Revenge of the Investor

Angry shareholders are investigating brokerage fraud, waging proxy fights, and agitating for securities reform

When he saw the news on the Securities & Exchange Commission Web site, Floyd Schneider couldn't help but gloat. He swiftly contacted his friend and colleague, Richard M. Cocchieri, whose reaction was more subdued: satisfaction and professional pride. There it was, about halfway down the SEC News Digest of Sept. 30, 2002: The SEC was launching a civil enforcement action against 17 defendants, led by a Texas brokerage named Salomon Grey Financial Corp., accusing them of engaging in a pump-and-dump stock swindle.

These were the targets of their investigation--Schneider's and Cocchieri's. This was, as far as they were concerned, their enforcement action.

These two men are investigators--but they don't work for the SEC or the NASD or the FBI. Cocchieri is a dentist, Schneider a mortgage broker. They are in their early forties and live in the northwest suburbs of New York City. They don't hunt corporate wrongdoers to dig up grist for lawsuits or to snag government bounties. It's not about getting money. It's about getting even.

Like thousands of other investors, they became involved in the markets in the late 1990s and were disillusioned, big-time. Usually the story would have ended there, with a deflated portfolio, a pile of unopened brokerage statements, and a vow to stay away from stocks.

With stocks tanking, widespread economic misery, and scandals draining portfolios--$170 billion in direct losses from the eight major corporate and accounting controversies--it's no surprise that investors are fleeing. Some $2.4 billion poured out of equity mutual funds through Aug. 31, vs. net inflows of $43.6 billion of new money in the same period last year. But amid all the frustration, a new dynamic is emerging.

Many investors are taking matters into their own hands. They are fighting back--and winning. It's almost as if the Peter Lynch credo of the bygone bull market has been turned on its head. In his classic 1989 book, One Up on Wall Street, the legendary former Fidelity

Magellan manager preached the virtues of self-help. That spirit is still very much alive today, only now, instead of picking stocks, investors have turned to picking on their adversaries--stock promoters, online investment letters, and brokerages that push questionable stocks. Some, like Schneider, Cocchieri, and dozens of others, are investigating potential miscreants. Others are waging proxy contests and pressing for changes in SEC regulations. And they have turned state regulators around the country into the No. 1 engine of Wall Street reform.

The void at the top of the SEC--and the months of Harvey L. Pitt's widely criticized leadership--is a key reason for all this. Wall Street's own numbers tell the tale. A massive 41% of investors say that "dishonesty" is the main issue facing the securities industry today, vs. 8% a year ago, according to a survey conducted for the November annual meeting of the Securities Industry Assn., the brokerage trade group. And only 26% have much confidence that the Sarbanes-Oxley Act--which created a new accounting board and included other confidence-building measures--will substantially reduce corporate chicanery or accounting fraud.

Amid this meltdown in public confidence, investors are finding ways of compensating for the power vacuum in Washington. Investor-activists, by providing a kind of early warning system against small-stock fraud, offer crucial tips and research to an overburdened SEC in battling a $10 billion-a-year investor rip-off. Reacting to the portfolio losses of the rank and file, labor unions brought 40% of shareholder resolutions during the past year's annual meetings. The AFL-CIO is pushing for rules that would give small investors even more clout.

And if Wall Street thinks New York State Attorney General Eliot Spitzer is its worst nightmare, there are 49 other potential nemeses in the wings. In Utah alone, state regulators have referred 66 securities-fraud cases for criminal prosecution so far this year, vs. 35 during all of 2001. And more states are following suit by beefing up their securities-fraud laws and staffing up on scam-busters.

Even the securities industry's most cherished sacred cow, the arbitration system for settling disputes, is feeling the ferocity of investor wrath. Though the system is widely perceived as unfriendly to investors, their claims against brokers are running 12% higher than 2001's record levels. And a move by California to reduce arbitrator conflicts of interest is unfolding as a challenge for Wall Street's longtime control of the dispute-resolution process. Even before any laws change, some arbitrators are shedding their tendency to give the benefit of the doubt to large firms--as evidenced by a nearly $8 million judgment that was recently won against Merrill Lynch & Co. (MER ) for allegedly failing to execute a sell order. "The pendulum is shifting in favor of the investor," says Jacob Zamansky, a New York securities lawyer who has successfully taken on Merrill.

BusinessWeek has probed the depths of investor activism. The findings are surprising and, in a way, reassuring. If government continues to fall short, investors themselves will step in to do the job.


