions on over-optimistic projections of future oil prices, records indicate.

Graham says it exercised good judgment, not always emerging as the highest bidder on properties; it says its assumptions about oil prices were reasonable.

Nonetheless, the net result, investors’ lawyers say, is losses of about $750 million, counting income that customers were told to expect and the interest it would have earned.

In short, the partnerships turned out to be a good deal for Graham, Pru-Bache, Prudential and their executives--if not for the 137,000 investors who had put money into the funds.

Why Sales Continued

A mass of internal documents released by the New Orleans federal judge presiding in one of the class-action lawsuits helps clear up one of the central mysteries in the Energy Income Funds saga: Why, when the results from the early partnerships were so poor, did Pru-Bache continue to sell the program so enthusiastically?

By the end of 1992, the records show, fees and commissions charged to Energy Income Funds investors by Pru-Bache and Graham totaled $388 million--almost 27% of the $1.44 billion they had invested. (Prudential Securities said it could neither confirm nor deny the accuracy of these figures.)

Most of that sum--fully 15%--came off the top as soon as investors put their money in.

Pru-Bache and its brokers collected sales commissions of 7.5% to 8.5%--far higher than the 1% or less commission on most municipal bonds or the 3% to 5% charged on most stocks and mutual funds. An additional 0.5% went to Graham. The commissions totaled more than $100 million, records show.

Graham and Pru-Bache also shared a property “acquisition fee” of 3.5% of the purchase price--regardless of how a particular property ultimately performed. For later partnerships, this fee was taken out as soon as investors paid in their money--often before any properties had been bought. Overall, the firms collected acquisition fees of over $50 million, records show.

In addition, the companies were reimbursed for “organization and offering” costs, including the overseas trips and the expenses involved in the huge promotional campaign mounted to persuade investors to put in their money.

These costs exceeded $50 million as well, according to William F. Jordan, a Florida State University accounting professor who is serving as an expert witness for investors’ in their lawsuits and also has been retained by state securities regulators investigating Prudential.

Beyond the 15% up-front fees were whole other categories of charges and expenses that Graham billed to the limited partnerships.

There was, for example, the “operator overhead” Graham was allowed on oil and gas properties where it operated the wells itself. A 1986 internal memo stated that this charge was the single largest contributor to Graham’s profits.

The memo by Graham executive Mark W. Files made clear that Graham actively sought properties on which the firm could charge high overhead.

“It behooves us,” Files wrote, “to go out of our way to look for those kind of transactions.”

In an interview, John Graham, the firm’s chairman and chief executive, denied that Graham Resources had picked properties on the basis of how much overhead could be charged for operating the wells.

Finally, there were “General and Administrative” fees--the expenses Graham charged each quarter for running the partnerships.

Clinton A. Krislov, a Chicago attorney for some partnership investors, has charged in court that Graham’s G&A; expenses were grossly excessive and poorly documented. Each partnership, for example, set up and owned a separate “producing partnership”--and Graham and various subsidiaries charged G&A; expenses to both entities.

Even if the partnerships ever had earned enough to pay back customers’ original investment, some investors’ share of any profits would have been much smaller than they had been told to expect, an independent analysis concluded.

Under partnership rules, investors would receive 80% of the profits, with the rest retained by Graham and Pru-Bache. John Graham, indeed, said the 80-20 split was the best deal available from any similar partnership.

But for the later partnerships, investors never would have received more than 66% of any profits, because fees, commissions and loan interest had reduced their stake in the oil and gas properties, according to a report by Robert Stanger & Co., a firm that analyzes limited partnerships.

“No other traditional Wall Street investment that I know of impairs an investor’s capital to the extent reflected in these . . . percentages,” said Jordan, the accounting professor.

Growth by Graham

“We have lived well as officers of Graham; our investors have not.”

--Minutes of an August, 1989, meeting of Graham Resources’ management committee.

For executives of Graham and Prudential, the fees and charges produced large benefits.

