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Why Merrill Lynch Is Bullish

Apr 12, 2002 | The company's analysts issued misleading stock ratings to lure business.

No one was more bullish on the stocks than Merrill Lynch. Even when less-sophisticated market-watchers started wondering whether the Internet company stocks were dangerously overpriced, the famed Wall Street brokerage firm refused to advise its clients to sell.

When the bubble burst, sending millions of dollars in investments by average Americans into the ether, Merrill Lynch invoked the Stupid Defense. It asked everyone to believe that one of the oldest, largest market analyst companies in the world didn't see the collapse coming.

Ordinarily, this would not be considered a good marketing strategy for a company whose profit rests on a reputation for being smart about such things. Now, it appears, claiming ignorance was clearly the lesser of two evils for Merrill Lynch.

According to New York Attorney General Eliot Spitzer, not only did Merrill Lynch analysts know the Internet stocks were tanking, but also they deliberately issued misleading positive ratings for them because Merrill Lynch was also soliciting those firms as investment banking customers.

In other words, Merrill Lynch put out phony stock ratings to shore up its corporate clients (and thus help Merrill Lynch), while hurting thousands of individual investors who trusted its advice.

You can now see how claiming to be stupid makes more sense than admitting you lied to people so you could make money even though they lost theirs.

Spitzer's damning charges are contained in a 37-page affidavit filed with the courts. They are the result of a nearly yearlong investigation of Merrill Lynch and are buttressed by thousands of internal e-mails among Merrill Lynch employees that make for fascinating, if infuriating, reading.

The affidavit details the honest appraisals of Internet companies, as contained in e-mail conversations between researchers and other company employees. These internal ratings ranged from "piece of junk" to "piece of crap" and "no hopeful news to relate …"

Meanwhile, the official published ratings of those stocks never went below a three (neutral) on a five-point scale. No stock ever got a four (reduce) or five (sell) rating, however poorly Merrill Lynch estimated it would do. The company avoided the embarrassment of giving a client a sell rating by simply not covering any stocks that it rated below three. This helped the corporate clients by keeping bad news quiet, but, again, it hurt individual investors who may not have recognized that the neutral three rating was, in fact, a distress signal.

Beyond that, Merrill Lynch gave one and two ratings to stocks its researchers knew were destined to collapse because the companies had nothing to offer. According to Spitzer, this was the result of conflicts of interest among Merrill Lynch's supposedly independent Interent research analysts.

These analysts apparently were expected to recruit and maintain banking customers – and were compensated for doing so. This, despite the supposed "Chinese Wall" between bankers and research analysts at securities firms. This wall is supposed to prevent bankers from sharing inside information with other employees and from trying to influence supposedly independent analysts to give investment clients or potential clients good stock ratings. But this sharing of information and manipulating of ratings to benefit major investors appears to have been standard operating procedure at Merrill Lynch. In fact, the company seems to have used the promise of favorable ratings as a lure for potential banking customers.

The word on Wall Street is that this method of doing business is not limted to Merrill Lynch. If true, we should know soon enough because Spitzer's office is investigating other top securities firms as well. Criminal charges are possible. But this report, on top of the outrageous behavior of executives, accountants and analysts in the Enron collapse and other recent corporate fiascos illustrates how lax enforcement has been of rules and laws governing the financial markets.

Spitzer has managed to get a court order requiring Merrill Lynch to reveal whether it has any business relationship with a firm on which it issues stock reports. At a minimum, this should be the case. The company itself says it will no longer tie analysts' pay to business brought in, but rather to how well they analyze stock performances. That will help to rebuild the wall, but federal regulators need to make it stronger.

Spitzer may have spilled one of Wall Street's dirty little secrets with this report. If so, good for him, and us. Millions of average Americans are now invested in the stock market. They need to know they can trust the advice they get from the Merrill Lynches of the world, within the boundaries of human error, not the limits of human deceit.

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