Merrill a `boiler room’ during tech boom

During the heady tech stock boom, Merrill Lynch & Co. Inc. had one distinct advantage in the intense struggle for initial public offering deals — the largest brokerage force in the world.

Known as the Thundering Herd, the New York company’s then nearly 20,000 full-time brokers were a potent marketing force.

But as Merrill’s star analyst Henry Blodget and others in the company’s Internet group relentlessly hyped Internet stocks, the herd was torn by internal misgivings.

Some brokers stampeded their clients toward a cliff by loading them up with Mr. Blodget’s stock picks, while others broke from the pack, according to an examination of lawsuits and investigative files, and interviews with brokers, and lawyers who are suing the company.

Tellingly, the maverick brokers slammed Mr. Blodget’s research and worried about the risks of exposing their clients to the company’s Internet stock picks.

In all, the files, court papers and interviews provide a revealing snapshot of what it was like for brokers on the front line of the bull market as their company pumped up the Internet stock bubble.

Blowing the lid off

That snapshot shows that Merrill’s brokers were an integral part of a well-oiled and highly orchestrated machine.

At its core, the company’s investment banking operation churned out IPOs, while analysts hyped the stocks with “buy” and “accumulate” recommendations.

Brokers in turn cited the recommendations to sell the stocks to their clients, who in many cases were either trustful or eager to catch the tech stock wave.

“It’s no different from what boiler rooms were doing in the ’90s,” says Jacob Zamansky, a New York lawyer who is handling cases against Merrill for a number of clients.

New York state Attorney General Eliot L. Spitzer’s investigation into Merrill Lynch blew the lid off of the conflicts of interest that existed between the firm’s investment bank and its stock analysts.

Other top Wall Street firms have since faced similar accusations involving conflicts between analysts and investment bankers.

Only last week, Congress subpoenaed Citigroup Inc. of New York for documents concerning Salomon Smith Barney Inc. and the brokerage subsidiary’s telecom analyst Jack Grubman, who resigned Thursday.

But the role played by brokers at Merrill and other firms has gone largely unexamined.

Mr. Zamansky, among others, sees a direct connection to the tech stock hype machine. “Blodget and Grubman were plugged into the brokers,” he asserts. Through the companies’ squawk boxes, analysts spoke to brokers “at least once a week, and maybe several times,” he says.

Indeed, Merrill’s marketing pitch to potential investment banking customers touted how its richest clients — members of its elite Private Client Group — were investing deeply in Internet and technology stocks, according to one court document.

At the same time, Merrill kept a tight rein on the research that its field brokers were allowed to use, according to one attorney involved in arbitration claims against the company.

A Merrill Lynch spokesman declined to comment on the Internet stock case.

Pivotal time

When Mr. Blodget arrived at Merrill Lynch in February 1999, it was a pivotal time for the company. The firm was lagging in the race to grab technology and Internet IPO deals.

At the same time, Merrill Lynch was fundamentally changing its business model. The company wanted to become a “wealth manager” and was eager to attract rich clients.

As a result, it eventually began paying its brokers more to put clients in fee-based programs and limited commissions on stock sales to transactions in accounts of more than $100,000.

While the company was redirecting its brokers, it was seeking out people such as Dr. David Yanoff.

He became a client in January 2000 after investing on his own for about two years during the bull market.

Dr. Yanoff says he went to Merrill Lynch in large part because he wanted access to the firm’s then highly regarded research on Internet and technology companies.

The 48-year-old orthopedist from Allentown, Pa., says he gave his Merrill Lynch broker “free range” to invest $1 million in retirement and other assets in a “fairly aggressive but diversified” portfolio.

Despite the size of his account, Edward F. Skilton, a novice broker who knew the doctor through a previous job as a medical supplies salesman, was assigned to oversee the portfolio.

Mr. Skilton heavily weighted the portfolio with tech stocks, and Merrill Lynch proprietary telecom and Internet stock baskets called Holdrs, says Dr. Yanoff.

Mr. Skilton also obliged Dr. Yanoff’s desire to get his hands on Merrill research. Over the next two years, he sent the physician research on companies and funds he owned, including Internet Capital Group of Wayne, Pa.

In August 1999, Merrill began covering Internet Capital and gave it a “long-term-buy” rating. Merrill earned $17.3 million in banking fees from three deals with the company, according to a court affidavit.

