It appears that the drain of paying for criminal defense attorneys is having an impact even on mega-plaintiffs lawyer Dickie Scruggs, whose share of fees from the late 1990s tobacco settlements is thought to have approached $1 billion.

Since September 2006, Scruggs had been paying all fees and expenses for two “whistleblowers” who had been sued by their employer due to actions they’d taken to assist Scruggs in his assault on the insurance industry over its post-Hurricane Katrina claims-handling practices. (Basically, they stuck their necks out for him, so he was covering their back-sides.)

But on Tuesday, one of the two law firms defending the whistleblowers – Cori and Kerri Rigsby – asked to withdraw, citing “the inability of the Rigsbys and others” to pay its fees going forward or to even “adequately satisfy existing fee and expense obligations.” The motion is here.

The withdrawing firm is Washington, D.C.’s Zuckerman Spaeder, and its team was led by William W. Taylor, III, who is also the lead criminal defense lawyer for indicted class-action firm Milberg Weiss (or, as of today, Milberg LLP, see here). I have a call into Mr. Taylor, but given today’s activity in the Milberg case – founding partner Mel Weiss’ expected guilty plea, see here – I suspect I may be low down on his call-back list. Scruggs’ counsel, John Keker, declined to comment on Zuckerman’s motion and what it might mean.

The Rigsby sisters’ employer, E.A. Renfroe & Co., sued them in September 2006 for allegedly violating their employment contracts by photocopying confidential documents belonging to State Farm (to whom Renfroe was supplying supplemental claims-adjusters) and giving them to Scruggs. In addition to paying the Rigsbys’ costs of defending the suit, Scruggs had also taken on at least an oral commitment to indemnify the sisters for any judgment they might ultimately incur, according to a statement filed by the Rigsbys’ lawyers last December. See here.

Scruggs pled guilty Friday to conspiring to bribe a Mississippi state judge in Oxford in 2007, but his legal problems are not over. Prosecutors in Oxford contend he was involved in attempting to bribe a different state judge in Jackson in 2006, and a different set of prosecutors in Birmingham, Ala., are pursuing him on a criminal contempt charge, arising from Scruggs’ alleged defiance of a December 2006 court order. (The contempt charge was dismissed on February 29, but the Alabama prosecutors are contemplating an appeal.)

Scruggs is also likely paying the criminal defense costs of his son and co-defendant, Zach Scruggs, who faces trial March 31, and currently has at least 7 lawyers at 4 firms representing him, according to electronic court records. One would also expect that Scruggs would be footing the bills for his law partner Sid Backstrom, who also pled guilty Friday.

According to the withdrawal motion, the Rigsbys will continue to be represented by Birmingham’s Battle Fleenor Green Winn & Clemmor, who were also previously paid by Scruggs.

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.

[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.

“We hate them,” says class-action lawyer Russel “Cap” Beatie, Jr., referring to his competitors at the now-indicted firm of Milberg Weiss. “We’d like to step out into the back alley and shoot it out with them.”

Beatie, of Beatie & Osborn, filed last week’s class-action civil RICO suit against Milberg Weiss (the WSJ’s law blog item about it is here), which he candidly characterizes as “in the nature of a religious crusade.” Blustery and profane, Beatie says he blames Milberg Weiss for blackening the reputations of all class-action firms, thereby strengthening the hand of tort reformers. But there’s little question that his suit is even more personal than that.

The named plaintiffs in Beatie’s suit are six members of class actions in which Milberg Weiss served as lead counsel. In part, the complaint repeats, of course, the charges contained in the government’s May 2006 federal indictment, which alleges that the firm secretly paid named plaintiffs in more than 150 cases to induce them to neglect their duty to look after the interests of absent class members.

But Beatie’s suit also goes beyond the indictment, showcasing charges in which the most obviously injured parties (assuming there was wrongdoing) were Milberg Weiss’s rival firms in the class action bar — like Beatie & Osborn, for instance. (Neither Beatie’s firm nor any other plaintiffs firm is actually named as a plaintiff, however.) Beatie claims that Milberg Weiss repeatedly inflated its clients’ losses in court filings in order to trick the judge into appointing it “lead counsel” in the case. The lead counsel controls the case and gets the lion’s share of the attorneys fees. Beatie’s suit alleges misconduct along these lines in shareholder litigation involving Network Associates (MFE), Oxford Health Plans (UNH), Safeskin Corp. (KMB), Linux VA (LNUX), Aurura Foods, Chubb (CB), Waste Management Inc. (WMI), MicroStategy (MSTR), Sonus Networks (SONS), and Organogenesis. Beatie’s firm had unsuccessfully sought lead counsel status in at least three of these cases.

Two Milberg Weiss spokespersons failed to respond to emails left Friday seeking comment. (The firm’s position on the indictment is laid out at MilbergWeissJustice.com. There it proposes as the firm’s calling card: “Committed to the Truth.”)

In fairness, computation of losses is often not simple — clients may have made lots of buys and sales during the class period, for instance, and some of them may have held short positions as well as long positions. Honest mistakes undoubtedly occur.

