Yesterday a special master in a federal shareholders class-action suit against The Coca-Cola Company (KO) recommended that the law firm of Coughlin Stoia Geller Rudman & Robbins be barred from serving as class counsel because it had purchased “stolen” company documents from a disgruntled former Coke executive.

“Class Counsel engaged in extremely troubling conduct,” wrote Special Master Hunter R. Hughes, III, “by paying for documents stolen from Coke, and then exacerbated the [situation] by refusing to accept responsibility for that conduct and by continuing, to this day, to defend that conduct through the use of arguments that appear to be pretextual.” Hughes’s ruling is here. (The pertinent pages are 49-69.)

Hunter’s recommendation was submitted to U.S. District Judge Willis B. Hunt, Jr., of Atlanta, who will wait to receive comments from the parties before deciding what action to take.

Hunter acknowledged that Coughlin Stoia’s lawyers had “vigorously and skillfully prosecuted this case for now seven years,” and said that “had they addressed this issue head-on, recognizing the impropriety of the arrangement they made . . . that might well have served to mitigate the circumstances. But they did not. Instead, they turned a blind eye to the terms of the consulting agreement pursuant to which they paid for the company documents and continue even now to make unfounded arguments which only obfuscate the issue.”

Coughlin Stoia partners (on the West Coast) were not immediately available to respond to email inquiries sent early this morning (from the East Coast), but any comment received will be inserted when it arrives.

(Coughlin Stoia, formerly known as Lerach Coughlin, is the firm founded by William Lerach in 2004, when he split away from Milberg Weiss and took that firm’s West Coast office with him. Lerach began serving a two-year federal prison term earlier this month after pleading guilty to conspiring to obstruct justice in connection with an unrelated kickback scheme at Milberg Weiss. Milberg Weiss has pleaded not guilty to the same charges, and is scheduled to go to trial in August.)

The case against Coke, filed in October 2000, alleges that the company artificially inflated its revenues through “channel-stuffing.” (A company channel-stuffs when it cajoles distributors into buying more product than they really need, to make it look to shareholders like consumer sales are brisker than they are.)

About four months after the case was filed, two former Coke executives approached the class’s law firm (then still known as Milberg Weiss) to offer help on the case, according to Hughes’s report. One of the two former execs, Greg Petro, told class counsel that he’d taken about 3,000 Coke documents with him when he had been terminated. The law firm then signed a “consulting agreement” with the two former executives, agreeing to pay them $200 an hour but, in any event, no less than $75,000, if they would provide information to the firm “including . . . documentation in any form, written or electronic, concerning Coke.” Petro then turned over 3,023 company documents, including many marked “confidential.” Some were then used in connection with an amended complaint filed in the case.

When the consulting agreement came to light more than a year ago, Coughlin Stoia lawyers backed Petro’s claim that neither he nor they had thought he was taking Coke documents without authority because, among other things, Petro had been ordered, when terminated, to “clean out his office.” Special Master Hughes found that such a command could not “rationally be construed to authorize Petro to walk off with company documents, any more than it authorized him to take the company’s desk, chairs, and computer.”

Hughes also rejected arguments that the firm was not really buying the documents, just entering into a consulting agreement, and a public-policy style argument that Petro’s conduct should be condoned because he was a whistleblower trying to expose corporate wrongdoing.

In a footnote, Hughes found that public policy arguments weighed in the other direction: “On a very practical level, for the Court to give Plaintiffs’ counsel a pass on this conduct, would simply invite terminated employees, particularly of public companies, to on a wholesale basis remove company documents following their termination in hopes they can sell them should the company be sued.”

In the silver-lining department, Special Master Hughes did find that the mere past involvement of Bill Lerach in the case, and Lerach’s subsequent admission of unrelated criminal conduct, did not warrant barring Coughlin Stoia from serving as class counsel.

Correction: Earlier version of this story had wrong the wrong month for when Milberg Weiss is set to go to trial. Correct month is August. Regret the error.

Yesterday a special master in a federal shareholders class-action suit against The Coca-Cola Company (KO) recommended that the law firm of Coughlin Stoia Geller Rudman & Robbins be barred from serving as class counsel because it had purchased “stolen” company documents from a disgruntled former Coke executive.

“Class Counsel engaged in extremely troubling conduct,” wrote Special Master Hunter R. Hughes, III, “by paying for documents stolen from Coke, and then exacerbated the [situation] by refusing to accept responsibility for that conduct and by continuing, to this day, to defend that conduct through the use of arguments that appear to be pretextual.” Hughes’s ruling is here. (The pertinent pages are 49-69.)

Hunter’s recommendation was submitted to U.S. District Judge Willis B. Hunt, Jr., of Atlanta, who will wait to receive comments from the parties before deciding what action to take.

Hunter acknowledged that Coughlin Stoia’s lawyers had “vigorously and skillfully prosecuted this case for now seven years,” and said that “had they addressed this issue head-on, recognizing the impropriety of the arrangement they made . . . that might well have served to mitigate the circumstances. But they did not. Instead, they turned a blind eye to the terms of the consulting agreement pursuant to which they paid for the company documents and continue even now to make unfounded arguments which only obfuscate the issue.”

Coughlin Stoia partners (on the West Coast) were not immediately available to respond to email inquiries sent early this morning (from the East Coast), but any comment received will be inserted when it arrives.

(Coughlin Stoia, formerly known as Lerach Coughlin, is the firm founded by William Lerach in 2004, when he split away from Milberg Weiss and took that firm’s West Coast office with him. Lerach began serving a two-year federal prison term earlier this month after pleading guilty to conspiring to obstruct justice in connection with an unrelated kickback scheme at Milberg Weiss. Milberg Weiss has pleaded not guilty to the same charges, and is scheduled to go to trial in August.)

