March 31, 2002
By Gretchen Morgenson
The New York Times
It was February 1999, and after 10 years of work in the communications industry, Kimberly Smith was about to realize her dream. A single mother with an infant son, Ms. Smith had amassed $1.1 million in savings and in stock options on WorldCom (news/quote) 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.”
But when she called the toll-free number provided by WorldCom for employees interested in exercising their options, she recalled, she was told that the transaction could not be completed at the time. 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.
Which she did.
Ms. Smith, who is now 37, did not know it at the time, but her dream was about to become a nightmare. Less than two years later, she had lost her $1.1 million nest egg. A stock market neophyte, she said she was pushed by a Salomon Smith Barney broker in an Atlanta office to exercise her options, hold her WorldCom stock and borrow from the firm to pay for the transactions. When WorldCom and other technology stocks collapsed in 2000, she was left with margin loans and taxes that had destroyed her life savings.
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 (news/quote), 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.
Salomon declined to comment in detail about that investigation or the suits filed by WorldCom employees, many of which are now in arbitration. Susan L. Thomson, a spokeswoman at the firm, said: “We take all client claims seriously and review each on its own merits. Many of these claims rely largely on the benefit of clear market hindsight. These employees strongly believed in the ongoing prospects for their company and had confidence in the continued appreciation of their company’s stock. As a result, it was their expressed desire to keep their WorldCom holdings intact.”
But six current and former WorldCom employees and lawyers who are handling the cases of many others dispute that assessment. They paint a picture of a brokerage office in Atlanta that was out of control.
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.”
When challenged in the past over similar stock option cases, brokerage firms have maintained that losses incurred by employees like Ms. Smith stemmed from their own greed or poor judgment. But at least one arbitration panel has recently ruled otherwise. Earlier this month, in a case that did not involve WorldCom stock, arbitrators found that a Merrill Lynch (news/quote) employee had given questionable advice to a client exercising his stock options. They awarded the customer $3 million in damages; he had asked for $3.8 million.
That may be the first of many payments by brokerage firms, said Lawrence Klayman, a lawyer at Klayman & Toskes in Boca Raton, Fla. He represents 20 WorldCom claimants against Salomon whose losses total $20 million. “I believe the industry will probably pay out $20 billion in the next five years in option cases,” he said.
Though many employees of technology companies lost money when the stock bubble burst in 2000, WorldCom employees appear to have been hit especially hard. In part, that is because many had to act fast. In September 1998, WorldCom merged with MCI, and many employees lost their jobs in layoffs meant to cut costs at the combined companies. Like most options plans, the WorldCom program gave departing employees up to one year to exercise their stock options before they expired.
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. Although such an arrangement is not unusual, it was not the way the stock option plan had been run at MCI. There, former employees said, they could choose one of three brokerage firms to deal with stock option exercises.
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.
The head of the WorldCom stock option plan for Salomon was Philip L. Spartis, 49, a broker who joined the firm in 1984. Mr. Spartis, who had landed the account for Salomon in 1997, was helped in handling it by two more brokers, William David Hobby, 35, and Amy Jean Elias, 36, a former insurance agent.
Securities industry records show that Mr. Spartis and Ms. Elias were terminated by Salomon on March 1 for abandoning their jobs. Their lawyer did not return repeated calls for comment. They, too, have gone to court, filing suit against Salomon and Jack B. Grubman, the firm’s prominent telecommunications analyst. 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.
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.
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.
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.
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.”
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.
Terri Howell, a former spokeswoman for WorldCom who left the company in 1998 to take care of her ailing mother, 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.”
Besides dropping Mr. Grubman’s name, Mr. Spartis, according to several clients, would often refer to discussions he had had with Scott D. Sullivan, the chief financial officer of WorldCom, as a friend and client. These references often came, the former customers said, when WorldCom stock was falling and Mr. Spartis was trying to persuade customers to hold onto it.
It is common for a brokerage firm that provides investment banking services to a company to try to win other business as well, like its stock option administration, and Salomon was WorldCom’s investment banker. Personal relationships between corporate officials and a particular broker are also helpful in deciding which firm gets a company’s option plan, said Bruce Brumberg, co-founder of the Web site myStockOptions.com. “It’s very personal,” he said. “A lot of C.E.O.’s and C.F.O.’s in certain companies may show favoritism to a brokerage firm they deal with.”
It is not clear how Mr. Spartis won the WorldCom account, though the company had had dealings with the Atlanta branch before it was designated to handle the company’s option program. Mr. Spartis and Mr. Sullivan may have become acquainted in the early 1990’s, when Mr. Sullivan was treasurer of Advanced Telecommunications, which had offices in the same building in Atlanta where Mr. Spartis worked for Salomon Smith Barney.
The WorldCom spokesman said Mr. Sullivan was not involved in the decision to tap Salomon for the company’s option program.
Salomon is one of the largest firms in the business of managing stock option plans. But a document filed in one of the WorldCom arbitration cases against it asserts that the Atlanta brokers “were untrained for the intricacies of employee stock option exercise and management of investments of high net worth individuals with concentrated positions.”
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.
The arbitration document also argues that Mr. Spartis operated virtually without supervision from the branch manager, Michael J. Grace. Whenever Mr. Grace tried to supervise the brokers, it says, Mr. Spartis threatened to take his unit to another Salomon branch.
While many WorldCom workers wound up losing everything in their dealings with Salomon, employees of Salomon made a lot of money. They received fees based on the assets under management and on margin loans.
Mr. Spartis, as head of the group, probably reaped the most from the WorldCom business. And he lived well. According to real estate records, in late 1998 he bought a 13-room, colonial-style home in Atlanta for $752,000. He also owns a 23-foot Sea Ray motorboat.
As branch manager, Mr. Grace shared in the money Mr. Spartis’s group was generating. In 1999, he sold a house for $515,000 and moved into a $1.1 million house with five bedrooms, six fireplaces, a three-car garage and a pool, according to real estate records. Mr. Grace forwarded a call seeking comment to Salomon headquarters in New York City.
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.
With suits from both former employees and clients, Salomon is battling the WorldCom situation on two fronts. 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. Another broker, Mr. Hobby, who is still with Salomon in Atlanta, has two additional suits against him, and Christopher Cahillane, a broker in a group from the Atlanta office that left to join UBS Paine Webber in 2000, has three suits against him. Salomon declined to make Mr. Hobby available for comment. And through a UBS spokesman, Mr. Cahillane declined to discuss his case.
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. Mr. Lipner, whose first arbitration case is scheduled to be heard in May, said Salomon was going to extraordinary lengths to prevent the public from knowing what went on in the Atlanta office.
“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.”
A spokeswoman for Salomon said the request for confidentiality was often made by its lawyers.
Some former clients who lost life savings and college education funds for their children because of the Atlanta brokers feel betrayed by Salomon. They expected more from a well-known brokerage firm.
But Mr. Klayman said: “Whether you’re doing business at a major firm or at a bucket shop, the mentality is the same. Write the tickets, generate the commissions, and we’ll worry about it later.”
Now, WorldCom is reconsidering its employment of Salomon as the company’s option administrator. Its stock closed last week at $6.74.