Merrill Received Fraud Warning About Trader Dan Gordon in 2001
25/8/2003 12:27
Two weeks before Merrill Lynch & Co. underwrote a $667 million public stock offering for Allegheny Energy Inc. in April 2001, it received a letter from a law firm saying Allegheny's chief energy trader, Daniel Gordon, could be involved in a criminal fraud. Merrill made no public disclosure of the allegation before selling the stock.
The law firm of Davis, Hatley, Haffeman & Tighe PC in Great Falls, Montana, representing K2 Energy Corp., wrote the letter, dated April 13, 2001, to Merrill and Allegheny. A month earlier, Allegheny had purchased Merrill's energy-trading unit, and hired Gordon to run it. The U.S. Justice Department is now investigating Gordon, 27, for embezzling $43 million from Merrill, according to federal documents.
``I wrote a very pointed letter to Merrill and Allegheny warning of possible criminal conduct by Dan Gordon,'' said attorney Max Davis, whose client K2, is a Calgary-based natural- gas exploration company that had sought a $7 million investment from Merrill's energy-trading unit. ``Merrill and Allegheny were on notice that something stinky was going on with this guy.''
In the letter, a copy of which was obtained by Bloomberg News, Davis expressed concern about possible fraud by Gordon in arranging that investment. He said K2 had learned that ``certain actions'' taken in pursuit of that transaction ``are being referred to the appropriate authorities (on an international basis) for investigation of possible criminal charges.''
Merrill, the largest securities firm by capital, had an obligation to investigate Davis's allegations against Gordon before selling the stock to the public, said Constance Bagley, a securities lawyer and associate professor at Harvard Business School.
`Independent Investigation'
``The main problem here is Merrill did the underwriting for Allegheny and had reason to believe a key employee of Allegheny was a crook,'' said Bagley, author of three books advising executives how to deal with legal issues. ``The underwriters are supposed to do an independent investigation of the accuracy of the prospectus. Clearly they were on notice here.''
Merrill and Goldman, Sachs & Co. led the public offering together. Davis said he didn't send his warning letter to Goldman.
In the prospectus, Merrill disclosed its previous transaction with Allegheny. Merrill said it had agreed on Jan. 8, 2001, to sell its energy-trading unit to Hagerstown, Maryland- based Allegheny for $490 million and a 2 percent interest in Allegheny Energy Supply, an Allegheny subsidiary.
Merrill Lynch, based in New York, didn't do anything wrong in its handling of the letter from Davis or the underwriting of Allegheny's stock sale, said spokesman Bill Halldin.
Allegheny Employee
``Based on our conversation with K2, this appeared to involve a former employee's personal investment that was in dispute,'' Halldin said. ``We knew Allegheny was aware of this situation involving their employee and that Allegheny had thoroughly looked into it.''
Allegheny spokeswoman Cynthia Shoop declined to comment on the allegations against Gordon.
On April 21, 2001, eight days after K2's attorney Davis sent the letter to Merrill and Allegheny, Gordon wrote a $3 million personal check to K2 as a ``break-up fee,'' in exchange for K2 withdrawing the letter and agreeing to keep its contents secret, Davis said. The agreement canceled the proposed $7 million investment in K2.
`Hush Money'
``The scenario makes it seem the money was more likely hush money than a break-up fee,'' said James Cox, a professor of law at Duke University in Durham, North Carolina.
James Livingstone, then-chief executive of K2, said in an interview that K2 had turned down a $5 million investment offer from another company because it was expecting the $7 million investment from Gordon's unit. He said the $3 million payment from Gordon was fair compensation. ``It was to make us whole,'' he said.
Merrill knew the dispute between Gordon and K2 had been settled, although it did not know the terms of that settlement, Halldin said. ``Within days, we learned that the dispute had been resolved to the satisfaction of the company that had made the complaint,'' he said.
Gordon is being investigated for embezzling $43 million from Merrill Lynch when he worked for the firm in 2000, according to a letter written by Assistant U.S. Attorney Jane Levine on Nov. 22, 2002, to Gregg Lepp, director of special prosecutions for the Alberta attorney general's office. Gordon disguised the theft as an energy trade, the letter said.