Graham Resources had employed about 100 people before it hooked up with Pru-Bache in 1983. But by 1987, it had grown to more than 350 employees--at least 80 of whom got leased company cars.

By then, the firm had moved from its nondescript offices in a modest New Orleans suburb to a new location on the fashionable north shore of Lake Pontchartrain--a leased, $11-million headquarters designed and decorated to the specifications of John Graham’s wife, Suzy. A row of fountains marked the entrance from the main road. The offices looked out on acres of man-made ponds, waterfalls and streams.

“There’s an ambiance about this kind of atmosphere that makes it easier to focus on high-priority issues,” John Graham told the New Orleans Times-Picayune at the time.

At the end of 1986, the year oil prices crashed, Graham collected a $125,000 bonus on top of his $220,000 salary, part of a $1.45-million bonus pool for top employees. Though partnership values had plunged that year, Graham told his board of directors: “We have raised more money than ever before.”

Graham took pains to share its custom of gracious living with key Prudential executives. An internal Graham Resources memo described Darr and other Prudential executives as men to treat as “kings.”

There were frequent, all-expense-paid hunting trips to places such as the 3,200-acre Longleaf Plantation in Purvis, Miss.

There, for about $450 a day per person, the attentive staff released fattened, farm-raised, bobwhite quail, and the air filled with the crack of shotgun fire as Darr, Prudential Insurance executive Matthew J. Chanin or other executives enjoyed the thrill of the hunt. Nights were spent enjoying sumptuous meals of roast quail in wine sauce served by tuxedo-clad waiters. The Prudential executives were sent back to New York with extra fowl, dressed and packaged.

Enforcement officials with the National Assn. of Securities Dealers declined to comment on the free travel and entertainment given to the Prudential executives. But John Pinto, the NASD’s enforcement chief, said gifts worth as much as the $34,000 that the Darrs ran up on the 1986 trip to London probably would have violated NASD limits on gifts that brokerage executives could accept.

Prudential Securities’ own internal rules say that even nominal gifts should not be accepted if “to a reasonable observer” it might appear that the gift could influence a business decision.

William E. Brown, a lawyer for Graham, said the purpose of the hunting trips was purely business--”to get people away from their offices and phones and other distractions and get a day or two of concentrated effort on a project.”

As for the trips for brokers on which Darr and Graham officials went along, Brown called them Prudential’s responsibility.

“The decisions to have the trips and conduct the trips were Prudential’s,” he said.

For its part, Prudential Securities said the idea for the trips was Graham’s and that, in any event, the use of investor funds to pay for them was disclosed in partnership prospectuses.

The $34,000 London trip was small, however, compared to a $500,000 investment Graham Resources proposed later in 1986 that also would have benefitted Darr personally.

At the time, Graham was trying to persuade Pru-Bache to drop its opposition to allowing other brokerages to sell units in Graham-managed oil holdings. After Darr and Graham’s second-in-command, Anton H. Rice III, had talked about Darr’s interest in opening a string of health fast-food restaurants, Graham offered in June, 1988, to help finance the personal investment--if Pru-Bache had a change of heart.

The minutes say that Rice, who had become a close friend of Darr’s, expected to talk to the Pru-Bache executive about the proposal the next day.

“We will relate Graham’s $500,000 Indication of Interest in Dietco (a Darr-controlled enterprise) to a successful filing of the new (Graham) Income Fund,” state the minutes of a June 14 management committee meeting.

Pru-Bache never dropped its opposition to the separate Graham fund.

Darr resigned from Pru-Bache late in 1988, after questions had been raised about his financial relationships with firms that were managing other Pru-Bache limited partnership programs.

Documents show that Pru-Bache hired a law firm to investigate Darr that year. The lawyers’ findings never have been disclosed. Prudential Securities recently filed suit against the NASD, trying to block an order to turn over the report to investors who have filed arbitration cases against the firm.

Darr said his resignation had nothing to do with the investigation, and he strongly denies any improper financial relationship with any firm with which Pru-Bache did business. He notes that no charges have been filed against him.

