May 16, 2005
In Perelman Suit, Judge Says
Firm Acted in 'Bad Faith';
It Blames Honest Errors
A Trove of Tapes in Brooklyn
In June 2004, a Morgan Stanley technology executive signed a court document certifying he had handed over all emails the firm had agreed to produce in a suit filed against his firm by billionaire financier Ronald Perelman.
But two weeks earlier, the executive, Arthur Riel, hadn't been so sure. "The storage folks found an additional 1,600 backup tapes in a closet," Mr. Riel told two Morgan Stanley lawyers, he recalled in a deposition quoted in court papers. The tapes hadn't been searched for emails before Mr. Riel signed the document, the firm acknowledged in court.
To the Florida state judge overseeing the case, Mr. Riel's certification was false and one of many instances in which Morgan Stanley "deliberately" violated her orders to turn over documents, including some embarrassing to one of the firm's bankers.
As a result of what she described as Morgan Stanley's "bad faith" actions, Judge Elizabeth Maass made an extraordinary legal decision: She told the jury it should simply assume the firm helped defraud Mr. Perelman. Mr. Perelman is seeking $2.7 billion after Morgan Stanley rejected his offer to settle for $20 million. The firm already has set aside $360 million to cover potential damages, and, according to court transcripts, regulators are looking into whether the firm's conduct violated federal laws.
Morgan Stanley is in serious trouble because of the way it mishandled an increasingly critical matter for companies: handing over email and other documents in legal battles. Lawsuits these days require companies to comb through electronic archives and are sometimes won or lost based on how the litigants perform these tasks. Morgan Stanley kept uncovering new backup tapes, couldn't perform full searches because of technology glitches and gave material to the other side that was sometimes incomplete or late.
The legal problems come as Morgan Stanley is under a two-month-long siege by former employees seeking to depose Chief Executive Philip Purcell.
The Perelman fight is also the latest in a series of cases in which Morgan Stanley has gotten into trouble over how it stores and turns over documents. In 2002, the firm, along with five others, paid regulators $8.25 million for violating rules requiring securities firms to retain emails for three years. Last July, it was one of three firms fined $250,000 each for failing to hand over documents in investor-complaint cases. Two weeks later, it agreed to pay $2.2 million to regulators for delays in disclosing 1,800 complaints and misconduct incidents.
In a sex-discrimination case settled around the same time, Morgan Stanley told the Equal Employment Opportunity Commission that searching for emails would be too burdensome and expensive. In response, commission staffers told a federal judge that the firm had a new, "easily searchable" database. A Morgan Stanley spokesman says the system wasn't fully operational at the time because only a small percentage of its older emails had been moved over.
The New York Stock Exchange is investigating Morgan Stanley's contention in arbitration cases that reams of documents were lost in the Sept. 11 terrorist attacks. Morgan Stanley told one Kansas City investor her files were destroyed even though there were no trades in her account until October. The firm blamed a "simple and honest mistake," apologized and agreed to settle.
In a written statement responding to questions from The Wall Street Journal, Morgan Stanley says all of its recent "discovery problems" stemmed from honest mistakes, such as computer glitches and misplaced backup tapes, and were not attempts to stonewall adversaries. The firm says it has been working hard to fix the problems. In court, Morgan Stanley said it is considering a malpractice suit against the law firm that represented it in the Perelman case, Chicago's Kirkland & Ellis LLP. Kirkland continues to work for Morgan Stanley in other areas. Kirkland declined comment citing "confidentiality obligations to our client."
Among Wall Street firms, Morgan has sometimes stood out for its combative approach to legal issues. In 2003, when financial firms were settling charges that their stock research was tainted, CEO Mr. Purcell said retail investors needn't be concerned. He drew a public rebuke from Securities and Exchange Commission Chairman William Donaldson, who said Mr. Purcell's remarks showed "a troubling lack of contrition."
Among Mr. Purcell's first hires after arriving at Morgan Stanley in 1997 was trial lawyer Don Kempf, a longtime friend at Kirkland. As Morgan Stanley's chief legal officer, Mr. Kempf also ruffled regulators. While negotiating with the SEC to settle the stock-research case, he told some officials they had been "asleep at the wheel." He later apologized.
Mr. Perelman, chairman of cosmetics giant Revlon Inc., made his name as a corporate raider in the 1980s and became one of America's wealthiest men. In 1998, he agreed to sell an 82% stake in camping-gear maker Coleman Inc. owned by his holding company. The buyer, appliance maker Sunbeam Corp., paid $1.5 billion, including $680 million in Sunbeam stock. Later, Sunbeam spiraled into bankruptcy amid a massive accounting fraud.
Morgan Stanley was Sunbeam's investment banker and advised it on the Perelman deal. Coleman sued Morgan Stanley in 2003, alleging that the Wall Street firm knew about the accounting fraud and didn't speak up, thereby misleading the company and Mr. Perelman. Morgan Stanley says it knew nothing about the fraud.
