The New York Times, by Gretchen Morgenson

By Gretchen Morgenson

It has now become painfully clear, and last week's gyrations only added more proof, that Wall Street is a different place than it was even a short time ago. A brutish, bearish market has brought with it deflated hopes and new realities.

Among the harsh realities one stands out. Of all the hot air generated during the great bull market of the late 1990's, none propelled stock prices further than the notion that new economy stocks were a breed apart and should not be held to stringent, old economy investing standards. Internet companies and cutting-edge telecommunications concerns, after all, were revolutionizing the world. So, the thinking went, their share prices deserved equally radical valuation methods. Out went traditional methods used by securities analysis that prized earnings. In came freewheeling measures of worth, like revenue growth, Web site traffic and even customer "share of mind."

"The view was, `We've got a new technology, therefore it's perfectly okay to have a new way of approaching the income statement and balance sheet,' " said Anthony Maramarco, a portfolio manager at the Babson Value Fund in Boston. "But sooner or later you have to generate cash and if all you're doing is using cash, you can only play that game for so long."

That game, as investors are learning to their extreme distress, is definitely over. When stocks were galloping ahead, investors were happy to take their eyes off earnings and seize instead upon surging "page views" to justify high stock prices. Who needs positive cash flow when the numbers of "engaged shoppers" are flying? Why bother with the ways of Graham and Dodd, the classic value-hunters, when Wall Street was offering investors the lure of new investing metrics?

Henry Blodget, Merrill Lynch's celebrity Internet analyst, may have put the new economy view best on Jan. 10, 2000, when he wrote in a report, "Valuation is often not a helpful tool in determining when to sell hypergrowth stocks." Mr. Blodget was referring specifically to Internet Capital Group, an incubator of Web companies that was trading at $173.88 then -- and $3 a share now.

But he could have been discussing any one of the many highflying stocks that caught investors' fancies.

In their infatuations, perhaps the biggest mistake investors made during the bull market was to believe corporate propaganda about which numbers supposedly provided the best window on the state of their operations.

"Public relations is driving financial reporting," said Jack Ciesielski, publisher of The Analyst's Accounting Observer newsletter, and president of R. G. Associates, in Baltimore. "Everybody's picking the metric they will be judged on. But investors are partly to blame for not wanting to live with what the earnings were telling them. It sounds lame or unhip but, if the earnings aren't there, why grasp at straws?"

Now, with the prices of almost all these former highfliers in the cellar and the overall stock market deep in bear market territory, investors are seeing how wrong they were to ignore excessive valuation levels and to buy stocks based on ephemera like "engaged shoppers" or so-called pro forma results. Suddenly, new economy rationalizations to buy stocks look as ludicrous as the old economy measures looked hopelessly quaint a year ago. Shellshocked investors -- who have lost almost $4 trillion in market value since a year ago -- are wondering just what hit them and how to pick up the pieces.

Survivors of previous market fads that fizzled have some advice. The best thing investors can do to keep their portfolios safe from future devastation, they say, is to learn from their mistakes. Only by understanding how they allowed themselves to embrace the new economy valuation fad can they inoculate themselves from such ills in the days ahead.

Lesson One is as simple as caveat emptor: when investors rely on others for investment research, they must be extremely careful. Since the analysis provided by most big brokerage firms is tainted by their use of upbeat research reports as magnets for investment-banking deals, the painful truth is that investors who buy and sell individual stocks have to learn to do some of their own research on companies to judge their results and their prospects. Just in time for annual report season, stock investors have to go back to perusing balance sheets and income statements.

There ought to be a law in this country that before you're allowed to buy a stock you have to be able to read its balance sheet," said Bill Fleckenstein, a money manager at Fleckenstein Capital in Seattle. "That's where companies try to hide everything. That's where all the shenanigans show up."

A close scrutiny of balance sheets was decidedly missing during much of the late-1990's bull market, even in many Wall Street analysts' reports. As a result, many investors missed such warning signs as bloating inventories and rising accounts receivables that foretold a slowdown in sales at many technology companies. These included Gateway, Cisco Systems, Nortel Networks and Alcatel.

Steve Galbraith, an equity strategist at Morgan Stanley Dean Witter, said that in the final years of the technology stock boom, equity investors took on the role of financing fledgling companies -- early in their development -- that venture capitalists had traditionally assumed. Normally, companies cannot go public without a track record that proved their ability to turn a profit.

Not this time around. "The entire seasoning period for relatively high- risk equity investments was condensed into months, not years," Mr. Galbraith said. As a result, in the first quarter of 2000, fewer than one in five companies that made initial public stock offerings had profitable operations. In 1995, almost two- thirds of new issuers were profitable when they took their stocks public.

Another measure of how willing many investors were to suspend their disbelief during the mania was the period in 2000 during which the more money a company lost, the better its stock did, while the more money a company earned, the worse its stock fared. Think Amazon.com and Priceline, all of which took pride in the amounts of money they were spending.

Just as investors felt that earnings were no longer a necessary ingredient for stocks to steam skyward, neither did they find reason for concern when companies appeared to be burning through their cash. On July 12, 2000, for example, Michael Parekh, an Internet strategist at Goldman Sachs who oversees a group of analysts that cover 60 Internet companies, including Inktomi, DoubleClick and AOL Time Warner, wrote a report arguing that the cash burned by dot-com companies was "primarily an investor sentiment issue" and not a long-term risk for the sector.

Eight months later, a lack of cash has brought about the demise of hundreds of Internet companies and has hammered the results of leading companies like Yahoo. Mr. Parekh was correct that it was not a long- term risk for the sector. As it turned out, it was an immediate risk.

Mr. Parekh said on Friday that the slowdown in the economy that followed his July report suddenly changed the entire picture. "Cash burn is a critical issue for us and it is not a metric we ignored," he said. "But we've had a whole new set of issues around the economy which temper the pace at which traditional companies are spending on technology. These companies were making progress in the third quarter, then on top of that the universe of all these companies got hit by the economy slowing down."

Of course, analysts like Mr. Parekh cannot be held entirely accountable for the money investors have lost in new economy stocks. Investors themselves must take responsibility for succumbing to a market fad. After all, they allowed themselves to be convinced that these companies were in fact different from traditional concerns and should be subject to less-stringent valuation standards.

Every bull market has its own peculiar investment fad, of course. In the great one of the 1960's, for example, the conglomerate was king. Companies like Litton Industries and Textron thrived by swallowing up other companies on the theory that owning different kinds of businesses with different business cycles would protect them from downturns in the economy.

Between 1966 and 1969, when the ardor for conglomerates was at its height, investors believed that their share prices could never fall. Then, in 1970, they plunged, and with them went the conventional wisdom.

More recently, the investment fad was to justify exorbitant prices of technology stocks based, in part, on a litany of so-called nonfinancial metrics. These included customer loyalty, Web-site traffic and "engaged shoppers." Never mind that none of these translated into profits or even, in some cases, revenues.

Mary Meeker, a star Internet analyst at Morgan Stanley, was among the many Internet and technology analysts citing upbeat "usage metrics" as reasons to buy stocks. In a report on drugstore.com published in October, Ms. Meeker cited the company's popularity as a Web shopping destination as a reason to own the stock. She noted that page views per user per month rose to 14.9 in the third quarter, up from 12.5 in August. Then she pointed out the superiority of drugstore.com to competitor PlanetRX's monthly page views of 10.3 as an indication that drugstore.com customers were more satisfied.

"Additionally," Ms. Meeker pointed out, "drugstore.com maintained a level of 48 percent engaged shoppers (a unique user who views at least three minutes of content within the category) ahead of PlanetRx, which had 45 percent." No mention of whether an "engaged shopper" ever became a spending shopper. Drugstore.com recently traded at $1.16, down 54 percent from its price when Ms. Meeker penned her report. (PlanetRx, which Nasdaq has de- listed, is trading at 29 cents a share.)

Last week, Ms. Meeker explained that her use of nonfinancial metrics began back in 1993 with Intuit and AOL and had proved, in those cases, to be a fine way to measure future performance. Both companies lost money initially on their customers, but Ms. Meeker said she thought that if they kept their customers happy they could expand their customer base. And that would in turn drive revenues and, later, earnings. She was proven right.

