Company Employees
Exploiting Novice Investors

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A single mother with an infant son, Ms. Smith had amassed $1.1 million in savings and in stock options on WorldCom shares that she had received as an engineering director. Finally, she had enough to cash in her chips and stay home with her child. "I had this dream of having $1 million in the bank and living off the interest," she said. "That seemed really safe."
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When WorldCom and other technology stocks collapsed in 2000, she was left with margin loans and taxes that had destroyed her life savings. Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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This page explains the way in which inexperienced employees with share options were persuaded into risky investments which benefited Citigroup but bankrupted many employees.

CONTENTS

• Introduction
• Exploiting Employees Vulnerability
• Did Smith Barney benefit by trading on inside information?

Introduction

If Ms Smith (see above) had taken unreasonable risks she could only blame herself but she, like vast numbers of other employees was acting on the best advice available. It is now claimed that that advice was deliberately biased and seriously flawed.

The allegations relating to employee share options indicate that Salomon Smith Barney traded on the vulnerability of employees for its own benefit. There are also suggestions that it may have ignored conflicts of interest and used insider information about employees utilisation of share options for its own benefit. In the light of its other conduct this seems likely.

Exploiting Employees Vulnerability

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It may not provide much solace to Ms. Smith, but she is not alone in her misfortune. She is one of dozens of current and former WorldCom employees who have sued Salomon, a unit of Citigroup, to recover the tens of millions of dollars in losses incurred when they followed the advice dispensed by Salomon brokers in Atlanta.

The New York Stock Exchange has started an investigation into Salomon Smith Barney and the activities of its brokers there who advised WorldCom workers about their stock options. Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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Modern incentive management techniques try to ensure that employees have a financial incentive to be team players and support the company in its practices. While the idea of employees benefiting from their own efforts is welcoming, the extent to which this might prevent them from rocking the boat in the face of unsavoury conduct by their employer has become a major problem, particularly in health and aged care.

When employees are ripped off and ruined by the people who have been employed to advise and protect them, then we are plumbing new depths in capitalism. Employee options was very big business and the bankers contracted to look after them had no inhibitions about plumbing these depths for profit. WorldCom is the most publicised example of what happened but WorldCom employees were not alone. Contracts like this were one of the perks resulting from favourable analysts reports and share spinning.

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In telecom's heyday, and as WorldCom's shares roared, the business of helping the company's employees exercise their options exploded. With the phones ringing off the hook at Salomon's Atlanta office, other brokers were brought in to deal with WorldCom workers. According to documents filed in one of the arbitration cases against Salomon, the group had grown to a dozen by 2000 and had opened 2,000 accounts for WorldCom employees.
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Mr. Klayman, the Boca Raton lawyer, said that a lot of these Salomon clients had never had brokerage accounts before and that they were unsophisticated about the ways of Wall Street. "When Salomon Smith Barney tells you to do something, you do it," he said. "They are a very large, prestigious brokerage firm, after all." Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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In 1998, for example, WorldCom employees bought 49 million shares using options, about 5 percent of the shares outstanding. In 1999, employees exercised options on an additional 61 million shares.

Salomon was the only brokerage firm that WorldCom's employees could use to exercise their options. In 1999, Salomon gave Mr. Spartis a plaque for managing the WorldCom plan, which generated more revenue that year than any other at the firm. Over the four years before he was fired, he generated $2.3 million a year, on average, in gross commissions.

Salomon administers stock option plans for more companies than any other Wall Street firm, according to stock plan specialists. In a Broker's Notes, Trouble for Salomon The New York Times September 22, 2002

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One way of harnessing employees loyalty is share offerings. Employees of most of the large telecommunication companies were given share options. WorldCom is probably representative of what happened. One of the lucrative deals struck by Citigroup's Salomon Smith Barney (now called Citigroup Global Markets) was to get the contract to manage the share options. They were the only people able to sell these shares and it was to them that the employees came for advice.

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Through a spokesman, WorldCom declined to comment on the complaints filed by its workers. But the company hired Salomon in 1997 to administer the plan exclusively, so any worker exercising WorldCom options had to go to Salomon.
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Not only were the WorldCom workers captive to Salomon as a firm, but when they called the telephone number provided by WorldCom they were transferred to a group of brokers in just one office: the branch at 3455 Peachtree Road in the exclusive Buckhead section of Atlanta. Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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Instead of getting independent advice, employees allege the advice they got was intended to benefit Smith Barney. It increased the employees exposure to risk so that they were bankrupted when the company collapsed.

When employees tried to cash in their options every effort was made to obstruct this and put them into debt to Smith Barney by persuading them to borrow money, a high risk exercise. Some it is alleged were encouraged to mortgage their homes so that they could take up their options and hang on to the shares. When WorldCom collapsed the employees not only lost their investment but they had to find the money to pay back the Smith Barney loan. This pushed many into bankruptcy.

