NEW YORK – Douglas and Deborah Millar are about to become $7.7 million richer. The Pennsylvania couple didn’t buy a state lottery ticket. Instead, they played another popular game of chance: Sue Your Broker.
In granting one of the largest awards on record six weeks ago, a private arbitration panel ruled that Merrill Lynch failed to advise the Millars on how to protect the value of a stake in former Internet high-flier FreeMarkets that in better times was worth $48 million. Merrill has appealed, but legal scholars say arbitration awards are rarely overturned.
“There will be more big awards like this,” says Millar lawyer Robert Sommer. “The securities industry is going to be held to the same standards as the medical profession.”
For scandal-tarred Wall Street, that’s a sobering thought. For Merrill, it could be frightening.
More than any other Wall Street titan, the nation’s biggest brokerage firm has seen its name dragged into almost every major financial scandal this year. In May, the firm became the first to settle charges that its stock analysts defrauded investors by touting stocks of corporate clients while ridiculing them privately. New York Attorney General Eliot Spitzer forced Merrill to pay $100 million and agree to reforms.
Since then, the firm or its employees have been accused of helping Enron deceive investors, violating inside-trading laws in the ImClone/Martha Stewart case and succumbing to pressure from clients such as Enron and Tyco to rein in or replace critical analysts.
Merrill’s biggest worry could be its link to Enron. Federal prosecutors are looking into the firm’s role as one of the Houston energy giant’s investment bankers, focusing particularly on one deal involving Enron’s 1999 sale of a trio of Nigerian electricity-generating barges to Merrill. Prosecutors allege it was a sham transaction to pump up Enron’s earnings.
Merrill CEO David Komansky and President Stanley O’Neal, who both declined to be interviewed for this story, have said the firm did nothing wrong in the Enron affair.
“Merrill Lynch has said before and continues to believe that none of its employees engaged in any wrongful conduct during Merrill Lynch’s business relationship with Enron,” Merrill director of corporate communications Jim Wiggins said in a written response to USA TODAY’s questions.
He added in an interview: “We are going to reclaim our reputation for integrity and client focus.”
But if the bad news keeps piling up and the share price continues to sink, some fear that the 88-year-old firm could find itself on the wrong end of a hostile takeover, or worse. People close to the Enron investigation say Merrill could face criminal prosecution, raising the chances it might wind up like former Enron auditor Arthur Andersen, which lost its auditing business after it was convicted of obstruction of justice this year.
Merrill rejects the possibility, saying it has been assured by the Justice Department that it is not a target in the Enron investigation and that, unlike Andersen, it is fully cooperating with federal prosecutors. Two senior Merrill executives, including one of two vice-chairmen, were fired last month for refusing to give evidence in the Enron case.
Merrill also is being sued over its management of an energy-trading business it sold last year. Allegheny Energy, the buyer, alleges the business made fraudulent trades with Enron that inflated the energy unit’s revenue. Allegheny, which defaulted on its bank debt this week, is suing Merrill for more than $605 million. Merrill says the allegations are unfounded and Allegheny owes it $115 million.
“Both O’Neal and Komansky should do the honorable thing and resign,” says Larry Kudlow, a veteran Wall Street economist and co-host of CNBC show Kudlow & Cramer. “They should take responsibility for what has happened on their watch rather than making scapegoats of a few investment bankers. The fish rots from the head down.”
In contrast to its nickname, “The Thundering Herd,” Merrill’s comments about its reputation are carefully calibrated. In a recent speech, O’Neal, who graduated from the Harvard Business School and joined Merrill as an investment banker in 1986, acknowledged that the firm must follow the highest ethical standards.
“We have got to be more sensitive to the reputational risk of what we do – and how it may be perceived,” he said. “What was consistent with industry practice and acceptable yesterday … may not be acceptable tomorrow.”
The task of fostering a more scrupulous Merrill falls to O’Neal. The 51-year-old, whose father worked on a General Motors’ assembly line in Atlanta, takes over as CEO in December. Since being named the heir-apparent last year, O’Neal has replaced roughly half the executive committee that runs Merrill with his own lieutenants. Several layers of management from the Komansky era are also gone, sowing internal dissent.
“Wall Street firms with aggressive cultures have no choice (but to reform),” says Lynn Turner, head of the Center for Quality Financial Reporting at Colorado State University and the Securities and Exchange Commission’s former chief accountant. “This time, it may very well take people on Wall Street going to jail to change that culture.”
With almost $1.2 trillion in brokerage assets and more than 4 million individual investors in the USA alone, Merrill might find that the hits to its reputation get expensive.
Merrill’s Wiggins says “the concern is overblown.” Lawsuits increase in market downturns, he says, but he won’t estimate what the potential financial liability could be. Some Wall Street analysts say Merrill might end up spending $2 billion to $3 billion to fight or settle what could be hundreds of complaints from individual investors upset about its handling of their investments. Those complaints will be handled in arbitration cases.
Merrill also faces class-action lawsuits from law firms representing groups of disgruntled investors in companies such as Enron that were Merrill clients.
“Right now, spin is not the antidote to vile behavior and genuine losses,” says Eric Dezenhall, a Washington-based crisis management expert. “I don’t want a call from my broker saying he cares. I want my money back.”