"The value of a business is its future cash flows," Ms. Meeker said. "The challenge is figuring out what those future cash flows are. If a company wins in its marketplace, if the market is attractive enough and big enough, and if we can find the company that is going to be a leader, the challenge is to find out how customers can be monetized."

About drugstore.com, Ms. Meeker said the jury was still out. "These things take a long time to evolve," she said. "If there is a health and beauty market online, we think drugstore will be a leader. If there isn't, the stock will continue to be a disappointment.

Wall Street analysts were not the only ones citing nonfinancial metrics as key to investors. Last year, in its Global Online Retailing Report, Ernst & Young tried to identify performance measures most valued by e-commerce investors. The study of 31 public companies spanned 18 months, beginning in early 1999. In the second quarter of 2000, Ernst & Young found that investors were concentrating on two factors: gross profits (earnings before many expenses like depreciation and interest costs) and total Web-site visits. Net income, perhaps because so many e- commerce companies had none, was not relevant.

Another nonfinancial metric was the so-called share of consumers' minds that a company demonstrated. Homestore.com, for example, had a "leading mind share among consumers" according to a Morgan Stanley research report dated Oct. 20, 2000. The proof for this claim was that approximately 72 percent of the total time spent by Internet users on real-estate-related Web sites in September was spent on Homestore's properties.

But having a leading mind share could not keep Homestore.com's stock from sliding 26 percent to $19.31 since that report.

Ms. Meeker said: "On Homestore.com, our point of view is that many people will look for homes online and Homestore will be in a leading position. We're willing to make a bet that they will be able to monetize those users."

Mr. Ciesielski, the accounting expert, said investors' interest in nonfinancial information was not detrimental when combined with financial analysis. The problem is, during the Internet craze, investors weighed the nonfinancial data too heavily, he said. 'I used to cover railroads and airlines, and they used to have this wonderful nonfinancial information every month about miles traveled or carloads loaded," Mr. Ciesielski said. "Analysts looked at that, but just to reinforce where earnings were going to go. They weren't grasping at straws. If carloads were going down, you knew earnings were going down."

Although many chastened investors have sworn off the use of Internet page views or engaged Web shoppers to help them make their stock picks, another bull market promotional practice by corporations continues apace even after the bear has awakened. That is the peddling of so- called pro forma numbers, which eliminate pesky expenses from a company's results and make earnings look better. Using Alice-in-Wonderland explanations, new economy companies said that for them these figures better reflected their operating results than those arrived at using generally accepted accounting principles.

How pro forma earnings are conjured varies by company, but often excluded are line items like interest expenses and payroll taxes, thus burnishing the company's results.

Asking investors to ignore these costs -- which the companies must pay in cold, hard cash -- is asking them to accept a fiction about a company's results.

In the old days, companies would include pro forma numbers in financial statements after an acquisition to reflect how the two newly combined companies would have performed if they had been joined for the entire year before the merger. Now, pro forma numbers mean something much more sinister and are becoming practically ubiquitous. Anyone interested in the traditional earnings number has to dig deep into the press releases.

To measure how common pro forma numbers have become, investors can search the Web sites of BusinessWire.com or PRNewswire.com to find companies using them. In a three-day period alone last week, a search on PRNewswire produced 36 citings of pro forma figures.

Companies accentuating the positive through the use of pro forma numbers include Palm, Intel, Yahoo and Cisco. More obscure companies that do so include Stanford Micro Devices and Engage.

At Yahoo and Cisco, for example, pro forma operating income meant excluding the expense of payroll taxes. At Level 8 Systems, a software provider, a net loss of $4 million in the third quarter last year was transformed into pro forma net income of $1.8 million by adding back noncash charges like depreciation and amortization of intangible assets.

The creativity goes on and on. Mr. Ciesielski thinks that the vast number of corporations using pro forma figures have made earnings releases increasingly dubious. "The whole concept of what's earnings and what's on the cash-flow statement has become so bastardized that nothing makes much sense any more," he said.

Investors can thank the raiders of the 1980's for the current love affair with pro forma numbers, Mr. Ciesielski said. "Back then, people would look at companies with ugly earnings, but they had good cash flow underneath because depreciation was big," he said. The leveraged buyout boom, he said, "was largely fueled by amateurs trying to find companies with big depreciation charges."

"And in the 90's, we all jumped on that, taking out the parts we didn't need to prove our point," he added.

Mr. Ciesielski advises investors to pay no attention to pro forma numbers and to do their own math to find out where companies really stand.

Byron Wien, chief United States investment strategist at Morgan Stanley, is fearful that companies that spin their results using pro forma figures could do serious damage to investor confidence in the financial markets. "Corporations have a lot of flexibility in how they report results," he said. "Nobody knows more about the truth than the corporate executives themselves. Taking a short-term view of truth may make things look good in a quarterly report. But it will ultimately catch up with them."

That is a good description of what seems to be happening today.

© 2001, The New York Times Company

By Gretchen Morgenson

During the 1990's, Seattle echoed with tales of Microsoft millionaires, ordinary workers who became wealthy from stock options the company had awarded.

Now that Microsoft's stock has fallen to about half its peak, Seattle is abuzz with other stories, those of Microsoft employees deep in debt and filing for bankruptcy.

Mike Fitzgerald, the trustee overseeing Chapter 13 bankruptcy filings by individuals in the western district of Washington, estimated recently that he had seen 25 cases filed by Microsoft workers related to options. "These stock options looked so good that people lost track of what they were intended to do," he said. "They were a second-tier excuse for Microsoft instead of paying them a real salary. It's really a world of hurt."

As at other technology companies, the woes of workers at Microsoft stem in large part from tax bills incurred when the options were exercised. Worse still, some people who were experienced engineers and programmers yet naïve about the stock market turned their options into stock and then borrowed against those shares to pay their taxes. The high-risk practice, known as a margin loan, is more often a tool of speculators aiming to buy additional stock without additional money. As the stock fell, these workers' shares were sold, leaving them broke.

One midlevel Microsoft employee said that a broker at Salomon Smith Barney, the firm hired by Microsoft to administer its option program, pushed him to take such risks. At the peak, his shares were worth about $1.5 million. But last fall, when the stock began to dive, the firm began selling shares out of his account to pay off the loan. Now most of his stock is gone and he owes $100,000 in taxes, more than he makes in a year and more than he has. His only remaining asset is a modest Seattle home, which he and his wife fear they will lose.

His tale and those of others who say they unknowingly took on risks raise questions about whether brokers have failed to live up to regulatory requirements, including the need to determine if an investment or strategy is suitable for a client. The brokerage firms profited from the interest on margin accounts, while investors suffered.

Lena Diethelm, an enrolled agent at the tax preparation firm Numbershuffler in Palo Alto, Calif., said she had heard many similar stories from workers in Silicon Valley and faults brokers for urging employees to borrow to pay taxes.

"I think these practices are predatory," Ms. Diethelm said. "The brokerage firms have conflicts of interest, but the employees don't understand the relationship the companies have with each other. They don't understand the risks, and the brokers minimize the risks."

When a brokerage firm oversees a corporate option program, it has two masters: the company that pays it and the company's employees, who are often steered its way for financial advice. The brokerage firm is paid to help employees exercise their options, and it profits when employees bring it additional business. Likewise, the company that issues options reaps tax breaks and can get other financial benefits when employees exercise them.

Microsoft and Salomon Smith Barney, which is now part of Citigroup, maintain that there was no conflict of interest because their contract extended only to the exercise of options and employees were free to approach any firm for financial advice.

Any advice comes from a division of Salomon separate from the one it pays for administration, Microsoft noted. Susan Thompson, a Salomon spokeswoman, said, "They're actually entirely separate businesses that serve different clients and different client needs."

But it is no surprise that many Microsoft workers wind up taking financial advice from Salomon. In company documents, Salomon is identified as Microsoft's "preferred broker" and employees are told they can "take advantage of additional products and services" by opening a full-service account at Salomon.

When asked whether Salomon has a policy governing its customers' use of margin, the firm declined to comment. But its Web site says "margin accounts can be very risky, and they are not suitable for all investors." Among the risks described, "you can lose more money than you have invested" and "you may be forced to sell some or all of your securities when there is a decline in your account equity value."

Microsoft recognized early on that options allowed it to attract talented employees and keep salaries in check. The company and its workers benefited as the stock surged.

