Wealthy investors sue Alex. Brown over losses

Market plunge in 2000 wiped out funds intended to avoid capital gains tax

May 27, 2004|By Paul Adams | Paul Adams,SUN STAFF

As wealthy executives and founders of some of the fastest-growing companies in America, they could afford some of the best financial advice that money can buy.

But in hundreds of pages of legal documents, lawyers for dozens of well-heeled corporate titans say that former Alex. Brown Management executives in Baltimore misled them in a pair of niche investments that were supposed to help participants avoid paying taxes in the late 1990s while diversifying their sizable portfolios.

Lawyers allege that instead of getting shares in two diversified investment funds safely hedged against market losses, the executives, who paid a minimum of $1 million each, joined funds that were loaded down with volatile technology and telecommunications stocks that plunged in value when the market bubble burst in late 2000.

Today, the investments are worth a fraction of their original value, and investors are unable to cash out because of the legal and financial tangle surrounding the funds.

"If you can't get rid of it, it's worthless," said Frederick G. Smith, vice president and director of Sinclair Broadcast Group in Hunt Valley. He contributed 81,000 shares of Sinclair stock that he owned, which had a value of about $3 million then.

"It's fairly clear to me the methodology with respect to how the accounts were managed did not meet the standard of the community."

Smith joined at least 70 big investors, who had contributed $115 million worth of stock to the funds, in suing Deutsche Bank AG, the German banking giant that purchased Alex. Brown in 1999.

Also named in the suit are former managers and advisers to the funds, including the Nashville-based DC Investment Partners.

Rahini Pragasam, a Deutsche Bank spokeswoman, said the bank does not comment on pending litigation.

Unusual lawsuit

"Oftentimes, I think there's almost an expectation with sophisticated investors that they took the risk, they lost money and they should walk away from it," said Howard S. Suskin, a securities litigation expert with Jenner & Block in Chicago. "It's relatively unusual to have investors of this caliber band together and sue."

The list of angry investors includes some of the brightest names in American industry.

Among them are W. James Hindman, the former Western Maryland (now McDaniel) College football coach who founded Jiffy Lube International in 1979 and then Youth Services International, which managed correctional homes for juvenile offenders; Roger A. Strauch, former chairman and CEO of Internet search engine Ask Jeeves; and Bruce E. Toll, co-founder of Pennsylvania-based homebuilder Toll Brothers Inc.

Better informed

Unlike everyday investors who have sued to try and win back their market losses, legal analysts say that wealthy investors have historically had a difficult time convincing a judge or arbitrator that they deserve a refund when investments go bad.

The assumption is that they should have known better because most have access to advice that ordinary investors can't afford.

Through their business dealings, the investors in the Alex. Brown funds all had accumulated large amounts of stock in a single company, subjecting them to potentially high capital gains taxes as the shares appreciated.

To minimize their risk, all invested in so-called exchange funds launched by Alex. Brown beginning in 1997. Such funds allow similarly positioned investors to avoid taxes by exchanging their shares of a single stock for shares in a diversified portfolio. At the end of a specified holding period - usually five years - investors are supposed to be able to redeem their shares for a profit.

The suit alleges that in promotional materials, fund managers pledged to carefully screen contributors to the funds in order to ensure a diverse mix of securities in the portfolio. They also pledged to employ a variety of hedging strategies to protect the funds against losses if the market fell.

But management failed on both counts, says Steven E. Fineman, an attorney representing the investors. He says fund managers misled investors about the mix of securities in the portfolio, which was made up largely of telecommunications and technology stocks.

As the market soared in the late 1990s, many of the fund managers' hedging strategies backfired, leading to losses that forced the funds to borrow cash from banks to pay margin calls and cover other expenses.

To compensate, Fineman said, fund managers abandoned their hedging strategy, leaving investors exposed to the market plunge in 2000.

"I think they got duped because they were lied to and the facts were concealed from them," Fineman said. "Our allegation is they didn't properly structure the funds from the outset and didn't hedge as they said they would, and didn't disclose to investors the significance ... of the liquidity problems or the hedging problems."

Suskin said the investors have a tough case to prove.

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