Chapter 1
The Greatest Stock Scam of All Time
The primary cause of the Great Stock Panic is not the vile acts of 19 terrorist hijackers. Nor is it the threat of future attacks. Rather, it is the Great Stock Scam of the 1990s, probably the greatest scam of all time.On April 26, 1999, Morgan Stanley Dean Witter & Co., plus 18 other Wall Street brokerage firms, gave you a recommendation that could have transformed a comfortable retirement into a life on welfare.
They recommended Priceline.com as "a quintessential virtual business model," and gave it a "strong buy" rating or equivalent. When they made this recommendation, Priceline was selling at $104. Twenty-one months later, it was trading for $1.50 a share. If you listened to Morgan Stanley, or to any of the other 18 firms, and you sank $10,000 into this turkey, you'd be left with a meager $144. That's a whopping 97% loss.
Then there's Amazon.com (a.k.a. "Amazon.bomb"), also much beloved on Wall Street. In December 1999, Merrill Lynch and 32 other Wall Street brokerage firms gave it superlative ratings and told investors like you to scoop it up. If you'd put $10,000 into this company at $113 a share, you'd have lost a whopping $8,761 by year-end 2000, as it plummeted to a meager $14 per share.
What about that other Wall Street favorite, Drkoop.com, which also had several Wall Street brokerage firms touting its stock at $45 a share? If you'd followed Wall Street's advice, you would have lost more than $99 out of every $100 you invested.
The battering you'd have taken if you'd followed Wall Street's advice doesn't stop there. If you'd invested in Procter & Gamble, you'd have lost 56%. You'd have lost another 57% in Cisco. Investing in Oracle would have cost you 53%. Intel, another 60% loss. Not to mention the 2,500 other tech stocks � like Software.com, BEA Systems, CNET, 3Dshopping.com � that Wall Street brokers kept telling you to scoop up as "bargains."
All told, the total market value of the over 4,300 stocks listed on the Nasdaq plunged from $7.58 trillion on March 10, 2000 to $2.39 trillion on April 6, 2001. Investors lost $5.19 trillion � more money than was lost in the worst crashes of all recorded history, the equivalent of nearly half the entire GDP (Gross Domestic Product) of the most powerful economy in the world. All in just 15 months.
A key cause was the companies' earnings, which turned out to be far lower than most everyone expected. Some companies couldn't claim a penny in earnings. Others couldn't even claim a penny in sales. But nearly all continued to brag about great results and get Wall Street's best ratings virtually until the bitter end.
What happened? How could the earnings information and investment advice given to so many investors have been so far off from the truth? And how was it possible for so many investors to lose so much money so quickly?
Many investors blame themselves, regretting their own weaknesses to greed or fear. And certainly, those emotions do play a role. But if you've lost money in the debacle, you should know that it's probably not your fault. You've most likely been the victim of a massive, elaborate scam, which by sheer virtue of its enormity, is more sophisticated than even the savviest of investors.
This great scam is not planned in a conspiracy; it has evolved naturally in an environment of complacency. It is not perpetrated by one, two, or even a dozen exceptional institutions; it envelops almost everyone � chief financial officers at major corporations, the most respected research analysts on Wall Street, and tens of thousands of individual brokers.
Their ubiquitous tool: misinformation. Indeed, the critical information you need to make sound investment decisions is passed through a series of filters, each removing some piece of bad news, each adding a new layer of hype, distortion and even outright lies.
In this chapter, I'll follow the trail by tracking the flow of information � from its source (the corporation), to the Wall Street research analysts and, finally, to the brokers who serve individual investors. I'll start at the source ...
31% of Companies Listed on US Stock Exchanges Are Suspected of Manipulating Earnings Reports
The single most important piece of fundamental information you need about a company is its current earnings. So it's no coincidence that earnings information is often the prime target for manipulation and distortion � by none other than the company officials responsible for compiling and issuing the data each quarter.These company officials come under intense pressure to meet Wall Street's overblown expectations. If they don't, they know their shares will most likely be severely punished. So when they realize their actual earnings are falling short, many resort to gimmicks � both legal and illegal � to twist the truth. The consequences for investors are disastrous.
