Suit alleges big law firm let Ponzi scheme unfold

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PHILADELPHIA -- After W. Roderick Gagne's law firm here disbanded 10 years ago, he joined the city's bigger and more prestigious Pepper Hamilton. He brought along a young client named Andrew Yao, whose business involved repackaging loans to students at trade schools.

The relationship was lucrative for Pepper Hamilton, which billed Mr. Yao $3.2 million over six years. It also was helpful for Mr. Yao, who was able to use his tie to an old-line Philadelphia law firm to help persuade a bank to lend to him.

And the relationship worked for Mr. Gagne himself, though in an unorthodox way: For years, the law partner's family lent millions of dollars to his law client, at interest rates as high as 15 percent.

Then Mr. Yao's business collapsed. A federal prosecutor in Delaware later charged Mr. Yao with fraud and money laundering. And Pepper Hamilton, a 117-year-old law firm with 11 offices and 450 lawyers, is caught in a messy legal dispute, accused in an insurer's suit in federal court in Delaware of having been "essential to (Mr. Yao's) success as a ponzi-like scheme."

The business collapse led to $500 million in losses, says another suit in the same court, filed by a bankruptcy trustee overseeing the liquidation of Mr. Yao's business. Both suits allege Pepper Hamilton helped hide the fact that growing numbers of the student loans were in default. The trustee also alleges a conflict of interest at Pepper Hamilton, because the firm simultaneously represented Mr. Yao's business and Gagne family members who lent to it.

Mr. Gagne referred calls to Pepper Hamilton's executive partner, Robert Heideck, who said the law firm acted appropriately and "denies each and every allegation." He said any conflicts of interest in Pepper Hamilton's representation of Mr. Yao's firm -- called Student Finance Corp., or SFC -- were waived in writing by all concerned.

"When we learned that everything was not as it had been represented by SFC, Pepper insisted that SFC make immediate disclosure and take immediate internal corrective actions," he said. "After it failed to comply, we withdrew any further representation." Mr. Gagne, 52, remains at Pepper Hamilton.

SFC's founder, Mr. Yao, couldn't be reached. He has pleaded not guilty. Someone who was his attorney until recently declined to comment. His new attorney didn't return calls.

Pepper Hamilton was founded in 1890 by George Wharton Pepper, who years later successfully argued Major League Baseball's case for an antitrust exemption before the Supreme Court. The firm has expanded rapidly in recent years. In 1997 it absorbed nine lawyers from a crosstown firm that was disbanding, Clark Ladner Fortenbaugh & Young. Among them was Mr. Gagne, a tax-planning specialist, who brought along a top client: Mr. Yao.

A son of Chinese immigrants, Mr. Yao was an ambitious but little-known entrepreneur in the student-loan business. When he sought a $25 million bank line of credit in 1999, Mr. Gagne vouched for Mr. Yao's probity and business skills, according to testimony by an officer of the bank lender, Wilmington Trust, which years later sued Mr. Yao. Other lenders and insurers also were provided with documents prepared by Mr. Gagne that detailed the quality of Mr. Yao's student-loan portfolio.

Mr. Yao rose swiftly within Philadelphia society. He paid himself at least $26 million from his business between 1995 and 2002, according to a suit by the bankruptcy trustee against Mr. Yao, in federal bankruptcy court in Delaware. He and his wife lived in a $1.8 million home on the Main Line and joined the Merion Cricket Club. The couple bought a New Jersey beachfront home, then traded up to a 6.5-acre estate in Nantucket. They began building a home in Bryn Mawr, Pa., containing 33,000 square feet, his wife said in a deposition for a lawsuit, later settled, by Wilmington Trust.

The couple also owned two jet planes, a boat, several luxury cars and a chauffeur-driven limousine, she said, and employed a personal chef. They were active on the charity circuit, pledging $500,000 toward a new Philadelphia Orchestra hall. At an auction, they paid $178,000 for a spacesuit said to have been worn by Neil Armstrong and donated it to the Franklin Institute space museum.