Gordon Was Fired
Gordon is also under investigation for allegedly defrauding Allegheny of $2.5 million by funneling Allegheny money to companies controlled by Gordon, the Nov. 22 Justice Department letter said.
Allegheny fired Gordon last September for violating conflict- of-interest rules, said Shoop, who declined to specify which rules were broken.
Gordon, who served as chairman of Daticon Inc., a legal- document-storage company in Norwich, Connecticut, until December, was reached on his mobile phone Wednesday night and hung up after the caller identified himself as a reporter. His lawyer, Alan Levine, managing partner of Kronish Lieb Weiner & Hellman LLP in New York, declined to comment.
K2 attorney Davis said he wasn't aware of the $43 million embezzlement when he wrote to Merrill in 2001. He said he was prepared to tell Merrill in April 2001 that Gordon had fraudulently concealed his involvement with an offshore company, Ostrich Capital Partners, in negotiations with K2. Shares of K2 are traded on the Toronto Stock Exchange.
$43 Million Moved
After the U.S. Justice Department began investigating Gordon, the investigators learned he had moved most of the $43 million through Ostrich, according to the Justice Department letter. Gordon incorporated the company, Ostrich Partners, in the Marshall Islands in the Pacific Ocean, the letter said.
The corporate climate in America has changed since accounting scandals sent Enron Corp. and WorldCom Inc. into bankruptcy, resulting in billions of dollars of losses to investors, said Frank Partnoy, a securities-law professor at the University of San Diego School of Law.
``If Merrill got that letter from K2's lawyer today, they'd be all over it,'' he said. ``The attitude financial services firms had several years ago was: Push it under the rug, nothing good can come from disclosure.''
Didn't Follow Rules
Assistant U.S. Attorney Levine wrote in the Nov. 22 letter that Merrill hadn't followed its own rules in allowing Gordon to wire $43 million of Merrill's money to an offshore shell company - - a company with no employees or operations.
``The usual credit-check and due-diligence procedures in place at Merrill Lynch were not followed,'' Levine wrote, citing interviews with witnesses in Merrill's credit department and internal communications.
The questions about Merrill mark the third time reported in the past year in which Merrill's due diligence has been challenged.
In March, Merrill agreed to pay $80 million to settle Securities and Exchange Commission charges that it had helped Enron Corp. commit accounting fraud. In April, Merrill agreed to pay $200 million to settle accusations by state and federal regulators that the firm allowed conflicts of interest by its research analysts.
Merrill neither admitted nor denied wrongdoing in either case.
Merrill is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.
Davis Letter
The letter from Davis, the K2 attorney, was sent by fax and Federal Express on April 13, 2001, to George Schieren, then senior vice president and associate general counsel of Merrill Lynch, and Michael Morrell, then senior vice president of Allegheny.
The letter said that K2 was negotiating with Gordon for an investment from Ostrich Capital Partners. It said K2 began negotiating with Gordon while he was still running Merrill's energy-trading unit, and the talks continued after Gordon moved to Allegheny.
``The nature and extent of the misconduct which has been visited upon K2 Energy Corp. is a matter of the utmost gravity for us,'' the letter said. ``Initiation of civil proceedings on behalf of K2 Energy Corp. for fraud and RICO violations, amongst other claims, would appear well justified.'' RICO refers to Racketeer Influenced and Corrupt Organizations, a federal law used to prosecute criminal enterprises.
Schieren, who left Merrill in January to become a partner at Clifford Chance US LLP, the world's largest law firm, was on vacation and unavailable for comment, his secretary said. Morrell didn't return a voicemail message requesting a comment.
Offer Declined
In his April 2001 letter, Davis offered to fly immediately from Montana with K2 Chief Executive Officer James Livingstone to Merrill's corporate headquarters in New York and Allegheny's headquarters in Hagerstown to provide the executives with details of the allegations. Neither company took him up on his offer, Davis said in the interview.
Cox, the law professor at Duke, said that was a mistake.
``When you have a former chief energy trader and such a letter, I think that requires a serious internal investigation, including one that looks at any offshore vehicles,'' said Cox, co- author of ``Corporations,'' a multi-volume legal treatise, and ``Securities Regulations: Cases and Materials.''
Livingstone, K2's CEO, said in an interview he was surprised Merrill and Allegheny hadn't taken Davis's letter more seriously. ``Getting a letter at the highest level at two companies telling you your poster boy isn't what you thought he was isn't something you sweep under the rug,'' he said.