- Nine West, a large women's footwear and accessories firm, misrepresented revenues following its 1995 acquisition of U.S. Shoe Corp. When the company disclosed that it was under investigation by the Securities & Exchange Commission (SEC) for this matter, its stock fell 87.1%.
- When Mercury Finance disclosed that "accounting irregularities" had grossly overstated its profits in previous years, its shares lost 80% of their value.
- Shareholders in Summit Medical saw their stock slide nearly 90% for similar reasons.
- McKesson HBOC Inc. was forced to restate three years' worth of revenues because of "accounting improprieties." The stock plunged 82.3%.
- Sunbeam Corp. falsely reported $96 million in "income" it never earned. Its stock was virtually wiped away � down 93.4%.
- Tyco fell 58.2% ... Informix fell 89.1% ... and Safety-Kleen lost a whopping 95.8% � all because their earnings had been distorted.
How widespread is this problem? To answer that question, my staff and I took a closer look at 6,095 companies listed on US stock exchanges, and we compared their stated earnings with their actual cash flow.
Normally, these two measures of performance should be in synch. But in 1,687 companies � nearly one out of three � we found significant discrepancies. Such discrepancies between earnings and cash flow are not proof positive of hanky panky. But they're a red flag, leading us to the suspect earnings manipulations, legal or illegal.
This is absolutely mind-boggling to me. Once upon a time, you could usually trust the earnings reports of nearly all major US companies. They stuck to Generally Accepted Accounting Principles (GAAP). And they were sticklers for accuracy when reporting key financial information to shareholders. But by the late 1990s, in their growing desperation to meet Wall Street's expectations, more and more companies resorted to various schemes to manipulate earnings.
That's why, in one typical quarter, the operating income of 665 major companies reviewed by the Wall Street Journal rose 9.6%. But when adjusted for all costs that would normally be charged under GAAP, actual corporate earnings fell 4%.
What's the motive? Simple. The officials of America's corporations can get up to 90% of their compensation in stock and stock options. So there's everything to gain by putting out information that will boost the value of their own investments in the company.
Consider, for example, AOL's Stephen Case, who was paid a little over $1 million in salary as recently as 1998, but over $158 million in stock and stock options ... or Craig Barrett at Intel, with a salary of $2.6 million plus more than $114 million in stock and stock options ... or Sanford Weill at Citigroup � $10.5 million in salary and about $156 million in stock and options ... or Henry Silverman at Cendant � $2.9 million in salary and $61 million in stock and options.
And don't forget Disney's Michael Eisner, the all-time income champ among American CEOs. Salary � about $5.7 million. Additional compensation in the form of stock and stock options � a staggering $569 million!
The options portion of the exec comp package is pivotal. If you hold options to buy your company's shares ("call options"), you have the right � but not the obligation � to purchase the shares at a relatively low price and then immediately sell them at a much higher level. If the company's stock fails to go up, the options could be totally worthless. But if the stock soars, the options alone could be worth more than the entire balance of the compensation package for several years.
So it doesn't take a rocket scientist to figure out what happens when any of these companies' stock drops, say, by 30%: The Big Cheese loses one-third, one-half, or even two-thirds of his personal wealth.
Depending on the company, that percentage can translate into hundreds of millions of dollars. And these corporate CEOs aren't dumb. They know that nothing can drive their stock prices higher more quickly than a positive earnings report. So once each quarter, unscrupulous CEOs massage the numbers, hide losses any way they can, artificially inflate revenues, and when all else fails, look you square in the eye and lie their rich, well-tailored fannies off.