Dr. Yanoff says he bought Internet Capital at $118 — a few weeks after it had touched its peak of $200 per share — and held it until it was trading at less than $1 per share.

He says he questioned Mr. Skilton about Internet Capital. “His response was, `It’s a good company,”‘ Dr. Yanoff says.

During the second quarter of 2000, Merrill rated Internet Capital “accumulate.”

Loading up

Indeed, Merrill customers owned a staggering amount of the stocks that Mr. Blodget rated, and the company made that well known.

“Merrill Lynch’s private-client system is a substantial holder of many leading technology companies,” reads a headline on one page from a presentation for Go2Net, one of 12 highflying Internet companies mentioned in the report.

Of those 12 companies, Internet Capital Group made up the largest position held by Merrill Lynch’s clients. As of March 1, 2000, that position totaled $9.8 billion, more than nine times the amount held by clients of the company with the next-largest holding in Internet Capital, FleetBoston Financial Corp.

Merrill’s private-client group also was the largest holder of 24/7 Media of New York, which once traded at $65 a share. The global Internet advertising firm merged with a competitor, Real Media, last October.

In the now-infamous e-mails that later were uncovered by Mr. Spitzer’s investigation, Mr. Blodget refers to the company as a “POS” (piece of shit). At the time, the company held an “accumulate” rating on the stock.

At least one former Merrill broker claims that the company used the stock recommendations to mislead him and other brokers.

In April, the broker, Shadi Dabit, filed a class action against the company in federal court in Oklahoma City, charging that the misrepresentations caused his book of business to collapse as clients found themselves saddled with mounting losses.

Mr. Dabit contends that Merrill Lynch encouraged brokers to hang on to the plummeting stocks of Internet and technology companies the firm had taken public and others its analysts covered.

The firm “demanded that brokers in its various retail offices throughout the country sell the [Merrill Lynch] stocks to public customers without regard to the propriety of these stocks as an investment for the customer,” according to the suit. “This was done to artificially create a market for the [Merrill Lynch] stocks.”

“The firm required its brokers to discourage and in some cases to refuse to allow customers to execute sell orders relating to [Merrill Lynch] stocks,” the suit alleges.

Daniel Woska, a colleague of the lawyer representing Mr. Dabit, says that Merrill, over 1998 and 1999, developed a more centralized research system known as QRQ to direct brokers’ investment choices and limited their exposure to outside research.

At the same time, he says, it began to discourage brokers from doing independent research. Twice each morning, it sent out stock analysis through its squawk box.

The farther a broker was from New York or a big city on the West Coast, the more the broker had to rely on Merrill research. “I guarantee that’s what happened” in places such as Oklahoma, says Mr. Woska.

Before 1998, the firm’s research came from different quarters, he claims.

Elizabeth Holbrook, who has hired a lawyer to file an arbitration complaint, tells a similar story.

She says she went to a Merrill Lynch broker in Long Beach, Calif., on March 10, 2000, literally at the top of the tech stock boom.

Ms. Holbrook, a marketing executive with a subsidiary of Tyco International Ltd., had sold stock options worth $500,000 and was looking to diversify.

She says her broker, Kelly Caves, bought a number of tech and telecom stocks, along with a sprinkling of blue chips such as General Electric and Johnson and Johnson.

As the market sank, she says, a large part of the broker’s justification to hold on to the stocks was based on Merrill Lynch’s analysts.

“It was constant rhetoric about Merrill, the analysts, the bullishness,” Ms. Holbrook says. “It was an invocation of them as being prophets.”

As much as some brokers followed Merrill’s analysts, others were anguished by their research.

“Before joining Merrill Lynch, I was a securities lawyer for seven years. Shame on me for not doing the due diligence that I and other [brokers] assume you and other analysts are doing,” writes broker Jeff Sexton of Louisville, Ky., in an Oct. 20, 2000, e-mail to Mr. Blodget.

Mr. Sexton was motivated to write after discovering that one of the star analyst’s top stock picks, InfoSpace Inc., had filed an annual report with the Securities and Exchange Commission that was partly handwritten.

“A handwritten annual report for a company that you have a `buy’ rating on with a price target of $100 is disconcerting, to say the least,” Mr. Sexton wrote.

