October 2, 2002

Three years ago, New York Attorney General Eliot Spitzer got some interesting advice from a job applicant: Dust off the Martin Act, he was told.

The 1921 state law could be used to transform the sleepy office of attorney general into a tough corporate regulator, Mr. Spitzer recalls being told by Eric Dinallo, now head of his investor-protection bureau. "We followed his advice," Mr. Spitzer says.

In his boldest move yet to regulate practices on Wall Street, Mr. Spitzer on Monday sued five current and former telecom executives, including former WorldCom Inc. Chief Executive Bernard Ebbers, seeking the return of more than $1.5 billion in allegedly ill-gotten profits from stock sales.

And in doing so, Mr. Spitzer may have once again pulled ahead of other regulatory officials in what has become a heated public-relations race over which regulator will take the highest profile in the corporate-malfeasance crackdown.

Mr. Spitzer and Robert Morgenthau, the Manhattan district attorney, have used the Martin Act to help regulate Wall Street, drawing more attention than the efforts of the Securities and Exchange Commission and the National Association of Securities Dealers' regulatory division.

Disclosure Provisions

Though Mr. Spitzer's suit doesn't name Citigroup Inc.'s investment bank Salomon Smith Barney, the suit alleges that the executives were able to make $1.5 billion from sales of their own company stock, including the exercise of options, because of favorable ratings from Salomon analysts that inflated the value of the shares. Salomon benefited by getting investment-banking business from the companies, Mr. Spitzer contends. He says the arrangement defrauded other investors and violated the disclosure provisions of the Martin Act, a broad law barring fraud in the sale or offering of securities.

The Race to Root Out Wall Street Abuses: Eliot Spitzer, the New York Attorney General, and Robert Morgenthau (right), the New York District Attorney, have used the Martin Act to help regulate Wall Street, leaving SEC Chairman Harvey Pitt (left), and Mary Schapiro (second from left), head of NASD Regulation, in the dust.

That allegation could have far-reaching consequences and could lead to civil lawsuits or even criminal prosecutions against other executives, legal experts predicted. "If you are an executive who is engaged in the same course of conduct, I'd join your fellow executives and form a line outside the attorney general's door," said David J. Kaufmann, a former state prosecutor and expert on the Martin Act.

"He is pursuing an area that is widely known and is almost the dirty little secret of Wall Street: that analysts are bending their coverage to help get investment-banking business," said David Gourevitch, a former state prosecutor who has used the Martin Act in criminal cases.

In addition, the suit Mr. Spitzer filed Monday alleges that Salomon directed shares in initial public offerings to the five executives in exchange for their companies' awarding the firm valuable investment-banking business.

What makes Mr. Spitzer's case unique, legal specialists said, is that he is citing the act's less-commonly used civil side -- and throwing the alleged investment-banking relationships into the mix. Mr. Morgenthau, who has used the Martin Act extensively since the mid-1990s to bring criminal securities-fraud cases, has also invoked the act to charge former Tyco International Ltd. CEO L. Dennis Kozlowski with reaping hundreds of millions of dollars in illicit gains from the sale of Tyco stock. Mr. Kozlowski has denied the charges.

To prove his case, Mr. Spitzer would have to show by a preponderance of the evidence that an undisclosed conflict of interest between the executives and Salomon hurt investors by artificially inflating the price they paid for their shares.

IPOs as Proof

But legal experts said the attorney general might need to show only that the executives received the IPO shares, that Salomon got millions of dollars in investment-banking business, and let a jury "infer" the reason. "Nobody has to have said in capital letters, 'hey, we're giving you an IPO because you gave us tens of millions of dollars in investment-banking business,' " said Mr. Kaufmann. "They're not going to find a letter or an e-mail like that, but they're not going to need it."

The Martin Act is spoken of reverentially by state securities regulators because it is widely considered the broadest and most potent securities law in the nation. Mr. Spitzer, experts said, is merely applying it to the current climate of intense public pressure to crack down on corporate fraud.

In racing ahead of federal regulators to crack down on Wall Street fraud, Mr. Spitzer is following a tradition of leadership that dates back to the Martin Act's passage in 1921. The law -- named after Francis J. Martin, a New York state legislator who later became a state court judge -- was adopted in response to numerous securities-fraud scandals that were wracking investors nationwide.

Around the same time, more than 40 states passed similar "blue sky" laws while the federal government failed to act, said Mr. Kaufmann, who is now senior partner at Kaufmann, Feiner, Yamin, Gildin & Robbins in New York.

New York's law—which was in part a model for the federal statute that created the U.S. Securities and Exchange Commission in 1934—emerged as by far the nation's toughest.

Most other state laws merely required brokers to register with the state. But New York's then-governor, Al Smith, "realized that with New York being home to the nation's major stock exchanges, the state securities law had to be particularly vital and comprehensive," Mr. Kaufmann said.

The law defines securities and the fraudulent sale of them far more broadly than any other statute. And unlike federal statues, it doesn't require that prosecutors prove an intent to defraud when they bring cases.

Even the SEC tried -- but failed -- to get that power. In 1980, the U.S. Supreme Court rejected an effort by the agency to interpret federal securities law so that intent wouldn't have to be proven.

Still, the Martin Act was used sparingly at first, partly because it wasn't amended until the mid-1950s to allow for criminal prosecutions. Even today, only the state attorney general and local district attorneys can use it. Unlike federal securities laws, it can't be used by individuals to claim securities fraud in private lawsuits.

But state attorneys general used the law extensively in the 1970s and 1980s, to crack down on everything from scams that defrauded various investors to attempts by organized-crime families to sell illusory "franchise" rights to businesses. In the mid 1970s, the attorney general even sent uniformed state troopers onto the floor of the American Stock Exchange to arrest brokers accused of falsely inflating trading volume on the ticker.

In Manhattan, Mr. Morgenthau has been using the law extensively since the mid 1990s in a series of prosecutions targeting now-defunct brokerage houses.

While no one has used the Martin Act in quite the same way Mr. Spitzer is trying to now, legal specialists said it is very likely to be deemed permissible by state judges if it is challenged. A long series of state court decisions, dating back to 1926, have upheld the Martin Act's broad definition of securities fraud and the fact that prosecutors don't need to prove criminal intent in pursuing cases.

"This is considered broader in scope than any securities law in the country," Mr. Gourevitch said. "It covers things that seemingly have nothing to do with securities: the sale of tax shelters, condo conversions."

In one memorable case from 1936, Mr. Gourevitch said, a state court in upstate New York ruled that burial plots being sold by a cemetery were considered securities as defined by the Martin Act. State prosecutors who were investigating the plots had asked for permission under the Martin Act to issue a subpoena. The request was granted.