The case against Coke, filed in October 2000, alleges that the company artificially inflated its revenues through “channel-stuffing.” (A company channel-stuffs when it cajoles distributors into buying more product than they really need, to make it look to shareholders like consumer sales are brisker than they are.)

About four months after the case was filed, two former Coke executives approached the class’s law firm (then still known as Milberg Weiss) to offer help on the case, according to Hughes’s report. One of the two former execs, Greg Petro, told class counsel that he’d taken about 3,000 Coke documents with him when he had been terminated. The law firm then signed a “consulting agreement” with the two former executives, agreeing to pay them $200 an hour but, in any event, no less than $75,000, if they would provide information to the firm “including . . . documentation in any form, written or electronic, concerning Coke.” Petro then turned over 3,023 company documents, including many marked “confidential.” Some were then used in connection with an amended complaint filed in the case.

When the consulting agreement came to light more than a year ago, Coughlin Stoia lawyers backed Petro’s claim that neither he nor they had thought he was taking Coke documents without authority because, among other things, Petro had been ordered, when terminated, to “clean out his office.” Special Master Hughes found that such a command could not “rationally be construed to authorize Petro to walk off with company documents, any more than it authorized him to take the company’s desk, chairs, and computer.”

Hughes also rejected arguments that the firm was not really buying the documents, just entering into a consulting agreement, and a public-policy style argument that Petro’s conduct should be condoned because he was a whistleblower trying to expose corporate wrongdoing.

In a footnote, Hughes found that public policy arguments weighed in the other direction: “On a very practical level, for the Court to give Plaintiffs’ counsel a pass on this conduct, would simply invite terminated employees, particularly of public companies, to on a wholesale basis remove company documents following their termination in hopes they can sell them should the company be sued.”

In the silver-lining department, Special Master Hughes did find that the mere past involvement of Bill Lerach in the case, and Lerach’s subsequent admission of unrelated criminal conduct, did not warrant barring Coughlin Stoia from serving as class counsel.

Correction: Earlier version of this story had wrong the wrong month for when Milberg Weiss is set to go to trial. Correct month is August. Regret the error.

Steve Schulman, a former top Milberg Weiss partner who agreed to plead guilty to racketeering charges in September, has sued his former firm for nonpayment of his criminal defense attorneys’ fees. The complaint is here.

Schulman seeks an injunction that would force the class-action law firm — which is still defending its own indictment on related charges — to continue to pay the attorneys’ fees Schulman is incurring while cooperating with the government against the firm and its founder, Mel Weiss. The firm and Weiss have pleaded not guilty.

Schulman has also sued the law firm of Coughlin, Stoia, Geller, Rudman & Robbins (formerly Lerach Coughlin, etc.), the spin-off firm formed by former Milberg partner Bill Lerach in May 2004. Bill Lerach agreed to plead guilty in September in a deal in which the government agreed not to prosecute Coughlin Stoia or its top partner Patrick J. Coughlin.

Schulman says that until September, Milberg Weiss and Coughlin Stoia had been splitting his defense costs 50/50.

Until 2004, Milberg Weiss was the leading class-action plaintiffs firm in the nation; Coughlin Stoia is still one of the leaders today.

“Acting maliciously and in flagrant bad faith,” the complaint asserts, the two law firms “have wrongfully stopped paying petitioner’s legal fees in retaliation for his agreement to plead guilty and cooperate with the Government in its ongoing investigation and prosecution of Milberg Weiss and its founding partner, Melvyn I. Weiss.”

Schulman characterizes his former partners as attempting to “punish” him “for agreeing to cooperate with the government,” and calls the effort “a gross violation of public policy and a flagrant breach of . . . contractual obligations.”

Milberg Weiss partner Sanford Dumaine said he could not comment, but would be filing papers responding later this afternoon. Dan Newman, a spokesman for Coughlin Stoia, did not immediately return a voicemail seeking comment. I’ll post his comment when received. (In the meantime, I’ll note that the law firms very likely will have some nontrivial arguments on their side for not reimbursing Schulman once he acknowledged criminal wrongdoing. Contracts to reimburse people for costs incurred in connection with criminal acts are often void as against public policy.)

Schulman claims that without the firms’ subsidization of his fees, he faces “imminent risk of being deprived of his constitutional right to criminal counsel of his choice guaranteed by the Sixth Amendment.”

Under Milberg Weiss’s 1991 partnership agreement the firm agreed to reimburse partners for attorneys’ fees “for which a partner becomes liable in connection with the rendition of services to a client,” according to the complaint.

When Bill Lerach split away in May 2004 and formed Lerach Coughlin, the complaint continues, the two firms entered into a “joint defense agreement” and agreed to “retain joint counsel in connection with the pending grand jury investigation.”

Then on May 11, 2006 — seven days before Schulman was indicted — Schulman signed a “leave of absence agreement” with Milberg Weiss in which that firm specifically committed to reimburse him for legal fees “even in the event [Schulman] were to be convicted of a felony, until such time as such conviction has been upheld by a final non-appealable court order.” Schulman says he bargained for this valuable clause, and in exchange passed up the opportunity to share in fee awards from pending Tyco (TYC), Nortel (NT), Sears, and Enron class actions.

From May 2006 until September 2007, Schulman says, Milberg Weiss and Coughlin Stoia had split the costs of his civil and criminal attorneys fees 50/50, paying about $4.5 million to his defense lawyers at Stern & Kilcullen and McDermott Will & Emery.

