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Alston Set to Settle Malpractice Suit
Tangled tale of financial pitfalls, alleged failure to warn told by bankruptcy trustee; he says bad advice paved jeweler's road to ruin
Fulton County Daily Report
June 10, 2008
Alston & Bird and the bankruptcy trustee for one of its former clients, the beleaguered Friedman's Jewelers Inc., are on the verge of settling a suit over allegations that the firm committed legal malpractice.
The suit and potential settlement grew out of the investment problems, bankruptcy reorganizations, and other legal troubles -- including the criminal conviction of Friedman's former CEO and a guilty plea by one of its former directors -- that for years have plagued what was once the nation's third-largest specialty jewelry retailer.
Alston & Bird, which served as Friedman's outside general counsel from the 1990s until the company terminated their relationship in 2004, contributed to some of those troubles, according to Alan Cohen, Friedman's bankruptcy trustee. He filed a complicated adversary complaint on behalf of the Friedman's Creditor Trust against the law firm and five other defendants in the U.S. Bankruptcy Court for the Southern District of Georgia in January 2007.
The action later was moved to the U.S. District Court there, where, in January, Judge B. Avant Edenfield dismissed a breach of fiduciary duty claim against the firm.
But in the January order and in another order, handed down in April, he cleared the way for three other claims by the trustee, all of which the firm denies.
The first claim is that Alston & Bird committed legal malpractice by failing to disclose material facts related to Friedman's $85 million investment in Crescent Jewelers Inc., which became irrecoverable when Crescent declared bankruptcy in 2004.
In the second claim, the trustee complains about the fees Alston charged Friedman's. He claims that Alston took $5 million in legal fees but did not give an equivalent value of services. In the third claim, the trustee alleges that Friedman's -- while it was insolvent -- paid Alston almost $700,000. That's more than the company should have paid, given its financial posture, under the Bankruptcy Code, according to the trustee.
Now, more than a year later, the parties are close to striking a deal to resolve those disputes.
"We reached a settlement in principle in early- to mid-April, and we're in the process of documenting it," said Steven M. Collins, a partner at Alston & Bird who is also the firm's general counsel. "There's no admission of liability whatsoever in connection with the settlement. Our reasons for settling are to avoid what would have been very expensive litigation and to avoid the cost and distraction of that."
At this point, he said, the financial aspects of the settlement are confidential, and the parties expect them to remain so. But, he added, because the agreement still is pending, the parties or a judge ultimately could decide otherwise.
Alston & Bird is represented by, among others, Robert Cary at Williams & Connolly in Washington. He did not return a call seeking comment.
The trustee is represented by David W. Adams of Ellis, Painter, Ratterree & Adams in Savannah, Ga. Adams declined to discuss or even confirm the settlement, referring comment to another of the trustee's lawyers, William Fredericks at Bernstein, Litowitz, Berger & Grossman in New York. Fredericks did not return two calls seeking comment.
The settlement, if it is finalized, will wind up one more thread in the tangled skein of litigation that has ensnared Friedman's and the companies, investors, directors, officers, accountants and lawyers connected with it.
A 'PARASITIC' RELATIONSHIP
Many of Friedman's troubles began, apparently, with what the trustee's complaint refers to as its "parasitic relationship" with Crescent, once a privately held retail jewelry corporation based in California, whose Web site now identifies it as a division of Friedman's.
That connection between Crescent and Friedman's, founded in Savannah in 1920 and now headquartered in Addison, Texas, turned on a web of relationships between some of Friedman's executives and directors and Phillip E. Cohen, one of the defendants in the trustee's suit. (There is no indication he is related to the Friedman's trustee, Alan Cohen.)
According to his answer to the trustee's suit, Phillip Cohen at one time controlled Morgan Schiff & Co. Inc., a now-defunct registered broker-dealer and investment firm in New York, which provided investment banking and financial services to Friedman's and Crescent. Both Cohen and Morgan Schiff are defendants in the trustee's case.