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Rather than provide investment advice to the WorldCom workers based upon each one's circumstances or appetite for risk, the dozen or so brokers in the office seemed to push as many clients as they could to use the same strategy: exercise their options, hold onto the WorldCom shares and borrow from Salomon to pay the costs of the transactions and the taxes that were generated. That not only put the clients at substantial risk if Worldcom shares declined but also, because of Salomon's compensation system, generated big fees to the brokers who recommended them.

"There was a pattern and an overlay being applied to all WorldCom employees regardless of what their situation was," said Laurence S. Schultz, a lawyer at Driggers, Schultz & Herbst in Troy, Mich. "That is, on its face, improper for a brokerage firm to allow."
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The representative answering the phone at Salomon Smith Barney, the firm hired by WorldCom to administer its employee stock option plan, said Ms. Smith could not immediately exercise the $500,000 worth of WorldCom options and receive a check for the proceeds. In fact, she could have done that. But Ms. Smith said the representative told her, "It's too many shares to do."

"She said she had to transfer me to the investment advisory group," Ms. Smith recalled.
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OTHER WorldCom claimants and their lawyers all recount identical experiences. The brokers who picked up the phone in the Atlanta office always recommended that customers exercise as many options as they could so as to have a low cost basis on their shares, minimizing taxes. Because WorldCom stock would undoubtedly be higher the next year, the brokers argued, it would be most beneficial for clients to buy the shares at their relatively low exercise prices and to hold on for long-term capital gains tax treatment. Borrowing money from Salomon to pay the taxes owed at the time of the exercise and to pay for the exercise itself was a good idea, the brokers said, because margin interest is tax-deductible.

In presentations to WorldCom clients, the brokers showed charts and graphs specifying the profits workers would make if the shares rose -- just as many brokers do. But never, these former clients said, did the brokers explain what would happen if the shares sank. Nor did they discuss the risks of borrowing on margin. Instead, the brokers called the loans a credit line rather than a margin account, the former customers said.
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To bolster their arguments to buy and hold WorldCom shares, the brokers regularly invoked the name of Mr. Grubman, the powerful telecom analyst at Salomon who was perpetually bullish on WorldCom, a telecommunications colossus.
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Instead of providing personalized advice, the filing said, the brokers developed what was essentially a script that was used to open and maintain as many accounts as they could. The sales pitch involved the exercise-and-hold recommendation without any use of hedging strategies to protect the clients' portfolios in case WorldCom stock declined. And in almost all cases, the brokers advised clients to use a credit line to pay for the transactions and the taxes associated with them. Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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According to Mr. Spartis, after Salomon won the exclusive right to WorldCom's stock option administration, the firm encouraged its brokers to offer clients mortgages that used the stock they held in their accounts as collateral. "I'm sure people have lost their homes," Mr. Spartis said. "The firm's objective seemed to be to get every dollar from every corner there was."

Salomon also became much more lax in approving loans for people who wanted to buy more stock than they had the money for, Mr. Spartis said. "Prior to the bubble, margin loans had to be preapproved before you could commit to the client," he said. "There were three approval levels that margin loans had to go through where compliance people considered suitability. But later, our margin loans were processed without any questions." In a Broker's Notes, Trouble for Salomon The New York Times September 22, 2002

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Employees were advised to hang on to their shares right to the end using Grubman's reports to justify this. They were discouraged from getting out while they could. The brokers who gave this advice subsequently sued Smith Barney and Grubman for invalid research.

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In it, they contend that Mr. Grubman's continual bullishness on WorldCom stock led them to recommend that their clients hold on as the shares fell. In essence, they contend that they were victims of their own firm's research.
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Terri Howell, - - - - exercised her options in February 1999 at $79, when Mr. Grubman was saying that the stock was destined for $130 a share. The following August, when the stock dipped below Ms. Howell's exercise price, she called her broker in Atlanta expressing concern. "He sent me a report from Jack Grubman saying that they would be backing up the truck buying with both hands," Ms. Howell said. "So I held on." Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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Smith Barney also flouted the terms of its agreement with WorldCom in other ways.

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Though the contract with WorldCom banned Salomon brokers from soliciting business from WorldCom employees, that did not stop some brokers, according to an employee who has sued Salomon but who declined to be identified. He said Salomon had called him and pushed him to cash in his options. The brokers in the Atlanta office knew how many options he had, he recalled, and badgered him to exercise them, hold onto the stock and borrow to pay transaction costs and taxes. By following their advice, he lost his entire seven years' worth of option grants, which were valued at $700,000 when he exercised them. Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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Not surprisingly following the exposures of Smith Barney's practices employees have taken to the courts claiming that Smith Barney's advice was not only flawed but deliberately flawed in order to get more money from them.