Schulman agreed to plead guilty on September 20, 2007, the same day that Milberg Weiss co-founder Mel Weiss was indicted. But upon agreeing to plead guilty, he says, both firms stopped paying his fees.

Though Schulman did plead guilty on October 9, he contends that he is still entitled to payment under his Leave of Absence Agreement, since has not yet been formally “convicted.” That event will not occur until his sentencing, which is currently scheduled for June 23, 2008, he argues. He has already run up about $1.2 million in unreimbursed fees since September, according to his complaint.

Schulman filed the suit in state supreme court in Manhattan on November 27. Though Schulman has already initiated arbitration proceedings against Milberg Weiss and, the complaint says, will soon do so against Coughlin Stoia, Schulman has gone to court to seek an emergency order that the firm keeping paying his fees while the arbitrations are pending.

In passing, Schulman notes that as a partner at Milberg Weiss he earned $15 million in 2005. He says his equity share that year was 15.5 percent, which was third behind founder Mel Weiss (17 percent) and David J. Bershad (16 percent). Bershad was the first Milberg Weiss partner to agree to plead guilty.

In his 1,500 word sermon in Sunday’s Washington Post, shareholder class-action impresario Bill Lerach argued that “the legal system is a lot tougher on shareholder lawyers than it appears to be on Wall Street executives.” He was referring to the fact that neither Citigroup (C) CEO Chuck Prince nor Merrill Lynch (MER) CEO Stan O’Neal are headed to jail, while Lerach is. (For his article, click here.)

I’m not going to spend much time addressing the thrust of that argument, except to note in passing that the sparse dataset he relied upon did not seem sufficient to prove his thesis. Neither Prince nor O’Neal, who each presided over subprime mortgage debacles at their companies, has (yet) been accused of much more than stupidity or mismanagement, which aren’t crimes. Lerach, on the other hand, has pleaded guilty to conspiring to make intentional false statements and obstruct justice in more than 150 court cases during a two-decade period, for which he stands to serve — if a judge accepts on January 14 the terms of his breathtakingly lenient plea agreement — a maximum of only two years. (Former Enron CEO Jeff Skilling is serving 24 years; former Tyco (TYC) chief Dennis Kozlowski is doing 8 1/3 to 25; and former WorldCom CEO Bernie Ebbers is looking at 25.)

Nor was I going to focus on Lerach’s apparently misguided belief that he’s being incarcerated because, as he puts it, “in my zeal to stand up against this kind of corporate greed over the years, I stepped over the line.” In fact, of course, the crimes he has pled guilty to have nothing to do with standing up to corporate greed. They relate to undermining the rights of the investor classes he ostensibly represented (by providing secret payoffs to their named representatives) and using illegal means to gain a competitive advantage over rival firms in the plaintiffs bar (who were also theoretically trying to fight corporate greed).

I was writing instead to focus on a telling and refreshing concession in the piece. After discussing how big O’Neal’s and Prince’s salaries were (unconscionably large, but fully disclosed), he recounts how much money their inattentiveness or incompetence has cost shareholders. “The previously reported profits have been wiped out,” he writes, “and rumors of billions more in coming write-offs abound.” Then comes the capper: “Who knows what the class-action suits against Merrill and Citi for stock fraud will cost?”

Well, exactly. But let’s drill down on that last insight. What he’s saying is that the innocent Citi and Merrill shareholders whose fate he is bewailing are about to lose even more money because they will have to foot the bill for the defense attorneys fees and settlement payments and increased insurance premiums being brought down upon those companies by the shareholder class-action suits that are reflexively coming down the pike. Shareholder suits brought by lawyers who aspire to become the next Bill Lerach.

Getting confused? You should be. You’re noticing something distinctive about Lerach’s life’s work, and it’s something that’s true even if you were to assume, for the sake of argument, that all of his cases were actually nonfrivolous — i.e., arguably had merit. The weird thing about those cases is this: Most of them probably didn’t benefit most of the people for whom they were brought.

There’s actually a remarkable consensus about that fact in legal academia today. Here’s why.

In the typical fraud suit prompted by a sudden drop in stock price, the vast majority of investors who get hurt—i.e., the ones who bought when the stock price was allegedly inflated by the fraud, and sold after it had fallen back to true value—purchased their stock from other innocent investors. Those innocent sellers inadvertently benefited from the fraud (i.e., they sold at an artificially inflated price), but the law does not require them to cough-up their windfalls. Instead, the injured investors go after the corporation itself for their reimbursement. But everything the corporation pays as a consequence—attorneys fees, insurance premiums, settlements, judgments—ends up hurting its current shareholders, who also happen to be innocent of any wrongdoing.

It gets worse. In real life, most diversified investors, like pension funds and mutual funds, aren’t harmed by most securities frauds to begin with. If a pension fund holds a portfolio of 1,000 stocks, and 100 of those companies are accused of fraud in a given year, the fund most likely will be a net buyer (i.e., loser) as to 50 of those inflated stocks, but a net seller (i.e., winner) as to the other 50. Empirical studies appear to confirm that the majority of diversified investors—which is the vast majority of all investors—don’t suffer net damages. Any compensation they receive from lawsuits is overcompensation.

What about the undiversified investors—the widows and orphans? Too often private shareholder suits don’t help them either. Undiversified investors are typically “buy-and-hold” investors. To be a class member, though, investors must have bought their stock during the period when the alleged fraud was in effect, which is usually less than a year before the date of the price drop. Buy-and-hold investors will often have bought too early to qualify.

