Investor Victory: NASD Arbitrators Hit SSB with Punitive Damages

Information for Attorneys

• Recent News in Securities Fraud
• Margin Investing and Borrowing
• Employee Stock Options
• Recent Securities Fraud Issues

The burst of the tech stock bubble, crash of the NASDAQ market in 2000-2001, and the harsh bear market of the past three years, have resulted in losses of billions of dollars for investors who trusted their brokers and brokerage firms to protect their accounts. Angry investors nationwide who lost substantial amounts of their life savings feel their trust was betrayed, and they are demanding to know who is responsible. From a legal perspective, the answer may well be the brokerage firms and stock analysts who acted as cheerleaders for their stocks.

Analyst Superstars. By the late 1990s, stock analysts of the major brokerage firms had become media superstars. Analysts such as Henry Blodget of Merrill Lynch, Jack Grubman of Salomon Smith Barney ("SSB"), Mary Meeker of Morgan Stanley, and Frank Quattrone of Credit Suisse First Boston ("CSFB") were the gurus of the technology market boom. The media attention given to these expert prognosticators reinforced the trust of investors with little understanding of the technological and economic forces at work in the market.

Brokerage firms created these media celebrities by feeding on the market frenzy and prospects of unimaginable wealth for "savvy" investors. The analysts held the keys to unlocking that wealth for ordinary investors. The wisdom of these powerful seers could answer every wish and turn dreams into realities and investors hung on to their every word.

Doing NASDAQ. Stock analysts' "objective research" reports frequently touted the stock of companies they covered. Strong buy recommendations and increasingly high price targets set by analysts were accompanied by rosy forecasts. The analysts had become cheerleaders. The boundless excitement for NASDAQ tech stocks was in no small measure responsible for causing what is now described as "irrational exuberance."

The valuation criteria and access to information of the top brokerage firms gave the statements of these influential experts an aura of untarnished, independent truth. These analysts were operating in an environment tainted by huge investment banking fees. The traditional "Chinese Wall" between the research and investment banking divisions of brokerage firms had crumbled.

Major brokerage firms were providing investment banking services for high-tech companies that were being touted by their analysts. The analysts' activity was critical for firms to secure the lucrative investment banking business. Underwriting fees of hundreds of millions of dollars were generated for the Wall Street firms. The analysts, as cheerleaders of Wall Street, were key to this endeavor and rewarded accordingly.

Contrary to the public perception promoted by brokerage firms, these analysts were not unbiased experts providing independent research based on an objective, analytical process. Rather, they were actively encouraging investors to purchase and hold those stocks for which their firms were investment bankers, and the analyst's compensation was tied to the banking business.

Analyzing the Analysts. Although this is a developing area of the law, it seems clear that analysts will be held to certain legal standards, and brokerage firms will be liable for the actions of their analysts which fail to meet those standards. Federal and state regulators have entered an historic $1.4 billion settlement with Wall Street firms based on the investigations of biased analyst reports.

The Massachusetts Securities Division filed a complaint against CSFB alleging fraudulent and deceptive conduct in the issuance of biased and misleading research analyst reports. The regulatory investigation determined that CSFB issued analyst reports favorable to companies that were its investment banking clients (such as AOL), when their analysts actually had negative views of the companies.

Massachusetts Secretary of State, William Galvin, stated, "It appears at least in some cases that [analysts] treated investors like suckers, and apparently the motive was simply more profit for the company [CSFB] with a reckless disregard for the rights of investors." The NASD has also filed a complaint against CSFB's former tech star, Frank Quattrone, for allegedly promising investment banking clients favorable research analyst coverage.

New York Attorney General, Elliot Spitzer, brought an action against Merrill Lynch and its superstar internet analyst, Henry Blodget, to "prevent further fraud, to protect the rights of the investing public…." Merrill agreed to pay a fine of $100 million and made a commitment to maintain "objectivity" in stock picks.

In a separate action involving SSB, Spitzer found: "Grubman issued misleading ratings of stocks in favor of investment banking clients…[T]he ratings Grubman issued were not independent, objective or on the merits." Grubman is now banned from the securities industry, and SSB agreed to pay $400 million as part of its settlement with securities regulators.

Legal Standards For Analyst Liability. Securities laws hold brokerage firms liable for damages caused by misrepresentations of their agents. Securities rules also require a reasonable basis for recommendations. Investors may have a right of recovery for securities fraud based on the failure to disclose a conflict of interest, such as the firm and analyst's financial interest in the stock being recommended and investment banking fees tied to it.

The SEC has adopted new rules in response to the recent, much publicized securities and corporate accounting scandals. The rules address the analysts' conflict of interest. Full disclosure is now required, along with a separation between research and investment banking, and there is a strict prohibition against analyst compensation based on investment banking business.

