During the internet boom, a senior research analyst from Merrill Lynch was inconsistent with his views on a few internet companies. He was negative about them but went ahead to publish more rosy opinions in his analyst reports.
He was eventually exposed through his email correspondence with his colleagues.
Independence of research team in question
Apparently, the research team is not independent in their views and is influenced by the prospect of investment banking deals (SEC COMPLAINT):
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
“Merrill Lynch’s research department provided a service function within the firm and was not an independent profit center. Merrill Lynch funded its research department through firm revenues received from a number of businesses at the firm, including investment banking. Merrill Lynch’s investment banking department generated substantial revenues for Merrill Lynch. Merrill Lynch encouraged Internet research group analysts to assist investment banking activities. Merrill Lynch expected its Internet research group analysts to vet initial public offerings, review and opine on other prospective investment banking deals, attend “pitch” sessions with investment bankers in which the bankers competed for the issuer’s investment banking business, and talk with institutional investors about those issuers. When the Internet research group could not support favorable research ratings, it vetoed the investment banking deals.
Merrill Lynch’s investment banking group used the Internet research group’s ratings and coverage to support its business. In March 1999, within weeks of joining Merrill Lynch, Blodget circulated to research management and senior investment bankers an e-mail entitled “Managing the Banking Calendar for Internet Research.” In that e-mail, Blodget stated,
[w]e are now up to 11-12 Internet banking transactions in the pipeline . . . . The current schedule for this week . . . is 85% banking, 15% research . . . .
Blodget estimated that his team would devote the majority of its time that week to assisting in investment banking efforts, and cautioned that if he failed “to allocate at least 50% of [his] time and the overall research team’s time” to performing research and institutional marketing, then his, and his team’s, reputation among institutional investors might suffer.”
“Investment banking revenues generated in the Internet sector were a factor in evaluating Internet analysts’ performance and, consequently, in determining their compensation. In November 2000, Merrill Lynch’s research management requested that all equity analysts submit a report detailing their contributions to investment banking during the year and highlighting instances where their research coverage played a role in originating and securing an underwriting mandate or advisory work on mergers and acquisitions. Blodget’s e-mail response highlighted his Internet group’s involvement in over 52 completed or potential investment banking transactions and included among his team’s activities: pitching the client, marketing the offering, and providing research “coverage for future banking.” Blodget estimated that from December 1999 to November 2000, the Internet research group was involved in activities relating to investment banking deals that produced approximately $115 million of revenue for Merrill Lynch.”
Inconsistent with Rating System
“Each Merrill Lynch research report included an investment rating that was intended to reflect the analyst’s opinion on how the stock would perform. During 1999 to May 2001, Merrill Lynch stated that it used the following five-point rating system:
1 — Buy
2 — Accumulate
3 — Neutral
4 — Reduce
5 — Sell
The descriptive words were to reflect the analyst’s opinion of the stock’s price appreciation potential over the intermediate term (0 to 12 months from the date of rating) and long term (more than 12 months from the date of rating): 1 — Buy (more than 20% appreciation), 2 — Accumulate (10-20% appreciation), 3 — Neutral (between 10% depreciation and 10% appreciation), 4 — Reduce (10-20% depreciation), and 5 — Sell (more than 20% depreciation). Although some of Merrill Lynch’s research reports disclosed the stock appreciation percentages associated with the intermediate and long-term ratings, none of the research reports discussed below contained such disclosure.”
“During the relevant period, Merrill Lynch’s Internet research group assigned consistently positive intermediate and long-term ratings on the Internet stocks it covered. During 1999 and 2000, virtually all the stocks covered by Blodget had a “1” (buy) or a “2” (accumulate) rating. Until late 2000, Blodget rarely used a “3” (neutral) rating. As a junior analyst in the Internet group explained to the management of an investment banking client in September 2000, Merrill Lynch’s ratings “range from 1-5, but we don’t cover anything below a 3.”
“The initial research report on GoTo was published in January 2001 and expressed views contrary to the privately expressed negative views of Blodget and his fellow analysts during the period November 2000 to January 2001. On November 15, 2000, a junior analyst e-mailed Blodget and stated, “[another firm] initiated on GoTo.com with a buy . . . i guess they are angling for the M&A [mergers and acquisitions] business too!”
The next day, while working on the initiation of coverage report, Blodget e-mailed a junior analyst and queried,
What is your honest take on the stock? No reason to own it . . . or going a lot lower[?] [In my humble opinion], I think the first [rating] should be a 2[-]2 . . . the second a 3…
Later that day, the junior analyst responded:
. . . I think both — no reason to own now. . . . totally could go lower. who are we trying to please by doing a 2-2 ? I don’t want to be a whore for f-ing mgmnt. if 2-2 means that we are putting half of merrill retail into this stock because they are out accumulating it, then I don’t think that’s the right thing to do. we are losing people money and I don’t like it. [hypothetical retail clients] john and mary smith are losing their retirement because we don’t want [GoTo’s CFO] to be mad at us. [Merrill Lynch’s investment banking relationship manager for GoTo] said he is fine with a 3-2 (I said to him the whole idea that we are independent from banking is a big lie — without banking this would be a 3-2 and he said “no-you guys are independent you can do what you want — I’m fine with that[“] -I would put it back to the company to convince you that there is a reason you should own this at 54x [year 2002 earnings per share]. . . so that’s my feeling. . . .