I hate it when rich corporate fat cats get richer through deceptive practices. And I am especially enraged when investors like you have to pay the price for corporate greed and deceit. But what's most frustrating of all is the fact that many of the methods commonly used to manipulate earnings reports are actually considered legal. Some examples:
The Bad "Goodwill" Deception
A Fortune 500 company buys up a hot, new upstart firm for $10 billion. It's an outrageous price that's 10 times greater than the actual market value of the company's assets. The accountants are then given the job of allocating the purchase price to the company's assets. But they say: "Hey! We can only find assets worth $1 billion. What are we supposed to do with the other $9 billion?"Management's response: "Create a 'goodwill account' and slap the entire $9 billion into it." This, in itself, is a big hoax. Since when is it normal for 90% of a company's assets to be in an intangible, mostly bogus, asset? Yet, it's a deception that is routinely acceptable on Wall Street.
The goodwill scheme doesn't end there, though. Each year thereafter, the accountants are supposed to charge off a portion of that goodwill. If they stretch it out for, say, 10 years that would mean $900 million per year in costs.
But no. The managers don't want to do that because it would mean their earnings would be reduced by $900 million each year. So they find all kinds of gimmicks to get around it. First, they stretch it out for 40 years (the absolute maximum allowed), using all kinds of rationalizations for why the goodwill has such an incredibly long lifespan.
The resulting exaggeration of earnings is mind-boggling in its dimensions. If the company had a profit of $1 billion and charged its goodwill over 10 years, at the rate of $900 million per year, its bottom line would be $100 million. But stretched out over 40 years, the charge is only $225 million per year, leaving a profit of $775 million, or nearly eight times the actual profit.
Then, guess what? Three or four years down the road, the company has either a great year with windfall profits or a horrendous year with huge losses. If it's a great year they say:
"Let's declare the goodwill worthless after all and charge it all off right now. Since we have such huge profits this year, no one will notice the difference." If it's a horrendous year, they say essentially the same thing: "Let's declare the goodwill worthless. Our stock has already gotten clobbered because of our huge losses. So who cares if we take an even bigger loss this year?" Either way, the 40-year asset is conveniently transformed into a three-year asset, past and future earnings are grossly exaggerated and investors are the losers.
Padded Sales Reports
Top executives aren't the only ones getting fat compensation packages, loaded with stocks and options. Sales managers also have piece of the pie. So to boost the value of their own shares and options, they went far beyond just tweaking their financial numbers � they completely perverted and undermined their company's business model.Tony Sagami, a good friend of mine who's a partner in a small but profitable web-based businesses, had a personal encounter with this phenomenon in early 2000. He and his associates needed to buy a batch of new computer servers and invited bids from various manufacturers.
Manufacturer A came back with an offer to sell them the equipment for $2 million, with zero down and a payback terms over five years. Tony's reaction: "No money down? Wow! For a small, upstart firm like ours, with very little cash or collateral, this is darn attractive."
But the reps from Manufacturer B did even better. They offered similar equipment, also for about $2 million, also with zero down and payments over five years. And to sweeten the deal, they said: "Look, it's going to cost you money to hire technicians to set up your new servers and workstations. So on top of the $2 million of hardware, we'll write you a check for $100,000 to help you pay for all of the setup expenses."
Tony and his partners were ready to grab this great deal when still a third manufacturer came along and completely blew their minds with this proposal: "We'll ship you the $2 million in servers. We'll write you a check to cover all the installations and ancillary expenses. And you don't have to pay us a penny � ever! Just give us a 5% share in your company."
Hard to believe? Maybe. But remarkably common. In each case, no matter how crazy the terms, the sales managers booked the sales immediately, the financial officers boasted to Wall Street analysts about their "wonderful sales growth," and the analysts promptly raised the hype for the company by another octave. Investors ate it all up. They rushed to buy the stock in droves and sent the shares through the roof.
All this continued to snowball until one totally predictable event: Equipment buyers failed to pay up. And the game was over.
