Jones Day: Did It Do Its Duty In The Keating Affair?

In February, 1986, lawyers at Jones Day Reavis & Pogue were all set to cash in. The Cleveland-based law firm had signed on to represent Charles H. Keating's Lincoln Savings & Loan of Irvine, Calif., one of the new breed of thrifts profiting from Washington's deregulatory spirit. The firm had assembled a team of 30 lawyers for the lucrative task of reviewing Lincoln's books in preparation for an examination by banking regulators. Jones Day even had the perfect lawyer to head up the work, a Washington partner who had been chief examiner for the federal agency overseeing the thrift industry.

Fast forward six years. The 99-year-old firm of 1,200 attorneys, with such blue-chip clients as Citicorp and Pepsi, finds itself in an unfamiliar role. One of the world's largest law firms is now a defendant in a $50 million suit filed by the Resolution Trust Corp., the successor to the federal agency that in 1989 closed down the high-flying Lincoln. The RTC wants to hold Jones Day partly responsible for the demise of Lincoln, whose failure is expected to cost taxpayers $2.6 billion. It's "a garden-variety malpractice claim," says Michael Manning, a Phoenix lawyer representing the RTC.

Yet a review of dozens of documents in the case suggests that Jones Day isn't just another group of professionals blinded by big fees to its clients' misdeeds. Court records show that the firm uncovered numerous irregularities and informed the general counsel about the practices. In fact, its insistence that Lincoln mend its ways and come clean with regulators cost Jones Day an assignment that netted it $1.3 million in fees before it was replaced by Kaye Scholer Fierman Hays & Handler in July, 1986.

The Jones Day lawyers, who deny any wrongdoing, are in trouble with regulators even though they were shown the door. The RTC says the firm neglected its duty to Lincoln by not informing the thrift's board of the problems it uncovered, especially since some of the abuses involved Lincoln officials. The dispute, which is set for a trial this fall, goes to the heart of the attorney-client relationship. Typically, when a lawyer represents a corporation and suspects a corporate official of wrongdoing, ethical rules suggest that the lawyer take the matter to a higher authority, even to the board. But these are gray areas, and such actions are rare.

In the Jones Day case, the issue was further clouded: The firm had two clients, Lincoln and its parent, American Continental Corp. Jones Day reported the problems in Lincoln's files to ACC's general counsel. But the RTC alleges that ACC was using Lincoln for its own benefit. The RTC argues that Jones Day's failure to inform Lincoln's board was motivated by its "fear of alienating Keating." Jones Day claims that the ethical rules dictate going to the board only when lawyers know of continuing, and not past, wrongdoing.

`BLOODY HARD PLACE.' The case against Jones Day is but one of a slew that banking regulators have filed against the professionals who helped Lincoln and its go-go industry brethren operate at the law's edge. In the most dramatic action so far, the Office of Thrift Supervision in March sought $275 million in damages from Kaye Scholer. The government had accused the firm of assisting Lincoln's abuses. Facing an asset freeze, the firm quickly settled for $41 million. But the case prompted the American Bar Assn. to form a task force on Mar. 31 to address the role of lawyers in regulated businesses. "A lawyer is caught between a rock and a bloody hard place," between a duty to clients and duty to the state as an officer of the court, says Henry Kelly, former ABA chief on professional liability.

When Jones Day snagged Lincoln as a client, it was sure it knew the rules of the game. William Schilling, the Washington partner overseeing the review team and a defendant in the RTC suit, had headed the examination and supervision staff of the Federal Home Loan Bank Board, then the chief government thrift regulator. Jones Day's role would be circumscribed. It had almost no direct dealings with regulators, reviewing only past loans and investments and giving no advice on prospective deals.

The lawyers quickly detected that Lincoln lacked the loan documentation that regulators would demand. Dozens of loans, many in excess of $1 million, had been granted without any risk analysis or proof of the borrower's credit. The S&L often hadn't obtained routine appraisals or cash-flow projections of properties. Jones Day found that a Lincoln employee had back-dated documents and had signed the directors' names on board minutes. The Jones Day lawyers urged ACC and Lincoln's in-house lawyers to notify regulators and to remedy such practices. Thrift officials assured the firm that the irregularities wouldn't reoccur, say court papers.

