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Liability for "Tainted" Stock Research After the Global Wall Street Settlement
by Jacob H. Zamansky*

In the wake of the landmark $1.4 billion Wall Street research settlement with the securities regulators, investors have sought to recover their losses from Wall Street firms in class actions filed in courts and in individual customer arbitrations filed with the NYSE and NASD. Recent federal court decisions dismissing "research" based class action cases against Merrill Lynch by online, non-customer traders have raised questions about whether investors can recover their losses. In fact, customers of Wall Street firms who bring claims in arbitration and can prove that they "relied" upon fraudulent research in deciding to buy or hold a stock are likely to prevail.

The key distinction between the online traders' claims against Merrill Lynch and the arbitration claims brought by customers of Wall Street firms is that arbitration customers and their brokerage firms have a contractual relationship. Firm customers pay higher commissions, deal with a "real" broker, and have a legitimate expectation of honest and objective research. Firm customers who can show that they relied on tainted research in deciding to buy or hold a stock should be able to prove their cases in arbitration. As discussed below, evidence of such reliance generally is found where a customer can prove that he or she made an investment decision (buy or hold) contemporaneously with the receipt of the allegedly fraudulent research report.

Significantly, not all claims of this ilk are being denied-even in the courts. As discussed below, the court in the WorldCom class action case denied the motion of Salomon Smith Barney ("SSB") and its former superstar telecom analyst, Jack Grubman, to dismiss the complaint as against them for issuing alleged fraudulent research. The court held that investors were misled by SSB's research, which misrepresented WorldCom's true financial condition and failed to disclose key information regarding the nature and extent of an illicit quid pro quo arrangement between SSB and WorldCom.

This article examines the recent court decisions and offers a blueprint for arbitration customers to prove their "research" cases.

Background
The fall of the NASDAQ market from its high of 5,000 in March 2000 to below 2,000 in March 2001 has been largely attributed by many financial market observers to false and misleading "buy" recommendations issued by major brokerage firm analysts such as Henry Blodget of Merrill Lynch and Jack Grubman of SSB. These analysts have been criticized for failure to disclose material conflicts of interest-namely, their firms' financial interest in the stocks they were touting and the use of newly minted "valuation criteria" to justify their buy recommendations and high stock price targets.'

Firm customers who can show that they relied on tainted research in deciding to buy or hold a stock should be able to prove their cases in arbitration.

During the 1998-2000 Internet stock market frenzy, major brokerage firms created media superstar Internet analysts as a means of enticing the investing public (who watch CNBC and other financial shows) to purchase Internet and high technology stocks. These analysts also were used to generate investment banking business for their firms. Thus, critics argue that the analysts no longer perform objective unbiased analytical functions (as required by industry standards) but, instead, are mere "touters" or "cheerleaders" for the companies they cover.

Lastly, research analysts and investment bankers are by regulation required to be separate and to maintain a "wall" between their functions. In reality, the "wall" fell; analysts have been criticized for becoming mere tools for their investment banking departments to generate underwriting and other business.

The Merrill Lynch/Henry Blodget Analyst Arbitration
The first known legal attack on analyst conflicts of interest occurred in March 2001 with the filing of an arbitration case by a public investor against Henry Blodget. In a groundbreaking NYSE arbitration in which this author represented the Claimants, a physician, Dr. Kanjilal, claimed securities fraud and gross negligence based on Blodget's misleading buy recommendation on InfoSpace, an Internet wireless company. The case alleged that Blodget issued his recommendation at a time when Merrill Lynch stood to receive substantial compensation in connection with its role as a financial advisor to a merger of InfoSpace and Go2Net. Blodget's buy rating did not disclose Merrill Lynch's financial interest-a material fact that Dr. Kanjilal claimed would have affected his decision to buy, sell, or hold the stock. On July 20, 2001, Merrill Lynch report edly agreed to pay $400,000 in order to settle the arbitration claim, thus ending the case.

The Merrill Lynch/New York Attorney General Settlement
Following the Kanjilal case settlement, this author received a subpoena from the New York Attorney General's ("NYAG") office seeking documents relating to the case and the alleged conflicts of interest at Merrill Lynch. These documents all were produced. It has been reported that the Kanjilal case was the catalyst that spurred on the investigation of Merrill Lynch by the NYAG.