For countless investors, these reforms come too late. Their only recourse may be securities arbitration against the brokerage firms responsible for the analysts.

Brokerage firms are vigorously defending these cases. But for investors who have been victims of the fraud and the conflicting interests of stock analysts, filing claims in arbitration against the firms who employed the analysts may be the best hope for obtaining some restitution of their losses.

Whose Money is it Anyway?
Margin investing and borrowing in bull and bear markets.

During the bull market years leading up to the Spring of 2000, many individual investors broke new ground with their portfolios, doing things that they had never done previously. With the markets steadily climbing higher, many investors for the first time moved from diversified mutual funds to buying individual stocks. Many for the first time were willing to spend $220 for a single share of a company's stock. And many investors, for the first time, began to use margin to leverage their portfolios to increase their invested assets.

The additional leverage offered by margin loans significantly increased the potential for investing gains, however, it also accelerated portfolio downturns once the markets hit their peaks and the bubbles began to burst. For some, the successes (and excesses) of margin investing that led to double digit returns in 1999 and 2000, resulted in complete portfolio sellouts and outstanding margin calls during 2001 and 2002.

In decades past, many people thought that margin investing was only for those highfliers who truly "played the market." But as technological changes and a broader access to information have prompted individuals to become more active in their own investment accounts, many see margin as an investing tool for the common man. Any fear or unease that these individual investors might have once had with borrowing thousands of dollars on margin, secured by the value of stocks that are exposed to the market, has now worn off.

Margin investing is not for everyone, and the appropriate level of risk for any individual portfolio must reflect the investment objectives, financial needs, and personal comfort level of the investor. There may be very good reasons to maintain a margin account. For example, a brokerage account that is used both for carrying investments and paying regular living expenses -- perhaps through a credit card or check writing feature tied to the account -- might benefit from the added flexibility that margin offers. The investor does not need to closely watch his cash balance every day to ensure that there will be funds to pay his bills. If the cash runs out, he can cover his bills with margin funds and either add funds or sell securities at his convenience to readjust his cash and margin balances.

On the other hand, there are many questionable -- and perhaps ill-advised -- reasons for investing on margin. Some individuals who suffered losses in the market might see margin as a way to "get back in the game" and make back their losses. The problem is that such an investor is playing with money that he does not own and which he will have to pay back to the brokerage firm regardless of how the market turns and his investments fare.

Investing with borrowed funds creates a significantly higher level of risk, and that is true whether the funds are borrowed through a margin loan or from some other source. An all-to-common reaction to dramatic market losses in the last several years has been for individual investors to prop up account values by borrowing money from other sources, such as home equity loans or even cash advances from credit cards. Such an investment strategy, if ever advisable, would be so for only the most aggressive investor. If any broker or investment advisor were to recommend this aggressive strategy, he likely would be running afoul of the federal regulations governing margin, not to mention the sound fundamentals of securities investing.

Investors also should be aware of recent changes in the financial services world, which to a certain extent have blurred the once clear lines between brokerage firms and banks. Many full-service brokerage firms now offer other financial products such as home mortgages, lines of credit, and other forms of loans. Many of these financial products may include some variation of margin borrowing. For example, a brokerage firm might offer a home mortgage with no down payment as long as the homebuyer pledges and maintains a securities portfolio of a certain minimum value with the firm. The homebuyer essentially is using the value of his pledged securities to satisfy the down payment requirements. Although there is no actual loan of funds for the down payment, there is a form of forbearance, and the homebuyer's securities, as well as his house, are leveraged in exchange.

A broker or financial services professional may be able to offer helpful advice about using margin, however, every investor should keep a couple of points in mind. First, brokers generally are not afraid of margin, and they may deal with margined accounts so regularly that they are likely to discount the significant risks inherent in margin investing. An investor on margin always must consider the possibility that he could lose the full value of his securities as well as the full value of the margin he has used.

Second, consider that a broker is likely to increase his own compensation if he persuades his client to invest on margin. If the broker is paid by commission, a margin loan will increase the level of buying and selling in the account. If the broker's compensation is based on the amount of assets he has under management, then that figure will increase as well with a margin loan. Finally, the firm and perhaps the broker also will benefit from the margin interest that the investor will pay out of his account each month for the borrowed funds.

Employee Stock Options: Stockbrokers' Goldmine, Employees' Bust

Imagine you are a high-tech employee, familiar with bits and bytes not bids and asks. After years of hard work, you receive employee stock options worth hundreds of thousands of dollars. High-tech company employees during the 1990's struck gold with employee stock options. As high-tech companies' stock rose in the market, employees suddenly found themselves with options worth much more than their other assets combined.