In an interview, Darr confirmed that he planned to invest in the restaurants. But he insisted that his discussion with Rice was “just a casual conversation” and that he never asked Rice or Graham to invest. In deposition testimony, Rice said the offer was not meant to influence Darr.

Role of Parent Firm

Prudential Insurance, the “rock solid” financial services giant, got a much better deal than other investors when it bought into the initial Energy Income Fund partnerships, the newly disclosed records show.

The firm’s role in the funds is one subject of an investigation by state securities regulators.

In a deposition, Prudential Insurance executive Chanin testified that the insurer did not have to pay the sales commissions or organization and offering costs charged to small investors. Prudential bought 10% stakes in the first 15 partnerships--a vote of confidence that brokers noted in selling units to small investors.

Also, rather than paying an acquisition fee on oil properties like the small investors, Prudential received part of those fees for its role in evaluating acquisitions.

Even after Prudential stopped investing and withdrew from the board of the Energy Income Funds in 1987, it continued to collect fees for monitoring the performance of the earlier partnerships. Chanin testified that the monitoring essentially was limited to one meeting a year.

Records obtained by The Times and interviews with Prudential executives show that Prudential also had a series of separate, private investments with Graham. Although the investments brought in profits to the insurance company, at times over $30 million in Prudential capital was at risk, posing a threat of losses if sales of still more Energy Income partnerships were halted.

Along with lawyers for the investors, accounting professor Jordan contends that the deals amounted to a serious conflict of interest, since Chanin and another Prudential executive sat on the board of the Energy Income Funds and had a responsibility toward the partnerships.

For example, in a purchase separate from the Energy Income Funds, Prudential took an $85-million slice of Graham’s giant acquisition of oil and gas properties from Petro-Lewis Corp. in 1984. Investors’ lawyers have questioned whether the insurer received terms more favorable than those granted the partnerships. Chanin denies it, but Prudential has declined to make available any documents about the purchase.

“That was a private transaction,” Prudential spokesman Joe Vecchione said.

Prudential also lent Graham $20 million of the $66 million in financing it needed to hold onto an interest in some Petro-Lewis properties pending their transfer to future Energy Income partnerships that had not yet been sold to investors.

Under terms of the financing, a Houston bank would get paid back first if the venture got into trouble. So in this case, Prudential had $20 million at risk if Pru-Bache failed to sell investors on the next series of partnerships.

(For its trouble, Prudential collected the interest on the loan, a 2.5% “finders fee” for the financing--ultimately paid by the limited partners--and the right to 1% of the cash flow of the properties once newly-formed Energy Income partnerships bought them.)

Chanin said in an interview that he never urged a halt to sales of the partnerships, because he believed both the risks and the side deals were fully disclosed in the prospectuses. He denied that Prudential’s investments with Graham had any influence on decisions he made as an Energy Income Funds board member.

Graham’s accounting firm never raised any questions, either, about the firm’s fees, borrowings or other practices, the newly released documents indicate. Three top Graham executives--including executive vice president Alfred B. Dempsey and Paul F. Giffin, Graham’s treasurer--had previously worked for the accountants, the New Orleans office of Arthur Andersen & Co.

The investigation of the Energy Income Funds by a task force of state regulators includes an examination of whether Andersen allowed Graham to hide the use of borrowed funds for making payouts to investors and overstate the value of oil and gas reserves, sources close to the inquiry said.

In a written response to questions, Andersen said it complied with “generally accepted auditing standards” and denied that the former Andersen employees at Graham had any influence on audits.

” . . . We approached our work on these assignments no differently than we would have had these former employees not worked for the client,” the accounting firm said. Arthur Andersen spokesman Jack Ruane added that the firm had not been notified of any investigation.

Principal Declined

By 1989, cash distributions to Energy Income Funds investors began to rapidly drop off.

