E-Mails Open New Probe of Analysts

Imagine you’re a Merrill Lynch stock broker trying to explain to your clients why shares of Company X are a good buy now. And as evidence, you cite a recent bullish research report that a Merrill analyst wrote about the company.

If your clients have been reading the newspapers lately, their first question may be: Could we see the analyst’s private e-mails about this stock, rather than rely on the research report?

Last week, the New York state attorney general shocked Wall Street by going public with some of his office’s findings from a 10-month investigation of Merrill’s Internet-stock research group and its conduct during the technology stock boom, then bust, of 2000 and 2001.

The brokerage industry was stunned because it had been expecting, or at least hoping, that regulators’ investigations of analysts’ potential conflicts of interest in their stock touting could be settled without the release of inflammatory internal communications and documents.

Instead, New York Atty. Gen. Eliot Spitzer dropped a bomb: a 37-page report filled with e-mails between Merrill analysts and investment bankers. Spitzer contends the e-mails show that analysts often were driven to tout Internet stocks simply to assist Merrill’s pursuit of lucrative investment-banking work with the subject firms. In private, the analysts viewed many of the stocks as garbage, Spitzer alleges.

The report has made Spitzer an instant hero to many investors (and their attorneys), and an instant nemesis to Wall Street.

The battle between Spitzer and the brokerage industry may have only begun: Subpoenas have gone out to other major brokerages. Spitzer has said he may seek criminal charges under the authority of New York anti-fraud laws.

The state’s probe is creating problems for other regulators. The U.S. Securities and Exchange Commission has been drafting its own ideas for industry reform, after congressional hearings last year that focused on analysts’ objectivity, or lack thereof, in feeding the great bull market of the late-1990s.

The SEC had little to say last week about Spitzer’s report, but sources say the federal agency this week will get copies of the documents the attorney general has collected. The SEC could have sought the same e-mails from Merrill and other brokerages, but according to one source, the agency, in its own investigation, didn’t ask the brokerages for e-mails.

Research, Banking Not Totally Separate

Spitzer’s supporters say that, in going public with the material, he shined a bright light on how things really work in the research departments of major brokerages.

Institutional investors have always taken the view that much of what Wall Street publishes on individual stocks is at least somewhat suspect, because investment banking is what pays the bills at firms like Merrill, while research is a cost center rather than a profit center.

Despite the supposed presence of a “Chinese wall” between research and banking, there’s no way one side can be completely ignorant of the activities on the other side, critics have long argued.

But most small investors sucked into the market by the tech-stock hype of 1999 and 2000 arguably didn’t understand that potential for conflict of interest. So when Merrill analysts officially rated a stock “buy,” the public took the brokerage at its word, Spitzer said.

That obviously didn’t work out so well for buyers of many Internet-related shares in 2000 and 2001. The dot-com stock meltdown has been one of the greatest busts in Wall Street history, and it still hasn’t run its course: The Interactive Week magazine index of 48 Net-related shares is down 25% this year after plunging 51% in 2000 and 48% in 2001.

One part of the attorney general’s report contends that Merrill analysts had the firm’s top rating--a “1-1”--on shares of Net services firm InfoSpace in July 2000, when the stock was in the mid-$30s (down from a peak of $130 that winter).

Yet a private e-mail in July 2000 from Henry Blodget, the head of Merrill’s Internet research team, called the stock “a powder keg, given how aggressive we were on it earlier this year and given the ‘bad smell’ comments that so many institutions are bringing up.”

By December 2000, InfoSpace shares had plunged under $10. The stock now is at $1.46.

In October 2000, Merrill’s official rating on Internet Capital Group was a “2-1.” Under the firm’s rating system, the first number gauged the stock’s potential in the near term (12 months) and the second number rated the longer-term potential. Each stock was rated between “1” and “5” for each time horizon, with a “1” meaning “buy” and the other numbers meaning, in order, “accumulate,” “neutral,” “reduce” and “sell.”

Although Internet Capital got Merrill’s second-highest official rating in October 2000, with the stock at $13 (down from a record high of $183 in 1999), an e-mail from Blodget to another Merrill analyst said the price was “going to 5,” according to Spitzer’s report.

Blodget was right: By December 2000 the stock was under $5. It now trades for 58 cents.

Blodget, who left Merrill in December 2001, has declined to comment on the attorney general’s report, referring inquiries to Merrill.

Merrill’s initial response to Spitzer’s report was outrage. “There is no basis for the allegations,” the firm said in a statement last week. “E-mails are only one piece of a continuous conversation, isolated at a single point in time--not the end conclusion.

“As with oral conversation, e-mails may include ill-chosen words and offensive language, but this does not add up to evidence of wrongdoing,” Merrill said.

The firm also said Blodget “repeatedly and publicly warned that a substantial majority of public Internet companies would never make money and would disappear, and that investors should commit only a small amount of their total portfolio to a diversified basket of stocks which they were prepared to hold long-term.”

Report Questions Analysts’ Independence

Privately, Merrill officials are livid that Spitzer released the report for public consumption. They also point out that though Spitzer took sworn testimony from about 20 people, the report includes no comments that any of them may have made in Merrill’s defense.

Some of those called to testify for the report may have had relatively little to say. The report says at the outset that “while Merrill Lynch has been cooperative in producing evidence, some of the key witnesses examined have displayed an implausible lack of recollection of key conversations and documents, even when they authored or received such document and it was placed before them.”

If there is a smoking gun in Spitzer’s report, it may be an e-mail said to have been sent by Deepak Raj, Merrill’s co-head of global equity research, to all of the firm’s analysts in fall 2000.

Merrill, Spitzer says, had long insisted that its research analysts were independent and unbiased. But the Raj e-mail contradicts that idea, the report says, because it suggests that analysts’ compensation was directly linked to investment-banking deals they helped to generate.

Raj wrote to his analysts: “We are once again surveying your contributions to investment banking during the year....Please provide complete details on your involvement in the transaction, paying particular attention to the degree that your research coverage played a role in origination, execution and follow-up.”

In its response to Spitzer’s report, Merrill said: “Research analyst compensation is based on broad factors and is not tied directly to the success of investment banking transactions.”

Though Spitzer’s report attacks Merrill’s analysts for their conduct, it also paints them as victims, describing a “tortured relationship” between the analysts and the firm’s investment bankers.

One e-mail between analysts said simply: “The whole idea that we are independent from banking is a big lie.”

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Tom Petruno can be reached at tom.petruno@latimes.com.