I could cite hundreds of examples. Here's just one: Lucent offered Winstar a financing arrangement for up to $2 billion, half of which was available at any given time for the purchase of new equipment from Lucent. Just a few months later, by September 2000, Winstar had borrowed almost $500 million, while other companies had borrowed another $4 billion. And less than one year later, Winstar was in bankruptcy, suing Lucent for $10 billion in damages.
Result: Lucent's credit rating was reduced to "junk" status, with huge debts of its own, mountains of unshipped inventory, and its stock in a tailspin.
The Great Options Boondoggle
The biggest payoff for executives from all this is the lucrative stock option deals like the ones I mentioned earlier, and therein lies an even greater deception.If the stock options are clearly a form of compensation to the managers, they should be deducted from earnings as an expense, right? But they're not deducted. Again, earnings are exaggerated, and investors are the ones who suffer.
To sweeten the deal for themselves even further, if the stock in the company falls, the company may simply replace the old options with new, better options.
Here's how it works: Let's say you're a senior executive at XYZ Corp., and the stock is selling at $18 per share. To fatten your compensation package, the company has given you options to buy 10,000 shares at $20, only $2 above where the stock is now. That alone is a great deal.
If the shares rise to, say, $50, the options give you the right to buy the shares for $20, sell them immediately for $50, and pocket the $30-per-share profit. If you have options to buy a million shares, that's $30 million with this one transaction alone. So you see how options can multiply the value of your compensation package by 5, 10, even 20 times.
But instead of going up, let's say the shares fall from $18 to $8. You still have the options and you still have the chance to make a bundle if the stock recovers. But you say: "I don't want to have to wait for the stock to recover before my options are worth something. I want the company to restore the value of my options to what they were before the stock fell. Instead of an option to buy XYZ Corp. at $20 per share, I want you to change it to an option to buy at $10 per share."
Unbelievable as it may seem, the board members � who themselves may have a direct or indirect interest in the options � typically vote to do just that. This practice, called "rolling down the strike price," has been widespread during market declines.
Then, if the market recovers, the executives are actually able to cash out with even more profits than they were promised at the outset. They roll down the strike prices when the market plummets ... and then when the market recovers they keep the better options. The result is that they have the potential to earn double, triple, even quadruple the profits anticipated in their original compensation packages. And all of this happens without deducting one penny of cost from reported earnings.
The effect on the individual investor, once again, is dramatic. According to Smithers & Co. Ltd., a highly respected research institute in London, if US corporations properly accounted for the costs of just the stock options they granted, their aggregate published profits would have been 56% lower in 1997 and 50% lower in 1998. The same is happening now in many of the stocks whose bubbles have been burst. While the average investor got clobbered by the decline, executives and other insiders rushed in to protect their compensation packages.
Cendant Corp. repriced 46.3 million options for its CEO, lowering the strike price from as high as $23.88 all the way down to $9.81. This occurred just six days after the stock hit its low. Because the strike price was lowered, any rebound in the shares would be pure gravy for the CEO. But shareholders wind up paying the full price for this practice.
At Advanced Micro Devices, options were repriced not once, not twice, not even three times. Chairman Jerry Sanders had his options' strike prices ratcheted down six times throughout a six-year period. Although the stock was performing well, by lowering the strike price so many times, Sanders virtually guaranteed himself a nice wad of money regardless of happened to the stock.
Later, when the cost of these packages is finally booked, investors like you and me wind up picking up the tab in the form of sharply lower share prices caused by "surprise" drops in earnings. But in the meantime, the company's executives, protected from the real world, are cleaning up.
Warren Buffet was so outraged by this all-too common practice that when he acquired General Re Insurance, he decided to completely do away with stock option programs in the company. He got the managers to convert their options to cash bonuses on the spot and charged the entire expense to earnings.
That's admirable. Unfortunately, however, few companies are following Buffet's example. They know that if they come clean, they'll have to report a serious drop in corporate earnings. Their shares would be knocked for a loop, and their own riches would be history.
