Who's calling the tune at brokerage firms
By MATHEW INGRAM
Globe and Mail Update
For anyone still under the illusion that brokerage analysts issue unbiased, objective research for the benefit of investors, the allegations made about Merrill Lynch this week by New York's Attorney-General will come as a shock. For others, the case will probably just confirm the impression they already have — that analysts, even the ones at 'blue chip' brokerage firms, are severely conflicted about whose interests they are serving. The sooner investors get used to that idea, the better off they'll be.
After a 10-month investigation, the New York AG's office won a court order on Monday that forces Merrill Lynch to reveal in its research reports whether it currently has an underwriting relationship with the company, and whether it is trying to win that company's business. The case took 10 months and involved 30,000 documents, including thousands of e-mails between Merrill analysts in the Internet research group and other senior executives.
In addition to the court order, the Attorney-General's office said that criminal charges could be laid against Merrill and other brokerage firms under the state's Martin Act, which "makes illegal any fraud, misrepresentation, deception, concealment, promise or representation that is beyond reasonable expectation while engaged in the issuance, distribution, investment advice, sale or purchase of securities." Unlike federal securities laws, there doesn't have to be an actual purchase or sale of stock in order to prove an offence, nor does any resulting damage have to be shown.
In a statement, Merrill Lynch said that "There is no basis for the allegations," and that they "reveal a fundamental lack of understanding of how securities research works within the overall capital-raising process." The firm said the e-mails cited were taken out of context and were just "one piece of a continuous conversation, isolated at a single point in time." Still, the e-mails the Attorney-General excerpted are revealing.
For example, the affidavit cited the case of InfoSpace Inc., in which Merrill kept the stock on its high-profile Favored 15 list from August 2000 until December 2000 — even though Internet research head Henry Blodget (who has since left the firm) said in an e-mail to a colleague as early as July of that year that the stock was a "powder keg" and "many institutions" had raised "bad smell comments" about the company's coverage. By October 2000, the Internet analyst was calling it a "piece of junk," despite the fact that the firm was continuing to recommend it highly.
Some e-mails, the AG says, made it clear that Merrill Lynch's research department was used as an adjunct to its underwriting business, something that violated the 'Chinese Wall' that brokerage firms are supposed to maintain between their corporate finance and research divisions. After initiating coverage of GoTo.com, for example, Mr. Blodget was allegedly asked by an institutional investor "What's so interesting about GOTO except banking fees?," to which the analyst replied: "'Nothin' <ic>sic <nm>".'
The affidavit also mentions the case of Internet Capital Group, a once highly-regarded Internet 'incubator.' On Oct. 5, 2000 when the stock was at $12.38 (U.S.) — having fallen from a high of $212 in December 1999 — Mr. Blodget allegedly said in an e-mail that the stock was "going to 5." The following day he said "This has been a disaster ... there really is no floor to the stock." But the firm didn't downgrade the stock for over a month, and even then maintained it at the equivalent of an 'accumulate' rating.
Analysts were affected by the fact that their compensation was based on how much underwriting business they helped win, the affidavit says. Therefore, they kept 'accumulate' ratings on stocks even while "analysts were saying that there was 'no reason to buy more of' the stock and its business was 'falling apart' ... or internally disparaged other stocks [rated accumulate] as a 'piece of shit,' and 'such a piece of crap.' " On stocks that were rated a 'neutral,' the statement says, analysts were saying internally that the company was "crap" or "a dog" or was "going a lot lower."
According to the affidavit, one analyst wrote that "part of the reason we didn't highlight [a risk] is because we wanted to protect ICG's banking business." Another stated point blank in an e-mail: "the whole idea that we are independent from banking is a big lie," and another member of the research team said "we are off base on how we rate stocks and how much we bend backwards to accommodate banking, etc." At one point, Mr. Blodget himself even threatened in an e-mail to "start calling the stocks ... like we see them, no matter what the ancillary business consequences are."
In some cases, the AG's statement says, companies were consulted about what rating they would prefer — and in one case even helped to draft a research report that came out in tandem with a share issue Merrill was to be involved in. In one instance, the affidavit says, a company agreed to a particular rating with the understanding that "its main competitor's stock would be downgraded to that same rating." The Internet group also considered giving a stock coverage in their research reports as an "accommodation for an important client," but only for six months, after which coverage would be dropped.
In a note written to a company that Merrill had hoped to handle a share issue for, according to the affidavit, a senior executive said "I was very dismayed to learn that they were leaning toward CSFB as the lead book running manager, particularly given the tremendous effort we have put forth on the Company's behalf. Not only did Henry Blodget show leadership by initiating on the stock near its low point but he recently upgraded it and sponsored a set of investor and Merrill sales force meetings for management in New York, which dramatically moved the stock price."
The allegations in the New York affidavit have yet to be proven, but these kinds of comments are still enough to give some investors pause. And while they refer specifically to the behaviour of Merrill's Internet group, they are not just a symptom of the investment frenzy that surrounded the dot-com bubble. Nor is the tangle of conflicts and attitudes they describe restricted to one firm — it is symptomatic of the brokerage business as a whole. |
