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Couple defeats Merrill Lynch's stock rating system

$1m aberration

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The case doesn't have the big name analysts, damaging documents or internet stocks. But a dispute between a pair of small-time investors and Merrill Lynch does have the same allegations of hyping shares that surrounded a high-profile settlement between major brokerage houses and the US SEC (Securities and Exchange Commmission) and NYSE (New York Stock Exchange) in 2003.

Merrill Lynch has been ordered to pay $1m to Florida residents Gary and Lisa Friedman by an arbitration panel of the National Association of Securities Dealers (NASD). The couple sought $4m but were awarded $730,000 in compensatory damages and another $300,000 in punitive damages. The panel declared that evidence showed Merrill Lynch's "employees were guilty of intentional misconduct in that they had actual knowledge that many of the companies for which they were issuing and/or maintaining ratings . . . were, in reality, overvalued by this rating system."

You won't find any internet high-flyers in the portfolio held by the Friedman's from May of 1999 to May of 2002. Their holdings were dominated by blue chip shares such as Walt Disney, Monsanto, Microsoft and Agilent. The couple's lawyer insists that Merrill Lynch applied similar tactics with these bellwethers that it did with internet shares - namely placing buy ratings on the shares in the hopes of securing investment banking business.

"What we have proved was that all of the analysts - not just ones in the internet sector - supplied memorandum or emails to top management at Merrill Lynch identifying their contributions to the investment banking business," Bob Pearce, the Friedman's lawyer, told The Register. "We showed that all the analysts were getting paid huge bonuses after they sent in memos identifying their contributions."

In the extreme, the Friedmans are questioning Merrill Lynch's entire rating system. This didn't elude Merrill Lynch, which said Pearce presented no facts that support the panel's decision. The couple, who like many invested in blue chip consistent shares, lost their money due to a sudden collapse in the financial markets, not because of a rating system, Merrill Lynch said.

"We have won the overwhelming majority of these research cases," said Merrill Lynch spokesman Mark Herr. "This case is clearly an aberration."

Before the 2003 settlement between the SEC and major brokerage houses, Merrill Lynch agreed to pay a $100m fine, following an investigation into the relationship between its investment bankers and analysts by New York Attorney General Elliot Spitzer.

Pearce has tried to build on that settlement by questioning Merrill Lynch's rating system for stocks that ranged from Buy, Accumulate, Neutral, Reduce to Sell during the period in question.

"In the mid 1990s the Merrill Lynch 'QRQ' ratings became corrupted and Merrill Lynch investment bankers seized control of its research analysts," Pearce wrote in the original complaint. "By 1998, the overwhelming majority of stocks covered by Merrill Lynch’s research analysts had a '1' (buy) or a '2' (accumulate) rating. Merrill Lynch research analysts infrequently used a '3' (neutral) rating and they rarely covered anything below a '3.'"

Merrill Lynch flagged just five companies with a Reduce or Sell rating out of the 1,485 it covered in December 2000, according to Pearce. In May 2001, this fell to 4; but then in May of 2002, after the regulatory investigations had started, Merrill Lynch gave 37 of the 1,475 companies it followed a reduce or sell rating.

The Friedmans didn't own any pure dotcom stocks, but they did own a number of tech shares, including those of Sun, Compaq, TI, AOL Time Warner, Cisco and Motorola. Two-thirds of the companies they owned did investment banking business with Merrill Lynch.

Pearce is currently reviewing a couple of similar cases. ®

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