When class actions are initiated, many law firms will usually file very similar complaints, all vying to represent the same class of shareholders. Until 1995, the first to file suit had an advantage in winning the lead counsel designation, resulting in an unseemly “race to the courthouse.” In an attempt to end that phenomenon, a 1995 federal reform law dictated that, beginning in 1996, the law firm that represented the plaintiff with the largest claimed losses was now supposed to win lead counsel status, all things being equal.

Accordingly, one of the first things that happens in a class action filed today is that the rival plaintiffs firms submit “certificates of loss” purporting to set out their clients’ losses in share value during the class period. But, in practice, the accuracy of these certificates tends to rely on the honor system, since the depositions and document production that are needed to verify or disprove their accuracy usually will not occur until many months after the lead counsel has already been selected. By that time the lead counsel is already deeply steeped in the minutiae of the case, and the rivals firms are long gone from the scene. If an error in a certificate comes to light at that late date, a judge may be loath to throw a wrench into everything by forcing a expensive, time-consuming change in counsel.

In the MicroStrategy case, for instance, Judge T.S. Ellis III of Alexandria, Virginia, chose Milberg Weiss as co-lead counsel in 2000 because its client, a union pension fund, claimed $610,000 in losses — the most among institutional clients vying for the lead plaintiff role. Many months later, though, when the fund was being prepared for depositions, Milberg Weiss said it discovered that the fund’s losses were actually only $80,000. Judge Ellis acknowledged that, if not for the mistake, he never would have appointed Milberg Weiss co-lead counsel. Nevertheless, he also found that Milberg Weiss’s error was “innocent, an act of negligence rather than bad faith,” and imposed a very modest penalty on the firm — about $50,000 out of a $25 million fee.

Evidently Beatie hopes that in light of the government’s criminal allegations — e.g., the secret safe in the credenza (see here), the cash passing under the table at a Howard Johnson’s (see here), etc. — Milberg Weiss may lose the benefit of the doubt that it has previously enjoyed.

RICO suits offer plaintiffs the prospect of treble damages, and the number Beatie hopes to multiply by 3 would not just be the $11 million in kickbacks that Milberg Weiss allegedly paid to three professional plaintiffs, according to the indictment, but the entire $216 million the firm recovered in fees from those cases. (Each of those benchmarks may be low, since the government has now located at least three additional plaintiffs in Florida whom it claims were also regularly paid by Milberg Weiss, according to the statement of facts submitted in connection with David Bershad’s guilty plea last month. See here.)

Losing your entire fee used to be the standard penalty for disloyalty to a client, regardless of whether the client was harmed, according to ethics professor Stephen Gillers of New York University Law School. In the last 15-20 years, however, many courts have softened that draconian rule, Gillers continues, and they now may consider the extent of the misconduct, whether it was intentional, and the evidence, if any, of actual harm. Since class members’ settlement awards in all these cases were ultimately approved as “fair” by the presiding judges, actual harm may be difficult to prove here.

A gay S&M sex club, closed down in November by New York City health authorities for allegedly constituting a criminal nuisance, operated for seven years out of a small Lower East Side building co-owned by a Milberg Weiss attorney, who also lived on the premises.

The attorney, Paul D. Young, 48, was a partner at Milberg Weiss until late January or early February 2005, when his status at the firm changed to “of counsel,” which is what it remains today. Neither he nor the firm would comment on why his status changed — or, indeed, on any other aspect of this article. (“Of counsel” is a grab-bag term with many meanings; sometimes it refers to partners who are retired or semi-retired, or phasing out their practices.)

Young, a Fulbright scholar who graduated from Yale college and Columbia Law School, handles shareholder and consumer class actions for the firm. He has been involved in cases against such defendants as Tyco International (TYC), Bear Stearns (BSC), electronics manufacturer Flextronics (FLEX), and uranium supplier USEC Inc. (USU).

(Milberg Weiss and two of its name partners were indicted in May 2006 on unrelated federal charges of secretly paying plaintiffs in at least 180 cases and lying about that fact to courts. See prior posts here and here, for instance, and a Fortune feature story by editor at large Peter Elkind here. The firm and one indicted partner, Steven Schulman, have pleaded not guilty, while the other indicted partner, David Bershad, pled guilty earlier this month.)

In 1998, Young and another man, Peter H. Hochschild, 50, bought a small, three-story tenement at 253 East Houston Street. Both men live on the premises, according to voter registration records. (Reached by cell phone, Young hung up after I identified myself and said that I was calling about the sex club, called El Mirage. He has not responded to voice messages left at his home and office numbers. Through a spokesperson, the Milberg Weiss firm also declined to comment on any aspect of this article.)

In 1999, Young and Hochschild leased out the basement and first floor to a newly formed tenant called the El Mirage, which held itself out to be a male nudist club. According to health authorities, it was a place where men went to have anonymous sex with one other. A club membership cost $40, each admission cost $22, and the fee for the mandatory clothes-check was $3, according to the affidavit of an undercover health inspector that was later filed in court.

