When A Broker Feels Betrayed By His Firm

Every broker knows the cardinal rule of the industry: Be loyal to your firm. But as any experienced broker knows, obeying your employer can sometimes mean hurting your customers.

Howard J. Clark learned this lesson the hard way. He has been waging a bitter battle against PaineWebber Inc., his former employer, to protect the interests of his customers who lost money in a troubled limited partnership. Essex Financial Partners LP, was sponsored by PaineWebber, and its goal was to buy savings and loan associations. Essex, though, produced huge losses for the 2,700 customers who bought $40 million worth of Essex during 1989-90. After Clark failed to persuade top PaineWebber officials to compensate 27 of his clients who invested in Essex, he quit the firm. In an act of disloyalty to PaineWebber--but loyalty to his customers--he is supporting his clients in a New York Stock Exchange arbitration action filed against PaineWebber in 1993. The case is pending.

NO REPORT. For PaineWebber, the Essex affair is an embarrassing black eye, an aggressive marketing campaign to attract investors that turned out to be mostly fantasy. In pitches to the firm's brokers, PaineWebber said Essex, which was listed on the American Stock Exchange, was a stable investment for income-seeking investors--"well suited for pensions." The firm said it would pay an immediate 8% annual return and an additional 7% down the road. PaineWebber, which had oversight over the LP, said it had chosen an experienced management team to run Essex. And it said the firm's analysts would issue regular research on the investment.

In fact, Essex turned out to be a speculative, high-risk proposition. It began trading at 20, then sank sharply below 1--and now trades at around 3. The luckiest investors got little more than their money back, while others suffered an estimated $37 million loss. PaineWebber ousted Essex's management team in 1992. And the firm never issued a research report on Essex.

The Essex episode comes at a difficult time for PaineWebber. The firm is acquiring Kidder, Peabody & Co. and is trying hard to stop competitors from luring away Kidder's top-producing brokers. Those brokers may think twice before opting to stay and sell PaineWebber products. They might also be influenced by Clark's experience at the firm. "They are trying to portray me as a rogue broker," Clark says. "They are rogue senior managers. They don't serve the public."

Nonsense, says J. Richard Sipes, a PaineWebber executive vice-president who was on Essex' oversight committee. "We are guilty of a bad economic investment," he concedes. But "we are not guilty of what one dissident alleges"--referring to Clark. Sipes attributes Essex' plight to poor management by Essex, an unexpectedly sharp drop in interest rates, and overzealous regulators, who hobbled the Essex business plan. Says Sipes: "I don't think any marketing material, any prospectus, any oversight board can control what happened there."

"HIGH ROAD." Sipes insists that PaineWebber has acted more than responsibly to help its customers. It removed Essex management as soon as it could, under the terms of the partnership. And rather than walk away from Essex, the firm put in more than $20 million to keep it afloat. "We conceived it, stuck with it, and took the high road," he says. "We were by far the biggest losers." Although Essex investors lost money, Sipes points out that they were free to sell their holdings at any time.

Getting into a public battle with PaineWebber is something Clark, 40, never would have dreamed of back in 1986, when he signed on with the firm in its Pearl River (N.Y.) office. Over the next three years, he worked his way up to PaineWebber's Pacesetter Club for brokers making at least $250,000 a year in commissions, a modest but respectable level. His clientele consisted of conservative investors looking for income.

Although the LP boom was well under way when Clark joined PaineWebber, it wasn't until 1988 that the firm stepped up efforts to originate and market partnerships by hiring a team from E.F. Hutton Group Inc. Limited partnerships are vehicles that make direct investments in areas such as real estate and equipment leasing. In a PaineWebber magazine, Stephen Hamrick, head of the direct-investment department, noted that while 49% of Wall Street's retail clients had invested in LPs, only 13% of PaineWebber clients owned direct investments. "That spells real opportunity for our brokers," Hamrick said. Hamrick didn't return calls from BUSINESS WEEK.

Essex was one of Hamrick's first ventures. The idea was sound: The partnership would buy undercapitalized but otherwise healthy thrifts on the cheap, assemble them into a larger regional bank, and then sell it, reaping a handsome premium for investors--as much as $60 a share, compared with its initial $20 price, according to Essex' pitch to brokers.

PaineWebber knew little about banking ventures. But it figured it could rectify this by teaming up with a seasoned banker, Lawrence N. Smith, who had been president of United Virginia Bank, now Crestar Bank, a large regional outfit in Richmond, Va. In 1984, Smith and his team bought its first property, a small Elizabeth City (N.C.) thrift named Essex, which became the LP's core holding. PaineWebber, says Sipes, did exhaustive background checks on Smith and found his credentials "pristine."

Next, PaineWebber whipped up its brokers to sell Essex. In addition to "low volatility," a skilled management team, and the LP's liquidity as an Amex stock, the Essex marketing material cited the lush 15% annual return: 8% initially, then an additional 7% after Essex had created and sold the regional bank, plus 45% of any additional appreciation.

Essex' prospectus emphasized that PaineWebber, as a "special limited partner," would watch over the investment and intervene if Essex ran into trouble. Brokers were told in an internal brochure that Essex would "be followed by PaineWebber research," which presumably would provide quasi-independent oversight. In 1990, the firm's savings and loan analyst, Gary Gordon, issued a positive opinion on Essex in an audio tape to brokers.

