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What does the Merrill agreement mean?
The foundations of investment banking won't shake, but brokerages will have to change.
April 22, 2002: 3:14 PM EDT

NEW YORK (CNN/Money) - Brokerages will still tout the stocks of companies that pay them investment banking fees, no doubt, but analysts might feel empowered to judge stocks a bit more severely than they did in the waning days of the great bull market.

That's the likely result of an agreement reached last week between Merrill Lynch, the nation's largest retail brokerage, and New York state Attorney General Eliot Spitzer.

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After a 10-month investigation, Spitzer won a court order on April 8 requiring Merrill to tell investors more about its investment banking relationships and stock rating system. Merrill contested the order, and the brokerage and Spitzer agreed late last week that Merrill would publicly disclose all its investment banking clients as well as the percentage of stocks it sells that it rates "strong buy," "buy" "neutral," or "reduce/sell."

While the agreement applies only to Merrill, it's likely to ripple across other brokerages that have large investment banking businesses. At issue is the trustworthiness of stock analyst research. Since the bursting of the dotcom stock bubble in 2000, Wall Street firms have been under increasing pressure to reform the common practice of issuing glowingly positive research reports about companies that are the sources of huge underwriting and merger and acquisition advisory fees.

Among the evidence Spitzer released in the Merrill probe were e-mails from analysts suggesting that they were uncomfortable with the pressure being applied by investment banking customers in reaction to potential negative comments about their stocks.

"The more I read of these, the less willing I am to cut companies any slack, regardless of the predictable temper-tantrums, threats and/or relationship damage that are likely to follow," reads one e-mail from Henry Blodget, the firm's former Internet stock analyst. "If there is no new e-mail forthcoming from (Merrill management) on how the instructions should be applied to sensitive banking clients/situations, we are going to just start calling the stocks ... like we see them, no matter what the ancillary business consequences are."

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David Lipton, head of Catholic University's Columbus School of Law securities regulation program, said Spitzer "didn't have the goods" to prove that Merrill analysts had "real inside information" from the banking arm that a stock was worthless, yet still touted the stock. That could have resulted in a strong push by reformers to break up the investment banking and brokerage businesses, much as the Enron scandal has led accounting firms to separate their consulting and auditing businesses.

But experts also said that the Merrill agreement may lead to real reform, even if the foundations of investment banking remain unshaken. For example, it may make public-relations sense for all brokerages to explain their internal procedures for coming up with recommendations, said Merritt Fox, a professor of securities law at the University of Michigan Law School.

And Henry Hu, a corporate and securities law professor at the University of Texas Law School, said the part of the Merrill pact that requires the company to disclose the percentage of stocks receiving different ratings will affect brokerages across the board.

Merrill's disclosure agreement could help foster a "nice kind of competitiveness" among brokerages, with each one stressing the fairness of their ratings as a selling point, said Hu. The agreement could also help foster analyst independence from investment banking, as analysts could point to the public scrutiny of their "scorecard" if pressured to give a certain rating to a client's stock.

All this disclosure, Hu added, should help both average and sophisticated investors.

"The ordinary investor may not realize that in the usual brokerage house the overwhelming recommendations are 'buys' and 'strong buys,'" Hu said.

"And it even provides information to the sophisticated investors. For example, I can't tell you what the difference is (in percentage of buy or sell ratings) between Goldman Sachs and Bear Stearns."

The agreement doesn't end Spitzer's case against Merrill. Hu said Spitzer still has a range of penalties he can seek to impose on Merrill, including separating the banking and research arms, or even criminal charges. But according to sources with knowledge of the discussions, the main point of disagreement in ongoing settlement talks is how much Merrill will pay for restitution. A Merrill spokesman has said that a $100 million payment is unacceptable, but the attorney general's office wants much more.

Spitzer has also said he is anxious for the Securities and Exchange Commission to join the investigation, and according to Spitzer's office, talks with the SEC have been ongoing and productive.  Top of page