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Brokerage Probe Gains Momentum

Wall St.: Investigation of potential conflicts of interest by analysts widens, raising question of industry reform.


The New York state attorney general's investigation of brokerage analysts' potential conflicts of interest is stoking a new firestorm of debate over Wall Street practices and how best to reform them.

Atty. Gen. Eliot Spitzer, in a legal action Monday, alleged that Merrill Lynch & Co.'s Internet-research department routinely made stock touts driven largely by the firm's desire to snare lucrative investment banking work from the recommended companies.

Now, Spitzer is taking the inquiry industrywide: According to sources, six other major brokerages--Credit Suisse First Boston Corp., Morgan Stanley & Co., Bear, Stearns & Co., Citicorp Inc.'s Salomon Smith Barney unit, Goldman Sachs & Co. and UBS PaineWebber Inc.--have received subpoenas, some of them in the last two weeks, and more are likely to be handed out as the probe unfolds.

A spokesman for the attorney general's office confirmed only that several other firms have been subpoenaed as investigators seek to preserve records, but declined to name the firms.

"This investigation could be the tip of the iceberg," spokesman Daren Dopp said. "Based upon the e-mail correspondence at Merrill Lynch, it's clear that Merrill analysts were fearful of competitors wooing many of the same investment banking clients."

Spitzer's affidavit filed Monday detailed findings from a 10-month probe of Merrill's Internet-research group formerly headed by high-profile analyst Henry Blodget. Spitzer's report, based on a review of 30,000 documents, including thousands of e-mails, alleges the analysts often publicly recommended stocks that they privately believed were "junk."

A stock featured prominently in the attorney general's inquiry is, now Overture Services. The report alleges that Merrill tried to win banking business from the Pasadena-based firm in 2000 and 2001 by twisting its recommendations on the stock to please the firm's management.

Overture officials did not return a call for comment Thursday.

Spitzer's legal filing Monday asked a state Supreme Court judge to force Merrill to immediately add new disclosures in its research reports, pending the outcome of his investigation. The disclosures would involve Merrill's relationships or potential relationships with firms it may recommend.

On Thursday, Merrill won a delay until April 19 to comply with Spitzer's disclosure request.

Spitzer's report roiled an industry already struggling with credibility problems and parallel investigations by federal regulators, industry self-regulatory groups and the New York Stock Exchange.

Industry sources said most if not all major securities firms had been working with the Securities and Exchange Commission, the National Assn. of Securities Dealers and the New York Stock Exchange to develop new research-disclosure rules similar to, and in some cases stronger than, those Spitzer asked the judge to impose on Merrill.

"The SEC is furious because they've been working on this with the investment banks," said one source at a major bank, speaking on condition of anonymity. "It's like the situation with the tobacco litigation--unmanageable with the feds and the state thing going on at once."

At Merrill, which on Monday rejected Spitzer's charges as "just plain wrong," officials tried to portray the firm as a leader in ensuring that disclosures are complete and that analysts operate without conflicts of interest with investment banking.

Unlike some firms, Merrill never allowed analysts to purchase pre-initial public offering shares of companies in their coverage areas, and last summer it prohibited analysts from acquiring any more shares in companies in their industries, spokesman Bill Halldin said.

Some brokerages said they were not aware of whether Spitzer is investigating them. Goldman Sachs and J.P. Morgan Chase & Co. said they had received nothing indicating they are targets.

Nonetheless, investment banking sources said Spitzer's report appears to present huge new legal and credibility problems for Merrill and probably the entire industry.

Spitzer's investigation may have enough momentum, and evidence, to force major reforms in the industry to restore analysts' credibility, some say.

Although Wall Street firms have been scurrying to unveil changes to their stock rating systems, the overwhelmingly positive bias among analysts appears to be shifting only gradually.

As of April 1, 2.6% of brokerage stock recommendations were negative, according to data tracker Thomson Financial/First Call, up slightly from 1.4% a year earlier.

The rest of the analysts' recommendations were either "buy" or "hold" suggestions.

But experts are divided on how far industry reform can and should go. Some investor advocates, such as Nell Minow, Washington-based editor of the Corporate Library, believe brokerage investment banking and research units should become separate firms--a step Spitzer has tried to negotiate with Merrill.

"Now that analysts' credibility has been so thoroughly undermined, what's the point in having them? They are a throwback to the days when information was received by ticker tape," Minow said. "The only way this can work is if you separate investment banking and research completely."

Others say separation may be an unrealistic goal.

"Is there a workable device for enforcing monastic neutrality between research providers and investment bankers? I doubt it," said Roy Smith, a finance professor at New York University.

Meaningful reform may have to come voluntarily from within the industry, many say.

"Wall Street is going to have to do whatever it takes to regain its credibility within the investor base," Smith said. "If the industry fails to regain credibility, it has a much more serious problem than Eliot Spitzer."

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