Plaintiffs’ lawyers must be salivating. A lawsuit filed this week by the New York State Attorney General against Merrill Lynch & Co. has opened the door to claims by thousands of customers who relied upon the advice of the Merrill Lynch analysts.
The court action was initiated after a lengthy investigation revealed that the brokerage firm’s supposedly independent and objective investment advice was actually biased to favor the firm’s investment banking clients. It has already taken a significant turn. On April 8, 2002, New York Attorney General Elliot Spitzer announced that the New York State Supreme Court had issued an order requiring immediate reform of investment analysis practice at Merrill Lynch.
The Attorney General’s action may come as a surprise to those who believed that a “Chinese Wall” separates a brokerage firm’s analysts from its investment bankers and salespersons. An extensive investigation revealed that Merrill Lynch did not maintain a fully independent and unbiased research group. Instead, the New York Attorney General’s lawsuit charges that Merrill Lynch distorted stock ratings in order to attract, and keep, investment banking business. Indeed, Merrill Lynch analysts were compensated for recruiting investment banking clients. As a result, analysts gave favorable ratings to the firm’s clients, even when they acknowledged internally that those stocks were not sound investments.
Other regulators have expressed concern about the independence of brokerage firm analysts. On July 2, 2001 the National Association of Securities Dealers proposed new rules requiring analysts to disclose potential conflicts of interest. The Securities and Exchange Commission has voiced similar views; an SEC “Investor Alert” warns investors of such potential conflicts. See Cracks in the Wall.
The case against Merrill Lynch demonstrates that such concerns are merited. Saying that this action “must be a catalyst for reform throughout the entire industry,” Spitzer characterized Merrill Lynch’s behavior as “a shocking betrayal of trust by one of Wall Street’s most trusted names.”
In preparing its case, the New York Attorney General’s Office reviewed over 30,000 documents, consisting of more than 100,000 pages. They discovered that the Merrill Lynch rating system was a sham since analysts declined to issue “reduce” or “sell” recommendations concerning the firm’s clients, even when they privately expressed concerns about the future of those companies.
Indeed, internal e-mails revealed that the analysts’ recommendations often were inconsistent with their actual opinions. For example, one internal e-mail acknowledged that there was “No helpful news to relate” regarding the firm’s investment banking client, Internet Capital Group. Still, while analysts conceded in private correspondence that “there is really no floor to the [Internet Capital Group] stock,” they did not immediately lower their rating.
An affidavit submitted by the New York Attorney General in support of the lawsuit noted similar discrepancies between the published ratings and internal comments by analysts concerning such Merrill Lynch clients as Aether System, Excite@home, GoTo.com, InfoSpace, Lifeminders and 24/7. In one instance, an analyst made highly disparaging remarks about the management of a company and called its stock “a piece of junk,” yet gave the company, a major investment banking client of the firm, the highest possible rating. In other cases, analysts used expletives to describe companies to one another, but continued to maintain unrealistically high ratings for the stocks.
According to the Attorney General’s affidavit, Merrill Lynch analysts “knew very well that investment banking business translated into compensation for them personally and the firm generally, and that their research played a role in attracting and keeping that investment banking business.” As a result, there was a conscious effort to protect investment banking business by managing ratings.
While Merrill Lynch analysts seemed diligent in their desire to mollify their investment banking counterparts, they paid little heed to the right of investors to receive accurate, untainted information. The court order obtained by Attorney General Spitzer seeks to rectify that situation. It requires Merrill Lynch to disclose to investors its relationships with investment banking clients, and to provide more context for its stock ratings.
That should mean that Merrill Lynch will be gearing up for a wave of investor lawsuits. And Attorney General Spitzer promises that the investigation into other brokerage firms is continuing.