The Microsoft worker who told his story on the condition that he not be identified said he had not planned to turn the options into stock for some time, believing Microsoft's price would continue to rise. Because the difference of the price of the option from the market price of the stock on the day of purchase, known as the spread, would be taxable as ordinary income, the couple would have a big tax bill. Most people sell shares immediately to pay the taxes, as the couple had done in the past.

The couple was persuaded to buy some 20,000 shares with options in 1999 and 2000 by Salomon Smith Barney, they said, and advised to put the shares in a margin account to generate cash for taxes and other expenses like home improvements.

Larry Feinstein, a partner at the law firm of Bortman & Feinstein in Seattle, has a handful of Microsoft employees as clients who borrowed against their shares to pay taxes. "These are middle-management people that all of a sudden have to file bankruptcy," he said. "The brokers are more than happy to loan you the money and charge interest on it."

Having borrowed against the shares, the programmer and his wife received calls for cash from their broker when the stock fell last year. Although rules at brokerage firms vary, a customer who pledges stock for a margin loan may have to put up more money when the shares decline to 40 percent of the value of the loan.

When the couple could not put up more cash, their shares were sold to meet repeated margin calls. They now have a looming tax bill and virtually no equity.

Salomon, they said, did not fully explain the risks of margin. "They should have been a lot more forthcoming with the information," the programmer said. "We did not get into the stock market voluntarily. We were paid in stock and were forced into the stock market with stock options. We trusted our broker to have our best interests at heart."

Lewis D. Lowenfels, an authority in securities law at Tolins & Lowenfels, a law firm in New York, said that the broker in this case might have run afoul of the suitability requirements of the National Association of Securities Dealers. "It does not appear to be suitable to take people with these limited means and to leverage them so that their entire net worth is at the mercy of fluctuations in the price of Microsoft stock," he said.

Salomon's profits on the margin loan taken by the Microsoft programmer were sizable. According to a computation by the worker's accountant, the annual interest charged by Salomon on his margin loan was $60,000 to $80,000 -- roughly his yearly salary. At one point the loan, which fluctuated based both on the level of borrowing and the stock price, approached $800,000.

Of course, there are times when it is wise to cash in stock options. Most employee options have a finite life. People who are convinced the stock is going higher may choose to exercise options before they expire, pay the taxes on the income that is generated and hold the shares so that any future profits are taxed at the lower long-term capital gains rates.

According to the couple in Seattle, the Salomon broker made this argument in late 1998. Roughly 40 percent of the programmer's options would begin expiring in three years, the broker said, so they should start turning them into shares.

Initially, the couple rejected the idea because of the tax bill it would create. Then came a different pitch.

"The stockbroker said one reason to exercise the options was because if I got hit by a bus, my wife would have no access to them," the programmer said. Only recently, when the couple reread the option plan did they find that the options would have gone to her if he had died.

The Salomon spokeswoman said: "We don't comment on anonymous allegations."

The Microsoft programmer now acknowledges that it was a mistake to rely on his broker to the degree that he did and not to read the documents before deciding to exercise the options.

Like Salomon, Microsoft stood to benefit when its employees exercised their options. The company gets a tax deduction equal to the spread on which the employee pays income taxes. In fact, the tax break has greatly reduced and in some cases eliminated tax bills at profitable corporations like Microsoft, Cisco Systems in recent years.

And when workers exercise options, they help their employer in another way, by reducing the number of options outstanding. Around the time the programmer and his wife say they were encouraged to exercise options, Microsoft was under pressure from institutional investors to reduce its options outstanding.

By 1999, the number of options that Microsoft had set aside for grants had ballooned.

Pat McGurn, president of Institutional Shareholder Services, said that the amount of Microsoft options, which dilute the voting power and value of existing shareholders, was roughly three times the recommended level in its industry.

"The real problem is that these plans are growing so quickly," Mr. McGurn said. "So companies have made a conscious effort in recent years to get people to push more options through the pipeline."

Caroline Boren, a Microsoft spokeswoman, said the company had never tried to influence personal financial decisions of its employees.

"Microsoft cares deeply about its employees and wants them to be successful financially, even in a tough economic climate," Ms. Boren said. "The company makes it easy for employees to access and complete transactions regarding their stock options, but ultimately the decisions on how and when to utilize these benefits reside with the employee."

While employees receiving options typically have to sign a document to signify their acceptance of the plan's terms, as the programmer did, there is little regulation of such materials to ensure that the risks are clear. This contrasts with employee pension plans, which must disclose benefits and risks in plain English to employees, according to Christine Jolls, professor of law at the Harvard Law School.

"Options are a whole new form of employee benefit that has grown up relatively recently," Ms. Jolls said. "It does seem to be a new development in the employee relationship that the law hasn't focused on."

Mr. McGurn said that the prospect of employees being forced into bankruptcy is an unforeseen consequence of the option boom. "We've given options to fairly financially unsophisticated individuals and to people who don't understand the risk inherent in them," he said. "You wouldn't allow these folks to invest in a hedge fund, but we allow them to make six-figure bets on stock options without the benefit of any independent financial advice."

© 2001, The New York Times Company

By Gretchen Morgenson

More than a dozen current or former employees of WorldCom are accusing brokers at Salomon Smith Barney, the firm hired to oversee the company's employee stock option program, of pressing them into a risky investment strategy that left them with significant losses and onerous tax bills when WorldCom shares fell last year.

According to regulatory records, at least a handful of customer complaints have been lodged with securities regulators about the matter in recent months. One arbitration case has also been filed against Salomon Smith Barney, a subsidiary of Citigroup.

According to the aggrieved employees, Salomon's brokers pushed them to exercise their options and borrow against the shares by placing the acquired stock in a margin account. In some cases, they were called repeatedly and urged to buy the stock. Most of these people say the brokers discouraged diversification and did not fully explain the risks should WorldCom's stock decline.

All the complaints focus on the activities of a handful of brokers in a Salomon branch office in Atlanta.

Terri J. Howell, a former chief spokeswoman at WorldCom, is one of the Salomon clients who agreed to tell her story. She left the company after its merger with MCI Communications in the fall of 1998 and had one year to exercise her options. She said a WorldCom executive identified the brokerage firm's Atlanta office as the group assigned to handle WorldCom executive stock option portfolios.

Ms. Howell said that when she exercised her options in early 1999, the Salomon broker encouraged her to borrow from the brokerage firm, using the shares as collateral, to pay income taxes and to cover the costs of buying the shares. Such borrowing is done by placing the underlying shares in a margin account on which the broker charges interest each month. Yet Ms. Howell said her broker never explained that he was opening a margin account for her, instead calling it a "portfolio credit line." She said she thought it was akin to a home equity loan.

More disappointing, Ms. Howell said, the Salomon broker discouraged diversification even as WorldCom's stock was plummeting last year. Such advice raises broad questions of suitability, as defined by securities regulators

"I deposited my entire inheritance from my dear mother into that account, and within a short time I lost it all," Ms. Howell said. "These were utility stocks, mortgage bond funds, and I was advised to sell those first to cover my margin calls."

A spokeswoman for Salomon declined to discuss Ms. Howell's complaint. She said the firm was "committed to providing the highest level of client service to all our clients," adding, "We take seriously any issues raised by clients and will carefully review the specifics of each situation.

A spokesman for WorldCom, in Clinton, Miss., declined to comment on the complaints.

Brokerage firms that oversee employee stock option programs hope to bring in additional assets. Bruce Brumberg, co-founder of myStockOptions.com, which provides educational materials on options, said: "To run a plan is very expensive. A lot of brokerage firms stayed away from it because it is not a money maker. Only selected brokerage firms decided to do it because they want to keep the assets under management."

Salomon Smith Barney is one of the three biggest firms in the business, Mr. Brumberg said. It runs Microsoft's plan, and some employees there have also complained about aggressive brokerage tactics. Salomon's main competitors are Merrill Lynch and PaineWebber.

According to someone close to the situation, the contract between WorldCom and Salomon does not allow the brokerage firm to solicit the company's employees to exercise options. WorldCom and Salomon would not discuss the terms of the contract.

Brokerage firms have good reason to want the employee assets that often follow stock option plans. In recent years, the firms have been valued based on their ability to increase assets under management. So a brokerage firm that keeps an employee's assets after options have been exercised stands to profit now and in the future when those assets are redeployed.