In August six influential law professors—four of whom are generally considered moderate-to-liberal on shareholder issues—wrote SEC chairman Christopher Cox urging him to convene a series of roundtable discussions on these subjects with a view to proposing reforms. The letter, authored by Donald Langevoort of Georgetown University Law Center, emphasized the professors’ unanimous concern about the “immense amount of ‘pocket-shifting’” that is currently occurring (i.e., innocent investors senselessly paying innocent investors, with much of the money being lost to attorneys fees en route), and the need to pay “more attention to the burden imposed on smaller investors whose inactive trading makes it more likely they will be funding the pay-outs than receiving them.” The professors’ letter is available here.

The SEC general counsel Brian Cartwright wrote back indicating that these were just the sorts of issues the Commission hopes to look into in an upcoming “formal roundtable” it wants to convene “to explore the topics of private securities litigation, its relationship to Commission enforcement efforts, and its effects on U.S. capital markets, competitiveness, shareholder value, and investor protection.” (The precise schedule and agenda has not yet been announced.)

It’s a welcome development. Too bad it won’t come in time to protect those poor Citi and Merrill shareholders from the drubbing Lerach acknowledges they’re about to sustain from benefactors like him.

In his 1,500 word sermon in Sunday’s Washington Post, shareholder class-action impresario Bill Lerach argued that “the legal system is a lot tougher on shareholder lawyers than it appears to be on Wall Street executives.” He was referring to the fact that neither Citigroup (C) CEO Chuck Prince nor Merrill Lynch (MER) CEO Stan O’Neal are headed to jail, while Lerach is. (For his article, click here.)

I’m not going to spend much time addressing the thrust of that argument, except to note in passing that the sparse dataset he relied upon did not seem sufficient to prove his thesis. Neither Prince nor O’Neal, who each presided over subprime mortgage debacles at their companies, has (yet) been accused of much more than stupidity or mismanagement, which aren’t crimes. Lerach, on the other hand, has pleaded guilty to conspiring to make intentional false statements and obstruct justice in more than 150 court cases during a two-decade period, for which he stands to serve — if a judge accepts on January 14 the terms of his breathtakingly lenient plea agreement — a maximum of only two years. (Former Enron CEO Jeff Skilling is serving 24 years; former Tyco (TYC) chief Dennis Kozlowski is doing 8 1/3 to 25; and former WorldCom CEO Bernie Ebbers is looking at 25.)

Nor was I going to focus on Lerach’s apparently misguided belief that he’s being incarcerated because, as he puts it, “in my zeal to stand up against this kind of corporate greed over the years, I stepped over the line.” In fact, of course, the crimes he has pled guilty to have nothing to do with standing up to corporate greed. They relate to undermining the rights of the investor classes he ostensibly represented (by providing secret payoffs to their named representatives) and using illegal means to gain a competitive advantage over rival firms in the plaintiffs bar (who were also theoretically trying to fight corporate greed).

I was writing instead to focus on a telling and refreshing concession in the piece. After discussing how big O’Neal’s and Prince’s salaries were (unconscionably large, but fully disclosed), he recounts how much money their inattentiveness or incompetence has cost shareholders. “The previously reported profits have been wiped out,” he writes, “and rumors of billions more in coming write-offs abound.” Then comes the capper: “Who knows what the class-action suits against Merrill and Citi for stock fraud will cost?”

Well, exactly. But let’s drill down on that last insight. What he’s saying is that the innocent Citi and Merrill shareholders whose fate he is bewailing are about to lose even more money because they will have to foot the bill for the defense attorneys fees and settlement payments and increased insurance premiums being brought down upon those companies by the shareholder class-action suits that are reflexively coming down the pike. Shareholder suits brought by lawyers who aspire to become the next Bill Lerach.

Getting confused? You should be. You’re noticing something distinctive about Lerach’s life’s work, and it’s something that’s true even if you were to assume, for the sake of argument, that all of his cases were actually nonfrivolous — i.e., arguably had merit. The weird thing about those cases is this: Most of them probably didn’t benefit most of the people for whom they were brought.

There’s actually a remarkable consensus about that fact in legal academia today. Here’s why.

In the typical fraud suit prompted by a sudden drop in stock price, the vast majority of investors who get hurt—i.e., the ones who bought when the stock price was allegedly inflated by the fraud, and sold after it had fallen back to true value—purchased their stock from other innocent investors. Those innocent sellers inadvertently benefited from the fraud (i.e., they sold at an artificially inflated price), but the law does not require them to cough-up their windfalls. Instead, the injured investors go after the corporation itself for their reimbursement. But everything the corporation pays as a consequence—attorneys fees, insurance premiums, settlements, judgments—ends up hurting its current shareholders, who also happen to be innocent of any wrongdoing.

It gets worse. In real life, most diversified investors, like pension funds and mutual funds, aren’t harmed by most securities frauds to begin with. If a pension fund holds a portfolio of 1,000 stocks, and 100 of those companies are accused of fraud in a given year, the fund most likely will be a net buyer (i.e., loser) as to 50 of those inflated stocks, but a net seller (i.e., winner) as to the other 50. Empirical studies appear to confirm that the majority of diversified investors—which is the vast majority of all investors—don’t suffer net damages. Any compensation they receive from lawsuits is overcompensation.

What about the undiversified investors—the widows and orphans? Too often private shareholder suits don’t help them either. Undiversified investors are typically “buy-and-hold” investors. To be a class member, though, investors must have bought their stock during the period when the alleged fraud was in effect, which is usually less than a year before the date of the price drop. Buy-and-hold investors will often have bought too early to qualify.