Met With Gordon
Livingstone said he had lunch with Gordon at Merrill Lynch headquarters in New York on Feb. 5, 2001, to discuss the $7 million investment K2 was seeking from Gordon's unit. He said two Merrill employees who worked for Gordon flew to Calgary on Feb. 16, 2001, to negotiate terms for the investment contract.
On March 13, 2001, K2 issued a press release announcing that Ostrich Capital Partners, a Delaware corporation, had agreed to invest C$10.8 million (US$7 million) for control of K2, in the form of 27 million shares and 10.8 million options. The press release identified Ostrich as ``a Delaware corporation controlled by Daniel L. Gordon, an accredited investor.''
On April 5, Livingstone said he flew to New York for a scheduled meeting with Gordon to sign the investment contract and receive the $7 million. Gordon canceled at the last minute, Livingstone said.
Two Ostrich Companies
K2 executives became alarmed when they discovered that Gordon controlled two companies called Ostrich Capital Partners, Livingstone said, one based in the Marshall Islands and incorporated in August 2000 and the other based in Delaware and incorporated on March 15, 2001.
Until the first week of April 2001, K2 believed there was only one Ostrich, he said. Gordon never disclosed this second Ostrich to them, he said.
K2 learned of the two companies from Michael Ritter, president of Newport Pacific Financial, an Edmonton, Alberta-based company that Gordon used to set up his offshore companies, Davis said.
Davis said he began to have doubts about Gordon when Ritter told him he found that Gordon had altered the investment contract provided to the Marshall Islands Ostrich company, which was held in trust by an affiliate of Newport Pacific. The concealed contract had removed all references to the 10.8 million options, which Ostrich was to receive in addition to stock for its $7.2 million investment.
Became Suspicious
Davis said Ritter told him he suspected Gordon had set up the Delaware corporation to steal the 10.8 million options from the Marshall Islands company called Ostrich and conceal the options transfer from Ritter, whose firm was the trustee of the offshore company.
``We thought a bad broker was trying to screw his clients who weren't in the U.S.,'' Ritter said in an interview. He said his discussions with Gordon led him to believe Gordon was a stockbroker for Merrill.
It was this offshore Ostrich, as well as Falcon Energy Holdings SA, another shell company incorporated in the Caribbean island of Anguilla, that Gordon might have used to embezzle and launder $43 million of Merrill Lynch money in August 2000, according to prosecutor Levine's letter.
Ritter said in an interview that he became suspicious of Gordon after $32.5 million of the Merrill money was wired out of the offshore accounts shortly after they were opened. The rules for the account required Gordon to keep at least $15 million of the $43 million at AIG Private Bank Ltd. in Zurich.
Contacted Merrill
Ritter said he contacted Merrill lawyers shortly after Allegheny purchased the Gordon-run energy unit from Merrill on March 16, 2001. Ritter said he tried to alert Merrill to his suspicions the account had been used for money laundering.
``They didn't seem concerned,'' Ritter said. ``They seemed relieved it wasn't their problem.''
In the week following Davis's April 13 letter to Merrill and Allegheny, Gordon tried to cancel the proposed $7 million investment in K2, Davis said.
Gordon was represented by the Washington law firm of Williams & Connolly LLP to negotiate with K2 on his behalf, Davis said. On Saturday, April 21, Davis and Livingstone flew to Washington and picked up a check, written on Gordon's personal account, for $3 million, written to K2.
Williams and Connolly partner Gerald Feffer declined to comment.
`That Smells'
Theresa Gabaldon, professor of securities law at George Washington University Law School, said the settlement didn't resolve allegations of wrongdoing. ``That almost makes it look worse to me, that Gordon was willing to pay $3 million, or 40 percent of the proposed investment, to walk away,'' she said. ``That smells.''
One week later, on April 27, K2 issued a press release saying its previously announced investment agreement with Ostrich Capital Partners, a Delaware corporation, had been canceled, and K2 was paid a ``break-up fee'' of C$4.6 million Canadian (US$3 million).
On the same day, Allegheny Energy issued a release saying Merrill Lynch was co-underwriting a stock sale to the public. Allegheny raised $667 million by selling 14.3 million shares, at $48.25.