On April 8, 2002, NYAG Elliot Spitzer commenced an action pursuant to New York's "Martin Act" against Merrill Lynch, Henry Blodget, and other analysts at the firm seeking immediate equitable relief to "prevent further fraud, to protect the rights of the investing public, and to educate it" pending completion by the NYAG of its "investigation into Merrill Lynch and other financial institutions."

The NYAG made public an affidavit and supporting exhibits, which contained information and "smoking gun" e-mail evidence of alleged fraudulent conduct by Merrill Lynch. The now infamous e-mails show that research analysts privately disparaged the Internet stocks their firm took public as "dogs," "crap," and "pieces of junk" while they touted these stocks to the public with "strong buy" recommendations.

On May 22, 2002, Merrill Lynch agreed to a settlement of all charges with the NYAG. The settlement terms required Merrill Lynch to pay a $100 million fine to New York State and to other state regulators, to create new policies to separate analysts' pay from the firm's investment banking business, to create a new committee to oversee the "objectivity" of stock picks, and to establish a new system to monitor e-mails between investment bankers and stock analysts.

Merrill Lynch claimed that the settlement did not contain any "admission of wrongdoing" but in a public "statement of contrition" the firm admitted that its employees had engaged in "inappropriate communications," some of which "violated internal policies" and "failed to meet the high standards" of the firm.

Salomon Smith Barney's Response to Analyst Conflicts
Following the Merrill settlement, SSB agreed to change the structure of its stock research department to mirror the changes agreed to by Merrill Lynch. SSB stated that it would create a research review committee to oversee research analysts' recommendations and also would separate "the evaluation and compensation of equity research analysts from investment banking."

SSB is the target of investor lawsuits largely based upon the research reports issued by Jack Grubman regarding telecom stocks. Many of the companies Grubman recommended have filed for bankruptcy or are selling at a fraction of their share prices from 2000.

Investor Claims
Following the Kanjilal case and the NYAG investigation, numerous investors filed arbitration claims or attempted to initiate class actions claiming that investors were misled by analyst research that failed to disclose material conflicts of interest. In cases against Merrill Lynch, investors are arguing that the research was misleading insofar as it did not disclose that the research analysts privately disparaged certain Internet stocks while recommending that the public buy them. Claims against other firms, such as SSB, argue that analyst recommendations were misleading because they did not disclose the firm's or the analyst's financial interest or compensation for recommending stocks of companies with which their investment banking departments had lucrative financial arrangements. SSB customers likely will point to notes by SSB's head of investment banking, who cited concern for "research integrity" and reported that the firm's ratings were the "worst" on the Street and "ridiculous on [their] face."

The Wall Street "Global" Settlement
On April 28, 2003, ten of the nation's top investment firms agreed to settle enforcement actions brought by the SEC and NYAG involving conflicts of interest between research and investment banking. Pursuant to the settlement, the ten firms agreed to pay a total of approximately $1.4 billion in fines to settle these charges. Individual firm settlement payment amounts range from $400 million (SSB) to $35.5 million (Piper Jaifray). Significantly, the SEC in the settlement reported that Merrill Lynch, SSB, and CSFB had issued "fraudulent" research reports.

Under the settlement deal, the ten firms will pay (i) a total of $875 million in penalties and disgorgement; (ii) $433 million for five years for outside, independent research to clients; (iii) $80 million for investor education; and (iv) $399 million to the SEC as a "restitution fund" for distribution to investors. Investors qualifying for the restitution fund must have suffered a net loss on their stock purchase, which must have been made after the publication or receipt of the tainted research. Investors making claims also must be customers of one of the brokerage houses in question.

The $399 million restitution fund is unlikely to provide much in the way of recovery for investors, given the hundreds of billions of investment losses in the stocks subject to the settlement. In fact, a leading securities regulator stated that a proportionate distribution of the restitution fund would give investors only enough to buy a pizza or cup of coffee.'

Finally, as part of the settlement, Jack Grubman and Henry Blodget were barred for life from the securities industry and fined $15 million and $4 million, respectively.