In August six influential law professors—four of whom are generally considered moderate-to-liberal on shareholder issues—wrote SEC chairman Christopher Cox urging him to convene a series of roundtable discussions on these subjects with a view to proposing reforms. The letter, authored by Donald Langevoort of Georgetown University Law Center, emphasized the professors’ unanimous concern about the “immense amount of ‘pocket-shifting’” that is currently occurring (i.e., innocent investors senselessly paying innocent investors, with much of the money being lost to attorneys fees en route), and the need to pay “more attention to the burden imposed on smaller investors whose inactive trading makes it more likely they will be funding the pay-outs than receiving them.” The professors’ letter is available here.

The SEC general counsel Brian Cartwright wrote back indicating that these were just the sorts of issues the Commission hopes to look into in an upcoming “formal roundtable” it wants to convene “to explore the topics of private securities litigation, its relationship to Commission enforcement efforts, and its effects on U.S. capital markets, competitiveness, shareholder value, and investor protection.” (The precise schedule and agenda has not yet been announced.)

It’s a welcome development. Too bad it won’t come in time to protect those poor Citi and Merrill shareholders from the drubbing Lerach acknowledges they’re about to sustain from benefactors like him.

[UPDATE: I originally wrote this post on October 8, but am now updating it on October 9 after attending the oral arguments in the case. The updated portions are indicated below in italics.]

On Tuesday morning the U.S. Supreme Court heard oral arguments in what has been widely described as both the most important business case of the term and the most important securities case of the decade.

Though everyone advises against making predictions based on justices’ questions at oral arguments, everyone does so anyway. For what it’s worth, it seemed to me the Court was tending in the pro-business direction by about a 5-3 margin. (Justice Stephen Breyer did not participate.)

Chief Justice John Roberts stressed that in recent years Congress has been active in defining precisely which sorts of securities fraud actions private parties – as opposed to the Securities and Exchange Commission – should be allowed to bring, and that he felt the plaintiffs were asking the Court to “expand” upon those remedies. “We did that sort of thing in 1971,” the Chief Justice said, “But we haven’t now for some time.”

The case, known as Stoneridge Investment Partners v. Scientific-Atlanta, will determine how easy or difficult it will be for plaintiffs lawyers bringing class actions for alleged securities fraud to sue third-parties in addition to the corporation that issued the stock in question. The third parties most frequently targeted are accounting firms, law firms, investment banks, and vendors who did business with the issuer.

Today, if third parties formally sign documents that are included in an issuer’s SEC filings — the way auditors do when companies file their annual reports — there is no question that they can be held liable as “primary violators” if they make false statements. But if their role is anything less direct than that, they can currently be sued, if at all, only under a controversial theory known as “scheme liability”: I.e., they are accused of having committed acts with the “purpose and effect” of furthering the issuer’s allegedly fraudulent scheme. In the Stoneridge case, the Court will either accept or reject “scheme liability” as a legitimate basis for suing third parties in private class-action suits. (The Court is not expected to rule until several weeks after the oral argument, at a minimum.)

In today’s arguments, Chief Justice Roberts and Justices Anthony Kennedy, Samuel Alito, and Antonin Scalia all asked tough questions of Stanley Grossman of Pomerantz Haudek Block Grossman & Gross, who was representing plaintiff Stoneridge, while generally letting Stephen Shapiro of Mayer Brown Rowe & Maw, who argued for the defendants, off more easily. If Justice Clarence Thomas (who, as is his custom, asked no questions) votes with the other conservatives, that would make a majority. (Deputy Solicitor General Thomas Hungar also argued for the United States, supporting the defendant.) On the steps of the courthouse afterwards, former SEC commissioner Joseph Grundfest, the co-director of Stanford University’s Rock Center on Corporate Governance, said – after stressing the usual provisos about the futility and inadvisability of making such predictions – that his count was at least 5-3, and possibly 8-0. (Grundfest had joined a friend-of-the-court brief opposing the concept of scheme liability.)At a stand-up interview being televised elsewhere on the plaza, Nina Totenberg told Stoneridge’s counsel Grossman that, after watching the argument, she couldn’t see how he could get five votes. Grossman replied, “I wasn’t counting.”

The recurring theme of the conservative justices’ questions was that they could not see a practical difference between “scheme liability” and the older, more familiar theory known as “aiding and abetting” liability, which the U.S. Supreme Court barred private plaintiffs from invoking in securities fraud cases in the 1994 case known as Central Bank v. First Interstate Bank. Even Justice David Souter asked plaintiffs counsel Grossman at one point, “are you making a distinction that in the real world is not a distinction?”

On the other hand, questions from Justices Ruth Bader Ginsburg, John Paul Stevens, and, at times, Souter, too, suggested that they might still see room for a meaningful distinction to be drawn between the two concepts.

Six of the nine justices on the Central Bank court are still sitting. Three were in the majority that disallowed the aiding and abetting theory in that case – Justices Kennedy, Scalia, and Thomas – while three were among the dissenters: Justices Ginsburg, Souter, and Stevens. Justice Kennedy, who is often now seen as the Court’s swing vote – because he is the most moderate member of the five-justice conservative faction – wrote the pro-business majority opinion in Central Bank.

More than 30 interested outside groups have submitted “friend-of-the-court” briefs. Briefs in support of the scheme liability concept have been submitted by several of the nation’s largest pension funds, attorneys general for more than 30 states, major labor unions, AARP, the Consumers Federation of America, and the trial lawyers trade group, now known as the American Association for Justice. Briefs opposing the concept have been filed by the U.S. Chamber of Commerce, the major securities exchanges, the securities industry, accounting industry, banking industry, insurance industry, law firms, and law firm insurers. The Solicitor General of the United States has weighed in on the side of the business community – i.e., opposing the scheme liability concept – though it did so over the objections of the Securities and Exchange Commission, which voted, 3-2, to support the concept. (All key briefs are available here.)