But investors had no reason to suspect that they had suffered enormous losses of their principal. Until well into 1991, their monthly statements from Prudential Securities continued to list the value of their holdings as the price they had originally paid.

In fact, the partnership units by then were worth far less than the original purchase price; some were paying annual distributions of less than 1%. There was little market for them. When buyers could be found, the prices they offered were a tiny fraction of what the original investors had paid.

As press accounts began to raise questions about Prudential’s whole limited partnership program--suggesting that investors actually stood little chance of getting their original investments back, let alone making money--Prudential relabeled the “value” column on the monthly statements “face amount.”

And as the investors began to realize the extent of their losses, they turned to lawyers and regulators.

The NASD last September expelled Graham Securities, the Graham subsidiary that basically was the wholesaler of partnership units to Pru-Bache and provided much of the promotional material. Graham agreed to the unusually severe penalty without admitting or denying improprieties, including charges that it used misleading sales information.

The Securities and Exchange Commission, meanwhile, is investigating Prudential Securities’ partnership sales, along with other allegations of fraudulent marketing practices by the firm. Among the issues: whether the firm violated terms of an earlier settlement with the SEC.

And the U.S. attorney’s office in Manhattan has launched a criminal probe into Prudential’s limited partnerships, of which the Energy Income funds were the biggest. In all, investors put some $6 billion into Prudential limited partnerships in the 1980s. Prudential Securities agrees that investor losses totalled at least $1 billion; state regulators said in interviews they believe the losses are significantly higher.

With regulators from coast to coast receiving an unprecedented number of complaints about the partnership programs, all 50 states have signed onto an investigation led by a six-state task force of securities regulators. In several states law enforcement authorities are considering criminal charges.

“This is the biggest joint investigation the states have ever conducted,” said Wayne Klein, chief of the Idaho Securities Bureau, who heads the multistate task force. “It was such a big, big investment program that you have to ask, ‘Who was minding the store?’ ” he explained.

Other senior regulators said the states have been pressing Prudential Securities to come up with a settlement offer at least as big as the record $650 million Drexel Burnham Lambert agreed to pay in 1988 to settle charges related to its sales of junk bonds. Sources said Prudential Securities a few days ago raised its settlement offer to $200 million. But one state regulator this week said a settlement was not close, adding that the distance between the parties was “as wide as a canyon.”

Sources say the Arizona attorney general’s office, finally, is conducting a criminal inquiry that focuses partly on another Graham subsidiary, Graham Energy Marketing Corp.

Records show that the unit marketed large volumes of the partnerships’ oil to several middlemen, receiving premiums of more than $5 million above the wellhead price. Unknown to partnership investors, the premiums were paid by separate checks to Graham Energy, rather than being included in the middlemen’s payments to the partnerships for the oil.

Arizona authorities are looking into allegations that the premiums--most of which legally belonged to the partnerships--may have been diverted. Graham lawyer Stephen H. Kupperman denied that any money was diverted, saying the funds were properly apportioned to the partnerships.

Prudential Securities declined to comment on any of the pending investigations. Prudential Securities spokesman William J. Ahearn said the company’s policy is not to comment on any “regulatory matters.”

Besides confronting the web of investigations, Prudential Securities over the last few months has struggled to return more money to unhappy investors.

The firm plans to sell the limited partnerships to Parker & Parsley Petroleum, a Texas oil company, in a deal that would provide investors with about $491 million in cash. The deal--which still would leave investors about $300 million short of breaking even--has been thrown into question, however, because not enough investors have agreed to tender their shares. Parker & Parsley said Tuesday it had extended a Monday midnight tender deadline until midnight on July 2.

As part of its efforts to contend with the legal fallout from the Energy Income program, Prudential Securities has said it plans to buy Graham Resources. For reasons it has not disclosed, Prudential also agreed to indemnify John Graham and other senior Graham executives for any judgments that may result from investors’ lawsuits.

