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Judge Faults Merrill Lynch Internet Stock Research

Apr 9, 2002 | A New York judge has ordered Merrill Lynch (NYSE: MER)to reform its stock research unit after a 10-month investigation by the state's attorney general uncovered evidence that the firm's research on a host of Internet companies misled investors.

The order requires that Merrill Lynch make disclosures to investors about its relationship with investment banking clients and provide more context for stock ratings.

The preliminary order came in response to a 38-page complaint by New York Attorney General Eliot Spitzer. Based on 100,000 pages of documents, including thousands of e-mails, the affidavit shows that Merrill analysts publicly maintained positive ratings on stocks while deriding them privately, Spitzer said.

The investigation focused exclusively on the firm's Internet division. Well-known Internet researcher Henry Blodget, who gained fame as an early cheerleader for such Web stocks as (Nasdaq: AMZN) and eBay (Nasdaq: EBAY) , was one of 10 Merrill employees interviewed under oath by investigators.

"This was a shocking betrayal of trust by one of Wall Street’s most trusted names," Spitzer said. "The case must be a catalyst for reform throughout the entire industry."

Allegations Denied

Late Monday, Merrill Lynch issued a statement saying there is "no basis" for the allegations.

"We are outraged that we were not given the opportunity to contest these allegations in court," the statement said. "We are confident that a fair review of the facts will show that Merrill Lynch has conducted its research with independence and integrity."

But Spitzer said the investigation revealed a "serious breakdown of the separation between the Merrill Lynch banking and research departments" that resulted in almost exclusively positive coverage of Internet stocks from the spring of 1999 to the fall of 2001.

Familiar Territory

Merrill has been named in earlier lawsuits by investors in dot-com stocks. Among the names Spitzer said Merrill boosted were eToys, Webvan, and

Spitzer cited internal e-mails in which analysts referred to stocks as "a piece of junk," "crap" and "a dog," despite publicly maintaining "buy" or "accumulate" ratings.

The same e-mails also seem to show that some analysts, including Blodget, eventually grew weary of promoting unworthy stocks.

Late in 2000, Blodget threatened in an e-mail to "just start calling stocks ... like we see them, no matter what the ancillary business consequences are." Fellow analyst Kristen Campbell said in a separate communication, "We are losing people money and I don't like it."

Process Faulted

For its part, Merrill faulted the investigation for relying so heavily on e-mail messages.

"The allegations reveal a fundamental lack of understanding of how securities research works," the firm said. "E-mails are only one piece of a continuous conversation, isolated at a single point in time -- not the end conclusion."

Merrill also argued that the e-mails show healthy debate among analysts about the companies they were assessing.

Examples Cited

Spitzer focused on two cases, involving (now known as Overture) and InfoSpace (Nasdaq: INSP) , as examples of the breakdown.

In the GoTo example, the complaint alleges that Merrill initiated coverage on the search engine shortly after the firm was hired to help manage an equity placement from European investors. At the same time, Blodget told a client in an e-mail that there was "nothing" interesting about beyond "banking fees."

Merrill later downgraded GoTo on the same day that Credit Suisse First Boston won the right to handle a follow-on stock offering, beating out Merrill Lynch.

In the case of InfoSpace, the complaint charges that Merrill held off on lowering its rating on the stock until Merrill's banking unit successfully completed the sale of Go2Net to InfoSpace.

The judge's order is designed to protect investors while the investigation continues, Spitzer said.

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