To exercise an option, which would expire if left untouched, most employees called their stock option administrator and exercised via touch-tone telephone. After a deduction for the option cost and the applicable taxes, an "exercise-and-sell" resulted in cash. There was also an alternative to "exercise-and-hold" for stock rather than cash.

Left to their own devices, most employees exercised relatively few options for cash and paid down mortgages and education expenses, or funded retirement accounts. The remaining options accrued over time and became very valuable. Many high-tech employees were not market savvy. After all, they did not purchase their stock options in the market, they received them as compensation regardless of their investment acumen. They knew they needed professional investment advice to preserve this once-in-a-lifetime motherlode.

In the late nineties, certain securities brokers realized that employee stock option business was a goldmine. Brokers could rake in huge management fees and margin interest if they could convince employees to invest with them rather than cashing in options for mortgages, retirement funds, and the like.

By 1998, many brokers solicited employees at work, and put on "financial planning" seminars touting purportedly safe strategies for investing stock options. Especially plugged was the low maintenance, yet for brokers, highly compensating, exercise-and-hold strategy. As a hook, brokers hyped supposed long-term tax savings from holding stock for a year. They recommended that the employee exercise all of their options, hold the stock for a year, watch the stock go up in value as the broker and broker's analysts were virtually guaranteeing, and sell thereafter to realize profit at a lower tax rate.

To hold the most stock, and supposedly save the most taxes, brokers touted a "creditline." The creditline was used to cover option exercise costs and taxes (which brokers withheld at the lowest rate to maximize the amount of stock held - yet the customer bore the risk of not being able to pay the remaining tax later). Brokers also represented that the creditline could be used to purchase other stocks to supposedly provide portfolio diversification.

While glossing over their customers' questions, brokers sold themselves as full service financial advisers who put their clients first. They promised that in the unlikely event that the stock price went down, they would act to preserve an account's value. Brokers presented the exercise-and-hold strategy as tax-wise and conservative. Supposedly, systems were in place to make this a no-lose recommendation.

Not mentioned was the high risk of a super-leveraged, over-concentrated account, sensitive to the slightest market downturn, and -- unbeknownst to the customers -- devoid of the promised techniques to protect account value. The benign sounding creditline, which many employees believed was an unsecured line of credit, was really a margin loan subjecting the investor to risk of total loss. The brokers' "diversification" was a mirage. Instead, brokers margined stock purchases in the same sector as the company stock in which the customer was already concentrated. And, the addition of further margin added to the extreme account leverage. These customers had no idea how precariously their brokers had positioned their nest-egg.

As the stock market fell, the margin house of cards crumbled. Employees were shocked to see their account values evaporate as quickly as their brokers' empty promises at the hands of the previously unexplained margin call. The brokers' firms issued flurries of margin calls demanding cash or stock liquidations.

Brokers who had touted themselves as financial advisors, not just salespeople, had no meaningful financial advice to hedge, sell, or otherwise stop the accounts from sliding. Instead, brokers extolled their analysts' proclamations that stock was strong and price dips were temporary. Even in the face of margin calls, investors were told not to sell and "lock in losses" but to hold the stock. Trusting their advisors, many investors lost everything.

Because the exercise-and-hold strategy is risky, one wonders why brokers recommend it to anyone but speculative and already wealthy investors. The answer lies in brokers' compensation schemes. The exercise-and-hold strategy involved few transactions. Brokers could work less and profit more by charging asset-based management fees on accounts over-concentrated in fast-growing company stock than they could building a diversified, stable portfolio on a commission basis. And brokers charged management fees based not only on the stock in the account, but also on the margin balance upon which they already charged interest. In a bull market, a fee-based broker is incentivized to gamble customers' assets in riskier, leveraged, and fast growing stocks that swell the account and fee.

Perhaps what is most egregious about the exercise-and-hold strategy, so highly touted as a tax-wise scheme by brokers, is that it delivered no special tax-savings. The long-term capital gain rate would have applied whether or not the options were exercised-and-held, or sold and reinvested into a safe, diversified portfolio which was held for over a year. The employee stock option customer, placed by their broker into the exercise-and-hold strategy on the basis of tax savings, or any other false premise, was defrauded.

Recent Securities Fraud Issues
2001 - A Year in Review

 2001 was a turbulent year for the securities industry. There was a continuation of the overall decline in the markets that began in April 2000 making it clear that the bull market of the late1990's has come to a halt. What remains from the 90's however are the technological advances and new business practices that revolutionized the industry. In particular, on-line brokerage accounts and day trading pose significant challenges to regulators who will be asked to re-write old laws in order to level the playing field between institutions and investors. Reacting to these changes during the economic woes of the past year has been a difficult task. And, as regulators slowly adapt, most investors have suffered large monetary losses, in some cases due to antiquated rules and regulations.