From September to December, 1989, Clark sold $400,000 worth of Essex shares to his customers, mostly in chunks of $6,000 to $30,000. When representatives of the direct-investment group urged him to sell more, Clark decided to investigate on his own: Along with his branch manager, he visited Smith at Essex headquarters in Virginia Beach, Va.--at PaineWebber's expense. "Smith reassured me," recalls Clark. "He said, `I'm a very conservative banker. You have nothing to worry about."' Back in New York, Clark sold an additional $240,000 worth of shares.

NO DICE. But disasters began buffeting Essex almost as soon as it was listed in July, 1990. A commercial loan went bad, requiring a big increase in the loan-loss reserves. Earnings for 1990 were a mere $476,000, or 3 cents a share--$1.57 shy of the $1.60 needed to pay an 8% return.

Furthermore, consolidating the thrifts Essex acquired in Florida, North Carolina, and Virginia proved impossible, says Sipes. While the Federal Home Loan Bank had approved Essex' business plan, the new Office of Thrift Supervision insisted that each must remain a stand-alone entity, nixing anticipated economies of scale.

The biggest losses were caused by a sharp shift in strategy--a risk not mentioned in the marketing materials. In early 1991, to boost returns, Essex bought more than $20 million worth of mortgage-servicing rights. These entitle the holder to principal and interest payments on existing mortgages. Essex paid for the rights by selling $23.4 million in 11% notes in a PaineWebber private placement to 600 of the firm's richest or "accredited" investors. With interest rates declining, PaineWebber and Essex thought Essex would profit by borrowing at low rates and collecting higher rates on the mortgages.

There was only one problem: Homeowners with high-rate mortgages also took advantage of lower rates, which fell much faster than expected, and refinanced. This left Essex with a rapidly depreciating asset. In 1991, Essex lost $7.4 million. By mid-1992, Essex was trading at 7 and had not paid dividends to investors for three quarters. PaineWebber removed Smith after 2 1/2 years--as soon as they could, says Sipes. "We were not real happy with Lawrence Smith," he says. Smith puts the blame on PaineWebber, which, he says, mismanaged Essex after he left.

But PaineWebber's move came too late. By November, 1992, Essex was on the verge of defaulting on the Essex notes. To avoid bankruptcy, PaineWebber injected money into Essex by buying back the 11% notes.

Throughout this period, says Clark, he was being advised by the direct-investment group to stick with Essex. Sipes denies that brokers were given any such assurance. "We did not suggest to brokers that they buy or sell the security," he says. He adds that the firm never produced a research report because of the departure of several bank analysts. In a note to Clark in late 1992, Hamrick remarked: "Like you, I am exasperated and increasingly embarrassed by the inability to get you information you can use with your clients."

DISTRAUGHT. Clark wasn't the only one concerned about what was going on. On Jan. 11, 1993, in a letter to PaineWebber President Paul Guenther, a PaineWebber broker complained: "I have 43 clients holding the units and 13 clients holding $440,000 of the capital notes. These are among my best and most faithful clients, and if Essex is allowed to fold, I have basically `burned my customer book' after 30 years in the business. Please do what is morally right and ultimately in the best interest of PaineWebber, its clients, and its brokers."

Increasingly distraught, Clark wangled a meeting in January, 1993, with Joseph J. Grano Jr., head of PaineWebber's retail brokerage division. Clark says he complained about Essex' performance and said he had been misled by the private investment group. Grano was sympathetic and said a solution was at hand.

That turned out to be the buyback of the Essex notes, which not only kept Essex afloat but also gave the accredited customers who held the notes 100% of their money back. But the move did little for Clark's clients who owned the rapidly depreciating LP interests. "That's when I realized I was going to stand up for my clients," says Clark.

Clark resigned in September, 1993, and referred his clients to another PaineWebber client who was organizing an arbitration action with the NYSE against the firm. Although he wouldn't be part of the arbitration, he knew he couldn't work with his clients and their lawyer against PaineWebber while still employed there. In December, New York lawyer Bruce S. Schaeffer filed the case on behalf of 27 of Clark's clients who owned Essex.

"A TRAVESTY." In January, 1994, Richard L. Coffman, a Texas lawyer at Provost & Umphrey, filed a class action in federal court against PaineWebber on behalf of 13 PaineWebber client accounts. The suit was settled in October. The settlement's main feature was that PaineWebber forgave the mutstanding $20 million in Essex notes. That strengthened Essex' anemic balance sheet, causing the stock to rise from 2 to 3, which modestly helped the LP investors. Investors who had already sold Essex were promised $1 million. Coffman says that he is "thrilled" with the settlement, while Schaeffer calls it "a travesty." Schaeffer believes his clients will do better in arbitration.

Essex is now reorganizing and trying to raise more money. Its architects have gone on to other pursuits: Smith is running Resource Bank, a community bank in Virginia Beach. Hamrick has jumped to Wall Street Investor Services, which markets investment products to banks.

Clark faces a more uncertain future. Now at an independent broker-dealer, he is making only one-third of his former income. He is fearful of a PaineWebber vendetta, a possibility the firm dismisses. In February, PaineWebber filed an amendment to Clark's U-5, an important employment record maintained by the National Association of Securities Dealers. The amendment erroneously said that he had been the subject of a customer arbitration complaint. PaineWebber withdrew the amendment when Clark protested. But a NASD investigation is still pending, Clark says. And Sipes suggests that Clark may be guilty of misrepresenting Essex' prospects to clients. Says Clark: "I was doing exactly what the firm was telling me to do."

In the end, the Essex saga is a cautionary tale for investors. In choosing his clients over his firm, Clark found himself with very little to gain and a great deal to lose.

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