Dreade Locke

What happens when a top law firm gets two crooks for clients? At Locke, Liddell, and Sapp, the result was a $30 million settlement for angry investors.

November 2001By Comments

Locke Purnell Attorney Jane Matheson’s note on the back of a trade agreement her firm was editing for client Russell Erxleben in February 1998 got right to the point: “Tell the truth.” Erxleben, an All-American punter and place kicker for the University of Texas Longhorns in the seventies, had enlisted the 110-year-old, blue-chip Dallas law firm to keep his company, Austin Forex Investments (AFI), from running afoul of state and federal securities regulations. AFI made its money through short-term investments in the volatile foreign-currency market, and it had a fiduciary duty to be open and honest with its investors. If, for example, AFI was telling clients that the company was doubling their money when it was really millions in the hole, then it was committing securities fraud.

This hypothetical example turned out to be the case. Seven months after Matheson scribbled her note, AFI closed its doors. A year later another client of the firm, Brian Russell Stearns, was arrested and charged with securities fraud after bilking investors out of more than $30 million, including $4.5 million from clients in his wife’s hometown of Brady. Both Erxleben and Stearns turned out to have been running Ponzi schemes, using money from new investors to pay old ones. Before the two businesses collapsed, Locke Purnell’s lawyers wrote letters on behalf of their clients, edited solicitations of investors, and negotiated deals, lending the firm’s expertise and, by extension, its good name. By all accounts, their clients were no less willing to lie to the firm than to anyone else. But when the businesses failed, desperate investors with no chance to recoup their money from Erxleben or Stearns looked through the maze of transactions for a party with deep enough pockets to make them close to whole. They found Locke Purnell, which by that time had merged with Houston’s Liddell Sapp to form Locke, Liddell, and Sapp, the state’s sixth-largest legal shop. In April 2000 the firm agreed to pay defrauded AFI customers $22 million. Not even a year and a half later, a Travis County district judge okayed an $8.5 million settlement by Locke Liddell for Brian Stearns’ investors. Although most of the $30 million tab will be picked up by the firm’s malpractice insurance, the size of the claims, that nasty word “fraud,” and Locke Liddell’s surrender without going to trial—as well as a $26 million suit brought by other Stearns’ investors that the firm is still fighting in New York City—sent shock waves through the Texas legal community. The firm brought in $175 million in gross revenue last year and employs some 435 attorneys spread out in offices in Dallas, Houston, Austin, and New Orleans. One of its co-managing partners at the time, Harriet Miers, a former president of the State Bar of Texas and onetime lawyer for George W. Bush, is on the White House staff. So how is it that the sins of the clients came to be visited upon the firm?

The clients were indeed world-class con artists, with an abundance of charm and an absence of conscience that enabled them to talk folks into turning over their entire life’s savings. Both men hid previous legal trouble from investors, lied about the growth of their funds, failed to disclose losses, and pooled their clients’ money (something only registered securities dealers can do) instead of segregating it in individual accounts—all significant violations of securities regulations. Locke Liddell attorneys worked on many of those transactions, representing Erxleben from April 1997 until AFI closed its doors and Stearns from August 1998 until he was arrested. According to John McElhaney, a senior shareholder and a member of the firm’s risk-management team, Locke Liddell was duped much like the investors: “One of these cases involved a client [Erxleben] who was not following our advice, and the other involved a client who was misrepresenting the facts entirely, so we weren’t able to give adequate advice because we were being fooled as to what he was doing.”

The problem with that explanation is that judging from Locke Liddell’s own documents—attorneys’ notes and memos, billing sheets, and correspondence, all of which were inherited by the court-appointed receiver who took over the two enterprises—the firm would be hard-pressed to convince a jury that it had been duped. The paper trail, pieced together by plaintiffs lawyers Mike Shaunessy and Jim George (George represents this magazine), could be evidence that Locke Liddell either knew or should have known that someone was being had. The attorney who worked the Stearns file for Locke Liddell was Phillip Wylie, a corporate lawyer who, despite 26 years of practice, the last 6 of them with Locke Liddell, was “of counsel” to the firm, not a shareholder. He took over Stearns’s file when another attorney had concerns about inconsistencies in Stearns’ stories. For instance, Stearns initially told the firm he was worth $547 million, but a rare client-background check turned up just a small house in Austin and a couple of secondhand cars, barely $150,000 in assets. Undeterred, Wylie took over the file. He responded to a State Securities Board inquiry by writing that Stearns was not selling securities in Texas, even though Stearns’s earliest statements to the firm indicated that he was. In a letter to a man who was mulling over an $8 million loan to Stearns, Wylie wrote under the firm’s letterhead that Stearns “honors all the commitments that he makes and he pays his bills when they are due.” Yet Wylie had previously written two letters to Stearns demanding that he pay the firm’s bill that was overdue. He had also helped Stearns clear up $60,000 in hot checks and had failed to check out a report from another client of the firm that Stearns had been convicted of felony fraud in Maryland. When Wylie was deposed, he contended that Stearns had good explanations for those irregularities and plenty of others, and maybe Stearns did have him convinced: The firm sent Stearns a bill two months after he was arrested.