Since 1985 the New York State and City health laws have forbidden commercial establishments from making “facilities available for the purpose of sexual activities where anal intercourse . . . or fellatio take place.” In the context of the AIDS epidemic, the state’s Public Health Council had determined these to be high-risk activities posing a “threat to the public health.” (In 1994 “vaginal sex” was added to the list of “high-risk” activities.)

That the El Mirage was a sex club was a fairly open secret, and blog entries and online gay tourism guides have been describing it as such since at least 2001. Several pornographic gay S&M movies have been promoted as having been filmed there. Culture critic Michael Musto of the Village Voice reviewed the El Mirage as a “sex club” in December 2005. See here. Musto wrote that upon paying his fees he was handed a “frequent f—er’s card” that would entitle him to one free admission after 18 visits. (Musto reviewed the club poorly, complaining that “every single guy there seems to be a five.”)

In March 2006 the New York City Department of Health and Mental Hygiene sent an undercover inspector into the club, who later described it in an affidavit as having been equipped with such features as a “tree-house,” two “swings” (I think they are more often called “slings”) and “an enclosed corner dungeon room.” He observed multiple acts of anal sex and fellatio occurring there, as he did on each of about 15 subsequent inspections throughout March, April, and May. The patrons also often used “inhalants (poppers)” while having sex, he noted.

In early June 2006, the department sent warnings to Young, Hochschild, the club, and its manager warning them of what they had observed, advising them these such activities violated state and city laws, and demanding abatement of the nuisance. The El Mirage’s attorney responded to the department on June 20, stating that his client would address the situation. (There is no record in the court file of any response to the warning specifically from Young or Hochschild, who were both later represented by Young.)

The inspector then resumed his undercover visits. Throughout June, July, August, September, and October, he continued to observe fellatio and anal sex occurring there “at an alarming rate,” according to his affidavit. In all, after about 30 visits (for the sake of the City’s taxpayers, one hopes he used his “frequent f—er’s card”) he reported observing 228 acts of anal sex or fellatio involving 232 people. I suspect that “228” was a typo and that “128” is what he meant to write, but it obviously doesn’t really matter. At least as much sex was occurring at the club after the warning as before it.

On November 3, 2006, the City and the health department sued Young, Hochschild, the premises, the El Mirage, and the El Mirage’s manager in state supreme court in Manhattan. The city sought to close down the club. The complaint accused all defendants of maintaining a criminal nuisance under Penal Law 240.45 (a misdemeanor) and threatening the public health.

The health laws in question make no distinction between unprotected sex and protected sex, but in his affidavit the undercover inspector stated that virtually all acts of fellatio were unprotected (i.e., without condoms), while about 20% of the anal sex acts were unprotected. After the club was shut down in November, its attorney, Paul O’Dwyer, argued to a gay newspaper, see here, that this data actually reflected well on the club, since he regarded unprotected anal sex as the only truly high-risk activity, and 80% of the anal sex going on at the club was protected.

On November 15 the court granted a temporary restraining order shutting down the club until a hearing could be held. Two weeks later, the day before the hearing was to take place, the parties settled, with the defendants agreeing to essentially all of the city’s requested relief ­- expelling the tenant, shutting down the commercial space for a year, and requiring Young and Hochschild to obtain the City’s approval of any new tenant before reopening.

New York’s professional conduct rules forbid attorneys from engaging in “illegal conduct that adversely reflects on the lawyer’s honesty, trustworthiness or fitness as a lawyer” or, even more open-endedly, “any other conduct that adversely reflects on the lawyer’s fitness as a lawyer.”

“This conduct could fall within either rule,” says Stephen Gillers, a law professor and professional responsibility expert at New York University, “but I think that is only likely based on the conduct of continuing the activity following notice of its illegality” — i.e., after the City sent out its letter of warning in June 2006.

As for the firm’s responsibilities upon learning of the situation — if it ever did learn of the situation — Gillers says it would mainly face a practical business decision: weighing the need to protect itself “against adverse publicity” against that attorney’s value to the firm. He continues: “A firm is not required to police a lawyer’s private life. This is not a client-related activity. . . . I don’t think this conduct, even if conscious, would trigger a reporting duty” — referring to the obligation that an attorney sometimes has to, basically, rat out a fellow attorney to the bar disciplinary authorities if the latter’s ethical violations are serious enough.

The closest analogy to this situation that I could find from a quick look at the case law was a situation that the New Jersey Supreme Court considered in 1987. There an attorney had co-owned a strip club in New York where, once a year, on Mardi Gras night, performers would interact sexually with patrons in exchange for tips. The court approved a two-year suspension of the attorney’s license.

So, readers, I think the case tees up at least three issues ripe for comment, though you may see others:

1. Do the health department’s accusations against Young have any bearing on an attorney’s fitness to practice?

2. Does Milberg Weiss, once it finds out about the situation, have any obligation to act in any way?

3. Should I have written this story at all?

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. )