All these methods that corporations commonly use to manipulate earnings � plus many more � add up to one, gigantic house of cards supported by little more than lies and hot air. That helps explain why so many stocks have crashed and burned: All it takes to knock down the house of cards is whiff of fresh air � the truth. As soon as the truth comes out, down go the shares.
In an address on the quality of financial reporting in corporate America, former SEC Chairman Arthur Levitt warned: "Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices.
"Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation. . . . As a result, I fear that we are witnessing an erosion in the quality of earnings and, therefore, the quality of financial reporting. Managing may be giving way to manipulation; integrity may be losing out to illusion."
The chief accountant at the SEC, Lynn E. Turner, put it more succinctly: These corporate releases are nothing more than "EBS � Everything but Bad Stuff."
Years ago, most Wall Street research analysts would typically pore through all the "EBS" from the companies, try to cull out any lies and inaccuracies, and give the stock a rating based on their own independent opinion. Unfortunately, as I'll show you in the section that follows, that is not the standard practice today.
How Wall Street Stock Ratings Are Bought And Paid For By The Companies They Rate
Wall Street's typical pattern today is to take the already-distorted data coming from the nation's corporations and add on a whole new layer of hype and distortion. What changed? How were supposedly independent research analysts transformed into virtual stock promoters?It all started when the nature of the brokerage business changed radically. You see, back in the old days, brokers made most of their money from commissions � revenues they earned whether you bought or sold. But starting in the 1980s, the entire brokerage industry began to suffer from a plunge in commission rates. Established brokerage firms came under pressure from a whole new crop of brokerage firms � discount brokers � that began offering cut-rate commissions. And over time, that forced the entire industry to cut nearly all commission rates dramatically.
So to continue to grow their profits, most Wall Street firms decided to expand aggressively into another, far more profitable business: Helping companies sell their shares to the public, either in an initial public offering (an IPO) or in a secondary offering.
In this business, called "underwriting," the Wall Street firms play a totally different role. Instead of serving investors like you, they cater to big or upcoming corporate clients like Procter & Gamble, Intel, or DrKoop.com.
Instead of earning a small commission, they get a share of the proceeds.
And instead of making money whether you buy or you sell, they only make money when you buy. They have a direct, vested interest in a positive result. They want to see only good news about the company, only a positive reception from investors, and only a rising price in the shares. They are promoters, not brokers.
The inevitable consequence: Rather than offering objective research and advice, they instead try to sell you a bill of goods. That means hyping up the company's performance and touting the stock. It means cherry-picking the best numbers, sugarcoating any difficulties, covering up real problems, and putting out misleading, deceptive, effectively falsified "ratings."
For individual research analysts, the incentive to deceive is large, and the penalty for being honest, even larger.
According to the Wall Street Journal, analysts at Morgan Stanley get bigger bonuses when they make a positive contribution to underwriting revenues. At the same time, the Journal reported that Morgan Stanley analysts who refuse to suppress negative information about underwriting clients find themselves transferred to other, far less remunerated jobs. Still others find themselves out of work and on the street, blackballed in the industry, career destroyed.
A few years ago, an analyst at a brokerage firm wrote a stinging report on Donald Trump's Taj Mahal casino. The report alerted investors to serious problems underlying the hyped-up issue. But when Trump got wind of the negative analysis, he immediately threatened the brokerage firm with a lawsuit. The analyst was fired and the report was pulled.
In another situation, Merrill Lynch was slated to be the lead underwriter of a major bond issue by Conseco. As usual, it was a lucrative deal, expected to bring Merrill $1 million in fees. But one of Merrill's analysts made the fatal mistake of issuing a negative report on Conseco. Merrill Lynch, to its credit, stood by its report. But Conseco reacted by firing Merrill as the lead underwriter and taking its business elsewhere � to none other than Morgan Stanley. The message to Wall Street was clear: "Tell investors what we want you to tell 'em, and you win. Tell them the truth, and you lose."