Cocchieri, Schneider, and people like them are the purest expression of investor self-help. When their profits turned to losses in the late 1990s, they didn't just give up. They turned the powerful information resources of the Internet against interconnected networks of promoters who use the Net to peddle stocks. The two men--at first "dumb as a rock," as Cocchieri puts it--have built a veritable armory of mostly free Net resources, including Web sites with SEC and other public documents, as well as search engines that mine other search engines. And they use them every single day.

Their research has led to a series of coups. For example, Schneider and Cocchieri honed in on a convicted stock manipulator named Theodore R. Melcher Jr., who pleaded guilty to stock-fraud charges in 1997 in one of the first federal prosecutions of Internet fraud. Melcher ran a Web site that was shut down when he was imprisoned. But after he was released in 1998, the pair found, he had gone back in business, quite legally running an investment Web site and continuing to promote small-cap stocks. Tracking the stocks that Melcher was pushing has led to other stocks and other promoters, information the two men shared with investigators.

The results of the past few months have been gratifying. Only 17 days after the Sept. 30 SEC action--which Salomon Grey, in papers filed with the SEC, has denounced as "frivolous"--the NASD brought action against a firm called National Capital Securities, which was the focus of an extensive investigation by Schneider. The NASD maintained that National Capital provided fraudulent research reports online. The NASD, citing longstanding policy, won't comment on whether information supplied by investors played a role. A person who answered the phone at National Capital's parent company said the securities firm was shutting down and that no one was available to comment.

Other investor activists are using the Internet to exchange information and put pressure on companies. The initial results have been encouraging. In late 2000, shareholders in the Texas-based Luby's Inc. cafeteria chain got organized through Yahoo! Inc. (YHOO ) message boards. As a result, the Committee of Concerned Luby's Shareholders ran its own slate of directors and won a respectable 24% of the vote. The dissidents say they deserve at least part of the credit for the departure of then-CEO Barry J.C. Parker, who they had slammed for failing to boost flagging sales. The committee went on to petition the SEC to make it easier for shareholders to run their own slates of directors. The rule change is pending.

There are limits to this kind of activism. Les Greenberg, a semiretired California lawyer who heads the Luby's committee, notes that staging a full-fledged proxy contest is something few small investors can pull off. It's complex, expensive, and requires professional assistance. Fortunately, help is at hand--from a traditional foe of the investor class.


For years, AFL-CIO's Office of Investment labored in obscurity. It opened in 1997, to act as a shareholder advocate for labor unions' billions in pension fund holdings. No one paid much attention--not union members, not company managements, and certainly not the SEC. But today, the AFL-CIO is a player. The office's director, Bill Patterson, can hardly keep pace as he pursues one reform demand after another, ranging from corporate governance to accounting standards. He's desperately hiring staff to help push new shareholder initiatives.

Corporate America has felt labor's sting most directly in a hail of proxy resolutions. Last spring, unions placed 191 resolutions on company ballots, with that number comprising two-thirds of those put forth by institutional shareholders, according to the Investor Responsibility Research Center. Increasingly, companies are taking heed. For example, in October, Norfolk Southern Corp. (NSC ) and Bank of America (BAC ) adopted union-backed demands for restrictions on golden parachutes for executives. BofA now will require shareholder votes on top officers' severance payments that are more than double their annual pay. The AFL-CIO also is urging the SEC to allow stockholders who can muster support from, say, 10% of shareholders to nominate their own director candidates alongside management slates.

Already, unions are gearing up for the 2003 proxy season. They plan resolutions at every Standard & Poor's 100 company plus dozens more, bringing the total to close to 400. Patterson expects to win some of these battles before they even get to a vote. For example, this year the AFL-CIO negotiated standards on analyst independence with Goldman Sachs (GS ), Merrill Lynch (MER ), and J.P. Morgan Chase (JPM ), long before Spitzer turned his gunsights on the issue.

Wall Street firms might feel beleaguered by the constant drumbeat of investor-driven demands. But guess what? It's about to get worse.


The campaign for Indiana Secretary of State doesn't generally get much attention, even in Indiana. This official issues licenses and registers corporations. Humdrum stuff. But in Indiana, the secretary of state is also in charge of securities regulation. And this year, the heat was turned up in what is usually a yawn-fest.

In this contest there wasn't a dime's worth of difference between Republican Todd Rokita, who won on Nov. 5 with 54% of the vote, and his Democratic opponent, John Fernandez. At least, not when it came to the newest mom-and-apple-pie issue--securities regulation. Both men vigorously hacked away at a theme that had great voter appeal in this solidly Republican state in 2002: The urgent need to incarcerate corporate wrongdoers.

