Small fry takes on Goliath in Texas

At first glance, it didn’t look like a fair fight. On one side: an enormous and powerful global consulting company. On the other: the retired founder of a smaller turnaround firm who has become a thorn in the side of its larger rival.

But the brawl that is underway in the federal bankruptcy court in Houston has the potential to cause big problems for the consultancy McKinsey & Co.

The courtroom fight hinges on whether McKinsey or its clients have hidden interests in a bankrupt coal company that the firm has been advising, a practice prohibited by federal laws meant to ensure that one insider can’t effectively cut itself or its friends a great deal at the expense of others.

The man leveling the accusations, Jay Alix, is a retired turnaround expert who has made it his personal mission to harry McKinsey. Alix has spent four years first needling the firm’s leadership, then attacking it in court, accusing it of violating federal laws and unethical behavior.

Normally, a firm of McKinsey’s size would swat away a gadfly’s attacks. But in this case, which involves the bankruptcy of Colorado’s Westmoreland Coal, Alix has a powerful ally: the U.S. Justice Department.

On Dec. 14, the department said in a court filing that McKinsey was fraught with “pervasive disclosure deficiencies” and should be dismissed from the Westmoreland case immediately and stripped of the fees it had earned so far.

If that were to happen, it would deal a severe blow to McKinsey’s reputation, as well as its argument that the firm is free of conflicts of interest.

The judge overseeing the Westmoreland bankruptcy case, David R. Jones, warned both sides in a hearing this month about the rising stakes. “The way this has been teed up, I don’t see an out for both sides,” said Jones, chief judge of the U.S. Bankruptcy Court of the Southern District of Texas. “The harder you push all this, the more you ensure that someone doesn’t survive.”

Westmoreland had been sprinting through a bankruptcy process that started in October and was on track to be wrapped up in February. But then Alix filed a 163-page objection, accusing the prestigious consulting firm not just of hidden conflicts of interest, but of crimes including fraud — “all sorts of heinous acts,” as Jones put it.

Westmoreland asked Jones to overrule Alix’s objection, but he said he couldn’t do that.

“I don’t like someone to stand up in my court and accuse someone of committing a crime,” he said. “There has to be an airing of this issue, given what’s been done.”

Now, both sides are aiming for a trial late in January, where Jones would rule on what he called Alix’s “incredibly inflammatory” accusations.

Jones warned that if Alix could show under oath that he had a reasonable basis for accusing McKinsey of fraud, the dispute would escalate in unpredictable ways.

McKinsey’s lawyer, Christine Chung, said in court that she did not think Alix would be able to do that.

In an email, referring to Alix’s company, Chung said: “Judge Jones accurately described Mar-Bow’s allegations of fraud as ‘incredibly inflammatory’ and ‘problematic.’

“We welcome the fact-finding ordered by Judge Jones — including an immediate sworn deposition of Jay Alix — and are eager for the opportunity on Jan. 28 to present evidence in court,” she said. “We stand behind our disclosures, which have always complied with the law, and are confident that the court will find that Alix’s allegations of fraud were reckless, without basis, and should never have been made.”

Alix has spent more than four years building a case against McKinsey. He says the firm makes a practice of working both sides of the table in bankruptcy, something McKinsey denies. Alix has already sued McKinsey under the Racketeer Influenced and Corrupt Organizations Act in New York and is trying to reopen another bankruptcy case in Virginia, on the argument that McKinsey committed a fraud on the court.

McKinsey says Alix is acting on a vendetta borne of McKinsey’s ability to outcompete the restructuring firm he founded, AlixPartners. Alix no longer works for AlixPartners, but he has a seat on the board and a minority ownership stake.

But the Justice Department, through its Office of the U.S. Trustee, also has sought to reopen the Virginia bankruptcy case, which involves another coal company, Alpha Natural Resources. The Justice Department is in charge of enforcing conflict-of-interest laws in bankruptcy court.

At the heart of Alix’s accusations is McKinsey’s investment division, a $25 billion fund known as MIO Partners that invests on behalf of McKinsey’s tens of thousands of employees, retirees and alumni around the world. Its activities are confidential. But regulatory filings and records of various bankruptcy proceedings make clear that the fund has sometimes invested in the securities of the entities McKinsey is advising.

In Puerto Rico’s bankruptcy, for example, a New York Times review of court records found that McKinsey held both direct and indirect investments in the territory’s bond debt while also serving as a strategic adviser to the island’s federal oversight board. Critics called it a hidden conflict of interest, albeit one that was not illegal.

Alix argues that, in some cases, such investments put McKinsey in violation of the U.S. Bankruptcy Code’s requirement that all professionals working on a case be disinterested.

McKinsey disputes that, saying that MIO Partners is completely separate from the firm’s consulting business and its investments do not taint the advice its consultants provide to clients.

Alix is calling for court-ordered access to MIO Partners’ books, to see how the fund’s trading activities may or may not coincide with McKinsey’s work with its clients.

McKinsey’s lawyer, Chung, said that was a nonstarter. “What we reject is the notion that we have to just open up our file cabinets” in response to Alix’s accusations, she said.