Persistent Pitfalls

How Hazards for Investors Get Tolerated Year After Year

Corporate Board Minutes Are Altered; Judgments In Arbitration Go Unpaid

Tainted Wall Street research. IPO chicanery. Mutual-fund trading abuses. Corrupt corporate accounting.

Investors have been hit with a wide array of scandals over the past two years, tarnishing the reputations of some of the nation's largest corporations and financial institutions. The facts have varied, but the scandals share a common thread: bad behavior that had been tolerated for years, often with regulators and industry insiders looking the other way.

Savvy investors long knew that some research analysts were overly bullish in recommending shares of their firm's banking clients. But regulators ignored complaints until Eliot Spitzer, the New York attorney general, launched a probe leading to a $1.4 billion settlement with 10 top securities firms last year. Ditto for Wall Street firms that doled out hot initial public offerings of stock to corporate executives to get their companies' financing business -- and in the process, shut out the little guy.

It also was no big secret that corporate boards rubber-stamped management decisions, stomping shareholders in the process. Abuses were left unchecked until a rash of accounting scandals led to sweeping reforms in 2002 that redefined the duties of directors.

There are many more such "open secrets": practices that raise eyebrows but persist on Wall Street and in corporate boardrooms. Here are three open secrets -- regarding corporate-board minutes, payment of arbitration awards and pricing of municipal bonds -- that exemplify the hazards to investors.

Altered Minutes

One reason it has been so difficult to determine what top management and directors knew about -- and did to cause -- the business disasters of the late 1990s is the distortion of corporate-board minutes. All too often, these critical records are altered or left incomplete. When fraud comes to light, investigators struggle to assign blame, making it harder for investors to recoup losses and less likely that misbehavior will be deterred in the future.

"The attitude is that it's OK to lie by omission in board minutes," says Charles Niemeier, a member of the Public Company Accounting Oversight Board. "It's the way it gets done, and the problem is that we have become accepting of this." The oversight board was set up under the Sarbanes-Oxley Act, legislation Congress passed in 2002 to improve corporate accountability. While the act addressed financial statements and public filings, lawmakers didn't look closely at problems concerning internal corporate documents.

Name a corporate blowup, and there is usually an example of board minutes being altered or left incomplete. At Enron Corp., investigators traced the board's knowledge of one dubious off-balance-sheet vehicle only through handwritten notes taken by the corporate secretary during a board meeting in May 2000. The information from the scribbled notes suggested that at least some Enron directors knew the arrangement was an accounting maneuver, rather than something aimed at substantive economic activity. But the formal board minutes from that meeting contained no reference to the directors' knowledge on this point.

There aren't hard rules on how thorough board minutes should be. As a result, some corporate lawyers routinely use bare-bones minutes as a shield to protect companies from liability.

"There is a huge gulf between the two schools of thought on board minutes," says Rodgin Cohen, a partner at the New York law firm of Sullivan & Cromwell. "One is that they should be a full recording. The other is that they should be limited. Most lawyers would suggest that they should be quite limited," he says. "It's like anything: The more words you put down, the greater exposure you have." Mr. Cohen says that he advocates more extensive minutes.

Amy Goodman, a lawyer at Gibson, Dunn & Crutcher who specializes in corporate-governance issues, says that after the recent wave of scandals, many corporate attorneys and their clients are re-evaluating whether they need to include more detail in minutes "to be able to show that directors have acted with due care and in good faith."

In the WorldCom Inc. fiasco, a court-appointed bankruptcy examiner has found that the company created "fictionalized" board minutes in connection with its announcement in November 2000 of plans to create a so-called tracking stock that would correspond to the performance of its consumer business. The long-distance telephone company, now known as MCI, said at the time that the board had approved this move.

In fact, the board hadn't given its approval, the bankruptcy examiner, Richard Thornburgh, a former U.S. attorney general, concluded. The board had held only a "minimal" discussion of the idea during a brief "informational" meeting on Oct. 31, 2000, Mr. Thornburgh's report said. WorldCom management decided to transform records from the October meeting into minutes of a formal board meeting, complete with references to a discussion about the tracking stock that hadn't really taken place, the report found.

One WorldCom lawyer said during the examiner's investigation that transforming the Oct. 31 meeting into a "real meeting was 'wrong' and made the transaction 'look nefarious' when that was not the case," the report said. The examiner faulted former senior WorldCom executives for the decision, although board members and WorldCom lawyers also bear responsibility, the report said.

The practice highlighted the lack of oversight by WorldCom's board, which contributed to the company's downfall and made it into a "poster child" for poor corporate governance, Mr. Thornburgh has said.

Bradford Burns, an MCI spokesman, says the company has instituted reforms "to ensure what happened in the past will never happen again."

Unpaid Judgments

On those occasions when investors catch their brokers cheating and win an arbitration award -- no small feat -- the customer still sometimes ends up losing.

IN PLAIN SIGHT Here are three 'open secrets' known to regulators and financial-industry insiders but still harmful to investors • Corporate-board minutes are often manipulated, with important facts changed or left out. That makes it difficult, once fraud is discovered, to determine what directors and top managers knew and what they did.   • Arbitration awards to investors who have been cheated often go unpaid, as, for example, when suspect brokerage firms simply shut down. Wall Street has opposed certain changes that would ease the problem, such as requiring brokerage firms to have increased capital and more liability insurance.   • Municipal bonds are difficult for individual investors to price because of a lack of information, often resulting in their paying too much. There have been improvements lately, but bond dealers are opposing certain additional reforms that would give investors real-time bond data.

Fabien Basabe says that in the late 1990s, his brokerage firm recklessly traded away nearly $500,000 of his money. The 65-year-old Miami restaurateur filed an arbitration claim with the National Association of Securities Dealers, as many investors do when they clash with their brokers. In 2002, after a two-year fight, a state court in Florida confirmed an NASD arbitration-panel award ordering J.W. Barclay & Co. to pay Mr. Basabe more than $550,000, plus $150,000 in punitive damages.

The problem was that the small New Jersey securities firm had closed its doors in early 2001, after it lost the initial round of arbitration. Mr. Basabe has yet to see any money. "I went through all of it for nothing," he says.

In the first quarter of 2003, the NASD imposed $99 million in damage awards against brokerage firms and brokers nationwide. What the NASD doesn't trumpet is that investors haven't been able to collect $30 million -- or almost one-third -- of that amount during that period, the most recent for which numbers are available. For 2001, the most recent full year for which figures are available, 55% of the $100 million in arbitration awards went uncollected.

The NASD can suspend the license of a broker or securities firm that refuses to pay up. But many firms and brokers just walk away rather than pay. Because of his disaster with Barclay & Co. (no relation to the big British bank Barclays PLC), Mr. Basabe says he lost his Italian restaurant, I Paparazzi, in the Breakwater Hotel in South Beach.

In 1987, the Supreme Court ruled that securities firms may require customers to waive their right to sue in court as a condition of opening a brokerage account. Since then, arbitration generally has become the sole forum for customers to seek redress from Wall Street firms. And Wall Street has resisted some steps that could protect investors when firms fail to pay.

In 2000, the General Accounting Office, the investigative arm of Congress, issued a report calling for improvements in arbitration-award payouts. The NASD has responded by installing a system that tracks unpaid awards and requiring firms to certify they have paid, among other steps.

But securities firms have successfully lobbied against two other potentially effective reforms. One would increase capital requirements, so that firms would have cash on hand to pay awards. The other would require firms to carry more liability insurance to cover awards. The Securities and Exchange Commission, which oversees the NASD and has jurisdiction on these issues, has reinforced this resistance in its own comments to the GAO.

In reports released in 2000 and last year, the GAO recounted arguments made by the SEC that increasing capital requirements could force many brokerage firms out of business and potentially penalize responsible firms. The SEC also has argued that stiffer insurance requirements could raise investor costs. Securities-industry executives have told the GAO that carrying more insurance to cover arbitration awards "could raise costs on broker-dealers industrywide and ultimately on investors."

An SEC spokesman says the agency "continues to explore ideas about how to improve investor recovery of losses from firms that go out of business."

Investors' inability to collect arbitration awards has broader ripple effects: "A lot of lawyers won't even touch these cases because they know they have no hope of collecting money," says Mark Raymond, Mr. Basabe's attorney.

The NASD arbitration panel found that the Barclays broker who handled Mr. Basabe's account, Anton Brill, engaged in "intentional misconduct" when he made unauthorized trades. Mr. Brill now works at another securities firm in Florida. He has yet to pay the $6,000 in punitive damages levied against him, or any of the remainder of the arbitration award, for which he is jointly liable.

In an interview, Mr. Brill said the case took place "a long time ago," adding that the matter is "still under negotiation." He declined to elaborate. After receiving questions about the case from The Wall Street Journal, an NASD spokeswoman said that the association had begun proceedings to suspend Mr. Brill's license.

Murky Municipals

In October 2002, John Macko bought $15,000 of municipal bonds issued by a trust organized by the government of Puerto Rico. The 57-year-old lawyer in Geneseo, N.Y., discovered after the fact that he had paid $25 to $44 more per $1,000 bond than brokers paid for the same type of bond during the same trading day. This information wasn't available to him at the time he made his purchases. The muni-bond market, Mr. Macko says, "is very opaque."

State and local governments issue municipal bonds to raise money for public projects. The bonds typically are exempt from federal taxes, and most are seen as relatively safe investments. Munis trade on an open market, but there isn't a place small investors such as Mr. Macko can go to figure out whether they are getting a fair price. (In contrast, stock prices are reported minute-to-minute by exchanges, and mutual-fund prices are set once a day. Treasury bonds and many corporate bonds are priced throughout the day with a short delay.)

Bond dealers, with their superior knowledge of the market, can make a legitimate profit on the difference between what they buy bonds for and their sales prices. But dealers have gone a step further: opposing full online dissemination of real-time muni-bond prices that would help small investors. The dealers say that because many munis trade infrequently, it's difficult to determine precise prices. Immediate disclosure of some prices, they add, might increase volatility in the market and cause some dealers to stop trading certain bonds.

Without fresh data on bond trading, individuals can fall prey to brokers who tack on excessive "markups." An example: Last May, the NASD alleged that Lee F. Murphy, a former broker at Morgan Keegan & Co., charged too much in 35 bond sales, including deals in 2001 for bonds sold by St. James Parish, La., to raise money for solid-waste disposal. Mr. Murphy obtained markups from investors ranging from 4.07% to 7.18%. There aren't specific limits on markups, but the industry rule of thumb is that margins should be well below 5%, unless there are exceptional circumstances, such as the strong possibility that a municipality will default.

In the case involving the Morgan Keegan broker, the bonds "were readily available in the marketplace, and Murphy offered no special services justifying an increased markup," the NASD alleged. Mr. Murphy, who settled the administrative charges without admitting or denying wrongdoing, was suspended for 15 days and fined $6,000.

Thomas Snyder, a managing director at Morgan Keegan, says the trades were part of a unique situation in which Mr. Murphy didn't have full information about a volatile, unrated bond. Morgan Keegan officials add that the firm hadn't been sanctioned and that it canceled the trades in question and reimbursed investors. Mr. Murphy wasn't available at the New Orleans office of his current employer, Sterne, Agee & Leach Inc.

Investors in theory can shop around, as they would for a car. But as a practical matter, most individuals buy municipal bonds through their regular broker and don't do much comparing. Securities laws hold brokers to a higher standard of protecting customers' interests than is applied to merchants such as car dealers.

Individual investors -- who directly own an estimated $670 billion of the $1.9 trillion in outstanding munis -- are better off than they were just a year ago. That's when the Municipal Securities Rulemaking Board expanded the amount of muni-bond data available on a Web site called Investinginbonds.com. The MSRB, a congressionally created self-regulatory body, provides the price, size and time of each trade -- but typically with a delay of up to 24 hours. The board plans to report same-day trade data for many bonds beginning next year.

But Wall Street is resisting. Brokers are lobbying the MSRB to delay the release of real-time data for some larger trades and lower-quality bonds so that the impact of the disclosures can be examined. These brokers point to the argument about increasing volatility, which, they say, could heighten the risk of trading losses for both dealers and investors.

Regulatory actions such as the NASD's move against Mr. Murphy have been relatively infrequent, but that may be changing. The SEC and the NASD have launched separate probes of bond pricing, focusing on whether brokers have choreographed transactions among themselves that drive muni prices up or down, to the detriment of customers.