March 1, 2002
By David A. Gaffen
Registered Rep.
On one side is a growing group of WorldCom employee-shareholders, who are looking for more than $35 million that they claim was lost because of improper handling of their brokerage accounts. On the other side is Salomon Smith Barney, a major underwriter for telecom companies, including WorldCom, and — through an Atlanta office — the retail broker that handled the stock option business of hundreds of WorldCom employees.
In the middle are two Smith Barney brokers who built a $2 billion book off the WorldCom options business and are now being accused of mishandling some of those accounts. The complaints, filed with the NASD, range in size from $219,000 to $14 million, among the complainants is Gary Brandt, former WorldCom head of investor relations.
The brokers, Philip Spartis and Amy Elias, who clashed with Smith Barney when it began settling the suits, are out of a job and fear their prospects in the business have been destroyed. Now they’re fighting back. They’ve hired well-known securities attorney Jeffrey Liddle and are going after their former employer, as well as high-powered telecom analyst Jack Grubman.
The two say they have been made scapegoats by the firm, which they say is seeking to quietly settle some of the claims, in part to protect Grubman, who generated lots of banking business for Smith Barney. Current and former WorldCom employees have lodged more than 25 different complaints against brokers at Smith Barney, according to attorneys for Spartis and Elias. As of Feb. 13, NASD filings showed 11 complaints — most of which do not explicitly name WorldCom — on the U-4 form of Spartis, seven against Elias, and eight against a third broker in their corporate client group, David Hobby. Some have been settled and some are in arbitration.
Complainants say the brokers encouraged investors to take on margin risk, allowed them to be over-concentrated in WorldCom stock and failed to apprise clients of the growing precariousness of the strategy as WorldCom’s stock weakened.
“Spartis, Elias and Hobby misrepresented, deceived and/or concealed from claimants material facts known to them with the intention…of thereby wrongfully lulling claimants into a false sense of security that Respondent Smith Barney would properly manage claimants accounts and solicit only suitable investment strategies,” reads one complaint, filed by attorney Lawrence Klayman of KlaymanToskes in Boca Raton, Fla., with the NASD. Salomon Smith Barney, through a spokeswoman, declined to comment on the litigation.
Spartis and Elias say they wanted to avoid settling because they did not want to have the information on their U-4 records–which, to them, was an admission of guilt. Officially, they were terminated from Smith Barney due to “job abandonment” in January, after the pair had been away from the office for three weeks. Their book of business has been handed off to other brokers.
In late December, Spartis and Elias hired attorney Jeffrey Liddle, partner at Liddle & Robinson in New York, who last summer won a historic $26.7 million judgment against Waddell & Reed for broker Stephen Sawtelle. Liddle says Smith Barney, along with analyst Grubman, should bear responsibility, because Spartis and Elias found their ability to properly advise the WorldCom clientele was seriously hindered by the ever-bullish Grubman.
Liddle has filed a cross-claim against Smith Barney, seeking an undetermined amount in damages for his clients as compensation for lost income and harm to their careers. He has also filed a third-party claim against Grubman, perhaps establishing a novel claim that a research analyst who continued to vigorously recommend a stock that was already tumbling can be liable for damages suffered by brokers who are being sued by their clients who heeded the analyst’s advice. Until now, only clients have attempted — largely unsuccessfully — to recover damages from analysts for making improper recommendations and concealing conflicts of interest.
It was Grubman’s cheerleading, Spartis and Elias assert, that convinced these investors — including some prominent WorldCom employees, Liddle points out — that it was okay to hold the WorldCom shares (at times bought with loans from Smith Barney), rather than sell some or all to diversify their holdings. Some clients who later filed claims borrowed against WorldCom stock to buy other equities. Grubman is being slammed by other investors for his excessive bullishness; his U-4 form turns up a number of complaints, several of which have been denied. Among the allegations are a failure by Grubman to notify investors of conflict of interests, issuing misleading research reports between 1996 and 2000 as well as making improper “buy” recommendations, and breach of fiduciary duty, according to NASD filings. (One suit filed in New York State was dismissed on a technicality.) Grubman did not comment for this article.
The heart of the legal strategy is Spartis’ and Elias’ claims that the two are being scapegoated for the firm’s internal policies — regarding Grubman’s investment advice, the way the firm monitored accounts and how the firm responded to what the two brokers insist were defensible claims. When Smith Barney began settling complaints last spring, Spartis and Elias were hot. “We spent weeks and weeks pulling together our defense,” Elias says. “But it was all about what they were going to pay.”