Mr. Yao, now 45, was also a bit of a carouser, according to testimony taken for Wilmington Trust's suit in Pennsylvania state court in Montgomery County. The bank cited wire-transfer records showing he spent $150,000 on a pair of Las Vegas trips and wired $650,000 to Alexandria "Lexie" Karlsen, Playboy magazine's Miss March 1999. Asked about this in a deposition, Mr. Yao initially said that he didn't know Ms. Karlsen and that the money was for repairing and maintaining his jets. When shown a photo of himself and Ms. Karlsen at the Playboy Mansion, he said the cash was for "a movie project that didn't go anywhere." The federal indictment of Mr. Yao last year accuses him of making false statements about these wire transfers, in another deposition.

Ms. Karlsen, 28, says that she dated Mr. Yao for about four months in late 2001 and that the money was a gift. "I don't know how to fly an airplane and I was never in the movies," she said in an interview.

Mr. Yao's business model was simple. His company, SFC, lent to students or purchased loans already made to them by their trade schools, many of which taught truck driving. SFC bundled the loans and sold notes based on them, promising investors fixed returns that came via the repayment of the loans. He could make money, in part, by buying the loans at a discount.

It seemed like a sure bet both for the banks that funded SFC and for note investors, because the student loans carried insurance promising to repay them even in the event of fraud.

The insurer was Royal Indemnity Co., a U.S. unit of London-based Royal & Sun Alliance Insurance Group PLC. Royal Indemnity now contends in a suit against Pepper Hamilton that Mr. Yao's business conspired with schools to make loans to students who were uncreditworthy and not employable as truck drivers.

The suit cites a 2001 memo in which an SFC manager told colleagues that some schools had issued loans to students with criminal records and physical or mental handicaps. At some schools, it says, more than 80 percent of loans weren't repaid. The trustee's suit adds that SFC itself owned interests in some trade schools.

SFC soon faced a cash-flow problem. Mr. Yao, in a December 1998 email to Mr. Gagne at Pepper Hamilton, mentioned a "$1.5 million shortfall" for the month. Mr. Yao asked if the man who had introduced the two of them -- Mr. Gagne's uncle, Robert Bast -- could "invest" that much in SFC to cover the gap, the trustee's suit says.

To mask high student-loan default rates, both the trustee's suit and Royal Indemnity's suit say, SFC sometimes made loan payments on behalf of the nonpaying students, calling these "forbearance payments." Mr. Gagne was "aware of SFC's practice of making payments to disguise student loan default rates from at least 1999," says Royal Indemnity's suit. The trustee's suit cites an email from Mr. Gagne to Mr. Yao in February 1999 saying, "You will just have to hit the school reserves in the normal course to fund the defaults."

A year later, in March 2000, Mr. Gagne told Mr. Yao that using company funds to make students' payments could be viewed as "manipulating the (loan) pool performance," according to the trustee's suit.

SFC not only continued the practice but increased it. SFC's forbearance payments totaled $2 million in 1999, $9.5 million in 2000 and then $45 million in the year leading up to SFC's June 2002 bankruptcy filing, according to the trustee's suit. Pepper Hamilton is just one of a number of parties the trustee is suing.

The other litigant facing off against Pepper Hamilton, insurer Royal Indemnity, maintains it relied on "fraudulent" information from the law firm in agreeing to sell insurance to SFC.

Royal's suit says the law firm failed to disclose "ghost payments" that SFC made to mask defaults. Royal -- which itself used Pepper Hamilton as legal counsel, in an unrelated matter -- argues that Mr. Gagne and his law firm "were SFC insiders and had every incentive to ensure the success of SFC's fraud."

Mr. Heideck denies Pepper Hamilton has any culpability. "Apparently, there were many people who were misled by Mr. Yao," he said. He also said that "Royal was responsible for determining the adequacy of the loans it insured."

Despite SFC's troubles, Mr. Gagne's family and relatives continued to lend. His uncle, Mr. Bast, was the biggest family lender, but they also included Mr. Gagne's wife and family trusts of which Mr. Gagne was a beneficiary. Their reasons for doing so haven't been explained.