Other brokers also were sounding off. “I have had it with the analysts’ postmortem downgrades or upgrades. I have stopped listening to the morning call,” states Martin Brown, a broker in Grand Rapids, Mich., in a Nov. 30, 2000, e-mail titled “Enough Already.”

Mr. Brown was unabashed about the problems he and other brokers faced.

“Sorry to unload on you, but we are on the front lines in jeopardy of losing massive amounts of clients and their assets over the next few months. Fix the problem, or get out of the forecasting business altogether and give us all a subscription to Value Line,” he writes to Mr. Blodget’s superior, Andrew Melnick.

Asking not to be named, one veteran broker in the Northeast says the hard sell was not part of the company’s strategy; to the contrary, it was fighting to keep clients.

The broker says clients were heading to online discount brokers such as Charles Schwab Corp. and Ameritrade Holding Corp. Or, frustrated by the lack of access to hot tech IPOs, they fled to rival wirehouses such as Morgan Stanley.

Some lawyers and brokerage executives also are quick to point out that the rocketing stock market sparked greed among investors.

The lawyers and executives say investors’ claims of wanting to invest based on specific analysts’ calls are hogwash, created purely for the sake of recovering stock losses through arbitration.

As they watched the news of hot IPOs on cable business news stations, investors couldn’t get enough Internet and technology stocks, the lawyers and executives say, and some investors ordered brokers to put money into high-tech stocks or mutual funds.

Seeking clients

Still, from Long Island to Houston to California, Mr. Spitzer’s investigation has spurred clients to file or consider arbitration claims with the National Association of Securities Dealers Inc. or the New York Stock Exchange.

“People are coming out of the woodwork with claims” against Merrill Lynch, says Ms. Holbrook’s attorney, Tracy Stoneman of Denver.

She says she is seeking former Merrill clients with potential claims through advertising on radio and in newspapers, and has two dozen cases pending. About 40% involve Merrill Lynch clients.

In the Dabit case, Merrill Lynch currently is trying to move the matter to arbitration, says William Federman, the attorney in Oklahoma City who represents the former broker.

An arbitration panel would have far less authority to require the firm to produce documents than a federal judge would, he contends.

According to documents on file with the NASD, five complaints are pending against Mr. Dabit that seek a little more than $2.5 million. Merrill Lynch settled another for $59,000.

That case, however, did not involve Internet stocks.

The biggest arbitration, a $1.5 million claim, was filed with the NASD in May, a week and a half after Mr. Dabit’s lawyer filed his class action.

The customer complaints claim that Mr. Dabit engaged in churning, securities fraud, and unsuitable and unauthorized trading.

Mr. Dabit, a 10-year veteran at Merrill, quit in January 2001. He’s now working at a branch of Prudential Securities in Oklahoma City.

The Merrill Lynch spokesman says, “We think there’s no merit to [Mr. Dabit’s] claim, and we’ll vigorously defend ourselves in that action.”

As for Dr. Yanoff, he says he liquidated his Merrill accounts at the end of 2001, after the value of his portfolio had dropped to $400,000.

His attorney, Robert H. Weiss of Jericho, N.Y., is anticipating filing an arbitration case with the New York Stock Exchange, most likely this month.

“I didn’t veto [any decisions by my broker], because of faith in the research,” Dr. Yanoff says.

Meanwhile, state regulators continue to focus on Merrill Lynch.

Two states were fielding specific complaints about Merrill Lynch prior to the publicity surrounding Mr. Spitzer’s investigation, says Ashley Baker, a spokesman for the North American Securities Administrators Association.

Mr. Baker declined to name the two states.

But the California Department of Corporations, which oversees the securities business, is seeking information from brokerage clients who bought stocks in 17 companies, of which at least 14 were investment banking clients of Merrill or were covered by its research.

From April 8, when Mr. Spitzer first announced he was investigating Merrill Lynch’s analysts, through last Thursday, the company’s stock price had fallen 32%. It closed Thursday at $36.32 per share.

Merrill last month announced David Komansky was stepping down as chief executive in December, a year ahead of schedule. He will retire in late April as chairman.

Despite the negative publicity, Merrill Lynch’s retail brokers brought in $4 billion in client assets during the second quarter.