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So far, 25 clients have filed complaints against Mr. Spartis. Salomon has paid $875,000 to settle three of them. Twenty are pending, and since settlements can be confidential the status of the two others is unclear
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Seth Lipner, a lawyer at Deutsch & Lipner in Garden City, N.Y., who represented the Merrill Lynch client who recently won $3 million, also represents about a half-dozen current or former WorldCom employees who have sued Salomon for losses of about $7 million.
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"Salomon Smith Barney has been ordered to produce documents, but they have asked the arbitrators to order that all documents produced by them in any given case be confidential and used only with respect to that individual case," he said. "That is extraordinary."

Harry S. Miller, a lawyer at Perkins, Smith & Cohen in Boston who represents 20 former Salomon clients who lost $20 million, said Salomon was blocking his requests for documents that are commonly produced in such cases. "They are required by securities regulations to establish and maintain a supervisory system for purpose of protecting public investors," he said. "But they don't want to disclose that information and have it fall into the public hands. It is a very unusual objection." Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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WorldCom was not on its employees side. It secured badly needed funds when employees took up their options. It wanted its share prices maintained so that it could continue to expand. Selling shares after taking up options lowered the price. Any employee selling shares was likely to earn a phone call from Mr Ebbers himself.

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WorldCom also benefited from its employees' option exercises. In 1999, the company received $886 million from workers exercising their options, half of WorldCom's free cash flow that year. In the same year, the company received a tax deduction of $820 million. Because their employees must pay the taxes owed on their stock option exercises, companies issuing the shares receive a tax deduction in the amount of tax that their employees have paid. Outrage Is Rising as Options Turn to Dust The New York Times March 31, 2002

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The New York Stock Exchange has been looking into Salomon Smith Barney for its role in persuading employees of Worldcom, the telecommunications company, not to sell some of their shares in the company a few years ago. By holding the stock, the employees helped lift Salomon's profits, but the decision ended up costing some people virtually their entire savings, as Worldcom's stock has fallen to $2 from a peak of $60 in 1999. Winners, Losers and Liars; The Long Boom's Ugly Side The New York Times May 12, 2002

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Did Smith Barney benefit by trading on inside information?

Another possible fraud relating to employee options was revealed by a past Smith Barney broker. Once again it involves conflicts of interest that required different sections keep information confidential. They did not see this as necessary.

If large numbers of employees were either buying or selling shares then the share price would rise or fall accordingly. This always happened around January when employees could exercise their right to buy shares at a discount then keep them or sell them. Anyone with information about what they planned to do could quickly make an easy profit. The brokers handling these accounts knew.

The broker who described this claims he was urged to make this information available to the managing director of Citigroup's global retail sales and trading which traded in shares. While he ducked the question and did not do so it seemed that no one else saw this as wrong and others probably did so. The way the shares traded subsequently suggested to him that all was not as it should have been but it was impossible to tell whether this was for the benefit of customers or for the Smith Barney traders.

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Someone who knew that a lot of stock would be for sale, for example, could have profited handsomely (and virtually risk-free)
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Mr. Spartis recalled a conference call at the end of 1999 in which Michael Santomossimo, an employee in Salomon's stock option administration group in New York, suggested that they give Michael P. Molnar, then managing director of global retail sales and trading, a "heads up" about the number of options that would be vesting.

"It seemed very routine for him to do this," Mr. Spartis said.
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"Santomossimo told Molnar that we have a major vesting coming up. Molnar asked how many WorldCom options would be vesting and how many orders to sell were in the electronic queue." Such information is not available publicly.
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To Mr. Spartis, giving away such information meant that the firm's trading desk could be in a position to profit at the expense of his customers - - - - . In industry parlance this is known as "front running," or trading ahead of customers, and is forbidden by the Securities and Exchange Commission and by Salomon's own code of ethics.

Although Mr. Spartis declined to share the information with others at Salomon, he recalled, Mr. Santomossimo said he could provide the figures Mr. Molnar wanted. The three men made a date to talk again before the market opened on Jan. 3, 2000.
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Mr. Spartis said that before the market opened that day there were several conversations about the hundreds of thousands of shares waiting to be sold.
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"Should the trading desk have had that information?" asked William Fleckenstein, a money manager at Fleckenstein Capital in Seattle. "My guess is probably not. If they used it to get a better execution for the customer, God bless 'em. But if they used it to profit for the firm disproportionately, it's wrong." In a Broker's Notes, Trouble for Salomon The New York Times September 22, 2002

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This page created January 2004 by Michael Wynne