As the Internet and technology bubble burst, many of these analysts whose research reports had hit gold and platinum began to fall (and, in some cases, dramatically) off the charts.

A customer arbitration against Merrill Lynch lead directly to an investigation by the New York State Attorney General’s Office against Merrill Lynch and several of the other big players on Wall Street. In March of 2000, a pediatrician from Queens, New York, filed a New York Stock Exchange (“NYSE”) arbitration against Merrill Lynch. The theory of the claim was that Merrill Lynch star analyst Henry Blodget had misled investors by fraudulently promoting the stocks of companies with which the firm had investment banking relationships. The case is believed to have settled for $400,000 in July of 2001.7 Shortly thereafter, New York State Attorney General, Elliot Spitzer launched an investigation into the stock research practices of several Wall Street firms. In June of 2001, the Office of the Attorney General commenced an investigation pursuant to New York GBL Article 23-A (the “Martin Act”) into stock recommendations issued by research analysts. The investigation focuses on recommendations of all stocks covered by the Internet research analysts at Merrill Lynch and, very recently, has expanded to include recommendations made by analysts at several other financial institutions8 including those of Jack Grubman at Salomon Smith Barney. 

As set forth in the Attorney General’s Affidavit In Support of Application for an Order Pursuant To New York General Business Law §354 (“Affidavit”), Mr. Spitzer stated he is entitled to “. . . an ex parte order to obtain respondent’s testimony, books and records when he believes the same to be ‘material and necessary’ to his investigation of their activities in the offer, sale and purchase of securities and investment advise for such securities within and from the State of New York.”9 

In addressing the substance underlying the request, the Affidavit further stated that “[s]ince late 1999, the internet research analysts (the “internet group”) at Merrill Lynch have published on a regular basis ratings for internet stock that were misleading because: (1) the ratings in many cases did not reflect the analysts’ true opinions of the companies; (2) as a matter of undisclosed, internal policy, no “reduce” or “sell” recommendations were issued, thereby converting a published five-point rating scale into a de facto three point rating system; and (3) Merrill Lynch failed to disclose to the public that Merrill Lynch’s ratings were tarnished by an undisclosed conflict of interest: the research analysts were acting as quasi-investment bankers for the companies at issue, often initiating, continuing, and/or manipulating research coverage for the purpose of attracting and keeping investment banking clients, thereby producing misleading ratings that were neither objective nor independent, as they purported to be.10 Attorney General Spitzer’s Affidavit goes on to state that “[b]ehind these ratings was a serious breakdown of the separation between the Merrill Lynch banking and research departments, a separation that was critical to the integrity of the recommendations issued to the public by Merrill Lynch. Though Merrill Lynch’s stated policies reflect an understanding that this separation is critical,” according to the affidavit, “the evidence reveals that at least with respect to the internet group, there was insufficient divide between research and banking.”11 

According to the Affidavit, the Attorney General indicated that the “investigation to date reveals that the compensation system for internet analysts was a significant factor contributing to the breakdown between the internet group and investment banking departments. Research analysts knew that the investment banking business they generated or participated in would impact their compensation, and management encouraged them to produce investment banking business.”12 It was also alleged that “[a]nalysts curried favor with potential or actual investment banking clients by giving them special treatment. At times, officers of clients or prospective clients were allowed to redraft their own coverage, write quotations in which the analysts would tout their companies, and indicate which ratings would be acceptable to them.”13 

The Affidavit also relates that “[t]he pressures put on the Merrill Lynch internet group to appease both investment bankers and clients led the group to ignore the bottom two categories of the five-point rating system (‘reduce’ and ‘sell’) and to use only the remaining ratings (‘buy’, ‘accumulate’ and ‘neutral’). The absence of clear guidance from Merrill Lynch management on how to resolve the conflicts created by these pressures led respondent Henry Blodget, the head of the internet group, in a moment of candor, to threaten to ‘start calling the stock (stocks, not companies) like we see them, no matter what the ancillary business consequences are.’”14 

Since this investigation has been launched, the New York Attorney General’s office has made public some potentially embarrassing email exchanges between Merrill Lynch’s analysts and bankers. These disclosures include “analysts [disparaging] stocks as ‘crap’ and ‘junk’ that they were pushing at the time.”15 

While Merrill Lynch has produced its email records from its analyst group, it has been reported that other firms may not have maintained complete email communications of its analysts and brokers16 as required by the record retention rules set forth at Rule 17a-4 of the Securities Exchange Act of 1934, as amended (the “1934 Act”). Rule 17a-4 requires certain exchange members, brokers and dealers to retain for a period of not less than three years certain business records including but limited to communications by broker-dealers, inter-office memoranda and communications relating to its business, as well as all other communications which are subject to rules of a self-regulatory organization of which it is a member.17

