Pacific Stock Exchange v. Cox Securities, et. al. ⇒ $1.54 million

The Law Offices of Cary S. Lapidus obtained an award of $1.54 million on behalf of the Pacific Stock Exchange who retained Lapidus as special counsel to prosecute the case. In addition to the monetary award, Lapidus obtained a Decision ordered the permanent bar of the Pacific Exchange member from membership with the Pacific Stock Exchange.

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“Cary Lapidus is probably the most well prepared attorney with whom I have ever dealt. He has excellent judgment and understanding of the law. Most important of all, he is highly ethical and those who deal with him know that his word is his bond.“
Paul Dubow
Opposing Counsel & Mediator in Six Cases

In The News

High-tech Companies And Their Investment Bankers Have A Cozy Symbiotic Relationship Regarding Stock Options.
Neil Weinberg
April 02, 2002

Two years ago Darryl Lewis was a Microsoft millionaire. Now he is a Microsoft pauper. For this he blames Merrill Lynch.
Lewis, a 36-year-old program manager at Microsoft, had received 63,000 stock options over six years but had exercised only 4,000. Then his broker offered some advice: Cash in those options, but instead of selling some of the shares to cover the exercise price and related taxes, just take out a margin loan. The advantage to this strategy: Lewis would convert ordinary income into lower-taxed capital gain, and he would participate in continued price appreciation in the stock.
Was it foreordained that Microsoft stock would keep going up? Some people had that delusion. If Lewis was one of those, he was perhaps egged on by a hypothetical projection from the broker that assumed Microsoft’s stock price would rise 25% a year for the next nine years.
It didn’t. As Microsoft shares tumbled in the tech crash, Lewis had to sell stock to meet Merrill’s margin calls, demands for more loan collateral. By year-end 2000 he had lost his entire stash, originally worth $1.3 million. All that was left was a $200,000 tax bill and a $1.1 million debt from a divorce settlement based on his options’ value before the carnage.
“If I’d just held my options the drop in the stock would have been no big deal,” says Lewis. “But those of us who got conned into exercising and holding our shares suffered the most.”
Conned? Therein lies an interesting legal debate that will be played out in many a securities arbitration case over the next several years. As sure as night follows day, a bear market brings out scores of brokerage customers who say their brokers did them wrong. These people were all too happy to have their brokers buy risky stocks or buy on margin, as long as the stocks kept going up; when the boom ends, they discover that they must have been misled.
Thousands of high-tech workers may be in Lewis’ fix. UBS PaineWebber has been sued for its handling of Enron accounts. Salomon Smith Barney is under investigation by the New York Stock Exchange for similar allegations involving WorldCom workers. The options debacle helped drive a 24% increase last year in arbitration cases filed with the National Association of Securities Dealers to a record 6,915.
Brokerage firms could easily win most of the cases but for one thing: In many cases the brokerages themselves promoted the risky approach and reaped lucrative fees from it. In some cases, plaintiff lawyers argue, conflicts of interest between firms and their investment bankers tainted advice. WorldCom used Salomon as its investment banker, giving the firm an interest in keeping WorldCom stock high. Salomon also handled WorldCom employees’ options and allegedly cited Salomon analyst Jack B.Grubman, infamously high on WorldCom, in advising workers to hold on to their shares and cover costs by borrowing.
“No sophisticated investor would exercise and hold, which is why most cases involve midlevel people who work 60 to 80 hours a week and rely on investment advisers,” says Cary Lapidus, a San Francisco lawyer handling 20 such complaints against Wall Street firms. “In the end, they don’t know what’s hit them until they’re wiped out.”
Darryl Lewis’ options odyssey began in 1998, when, he says, he was approached by a Merrill broker, Jeanine Luteijn , who introduced herself as a member of Merrill’s Private Client Group and dropped the name of a Microsoft colleague. Lewis had only one prior experience with options, having exchanged 4,000 for cash to buy a house in 1996. Luteijn visited Lewis at his office in Redmond, Wash. and advised him to exercise his options and hold on to Microsoft stock, borrowing from Merrill to cover the costs, says Lewis. The idea is to hold on to employee stock until at least two years after an option is granted and one year after it’s exercised. Do this and you get favorable long-term capital gain treatment. Sell too soon, and profit becomes ordinary income, taxed at much higher rates. (This scenario assumes that you can avoid the alternative minimum tax; if you can’t, the paper profit on exercise is immediately taxable, no matter how long you hold the stock.)