Attorney Klayman says it was ultimately the responsibility of the brokerage to make better decisions for its clients — to impress upon them the need for hedging strategies and greater diversification. “They just needed to do the right job, which wasn’t done,” says Klayman, who says he currently is representing more than a dozen claims against Smith Barney. “They wanted to be handled properly, and weren’t given advice or anything.”
Spartis and Elias say that 95 percent of their accounts were sufficiently diversified away from one stock. The remaining clients, the two brokers say, wanted to put all their chips on one bet, so to speak, and were burned for it. The pair claims that while they apprised customers of the possibility of using margin, they also discussed other strategies. They say they did not encourage highly concentrated positions, and discussed hedging and stops that would have stemmed some of the losses. “That discussion was had, but they didn’t hear you say it,” says Elias. “They didn’t want to hear you say it.” Why? Because the notion that WorldCom might fall “was an impossibility,” she says.
“You can lead a horse to water, but…you know the phrase,” Spartis says. “We had conference calls with many of these folks — some of whom have claims against us.”
Booming Business Busts
Spartis, 49, worked at Smith Barney since 1984, and specialized in corporate clients for the past 10 years. Some of the best clients were WorldCom employees, whose option-based wealth swelled through the 1990s as the colorful founder, Bernard Ebbers, conducted a non-stop deal binge that catapulted the communications upstart to the top of the long-distance and Internet-service business. WorldCom’s stock rose from $18 in 1991 to $90 in 1999 as the company swelled in size and investors bet heavily on surging demand for communications services.
Spartis added Elias to his group in 1995. She had moved to Atlanta from Bismarck, N.D., where she’d started in the brokerage business soliciting ranchers — often incurring the wrath of their wives, who felt being a broker was rather unladylike, she says. Elias, now 36, was extremely enthusiastic, Spartis says. She got interested in the brokerage business when, as a salesperson for a newspaper group in Illinois, she would spend hours with clients of hers — brokers — who would explain the market. She decided to become a broker and recalls how excited she was when she, self-taught, passed her Series 7 — on the second attempt. “I remember calling all my friends saying, ‘I’m going to be a stockbroker!’” she says.
In Atlanta, things went well for Spartis and Elias as the bull market soared. Spartis says his book of business was among the largest at the firm, thanks in part to the swelling volume of business from WorldCom employees exercising options. Liddle says Spartis and his team handled more than 80,000 transactions in their last two to three years. The business was so good that about seven other people were brought in to handle the overflow, Liddle says.
Many WorldCom clients sought to maximize their gains by actually purchasing the shares, rather than executing a cashless exercise. In such a transaction, the brokerage briefly lends the client the money to exercise the option, then immediately sells the shares and gives the client the difference between the market price and the strike price — less a small fee. With a non-qualified stock option plan (the type most WorldCom clients had, Spartis says), the profit is taxed as ordinary income, usually 39.6 percent, for the difference between the strike price and the market value of the stock.
But amendments to legislation changed the capital gains implications. Once that ordinary income had been paid off, there was a significant benefit to holding the stock for a year, as the long-term capital gains tax was lowered to 20 percent. This was especially appealing if a client believed that the stock had a good chance of making double-digit annual gains.
In the euphoria of the late 1990s, it was easy to overlook the downside of holding so much WorldCom stock. “Most people had their wealth concentrated, like many in telecom, and they thought, ‘Hey, if I can save myself 19.6 percent, why not?’” says Spartis. So, borrowing money from Smith Barney, clients exercised their options and wound up with WorldCom shares that were margined.
But why did they think the stock was going to go higher? Spartis and Elias say clients would assume either it was going higher, or they’d inquire about what Smith Barney was saying about the stock. And Grubman, who made a name for himself with his grand pronouncements about telecom companies, was steadfastly bullish on WorldCom. Grubman has maintained a “buy” recommendation on the stock even as it dropped steadily, from a peak near $100 a share in 1999 to its recent range around $7 a share. On Feb. 8, he reiterated his “buy” rating on the company, according to Salomon Smith Barney research reports.
Margin Euphoria
There was another factor influencing clients in those days of continually rising markets: The possibility of a margin call seemed remote. Indeed, New York Stock Exchange margin debt hit an all-time high of $278 billion in March 2000 — nearly double the figure from a year earlier.
That, of course, was when the market began to wobble. And it was not long before WorldCom’s fortunes began to wane. The company saw a potential deal with Sprint fall through in the summer of 2000, in part because of the declining value of telecom shares.
Still, Grubman remained bullish on the New Economy story, issuing encouraging reports on not only WorldCom, but also on companies like Global Crossing, termed a “speculative buy” up until October 2001 (it declared bankruptcy in January). On June 27, 2000, with WorldCom stock down more than 60 percent from its peak to $37.50, Grubman stated in a research report that WorldCom “remains the company every major global telecom company wants to look like in terms of assets,” and maintained an $87 price target.