Interest on margin loans -- now at rates of about 8 percent a year -- can be a significant profit source, too; for example, Salomon says it shares with its brokers a small percentage of the interest earned from their customers' accounts but only when margin interest exceeds $100,000.

Like many technology companies, WorldCom has awarded numerous stock options to its employees. When its shares were rising in the mid- to late-1990s, many employees became wealthy by exercising their options, paying their taxes and holding onto the highflying stock. And companies embraced options in part because they did not have to account for them as an employee cost and therefore could keep corporate expenses down.

When employees exercise the most popular type of stock options, known as nonqualified options, they must pay taxes at ordinary income rates on the difference between the price paid for the shares and the market price of the stock on the day they exercise. That difference in prices is known as the spread.

Companies receive many benefits when their employees exercise stock options. First is a tax deduction in the amount of the spread, which is the amount on which the employee pays income tax. That tax deduction has radically reduced or even eliminated tax bills in recent years for highly profitable companies, including Microsoft, Dell Computer and Cisco Systems

But other benefits accrue to corporations. When employees exercise options and pay the strike price, they may provide cash infusions for companies that might otherwise have to enter the capital markets for financing.

According to the complaints lodged by WorldCom employees against Salomon, 1999 was the year in which the firm's brokers became particularly aggressive in urging that options be exercised. WorldCom financial statements show that 1999 was indeed a big year for option exercises. The stock peaked that year at $63.50, adjusted for splits. Its employees exercised options on 61 million shares, at an average price of $15.32 each, or roughly 20 percent more options than they had exercised a year earlier.

All these exercises could have been useful for WorldCom. If the 61 million shares were bought at the average price, they would have generated almost $935 million for the company. That is equal to 12 percent of WorldCom's operating income in 1999 and almost all -- 97 percent -- of the interest expense WorldCom paid on its $18.1 billion in debt that year.

Employees with options also benefited until the stock began to fall and the consequences of the margin accounts became apparent. Margin calls can be devastating when stock prices fall because the shares that are held as collateral for the loan lose value and the investor is required to come up with more money to shore up the account.

Harry S. Miller, a partner at the law firm of Perkins Smith & Cohen in Boston, said that about a dozen individuals with WorldCom stock options had approached him with stories about being pushed to exercise options by Salomon brokers and to use the proceeds of margin loans to pay their taxes and cover the cost of buying the shares.

"Many of these individuals had minimal prior securities investing experience," Mr. Miller said. "There were no disclosures by Salomon Smith Barney as to the risks of margin and the lack of diversification. In all cases they were never advised by Salomon Smith Barney to diversify, and none were told what the tax consequences would be if value went down."

Mr. Miller said that he had heard from WorldCom employees in Colorado, Connecticut, Maryland, Nebraska, New Jersey and Texas but that all were advised by Salomon brokers in the Atlanta branch office. "We are forming a group for purposes of filing their claims in the appropriate legal forum," he added.

One employee that Mr. Miller represents who demanded anonymity said that some $700,000 was lost following the advice of the Salomon broker. Seven years' of options earned at WorldCom are gone, this individual said.

This person said that in the fall of last year, the Salomon broker became extremely insistent that the options be exercised, even though none were close to expiration. The broker made repeated phone calls during November. Finally, this person said, the broker warned that if the employee did not exercise the options, Salomon might have to close the customer's account.

Seth Lipner, a partner at Deutsch & Lipner in Garden City, N.Y., represents a former WorldCom employee in an arbitration case filed in February against Salomon. In April 2000, the former employee had WorldCom shares worth about $700,000, net of margin borrowings, according to the complaint filed with the National Association of Securities Dealers. Some 83 percent of the client's brokerage account was in WorldCom stock.

This customer, who began a relationship with Salomon in late 1998 holding 44,574 options, now has just 1,000 shares after paying taxes. WorldCom stock closed yesterday at $18.79.

"I have spoken to a number of people around the country," Mr. Lipner said, "all of whom tell the same story."

© 2001, The New York Times Company

By Gretchen Morgenson

© 2001, The New York Times Company

By Gretchen Morgenson

"I thought I was the only one who was this stupid," he said. "I found it quite amazing that other smart people at Microsoft bought into the same ride."

It took John Teeples six and a half years as a software salesman at Microsoft to amass the stock options and other assets he felt he needed to take a break from work and spend more time with his wife, Sharon, and their two young sons.

"I wanted to park the bus," Mr. Teeples, 45, said in a recent interview from his home in Reston, Va. "So I pulled the bus over to the side of the road, I took my stock options and said, `I can reacquaint myself with my 9-year-old, who thought Daddy wasn't there for him.'"

As Mr. Teeples was about to exit the fast track of 80-hour weeks in late 1999, he encountered two Morgan Stanley Dean Witter brokers: Arun Sardana, 36, and Michael Moriarty, 46, partners in the firm's office in Chevy Chase, Md. Assuring him that they would handle all his financial, tax and estate-planning needs, the brokers persuaded Mr. Teeples, who had never traded in the market, to entrust them with retirement accounts and stock options worth roughly $700,000.

Within 16 months, Mr. Teeples said, what had taken him years to build was gone. By this April, all that was left of his portfolio was $403.95 and a $40,000 tax bill due next April. Now he's fighting back.

With the stock market in the doldrums and the practices of brokerage firms under the microscope, executives at Wall Street firms are clearly worried that investors have lost faith in the industry. If Mr. Teeples's account of how his money was managed is any indication of what passed for investment advice and brokerage services in the market mania of the late 1990's, Wall Street should be worried indeed.

Unfortunately for the industry and investors alike, Mr. Teeples's story is just one of many tales beginning to emerge as investors realize that their decimated portfolios may never come back, and that for novices, investing is not as easy as it looks.

But perhaps the most troubling aspect of Mr. Teeples's story is that he is not the only current or former Microsoft employee to say he has lost his life savings under the guidance of Mr. Sardana and Mr. Moriarty. In several arbitration claims filed recently against the brokers and Morgan Stanley--most investor claims cannot go to court--a total of 13 customers on the East and West Coasts accuse the two men of a widespread pattern of sales-practice violations. These include recommendation of highly speculative stock trades and excessive use of margin borrowing. In about a year, these people lost $20 million, according to the complaints.

"Morgan Stanley Dean Witter's brokers were out of control," said Jacob H. Zamansky, a lawyer at Zamansky Associates in New York, who represents the Microsoft workers. "Young, inexperienced brokers preyed on hard-working people with little or no investment experience. They lost my clients' retirement and life savings."

Across the country, many workers at technology companies have been hurt by stocks that have fallen below their options' prices. Even worse, some have exercised options at high levels and watched the underlying stock collapse. But the Teeples case is particularly compelling because it brings together all the elements of the speculative frenzy of the late 1990's. Now that the bubble has burst, brokerage-firm practices like the ones Mr. Teeples encountered are coming under scrutiny. All of Wall Street is on the defensive.

As was the case at many technology companies, Mr. Teeples and his fellow plaintiffs had amassed sizable nest eggs through stock option grants earned at Microsoft. The other plaintiffs wish to remain anonymous because most of them still work at Microsoft. But their naivete in the ways of Wall Street made them easy pickings for aggressive brokers looking to make fortunes of their own. And these brokers, encouraged by the fee structure at Morgan Stanley, subjected their customers to high-risk strategies involving the heavy use of borrowed funds. Furthermore, by following the recommendations of the firm's research department, the brokers submitted their customers to what their lawyer calls biased analysts peddling overvalued stocks.

Bret Gallaway, a Morgan Stanley spokesman, said, "We are very comfortable leaving the disposition of Mr. Teeples's claims to the arbitration process he initiated." Mr. Sardana and Mr. Moriarty, who are still employed there, did not respond to several calls seeking comment.

According to the complaint, the money lost by the customers of Mr. Sardana and Mr. Moriarty is considerable. Seven of the 13 Microsoft workers lost a total of $1.3 million in JDS Uniphase, $555,000 in Cisco Systems and $366,000 in America Online. Numbers like these put into perspective exactly who lost the $5 trillion in stock market value since the Nasdaq crashed last year.

But perhaps even more astonishing is the amount that Morgan Stanley earned on this performance. According to a securities and accounting expert who has examined all of the trades made for the plaintiffs and who plans to testify on their behalf in the arbitration, Morgan Stanley earned at least 5 percent, on average, of the net assets in these customers' accounts. This amount, more than five times what an institution might pay, was made up of margin interest and aggressive money management fees. It is unclear how much of this went to the brokers involved, but the usual level is 35 percent to 50 percent of fees.