Class Action Litigation Decisions
Cases against Merrill Lynch
In July 2003, New York Federal District Judge Milton Pollack dismissed a class action case against Merrill Lynch by online traders who claimed they had lost money in two Internet stocks, 24/7 Real Media and Interliant, due to biased research analysis issued by Merrill Lynch and Henry Blodget.' Judge Pollack also dismissed a class action brought by online traders in Merrill Lynch's Global Technology Fund.'

In the 24/7 and Interliant case, Judge Pollack dismissed the claims because the plaintiffs were not customers of Merrill Lynch and could not show that there was any "causal connection" between their losses and the alleged fraudulent research. In a tersely written decision, Judge Pollack criticized the plaintiffs as "high risk speculators" who knew or should have known "the unjustifiable risks they were undertaking in the extremely volatile and untested stocks at issue, [ now] hope to twist the Federal Securities Laws into a scheme of cost-free speculators' insurance." Judge Pollack continued his criticism of the traders, whom he wrote "would have this court conclude that the Federal Securities Laws were meant to underwrite, subsidize, and encourage the rash speculation in joining a free wheeling casino that lured thousands obsessed with the fantasy of Olympian riches, but which delivered such riches only to a handful of lucky winners."

Judge Pollack delineated three key tests of liability for Merrill Lynch and its analysts for issuing fraudulent research, and held that the plaintiffs failed all three tests:

• The traders had "no customer relationship" with Merrill Lynch, and no fiduciary or "contractual relations" existed or were claimed;
• There was no "causal connection" between the traders' losses and the alleged fraudulent research. In other words, the traders failed to establish the crucial legal element of "reasonable reliance" upon the purported fraudulent research; and
• The traders were on "inquiry notice" of the alleged fraud over a year before their complaints were filed by virtue of articles published in the financial press, and thus their claims were barred by the one-year statute of limitations (which began to run on the date the articles were published).

Judge Pollack opined that the bursting of the Internet Bubble was the "intervening cause" of the traders' losses. He said he was "utterly unconvinced" that Merrill Lynch "intended to defraud" the plaintiffs or the market generally.

In dismissing a class action complaint against Merrill Lynch's Global Technology Fund, Pollack ruled that:

• The Fund had no duty to disclose to indirect purchasers that the Fund invested in companies with which Merrill Lynch had an investment banking relationship;
• The Merrill Fund was separate from Merrill's brokerage and investment banking arms and was not liable for failing to disclose the purported fraudulent research issued by those divisions; and
• The purported conflict between the Fund and Merrill Lynch was "public knowledge" long before the market for technology stocks peaked in 2000 and began its steep decline.'

Case against CSFB and Morgan Stanley
In another recent stock research case, on June 30, 2003, New York Federal District Judge Harold Baer, Jr. dismissed claims brought by traders in Covad Communications Company against CSFB and Morgan Stanley premised on alleged fraudulent research on the grounds that the claims were barred by the one-year statute of limitations.' Judge Baer held that the traders were on "inquiry notice" of the purported fraud over a year before they filed their claim because the law firm filing the claim had filed a "very similar lawsuit" against other investment banks for fraudulent research over a year earlier. Judge Baer also opined that the complaint lacked the requisite specificity for pleading fraud, stating that the general "industry wide conflict of interest" allegation failed to satisfy the pleading requirements.

Case against WorldCom
In stark contrast to these decisions, a slightly earlier decision by New York Federal District Judge Denise Cote denied SSB and Jack Grubman's motion to dismiss the complaint against them for alleged fraudulent stock research on WorldCom.' In WorldCom, the lead plaintiff claimed that Grubman's research was fraudulent because it failed to disclose an "illicit quid pro quo" arrangement that existed between SSB and WorldCom-namely, that SSB would issue "positive" research reports about WoridCom, provide WorldCom senior executives with valuable IPO shares, and loan WorldCom's corporate president Bernard Ebbers hundreds of millions of dollars, in exchange for WorldCom's investment banking business and the substantial revenue and personal compensation that business generated for SSB and Jack Grubman. The court agreed with the plaintiff, and also stated that SSB and Grubman's analyst reports issued on WorldCom in 2000 and 2001 were "false and misleading . . . because they misrepresented WorldCom's financial condition."

