Revenge of the Investors - May, 2006

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

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

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

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

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

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

Many investors are taking matters into their own hands. They are fighting back--and winning. It's almost as if the Peter Lynch credo of the bygone bull market has been turned on its head. In his classic 1989 book, One Up on Wall Street, the legendary former Fidelity Magellan manager preached the virtues of self-help. That spirit is still very much alive today, only now, instead of picking stocks, investors have turned to picking on their adversaries--stock promoters, online investment letters, and brokerages that push questionable stocks. Some, like Schneider, Cocchieri, and dozens of others, are investigating potential miscreants. Others are waging proxy contests and pressing for changes in SEC regulations. And they have turned state regulators around the country into the No. 1 engine of Wall Street reform.

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

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

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

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

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

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