Pulling away underwriting business isn't the only tactic corporations use to keep Wall Street's research departments in line. If there is a rating downgrade they don't like, they can close their own brokerage accounts at that firm and take their business elsewhere. This practice is so well known that analysts have a special expression for it: "They put us in the penalty box."
Do these things happen every single time? Of course not. They don't have to. The threat alone is enough to keep the heat on and have a chilling effect on objective research.
What bothers me is not only the shenanigans that reach our attention, it's also the ones we never hear about. We happen to know about Morgan Stanley only because some employees talked to the Journal. We heard of the incident with Donald Trump only because the analyst who was fired had the guts to sue the brokerage firm. (He won a $750,000 arbitration award.)
But what about the hundreds of analysts who don't sue or talk, who can't pin down the real reasons they were fired, who don't want to be blackballed by Wall Street, or who are simply scared? What happens to them? More importantly, what happens to you, the investor?
I'll tell you what happens: You risk losing a fortune, like the millions of investors who lost over $5 trillion in the great tech wreck of 2000-2001. But the analysts themselves continue to make big bucks:
In 2000, for example, an analyst at Goldman Sachs issued 11 gloriously positive ratings on stocks, which subsequently lost investors 71% of their money, or more. And yet he got paid $20,000,000 (twenty million dollars!) for his efforts. One of this guy's best performing recommendations of the year was down 70.98%; his worst was down 99.82% � and for that Goldman Sachs still paid him the $20 million?
How pervasive is the bias in Wall Street's stock ratings? Not long ago, the SEC ran a study to try to gain insight into the scope of the problem. They reviewed thousands of "buy," "sell," or "hold" stock recommendations issued by Wall Street brokers.
You'd expect some kind of a balance among these recommendations � say, one-third "buy," one-third "hold," and one-third "sell." But that's not what the SEC found. Quite to the contrary, only a pathetic 1% of the recommendations were to sell stocks. The remaining 99% encouraged you to hold or buy more. And this was a year when only about 32% � less than one-third � of the listed stocks on the major exchanges advanced. A startling 68.8% were losers.
Countless companies with no sales and no revenues are routinely rated "strong buys." Companies about to be decimated by obvious problems are, at worst, downgraded to "hold" or "market perform." And when stocks are virtually falling into oblivion � losing 70%, 80%, 90%, or even more of their value � the common response by many analysts is eerie silence. They quietly remove the fallen stocks from their list of rated companies, with no further comment or warning.
The conclusion is clear: Wall Street's stock ratings are effectively bought and paid for by the very companies that are rated. These ratings are then presented to you as objective opinions, but are often nothing more than glorified advertisements for the rated companies.
Look. If analysts at Consumer Reports were ever caught in this kind of hanky-panky, they'd be fired on the spot. If you were deciding which restaurant to go to or what movie to see, you'd never dream of relying on a cockamamie rating scheme like this one. And yet, here we have millions of investors basing critical decisions about their life savings on a stock ratings system that is fatally flawed.
10,000 Active Brokers Caught Swindling Their Clients
You've seen how thousands of corporations distort their earnings information at the source. And you've seen how the research departments of many large Wall Street firms add a second layer of bias and distortion in their published ratings and reports. But it doesn't end there.This information goes through still a third layer of possible manipulations � by the thousands of individual brokers who use them to push specific investments to their clients.
It's often difficult to pin down precisely how brokers misuse this information. But it's not hard to pin down even more serious abuses.
In 1994, for example, the auditing arm of the US Congress � the General Accounting Office (GAO) � conducted a thorough study of the nation's stockbrokers. Their finding: Almost 10,000 currently active brokers had been caught swindling clients. And I think it's safe to assume that if they swindle, they also misuse information.