Among the questionable transactions Jones Day reviewed was the sale, at nearly twice its original price, of the Hotel Ponchartrain in Detroit by one Lincoln subsidiary to a limited partnership whose members included Keating and members of Lincoln's legal department. The thrift hadn't gotten the regulatory approval for such an inside deal.

Rather than counsel Lincoln to fight with thrift regulators, as Kaye Scholer later would do, Jones Day advised a conciliatory approach. The firm even threatened to resign when it learned its advice against tampering with corporate minutes had been ignored. "We did not urge ACC and Lincoln to embark on a course of confrontation," says managing partner Richard W. Pogue. "Indeed, our advice was to the contrary."

It was advice that would cost Jones Day its job at Lincoln. In a move that now seems ironic, Jones Day was replaced by Kaye Scholer. An internal Kaye Scholer memo noted that Jones Day's lawyers had a negative view of Lincoln's lending practices and that this had created "a situation of mutual distrust and animosity."

The RTC does not dispute that Jones Day discovered discrepancies in Lincoln's files and brought the problems to Lincoln's lawyers. But the RTC says the law firm should have done more. "Jones, Day merely acknowledged the existence and the illegality of the abuses to the individuals who were responsible in the first place for the wrongdoing," the RTC argues in court papers.

NO NEST EGGS. Jones Day says it had no duty to go to Lincoln's board. "Jones, Day did exactly what it was asked to do," the firm argues in its court briefs. What's more, the firm counters, Lincoln's board learned of the regulatory problems within months of Jones Day's ouster when federal examiners presented their findings to Lincoln's directors. All in all, the examiners determined Lincoln would be more than $50 million short of the net worth required to meet federal capital standards. "They're in right on our heels, they find out what we find, and it takes them two more years to close this institution down," says one Jones Day lawyer.

Proving that the law firm's failure to notify Lincoln's board actually led to the thrift's demise could be the government's biggest hurdle. Jones Day gave a preview of its argument in March when it defended itself against similar charges brought by investors who bought ACC bonds. "Jones, Day was going down the track of regulatory advice, it was shunted aside to not deal with the regulators," Los Angeles lawyer Max Gillam told jurors. "Kaye, Scholer took over dealing with the regulators, and Jones, Day did other kinds of work for Lincoln/ACC with no reason to suspect that the client was not following their advice."

Of course, the best arguments don't always win cases. Jones Day chose to settle the bondholders' suit for $23 million rather than leave the verdict to jurors. The government case may be different, though. Unlike the bondholders' suit, widows' nest eggs aren't at stake. And the law firm will try to make the government's delay in shutting down Lincoln an issue. If Jones Day proceeds to trial this time, professionals may not have to wait until the next big scandal for some firm ground rules.

      FEBRUARY, 1986 Charles Keating hires the law firm Jones Day Reavis & Pogue to 
      review whether the loans and investments of Lincoln Savings & Loan Assn. 
      violate federal law
      APRIL, 1986 Jones Day tells Lincoln officials the thrift has serious problems 
      with incomplete loan files, back-dated corporate records, and questionable 
      JUNE, 1986 Federal regulators, who had reviewed the same files as Jones Day, 
      notify Lincoln of its potential problems
      JULY, 1986 Lincoln fires Jones Day and hires the New York law firm of Kaye 
      Scholer Fierman Hays & Handler. An internal Kaye Scholer memo later suggests 
      that Jones Day had antagonized the thrift's officials with its findings
      APRIL, 1989 Federal regulators shut down Lincoln. At $2.6 billion, Lincoln 
      becomes the largest thrift failure in U.S. history
      APRIL, 1991 The Resolution Trust Corp. files a $50 million suit against Jones 
      Day alleging breach of fiduciary duty for failing to tell Lincoln's board about 
      the thrift's questionable practices. The firm claims it wasn't obligated to 
      tell the board
      MARCH, 1992 Jones Day settles a suit by Lincoln bondholders for $23 million. 
      The RTC case is set for trial in the fall
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