Allegheny shares have fallen 72 percent since the sale, trading at $8.68 at the New York Stock Exchange on Friday at 4:01 p.m. New York time.
The law firm of Davis, Hatley, Haffeman & Tighe PC in Great Falls, Montana, representing K2 Energy Corp., wrote the letter, dated April 13, 2001, to Merrill and Allegheny. A month earlier, Allegheny had purchased Merrill's energy-trading unit, and hired Gordon to run it. The U.S. Justice Department is now investigating Gordon, 27, for embezzling $43 million from Merrill, according to federal documents.
``I wrote a very pointed letter to Merrill and Allegheny warning of possible criminal conduct by Dan Gordon,'' said attorney Max Davis, whose client K2, is a Calgary-based natural- gas exploration company that had sought a $7 million investment from Merrill's energy-trading unit. ``Merrill and Allegheny were on notice that something stinky was going on with this guy.''
In the letter, a copy of which was obtained by Bloomberg News, Davis expressed concern about possible fraud by Gordon in arranging that investment. He said K2 had learned that ``certain actions'' taken in pursuit of that transaction ``are being referred to the appropriate authorities (on an international basis) for investigation of possible criminal charges.''
Merrill, the largest securities firm by capital, had an obligation to investigate Davis's allegations against Gordon before selling the stock to the public, said Constance Bagley, a securities lawyer and associate professor at Harvard Business School.
`Independent Investigation'
``The main problem here is Merrill did the underwriting for Allegheny and had reason to believe a key employee of Allegheny was a crook,'' said Bagley, author of three books advising executives how to deal with legal issues. ``The underwriters are supposed to do an independent investigation of the accuracy of the prospectus. Clearly they were on notice here.''
Merrill and Goldman, Sachs & Co. led the public offering together. Davis said he didn't send his warning letter to Goldman.
In the prospectus, Merrill disclosed its previous transaction with Allegheny. Merrill said it had agreed on Jan. 8, 2001, to sell its energy-trading unit to Hagerstown, Maryland- based Allegheny for $490 million and a 2 percent interest in Allegheny Energy Supply, an Allegheny subsidiary.
Merrill Lynch, based in New York, didn't do anything wrong in its handling of the letter from Davis or the underwriting of Allegheny's stock sale, said spokesman Bill Halldin.
Allegheny Employee
``Based on our conversation with K2, this appeared to involve a former employee's personal investment that was in dispute,'' Halldin said. ``We knew Allegheny was aware of this situation involving their employee and that Allegheny had thoroughly looked into it.''
Allegheny spokeswoman Cynthia Shoop declined to comment on the allegations against Gordon.
On April 21, 2001, eight days after K2's attorney Davis sent the letter to Merrill and Allegheny, Gordon wrote a $3 million personal check to K2 as a ``break-up fee,'' in exchange for K2 withdrawing the letter and agreeing to keep its contents secret, Davis said. The agreement canceled the proposed $7 million investment in K2.
`Hush Money'
``The scenario makes it seem the money was more likely hush money than a break-up fee,'' said James Cox, a professor of law at Duke University in Durham, North Carolina.
James Livingstone, then-chief executive of K2, said in an interview that K2 had turned down a $5 million investment offer from another company because it was expecting the $7 million investment from Gordon's unit. He said the $3 million payment from Gordon was fair compensation. ``It was to make us whole,'' he said.
Merrill knew the dispute between Gordon and K2 had been settled, although it did not know the terms of that settlement, Halldin said. ``Within days, we learned that the dispute had been resolved to the satisfaction of the company that had made the complaint,'' he said.
Gordon is being investigated for embezzling $43 million from Merrill Lynch when he worked for the firm in 2000, according to a letter written by Assistant U.S. Attorney Jane Levine on Nov. 22, 2002, to Gregg Lepp, director of special prosecutions for the Alberta attorney general's office. Gordon disguised the theft as an energy trade, the letter said.
Gordon Was Fired
Gordon is also under investigation for allegedly defrauding Allegheny of $2.5 million by funneling Allegheny money to companies controlled by Gordon, the Nov. 22 Justice Department letter said.
Allegheny fired Gordon last September for violating conflict- of-interest rules, said Shoop, who declined to specify which rules were broken.
