Unprecedented Dewey charges put law firms on notice

March 6, 2014

Steven Davis, the onetime LeBoeuf Lamb chairman who engineered his firm’s 2007 merger with Dewey Ballantine, then presided over the titanic collapse of Dewey & LeBoeuf in 2012, is now an accused felon, along with Davis’s longtime deputy, Stephen DiCarmine, and Dewey’s former CFO Joel Sanders. The three criminal defendants and two other former Dewey financial professionals have also been named in an enforcement action by the Securities and Exchange Commission.

The New York state court indictment and the SEC complaint outline roughly the same allegations: When Dewey’s revenue came up short in 2008, the firm embarked on a disastrous course of accounting fraud that continued through its $150 million private placement in 2010 and, ultimately, its demise in 2012.

These are truly ruinous allegations. According to the New York District Attorney’s office and the SEC, Davis, DiCarmine and Dewey’s non-lawyer finance employees defrauded their bank lenders and the insurance companies that invested in the law firm’s private placement by various stratagems to “cook the books,” as CFO Sanders described Dewey’s accounting in an email to the COO in December 2008.

Among the supposed tricks (which I’ll describe in more detail below): encouraging clients to backdate checks to boost the previous year’s reported revenue; shifting unpaid costs deemed to be uncollectible from write-offs to receivables; characterizing salary payments to non-equity partners as equity distributions in order to reduce reported salary expenses; and wrongly booking a loan from a partner as income – then squabbling with the partner over repayment of the loan after double-booking it.

As my Reuters colleagues Karen Freifeld and Jon Stempel reported Thursday, the DA’s office says that this alleged accounting chicanery amounts to dozens of felonies against the three main Dewey defendants, ranging from falsifying business records all the way to grand larceny and securities fraud. (A fourth criminal defendant, a young client account manager, was charged with six counts of falsifying records in a separate indictment.)

The charges are unprecedented. I’ve been covering law firms for more than 25 years, and I can think of only two instances of law firm leaders facing prosecution when their firms collapsed: Marc Dreier and Harvey Myerson of Myerson & Kuhn. Their cases are easily distinguishable from the Dewey case since they profited personally and directly from their wrongdoing; the lawyers who led Dewey, by contrast, are not alleged to have had a profit motive beyond keeping the firm alive. As far as I can tell, none of the other big law firm implosions of the last quarter-century have prompted criminal charges. Even the death of Finley Kumble – which my old boss Steve Brill definitively exposed as an accounting mirage back in 1987 – didn’t lead to any prosecution.

That said, here’s a question to ponder: Is Dewey the only mega firm that has engaged in aggressive accounting when revenue falls short and lenders get antsy? I talked to three experts who have considerable experience with troubled or failed law firms, all of whom asked to remain anonymous because of client sensitivity. One said he’d never encountered allegations of conduct resembling the charges against the ex-Dewey lawyers. But the other two disagreed. One told me that private litigation between law firm partners is filled with stories about revenue and profits being manipulated. “I’m sure this is going on at other firms,” said the second expert, although he added that he hasn’t before seen the particular gimmicks Dewey is accused of attempting. Firms sometimes make the mistake of tinkering with their books in anticipation of revenue that will solve their problems. “They think when everything comes in, it’s okay,” he said.

Dewey seems to have been engaged in exactly that sort of magical thinking. For all of the dumb, damning emails in the Dewey case – including an exchange in which DiCarmine congratulated Sanders for his adept maneuver in reclassifying uncollectible disbursements as receivables by crowing, “We’ll buy a ski house next” – you can almost see how the defendants convinced themselves they weren’t really doing anything so bad. Dewey was against the wall at the end of 2008. Its agreements with four bank lenders included a $290 million cash flow pledge, but the firm was tens of millions of dollars short and terrified that the banks would pull Dewey’s line of credit.

The SEC characterizes the situation as an “existential threat.” So at the end of 2008 and the beginning of 2009, the firm’s financial professionals supposedly came up with a “master plan” to boost Dewey’s profits by “accounting tricks” as the firm’s former finance director described the tactic in a 2009 set of slides.

In addition to reclassifying about $4 million in uncollectible disbursements, the firm supposedly shifted about $14 million in compensation for three of counsel attorneys and two salaried partners from an expense account to an equity distribution account, even though none of the five held any equity in the firm. It also allegedly reversed the write-off of about $2.5 million in charges to a firm credit-card and supposedly hid the bogus receivable in a pending billable matter. “That would be less visible,” wrote one of the Dewey defendants in the SEC case in a 2009 email. In 2011, the same defendant was worried that the credit card receivable was getting stale: “I don’t see how we’ll get past the auditors another year,” he wrote. (Dewey professionals also joked about their “clueless auditor” from Ernst & Young.)

There was also the matter of a $1.4 million loan to the firm from a non-equity partner in Saudi Arabia. One of the partner’s clients owed several million dollars at the end of 2007 and said it would not be able to pay. The partner was concerned about the effect of the unpaid fees on his income, so he loaned Dewey $1.4 million in order to meet his billable target. According to the SEC complaint, he expected to be paid back when his client paid its fee. But Dewey supposedly recorded the loan as income, then after the client paid up, booked that entire fee as income as well, without accounting for the $1.4 million it owed the partner. He wasn’t paid back until Dewey raised $150 million in its 2010 bond offering.

In all, Dewey officials are accused of inflating the firm’s 2008 profitability by $36 million and misstating 2009 results by $23 million. That alleged deception of the firm’s bank lenders was compounded, according to the SEC complaint and the Manhattan DA’s indictment, when the firm made the extremely unusual decision to raise capital from outside investors through a private placement. Not only did the firm include the supposedly misleading 2008 and 2009 financial reports in the offering, it also allegedly deceived investors about other crucial information, including the millions of dollars in annual compensation Dewey guaranteed to its most valuable partners.

According to the experts I talked to, that bond offering was Dewey’s undoing. By tapping the capital markets, the firm exposed itself in ways other troubled law firms have not. The bond offering probably kept the firm alive for longer than it would otherwise have survived, but it also expanded the circle of victims of Dewey’s alleged wrongdoing and invited the SEC to look at the firm’s books. Without the bond offering, one expert told me, “I think it’s less likely” the alleged accounting fraud would have come to light.

Given the outcome for Dewey, I doubt any other big firms will raise money through a bond offering anytime soon, so the future collapsed mega firms probably won’t be investigated by the SEC. Dewey’s unusually lavish compensation promises also meant that the firm’s revenue shortfall produced an awful lot of furious partners, some of whom took their complaints to the Manhattan DA.

But the Dewey charges should nevertheless set off alarms. Once, running a firm meant scrutiny from your partners. As firms grew and began to rely on lines of credit, managing partners also had to be concerned about satisfying lenders. Now, for the first time, running a law firm has resulted in criminal charges. That’s a precedent that can’t be unmade.

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