In 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.

May 27, 2005.