Wall? What Chinese Wall?

New York State Attorney General Eliot Spitzer wants companies to get rated solely on their merits. Is this radical thinking?

Last week’s agreement between Merrill Lynch and the New York state Attorney General Eliot Spitzer appears to be good news for investors. It might make life more difficult for corporate executives, however.

Initially, management at Merrill had contested Spitzer’s court order requiring the firm to release additional information about the relationship between its brokers and investment bankers. But on Thursday, Merrill acquiesced to the New York attorney general’s demands.

Specifically, management at the largest brokerage house in the U.S. consented to publicly disclose the company’s investment banking clients. As of June 3, Merrill will state in all equity research reports whether it has received — or will receive — underwriting and M&A fees from the covered company in the prior twelve months. In addition, the securities firm agreed to indicate the percentage of stocks that it rates “strong buy,” “buy,” “neutral,” or “reduce/sell.”

Spitzer argues that such information will give investors a better understanding of the bank’s investment rating system. Indeed, some observers believe the April 18 agreement may mark the beginning of the end of the cozy relationship between bankers and brokers on Wall Street. “This was a shocking betrayal of trust by one of Wall Street’s most trusted names,” Spitzer said. “The case must be a catalyst for reform throughout the entire industry.”

At the very least, it could have analysts thinking long and hard about offering less-than-forthright research reports. For years, critics have charged that Wall Street brokerages issue buy recommendations for corporate clients of their investment banking units — even when those clients don’t merit a buy rating. Certainly, it’s easy to see why a brokerage might issue over-the-top research. The fact is, an investment bank stands to loose millions in potential underwriting and M&A fees if a corporate client gets miffed by negative comments — and takes its business elsewhere.

Over the years, that fear has apparently enabled some corporations to wrangle positive research reports from analysts. According to Spitzer, one analyst at Merrill Lynch sent an email to a colleague complaining about a buy rating for a struggling company: “I don’t think it is the right thing to do,” the analyst stated. “John and Mary Smith are losing their retirement because we don’t want a client’s CEO to be mad at us.”

Piece of Junk, Highest Rating

The case against Merrill began ten months ago. That’s when Spitzer began looking into complaints that the bank’s independent — and supposedly objective — investment advice was tainted by the desire to build up Merrill’s investment banking business. According to papers filed in court, Spitzer found evidence that analysts stock ratings were often designed to secure and maintain lucrative contracts for investment banking services.

In fact, Spitzer discovered that analysts at Merrill Lynch helped recruit new investment banking clients — and were paid to do so. According to court documents, the head of the equity division at Merrill sent an email to the bank’s analysts noting: “We are once again surveying your contribution to investment banking … please provide complete details on your involvement .. paying particular attention to the degree your research played a role in originating …banking business.”

Apparently, a number of analysts at the securities firm resented the intrusion. Henry Blodget, a former Internet stock analyst at the bank, seemed particularly unhappy with interference from the investment banking group. “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,” Blodget wrote to a colleague. “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.”

Indeed, internal emails show Merrill analysts often privately disparaged companies, but publicly recommended their stocks. Spitzer uncovered one memo in which a analyst made highly critical remarks about the management of an Internet business, calling the company’s stock “a piece of junk.” The Internet operator happened to be a big investment banking client of Merrill. The recommendation? The analyst ended up giving the company Merrill’s highest stock rating.

While the April 18 agreement vacates the earlier court order against Merrill, observers say it seems pretty likely the investment bank will pay some sort of restitution. It seems even likelier that Merrill will get hit with a class-action suit from investors who got burned by one of the firm’s strong-buy recommendations.

Moreover, Spitzer’s current investigation may not end with Merrill Lynch. Spitzer said his office has issued subpoenas to other securities firms, and he is reportedly trying to get the Securities and Exchange Commission involved in the investigation.

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