Some of the plaintiffs' stock market loss may be a result of conflicts of interest between Morgan Stanley's retail business and its investment banking business--the very conflicts, so pervasive on Wall Street, that have caught the attention of securities regulators and members of Congress.

Last week, Merrill Lynch settled a case in which a customer had accused Henry Blodget, the firm's Internet analyst, of maintaining a positive rating on a stock without disclosing a conflict. It paid $400,000, or most of what the customer had sought.

Of the 23 stocks that the brokers bought for Mr. Teeples and his wife, 12 were companies which Morgan Stanley had brought public or provided with other investment banking services. Ten were rated buys by Morgan Stanley analysts when they were bought. Three rose slightly, but seven fell, generating $85,000 in losses. By the time Mr. Teeples sold all his shares in those seven, they had lost, on average, half their value.

Mr. Teeples and his wife have taken out a second mortgage on their home in order to pay their bills, and he went back to work in November at a wireless-data company in Baltimore that he would not identify. But he is remarkably philosophical about it all. Mr. Teeples says he should never have trusted Mr. Sardana and Mr. Moriarty. But they seemed like nice guys, he said, and investing was something he knew nothing about.

"I was working hard on understanding Microsoft technology and how to solve my customers' problems," he said. "I had never had an investment account. My mother taught school and my father taught college. Money was foreign to me."

The Pitch

At a pool party given by mutual friends in the summer of 1999, Mr. Teeples recalled, he met Mr. Sardana, who struck up a conversation with him. He told him he managed money for many of Mr. Teeples's colleagues in Washington and Seattle. "He said he had gotten permission to do a series of seminars at the Microsoft office in D.C.," Mr. Teeples said. Mr. Sardana also told him later that he often flew to Seattle to work with Microsoft employees based at company headquarters.

In search of advice on how to handle the options he had received at Microsoft, Mr. Teeples decided to attend the next seminar sponsored by Morgan Stanley that fall. "It was called `It's All About Your Options,'" he said, "And there were about 15 to 18 people in the room." Mr. Sardana and Mr. Moriarty brought along a tax expert and an estate planner, calling the team a one-stop shop for financial advice.

At the seminar, the brokers handed out some pages describing their investment management strategies. "As Morgan Stanley Dean Witter Financial Advisors," the document stated, "Arun Sardana and Michael Moriarty provide affluent individuals with customized professional money management services. Each portfolio is individually managed to meet the personal goals and risk tolerance of the client."

Those attending the seminar, Mr. Teeples said, were given a "spreadsheet calculator" that indicated the riches they could earn within five years if they invested their money with Morgan Stanley. He said the brokers also explained that they would earn a flat fee of 1 percent to 2.5 percent of assets to manage the money. Other prospects said they were told that paying a flat fee would be cheaper than paying commissions on each trade.

Mr. Sardana gave a one-page summary of his background to people who attended the seminar. Born and raised in New Delhi, Mr. Sardana emigrated to the United States in 1988 at the age of 23 "to find better opportunities for supporting his family in India," it said. While working full time, he attended Johns Hopkins University, earning an M.B.A. "summa-cum-laude with a major in finance (investment management and portfolio analysis)," according to the summary. In more recent years, it said, Mr. Sardana "has developed a unique and customized educational program for employees with large concentrated stock positions such as those with incentive stock options."

"This program," the summary continued, "addresses real-life issues faced by these employees," like how to handle tax implications. Advice would also be given on "how to protect the loved ones against any unforeseen liabilities and events."

But Mr. Sardana's transcript from Johns Hopkins, obtained by the plaintiff's lawyer, showed that he did not earn his M.B.A. until this year, and a school official said such degrees are never awarded with the distinction he claimed.

When he met Mr. Sardana, Mr. Teeples was weeks away from quitting his job at Microsoft. He knew that when he left, he would have only three months to exercise his options. And because of the brokers' connections to other Microsoft employees, he felt no need to investigate them further. So in January 2000, he turned to Mr. Sardana for help.

The Nest Egg

In his years at Microsoft, Mr. Teeples reckoned that his annual cash compensation, beginning at $75,000 in 1992 and rising to $100,000 when he left, was 37 percent below what was paid in comparable jobs elsewhere. "The bet I made was that the options were going to make up for the difference," he said.

That bet seemed to be paying off as Mr. Teeples rose through the organization. When he left Microsoft, he had options for 12,000 shares, worth just over $500,000. He said he told Mr. Sardana that he wanted to achieve a reasonable growth rate on his money but added that he was interested in a conservative investment strategy. "He said that Microsoft was not going to grow at a fast- enough rate and we needed to diversify into other stocks," Mr. Teeples recalled. "He gave me a last-quarter performance on his picks that clearly showed he was brilliant."

According to the complaint, the list supplied by Mr. Sardana showed 10 stocks that had returned an average of 70.62 percent annually for the last 10 years. They were Clear Channel Communications, EMC, Tellabs, Cisco Systems, Dell Computer, Solectron, America Online, Microsoft, Amgen and MCI Worldcom.

All carried strong buy recommendations from Morgan Stanley analysts. The list did not disclose whether Morgan Stanley had relationships with the companies on it, as the National Association of Securities Dealers requires of any sales materials. In fact, half were clients of the investment banking department at Morgan Stanley.

Mr. Teeples said he was impressed with the stocks' performance. So when Mr. Sardana recommended that he exercise all his Microsoft options immediately and put the proceeds in a Morgan Stanley account, he agreed. The broker also advised Mr. Teeples to take out a margin loan to pay part of the taxes due on the transaction and to buy the recommended stocks at various strike prices -- as low as $4 for shares then selling at around $100. By Jan. 31, Mr. Teeples's account at Morgan Stanley held Microsoft stock worth $1.17 million. The margin loan stood at $620,524, leaving him with a net asset value of $551,000.

The next month, according to the complaint, Mr. Sardana sold 9,000 Microsoft shares for $820,000. Despite instruction from Mr. Teeples to preserve his capital so he could rest easily about his family's future, the broker bought 23 highflying technology stocks -- including Amgen, America Online, Cisco Systems, EMC, Dell Computer, JDS Uniphase, and Tellabs. All were bought using the margin loan.

Two months later, Mr. Moriarty persuaded Mr. Teeples to move his individual retirement account, then in Fidelity mutual funds, and a 401(k) at Microsoft, to Morgan Stanley. "Moriarty said, `You should bring it over here, you'll have more control over it,'" Mr. Teeples recalled.

So he cashed in his funds and 401(k) and deposited an additional $147,000 with Morgan Stanley.

"They said retirement is a long way off for you, you can afford to be more aggressive," Mr. Teeples said. So Mr. Sardana bought shares in Ariba, JDS Uniphase, Intel, PMC- Sierra, Exodus Communications, Texas Instruments and Microsoft for Mr. Teeples's retirement account.

The Plunge

March 2000 dawned. Technology stocks had risen to stupefying levels and were about to collapse.

Mr. Teeples's account, laden with speculative technology shares bought with borrowed funds, was ground zero for the earthquake that shattered investors' dreams.

How did the Morgan Stanley brokers react when prices started slipping? Reassuringly, at first. "They started putting out statements with these great graphs," Mr. Teeples said. "They'd say, `Our analysts say it's going to be all right.' Or, `The technicals look great.'" Then, with the exception of abrupt calls for more cash to shore up the margin loan, the communications from Morgan Stanley ceased.

Later last year, as the stocks kept falling, Mr. Teeples called the brokers several times in alarm. He said they told him "to hang in there."

Mr. Teeples learned the hard way how treacherous margin borrowing can be. When borrowing to buy stocks, the shares serve as collateral. When the shares fall in price, the investor must put up additional funds to shore up the loan. A margin call is typically set off when a stock has declined by about 40 percent from the purchase price.

Mr. Teeples said he was stunned by the speed at which his money vanished. That shares in free fall create calls for more money had never been mentioned by either Morgan Stanley broker, he said. "They did not explain to me the downside of margin," Mr. Teeples said. "I had no idea."

It was not until late fall, he said, that he got some advice from Mr. Moriarty. "He said it looked like it wasn't going to come back and he said we should go to cash," the investor recalled -- in other words, sell all the stock to cut the losses.