As WorldCom shares drifted lower, accounts in Spartis’ book were being hit with margin calls and were falling into negative equity. In the spring of 2001, a number of complaints were lodged against Spartis, Elias and Hobby, according to filings obtained from the NASD. Most of the complaints on each of the three broker’s U-4 forms overlap; they have identical case numbers, or an identical figure in alleged damages. Spartis and Elias say all but one of these were from WorldCom employees.
Among other things, the complaints charged misconduct and improper use of margin and the unsuitability of investments. Some of the claims against Spartis and Elias are in arbitration with the NASD. Three of the cases have been settled, according to the U-4 forms, including one $7 million claim — for $600,000 in damages.
Hobby, who is not being defended by Liddle, continues to work at Smith Barney. A call to him was transferred to Jinan Strickland, operations manager at the 3455 Peachtree Road office, who then referred calls to corporate communications in New York. Smith Barney, through a spokeswoman, did not comment on the status of the arbitration or on the individual consultants involved.
Lost Their Home
When the complaints started coming in, Spartis and Elias say they were caught off-guard. But they concluded that they could prove that they were not guilty of any improprieties in handling client accounts.
But Klayman at KlaymanToskes says his clients tell a different story. He says Smith Barney, through the representation of Spartis, Hobby and Elias, aggressively pushed people to lever up with a higher margin balance to increase the firm’s assets and gain new accounts, rather than just try to hold the assets created with a routine options exercise. “They did very clever marketing to gather assets,” Klayman says. According to the lawyer, Spartis and Elias encouraged clients to go long WorldCom stock, as well as take out margin loans for other purposes. The number of arbitrations involving margin calls has exploded, from 39 in 1998 to 375 in 2001, according to the NASD.
One claim, filed by Klayman against Smith Barney on behalf of Robert J. Grim, a 17-year employee of WorldCom, and his wife, Dawn Grim, charges that Grim was counseled by the brokers to exercise his accumulated 49,918 shares on March 31, 2000. At the time, the stock was at $42.56, for a total market value of $2,124,659. An exercise-and-hold strategy was employed, involving a margin loan of $785,432, according to the claim filed with the NASD.
Ultimately, the value of the portfolio declined $1,669,221. The final tally? Grim was responsible for $1,293,812 in taxable ordinary income, and suffered $916,741 in net short-term capital losses, which aren’t deductible against the ordinary income. This particular claim alleges damages of $1.75 million, including the sale of the Grim’s house.
Spartis says his clients were advised of their possibilities. “After educating the clients to the alternatives available, and given the fact that the stock had been up over the last 10 years, some of these people were inclined to borrow to gain the liquidity that they’d never had before,” Spartis says.
“The ability to use stock as collateral for loans became more appealing. Did we encourage margin? No. We explained it as an alternative method of financing an exercise and hold. We’d also ask if they could bring in extra outside cash, or sell other securities. We’d tell them, here are the sources for you to utilize: cash, other securities or margin, but we wanted them out of margin.”
Klayman says the investors should have been further educated about hedging strategies, such as zero-cost collars and other types of put options that would have offset the risk inherent in holding already-overvalued stock. Again, Spartis says he tried to protect clients, but some would not listen. “We’d talk about hedging, and stops, and Jack would say, ‘Higher, higher, higher,’ and they would bring in outside assets to shore up [their accounts] when the next decline happened,” Spartis says.
When WorldCom shares fell, Spartis and Elias also say they were unable to effectively monitor margin accounts that were running into trouble because of the firm’s inadequate internal system. They say the only way they could have identified the accounts in danger themselves would have been to comb through, from A to Z, account by account, which they say would have been impossible. “The system they had was inadequate, and it was impossible to get our hands around,” Spartis says.
The firm did not respond to questions regarding its systems. The branch manager during this period, Michael J. Grace, who is still listed on Smith Barney’s Web site as the senior branch manager, did not return a call seeking comment. He has five complaints on his U-4 record reflecting “alleged failure to supervise.” Those cases are currently in arbitration, according to NASD filings. The current branch manager, Brad Bradham, who started at Smith Barney on Jan. 22, did not return a call seeking comment.
The first claim against Elias and Spartis was settled in May 2001 for $190,000 that cited the “failure to disclose the risks associated with margin use” and “unsuitable investment strategy recommendations,” according to the U-4 forms of Spartis and Elias. Another complaint against Spartis was settled in July 2001 for $85,000 that also cited an “unauthorized margin balance” and “unsuitable investments.” When the settlements began and the charges appeared on Spartis and Elias’ U-4 forms, the two realized that their interests and the firm’s were diverging.