The economic climate of 2001 has magnified these problems and produced an unprecedented wave of securities litigation. According to a PriceWaterhouse Coopers report on securities litigation, a record number of 263 federal class action lawsuits have been filed alleging securities fraud. That number is up from 201 cases in 2000 and 207 cases in 1999.

The following are a few examples of some of the burgeoning legal issues that have emerged in 2001:

1.  Margin Problems - The lure of huge profits caused many brokers to place investors on margin without their knowledge or to convince them to trade on margin without fully disclosing the risks associated with this type of activity. In many instances, these recommendations were not suitable and investors lost money as a result.

On April 26, 2001, the Securities and Exchange Commission (SEC) responded by approving a National Association of Securities Dealers (NASD) proposal requiring member firms to deliver to non-institutional investors a specified disclosure statement that discusses the operation of margin accounts and the risks associated with trading on margin. This rule requires a separate document be presented to the customer prior to or at the opening of a margin account and the same document, or an abbreviated version, must be provided to customers on an annual basis. This rule became effective on June 4, 2001.

2.  On-Line Trading Cases - The SEC and NASD Rules generally regulate brokers and brokerage firms based on the advice they provide to investors. NASD Conduct Rule 2110 (suitability rule) states that the broker has an obligation to make "reasonable efforts" to determine the investor's background and investment objectives. The use of the Internet as a vehicle for personal trading has removed the broker from the equation. Therefore, the investor is a faceless individual placing on-line orders. The brokerage firm does not know the investor's background or objectives.

The SEC recognized this problem and acted by creating the Office of Internet Enforcement (OIE) in July 1998. Since then there has been a gray area in the law regarding the best way to regulate on-line brokerage accounts. In 2001, there were some decisions that acted to bring clarity to this ambiguous area. These cases state that there are instances of on-line trading in which brokerage firms may be held liable in a suitability case. If the investor receives recommendations off-line or is given specific information on the brokerage firm's web site, there may be liability. However, if the on-line firm simply acts as an order taker, there is probably no suitability claim that may be brought.

The other significant areas of litigation regarding on-line accounts are cases in which there is a computer glitch. These are instances where orders are not placed on the system, are placed multiple times, or are placed in excess of the customer's buying power. In March 1999, Charles Schwab settled a landmark case for up to $1.2 million with around 300 customers who could not cancel their market orders before theglobe.com (TGLO) started trading during its November 1998 IPO.

In June 2001, the NASD reacted by issuing several disciplinary penalties to on-line firms for misleading advertising materials, registration violations, improper loans to customers, improper sharing of commissions, short sale violations, trade reporting violations, and deficient supervisory procedures. Meanwhile, the SEC issued two new orders dealing with trade executions. One rule requires brokers to disclose where the brokerage firms send customer trades for execution. The other requires disclosure from the "market centers" that execute the trades. Despite regulatory action, some companies continue to experience delays in trading which may harm on-line investors.

3.  Initial Public Offering (IPO) Issues - The "hot" IPOs of the late 1990's, especially those in the high-tech sector, had investors clamoring to purchase shares on the ground floor with hopes of reaping huge returns. Over the past couple of years, these IPOs have begun to falter. In 2001, IPO underwriters (and recently public companies) were being named as defendants in a series of lawsuits. These lawsuits, the so-called "laddering cases", allege that companies and their underwriters allocated shares in IPOs in exchange for high, undisclosed commissions and the guarantee that investors would purchase additional shares in the after-market. Many major investment banks have been named in these suits alleging that the institutions took advantage of the demand in the marketplace. The claims may be difficult to prove, as the investor will need to demonstrate that there was a specific wrongdoing relating to their damages. However, it is an area to watch for in 2002.

4.  Conflict of Interest - Recent business practices in the securities industry have blurred the so-called "Chinese Wall" that is supposed to exist between the investment banking division and the retail brokerage division at brokerage firms. Analysts who gave positive recommendations on stocks, in which their firms were underwriters, are now finding themselves being named in lawsuits. In the spring of 2001, Merrill Lynch settled a significant claim against one of their top analysts, Henry Blodget, based on allegations of this type of conflict of interest. Although this was a substantial development, it is still unclear if this will be the exception or the rule regarding this issue.

Regulators have acknowledged this problem. In June 2001, the Securities Industry Association, a self-regulating organization, unveiled a new code of ethics for analysts and brokers. These rules call for analysts to make stock recommendations independent of any potential self-gain they may receive if their firm is acting as underwriter for that particular company. The rules also require more disclosure be given to investors.

Litigation will probably increase in 2002 as the impact of 2001 is fully realized. Investors who have been victims of the industry practices listed above should seek advice as to whether or not they have a potential claim. Meanwhile, investors actively trading should be aware of these potential pitfalls and take affirmative action to protect themselves and prevent unnecessary losses.

9279-3JAB Sec. Update 12-27-01

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