By December, Mr. Teeples's account value was down to $33,000 and he had $72 cash in his retirement account. The regular account kept dwindling: only $403.95 was left in it on April 30.

At the same time, Mr. Teeples had to pay $98,000 in taxes on the options he had exercised. Unable to pay it all, he appealed to the Internal Revenue Service to construct a payment plan for part of it. He figures that next April he will owe at least $40,000 more for early retirement account withdrawals he made to pay bills.

Mr. Teeples said he was surprised to learn later through Mr. Zamansky that he was not the only Microsoft employee who had entrusted his life savings to Mr. Sardana and Mr. Moriarty. "I thought I was the only one who was this stupid," he said. "I found it quite amazing that other smart people at Microsoft bought into the same ride."

Another surprise came when Mr. Teeples turned over his account statements to an accountant. He learned that he had paid $10,000 in fees on his account and $26,000 in margin interest. It is customary at Wall Street firms to pay brokers a portion of the margin interest earned in their accounts. A Morgan Stanley spokesman said that some brokers share in the margin interest generated by their clients, but that the rules depend on the account. Brokers who receive such remuneration have an incentive to put their customers into risky margin-trading strategies.

The Morgan Stanley brokers had another incentive to put customers on margin. The money management fees the firm charged to customers in its Morgan Stanley Dean Witter Choice Account -- 1 to 2.5 percent annually -- were based on total assets, including margin loans. Other firms calculate money management fees based on net asset values, the market value in an account after margin loan balances have been subtracted.

"The Morgan Stanley Dean Witter fee arrangement encouraged and rewarded brokers for putting clients on heavy margin," Mr. Zamansky said. "And the firm encouraged their brokers to generate huge fees by pushing stocks of companies with whom the firm had investment banking relationships."

Morgan Stanley made $36,000 on Mr. Teeples in fees and margin interest, or 4.25 percent of his assets on an annualized basis.

"I could have taken this money myself, put it in an E*Trade account and done better," he said.

Because each panel of arbitrators is different, it is difficult to predict how these investors will fare. But Lewis D. Lowenfels, a lawyer at Tolins & Lowenfels in New York and an authority on securities arbitration, said arbitrators rarely awarded customers all they sought to recover in losses or damages.

"The outcome of these cases will largely be determined by two factors," he said. "First, the ability of the Morgan Stanley customers to have their cases heard together by one or two arbitration panels. And second, by the suitability of each individual customer for the firm's recommended course of action."

For Mr. Teeples, life goes on. "I'm going to have to work three times as hard to recover from this series of lapses in judgment," he said. "I have my beautiful wife and two beautiful children. I've had a very, very lucky life. But it doesn't mean that this wasn't wrong."

© 2001, The New York Times Company

By Gretchen Morgenson

Last Dec. 5, Andrew J. Neff, a computer analyst at Bear, Stearns, issued a report extolling the virtues of Palm Inc., the maker of hand-held computers. After meeting with Palm's management, Mr. Neff had come away a believer in the company's future and its battered shares. With the stock near $44, Palm was well below its March 2000 peak of $165, reached on its first day of trading. He put a 12-month price target of $80 on the shares, reflecting his belief that they would trade at 19 times his 2001 sales estimate for the company.

By the next week, Palm shares had climbed to $56.625. But then they began to sink, until, on Jan. 3, they had reached $27.88. That day, Mr. Neff cut his target to a range of $37 to $48. Two months later, with Palm in the mid-teens, Mr. Neff lowered his target again. Finally, on May 17, the shares stood at $7.05 when he slashed his target to around $5. It closed on Friday at $5.36.

Mr. Neff was by no means alone on Wall Street in his misplaced optimism regarding Palm. But his remarkable and almost certainly unreachable target of $80 for Palm shares does exemplify one of the most deplorable practices found among analysts during the stock market mania: the assignment of target prices that were based more on fantasy than reality.

"Those price targets were the equivalent of snake oil being sold off the back of covered wagons in the Wild West," said Stefan D. Abrams, chief investment officer for asset allocation at the Trust Company of the West in New York. "The mere fact that you could not defend them by any rational means is evidence that these were nothing more than sales hype."

Yet while money managers like Mr. Abrams recognized price targets for what they were -- and laughed them off -- many individuals bought stocks at least in part on their promise. Now they are sorry.

Early in the mania, of course, investors who bought stocks based on wild targets did well. Amazon.com blew through Henry Blodget's famous $400 target about a month after he assigned it in December 1998. And for every seemingly crazy target that was subsequently met, the next one became more credible.

Because analysts kept raising their price targets as the stocks neared them, investors were emboldened to stay at the party even after the band had gone home. Rather than advising investors to sell overpriced stocks, analysts, with their escalating price targets, kept investors in the shares long after they had begun to fall.

Mr. Neff said his early optimism about Palm was based on a less rigorous methodology than he applied to the stock later. But he said that "it doesn't make intellectual sense to have an investment rating unless you have some sort of price target in mind."

Big and bold price targets are a relatively new phenomenon in Wall Street research reports. In the 1980's, an analyst might estimate a range within which a stock could trade, based on what the analyst expected the company to earn. But such targets were low profile and typically surrounded by caveats.

Robert A. Olstein, manager of the Olstein Financial Alert fund, said today's use of dubious targets was an extension of a trend among analysts toward predicting next week's earnings instead of valuing companies. "Today's analysts are soothsayers, because they're trying to predict where the crowd frenzy is going to take a stock," he said. "No one has ever been able to do that with any degree of certainty."

Other investment veterans say that howlingly high price targets became the rage in the late 1990's because analysts, in the midst of the huge bull market, found it difficult to differentiate themselves from the herd. "It was a way for an analyst to establish himself as the most bullish person on a particular issue," said Mitch Zacks, vice president of Zacks Investment Research in Chicago. "That was very useful for the investment banking business of the firm."

Surprisingly, while share prices of many former darlings are now in the cellar, and while Wall Street analysts, with their myriad conflicts of interest, are sweating under an increasingly unpleasant spotlight, wildly optimistic price targets can still be found on stocks. Instead of owning up to their too- rosy predictions, two of the largest brokerage firms acknowledge that in some cases, their analysts simply eliminate the price targets altogether without comment.

According to research conducted by Zacks, price targets on the nation's largest technology stocks are currently so high that their stocks would have to rise 80 percent, on average, to meet them.

Lucent Technologies, as of last Wednesday's close, would have to vault 204 percent to meet analysts' average target price, EMC would have to almost double and Hewlett-Packard would have rise 40 percent.

"The price target is the piece of data produced by Wall Street that is least tied to reality," Mr. Zacks said. "They tend to be overly optimistic. They tend to be very, very slow to change because lowering a target is a signal to the investment community that things have gone permanently sour."

RiskMetrics, a software analytics company based in New York that specializes in risk assessment for the financial community, recently conducted a study for Money & Business that examined 550 price targets assigned to some 300 technology stocks as of June 22. It looked at five major Wall Street firms' targets for companies in computer software, hardware and semiconductors, and calculated the probabilities that these targets would be met within the next 12 months. The firms are Goldman, Sachs; Merrill Lynch; Morgan Stanley Dean Witter; Prudential Securities; and the Salomon Smith Barney unit of Citigroup.

Fewer than 1 percent of the price targets in the study were below the stocks' levels as of July 24. While many of the targets had a better than 50-50 probability of being met based on past price action, 46 companies carried targets that had less than a 20 percent chance of being hit.

Consider a $50 price target on Inet Technologies, a communications software provider that closed at $9 on Friday. According to RiskMetrics, this stock has an 11 percent chance of reaching that price. An $80 target on Orbotech, a maker of optical inspection systems that closed on Friday at $26.35, has a 17 percent likelihood of being met. "There's no consistency even within a brokerage house in the creation of a price target," said Michael Thompson, RiskMetrics' global market commentator. "Too many times, these things come out of the air."

The RiskMetric study showed that the Prudential analysts had the highest percentage of price targets that were most likely to be reached -- 67 percent. Salomon Smith Barney took second place with 64 percent, followed by Merrill Lynch at 58 percent and Morgan Stanley at 57 percent. Goldman was last, at 49 percent.

A word of caution on these figures: this study was focused on one sector of the economy and based on data collected without the firms' help. The results could be quite different for research in other sectors.