George L. Ball, Pru-Bache’s chairman and chief executive from 1982 to 1991, disclaims any responsibility for what happened with the limited partnership program. Ball came to Pru-Bache after serving as president of E.F. Hutton & Co. After his departure, Hutton pleaded guilty to charges of conducting a massive check-kiting scheme during Ball’s tenure, though he never was charged with a crime.

At Pru-Bache, Ball said the details of the limited partnerships were handled by subordinates. He did not take it upon himself to make sure that there were no misrepresentations to customers, saying that was the responsibility of the firm’s legal department. Nor did Ball read the letters of complaint addressed to him by angry Energy Income investors, passing them on to others, he said.

Hardwick Simmons, Prudential Securities’ president and chief executive officer since 1991, declined repeated requests for an interview. He also declined to respond in detail to a list of written questions submitted.

In a brief letter, Simmons said: “While the partnerships have certainly generated a great deal of publicity, we don’t believe their impact on our business will be lasting, as clients recognize that these problems are unconnected with the Prudential Securities of today.”

Until the drumbeat of lawsuits and investigations began growing louder, Prudential Securities seemed undaunted by its limited partnership experience.

Last year, Simmons surprised Wall Street with the announcement that he was going to resume sales of limited partnership-type products. Stung by the earlier debacle, Prudential’s brokers rebelled: Spokesman Ahearn confirmed that they refused to sell the so-called private placements, and the program was scrapped.

In his letter, Simmons said Prudential is working to see that justice is done for Energy Income Fund customers. The firm is expected to make a new offer to settle at least one of the pending class-action lawsuits.

“We’re trying to deal fairly with investors who have valid complaints,” he wrote to The Times, “and hope to have the situation behind us as soon as possible.”

That comes as news to 67-year-old Lanell Mabry.

The Temple, Tex., woman sank $5,000--a quarter of her net worth at the time--into the Energy Income Funds in the mid-1980s. The sole support for a cousin and her mother--and with her own retirement from the Santa Fe Railroad not far off--Mabry said she was looking for safety. When a Prudential broker convinced her that the oil and gas partnership was “such a very sound, secure investment” that would pay her 12% to 15% per year, she borrowed the $5,000 from an uncle.

(Apparently to get around a requirement that investors have a net worth of at least $25,000, Mabry said that the broker persuaded her to add her mother’s name to the account.)

The investment never performed as she had been led to believe; Mabry said that for several years all payments stopped.

Today, Prudential is suing Mabry and her mother, now 93. The brokerage is striking back in state courts against the arbitration cases that Mabry and others with small claims have filed against Prudential. Under Pacific Stock Exchange procedures, arbitrators can make rulings based solely on documents submitted by both sides, without a costly hearing. Prudential contends that the simplified arbitration procedure is unfair.

Mabry’s attorney, Stuart Goldberg, and other investors’ lawyers charge that Prudential’s stance is part of a new strategy of legal hardball. The effect, he said, will be to prevent Mabry and the others from ever having their claims heard. For most investors and for Prudential, the cost of arguing the cases in state court will exceed the sums that the customers lost, Goldberg said.

Prudential also has filed a wave of lawsuits against former brokers and branch managers who have been testifying on investors’ behalf. Prudential claims they are violating confidentiality agreements.

Scott Muller, a Prudential lawyer, denied that the firm is using unfair tactics. The state court actions are not intended to intimidate investors, he said, but rather to stand up for an issue of justice.

In simplified arbitrations, “You don’t get a full and fair hearing,” Muller explained. “You don’t get any hearing at all.”

For her part, Mabry said she believes Prudential tricked her into investing and now is denying her the right to have her case heard.

“I thought Prudential was a very reliable company,” she said. “I believed what (the broker) told me, and all that stuff that they put on TV about Prudential being ‘rock solid.’ But this was really just a scam to defraud people. I think it’s rotten.”

In Their Own Words

Minutes of a June, 1988, meeting of Graham Resources’ management committee outlined the firm’s plan to invest $500,000 in a personal business of senior Pru-Bache executive James Darr. An excerpt: