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Merrill Lynch and Other Brokerage Firms Under Investigation
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Merrill Lynch & Co., one of the nation’s largest and oldest brokerage firms, engages in retail and institutional sales to its customers, publishes research ratings and reports on stocks, and provides investment banking services to businesses. In May 2002, Merrill Lynch and New York Attorney General Eliot Spitzer resolved an investigation into conflicts of interest in the stock research department at Merrill Lynch. The brokerage firm agreed to pay a $100 million fine to settle allegations that it misled investors with stock research.

The Affidavit in Support of Application for an Order Pursuant to General Business Law Section 354, filed in the case of In the matter of an inquiry by Eliot Spitzer, Attorney General of the State of New York, Petitioner, and Merrill Lynch & Co., et al., Respondents; Supreme Court of the State of New York, the Chief of the Investment Protection Bureau of the New York State Department of Law testified to the following:

Since late 1999, the internet research analysts (the “internet group”) at Merrill Lynch have published on a regular basis ratings for internet stocks that were misleading because: the ratings in many cases did not reflect the analysts’ true opinions of the companies; (2) as a matter of undisclosed, internal policy, no “reduce” or “sell” recommendations were issued, thereby converting a published five-point rating scale into a de facto three-point system; and (3) Merrill Lynch failed to disclose to the public that Merrill Lynch’s ratings were tarnished by an undisclosed conflict of interest: the research analysts were acting as quasi-investment bankers for the companies at issue, often initiating, continuing, and/or manipulating research coverage for the purpose of attracting and keeping investment banking clients, thereby producing misleading ratings that were neither objective nor independent, as the purported to be.

Behind these ratings was a serious breakdown of the separation between the Merrill Lynch banking and research departments, a separation that was critical to the integrity of the recommendations issued to the public by Merrill Lynch. Though Merrill Lynch’s stated policies reflect an understanding that this separation is critical, the evidence reveals that at least with respect to the internet group, there was insufficient divide between research and banking.

Our investigation to date reveals that the compensation system for internet analysts was a significant factor contributing to the breakdown between the internet group and investment banking departments. Research analysts knew that the investment banking business they generated or participated in would impact their compensation, and management encouraged them to produce investment banking business. Analysts curried favor with potential or actual investment banking clients by giving them special treatment. At times, officers of clients or prospective clients were allowed to redraft their own coverage, write quotations in which the analysts would tout their companies, and indicate which rating would be acceptable to them.

The pressures put on the Merrill Lynch internet group to appease both investment bankers and clients led the group to ignore the bottom two categories of the five-point rating system (“reduce” and “sell”) and to sue only the remaining ratings (“buy”, “accumulate” and “neutral”). The absence of clear guidance from Merrill Lynch management on how to resolve the conflicts created by these pressures led respondent Henry Blodget, the head of the internet group, in a moment of candor, to threaten to “start calling the stocks (stocks, not companies)… like we see them, no matter what the ancillary business consequences are.” (ML 68401) (emphasis added)…..

Analysts True Opinions Not Provided to Investing Public
The New York Attorney General’s investigation addressed the following:

The ratings for internet stocks set by the internet research analysts (the “Internet Group”) at Merrill Lynch, in certain cases, did not reflect the analysts’ true opinions of the companies. Until June 15, 2001, Merrill Lynch’s five-category stock rating system was as follows:

1. Buy Rating (20% or more price growth expected)
2. Accumulate Rating (10% to 20% price growth expected)
3. Neutral Rating (10% price growth to 10% price decline expected)
4. Reduce Rating (10% to 20% price decline expected)
5. Sell Rating (20% or more price decline expected)

The two lower ratings were- 4 (a Reduce rating) and 5 (a Sell rating). However, rather than assigning these unfavorable ratings to stocks they no longer favored, the analysts in the Internet Group silently discontinued covering the stock, creating an opportunity for the general investing public to be mislead.

Attorney General Spitzer’s investigation also uncovered instances where the Internet Group was contemplating a 2 (accumulate) rating on stocks while the group’s analysts were privately saying that there was “no reason to buy more of” the stock and its business was “falling apart”, or that the group expected the stock to be “flat over the next six months without any real catalyst for change”. Other comments from the Internet Group also included phrases, which contained profanity when referring to stocks that the group had given a 2 (accumulate) rating.

After a 10-month investigation, Attorney General Spitzer accused Merrill Lynch of manipulating the stock research to improve the financially successful investment banking business. Attorney General Spitzer also released a series of e-mails where Merrill Lynch analysts privately criticized companies they publicly promoted in their research reports. These Merrill Lynch e-mails contained phrases such as, the stock was “going a lot lower”, that the company was “crap”, or a “dog”, while, in the meantime, the Merrill Lynch Internet Group was publicly listing the stock with a neutral and, often, higher rating.

Stocks Included In Conflict of Interest Investigation
Below are some of the stocks the New York Attorney General included in his investigation of conflict of interest in the stock research department at Merrill Lynch:

Yahoo (YHOO)
Double Click (DCLK)
Homestore (HOMS)
CMGI (CMGI)
Etoys (ETYS)
My Points (MYFI)
24/7 Media (TFSM)
Pets.com (IPET)
Exodus (EXDS)
Real Networks (RNKW)
Ariba (ARBA)
Aether Systems (AETH)
Lifeminders (LFMN)
Ebay (EBAY)
Lycos (LCOS)
Priceline (PCLN)
Excite @home (ATHM)
Barnes and Noble (BNBN)
I Village (IVIL)
Quokka Sports (QKKA)
Infospace (INSP)
Inktomi (INKT)
Internet Capital Group (ICGE)
Vertical Net (VERT)
Goto.com (GOTO)

Lack of Independence of Analysts
Merrill Lynch apparently mislead its investors because of a conflict between the Merrill Lynch banking and research departments. Separation was critical to the integrity of the recommendations issued to the public by Merrill Lynch. Its stated policies reflect an understanding of this, but the investigation showed that, at least the Internet Group, was lacking independence.

Effect of Investment Banking on Analyst
The relationship between the banking and the research departments affected the selection of covered stocks and the ratings ultimately assigned. The analysts' compensation was driven in part by investment banking department, making the analysts' objectivity and independence suspect. Apparently, research analysts at Merrill Lynch were actively involved in evaluating and implementing investment banking transactions. From December 1999 to November 2000, the Internet Group was involved in investment banking deals that - on its own estimate - produced approximately $115 million of revenue to Merrill Lynch. The evidence examined to date supports that the analyst’s decisions about the coverage of a stock was not made objectively or independently of the investment banking group.

Wide Dissemination of Misleading Information
Merrill Lynch's QRQ Opinion System, available for use by its retail brokers, had the Merrill Lynch Internet Group’s investment ratings, which may not have been accurate. The system was designed to provide immediate access to the ratings by through the broker's quote terminal and distributed documents. When the retail broker asked for information on a particular stock on the quote terminal, it showed the investment ratings, the stock price, any changes to the price and certain historical data such as price range, price/earnings ratio, and dividend.

It appears that the research group exaggerated the ratings they issued in order to promote the interests of Merrill Lynch's investment banking business. These analysts apparently were rewarded for their help. On the other hand, individual investors were not apprised of this conflict so that they could make sound investment decisions.

Other Brokerage Firms Investigated
The New York Attorney General expanded his probe to include Salomon Smith Barney, Morgan Stanley, Credit Suisse First Boston, Goldman Sachs, and UBS Warburg for analyst conflict of interest in recommending stocks.

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