Ed Canaday, a spokesman for Goldman, said target prices are based on a moment in time and are not intended to be continuous, because so much about a stock can change.

So why do firms keep outlandish targets on stocks? The answer may be akin to the reason Wall Street issue so few sell ratings: the fear of losing investment banking business.

The firms deny that price targets are used to draw in banking business or to keep clients happy. But in the RiskMetrics study, in more than one-fourth of the cases when stocks carried an outlandish price target from a brokerage firm, that broker underwrote shares or provided other investment banking services for the company.

Individual investors should do as their institutional brethren do and pay no heed to price targets. As RiskMetrics' Mr. Thompson said, "We've got to stop the mumbo jumbo that's really not based on anything terribly meaningful."

© 2001, The New York Times Company

By Gretchen Morgenson

This is the story of Larry, Curly and Moe, three analysts whose writings on Polymedica illustrate why investors are right to mistrust Wall Street research.

Polymedica sells medical supplies directly to consumers, many covered by Medicare. Few big brokerage firms follow it.

The big sticks on Polymedica belong to John Calcagnini of CIBC World Markets, Joel Ray of First Union Securities and Ryan Rauch of Adams, Harkness & Hill. CIBC and First Union underwrote three million Polymedica shares on Oct. 7, 1999, generating $3.4 million in fees. The next day, Mr. Ray began coverage with a "strong buy."

When 2000 dawned, Polymedica shares began an impressive ascent. On March 21, Mr. Rauch, who had been an analyst at CIBC at the time of the offering, began covering the company with a "strong buy." The stock was $45; 10 days later it was $58.75.

But Polymedica is a volatile stock and by late May its shares had fallen to $27, perhaps because in April the company said it would sell $100 million in new shares.

To the stock's rescue rode Mr. Calcagnini, who began coverage on it with, what else, a "strong buy." During June, the shares rallied to $52. As they rose, Steven J. Lee, Polymedica's chairman, sold shares worth about $1.3 million. During the summer and fall, as the analysts sang Polymedica's praises, Mr. Lee sold stock worth $1.4 million. CIBC and Adams, Harkness handled the trades.

On Oct. 23, Safeco Asset Management, Polymedica's largest shareholder, filed its intent to sell 300,000 shares through Adams, Harkness. The next day, Mr. Calcagnini and Mr. Ray restated their "strong buy" recommendations.

The bottom fell out of the stock on Nov. 20 when Barron's quoted a Federal Bureau of Investigation official saying the agency was looking into possible health care fraud at Polymedica. In the article, Mr. Lee denied knowledge of an investigation; the stock lost half its value that day.

Back in the Amen corner, the analysts worked to reassure investors. Mr. Calcagnini reiterated his upbeat view on Nov. 21, putting a $70 target on the stock, then trading at $30.25. He cheered again on Jan. 11 and Jan. 16; the stock rose to $44 two days later on news of record earnings.

Mr. Ray took over in March, recommending the stock just after it fell by half on news of customer complaints being sent to the F.B.I. An overreaction, Mr. Ray said, adding that Polymedica did not appear to be under investigation. Management had told him so.

In late June, Mr. Ray advised clients that the company expected a letter from federal authorities resolving the rumors shortly, according to Mr. Lee. The stock was at $40.

Last weekend, Barron's reported a federal grand jury investigation of Polymedica. In an interview Friday, Mr. Lee said the company would be exonerated.

After the news, Mr. Ray said of his coverage: "I was basing my analysis on my discussions with the company. I felt that was the most accurate information."

Polymedica's stock stands at $15.02. All three scribes have dropped their ratings, telling investors to "wait for further clarity." Mr. Rauch threw in the towel last, saying, "Other companies guilty of Medicare violations have survived and prospered."

Neither Mr. Calcagnini nor Mr. Rauch returned phone calls. John Adams, chairman of Adams, Harkness & Hill, said he believed in Mr. Rauch's analysis. Asked if his firm's support of the stock was related to commissions generated by Polymedica insiders' trades, Mr. Adams said getting such orders is customary. "It's a way of saying thank you for the research coverage," he said.

© 2001, The New York Times Company

By Gretchen Morgenson

My criticism has its base in my fervent belief that our nation's capital markets are the best in the world. Identifying who the scoundrels are helps keep the markets safe for investors.

On Tuesday evening, I sat in the Church of the Incarnation in Midtown Manhattan, trying to make sense of the stupefying. When I picked up the nearest Bible, it fell open to the Book of Lamentations, Jeremiah's elegiac depiction of Jerusalem razed by Babylonian invaders.

"How doth the city sit solitary, that was full of people! How is she become as a widow! She that was great among nations, and princess among the provinces, how is she become tributary!"

Even on Friday, it was only starting to sink in how great was the tribute America is being made to pay, tribute in this case as defined in dictionary terms: "money or other valuables paid by one nation to another in acknowledgment of submission."

The twin towers and buildings around them are gone. It is a titanic loss of physical capital, but thanks to the unsinkable American spirit, some structures will be rebuilt quickly and defiantly.

Human losses are another matter, though. Men and women cannot be made to reappear.

"The real big loss was not physical capital," said Richard Sylla, professor of business history at New York University's Stern School of Business. "It takes much longer to replace the intellectual power that went down in this."

But what also went down on Tuesday is family power. The strength provided by a father, a mother, a spouse; the power of a brother or sister.

We are all trying to process the paralyzingly large numbers of people who were probably lost. The famous folks, we have read about. Those who are less well known should be honored, too.

Each person lost or missing had different strengths and weaknesses. Each one made a singular contribution through his or her life.

Let me now hail just a few of the missing thousands.

Gary Koecheler, a bond broker at Euro Brokers Inc., was a man of huge heart, faithfulness and total honesty. A Vietnam veteran, Gary always did the right thing, especially for his family, which includes me. The sort of man who would be among the last out of a burning building, after helping others escape.

George Morell, a broker of mortgage- backed securities at Cantor Fitzgerald, a securities firm that says it lost almost three- quarters of its New York staff, was a compassionate man with an infectious smile. When the World Trade Center was bombed in 1993, he carried a complete stranger down more than 100 flights of stairs.

Billy Minardi, a derivatives broker also at Cantor, could win over the toughest customer with his warmth and grace. Nobody didn't like Billy. He was The Natural, both professionally and as a father and husband.

Tommy Palazzo, a government bond broker at Cantor, was a man who had a million things to do in a minute. By 9 o'clock in the morning he had run a marathon, gone fishing and was at his desk. He would never pass by a person who needed help.

Others to be appreciated, friends of those close to me, include Tim Coughlin, gregarious, hard-working and a triathlete. Joe and Dan Shea, brothers in the securities business and straight arrows both. Ward Haynes, a young man who always put his family first, sadly just started working at the World Trade Center a few weeks ago. Teddy Maloney, another young rising star, started there even more recently. Joe Dickey, Jeff LeVeen, Frank McGuinn and Paul Sarle all brought professionalism to their work and joy to their families and friends. All were employed by Cantor Fitzgerald.

As a columnist and reporter covering Wall Street, I am often writing about brokers behaving badly or industry practices that harm investors. My criticism has its base in my fervent belief that our nation's capital markets are the best in the world. Identifying who the scoundrels are helps keep the markets safe for investors.

But so many on Wall Street are honest, like the men mentioned here, who worked to keep their markets just and equitable. Losing them is a huge loss for all.

© 2001, The New York Times Company

By Gretchen Morgenson

Covad Communications : Jan. 2, 1999-Aug. 15, 2001.

ICG Communications : Oct. 18, 1994-Nov. 14, 2000.

Northpoint Communications: May 6, 1999-Jan. 16, 2001.

PSINet Inc.: May 1, 1995-May 31, 2001.

Rhythms Netconnections: Apr. 6, 1999-Aug. 1, 2001.

Taken separately, the rise and fall of five once-high flying telecommunications concerns, all in bankruptcy, is hardly remarkable. But together, along with other recent telecom failures and those still likely to occur, they represent one of the most spectacular investment debacles ever. Bigger than the South Sea bubble. Bigger than tulipmania. Bigger than the dot- bomb. The flameout of the telecommunications sector, when it is over, will wind up costing investors hundreds of billions of dollars.

The telecommunications mess stands out for another reason: One man is at its center -- Jack Benjamin Grubman.