In November of 2001, the SEC reiterated its view that email messages are covered by Rule 17a-4 and must be retained.18 The policies for email retention among the largest brokerage firms vary widely. If firms are found by regulators to have mistakenly deleted messages that they were supposed to keep, they can face stringent (e.g., six figure) fines. “If the firms destroyed the messages purposely, the penalties will be more significant including suspension or expulsion from the securities industry. Prosecutors say that under New York state law, a firm that deleted email messages that it was required to maintain could be found guilty of falsifying business records. If the destruction of the email records was found to be intentional, the firm could face a felony charge.”19 

As of the date of this article, it has been reported that the Attorney General and Merrill Lynch are nearing “. . . a ‘framework’ for a possible deal that could soon settle an investigation into the firm’s stock research practices.”20 While, details of this framework are not immediately available and may not come to fruition, it has been reported that “. . . the proposal includes structural changes in Merrill’s research practices, including some separation of research and investment banking in the firm,”21 changes in Merrill’s research process and payment of an amount reported to be as high as $100 million in fines.22 

Attorney General Spitzer has extended the investigation to other firms including but not limited to Salomon Smith Barney. In the last thirty days, it has been reported that a subpoena has landed at Salomon Smith Barney in connection with Jack Grubman, Salomon’s All Star telecom analyst and guru.23 According to a New York Times article, Grubman was one of Wall Street’s highest paid analysts, believed to have earned over $20 million dollars in recent years.24 “During the height of the [telecom / internet] mania, in 1999 and 2000, he [Grubman] had “buy” recommendations on thirty companies, considerably more than most analysts,” according to the New York Times article.25 According to the article, “[s]ince 1997, Salomon has taken in more investment banking fees from telecom companies than any other firm on the Street. Because of Mr. Grubman's power and prominence, and because his compensation is based in part on fees the company generated with his help, a part of those fees went to him.”26

In response to growing criticism in the area of research reports, in June of 2001, the Securities Industry Association (“SIA”) adopted a set of Best Practice for Research guidelines. As of August 2001, at least thirteen brokerage firms had publicly signed on to these new rules,27 which recommend among other things that: (1) research should not report to investment banking and should not report to any business unit that compromises integrity; (2) research management should insure that recommendations fall within the overall framework of the firm’s standards and quality guidelines and are consistent with the analyst’s fundamental analysis, valuation work, and view of the security; (3) a research analyst’s pay should not be directly linked to specific investment banking transactions, sales and trading revenues, or asset management fees, but should reflect all aspects of the analyst’s job performance, including, among other factors, the performance of his or her investment recommendations; (4) an analyst should not submit research to investment banking or corporate management for approval of his or her opinions or recommendations; (5) bankers or other business producers should not promise or propose specific ratings to current or prospective clients when pursuing business; (6) firms should maintain effective confidential information barriers between investment banking and research and follow appropriate and clear procedures for any crossing of those barriers in connection with investment banking activities; (7) analysts should be independent observers of the industries they follow and earnings estimates should represent an analyst’s best judgment and should never be bound solely by the company’s input; (8) reports on securities should outline the valuation methods used and for recommended securities, should specify a price objective with a reasonable basis; (9) disclaimers should be legible, straightforward, and written in “plain English” in addition to complying with all relevant rules of self-regulatory organizations; (10) disclaimers should include all material factors that are likely to affect the independence of specific security recommendations; (11) analysts should not trade a security while they are preparing research on it or within a reasonable period of time after issuing research on it; (12) analysts should not be allowed to trade against their recommendations; (13) analysts should disclose whether they or members of their households hold direct ownership positions in securities they cover in all research reports concerning those securities; and (14) when a firm bringing a company public and a member of the analyst team that will cover the stock owns a stake, that fact should be disclosed. Other private investments or outside business interests should also be disclosed in related company reports when these are likely to create conflicts of interest.28 

In July 2001, the SEC issued an alert entitled “Analyzing Analyst Recommendations,” which cautioned investors about analyst reports and provided some information to help investors understand potential conflicts of interest which arise from the firms that publish these reports.29 

The magnitude of the problem and the perception that it has created has not been lost on the brokerage industry and its primary self-regulatory organizations ("SRO’s"), the National Association of Securities Dealers, Inc. (“NASD”) and the New York Stock Exchange, Inc. (“NYSE”). To address the issues swirling around analysts’ conflicts of interest, in February of 2002, the NASD proposed to amend its rules to establish a new rule, NASD Rule 2711 (“Research Analysts and Research Reports”). In April 2002, the NYSE proposed amendments to NYSE Rule 472 (“Communications with the Public”) and NYSE Rule 351 (“Reporting Requirements”). On May 8, 2002, the SEC approved these rules.30 

The NYSE rule changes and NASD Rule 2711 (which will be phased in over the next six months) contain very similar, though not identical, provisions. For example, the rules include among other things:31    

    • Promises of Favorable Research. The rules changes prohibit analysts from offering or threatening to withhold a favorable research rating or specific price target to induce investment banking business from companies. The rule changes also impose "quiet periods" that bar a firm that is acting as manager or co-manager of a securities offering from issuing a report on a company within 40 days after an initial public offering or within 10 days after a secondary offering for an inactively traded company.

