From Forbes Magazine

Top Of The News
Trouble Brewing For Merrill Lynch
Dan Ackman, 04.10.02, 9:10 AM ET

NEW YORK - It's not clear what he wants or where his probe is going, but the New York attorney general's investigation of Merrill Lynch could lead to trouble for the investment bank and its peers which are struggling to right themselves after suffering a black eye from the Internet stock deflation and the still-evolving Enron debacle.

Merrill's (nyse: MER - news - people ) supposedly independent analysts' advice was in fact driven by the desire to obtain investment banking fees, according to Attorney General Eliot Spitzer. Spitzer alleges that there were specific quid pro quo deals between the firm and its investment banking clients in what he calls a "shocking betrayal" and "a major breakdown in the supposed separation between the banking and research divisions." Henry Blodget, once Merrill's star Internet analyst, who has since left the firm, was especially egregious in spewing opinions that were products of a conflict of interest, Spitzer says. Spitzer says his ten-month investigation will continue and could result in either criminal or civil charges against the firms or their employees.

Attorney General Eliot Spitzer

These charges, which have already resulted in a provisional court order against Merrill, are old hat in a sense. They have been aired in congressional hearings and in the industry. But Spitzer's office has added details in the form of Internal e-mails and sworn testimony that could lead to serious lawsuits on behalf of shareholders who lost when their Internet stocks, as well as others, went from hero to zero.

Merrill says it is "outraged" by Spitzer's charges, which it says are based on a "fundamental lack of understanding" and are "just plain wrong." Its spokesman calls Blodget in particular "yesterday's news." But the idea that research departments have in recent years increasingly prostituted themselves to the investment bankers is widely held. Even inside the industry, the main question is what to do with the fundamental problem that research generates no fees and investment banking generates massive fees.

The real danger for Merrill--and the other investment banks under investigation, which Spitzer refuses to name--is that Spitzer adds details and his investigation could provide evidence to investors that those investors would be hard pressed to gain on their own, legal experts say. Another problem is that Blodget is no longer in the Merrill fold and is fighting with Merrill about his severance, according to sources close to the former analyst.

Spitzer, for his part, says his efforts to reach a settlement with Merrill foundered when Merrill insisted all the evidence his office had uncovered be kept under wraps.

That evidence could transform a vague sense of wrong into legal claims that are not readily dismissed. Lawsuits by investors who feel burned by spurious "price targets," talk of "monetized relationships" and hastily invented "metrics"--a few of which have already been made in court and in industry arbitrations--may suddenly gain a lot more weight.

Analysts traffic in opinions, not facts. This has been a problem for scorned investors and their lawyers, because an opinion can't be "wrong." But it can be dishonest, legal experts say. "If an analyst sincerely believes in his recommendation of a bad stock, there is nothing illegal," says Jeffrey Gordon, a law professor at Columbia University. "But if the recommendation is the product of the analysts' [other] interests, that may well be securities fraud."

The problem of proving "what the analysts actually believed" is extremely difficult, Gordon says. "People had a theory about there being a new economy, and based on that theory they got people to believe a story," he adds. Unlike the Enron (otc: ENRNQ - news - people ) case, the underlying economics of these companies was for the most part not hidden. But if there is proof that the analysts were saying one thing publicly and something else privately, as Spitzer's evidence apparently shows, that may be fraud.

In fact, much of the new-fangled Internet stock analysis was correct--for as long as people believed it. Amazon.com (nasdaq: AMZN - news - people ) did go to $400, just as Blodget said it would. But this kind of analysis--also known as the greater fool theory--is not the kind of thing Wall Street wants to appear to be selling. Especially not after reality--the Internet companies were not even close to generating cash to sustain operations--has intruded.

Merrill says it warned that Internet stocks were risky and that its analysts said most would never make money. It says analysts' comments calling stocks a "piece of crap" or "a disaster" were part of the give-and-take among the professionals rating the stocks. It insists that it has made reforms already. (See: No Problem But Merrill Fixes It)

Still, there are problems of price targets and placing stocks on recommended lists. Merrill and Wall Street want to get past the Internet crash. They want to look to the future. But the bust is not exactly ancient history--Pets.com left the scene almost two years ago and there may yet be bills to pay.