No single person can be responsible for the entire debacle, of course, and investors must take responsibility for some of their losses. But as resident guru on telecommunications at Salomon Smith Barney and one of Wall Street's highest- paid analysts, Mr. Grubman, 48, was surely the sector's pied piper. During the height of the mania, in 1999 and 2000, he had buy recommendations on 30 companies, considerably more than most analysts. Mr. Grubman lured more investors into securities of nascent and risky telecom companies than perhaps any other individual.

Anyone can make mistakes, but Mr. Grubman's cheerleading epitomizes the conflict- of-interest questions that have dogged Wall Street for two years: Even as he rallied clients of Salomon Smith Barney, a unit of Citigroup, to buy shares of untested telecommunications companies and to hold on to the shares as they lost almost all their value, he was aggressively helping his firm win lucrative stock and bond deals from these same companies.

The Beginnings of a Craze 

To some degree, the telecommunications crash is a case study in how Wall Street goes overboard in a bull market, raising capital for start-ups that should never have left the gate.

The craze had its roots in the Telecommunications Act of 1996, which deregulated the industry and swept out rules limiting competition. Soon, entrepreneurs saw a chance to build huge networks crisscrossing the globe to serve the big jumps in demand for data transmission.

Hundreds of new and established companies thronged Wall Street, looking for capital. Some, like Metromedia Fiber Network, hoped to build high-capacity transmission systems in American cities. Others, like McLeodUSA, sought money to compete with the entrenched regional Bell companies. Still others, like Global Crossing, planned to wrap the globe in fiber optic networks.

All that stood between the hope of these networks and the glory of their completion was money -- lots of it, because laying fiber networks, unlike starting Internet companies, required big purchases and laborious installation of costly equipment.

Some companies raised cash by issuing stock. But most network operations loaded up on what they thought would be a cheaper source of capital: debt. From 1996 to 2000, telecom companies raised $240 billion in the high-yield, or junk, bond market. When bank debt, money raised in convertible bonds and loans from vendors eager to sell equipment is added, the total raised by the sector climbs to $500 billion.

"A great number of these companies should never have been funded," said Alexi Coscoros, a high-yield analyst at Bear, Stearns. "As long as the market was prepared to buy them, Wall Street was quite happy to bring these companies to market. But high-yield investors were buying paper for companies that were not fully funded and that carried much higher risk than anyone understood."

Wall Street, of course, is not known for scaring off investors with too much talk of risk. But Mr. Grubman clung to his rosy view long after it became obvious to his counterparts that the telecom financing binge was going to end badly. On April 4, a year after most telecom stocks had begun steep descents, Mr. Grubman wrote a report titled "Don't Panic -- Emerging Telecom Model Is Still Valid" and recommended seven stocks: Allegiance Telecom, Broadwing, Global Crossing, Level 3 Communications, McLeodUSA, Metromedia Fiber Network and XO Communications. Since then, the stocks have fallen 58 percent, on average.

It wasn't until a few weeks ago that Mr. Grubman threw in the towel on three of his favorites. On Nov. 2, he downgraded to neutral, from buy, the shares of McLeod -- then selling at 60 cents each, down from a peak of $34.83 last year. He did the same for XO Communications, whose shares were trading at 85 cents, down from $66, and expressed caution on Williams Communications Group, whose shares were valued at $1.39, down from a high last year of $59.

Since then, the shares of all three companies are up by an average of 48 percent.

Mr. Grubman went pessimistic on McLeodUSA, a company that Salomon helped to expand through an initial stock offering in June 1996 and later with several other debt and equity issues, because he expected its third-quarter revenue to fall 4 percent from the previous quarter. "It will no longer be considered a growth stock," Mr. Grubman wrote, "and with free cash flow not expected until '06, it is still far from a value stock label, so investor interest is expected to be low."

Emmett Ryan, a former fund manager in Southport, Conn., who specialized in telecommunications investments, said that for Mr. Grubman, "everything was based on a model."

"They would project revenues, expenses and net cash flow out into the distant future and come up with a price target," Mr. Ryan said. "But when these things started going down, they would not adjust their projections until the thing was at zero."

What pushed these promising companies into the abyss? In short, the enormous demand for data transmission networks predicted by Mr. Grubman and others never materialized. Nor did the cash flows on which these companies depended to pay their interest costs. At least four companies recommended by Mr. Grubman have filed for Chapter 11 bankruptcy protection. More than half of the companies that he tracks are the equivalent of penny stocks, trading at less than $5 a share.

But back in the heady days of 1999 and 2000, analysts were saying the sky was the limit on telecommunications and were telling investors to climb aboard for the ride of their lives. Nobody pounded the table quite as assiduously, or as effectively, as Mr. Grubman.

From AT&T to Wall Street

Mr. Grubman, an only child, grew up in a family of modest means, living in a Philadelphia row house. His father was a carpenter for the city; his mother worked in a dress shop. He received a bachelor of science degree in mathematics from Boston University in 1975 and a master's in probability theory from Columbia in 1977. Then he went to work for AT&T.

At first, he analyzed the demand for long-distance services, using computer models. He later worked in corporate planning for the company's breakup in 1984. In January 1985, he left for Wall Street, joining Paine Webber as a telecommunications analyst.

His Wall Street beginnings were inauspicious. In May 1986, according to regulatory filings, Mr. Grubman failed the exam, called the Series 7, that anyone who wants to be an investment professional must pass.

He subsequently passed. But even more important, he figured out how to stand out from the crowd of analysts covering telecommunications, which in those days meant analyzing AT&T and its recently freed regional Bell offspring. Mr. Grubman's knowledge of the company's internal operations gave him an edge. According to an analyst who is no longer in the business, Mr. Grubman regularly beat out competitors with information on AT&T that nobody else had.

"Jack had information that was never made public," said this person, who like most others interviewed about Mr. Grubman asked for anonymity for fear of ruining relationships on Wall Street. "I covered the company like a rug, and it was extremely concerned about leaks at the time."

Mr. Grubman gained attention from investors by being cautious about AT&T in a crowd that was mostly positive. He may also have recognized that the advent of competition after the AT&T breakup meant that there would be many more stocks to take public and bonds to issue than there were in the one- company era.

"By being negative on AT&T, Jack was able to gain the ear of other telco C.E.O.'s," the former analyst said. In 1988, for example, Mr. Grubman met Bernard J. Ebbers, the entrepreneur who eventually built WorldCom into a telecom colossus. Mr. Grubman parlayed the information he gleaned from small players in the business to become an expert in the sector.

Finding Fame and Fortune

In 1994, Mr. Grubman, well on his way to becoming a star analyst, left Paine Webber for Salomon Brothers. By the time the firm was taken over by Smith Barney in 1998, Mr. Grubman had toppled rivals and gained the top ranking in his industry on the All-American Research Team, as listed by Institutional Investor magazine.

Fortune followed fame. In 1998, Goldman Sachs tried to woo Mr. Grubman from Salomon Smith Barney, but he stayed put. Telecom deals were pouring in, and Mr. Grubman became the go-to guy. He ended up earning an estimated $20 million from the firm in 1999.

In January of that year, he and his wife, Luann, bought a town house on the Upper East Side of Manhattan for $6.2 million in cash. Soon, they were renovating the entire house.

As the number of telecom deals ballooned, and as Mr. Grubman's picks ascended, his hegemony in the industry and the firm took hold. That attracted still more business from executives who knew both how positive he was on the sector and how powerful his buy recommendations could be. In March 2000, for instance, when he raised his price target for Metromedia Fiber Network, the stock jumped 16 percent in one day. Companies deluged Salomon Smith Barney for their capital needs, and Mr. Grubman churned out glowing research reports, annually collecting a multimillion-dollar pay package.

Increasingly, that was the way Wall Street worked. "Equity research is a loss leader in most firms," said Philip K. Meyer, a money manager in Rowayton, Conn., who worked as an analyst on Wall Street for 18 years. "What it does is oil the pipeline so you have a good relationship with clients, so when you do deals you have a good distribution channel. Because the money you make on I.P.O.'s is so much greater, the increased pressure from investment banking makes research dysfunctional."

Clearly, Mr. Grubman was very good at oiling the pipeline. Besides issuing securities, many telecom companies -- primed for growth -- were eager for advice on takeovers or mergers.

© 2001, The New York Times Company