What is getting Hoosiers up in arms nowadays can be summed up in three letters--A-E-S. AES Corp. acquired Indianapolis Power & Light Co. in July, 2000, only to see its share price collapse when wholesale electricity prices tumbled in the wake of Enron Corp.'s implosion. Investors were hit hard. "We have people in our own backyard now who have lost millions of dollars," says Fernandez. "The voters feel pain, and in typical political fashion, we're responding," says Rokita.

The measure that both Indiana candidates advocated--stepped-up criminal prosecutions--is not just empty political talk. Christine A. Bruenn, Maine's securities commissioner and president of the North American Securities Administrators Assn., says: "We preach it at every conference--that the way to get the message across is to bring a criminal action."

Regulators nationwide are saying "amen." In June, West Virginia adopted legislation making it easier to prosecute brokerage firms by strengthening the laws against securities sales practice and compliance violations. In Utah, the Attorney General's office has a financial crimes unit that prosecutes cases brought by the state's aggressive securities regulator, S. Anthony Taggart. In other states, despite widespread pressures on their budgets, securities regulators are quietly ratcheting up their forces--hiring a forensic accountant here, a prosecutor there.

So while Spitzer gets the headlines, his counterparts in the hinterlands are exercising their own muscle more and more. Missouri Secretary of State Matt Blunt, for example, has vocally objected to Merrill Lynch's proposed $100 million settlement with the states over charges that its analysts misled investors. Blunt is worried that fines are just "an operating cost for these companies: They pay the fine, which becomes just a cost of doing business." And he has a point. It's an article of faith in the securities industry that brokerage firms don't give a hoot about fines, unless they are huge. The real potential exposure comes from investors who feel they have been ripped off and would love to sue--but can't.


Through bull market and bear, one feature of Wall Street has remained the same--the arbitration system that handles disputes between brokers and customers. Administered by the NASD and New York Stock Exchange, it has long been criticized as biased against customers. Plaintiff lawyers contend that large firms have particularly benefited, because of a widespread assumption by arbitrators that they adhere to a higher standard of ethics than smaller, less well-known brokerages.

That's beginning to change. State regulators, led by California, are pushing to make arbitration fairer. And arbitrators and juries are delivering megaverdicts against big firms. In August, a couple in Pennsylvania won a $7.7 million judgment against Merrill Lynch, which allegedly failed to execute a sell order. Merrill Lynch is appealing. In October, an Ohio jury awarded $12 million in compensatory damages and $250 million in punitive damages against Prudential Securities Inc. In a class action, more than 250 investors claimed that a broker had sold investments in 1998 without authorization. Prudential is fighting the verdict. The biggest judgment of all, in November, 2001, was a $430 million arbitration award against a former UBS PaineWebber and Lehman Brothers Inc. (LEH ) broker, Enrique E. Perusquia, who had pleaded guilty to stealing from customers. The Houston securities lawyer who won that verdict, Thomas R. Ajamie, believes arbitration forums remain a hazardous place for investors. Even so, some plaintiff lawyers say they believe that the big brokerages are losing their advantage. "I think it's clear that the presumptions and the biases of the panels have dramatically shifted in one specific area--which is the good faith that major brokerage firms had, going into Day One of the arbitration," says Bill Singer, a New York securities lawyer.

Even if the arbitrators themselves resist the change, the system itself is under attack from the investor's new ally, the states. California fired the first shot in September, 2001, when it passed legislation requiring new ethics standards. It requires arbitrators to disclose their potential conflicts of interest, such as business relationships between the parties and arbitrators' family members.

The NASD and NYSE went through the roof. As soon as the rules took effect on July 1, the two filed suit against California's Judicial Council, claiming that the rules are excessively burdensome and are preempted by federal law. After a brief flurry of papers--with the SEC siding with the two exchanges--U.S. District Court Judge Samuel Conti on Nov. 14 dismissed the suit on the grounds that the 11th Amendment prohibits naming state agencies as defendants. The NASD and NYSE are mulling an appeal.

The struggle in California over arbitration rules illustrates the problems facing investors as they flex their muscles. Wall Street remains as eager as ever to protect its prerogatives. But in state after state their clout is being felt, whether through suburban investor-investigators or Washington labor lobbyists, arbitrators or local prosecutors. They're fighting to make investor voices heard, and for the first time in memory, people in power are listening.

By Gary Weiss, with Aaron Bernstein in Washington, Michael Arndt in Chicago, and Emily Thornton, Mara Der Hovanesian, and Heather Timmons in New York

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