Cohen's attorneys, M. Tyus Butler Jr. and D. Brian Dennison of Bouhan, Williams & Levy in Savannah, did not return calls seeking comment.
Phillip Cohen wielded extraordinary control over Friedman's and Crescent, according to the trustee's complaint. He was the sole owner of a corporation that held all of the Friedman's Class B voting stock, a position that gave him the power to elect 75 percent of its directors. In addition, through a variety of business entities, he owned approximately 14 percent of Crescent and served as the controlling shareholder of its holding company.
According to the trustee's complaint, Cohen and his companies had close ties to Friedman's one-time chief executive officer, Bradley J. Stinn, and to Sterling Brinkley, both of whom simultaneously served as directors at Crescent and Friedman's. Cohen also had ties, the trustee alleges, to Victor Suglia, who, during the same time period, served as the chief financial officer for Friedman's and for Crescent.
All three are defendants to the trustee's adversary complaint and have denied the allegations -- including breach of fiduciary duty, unjust enrichment and common law fraud -- made by the trustee.
Two are facing criminal sanctions related to the Friedman's matter. In 2007, Suglia pleaded guilty to conspiracy and mail fraud. In March, Stinn was convicted of securities fraud, mail fraud and conspiracy.
As Edenfield put it in his Jan. 10 order in the case, which relies heavily on the trustee's complaint, "Cohen used his influence over Brinkley and Stinn to have Friedman's financially support Crescent."
That support culminated in the failed $85 million investment -- allegedly engineered by Cohen, Brinkley and Stinn -- in 2002, and in an internal investigation launched a year later and conducted by Alston & Bird around the time Friedman's also was under investigation by the Securities and Exchange Commission and the U.S. Department of Justice.
Those two events -- the $85 million investment and the internal investigation -- form the foundation of the trustee's allegations against Alston & Bird.
THE $85 MILLION TRANSACTION
The trustee's primary contention against Alston & Bird concerning the $85 million investment is that the firm -- and in particular its New York partner, Mark McElreath -- never told Friedman's independent directors or a special committee of those directors deciding whether to make the investment that it would be unsecured and that Crescent was experiencing severe financial troubles.
McElreath, who was not sued individually, declined to comment on the litigation and the allegations against him personally, saying only that the last four years had been stressful. He referred comment to his firm's general counsel, Collins.
Collins said that while the trustee claimed the information constituted legal advice the firm was required to provide, Alston & Bird argued that the information was financial and constituted business advice it had no obligation to dispense.
Edenfield, in his order, found that given the scope of the firm's representation of Friedman's, it had a duty to inform the committee of "all material facts that were in its possession." On that basis, in part, he declined to dismiss the malpractice claim.
The specific allegations underlying the trustee's claim that Alston & Bird failed to disclose material facts to Friedman's prior to its decision to make the $85 million investment date back at least to 1999.
That's when, according to Edenfield, Crescent took out a $112.5 million credit line from Bank of America, and Friedman's guaranteed that loan. But in 2001, Crescent defaulted with $109 million still owed, and Friedman's, as the loan's guarantor, potentially was on the hook for the balance.
The trustee's complaint points to this event, and to McElreath's alleged failure to disclose to the special committee some of the financial information and analyses that followed as Crescent scrambled to obtain new financing, as evidence of Alston & Bird's alleged legal malpractice.
LOOKING FOR A LENDER
After the default, Crescent went shopping for a lender. Included in Crescent's pitch to those potential lenders was the idea that Friedman's would make a $70 million to $75 million subordinated investment -- which would have meant other investors could recoup their investments before Friedman's.
Ernst & Young Corporate Finance was called in to assess Crescent's chances of refinancing its outstanding debt through its original lender, Bank of America.
In his order, Edenfield says that two of the other lenders Crescent had approached told E &Y "that Crescent's refinancing would require an investment by Friedman's so large that it could be considered a fraudulent conveyance by Friedman's creditors and shareholders."
