Thomas H. Lee Partners, Ltd is the private equity firm that bought a big stake in Refco, Inc. last year and held a 38% equity stake in the company after Refco went public in August of this year. With Refco’s recent descent into bankruptcy, that equity stake is now worthless.
Notwithstanding that rather disappointing investment, Thomas H. Lee Partners is a defendant along with former Refco CEO Phillip Bennett and several other Refco executives and consulting firms in several civil lawsuits by investors seeking substantial damages that have been filed since the revelations about Mr. Bennett’s short-term lending arrangement between Refco and one of his personal investment companies. More lawsuits over its involvement with Refco and Mr. Bennett are almost a certainly for Thomas H. Lee Partners.
So, having made this stupendously bad investment and getting sued out the gazoo to boot, what should Thomas H Lee Partners do to defend itself? Well, how about go on the offensive?
By the way, in lining up other prospective defendants in Refco-related civil litigation, it was noted earlier that Grant Thornton was Refco’s auditor and that law firm Mayer, Brown advised a third party that was involved in the lending arrangement with Refco. The Thomas H Lee Partners lawsuit reveals some additional defendant prospects:
Over more than 10 months, Lee executives spent more than $10 million employing a number of firms – including the accounting firm KPMG and the law firm Weil, Gotshal & Manges – to evaluate Refco before it invested.
The private equity firm also hired the consulting firm McKinsey & Company to conduct customer surveys and to assess growth in the futures business; the insurance broker Marsh & McLennan to study risk management and the adequacy of insurance; Mercer Human Resource Consulting to look at human resource issues; and a private investigative firm to do background checks on Mr. Bennett and some of the company’s other top officials.
Thomas Lee executives also worked closely with a number of leading investment banks, including J. P. Morgan Chase, HSBC, Harris Bank and Goldman Sachs, all of whom had lent Refco money in the past, according to the suit, and Credit Suisse First Boston which represented Lee Partners in its acquisition of Refco. Goldman Sachs and Credit Suisse First Boston underwrote the company’s 2005 initial public offering.
Is there any mess in which KPMG is not involved these days?
Tom,
I check out your blog every few days because you do a good job of asking interesting questions, although we differ on the answers.
Lee Partners’ position certainly raises more than substantial questions about the participants in the due diligence process. It is a problem that we have witnessed again and again here in St. Louis.
Most recently, for example, the government charged Charter with having a major hole in its accounting. The corporate officers on watch plead guilty. What was amazing was that Charter was the end result of about 20 roll-ups and never during the due diligence for any of those roll-ups did the professionals ask about this rather obvious hole (how to account for disconnects).
It was a major income recognition problem about which no one said anything.
I believe I have a pretty good handle on why–Central Bank of Denver and Ernst & Young convinced a lot of folks that they had the supremce court in their pocket and could do anything for a fee.
The best evidence I ever read was a deposition the SEC took of a former St. Louis investment banker. When asked what was his crtical skill, the banker said, “Knowing how to say ‘No’. If you say ‘No’ the wrong way, then you can’t do the next deal.”
Beyond that, when you have someone do as much damage as Bennett has done to the capital markets, raising costs for everyone, I am hard pressed to understand why you see such as merely an agency problem.
John, your theory that fraud costs everyone who invests is probably correct, but so what? Markets adjust for that in the same manner as they do to other factors that impact markets. You aren’t suggesting that criminalization of fraud on the market is going to deter people such as Bennett from doing it in the future, are you? If so, then the history of the human race certainly contradicts your argument.
Look, I don’t have any real problem with the criminalization of fraudulent behavior. However, to avoid injustice, we must require that the criminal act is clear. Otherwise, the state’s overwhelming prosecutorial power will be unleashed and, as Sir Thomas put, neither you nor I will be able to stand in the ill-winds that will blow then. In cases where the evidence of fraud is not clear, then civil litigation that sorts out liability for the alleged wrongdoing is a much more reasonable — and safer — approach to dealing with the problem.
Tom,
You ask, “fraud costs everyone who invests is probably correct, but so what?”
It seems to me that it depends on what the cost happens to me.
One could argue, broadly, that fraud is really the opposite of the Rule of Law. There is not inconsiderable academic support for the proposition that economic development (i.e., the Industrial Revolution) happened principally because of the Rule of Law.
One could argue, narrowly, that higher costs (interest rates go up as fraud increases, to cover the moral hazard or risk) means lower economic growth. What if fraud caused a .5 per cent drop in GDP, per annum. Over ten years you are talking trillions, because of compounding.