Stoneridge specifically focuses on a fraud committed in 2000 by officials of cable operator Charter Communications (CHTR). (Several Charter officials ultimately pled guilty to criminal charges in connection with these acts.) To inflate its revenue, Charter asked two of its set-top box vendors, Scientific-Atlanta (a unit of Cisco (CSCO)) and Motorola (MOT), to bill it $17 million more than previously agreed upon, and then to use that extra money to buy advertising from Charter, which Charter then improperly booked as revenue. The vendors allegedly assisted in the scheme by backdating contracts and providing phony invoices and correspondence to help Charter deceive its accountants into approving the bogus revenue recognition. Neither vendor misrepresented its own finances to its own shareholders, and Charter’s shareholders never directly saw any of the misleading documents prepared by the vendors.

In April 2006 the U.S. Court of Appeals for the Eighth Circuit (in St. Louis) rejected the scheme liability concept and dismissed Stoneridge’s case against the vendors. Two months later, the U.S. Court of Appeals for the Ninth Circuit (in San Francisco) came out the other way in a case known as Simpson v. AOL Time Warner, approving the scheme liability concept. (Time Warner (TWX) is the parent of Fortune’s publisher.)

The most famous scheme liability case is one that is not directly before the Court, but whose presence will obviously loom large at the argument. After the Enron catastrophe, class-action impresario Bill Lerach filed a scheme liability case on behalf of holders of Enron securities against more than ten banks who had allegedly engaged in dubious transactions with Enron whose only apparent purpose was to help Enron draw up misleading financial statements. Lerach has already recovered $7.3 billion in settlements in the case from such banks as Citibank (C), J.P. Morgan Chase (JPM), and CIBC (CM). But in March 2007, the U.S. Court of Appeals for the Fifth Circuit (in Houston) ruled the same way the Eighth Circuit had, rejecting “scheme liability” and tossing out the case against the banks who had not yet settled, which included Merrill Lynch (MER), Credit Suisse (CS), and Barclays (BCS). (Lerach himself is scheduled to plead guilty on October 29 to conspiring to obstruct justice by bribing plaintiffs and deceiving judges in more than 150 shareholder class actions over more than two decades.)

The Stoneridge case is in one respect a very difficult case to decide but, in another, perhaps, quite easy. The difficult part is that, however the court rules, it will make a decision that works some real injustice to someone. If it rejects scheme liability, investors who have been hurt by mammoth frauds that have led to corporate bankruptcies will be unable to seek reimbursement from deep-pocketed third-parties who really do bear some responsibility for what happened to them. On the other hand, if the Court endorses the scheme liability theory, innocent third-parties will routinely and inevitably be joined as defendants in scores of frivolous cases and — having no way to get those cases dismissed at an early, inexpensive stage (i.e., on a “motion to dismiss”) — will be induced to pay extortionate settlement payments.

The potentially easy part of the case is that it may have already been effectively decided 13 years ago. “Scheme liability” sounds an awful lot like “aiding and abetting liability” — i.e., the notion that plaintiff shareholders should be able to sue third-parties who aided and abetted the issuer’s fraud. The U.S. Supreme Court rejected that theory, however, in its 1994 ruling in Central Bank v. First Interstate Bank. Though that 5-4 ruling was controversial at the time, Congress subsequently made its peace with that ruling — twice! In 1995, it restored by statute the right of federal prosecutors and the Securities and Exchange Commission to prosecute and sue aiders and abettors, but it specifically chose not to restore that right to private plaintiffs. Simply put, Congress decided that private securities actions were so subject to abuse that the costs to society of allowing private parties to sue alleged aiders and abettors were just not worth the benefits.

Congress then made exactly the same cost-benefit determination in 2002, when it passed the Sarbanes-Oxley legislation. Again it was asked to restore the right of private plaintiffs to sue aiders and abettors of securities fraud, and again it said no. Instead, it expanded the SEC’s power to impose fines and disgorgements on aiders and abettors – i.e., forcing them to cough up their profits – and then empowered the SEC to distribute those sums to defrauded investors in partial reimbursement for their losses. (These sums are not, however, as much as private plaintiffs could recover; so far the SEC in the Enron case has recovered about $400 million for shareholders, compared to the $7.3 billion collected by Lerach.)

Obviously, the plaintiffs in Stoneridge (and Enron) claim that scheme liability is distinguishable from aiding and abetting liability; they claim that with scheme liability the third-party has to be shown to have played a slightly more active role in the fraud than had been required to establish aiding and abetting liability, although the precise definition of that magic extra oomph has varied depending on the court and the facts of the case. The defendants and their amici argue, on the other hand, that scheme liability is just a semantic ploy; it’s old wine in new bottles. For what it’s worth, to me scheme liability and aiding and abetting liability sound like one and the same thing.

In an earlier post on these issues, see here, I came down on the liberal side of this dispute, because of the unfairness of depriving shareholders of the right to sue parties who aided and abetted in the frauds that injured them. (There are very few other areas of the law where aiders and abettors are not liable to the same degree as principals.) But after reading many of the briefs from both sides in Stoneridge, I’ve changed my mind. These issues were decided in 1994, and Congress has twice consciously chosen not to overrule the part of that Court decision that barred private suits against aiders and abettors, which is what Scientific-Atlanta and Motorola really were (if anything) here. Congress decided — reasonably — that shareholder litigation is so fraught with abuse, and is such a grotesquely inefficient and ineffective way of reimbursing fraud victims, that it was wiser to leave the deterrence and punishment of aiders and abettors to the SEC and federal prosecutors.