Gordon, who served as chairman of Daticon Inc., a legal- document-storage company in Norwich, Connecticut, until December, was reached on his mobile phone Wednesday night and hung up after the caller identified himself as a reporter. His lawyer, Alan Levine, managing partner of Kronish Lieb Weiner & Hellman LLP in New York, declined to comment.
K2 attorney Davis said he wasn't aware of the $43 million embezzlement when he wrote to Merrill in 2001. He said he was prepared to tell Merrill in April 2001 that Gordon had fraudulently concealed his involvement with an offshore company, Ostrich Capital Partners, in negotiations with K2. Shares of K2 are traded on the Toronto Stock Exchange.
$43 Million Moved
After the U.S. Justice Department began investigating Gordon, the investigators learned he had moved most of the $43 million through Ostrich, according to the Justice Department letter. Gordon incorporated the company, Ostrich Partners, in the Marshall Islands in the Pacific Ocean, the letter said.
The corporate climate in America has changed since accounting scandals sent Enron Corp. and WorldCom Inc. into bankruptcy, resulting in billions of dollars of losses to investors, said Frank Partnoy, a securities-law professor at the University of San Diego School of Law.
``If Merrill got that letter from K2's lawyer today, they'd be all over it,'' he said. ``The attitude financial services firms had several years ago was: Push it under the rug, nothing good can come from disclosure.''
Didn't Follow Rules
Assistant U.S. Attorney Levine wrote in the Nov. 22 letter that Merrill hadn't followed its own rules in allowing Gordon to wire $43 million of Merrill's money to an offshore shell company - - a company with no employees or operations.
``The usual credit-check and due-diligence procedures in place at Merrill Lynch were not followed,'' Levine wrote, citing interviews with witnesses in Merrill's credit department and internal communications.
The questions about Merrill mark the third time reported in the past year in which Merrill's due diligence has been challenged.
In March, Merrill agreed to pay $80 million to settle Securities and Exchange Commission charges that it had helped Enron Corp. commit accounting fraud. In April, Merrill agreed to pay $200 million to settle accusations by state and federal regulators that the firm allowed conflicts of interest by its research analysts.
Merrill neither admitted nor denied wrongdoing in either case.
Merrill is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.
Davis Letter
The letter from Davis, the K2 attorney, was sent by fax and Federal Express on April 13, 2001, to George Schieren, then senior vice president and associate general counsel of Merrill Lynch, and Michael Morrell, then senior vice president of Allegheny.
The letter said that K2 was negotiating with Gordon for an investment from Ostrich Capital Partners. It said K2 began negotiating with Gordon while he was still running Merrill's energy-trading unit, and the talks continued after Gordon moved to Allegheny.
``The nature and extent of the misconduct which has been visited upon K2 Energy Corp. is a matter of the utmost gravity for us,'' the letter said. ``Initiation of civil proceedings on behalf of K2 Energy Corp. for fraud and RICO violations, amongst other claims, would appear well justified.'' RICO refers to Racketeer Influenced and Corrupt Organizations, a federal law used to prosecute criminal enterprises.
Schieren, who left Merrill in January to become a partner at Clifford Chance US LLP, the world's largest law firm, was on vacation and unavailable for comment, his secretary said. Morrell didn't return a voicemail message requesting a comment.
Offer Declined
In his April 2001 letter, Davis offered to fly immediately from Montana with K2 Chief Executive Officer James Livingstone to Merrill's corporate headquarters in New York and Allegheny's headquarters in Hagerstown to provide the executives with details of the allegations. Neither company took him up on his offer, Davis said in the interview.
Cox, the law professor at Duke, said that was a mistake.
``When you have a former chief energy trader and such a letter, I think that requires a serious internal investigation, including one that looks at any offshore vehicles,'' said Cox, co- author of ``Corporations,'' a multi-volume legal treatise, and ``Securities Regulations: Cases and Materials.''
Livingstone, K2's CEO, said in an interview he was surprised Merrill and Allegheny hadn't taken Davis's letter more seriously. ``Getting a letter at the highest level at two companies telling you your poster boy isn't what you thought he was isn't something you sweep under the rug,'' he said.