The industry's response was that these 10,000 brokers are "just a small minority." But the GAO study covered only brokers who were caught in the act and whose offenses were so serious, they had to go through formal proceedings and be disciplined. The GAO's study did not include brokers who were disciplined informally � let alone brokers who were cheating their customers and getting away with it.
As a rule, I suspect that fewer than one in ten broker crimes are ever detected, reported, or prosecuted. So I estimate that at least 100,000 � over one-fifth of all the brokers working in the US today � could potentially be guilty of a variety of offenses.
If each one of those brokers has, say, 50 clients, that means that more than 5 million investors may now be doing business with brokers who cheat their clients. And assuming that each one of those 5 million investors has lost, at the very minimum, $2,000 apiece due to over hyping a stock, inappropriate investments, churning, or any number of other scams, that could be close to $10 billion that is virtually being stolen right out of investors' accounts.
But that's a very conservative estimate. The fact is, many of these brokers have been found guilty of stealing hundreds of thousands, or even millions, from their clients.
James Hugh Brennan III, a Chattanooga-based broker, was disciplined by The National Association of Security Dealers (NASD) for making unauthorized transactions, churning a customer's account with unsuitable recommendations/trades, and overstating the value of the account by $146,000.
Paul Michael Acosta, a Florida-based broker, was fined $3.65 million for collecting over $1 million in purchase payments from customers and failing to invest them as directed. He also gave forged account statements to at least one customer, and told others that their funds were invested in mutual funds, etc. The reality was that he was using these funds for his own business activities.
Frank James Hutton, a Mississippi-based broker, was censured, fined $757,500, and ordered to pay $101,525 in restitution. Hutton sold stock out of one customer's account without authorization, forged the customer's signature on a check for the proceeds of almost $30,000, and then changed the customer's address in his firm's records so that they wouldn't get their statement. To top it all off, he then prepared a fictitious statement that didn't disclose the sale and sent it to the customer directly. He also withdrew $96,552 from other customers' accounts, converted the funds to his own use, changed their addresses in the firm's records, and told the customers they would only get statements once every six weeks.
For many, many more examples, check the records for yourself, at www.sec.gov or www.nasd.org. And when you review the list, always bear in mind two things: These represent the minority who got caught. There are many more brokers who got away with it. And just because they got caught doesn't mean investors got their money back. Since 1995, the SEC has recovered only $1.69 of every $10 owed to investors by swindlers and schemers.
Even more troubling, however, are the many cases in which the entire firm is involved. Take initial public offerings (IPOs), for example, often an irresistible target for manipulators. First, the brokerage firms let their preferred clients � large investors, politicians, or special VIPs they owe a favor to � buy in at the offering price, which most investors can rarely get.
Within a day or two, the price of the new issue goes sky high. Then the brokers and the preferred clients "flip" the stock. They get out with a windfall profit, and the little investor gets stuck with an inflated price. In short, while you are buying, they are selling. Sooner or later, the truth comes out. An analyst says, "Hey, this stock isn't worth half of what they say it's worth," or the company just starts losing big-time dollars. That's when the stock crashes and small investors take it on the chin, over and over again.
Some recent examples: Robomatics, which was originally issued at $7 7/8, promptly plunged to 50 cents! Crescent Airways, which came out at $5 a share, also wound up at 50 cents. North American Advance, issued at $9, fell to $1.50. And perhaps the most shocking IPO disaster was VA Linux, a software company that went public on December 9, 1999 at $30 a share and closed that day at $239.25 a share. Just over 15 months later, on March 23, 2001, it was down to $3.44. Thousands of investors lost up to 99% of their money, while the underwriting firms lined their pockets.
An even more common crime perpetrated by entire firms is penny stock manipulations.
In a typical scheme, stock promoters assume control of a small, struggling company and all of its stock. They then launch a huge public relations campaign including promotional videos, press releases and planted news stories, while greasing the hands of brokers, "independent" financial advisers, and newsletter editors.
