O.C. Real Estate Investment Case Opens New Territory

SANTA ANA â€”  The first trial in what has become one of Orange County’s bulkiest court cases is set to start Tuesday as teachers statewide try to recoup some of the $100 million they lost in real estate deals.

The class action stems from the 1994 collapse of Teachers Management & Investment Corp., a Newport Beach firm that invested teachers’ money mainly in undeveloped land that lost value during the real estate depression of the early 1990s.

The teachers accuse accounting firm KPMG Peat Marwick of propping up the insolvent Newport Beach firm to suck $2.5 million in auditing fees out of TMI’s limited partnerships, in which the teachers invested.

Barring any last-minute settlement, jury selection will begin Tuesday in a case in which more than 3 million pages of documents and 2,049 motions have filled 222 volumes of court files, and the volumes are growing daily. The mounting paperwork is worrying the judge.

“A lot of people have written articles about the abuse of modern litigation,� Judge John C. Woolley told lawyers in the case last month, adding sardonically: “Maybe we’re heading in that direction.�

The case stems from the excesses of an overheated real estate market in the 1980s and the actions of many companies to pour good money after bad as the boom went bust.

TMI and its two operators, John R. Martin and Maurice B. Shuman, paid $4 million last year to settle accusations against them. Now, the teachers are going after the deep pockets of the Big 6 accounting firm that audited both TMI and the limited partnerships.

The trial will focus on the key issue of the auditor’s alleged lack of independence, a hot topic in the accounting profession.

The industry is trying to rewrite its ethics rules to reflect the growing changes in the accounting business, particularly the growth in consulting services. These services can create conflicts with the auditing function.

“The audit is a pipeline straight into the heart of the client,� said Rick Telberg, editor of Accounting Today, a trade publication. “Through that, they sell a host of consulting services. This case can demonstrate what can happen when an auditor’s independence is questioned.�

Nowadays, he said, major accounting firms make more money peddling various consulting services than they do in audit work. Regulators worry that firms may be compromising the independence of their audits by using them to sell more services to clients.

Even the U.S. Supreme Court has determined that accountants must “maintain total independence from the audit client at all times and . . . complete fidelity to the public trust.�

But the teachers allege that Peat Marwick’s auditors compromised their independence in numerous ways:

* Martin, who had been a Peat Marwick partner with a major role in the TMI account, retired in 1985 and joined long-time business associate Shuman in 1987 to buy TMI. Martin remained close to the Peat Marwick partners who continued auditing his company.

* Though it issued a qualified audit for 1988, saying it questioned whether TMI could remain a going concern, Peat Marwick never told the teachers that the following year it found that TMI had lost $9.5 million and was insolvent. The 1989 audit was never issued, and TMI was not audited after that time.

* Peat Marwick, unable to collect $400,000 in fees from what it knew was an insolvent TMI, instead agreed with TMI in 1990 to write off the fees over three years. They then continued to audit some three dozen limited partnerships and collected $2.5 million in fees from them.

* Peat Marwick sold TMI real estate, tax and other consulting services while serving as its auditor in the 1980s.

In addition, said Ronald Rus of Irvine, lead lawyer for the teachers, Peat Marwick knew that TMI was commingling partnership funds with its own money and was diverting funds to itself.

“The general partners stole money from the limited partnerships and never told the limited partners,� Rus told the court in a hearing last month. “And Peat Marwick knew it and helped keep it secret . . . and continued to participate in the scheme.�

The accounting firm has denied that it did anything wrong or that it compromised its independence in any way. It asserts that its auditors performed admirably, reporting what they should have reported and conforming to all applicable auditing standards.

Peat Marwick’s trial lawyer, Thomas Greene of Washington, said that his client simply audited the partnerships. It didn’t provide financial, legal or management advice.

In addition, he said, none of the investors even read the financial statements and therefore didn’t rely on the information provided.

“Not only did they not read the financial statements, these plaintiffs didn’t bother to read the subscription agreements, didn’t bother to read the offering circulars--they didn’t read anything,� Greene told the court last month. “They just had a pen put in their hand, and . . . they just signed expecting to make tons of money.�

Decisions that investors made to continue pouring money into the limited partnerships can’t be blamed on Peat Marwick, he said. Their reasons for investing had to be unrelated to Peat Marwick’s work, he said, because they never read the statements.

Last fall, the teachers won a court order designating Peat Marwick’s 250 California partners as a defendant class, an action that makes them personally liable for any losses that the accounting firm can’t cover. The partners, however, have been severed from the case and will go to trial later.

Judge Woolley issued the order because he found that Peat Marwick had little or no insurance at the time of the alleged wrongdoing. The Big 6 firms are mainly self-insured, though many have some layers of outside insurance.

Woolley determined that Peat Marwick had no outside insurance to cover possible losses. The judge acknowledged there was a good chance a jury would impose punitive damages on Peat Marwick.

Formed in 1968 by a group of educators and real estate specialists, TMI promoted itself as a way for teachers to save for their retirement by investing in real estate.

Some teachers even moonlighted as part of TMI’s sales staff, promoting the company’s theme: “Teachers helping teachers.� TMI’s symbol was a shiny red apple.

Over the years, TMI has owned through its limited partnerships a number of commercial properties, including hotels in Northern California, office developments and the Parducci Winery lands in Mendocino County, as well as thousands of acres of undeveloped land.

While the state’s real estate market was booming during the 1970s and ‘80s, TMI investors often saw annual returns of more than 30%. But when the market skidded in the late 1980s, those handsome returns ended.

Martin and Shuman, who were accused in the lawsuit of diverting funds for their own use, contended that the long recession of the early 1990s had eroded property values and caused the losses. They didn’t admit any wrongdoing in settling the case.

In addition, the Newport Beach law firm of Bruck & Perry also settled last year, agreeing to pay $2.2 million without admitting liability. The law firm had been accused of conflicts of interest and of helping TMI set up “sham� entities that TMI used to siphon cash from the partnerships. The law firm had denied any wrongdoing.