Met With Gordon
Livingstone said he had lunch with Gordon at Merrill Lynch headquarters in New York on Feb. 5, 2001, to discuss the $7 million investment K2 was seeking from Gordon's unit. He said two Merrill employees who worked for Gordon flew to Calgary on Feb. 16, 2001, to negotiate terms for the investment contract.
On March 13, 2001, K2 issued a press release announcing that Ostrich Capital Partners, a Delaware corporation, had agreed to invest C$10.8 million (US$7 million) for control of K2, in the form of 27 million shares and 10.8 million options. The press release identified Ostrich as ``a Delaware corporation controlled by Daniel L. Gordon, an accredited investor.''
On April 5, Livingstone said he flew to New York for a scheduled meeting with Gordon to sign the investment contract and receive the $7 million. Gordon canceled at the last minute, Livingstone said.
Two Ostrich Companies
K2 executives became alarmed when they discovered that Gordon controlled two companies called Ostrich Capital Partners, Livingstone said, one based in the Marshall Islands and incorporated in August 2000 and the other based in Delaware and incorporated on March 15, 2001.
Until the first week of April 2001, K2 believed there was only one Ostrich, he said. Gordon never disclosed this second Ostrich to them, he said.
K2 learned of the two companies from Michael Ritter, president of Newport Pacific Financial, an Edmonton, Alberta-based company that Gordon used to set up his offshore companies, Davis said.
Davis said he began to have doubts about Gordon when Ritter told him he found that Gordon had altered the investment contract provided to the Marshall Islands Ostrich company, which was held in trust by an affiliate of Newport Pacific. The concealed contract had removed all references to the 10.8 million options, which Ostrich was to receive in addition to stock for its $7.2 million investment.
Became Suspicious
Davis said Ritter told him he suspected Gordon had set up the Delaware corporation to steal the 10.8 million options from the Marshall Islands company called Ostrich and conceal the options transfer from Ritter, whose firm was the trustee of the offshore company.
``We thought a bad broker was trying to screw his clients who weren't in the U.S.,'' Ritter said in an interview. He said his discussions with Gordon led him to believe Gordon was a stockbroker for Merrill.
It was this offshore Ostrich, as well as Falcon Energy Holdings SA, another shell company incorporated in the Caribbean island of Anguilla, that Gordon might have used to embezzle and launder $43 million of Merrill Lynch money in August 2000, according to prosecutor Levine's letter.
Ritter said in an interview that he became suspicious of Gordon after $32.5 million of the Merrill money was wired out of the offshore accounts shortly after they were opened. The rules for the account required Gordon to keep at least $15 million of the $43 million at AIG Private Bank Ltd. in Zurich.
Contacted Merrill
Ritter said he contacted Merrill lawyers shortly after Allegheny purchased the Gordon-run energy unit from Merrill on March 16, 2001. Ritter said he tried to alert Merrill to his suspicions the account had been used for money laundering.
``They didn't seem concerned,'' Ritter said. ``They seemed relieved it wasn't their problem.''
In the week following Davis's April 13 letter to Merrill and Allegheny, Gordon tried to cancel the proposed $7 million investment in K2, Davis said.
Gordon was represented by the Washington law firm of Williams & Connolly LLP to negotiate with K2 on his behalf, Davis said. On Saturday, April 21, Davis and Livingstone flew to Washington and picked up a check, written on Gordon's personal account, for $3 million, written to K2.
Williams and Connolly partner Gerald Feffer declined to comment.
`That Smells'
Theresa Gabaldon, professor of securities law at George Washington University Law School, said the settlement didn't resolve allegations of wrongdoing. ``That almost makes it look worse to me, that Gordon was willing to pay $3 million, or 40 percent of the proposed investment, to walk away,'' she said. ``That smells.''
One week later, on April 27, K2 issued a press release saying its previously announced investment agreement with Ostrich Capital Partners, a Delaware corporation, had been canceled, and K2 was paid a ``break-up fee'' of C$4.6 million Canadian (US$3 million).
On the same day, Allegheny Energy issued a release saying Merrill Lynch was co-underwriting a stock sale to the public. Allegheny raised $667 million by selling 14.3 million shares, at $48.25.
Allegheny shares have fallen 72 percent since the sale, trading at $8.68 at the New York Stock Exchange on Friday at 4:01 p.m. New York time.
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