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The Devil Is In The E-Mail

Once, Brokerages Could Bury Prosecutors In Mountains of Irrelevant Paper. Now, As Merrill Lynch Is Learning, E-Dirt Is Much Easier To Dig

Apr 23, 2002 | In computer-security circles, Wall Street is considered a premier customer. Each major brokerage and investment-banking house spends huge sums to ensure that no one, but no one, breaks into its computer systems.

It's money well spent. Trust is the stock in trade of brokers and investment bankers. Investors must feel that their money is safe from a slick cybercrook. And the threat is real. It's entirely conceivable that a sophisticated hacker could empty a bank's coffers of millions of dollars with some simple keystrokes.

LOOSE USE. Now, it turns out that the biggest digital-security threat facing giant brokerage houses and investment banks may have nothing to do with firewalls, intrusion detection, and security engineers. It may lie with the loose use of e-mail and instant messaging by employees, who write things they would never dare to say out loud.

Witness the disturbing case that New York State Attorney General Eliot Spitzer is building against Merrill Lynch, the largest brokerage and investment bank in the U.S. Spitzer's probers have uncovered scads of e-mail implying that Merrill employees, including star Internet analyst Henry Blodget, privately disparaged companies they were publicly promoting.

Blodget called at least two of the companies a "piece of sh-t" at the same time that Merrill was recommending them to investors, according to documents released by the New York AG's office. Spitzer alleges that Merrill fudged research calls to please investment-banking clients, namely, publicly traded companies that Merrill analysts were following.

Skeptics have doubted a separation between banking and research

The AG still hasn't declared whether the case he's building against Merrill will be civil or criminal. That alone has the Street on edge. And Spitzer has already made it clear that Merrill is only the first in what could be a long list of targets. Should his allegations of misconduct hold up in court, Merrill could face millions in settlement payouts.

"WIDELY SUSPECTED." Large financial institutions have long claimed that a wall separates their analytical research on publicly traded companies from investment-banking units that sell services to the very same companies. But the skeptics have long doubted that divide. Now, Spitzer appears to have e-mail to prove the naysayers right.

"Prior to Spitzer's release of this information, it was widely suspected, but not proven, that there were close ties between investment banking and research," contends Mark Maddox, a former Indiana securities commissioner and partner at Maddox Koeller, Hargett & Caruso. "It was a suspicion that was difficult to prove unless you had a disgruntled employee. There weren't any 'smoking gun' documents. These e-mails seem to be that smoking gun." Maddox, an attorney, has represented investors in suits against some of the firms that Spitzer is investigating.

With the proliferation of e-mail, in 1997 the Securities & Exchange Commission redrafted rule 17a-4. This regulation first took effect in 1934 under the Securities Exchange Act. It required broker-dealers to keep paper records of certain communications between brokers and their customers. The revision tried to bring this rule into the Digital Age by mandating archiving of e-mail and other electronic communications under the same principle.

POWER SHIFT. Under the new draft, all broker-dealers must also keep records of electronic communications between clients and brokers as well as a significant portion of internal corporate communications. That seems to include even attachments to e-mail, according to Charles Weeden, CEO of 17a-4, an archiving company.

The New York Stock Exchange and the National Association of Securities Dealers have embraced the revised rule. "I think this dramatically shifts the balance of power to the customers. This will result in arbitration panels across-the-board giving people discovery [the right to view] of e-mail," says Jacob Zamanski, a Manhattan securities attorney.

E-mail had made it easier to gather clear evidence

He should know. Zamanski settled with Merrill last year for a $400,000 award against a $500,000 claim. He represented an investor who claimed that his Merrill broker was relying on positive in-house analyst reports to justify stock recommendations, often over the client's initial objections. However, the suit alleged that, in some cases, Merrill was working for these companies as an investment banker. Although Zamanski declined to discuss details of the case for this story, he says electronic evidence played a key role.

Before e-mail came along, such claims were tough to prove in court. Plaintiffs couldn't get clear evidence, and in their search for documents, they were often deluged with stacks of paper with no bearing on the case at hand, says Zamanski. As Maddox points out: "Inevitably, you had this he-said/she-said credibility stuff in disputes. When you get into this e-mail situation, you can occasionally stumble into these nuggets of gold."

FINDING PATTERNS. Now it's a whole new ball game. The SEC revision of 17a-4 not only mandates electronic storage of all e-mail but it also requires that archives be easily searchable. That's a piece of cake for database designers, who can put paper documents into a digital format where patterns are easy to discern. "I can go in and search through terabytes worth of data very quickly and easily," says Weeden.

Brokerage houses and investment banks have gotten the message. They're moving quickly to implement their own database-search functions and formulate new policies dictating what types of digital communications are permitted.

Meanwhile, companies that specialize in helping brokers comply with 17a-4 are rushing in, from Weeden's 17a-4 to IMLogic, an outfit that archives instant-message exchanges. IM conversations are considered under 17a-4 to be the same as e-mail. Already, many savvy clients have decided to communicate with their brokers only via e-mail and instant messages because doing so creates an easily traceable digital trail.

POSITIVE REPORTS. In what could be another closely watched case, on Apr. 12 Zamanski filed a suit against Salomon Smith Barney telecom analyst Jack Grubman, who was long known as an AT&T (T ) bull, rating it highly even as its shares plummeted. The suit charges that Salomon misled investors by allowing Grubbman to issue positive investment reports knowing that AT&T faced larger troubles and that Salomon did so to keep AT&T's investment-banking business.

Both Merrill and Salomon vigorously deny the charges being brought against them. But brokers and investment bankers, take note: It's only logical that the cost of archiving information will come down even more, thanks to technological innovation. Moreover, after the Enron scandal, the actions of analysts and stockbrokers are bound to remain the subject of increasing scrutiny.

In the future, analysts will be under growing pressure to make sure that what they say publicly is also what the say privately. That's transparency, and it's a healthy thing for capitalism. Wall Streeters are learning the hard way that every time they tap out an e-mail, they risk costing their firm millions.

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