Edenfield, in a footnote, writes that the "trustee fails to explain why the banks believed this to be a potentially fraudulent conveyance." He goes on to cite a legal treatise for the generic proposition that an "obligation incurred solely for the benefit of third parties" does not constitute fair consideration, and if it renders the debtor "insolvent or inadequately capitalized," it may be avoided in bankruptcy as a fraudulent conveyance.
In December 2001, Crescent and Bank of America struck a deal on an amendment to the existing credit line, but with very restrictive terms.
McElreath sent an e-mail to his partners at Alston & Bird and to Stinn and Suglia explaining, according to the trustee's allegations, that the agreement needed to be analyzed by Ernst & Young to see if Crescent could abide by it and still remain solvent.
The issue, McElreath wrote in an e-mail quoted in the trustee's complaint, was that if Ernst & Young issued an opinion questioning Crescent's ability to continue operating as a going concern, it might prompt Bank of America to call in Friedman's guarantee of Crescent's credit line.
If that happened, McElreath added, the auditors then would have to examine Friedman's ability to finance payment of the guarantee. If Friedman's lacked sufficient financing or funds from operations, it risked a going-concern opinion from the auditors -- which could affect the value of its Class A common stock and derail a $35 million secondary stock offering it was planning. A going-concern opinion, in this case, could have questioned Friedman's ability to pay its debts when they came due.
So, according to Edenfield's order, Ernst & Young set out to assess Crescent's ability to comply with the new terms of the credit line, and to provide a valuation of Crescent. The company needed to have assets that could at least cover its outstanding $109 million debt -- so that if Friedman's guarantee were called, it could offset that liability on its own balance sheet by the asset value of Crescent itself, since this was, at least according to the trustee, a secured investment.
The trustee's complaint says that McElreath was pressing to obtain completed audit opinion letters before the start of the long Christmas weekend.
At 9:22 p.m. on Friday, December 21, an Ernst & Young audit partner for both Friedman's and Crescent, the trustee says, sent an e-mail to McElreath: "Mark, we have issues with the valuation of Crescent which impacts [sic] the recoverability of the receivable."
The "issues" boiled down to this: E&Y was having a hard time valuing Crescent at more than its $109 million debt using generally accepted accounting principles, or GAAP. So, according to the trustee's complaint, they came up with a higher valuation using a non-GAAP method called "investment value," which assesses the value of a company to a particular investor -- a method the SEC later questioned in a comment letter -- as opposed to assessing its fair market value.
FAILURE TO DISCLOSE?
According to the trustee's complaint, Friedman's 10-K, issued just three days after Christmas in 2001, did not reveal several key pieces of information.
Among them: that Crescent couldn't find financing absent a significant financial infusion from Friedman's; that Friedman's management was considering an unsecured investment in Crescent and that at least two potential bank lenders approached about a refinancing package predicated on that investment raised fraudulent conveyance concerns; or that Friedman's ability to record Crescent on its balance sheet as an asset offsetting the $109 million liability came from a non-GAAP valuation of the smaller company.
"Of particular relevance here is that A&B (and McElreath in particular, who knew or should have known that there was a clear conflict of interest between … [Friedman's and Crescent] given their overlapping directors and officers and common controlling shareholder) did not disclose to Friedman's independent directors the facts referenced in the preceding paragraph, or otherwise disclose to them the severity of Crescent's financial condition," the trustee's complaint alleges.
It goes on, "Indeed, such facts were never disclosed to the independent directors during the relevant period ... when the Board approved Friedman's proposed $85 million investment in Crescent ... except, perhaps for the inability of Crescent to get substitute financing without support from Friedman's."
Without that necessary disclosure -- according to the trustee -- Friedman's in 2002 struck a deal with Crescent essentially to exchange its $112.5 million guarantee for that $85 million investment, for which Friedman's received $35 million in subordinated notes and $50 million in Crescent preferred stock.
Alston & Bird GC Collins explained some of Friedman's rationale for doing that deal.
"There were analysts who were critical of Friedman's for carrying that debt on its balance sheet, that it basically made both Friedman's and Crescent look rather leveraged," he said.