Luteijn provided spreadsheets showing that, even after paying Merrill 7.6% interest, Lewis would reap $54,000 more in 1999 than if he exercised and sold. By 2007, Luteijn’s figures showed, the exercise-and-hold-for-a-year strategy would turn Lewis’ 63,000 options into shares worth $34.6 million, or $11 million more than if he sold the shares immediately on exercising.
Lewis went for it. Starting in October 1998, when the stock was around $50, he began converting a total of 23,500 options exercisable at prices of $5 to $6 a share, netting Microsoft stock worth $1.3 million. He could have covered the cost by selling 10% of his shares. Instead, at Luteijn’s behest, Lewis says he borrowed from Merrill to pay for the options and a new home. By January 2000 he was in hock to Merrill for $1.1 million and paying $3,400 in monthly margin interest and fees.
Twelve months later Lewis’ small fortune was gone. He has filed a complaint with the National Association of Securities Dealers, alleging the firm failed to warn him of the dangers of margining his account or to discuss hedging the risk.
Luteijn, who left Merrill around the time Lewis’ account blew up, declines comment. Merrill says Lewis’ claim is bunk and the strategy was his. Yet Merrill encouraged precisely that approach, running ads in a magazine for the PRO Sports Club, where Microsoft gives 17,000 employees memberships. “Need Financing to Exercise Your Employee Stock Options? Exercise and Hold Using Portfolio Reserve,” the headline advised. “Capitalize on the stock’s upside potential … take advantage of the 20% long-term capital gains rate by holding shares for more than one year.”
Merrill says it had little motive to push the risky approach. A spokesman says broker loan commissions are “very minimal.” But a compensation guide the firm put out last year shows brokers receive 0.5% of the value of mortgages and securities-based loans over $100,000. At that rate Luteijn stood to earn $5,500 annually on Lewis’ $1.1 million balance. Merrill generates over half its revenue from interest income, and only 14% from commissions.
To high-tech firms options are like free money. Their cost doesn’t come out of the net income reported to shareholders. But when the option is exercised, the spread between the exercise price and the stock’s market value can be deducted from income on the corporate tax return. Merrill’s own figures show that if options were accounted for like other compensation, Microsoft earnings would have been 36% lower in 2000.
Showered with options and surrounded by corporate boosterism, employees are ill-equipped to find their way through all the complexities: staggered vesting periods, alternative minimum taxes, cashless exercises and protective collars. Employers are disinclined to give a peep of advice; if something didn’t work out, you can bet they’d be sued. Microsoft leaves workers to find their own brokers, or brokers to find them. Other companies designate a brokerage to exercise options–in some cases its own investment bank, creating a potential conflict of loyalties.
That is the gist of a Houston lawsuit filed by former Enron employees against PaineWebber. It charges the firm withheld negative information “for its own pecuniary gain,” because it acted both as the exclusive handler of employee options for Enron and as its investment banker. PaineWebber says the charges are without merit.
Kelly Kearney , a bubbly woman who sold telecom services for WorldCom in San Francisco, told her employer in January 2000 she planned to retire in two months. She says the personnel department told her she would have to exercise her options via Salomon Smith Barney, WorldCom’s main investment bank, or lose them.
Kearney, who wanted to study tilemaking and Italian, had little experience handling stocks or options. She called David Candib , a broker at Salomon’s Atlanta office who had been pushing Kearney to exercise her options for three years. He advised her to cash in her options and hold on to the stock for a year, citing (she alleges) analyst Jack Grubman’s rating of WorldCom as “the best stock in our universe.”
