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It was bad enough when Morgan Stanley found itself the target of a securities fraud lawsuit worth $2.7 billion. But things got even worse in mid-March when a Florida judge decided Morgan Stanley has to shoulder the burden of proof in defending itself from those allegations.

Coleman Parent Holdings Inc. and Ronald Perelman, a New York financier and chairman of Revlon Inc., brought the suit in 2003. They alleged Morgan Stanley colluded with Sunbeam Products Inc. to hide the appliance company's precarious financial state in 1998 when Perelman sold his majority stake in CPH to Sunbeam in return for cash and Sunbeam stock. Months after the deal, Sunbeam filed for bankruptcy, rendering Perelman's newly acquired stock worthless. Morgan Stanley had valued the stock at $680 million.

The unusual adverse inference arose from major errors in the discovery process in which Morgan Stanley allegedly destroyed and hid e-mails from the period leading up to the deal. Florida state court Judge Elizabeth Maass called the failure "grossly negligent." She punished Morgan Stanley by shifting the burden of proof to the defense. Now Morgan Stanley will have to affirmatively prove it didn't collude with Sunbeam to defraud Perelman.

But Morgan Stanley isn't the only party in hot water over the discovery snafu. In response to the judge's order, Morgan Stanley filed to have its lead counsel, Chicago-based Kirkland & Ellis, removed from the case only a week before the trial was to start. In its request for six extra months to prepare for trial with new counsel, Morgan Stanley said, "the court has lost all confidence in any statement or representation made by primary trial counsel."

Judge Maass gave Morgan Stanley one extra week.

"I have been at this for 50 years, this is the first thing of this kind I've ever seen," says Jerold Solovy, Perelman's lead counsel and chairman of Jenner & Block.

No Excuses

Judge Maass' order arose from a long and arduous dispute over what documents Morgan Stanley could be required to produce.

Kirkland partner Thomas Clare objected to CPH's initial discovery request in

March 2004, claiming "the scope of the e-mail request that they are seeking is improperly and unduly burdensome given the enormous costs that would be required, given the fact that the time period for which we have back-up tapes post dates the events by several years."

Judge Maass compelled Morgan Stanley to produce the documents anyway, and Morgan Stanley provided about 1,300 pages of e-mails in May 2004. It then certified that it was in complete compliance with the discovery order.

In November 2004, however, Clare contacted CPH counsel admitting Morgan Stanley had located additional e-mail backup tapes that contained relevant documents. According to CHP counsel, though, the company only produced a few of those documents.

As Morgan Stanley vacillated on whether it would turn over additional documents, CPH asked for summary judgment. Judge Maass held that Kirkland should have discovered and produced the tapes, and admonished the firm. But people close to the case believe Kirkland isn't truly at fault.

"Morgan Stanley is to blame," Solovy says. "They were constantly lying to the court. While they were destroying documents internally, they also failed to disclose that they had this archive that contained much of the information we were looking for, and made us go through extremely time-consuming and arcane procedures to retrieve the documents. This is a strategy to distract attention from how tremendously they dissembled."

Regardless of who was really responsible for failing to produce the tapes, Morgan Stanley's dismissal of Kirkland is shocking given the close relationship between the firm and the company. Morgan Stanley's general counsel, Donald Kempf, is a former partner at Kirkland, and the firm reportedly has a meeting room named after Kempf in its headquarters. The dismissal by a major client would be an embarrassment to any firm, but some believe a firm of Kirkland & Ellis' size and stature won't feel many aftershocks from one case that went awry.

"You wouldn't want to make this mistake if you were a smaller firm, but if it's managed well, a large firm can bounce back from a problem like this without lasting damage to its reputation," says Ross Fishman of Highland Park, Ill.-based legal marketing firm Ross Fishman Marketing Inc.

Others agree that this issue will roll off Kirkland's back.

"Kind of like Ronald Reagan was the Teflon president, K&E is a Teflon firm," says Mike Evers, director of Evers Legal Search. "This probably will bounce right off them in terms of their ability to attract and retain the best talent."

Diligent Discovery

Kirkland may escape the scandal relatively unscathed, but in-house lawyers can take an important lesson from the ordeal. The ultimate responsibility for ensuring discovery mistakes don't land the company in trouble falls to the legal department.

"What that case points out is that companies must assess the accuracy of their databases internally on an ongoing basis, and take proactive steps to keep them up to date," says a partner at a major law firm who wishes to remain anonymous. "If you don't you could end up with a discovery nightmare like this one."

Solovy agrees.

"Companies need to be zealous in meeting their discovery obligations, and be very proactive in ensuring discovery orders are complied with," Solovy says. "In-house counsel need to be concerned about having their inside procedures in line so they're properly preserving documents and can respond to discovery requests in an honest manner. Ninety-nine percent of corporate America already does this, and how something like this actually happens is beyond my comprehension."

For its part, Kirkland & Ellis believes it handled the case appropriately, and the failure to turn over the documents was simply a mistake.

"(We believe) the record will show that our attorneys in this case always acted in good faith," a Kirkland & Ellis spokesperson said in a statement.

The firm may have to prove so in court. In its request for a continuance, Morgan Stanley said it put Kirkland on notice of a possible malpractice lawsuit.

Both Morgan Stanley and Kirkland & Ellis declined to comment directly on the matter.

Staff Writer

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