As for Sir Thomas, seems to me that really is over the top. You may believe that Lay cannot get a fair trial, but he is odds on the favorite to get a fairer trial than any other federal criminal defendant will get in Houston or anywhere else in the next 100 years.
John, it seems that you are hung up on the fact that cheating is inevitable.
Inasmuch as neither of us has any problem with criminalizing clear fraud, the question becomes whether the cost of criminalizing merely questionable cases is worth the cost. Frankly, your estimates of the damage to the economy from fraud pale in comparison to the cost of future economic development that would result from criminalization of merely questionable business transactions.
As for our comment about Lay, he is not being allowed to defend himself with exculpatory testimony and must try to defend himself in the face of a jury pool that is overwhelmingly polluted with an anti-Enron bias. If you think that’s the prescription for a fair trial, then you and I have a far different understanding of the principle in our justice system.
Tom,
If power corrupts, then “cheating is inevitable.”
As Drucker had to repeatedly remind everyone, human institutions, public or private, are human institutions. Just as we must always guard against public abuses we must do the same viz private abuses.
However, don’t take my word for it. There is no academic study of any kind that supports your assertions but there are abudant studies showing that publiic companies in America are inherently fraudulent and dishonest.
Take more than a moment and read Michael C. Jensen, of the Harvard Business School. If you go to his webpage at HBS you will find a link to a paper called, Jensen, Michael C., Murphy, Kevin J. and Wruck, Eric G., ‘Remuneration: Where We’ve Been, How We Got to Here, What are the Problems, and How to Fix Them,’ Harvard NOM Research Paper No. 04-28 (July 2004) and ECGI-Finance Working Paper No. 44/2004.
Jensen explains why what he calls “paying people to lie” has thoroughly corrupted American business. He also includes in the paper substantial evidence that most all American public companies in America falsely report income, etc. Start at page 92 of his piece.
Jensen, by the way, is the No. 1 read person on SSRN.
Last, I didn’t say Ken Lay was going to get a fair trial. I said he will get a fairer trial than any other defendant in the federal system in the 100 years.
If you are truly concerned about people getting a fair trial in the federal system, can I assume that you oppose the nomination of Alito? He certainly has no plan, design, or intent to make federal trials fairer.
Joining this a bit late, but I have a few questions and comments.
About damage to the financial markets, I have to wonder just who is causing all the harm, i.e. is this damage the result of a crime wave or a wave of prosecutions? The corollary to that question is whether the business world has gotten more corrupt in the past, say, decade or is the dramatic increase in prosecutions a manifestation of something else?
We have all been and continue to be witness to what is, in my mind, a massive witch-hunt here in Houston involving former Enron executives and their colleagues in the accounting, legal and financial worlds, so have experienced first-hand the ability and willingness of prosecutors to distort the law and the facts. I am not familiar to any significant degree with the underlying facts in the other numerous other prosecutions with which our country is now burdened, but I certainly approach what is said about them by prosecutors ñ and written about them by the all too compliant press ñ with more than a hearty dose of skepticism. Shouldnít we all? Indeed, isnít skepticism of this sort the basis for the limitations on governmental power embodied in the Bill of Rights and elsewhere? Though these limitation have not proved particularly sturdy in the face of the irresponsible and in many cases tragic demonization of late of the business class and others, they are without a question a recognition of the dangers of the powers we the people have ceded to our government if left unchecked. Do we think our government has become so trustworthy that they are no longer needed? In my mind they are needed more now than ever, as the unprecedented and growing number of prosecutions would seem to attest.
And returning to my original questions about how the damage is being done to the financial markets, I am reminded of an observation by Professor Albert Fried in his McCarthyism; the Great American Red Scare ñ A Documentary History, p. 25 (Oxford Univ. Press 1997). There, he discusses the responses by the government to a ìproblemî perceived by the public ñ or perhaps more accurately the press ñ and how these responses only exacerbated the so-called problem:
The Truman executive order [the birthplace of the pernicious ìloyalty oathsî and other excesses] sought to reassure Americans. Its effect was the opposite; it heightened anxieties and thus invited promises of greater security, which in turn, further heightened the anxiety. A large component of McCarthyism was this process of cause and effect, effect and cause, feeding on each other.
It was a vicious cycle. Though a decidedly slow Supreme Court eventually limited the use of the loyalty oaths and other excesses of the Red Scare, it was too late for the many people whose lives were ruined by them — not to mention all the serious harm done to our society as a whole. We as a country claim to have learned much from that experience. But have we? I donít think so, and indeed the smugness of those who do is one of the greatest problems we face right now. Letís reinvigorate our ìrights as Englishmenî before it is too late, if it isnít already.