Documents in the Erxleben file raise similar questions as to who knew what, and when. In Jane Matheson’s memo about telling the truth, her full notes on the back of the draft agreement read “Should I say what it is? ‘Tell the truth’ ‘pooling’?” Matheson insisted in her deposition that the notes related to a separate conversation with someone at AFI. But it’s easy for a lawyer to cite that note as evidence that Locke Liddell knew its client was pooling money, particularly since her concern appeared to mirror one that had initially been raised by another Locke Liddell lawyer—her husband, Dan Matheson—when Erxleben first came to the firm, ten months earlier: Every investor’s money was going into the same account.

Dan Matheson also reviewed and approved glossy brochures used by AFI to drum up new business by claiming monumental profits on AFI accounts, when the lawyers knew AFI was actually losing money hand over fist: $2 million in total losses in February 1998, increasing to $8 million in March. Losses grew to $16 million in June, and then, by the time AFI was shut down, in September, $36 million. The Mathesons contend that they repeatedly advised Erxleben to conform to the law, they told him to stop pooling and to “tone the puffing down,” and they ultimately advised him to stop raising new funds. But when the closure of Erxleben’s shop appeared imminent, they also asked him to prepay his legal bills.

That evidence points to more than just sneaky clients, as federal district judge James Nowlin, of Austin, indicated this July, when he sentenced Stearns to thirty years in prison (Erxleben is serving a seven-year sentence). “I have a difficult time accepting that individuals like . . . Mr. Wylie, . . . could not on the basis of their experience, background, and education know what was going on,” said Judge Nowlin. But even if Locke Liddell could have shown that its lawyers had been fooled, it might still be on the hook. An adviser is liable for aiding and abetting securities fraud in Texas not only when he knows that false representations are being made but also when he recklessly disregards that the truth is being misrepresented.

Less certain is what Locke Liddell should have done once it became apparent that it had a couple of bad-apple clients. Some might suggest that the firm should have terminated its relationship with the clients and notified the investors, or at least notified state or federal securities regulators. But it’s impossible to reconcile either of those solutions with the ethical maxim forbidding lawyers to reveal confidential information without the client’s permission. (The American Bar Association voted down a recommendation by the American Law Institute that states change their legal conduct rules to allow attorneys to divulge privileged information where there is an imminent threat of financial injury to a third party.)

The surest way to avoid such trouble is to take care before the file is even opened. “You have to make sure you’re hiring right and that you start that flake meter running as soon as a new client walks in the door,” said the managing partner of one of the larger Austin-based firms who, like almost every other legal heavyweight in town, is tangentially involved in the Locke Liddell litigation and unwilling to be quoted directly. “A lawyer really has only three things: his reputation, his license to practice law, and his law school diploma. A bad client can take the first two of those in a heartbeat.”

Firms also need to keep their priorities in the right place. A good name is more valuable than a big-bucks client, but it’s easy to lose sight of that if a firm lets the bottom line become the brass ring. “It’s not the snot-nosed law school grad who’s going to get a firm in billion-dollar trouble,” said Walter Steele, a retired Southern Methodist University law school professor who now consults on legal ethics. “It’s the big dog senior partners who are treated like gods because they bring in so much money.” In fact, Dan Matheson was elevated to senior shareholder after he brought in Erxleben, and Wylie made more money in the nine months that he worked with Stearns than in any full year with Locke Liddell. “It’s difficult in that kind of culture to get everybody in the firm to join hands and say, ‘Let’s be vigilant and make sure everybody is doing the right thing,'” said Steele.

Weekly or even monthly conferences in which attorneys could meet and discuss their files would provide more protection for the firm too—but think of the billable hours that would be wasted. “Did you ever watch L.A. Law?” asked another retired law professor who had consulted in one of the cases. “Every episode was introduced with a meeting in which the firm’s senior partners discussed how each case was going. That always bothered me because it was so completely unrealistic and phony. No firm I’ve ever seen has been willing to spend the time or money to sit around for a couple of hours each week second-guessing one another.” Maybe, after the lessons of Locke Liddell, firms will decide they cannot afford not to.

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