[This is a guest column by my colleague, Fortune editor-at-large Peter Elkind. Back in the September 4, 2000, issue of Fortune, when the investigation of Milberg Weiss had not yet become public, he wrote a 9,000-word profile of Bill Lerach, available here, providing a remarkably prescient overview of things to come. In November 13, 2006 he wrote a 9,000-word cover story , available here, about what the investigation had unearthed by then.]

By Peter Elkind

I guess, at bottom, no matter how clear the rules, greed, unfettered power or feelings of omnipotence will lead some people into bad conduct.
–Mel Weiss, 2005 interview with Accounting Today

Last week’s events in the slow, stunning fall of plaintiffs’ juggernaut Milberg Weiss make a handful of points painfully clear.

The first is that 72-year-old firm co-founder Melvyn Weiss, indicted Thursday on four felony counts in the long-running federal kickback probe, isn’t just going down with his sinking ship. He’s taking the ship down with him.

In a remarkable statement on the eve of Weiss’ impending indictment, the firm—which has been crippled by its own indictment—announced that Weiss, in response to the new charges, has “decided to discontinue his involvement in firm management.”

No, Weiss isn’t leaving the firm—in fact, he’s not even taking a leave of absence. Far from it. “Mr. Weiss will remain available to counsel clients and Firm attorneys,” Milberg noted, as though offering a reassuring note.

But perhaps this should come as no surprise—even now. Unlike his former colleague, Bill Lerach—who leveraged the appeal to prosecutors of his own guilty plea to strike a plea bargain that protected the new law firm he spun off of Milberg Weiss in 2004—Weiss has stubbornly refused to even step aside, a move prosecutors have long demanded as a first step to any resolution of Milberg’s case. Devastating consequences be damned! This is an enterprise, remember, that represents public pension funds and small investors—and has long trafficked on claiming the moral high ground in the fight against corporate greed and criminality. (For more on Weiss’ missed opportunity to mitigate the damage to his firm, see here.)
How could Milberg’s 25-odd remaining partners put up with such a situation? Because the founder has always had a virtual strangehold on his firm. As one former partner told me last year: Milberg Weiss “was Mel’s world, and everyone else just lived in it.”

The indictment underlines this point. For years, Mel Weiss had veto power over any decision, even as his firm grew to more than 200 lawyers. Between 1983 and 2005, his individual stake in the firm—and its profits—ranged from 13.5% to 39.4%. Weiss’ take during that span: a stunning $209.9 million, according to the government.

If Thursday’s superseding indictment against Milberg, Mel Weiss, and two other defendants is to be believed—and it clearly rests on a solid foundation of evidence from (among others) two former Milberg name partners who have agreed to plead guilty and cooperate with prosecutors—Weiss was at the very center of the firm’s long-running scheme to secretly pay plaintiffs more than $11.3 million in kickbacks in 225 lawsuits.

As the government describes it, Weiss was personally involved in dirty dealings with all three of Milberg’s showcase paid plaintiffs—Steven Cooperman, Seymour Lazar, and Howard Vogel—each of whom secretly received millions for serving as name plaintiff in dozens of Milberg class actions. (Lazar, also a defendant in the case, has pled not guilty. Cooperman and Vogel have pled guilty and are cooperating with the government.) The indictment also ties Weiss to an unnamed trio of Florida residents who were paid to serve as plaintiffs in about 60 more lawsuits.

And the allegations are ugly. Weiss is no longer thinly masked, as he was in earlier government filings, as “Partner A.” The new indictment places him at the scene of the alleged crimes from the beginning.
It has Weiss, in August 1979, informing his number-two man, senior partner David Bershad (one of the now-cooperating former Milberg lawyers) that he had struck a deal with California investor Lazar to serve as a plaintiff in Milberg lawsuits in exchange for 10% of the firm’s attorney fees in those cases.
It has Weiss, in the early 1980s, informing Bershad not to worry about violating the law by paying a Florida plaintiff because they would be making the payments in cash, and thus there would be no paper trail and little risk of getting caught. Indeed, in the mid-1980s, the indictment says, Weiss personally carried “thousands of dollars in cash” from New York to Florida to make payments to two plaintiffs.
The indictment details how Weiss—along with Lerach and Bershad—in January 1986 included a provision in the firm’s partnership agreement that would allow the “conspiring partners” to tap the firm’s coffers to reimburse themselves for cash they’d each kicked in to a slush fund for paying plaintiffs. (Some of this cash was stashed in a safe in Bershad’s office at the law firm.) In December 1987, 1988, and 1999, according to the indictment, Weiss then “caused” the firm to reimburse him a total of about $380,000 in cash for such payments.

It has Weiss, in September 2003, advising name partner Steven Schulman (whose deal to plead guilty and cooperate was also announced Thursday) that because of the ongoing investigation into Milberg Weiss kickbacks, he wouldn’t negotiate a disputed payment to plaintiff Howard Vogel over the telephone. Two months later, according to the indictment, Weiss resolved the matter with Vogel’s lawyer face to face in Milberg Weiss’ New York office.

And finally, the indictment accuses Weiss of obstructing justice and making false statements in withholding an incriminating document that had been subpoenaed by prosecutors.
Weiss’ criminal lawyer, Benjamin Brafman, insisted his client would fight the charges. “We are confident that when the evidence is carefully reviewed at a trial of these charges, Mr. Weiss will be fully exonerated,” Brafman said in a statement.

