Brokers May Face More Suits Amid Probe

The brokerage industry may face a flood of legal actions from burned tech-stock investors, experts say, as a result of a New York state report alleging that Merrill Lynch & Co. analysts recommended Internet stocks to investors while at the same time privately scorning them as “junk.”

The report’s startling allegations are providing what purports to be a glimpse of the seamy side of the tech-stock boom that swept Wall Street in the late 1990s, creating billions of dollars in paper profits that later evaporated as once highly touted stocks plunged in value.

A 10-month investigation by New York State Atty. Gen. Eliot Spitzer, an initial report on which was released last week, turned up e-mails from a Merrill Lynch research team then headed by widely followed Internet analyst Henry Blodget.

In the e-mails, analysts speak in deprecating--and at times obscene--terms about stocks that at the time sported the analysts’ highest ratings. The ratings, such as “buy” or “hold,” are used by many investors when deciding whether to own a particular stock.

Among the firms mentioned was Pasadena’s GoTo.com, now known as Overture Services. The report alleges that Merrill skewed its rating on Overture stock in an effort to win business from the company. Overture officials said they are cooperating with the attorney general’s investigation and believe they were “a victim of Merrill’s practices,” a spokeswoman said.

The crux of the report is that Merrill analysts maintained high ratings on many Internet stocks largely to curry favor with the companies, in the hope that the firms would award the brokerage fee-rich stock underwriting business and other banking deals.

The Merrill e-mails “have confirmed what a lot of us have suspected for many years,” said Mark Maddox, an Indianapolis attorney who represents investors in complaints against their brokers. “The New York attorney general’s office was able to find the smoking gun evidence of this improper practice by Merrill Lynch.”

Merrill has rejected the allegations, saying the e-mails have been taken out of context and that Spitzer’s report did not give the brokerage an opportunity to defend itself.

But Spitzer’s inquiry is spreading: At least six other major brokerages have received subpoenas, sources say. And that has securities experts predicting waves of lawsuits on behalf of investors burned in the meltdown of Internet and telecom stocks over the last two years.

They also expect a surge in individual damage claims submitted to the National Assn. of Securities Dealers and the New York Stock Exchange for arbitration.

“It’s always nice to have journalists and government people do the expensive discovery for you,” said Henry Hu, a securities law professor at the University of Texas in Austin.

Indeed, Maddox referred to the New York probe as “a plaintiff attorney’s dream” and said he personally is reviewing a half-dozen previously filed claims against Merrill and a dozen other prospective cases.

“This is going to cause a lot more cases to be filed than otherwise would have been filed, and it’s going to make a lot of cases that were already on file better,” he said.

Spitzer’s allegations that analysts hyped stocks to generate investment banking fees for their firms--and million-dollar bonuses for themselves--are detailed in a 37-page affidavit he filed in state Supreme Court last week. Spitzer is seeking to force Merrill to immediately change how it discloses potential conflicts of interest to investors, pending a final report on his investigation. A court hearing is set for Friday.

The affidavit will resonate deeply with millions of small investors who lost money on tech stocks and may suspect they were tricked, Hu said.

“This is easy for anyone to understand,” he said. “It’s not like Enron--no complexities, no off-balance-sheet partnerships. It seems to be a clear issue of right and wrong, with an element of greed layered on top. It certainly plays into a paranoid view of Wall Street.”

Broadening the controversy beyond Merrill Lynch, Jacob Zamansky, an attorney whose claim against Merrill last year became the basis of the Spitzer inquiry, filed a new arbitration case with the NYSE last week. It raises similar conflict-of-interest charges regarding Jack B. Grubman, a high-profile telecom analyst at Citigroup Inc.’s Salomon Smith Barney brokerage unit.

The claim says George Zicarelli, 60, a CBS News videotape editor, lost $455,000 by investing in Global Crossing Ltd., whose plan to operate a worldwide fiber-optic cable network ended in the nation’s fourth-largest bankruptcy.

Zicarelli, who borrowed heavily to buy Global Crossing stock, was worried when the stock started falling in late 2000 and insiders including Chairman Gary Winnick were selling shares, the claim says. The complaint says Zicarelli’s broker persuaded him to buy more Global Crossing shares by showing him Grubman’s research, which urged investors to be “aggressive buyers” of the “cheap” stock.

Global Crossing shares, which topped $60 in 1999 and early 2000, were trading at 8 cents a share Friday.

Zicarelli, who has filed for bankruptcy protection from his creditors, is seeking to recover his $455,000 plus punitive damages of $10 million--an amount the claim contends was half of Grubman’s annual salary. Salomon Smith Barney spokesman Dan Noonan declined to comment Friday.

Zamansky alleges that Salomon Smith Barney won the job of handling Global Crossing’s initial public stock offering in 1998 largely as a result of efforts by the influential Grubman. Instead of producing neutral research, Grubman “was nothing more than a cheerleader,” with his salary dependent on drumming up business, Zamansky says.

Zamansky previously won $400,000 from Merrill in an NYSE arbitration claim filed on behalf of an investor who blamed steep losses in shares of InfoSpace Inc. on a “buy” recommendation from Blodget. Spitzer’s affidavit said that even as Blodget’s private e-mails called the stock a “piece of junk,” InfoSpace was on Merrill’s “favored 15” list of most-recommended stocks.

Describing himself as “usually pretty cynical” about Wall Street, UT professor Hu said he was “taken aback a little” when he read the lengthy affidavit.

“The gap between what was being said privately--unless somehow it was taken completely out of context--and what was being said publicly was just so huge,” Hu said.

He said it’s conceivable that New York authorities could file criminal charges in the case to send a powerful message to Wall Street, as the federal government has done in the Enron document-shredding case involving accounting firm Andersen.

“If you’re a securities analyst, even a 1% chance of being criminally indicted will affect your behavior profoundly,” he said. “On the other hand, do [prosecutors] really want to use it? Its very power is such that you’d only use it in the most egregious circumstances.”

A Spitzer spokesman said criminal prosecutions are possible under New York’s Martin Act, which has looser fraud standards than federal securities laws, but no decision has been made on whether to pursue a criminal case.