With the 2002 transaction, Collins said, "Friedman's was relieved of its guarantee, which means that debt would not show on Friedman's balance sheet, which was a significant positive aspect."
The deal, he said, helped capitalize Crescent -- an important factor given that Friedman's and Crescent were considering a merger. It also gave Friedman's financial rights superior to Phillip Cohen's, and it essentially whittled Friedman's financial stake in Crescent from $112.5 million to $85 million.
But, the trustee alleges, Alston & Bird never told the Friedman's directors that they had swapped a secured $112.5 million position for an unsecured $85 million position.
Collins, however, contends that Friedman's never was in a secured posture on the $112.5 million.
"In order for Friedman's to have had a secured position ... they would have had to pay off Bank of America in cash, in full, then theoretically they could step into the shoes of Bank of America as a secured lender," he said. "The issue is whether that was feasible for Friedman's."
Friedman's, he added, had $60 million in debt of its own at that point. He called any scenario in which the company could pay off the $112.5 million "unrealistic."
As for the trustee's allegation that Alston & Bird committed legal malpractice by not informing the board of the material financial aspects of the deal, Collins said, "We never advised anybody it was secured. ... Our position is that we didn't fail to disclose anything to the special committee, and the special committee, by virtue of it being a subset of Friedman's board, actually had better insight and information into the financial condition of Crescent than we did."
The trustee, however, alleged that when the special committee asked for a "downside analysis" of what would happen if Crescent defaulted on its new line of credit with Bank of America, Ernst & Young consulted with McElreath before issuing its opinion. That opinion came just 22 hours before the special committee was slated to vote on the $85 million investment, and according to the complaint, it said that even if Crescent defaulted, Friedman's could "step into the shoes" of the bank and foreclose on Crescent's assets and stock, at least in regard to a portion of the debt.
In its answer, Alston & Bird merely avers that the Ernst & Young "document speaks for itself."
"As it turned out, this conclusion was wrong, and in the subsequent Crescent bankruptcy [in 2004] Friedman's lost its $85 million investment," Edenfield writes in his order.
"The plaintiff has alleged that if the Special Committee had been informed of the dire financial condition of Crescent as known to A&B and the consequential loss of Friedman's secured position by making the $85 million investment, it never would have gone through with it," he added.
Edenfield noted that the trustee's complaint alleged that Cohen, Brinkley, Stinn and Suglia, "who owed loyalties to Friedman's, orchestrated this transaction to keep Crescent afloat at the expense of Friedman's."
INTERNAL INVESTIGATION
Hard on the heels of the $85 million investment -- and a year before Crescent went bankrupt -- Alston & Bird's representation of Friedman's expanded when Friedman's, Crescent and several other jewelers were sued by Capital Factors, a company that purchases accounts receivable and handles collections, for $30 million plus punitive damages.
Capital Factors' claim: that the defendants had misrepresented balances they owed to another jewelry company, Cosmopolitan Gem Corp., in order to induce Capital Factors to advance more money to Cosmopolitan.
Eventually the SEC and the Department of Justice launched their own investigations related to the Capital Factors complaint, and Friedman's audit committee decided to conduct an internal investigation of the company -- a common corporate response to a government inquiry.
Alston & Bird, Collins said, represented the audit committee.
"Of course, A&B was not independent, considering it was Friedman's general counsel," Edenfield wrote in his order, citing the trustee's complaint, "but this was disclosed, along with other conflicts of interest, to the Audit Committee in a letter from [Alston & Bird partner John] Latham to the Chairman of the committee and to Friedman's in-house counsel."
Latham did not return a call seeking comment.
Given that the SEC and the DOJ were investigating not only Friedman's accounting and credit issues but also many of the financial transactions that Alston & Bird had worked on, the trustee alleged that the firm never should have accepted the representation because of conflicts of interest.