In May 2003, the process of discovery, in which each side seeks documents from the other, got under way. As is common in pretrial fencing, Morgan Stanley resisted some requests. The firm said it would be an invasion of privacy to hand over the personnel files of employees on the Sunbeam account, including William Strong, the account's top banker. Judge Maass sided in part with Morgan Stanley and limited the request to any documents about the employees' "truthfulness, veracity, or moral turpitude."
Unbeknownst to the Perelman team, Mr. Strong had been tried on bribery charges in Italy in the 1990s stemming from a previous job with Salomon Brothers. He was acquitted after a trial, while working for Morgan Stanley, but the firm didn't produce any documents on the matter. Mr. Perelman's lawyers stumbled across a news clipping in early 2005 while researching the case. Morgan Stanley said the information wasn't in Mr. Strong's personnel file and wasn't subject to discovery. The judge said there was "no excuse" for not providing documents about the Italian charges and found that Morgan Stanley "purposefully withheld" the information.
The Perelman team's request for emails dating back to 1998 caused a bigger fight. Morgan Stanley said in court filings such a search would require "a massive safari into the remote corners" of backup computer systems. Morgan Stanley argued in court that the search would take months and cost hundreds of thousands of dollars.
Over the next several months, the document tug-of-war grew increasingly hostile. In April 2004, Judge Maass ordered Morgan Stanley to search its "oldest full backup" tapes for emails from 36 employees that mentioned 29 key words, including "grill," "camper," "Perelman" and two misspellings of his name. The firm was ordered to turn over all documents not excluded for legal reasons. It also had to sign a certification, an official court document asserting that the instructions had been complied with.
The task of overseeing the search fell to Mr. Riel, then head of Morgan Stanley's technology compliance group. Morgan Stanley says Mr. Riel was overseeing a multimillion-dollar project to put nearly 300 million emails into an easily searchable archive. Previously, Morgan Stanley stored emails on magnetic tapes. Morgan Stanley says Mr. Riel thought the project was mostly done and searched only the new database.
By early May at the latest -- before Morgan Stanley sent emails to the Perelman team -- somebody at the firm unearthed 1,423 computer-backup tapes in a closet in a Brooklyn office building. They hadn't been entered into the archive and no one had looked at them by this point, according to court testimony.
In mid-May, Morgan Stanley sent 1,300 emails to Mr. Perelman's attorneys but didn't include the required certification. It wasn't until early June that Mr. Riel told two Morgan Stanley lawyers, Soo-Mi Lee and James Cusick, about the recently discovered Brooklyn tapes -- at the time, he mistakenly said there were 1,600. Mr. Riel told the lawyers he would perform a search and let them know if they contained relevant email.
A couple of weeks later, Mr. Riel signed the certification, although the new tapes had not been searched, according to the judge's written order. In the certification, Mr. Riel said the oldest available tape was dated January 2000. In fact, Mr. Riel and his team determined by early July that the newly discovered tapes went back to the late 1990s, the period at issue in the suit. Morgan Stanley didn't disclose that discovery until November, according to court documents.
Mr. Riel's attorney, Jeffrey Pigano, says his client believed the certification only covered the archive, his area of responsibility, not tapes that hadn't yet been entered into it. In his deposition, Mr. Riel said: "I knew the litigators -- my internal clients -- needed certification...and I wanted to satisfy that concern."
A Morgan Stanley spokesman says that in general only a small fraction of its tapes contain email and that it didn't know whether the newly discovered tapes did so. As a result, the firm didn't believe it was obligated disclose them when Mr. Riel signed the certification.
In August, Morgan Stanley says it placed Mr. Riel on administrative leave for reasons unrelated to the Perelman case. The firm accused him of looking through co-workers' email in violation of company policy. Mr. Pigano says that explanation is "materially misleading." The attorney notes that his client was called a "whistleblower" by Judge Maass in connection with a separate SEC investigation into Morgan Stanley's relationships with third-party vendors. Morgan Stanley says "an initial internal investigation of [Mr. Riel's] allegations found no breach of law, regulation, or policy."
Mr. Riel's responsibilities were turned over to Allison Gorman Nachtigal. She testified that the department faced several problems: It had no written instructions explaining how to search one of its key systems for email; a software bug caused many searches to be case-sensitive; and there was a shortage of computer storage space. Asked in court why Mr. Riel hadn't addressed the space problem, Ms. Nachtigal responded, "I don't think he was very good at it."
In response, Mr. Riel's attorney, Mr. Pigano, says: "It appears she has absolutely no clue what she is talking about."
At the time, no one told Ms. Nachtigal to merge the newly discovered tapes with the department's database, according to her testimony. She put the task near the bottom of "a long list." Ms. Nachtigal hadn't been told about the Perelman lawsuit, she later testified.