    • Limitations on Relationships and Communications. The rule changes will prohibit research analysts from being supervised by the investment banking department. In addition, investment banking personnel will be prohibited from discussing research reports with analysts prior to distribution, unless staff from the firm's legal/compliance department monitor those communications. Analysts will also be prohibited from sharing draft research reports with the target companies, other than to check facts after approval from the firm's legal/compliance department.

    • Analyst Compensation. The rule changes will bar securities firms from tying an analyst's compensation to specific investment banking transactions. Furthermore, if an analyst's compensation is based on the firm's general investment banking revenues, that fact will have to be disclosed in the firm's research reports.

    • Firm Compensation. The rule changes will require a securities firm to disclose in a research report if it managed or co-managed a public offering of equity securities for the company or if it received any compensation for investment banking services from the company in the past 12 months. A firm will also be required to disclose if it expects to receive or intends to seek compensation for investment banking services from the company during the next 3 months.

  • Restrictions on Personal Trading by Analysts. The rule changes will bar analysts and members of their households from investing in a company's securities prior to its initial public offering if the company is in the business sector that the analyst covers. In addition, the rule changes will require "blackout periods" that prohibit analysts from trading securities of the companies they follow for 30 days before and 5 days after they issue a research report about the company. Analysts will also be prohibited from trading against their most recent recommendations.


  • Disclosures in Research Reports Regarding the Firm's Ratings. The rule changes will require firms to clearly explain in research reports the meaning of all ratings terms they use, and this terminology must be consistent with its plain meaning. Additionally, firms will have to provide the percentage of all the ratings that they have assigned to buy / hold / sell categories and the percentage of investment banking clients in each category. Firms will also be required to provide a graph or chart that plots the historical price movements of the security and indicates those points at which the firm initiated and changed ratings and price targets for the company.


  • Disclosures During Public Appearances by Analysts. The rule changes will require disclosures from analysts during public appearances, such as television or radio interviews. Guest analysts must disclose if they or their firm have a position in the stock and also if the company is an investment banking client of the firm.


  • Supervisory Procedures. NASD members will be required to attest annually to the NASD that they have adopted and implemented written supervisory procedures designed to insure compliance with these rules.

The new “. . . rules do not curtail analysts from working for clients of a firm’s investment banking arm. Nor do they offer any new legal remedies for investors who believe that they were misled by analysts or give such investors any greater ammunition in court proceedings.”32 In its promulgating release of the new and amended rules, the SEC requested that the NASD and NYSE report within a year of implementation whether they recommend any changes or additions to these rules.33

7   See Reuters Business, Salomon Analyst Grubman Latest to Be Hit, April 25, 2002.

8   See Attorney General of the State of New York Affidavit In Support of Application for an Order Pursuant To General Business Law Section 354, at 2.

9   Id. at 2.

10   Id. at 3.

11   Id. at 4.

12   Id. at 4.

13   Id. at 4.

14   Id. at 4.

15   See Marcia Vickers and Mike France et al., How Corrupt is Wall Street? New revelations have investors baying for blood, and the scandal is widening, Business Week, May 13, 2002, at 37.

16   See Gretchen Morgenson, Wall St. Firms Said to Break E-Mail Rule, N.Y. Times, May 7, 2002 at 1.

17   See 240 CFR Rule 17a-4.

18   See Securities and Exchange Commission Release Number 34-44992; File No. S7-26-98, November 2, 2001, at 14.

19   See Morgenson, supra note 16 at 1. 

20   See Charles Gasparino and Randall Smith, Merrill Arrives At Framework For Possible Deal To End Inquiry, Wall St. J., May 8, 2002, at C1.

21   See Id. at C1.

22   See Id. at C1.

23   See Gretchen Morgenson, Wall Street Inquiry Expanded, With a Subpoena to Salomon, N.Y. Times, April 25, 2002, at 1.

24   See Gretchen Morgenson, Telecom’s Pied Piper: Whose Side Was He On?, N.Y. Times, Nov. 18, 2001.

25   Id.

26   Id.

27   See Emily Thornton, Commentary: Wall Street’s Chinese Walls Aren’t Strong Enough, Business Week Online, August 27, 2001. (Online) Available at .

28   See Security Industry Association (“SIA”) “Best Practices For Research,” 2001. Many of these recommendations were adopted in the NASD and NYSE Rule amendments and proposals approved by the S.E.C. on May 8, 2002. 

29   See Securities and Exchange Commission Investor Alert, Analyzing Analyst Recommendations, July 13, 2001.

30   See Securities and Exchange Commission Press Release No. 2002-63, Commission Approves Rules to Address Analyst Conflicts SEC Also Requires EDGAR Filings by Foreign Issuers, May 8, 2002, at 1.

31   Id. 

32   See Stephen Labaton, S.E.C. Adopts New Rules For Analysts, The N.Y. Times, May 9, 2002.

33   See Securities and Exchange Commission Release 2002-63, supra note 30 at 2.