“We built the firm’s defense position, and they decided to mediate rather than arbitrate,” says Elias. “That really depressed me.” Spartis says they attempted to write on their U-4 forms: “We vehemently oppose this settlement.” But, he says, [the attorneys] “said we couldn’t do that.”
As the settlements commenced, Spartis began to think it might be best to put the whole thing behind him and met with then-branch manager Grace to ask about his retirement benefits. He then received a call from H. Wayne Hutton, regional director. “Wayne said, ‘I understand you think you want to retire; we think that would be a good idea,’” Spartis says. Spartis says he was offered about $300,000 in his own contributions to the firm’s capital accumulation program, his existing 401(k) and nothing more.
Spartis says he then asked what would happen to his book, figuring he could, under the firm’s franchise protection program, sell it to the firm, collect a large sum, and walk away. “But he [Hutton] said the book was useless because there’s too many liabilities,” says Spartis. Hutton did not return a call seeking comment.
In the fall of 2001, Spartis shifted tactics, figuring he could wait out the complaints. He and Elias hired an Atlanta attorney named Bill Leonard, who, Spartis says, told Smith Barney officials that Spartis wanted to come back to work. Spartis says Smith Barney prepared a document with four reasons why he shouldn’t return to work, charging him with unsuitability of investments for clients, concentration of position, excessive use of margin and unauthorized use of correspondence. Spartis says he defended these claims, and as a result, was asked to come back to work.
Shown The Door
The reconciliation didn’t last long, the two brokers say. Spartis made one other request to Hutton — that he not continue to report to Grace, because of what Spartis says was a poor relationship. Hutton agreed to this, when Spartis returned in October. He went to a meeting with Hutton, ostensibly to discuss compliance issues. “Wayne said, ‘You’re no longer the corporate client group director,’” Spartis says. After several stressful weeks, Spartis and Elias were again asked to leave in December, and he says the two were threatened with termination if they did not quit voluntarily. In December, “I got another call saying, ‘Wayne wants a meeting,’ so I gave him three timeslots, and when he picked Friday at 2 p.m., I knew this was not good,” Spartis says.
There was no official termination then, however, and Liddle says he believes the company did not want to risk a lawsuit for out-and-out firing the employees. Attorney Liddle says the two were essentially made to feel as if they’d been terminated. Finally, on Feb. 4, they received a letter signed by Hutton saying the two were no longer Smith Barney employees because they hadn’t been at work for the preceding three weeks, “an abandonment of their duties,” according to a letter FedExed to Spartis, Elias and Liddle on Jan. 31, obtained by Registered Rep.
Spartis and Elias maintain that they were forced out largely because they wouldn’t agree to the settlements and because they feel Smith Barney is responsible for the unsuitable investments. They say their claims were ultimately defensible and their talk of diversification and cashing in some gains were ignored because clients assumed the stock would continue to rise, and the brokers often found their clients quoting Grubman’s research back to them. “If people said, ‘What’s Jack think?’ And we said, ‘Well, he’s got a hold on this,’ don’t you think you’d be less excited about [purchasing on margin]?” Elias says.
While dragging Grubman into the suit will undoubtedly generate some more publicity for Liddle and his clients, it is not clear how it will play in arbitration. So far, investors have had little luck with this tack. Henry Blodget settled one case in July 2001 for $400,000 and soon after left Merrill. A case against Morgan Stanley Internet analyst Mary Meeker was thrown out of court.
So getting an analyst to pay damages to a broker may be unlikely. Although brokers are often strongly urged to follow the firm’s recommendations, Klayman says that it’s still the responsibility of the broker to judge the suitability of the investment for the particular client. “The minute they exercised, those brokers at Salomon Smith Barney had an obligation, because the assets were in their custody,” Klayman says. “How did they help them? It’s like a plastic surgeon doing surgery with a meat cleaver.”
Liddle’s battle against Smith Barney could drag on for years and the outcome is far from clear. What is clear, say Elias and Spartis, is the damage already inflicted on them by Smith Barney’s settlements. The various complaints on their U-4 forms charge that the pair “improperly handled accounts,” “engaged in breach of fiduciary duty, fraud and negligent misrepresentation, unsuitability and violation of state and federal statutes,” and misrepresentation and failure to disclose risk associated with margin. “We wanted to defend ourselves, and we thought that’s what was going to be happening,” says Elias.
Signing the complaints and agreeing to settlements, she says, “is like saying we were guilty.” For the moment, Spartis is waiting out what he calls a “nightmare,” though he knows his chances of getting back into the industry are dead. Elias is making up for some lost time with her children. “For two years, my kids haven’t had a good mom,” she says.