In November 2004, at least six months after the backup tapes were found, Morgan Stanley's outside lawyer on the case, Kirkland's Thomas Clare, told the Perelman team that the tapes included "some responsive emails." Morgan Stanley says most of the Brooklyn emails were put into the system between May and August. According to one of Judge Maass's orders, Morgan Stanley began to search the emails in November. The Perelman team demanded to know when the search would be complete so it could look for evidence helpful to its case.
Mr. Clare replied that his client couldn't "accurately estimate," a response Judge Maass later called "his usual stonewall tactic." The trial was set to start in less than three months. In a written statement, Kirkland says: "We respectfully disagree with the court's characterization."
Ms. Nachtigal was finally told about the Perelman case in mid-January 2005, she testified. After talking to Morgan Stanley lawyers, she made the matter a higher priority.
For a few days in February it looked as if the firm had solved the problem. Robert Saunders, another Morgan Stanley tech executive, said in a Florida deposition that he was confident a complete search for backup tapes had been conducted, according to court documents.
Back in New York a day or so later, he had second thoughts and personally searched Morgan Stanley's storage areas. In one office in midtown Manhattan he spotted 129 more tapes.
"They were not hard to find. They were just sitting on that metal shelf," Mr. Saunders said in court. That day, he found more tapes, including some at Morgan Stanley's headquarters. Asked in court how certain he was that all tapes in that building had been found, Mr. Saunders responded, "Very confident."
Mr. Saunders's boss, Richard Anfang, wasn't so sure. He decided to do his own search, he said in court, and turned up yet more tapes. Mr. Anfang said he planned to criticize his employee over the matter in a future performance review. "I don't know what was going through his mind," Mr. Anfang testified.
Also in early February, Ms. Nachtigal discovered software problems that prevented Morgan Stanley's system from searching email attachments and from searching 7,000 emails sent using a particular software program. Judge Maass delayed the start of the trial several times in response to the problems.
As the search continued, Morgan Stanley turned over additional email. It says none of the email discovered since the initial batch was handed over in May 2004 "is supportive of [Mr. Perelman's] underlying claims." A Morgan Stanley spokesman says the firm repeatedly offered to pay the court to delay the trial to give itself time to fix the problems.
A spokeswoman for Mr. Perelman says the additional email from Morgan Stanley produced "significant information" helpful to the businessman's case.
As March rolled around, Judge Maass decided she'd had enough. On March 1, she granted Mr. Perelman's request for a so-called "adverse inference" order. This is an extreme legal remedy that reverses the standard burden of proof. In a civil case, it's typically the litigant that needs to prove its case -- that is, Mr. Perelman's camp. Instead, Judge Maass said Morgan Stanley would have to prove it wasn't at fault because of the "willful and gross abuse of its discovery obligations."
"A reasonable jury could conclude that evidence of [Morgan Stanley's] misconduct demonstrates consciousness of guilt," she wrote in a court order.
In court in mid-March, another Kirkland lawyer worked to get back in Judge Maass's good graces, insisting "extraordinary efforts" were under way to find relevant emails. Her response: "Why would I not characterize this as the thief who's not sorry he committed the crime, but really sorry he got caught?"
The worsening situation prompted a falling out between Morgan Stanley and the Kirkland lawyers. In a phone conversation, Morgan Stanley's Mr. Kempf told the chairman of Kirkland's management committee, Thomas Yannucci, that the judge's order "raises the issue of malpractice."
In late March, Morgan Stanley fired Kirkland from the case and said in court it may sue for malpractice. After the firing, Judge Maass said: "There is no evidence before me that Kirkland & Ellis did anything other than follow the directions of its clients."
A day later, Judge Maass issued a partial default judgment against Morgan Stanley, essentially handing an automatic loss to the Wall Street firm, because "the [discovery] abuses have continued unabated." The judge said she would instruct the jury to assume that the firm had helped defraud Mr. Perelman.
"The prejudice to [Mr. Perelman's side] from these failings cannot be cured," she wrote. "The judicial system cannot function this way."
Judge Maass stopped short of granting the default judgment in full. She ruled Mr. Perelman must prove he lost money on the transaction and that he relied on information provided by Morgan Stanley or Sunbeam in making his investment.
When the trial opened in early April, Judge Maass read the nine-person jury a lengthy statement, saying, in part: "Morgan Stanley participated in a scheme to mislead [Coleman] and others and cover up the massive fraud at Sunbeam until Morgan Stanley and Sunbeam could close the purchase of Coleman."
Two weeks ago, Morgan Stanley hired David Heleniak, a senior partner at New York-based Shearman & Sterling LLP, as vice chairman overseeing the firm's legal and government-affairs units. Mr. Heleniak was inserted over Mr. Kempf, who had previously reported directly to Mr. Purcell, the chief executive.
The main portion of the trial concluded on Thursday after five weeks. The jury started deliberations Friday. It took the weekend off and will continue today.
Write to Susanne Craig at email@example.com
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