Moreover, unlike the Merrill Lynch decisions, Judge Cote ruled that the WorldCom plaintiffs could utilize the "fraud on the market" theory and need not prove actual "reliance" upon the alleged fraudulent research. Thus, the WorldCom plaintiffs are presumed to have relied on the market to have "performed a substantial part of the valuation process performed by the investor in a face-to-face transaction" and S SB'S alleged fraud influenced the market's valuation of WorldCom's stock. The WorldCom case will now proceed toward class action certification and a trial.'

Application of the Court Decisions to Customer Arbitration Cases
The court decisions dismissing class actions by traders who were not customers of the firm and could not prove "reliance" actually bolster the arbitration claims of individual firm customers who can show that they truly relied upon fraudulent research in deciding to buy or hold a stock. Individual firm customers have a contractual relationship with the firm, pay higher commissions, and deal with "real" (rather than virtual) individual brokers. These customers have a reasonable expectation of honest and unbiased research. Research, which is paid for through the higher commissions, is made available to firm customers through their brokers, who are required (by industry and firm rules) to make suitable recommendations to customers of stocks approved by the firm and for which the firm issues research reports.

Individual customers, who are required by their contracts with brokerage firms to arbitrate their claims, also have something of an advantage due to the nature of the forum. Judge Pollack, for example, was lambasting-and making generalizations about-a faceless group of investors. In an arbitration case, the character and sophistication of the individual customer cannot be ignored.

In an arbitration case, the character and sophistication of the individual customer cannot be ignored. To prevail in a research case, the customer first must prove the causal connection or reliance element. Reliance generally is proven by the fact that the customer received from his or her broker the firm's research report and then made a reasonably contemporaneous decision to buy or hold the stock that is the subject of the research report.'

Reliance also can be proven by e-mails exchanged between the broker and the customer showing that the broker discussed the research as a basis for a recommendation or that the research was a reason behind the customer's investment decision. Customers also can testify that they had conversations with their brokers regarding the research, and that those conversations led to the investment decision. (To be effective evidence, these conversations must be documented in the customer's or the broker's notes.)

Reliance is a case-by-case factual determination, which must be made based on the written and testimonial evidence proffered at the arbitration. Where there is strong documentary and testimonial evidence of reliance upon fraudulent research, a customer is likely to prevail in his or her arbitration claim. Indeed, the concept of recovery of losses by firm customers who can show reliance on tainted research is consistent with the requirements for recovery under the SEC Global Settlement Restitution Fund.

The issue of whether the customer should have been on "inquiry notice" due to financial press reporting of the conflicts of interest between research and investment banking is also a factual determination that must be made on a case-by-case basis. While experienced Wall Street insiders or traders may have known about the research conflicts of interest based upon media reports, it is likely that "Main Street" retail customers did not know of such conflicts, or at least did not appreciate the import of such conflicts, until after the publicity surrounding the announcement of the April 2003 Global Settlement. For example, retirees from a Rubbermaid plant in rural Ohio prevailed on their "suitability" claims against Merrill Lynch in arbitration (receiving an award of $310,000 on $172,000 in stock market losses) after showing they were unaware of the purported conflicts between research and investment banking.' Where firm customers can show in an arbitration forum that they were not sophisticated enough to understand the implications of what they may have heard about conflicts of interest, early inquiry notice is unlikely to be established.

Again, in customer arbitrations, as opposed to class actions, the individual's sophistication and knowledge of the conflicts of interest will be the determining factor.

Conclusion
While the court decisions appear to pose obstacles to traders prevailing in class action claims based upon fraudulent research, the opposite is true in individual customer arbitration claims. Where a customer of a firm can establish through competent evidence that he or she relied upon fraudulent research in deciding to buy or hold a stock, the customer is likely to prevail in an arbitration claim. The customer can establish "reliance" by virtue of the contractual relationship with the brokerage firm and through e-mails or other evidence showing that the fraudulent research was a basis of the broker's recommendation or the customer's investment decision. No doubt investors' recent setbacks in court are only the first chapter of what will likely be a series of individualized decisions in court and arbitration cases involving fraudulent re search that was the subject of the Wall Street Global Settlement.

VOL. 7, NO.4/Wall Street Lawyer! 13
2003 Glasser LegalWorks