The Water Street machine's ability to sell huge amounts of stock to retail customers made it a vital adjunct of the firm's activities on behalf of corporate clients. Shearson raised money for corporations by selling new issues of their stock, and supported those offerings by continuing to "make a market" in their shares. Shearson could buy large blocks of over-the-counter stock from its big, institutional customers who wanted to sell because the trading desk knew that the awesome Lehman retail sales force could get the risky stock position off the firm's hands and push it out to retail customers.
"The trading desk knew that if they took it to 55 Water they could get the job done," says one former Water Street broker.
The methods for doing so were often suspect, and often hurt retail clients.
One way 55 Water St. moved stock was with its so-called "specials." Specials, according to Water Street alumni, were extra fat commissions paid secretly to brokers to sell a stock, even if it looked like a loser. Virtually all brokers in the office participated in the specials, ex-brokers say.
In 1986, for instance, Shearson took charge of an initial public offering of stock by Prospect Group Inc. Once the offering was completed, Shearson made a market for Prospect Group stock. On one day in late May, 1986, Shearson as a market maker sold 1.6 million Prospect Group shares. One million of those shares were sold by the 55 Water office alone, helping Shearson's traders unload shares in their hands. But NYSE investigators found that the stock was sold at a higher price to nearly all of the 360 customers who bought it through the Water Street office than to customers of any other Shearson office that day. The NYSE said the office and its brokers profited from this secret markup, and illegally failed to disclose it to customers.
Shearson declined to comment on "specials" or to say if the practice has been stopped.
Former Water Street brokers still talk about "herpes warrants," so-called because many of them turned out to be injurious to customers' financial health. A warrant is the right to buy a share of stock at a specified price.
These were warrants issued by HPSC Inc., a small dental equipment leasing concern. Shearson made a market for the warrants from the time they were issued in 1984 until they expired in 1989. Market makers act as dealers, holding an inventory of a security and standing ready to buy or sell at publicly quoted prices. But price data shows that warrants sold at least from April, 1986, on were never profitable to exercise. And Dennis J. McMahon, HPSC's controller, says all or nearly all of the warrants issued were never exercised and expired worthless.
The price of HPSC's common stock plummeted steadily from late 1986 on, making the prospect of profitably exercising the warrants ever more remote. But records show that tens of thousands of the warrants continued to be traded every month. Former Water Street brokers say colleagues in the office continued to recommend the warrants to customers even though many of them harbored doubts about the company's prospects. The former brokers, who declined to be identified, asserted that this was because Shearson paid an unusually generous sales credit to brokers for each warrant sold. Shearson declined to comment on the HPSC warrants, and refused to say how big a sales credit was paid to brokers.
Whatever the sales credits were on the warrants, however, the amount was small potatoes compared to the money a small corps of brokers was making from an irregular arrangement involving huge blocks of new stock marketed by Shearson.
Confidential NYSE depositions show that into 1990, there was a long-standing arrangement involving at least six veteran brokers close to Tarlowe, the assistant branch manager who for a time became head of the whole Lehman retail division. These brokers received huge allocations of highly sought-after shares, which they funneled into accounts held by a man described in deposition testimony as a lifelong acquaintance of Tarlowe's. The acquaintance was New York real estate speculator Martin B. Tepper.
Seymour Passman, until 1991 the branch manager, testified behind closed doors in the NYSE investigation that the Tepper accounts were among the branch's biggest.
Executives in the Shearson department that handled new stock offerings always gave 55 Water a big allocation of shares because they knew they could rely on the office to sell all the shares it received.
In a July, 1990, NYSE deposition, Passman confirmed that, in an extremely unusual arrangement that he said still existed as of his testimony, an inner circle of brokers favored by Tarlowe was permitted to sell many of the shares allocated to the branch into the Tepper accounts and receive steep commissions, even though they weren't the designated brokers for the accounts. Sources say a similar arrangement also existed for several favored accounts not owned by Tepper.