The firm disclosed its conflicts but didn't identify the attendant risks, Edenfield wrote in his order. However, he continued, given Friedman's sophistication as a client and the fact that it was represented by in-house counsel, "it was possible for A&B initially to represent Friedman's and the Audit Committee despite its conflicts, so long as A&B properly disclosed all of those conflicts to Friedman's and obtained a waiver."
Collins said that at the beginning of the engagement, Alston & Bird "sent a detailed, multi-paged, single-spaced letter describing our prior role as counsel for Friedman's, which of course the audit committee already knew ... disclosing potential conflicts and ... that we were not independent as that term is used in connection with internal investigations."
The committee signed a conflict waiver and hired the firm anyway. Latham represented the committee, according to the order; McElreath was excluded because of his conflicts.
But while Friedman's sophistication made the early-stage waiver appropriate -- and not fair game for a malpractice claim -- that situation may have changed as the investigation progressed, Edenfield wrote.
"[T]he Court finds that the plaintiff has sufficiently pled a claim for legal malpractice against A&B for failure to obtain Friedman's informed consent to continue its representation as the investigation broadened and A&B's conflicts became more severe. ... it was part of A&B's duty of loyalty to Friedman's to inform it of material changes in the representation that might create new conflicts."
Specific among those alleged conflicts was the issue of Alston's continued representation of Stinn -- allegedly after the firm learned that his interests might be adverse to Friedman's -- and whether the firm disclosed that knowledge to the jewelry company.
The court pointed out that the firm advised Stinn, Friedman's then-CEO, to retain separate counsel to represent his interests in the investigation in October 2003. But about a week later, in a letter Latham wrote to the chairman of Friedman's audit committee, the firm stated that neither the SEC nor the DOJ had alleged any wrongdoing on Stinn's part.
Additionally, by November 2003, the court says, Alston & Bird had become aware that Stinn allegedly had received $600,000 from Crescent for pushing through the $85 million deal. Stinn, in an answer to these claims filed eight days after his conviction, denied that.
"This is a material fact that calls Stinn's integrity into question," Edenfield writes in his order. Citing the trustee's complaint, the judge adds, "Yet there is no indication that A&B subsequently disclosed to the Audit Committee what this meant as far as A&B's ability to continue its representation and the risks involved with it, even though this was an area of particular concern identified by A&B in its engagement letter."
Because of the procedural posture of the case, Collins said, his firm never addressed that issue in detail in its court filings. "Had the case gone to trial, we would have put in evidence that we were in very close communication with the audit committee, including [informing them of] anything related to conflicts of interest on our part," he said.
AWAITING SETTLEMENT
Friedman's troubles escalated once the government and internal investigations began in 2003, followed almost immediately by Crescent's 2004 bankruptcy and the loss of Friedman's $85 million investment.
The company was forced to restate more than three years' financial results from the early 2000s, and it placed on leave or terminated its CEO, Stinn; its CFO, Suglia; and the chairman of its board of directors, Brinkley. Friedman's also was hit with derivative and class action suits, and in 2005 it filed for Chapter 11 bankruptcy protection in the Southern District of Georgia. It emerged a year later, only to be slapped with an involuntary Chapter 7 in U.S. Bankruptcy Court in Delaware by creditors claiming they were owed more than $9 million.
That action was converted to a Chapter 11 in February, and in April the company began a court-ordered liquidation sale of its assets and the closure of some of its stores.
On May 15 one of the trustee's attorneys, David Adams with Ellis Painter in Savannah, wrote to the chief judge of the U.S. Bankruptcy Court for the Southern District of Georgia, Lamar W. Davis Jr., seeking an in-chambers conference to discuss, among other things, "approval of certain settlements" and "confidentiality procedures."
That letter signals what is likely to be the beginning of the end for this aspect of Friedman's troubles -- and for Alston & Bird's, as well. Collins said he expects the parties will ink a settlement in the next few days.
The case, in the Southern District of Georgia, is In re Friedman's v. Morgan Schiff & Co., No. 4:07-cv-041; in the U.S. Bankruptcy Court for the Southern District of Georgia, Cohen v. Morgan Schiff & Co., No. 07-04042.