Almost all stock brokerage firms require investors to agree when they open their accounts to waive their rights to a court trial and refer all disputes to arbitration. The New York Stock Exchange and National Association of Securities Dealers handle most investor complaints brought against stockbrokers.
Lawyers for individual shareholders estimate cases could total more than 5,000 industrywide this year. Although industry figures are unreliable, the number of cases has been rising since the market began to collapse in March 2000.
“Cases against Merrill are up significantly, almost exponentially,” says Philip Aidikoff, past president of the Public Investors Arbitration Bar Association. “Ten years ago, you rarely saw a Merrill case.”
Although all of Wall Street is under siege as the drumbeat for reparations and reform grows louder, Aidikoff and others believe Merrill has attracted more heat not just because of its size but because of a shift in the company’s culture in recent years that has valued quick profits over long-term reputation.
Not long ago, Merrill was a premier investment bank, built by colorful former Marines who took their reputations seriously.
“Merrill Lynch had real soul and a culture that was nurtured over the years by men like (former CEOs) Don Regan and Dan Tully,” says former SEC chairman Arthur Levitt. “A culture is a hard thing to preserve. I still have high regard for Merrill, but it is certainly not what it was.”
Merrill rejects such criticism, pointing to signs that business is improving. The firm reports no significant client defections and says $4 billion in new money poured into its private investment accounts in the second quarter. Earnings were $634 million for the period, up 17% from a year earlier but down 2% from the first quarter.
But with third-quarter earnings due Wednesday, more cost-cutting is expected. A deep industry slump has forced Merrill to slash 17,400 jobs – about a quarter of its worldwide staff – since the end of 2000. Profits tumbled 85% last year from the bull market peak in 2000.
Merrill shares, which closed Wednesday at $28.56, are off 64% from their $80 high in January 2001. Rivals, off about 40% from highs, are poaching investment-banking deals, particularly in bond underwriting, where Merrill once dominated. Merrill argues that its fall in some securities-industry rankings is the result of a new focus on profitability, not volume.
“I think Merrill’s valuation is pretty reasonable,” says T. Rowe Price money manager Anna Dopkin, who owns Merrill stock. “They have cut a lot of costs.”
Financial improvements might buff Merrill’s image on Wall Street, but the Main Street investors whose money it manages might demand something more.
“I simply don’t trust Merrill anymore,” says Michigan retail client Brian Walsh, 40, who says he was repeatedly pushed by his Merrill brokers to buy Tyco stock weeks before it collapsed under the weight of scandal. Walsh says he lost $15,000 and plans to sue.
Other small investors feel let down as Merrill shifts its focus to high-net-worth individuals with assets of $1 million and more.
“I was just about wiped out by Merrill,” says 52-year-old military veteran William Burton of College Park, Md., adding that he lost more than $150,000 investing in technology companies such as JDS Uniphase. “The Merrill broker didn’t care about me or my account and never even bothered to return my calls.” He, too, plans to sue.
Merrill’s aggressive culture was on full display this spring as New York Attorney General Spitzer wound up his probe into whether Merrill’s Internet stock analysts published biased research favoring the firm’s corporate clients. Rather than settle, Komansky and O’Neal chose to fight.
Two people from Spitzer’s office who are familiar with the negotiations say Merrill lawyers denied all wrongdoing during at least two meetings and several conference calls, arguing the New York attorney general did not understand the securities industry.
At the first meeting in Spitzer’s Manhattan offices, which have sweeping views of Ground Zero, a Merrill lawyer even gave a PowerPoint presentation she said was meant to give context to some of the now-infamous e-mail messages in which former star Internet analyst Henry Blodget made disparaging comments about companies that he was touting to small investors.
Spitzer refused to buy the explanations and insisted Merrill apologize, agree to reforms and pay a fine. Merrill refused, and Spitzer took the firm to court, wielding a powerful state securities law, the 1921 Martin Act, to force Merrill into a painfully public settlement.
Merrill says it couldn’t reach an initial agreement because Spitzer was insisting that the firm completely separate its research operation from the rest of the company – which would put Merrill at big competitive disadvantage. People close to Spitzer deny that, saying the real issue was that Merrill wanted to control which internal e-mail messages were released to the public.
In the Millar case, Merrill has also decided to play tough, calling the $7.7 million arbitration award “an outrage.”
The Millars, who own a Pittsburgh travel agency, say they watched an initial $200,000 of seed capital blossom into $56 million on the first day of FreeMarkets’ IPO in December 1999. On Sept. 1, 2000, Sommer says the Millars asked their Merrill brokers to sell half their FreeMarkets stake, worth around $8.7 million at the time. But the job was never done, the arbitration panel found. Merrill says the Millars’ never gave “an order to sell their stock,” adding that one of three arbitrators “issued a strong dissent” against the judgment.
Sommer, the Millars’ lawyer, says he offered to settle twice. But Merrill lawyers refused.
The brokerage is appealing. But its chances are slim: Arbitration awards can be reversed by courts only for exceptional reasons, such as finding that an arbitrator intentionally disregarded the law.
“Merrill needs someone at the top to remind everyone else in the firm that they are in a service business and reputation counts,” Sommer says. “It is never good enough, after a train wreck occurs, to simply circle the wagons and not listen anymore.”