That, of course, remains to be seen—as does the question of whether Milberg Weiss can survive long enough to witness such an outcome. On that issue, the firm on Thursday issued a second, stiff-upper-lip statement that suggested the gloomy prospects of what was once the most feared law firm in America: “Despite the government’s announcement today we will continue to fight for our clients and class members and to achieve the record recoveries for which our firm has long been known. The firm’s active partners, none of whom is alleged to have been involved in any wrongdoing, will maintain responsibility for the firm’s management and litigation activities. We will not be deterred from our work and will persevere throughout this difficult period.”

My colleague, Fortune editor at large Peter Elkind, has published a piece here reporting the next dominos to drop in the Milberg Weiss investigation: The indictment of name partner and firm founder Melvyn Weiss is expected to be announced tomorrow (Thursday), he reports, while previously indicted name partner Steven G. Schulman is expected to agree to plead guilty.

A quick aside on yesterday’s controversial plea agreement between the government and top defendant Bill Lerach. As reported elsewhere, it is a so-called 11(c)(1)(c) agreement, which means that if the judge approves it, he must order a sentence within the agreed upon range, which here is between 12 months and 24 months. A couple lawyers have commented to me that, despite the “binding” nature of these pleas, judges do, as a practical matter, still have bargaining leverage. That’s because if the judge disapproves such a plea, and says he won’t approve it unless he can impose, say, a 30-month sentence, it’s extremely hard for the defendant to respond by saying, “No, deal’s off, I’m going to trial.” Having crossed the mental Rubicon involved in admitting guilt and beginning to get put everything behind him, it is emotionally difficult to put oneself back into the fighting frame of mind.

In footnote 12 of a relatively obscure, 42-page legal memorandum filed by the government in the Milberg Weiss case yesterday, the prosecutors slipped in a zinger. They quote from testimony of a witness they refer to as “Stockbroker A.” The witness describes how defendant Steven Schulman — a former name partner at Milberg Weiss — would allegedly pass money to him in the process of “procuring individuals willing to serve as ‘named plaintiffs’ for Milberg Weiss.”

According to the testimony (for which, click here), Schulman and Stockbroker A would arrange to meet for breakfast at either a Holiday Inn or a Howard Johnson’s just off the thruway near Newburgh, N.Y. This drop point was selected because it was midway between Albany (about 90 miles to the north), where the stockbroker presumably worked, and Schulman’s New Jersey home (about 70 miles to the south). Stockbroker A would be accompanied by another man whose identity has been whited out in the copy of the testimony appended to the government’s papers. Here’s how the transcript goes from there:

A. We would be sitting at a table, having breakfast, and Mr. Schulman had a briefcase that was under the table, and I had my briefcase under the table. I would take out what was in his briefcase and put it into my briefcase, give him back his briefcase, close up my briefcase. And there were packages of hundred-dollar bills, packs of hundred-dollar bills.

Q. So the money was passed, literally, underneath the table?

A. Under the table.

[...]

Q. And then after you would receive the cash from Mr. Schulman, did you and [name whited out] do anything with respect to counting it or verifying that you had received what you had expected to receive from him?

A. Occasionally, there’s a men’s room that we’d go in and sometimes split it up right on the side.

This scene seems at odds with the one painted on the firm’s MilbergWeissJustice.com site, where it contends that: “Referral fees are an entirely legal, common and efficient way of ensuring that lawyers refer cases to specialists, such as Milberg Weiss, that have the resources and experience to handle complex litigation.” (See here.)

I’ve just emailed three of Steve Schulman’s attorneys seeking comment; I’ll print it when I get it.

(Thanks to Fortune editor at large Peter Elkind for noticing the footnote and telling me about it. )

In footnote 12 of a relatively obscure, 42-page legal memorandum filed by the government in the Milberg Weiss case yesterday, the prosecutors slipped in a zinger. They quote from testimony of a witness they refer to as “Stockbroker A.” The witness describes how defendant Steven Schulman — a former name partner at Milberg Weiss — would allegedly pass money to him in the process of “procuring individuals willing to serve as ‘named plaintiffs’ for Milberg Weiss.”

According to the testimony (for which, click here), Schulman and Stockbroker A would arrange to meet for breakfast at either a Holiday Inn or a Howard Johnson’s just off the thruway near Newburgh, N.Y. This drop point was selected because it was midway between Albany (about 90 miles to the north), where the stockbroker presumably worked, and Schulman’s New Jersey home (about 70 miles to the south). Stockbroker A would be accompanied by another man whose identity has been whited out in the copy of the testimony appended to the government’s papers. Here’s how the transcript goes from there:

A. We would be sitting at a table, having breakfast, and Mr. Schulman had a briefcase that was under the table, and I had my briefcase under the table. I would take out what was in his briefcase and put it into my briefcase, give him back his briefcase, close up my briefcase. And there were packages of hundred-dollar bills, packs of hundred-dollar bills.

Q. So the money was passed, literally, underneath the table?

A. Under the table.

[...]

Q. And then after you would receive the cash from Mr. Schulman, did you and [name whited out] do anything with respect to counting it or verifying that you had received what you had expected to receive from him?

A. Occasionally, there’s a men’s room that we’d go in and sometimes split it up right on the side.

This scene seems at odds with the one painted on the firm’s MilbergWeissJustice.com site, where it contends that: “Referral fees are an entirely legal, common and efficient way of ensuring that lawyers refer cases to specialists, such as Milberg Weiss, that have the resources and experience to handle complex litigation.” (See here.)

I’ve just emailed three of Steve Schulman’s attorneys seeking comment; I’ll print it when I get it.

(Thanks to Fortune editor at large Peter Elkind for noticing the footnote and telling me about it. )