The Wall Street Journal puts it this way: "Starting at ... pennies per share, it only takes a modicum of trading to push up the stock price of one of these small companies. Sometimes the same 1,000-share block of stock moves in a circle among a number of buyers who are in on the scheme, trading slightly higher each time it changes hands, to give the impression that the share price is rising. When the price rises to a suitable level, the promoters and other insiders dump their shares and leave the company's legitimate investors holding virtually worthless stock."
With all this going on, you'd think someone would have warned you. Unfortunately ...
Warnings Fall on Deaf Ears, or Never See The Light of Day
The Washington Post conducted a survey of the industry and reported that stockbrokers regularly lie as a "pervasive and routine part of doing business." But the response from readers was muted.Money Magazine, CNN, Smart Money and others ran special stories about broker dishonesty. Still not much response.
I myself mailed several million special reports to investors detailing the abuses, with the headlines "Wall Street Is Ripping You Off" and "Internet Apocalypse." Some listened. But for most, my message fell on deaf ears.
Even the National Endowment for Financial Education (NEFE) published a stinging 16-page attack on stockbrokers. The report described sales abuses that would make your hair curl. It told of brokerage firms that took away the sales staff's shoes every morning until they met their sales quotas with high-pressure sales campaigns to investors. It talked about rampant lying and abuse throughout the industry. And it named names. Major Wall Street firms were enraged.
The large Wall Street firms threatened to sue. And the NEFE immediately pulled its report out of circulation. Now, it pretends the report never even existed.
Regulators also tried to warn investors in an effort to combat the cheating, lying, and outright stealing. They set up a series of complex rules that brokers must abide by.
They added a host of programs for educating and re-educating brokers. And they ran massive sting operations to break up the largest stock scams. But it's abundantly clear that all of this was sorely inadequate. No matter what they did, the regulators ran up against the reality that the system itself undermines the relationship between the broker and the individual investor.
The brokerage firm is represented as a source of objective research. Unfortunately, as I told you earlier, it is primarily a source of marketing hype.
The individual brokers are represented as an investment counselor. Unfortunately, they are often forced to be little more than a salesperson � pushing stocks that the company wants to sell. In short, the firm and the company want you to buy precisely the same investments that they want to sell ... and be rid of.
Therein lie the powerful and fundamental conflicts of interest that are continually tugging at the broker to act against the client's best interests. There are, naturally, many brokers who want to do right by their customers. But to continually achieve that goal, they must ultimately sacrifice their own financial interests. For the broker, the whole truth and nothing but the truth could mean lower sales results, fewer bonuses, and even reduced chances for promotions.
That's why, despite the GAO's landmark of broker abuses, despite massive efforts by the regulators to reign in the offenses, despite the broad publicity given to broker scams by the media, there was little movement toward change.
Finally, in the wake of the tech stock disaster of 2000-2001, there was a glimmer of hope: A Congressional committee held special hearings on the threats to the independence of Wall Street analysts. The SEC issued stern warning to all investors using Wall Street advice. The NASD immediately followed with strict guidelines to brokers to disclose conflicts of interest. Even Merrill Lynch announced that it will require all brokers to liquidate their personal holdings of securities they track.
Each of these efforts deserves every bit of encouragement and applause. But the horse is already out of the barn � $5 trillion already lost. Moreover, all the investigations, warnings, or guidelines to date have largely failed to address the underlying cause of the abuses: That Wall Street's interests are in conflict with the interest of the investors.
Your Solution
If you want objective information and advice, you should throw every piece of research you get from a Wall Street brokerage firm into the trash can. Next ...- Separate the data provided by Wall Street from their opinion and advice. The former is usually accurate; the latter is often biased. This was true before the terrorist attacks on America. It continues to be true after.
- Get a second opinion from analysts who are not tied to any Wall Street firms and have no ax to grind.
- Determine the source of information used by the independent analyst. Are they doing their own research? Or are they mostly picking up from others?
- Finally, take advantage of my solution, which I tell you about in my next chapter ...
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