Kearney exercised 28,600 options and soon had $1.3 million in WorldCom stock sitting atop a $600,000 margin loan from Salomon. Never, she says, did Candib discuss the risks of holding the vast majority of her net worth in one stock with a high margin balance. WorldCom’s stock tanked in the summer of 2000, but Candib, again relying on Grubman’s reports, assured her it would come back, Kearney says. Instead, it fell further. As Kearney received over a dozen margin calls, she struggled to raise cash, draining $58,000 from other accounts and borrowing $195,000 against two homes. By October 2000 it was all gone. “I trusted David implicitly and believed what Grubman said,” she says. “Now I think the whole thing was a hoax and a scam.”
Candib left the brokerage industry shortly after Kearney lost her savings and could not be reached for comment. Grubman has come under criticism for touting WorldCom while drumming up investment banking for the firm. That includes a suit filed by two of Salomon’s own former Atlanta brokers who were named as defendants in NASD cases; the brokers claim they, too, were duped by Salomon and Grubman. Salomon chalks up the WorldCom claims to “market hindsight.”
Sometimes workers lose their jobs as well as their fortunes. Orlandes (Bud) Shuemake , 53, lost his job installing telecom gear in May 2001 shortly after his employer, Northpoint Communications , imploded. He has been unable to find work. The stress, he says, has made him lose large patches of hair. If things don’t get better soon, he and his wife will lose their home.
Shuemake marks the start of his financial demise to September 1999 when Northpoint personnel staff directed him to Morgan Stanley , an underwriter of Northpoint’s initial public offering. There, Shuemake was introduced to David Dunn , a vice president he says was described by the brokerage as specializing “in addressing the concerns of holders of concentrated stock and stock options positions.”
When Shuemake met with Dunn, the only stock he had ever owned had been in a 401(k) at Pacific Bell plus another 100 shares from a former employer. Shuemake says he told Dunn he hoped to retire in about two years, pay for his son’s education and support two disabled parents, so his first priority was preserving principal.
The details of who said what next are in dispute. Shuemake says Dunn encouraged him to exercise and hold his stock. Morgan Stanley says it advised its clients to diversify. Dunn isn’t talking. In any case Morgan Stanley exercised some of Shuemake’s options and in January 2000 sent a statement showing he owned $1.4 million in shares and vested options. It arranged a $98,000 margin loan with shares as collateral to help cover the tax bill on the exercise. And it used additional shares as security for a mortgage on a new home.
The stock crashed. By early 2001 his $1.4 million had been reduced to $15,000, and he had been forced to pull $60,000 from his 401(k) to refinance his mortgage. “David presented himself as someone who could help me retire and meet my goals. Instead, he ruined my life,” Shuemake says.
Anthony Schultz worked at Cisco for nine years, rising to manage an engineering group. An options packet he received at work included information about Salomon Smith Barney. In December 1999, two months before he planned to quit, Schultz decided to exercise most of his options. He figured he could save $500,000 in taxes by holding on for a year. Schultz spoke with Salomon broker David Mumford in Menlo Park, Calif. Mumford categorized him as a “moderate/capital preservation” investor yet advised him to hold as many Cisco shares as possible, Schultz says in his NASD complaint. He converted 128,000 options to $9 million in stock at the end of March and took out a $1.5 million margin loan to cover costs and to remodel his home.
Cisco started to slide. By March 2001 Schultz had lost 97% of his original $9 million in stock. Then, Schultz says, he received a form from Salomon requesting he change his specified investment objective from “moderate” to “aggressive.”
Salomon says Schultz “unjustifiably seeks to blame others for his conscious desire to speculate that the value of his remaining Cisco holdings would increase.” The firm, it adds, had no responsibility to recommend hedging because Schultz “controlled his account and Salomon Smith Barney had absolutely nothing to do with Mr. Schultz’s having acquired a large position in Cisco.”
“I sacrificed a lot in the 1990s thinking the thing to do was work in Silicon Valley and get out,” says Schultz, 40. “All that was taken away by a financial consultant who didn’t know what he was doing.”

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