In 2000, the bankruptcy trustee's suit says, Gagne family members lent SFC $6 million that was later repaid with interest plus a 7 percent "payoff premium." The interest rate itself varied from 10 percent to 15 percent on loans from the family, the suit says. Mr. Heideck says 15 percent was "at of below the market rate" for loans of that type.

Sometimes Mr. Gagne billed SFC to prepare documents for the loans and also signed them on behalf of his family members.

American Bar Association rules of conduct say lawyers shouldn't represent a client if "a personal interest" might limit their representation. They also must not have "a business transaction with a client." But the ABA rules make an exception if a transaction is fair to the client, is spelled out in writing, and is consented to by the client in writing.

Mr. Heideck says that "every single conflict was waived by the interested parties." According to the bankruptcy trustee's suit, Mr. Gagne twice sent Mr. Yao conflict-waiver letters and encouraged Mr. Yao to retain separate counsel because of "inherent conflicts of interest." Mr. Heideck says, "We were confident (Mr. Yao) signed whatever appropriate waivers there were or agreed to the waivers."

The trustee's suit says others at Pepper Hamilton should have known all wasn't right at Mr. Yao's business. In late 2001, the suit says, SFC hired a risk-management director named Kirk Monteverde, who quit after two weeks saying that SFC had "misrepresented its financial position." The suit says Pepper Hamilton attorneys prepared a severance agreement for Mr. Monteverde that paid him $150,000 and barred him from disclosing details about his work at the company. Mr. Monteverde declined to comment.

Without elaborating, Pepper Hamilton's Mr. Heideck said the "facts support our position and not the trustee's."

By early 2002, more difficulties at SFC prompted another injection of funds. Gagne family members and family trusts lent SFC $3.3 million on March 5, 2002, to "keep SFC financially viable long enough for the family to recoup their investments," the trustee's suit contends. It puts the total amount that the Gagne family lent to Mr. Yao's company at more than $35 million.

Two weeks later, Mr. Yao met with Royal Indemnity in Delaware and told the insurer SFC had been making forbearance payments to keep student loans from being reported as in default, Royal says in its suit. Royal canceled the policies insuring repayment of the loans, leaving SFC with scant ability to borrow more or attract new investors.

With SFC on the brink of collapse, Mr. Gagne sent a memo to his law partners on April 18, 2002, telling them SFC had "lied" to its investors, insurers and others and had destroyed executive-committee minutes. He said that no one at SFC "ever fully disclosed the use of the forbearance accounts" and that SFC officers lied about the issue in his presence. Excerpts of the memo are cited in both lawsuits against Pepper Hamilton.

Mr. Gagne's memo suggested that Pepper Hamilton stop representing SFC, and described the cascade of problems this step would cause. First, it would raise a cloud over SFC with both banks and investors, making it hard for the company to survive. And if it went under, another Pepper Hamilton client, Royal Indemnity, would be responsible for hundreds of millions of dollars in unpaid student loans.

"Adding to the ethical considerations is the fact that members of my family and trusts in which I am a beneficiary have made loans" to SFC, Mr. Gagne told his partners. He added: "We need to recognize the possibility that this firm will be sued."

He then took steps to make sure his family was repaid, securing a personal guarantee from Mr. Yao, says the trustee's suit. Mr. Yao emailed Mr. Gagne on April 23, 2002: "I will protect your family's investment in SFC, notwithstanding any adverse outcome that may result." According to the trustee's suit, to help repay the Gagne family, Mr. Yao pledged an interest he had in a chain of trade schools.

The next day, Pepper Hamilton withdrew its representation of SFC. The withdrawal led auditors to decline to endorse SFC's financial statements for 2001.

On June 3, 2002, Mr. Gagne told his uncle, Mr. Bast, a he had spoken with Mr. Yao and "learned we will not be receiving the SFC checks for a while." Two days later, four trucking schools petitioned the bankruptcy court to force SFC to liquidate, a process that is continuing.

Last March, federal prosecutors in Delaware indicted Mr. Yao on 14 counts of fraud, false statements and money laundering. A trial is set for this March on some of the counts. Pepper Hamilton's own day in court, against the bankruptcy and insurance company suing it, is scheduled for October.



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