Wall St.’s Penalty Phase Yet to Come

In a civilized justice system, the punishment is supposed to fit the crime.

But on Wall Street, it’s often difficult to judge the appropriateness of punishment meted out by regulatory authorities, because so little in the way of seemingly harmful corporate practices ever rises to the level of an actual “crime.”

That was demonstrated again last week when Merrill Lynch & Co. settled with state securities regulators the now infamous case of the brokerage’s allegedly tainted stock research.

Merrill apologized to investors, agreed to pay a $100-million fine, and said it will revamp oversight of its research, to reduce the chances of analysts’ opinions of stocks being swayed by the firm’s investment banking relationships with the subject companies.

But the brokerage didn’t admit that it had done anything wrong.

The Merrill settlement is, of course, typical of how such matters are handled in the financial industry: Pay a fine, agree to change the way you do business, maybe even say you’re sorry--but don’t admit guilt.

New York State Atty. Gen. Eliot Spitzer, who brought the case against Merrill after a 10-month probe that turned up private analyst e-mails disparaging stocks the brokerage was urging the public to buy, initially had vowed to force a guilt admission.

But Merrill evidently wouldn’t budge on that point. And Spitzer, at a news conference Tuesday outlining the settlement, explained the brokerage’s obstinacy: It would be a “death warrant” for Merrill to admit guilt, the attorney general said.

That’s because such an admission could have made it far easier for plaintiffs’ lawyers to successfully sue Merrill for damages, potentially devastating the firm’s capital and pushing it into bankruptcy.

Investors still may take Merrill to arbitration or join class-action suits, alleging that they lost money following bogus advice on stocks.

But their chances of winning aren’t nearly as high as they might have been if the brokerage had said, “Guilty, your honor.”

Despite his early blustering about a guilt admission, it wasn’t in Spitzer’s interest--or the interest of the nation’s financial system--to trigger the demise of one of the world’s largest brokerages.

That may be even more true in the context of Sept. 11, which was a major blow to Wall Street in every respect.

In the same vein, Merrill rival Credit Suisse First Boston in January settled Securities and Exchange Commission civil charges that it rigged initial public stock offerings in the late 1990s. Like Merrill, CSFB did not admit wrongdoing, even though it agreed to pay a total of $100 million to end the case.

Two months earlier the U.S attorney’s office in New York dropped a criminal case it had been pursuing against CSFB.

In part, the desire to penalize companies for abusive practices, without risking destruction of the businesses, is rooted in regulators’ desire to avoid further harm to the firms’ shareholders--who often pay for managements’ missteps in the form of lost stock value.

Merrill’s shares, for example, have fallen 20% since Spitzer announced his case on April 8. That’s a drop of $9.2 billion in shareholder wealth.

Another argument against substantial regulatory penalties or guilt admissions in these cases is that the marketplace may deal out the most significant justice: If Merrill’s customers don’t believe it to be a trustworthy firm, they can be expected to take their business elsewhere--or so the argument goes.

But that idea may not hold much water. Virtually every major Wall Street brokerage is under investigation by state and federal authorities for the same stock-tout abuses that Merrill is alleged to have committed.

As a practical matter, then, an angry Merrill investor seeking to take his or her account elsewhere might find few appealing ports in this storm.

Merrill, through a spokesman in New York, said Friday that it has seen “no evidence of an impact [on client accounts] from the investigation. Client retention this year is consistent with other years.”

It may be early in the process, however. Conceivably, some upset Merrill customers have been waiting to see how the firm handled a settlement with Spitzer.

At least one of Merrill’s biggest rivals is making a play for clients who may be on the fence. Charles Schwab Corp., the leading online brokerage that in recent years has increasingly been adding services for higher-end investors, has launched an ad campaign that claims “there’s never been a better time” to switch to Schwab.

“Now more than ever, individual investors deserve a level playing field,” the ad begins.

Though it’s not clear why individuals deserve a level playing field more today than, say, a year ago, the ad takes direct aim at the conflicts of interest that have long dogged major brokerages--which, unlike Schwab, try to cater both to companies (with investment banking services) and to individual investors (with supposedly objective stock research about the other clients, the companies).

“We’re not focused on investment banking. We represent you, the individual investor,” Schwab says.

Will that play well with Merrill customers in Peoria and elsewhere?

A Schwab spokesman says the company so far can’t measure whether there has been a noticeable shift in accounts. The ad campaign is just a week old.

“But we know anecdotally from the field that [Schwab representatives] are having interesting conversations with people,” the spokesman said.

That could mean nothing, of course. Yanking an account from a broker often isn’t easy. Many investors who’ve been with a particular firm for any length of time often find that, for better or worse, the ties are difficult to break.

The logistical issues of moving an account can prove daunting, depending on the assets involved.

What’s more, many investors’ view of the brokerage industry probably is the same as their view of the federal government: “I hate Congress, but I love my congressman.”

Indeed, some Merrill investors may have good reason to feel better, rather than worse, about their broker in the wake of the analyst scandal--if their broker ignored the firm’s official research hype about technology stocks in 2000 and 2001 even as the shares collapsed.

But don’t brokers always toe the official company line on stock recommendations? Younger brokers may. Veteran brokers, however, often survive and prosper in the business precisely because they offer their clients more than just some novice analyst’s opinion of a stock.

In fact, a standard joke in the business has long been that no smart broker followed his in-house analysts’ tips. If anything, the savvy bet was to do the opposite of whatever the research department was saying.

In the April issue of Registered Rep, a magazine for brokers, senior editor David A. Gaffen interviewed several brokers on the question of their analysts’ credibility.

For obvious reasons, brokers don’t allow their names to be printed when they’re talking openly about their companies.

But a typical comment, Gaffen wrote, was from a Morgan Stanley broker who said about his firm’s analysts: “I know where my bread is buttered, and it’s not here. They proved they were just watching their butts” on stock picks.

It may yet prove to be that the marketplace, rather than securities regulators, will exact the greatest punishment and force the most significant change in the brokerage business.

Individual investors now will be more skeptical than ever about Wall Street stock touts. Likewise brokers and other financial advisors, if they hope to retain any credibility with the clients who pay their salaries.

If a brokerage can’t provide objective advice, what, exactly, does it have to offer?

*

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web go to: www.latimes.com/petruno.