On January 4, 2001 the junior analyst e-mailed the investment bankers, “Research mgmnt  wants to go with a 3-2 on GoTo.” (Ratings on initiation of coverage were approved by Research Management and Research Compliance). One of the bankers responded to Blodget and the junior analyst:
Briefly, in talking to [Research Compliance] yesterday, I thought the strategy was to go out with the 3-1 as soon as the stock hit $10; if it doesn’t, I don’t think anybody has an interest in seeing initiation at a 3-2.
Blodget replied to the bankers: “my concern is that waiting for $10 is waiting for godot. . .” (The reference here was to the Samuel Beckett play Waiting for Godot. In that play, the central story line involves two characters who continuously wait for the arrival of an individual named Godot. He never comes.)
During the following week, GoTo traded intraday above $10 and, on January 11, 2001, Blodget initiated coverage on GoTo at a 3-1 (neutral-buy), the same rating reflected in the e-mail from investment banking. Blodget’s initiation piece reported that
GoTo has a pay-for-performance model, which should help it gain share in the current environment. . . . It is growing quickly and probably has enough cash to make it to break-even (estimated in 1Q02). . . . Given the current weak environment for online advertising, we do not see any near term catalysts. We expect the market to improve in 2H 2001, however, and we believe that GoTo will be a survivor.
On the same day coverage was initiated, an institutional client e-mailed Blodget to ask, “What’s so interesting about Goto except banking fees????” Blodget replied, “nothin.”
The initial research report on GoTo expressed views contrary to privately expressed negative views as described above, and did not disclose those contrary views, including Blodget’s belief that GoTo was “interesting” only for the banking fees it could generate. As a result, the January 11 research report was fraudulent.”
“On April 25, 2001, Blodget upgraded GoTo from 3-1 to 2-1 (accumulate-buy), based on GoTo’s very strong first quarter results and the observation that GoTo had “execut[ed] extremely well in a tough environment.” The upgrade set a price objective of $18-19 from GoTo’s then current trading price of $11.57.
On May 4, 2001, GoTo closed at $21.92. In a May 6, 2001 e-mail, an institutional client asked Blodget for buy recommendations that were “compelling currently”; Blodget responded: “I would have said GoTo and HOMS but both have had very strong runs and are overdone, in my opinion.”
On May 22 and 23, 2001, when GoTo closed at $23.90 and $23.43, respectively, Merrill Lynch issued additional research reports that reiterated GoTo’s 2-1 rating and stated, “We believe a few stocks are attractive. . . . we are recommending . . . GoTo. . . .” These research reports expressed views contrary to the views privately expressed by Blodget in his May 6 e-mail, and did not disclose Blodget’s view that the stock price was overdone.”
“On October 10, 2000, Blodget privately expressed a negative view about a 24/7 key product — its “Connect” proprietary advertising software. That day, another analyst e-mailed to Blodget a news article entitled “24/7 Media working to repair technology glitch.” The article highlighted glitches in 24/7’s “Connect” advertising software, resulting in the reporting of inaccurate results to 24/7’s clients. The analyst remarked,
Don’t know if you saw this, nothing revolutionary — but it probably confirms what you and [another fellow analyst] have talked about for some time.
That same day, Blodget responded, “That it’s a pos [piece of shit]? yes.”
On August 11, 2000, Blodget published a research report rating 24/7 a 2-2. In that report, Blodget’s only mention of Connect was to explain that 24/7 had yet to complete its full rollout, but that 24/7 was then serving over 80% of its U.S. network ads through Connect. Blodget’s November 8, 2000 report maintained the 2-2 rating and noted,
We hope to hear more about traction at Connect, including any new business from competitors based on Connect’s capabilities as opposed to those won on price.”
“By December 21, 2000, ATHM’s stock price had fallen to $4. On January 29, 2001, while Blodget still had a 2-2 rating on ATHM, Blodget expressed a view to a financial consultant that he did not think there was any reason to buy more shares of ATHM. Specifically, when a Merrill Lynch financial consultant e-mailed Blodget and asked if he would recommend buying more shares of ATHM at its then-current level (approximately $8), Blodget responded,
I don’t think it goes much lower, but I also don’t think there’s any reason to buy more of it… as a standalone business, it’s falling apart.
On January 26, 2001, Blodget published a research report on ATHM that maintained a 2-2 rating and noted
[ATHM] 3Q had a weak quarter, as expected, and gave a dismal outlook for 2001. However, the company believes it can hit double digit EBITDA margins in 2H. . . . [ATHM] might be on the right track , but never-ending state of flux makes forecasting (and investing) difficult. Pieces of the company remain attractive for acquisition, but we believe the value as a consolidated operating business continues to decline. If indeed the company is able to turn EBITDA positive and hit the double-digit margin targets in the back half of the year, the stock should act favorably. However, at this point, we have neither the visibility nor confidence in this happening, and maintain our “wait and see stance.”
He had also contravened his negatively expressed views with more rosy reports for other companies including Internet Capital Group, Homestore.com, LifeMinders and Infospace. In summary (taken from PBS):
There are bound to be such unethical behaviours in any field. Hence, we need to be selective and perhaps, be skeptical in whatever we read or hear from others. In this profit driven world, ethics are always greatly challenged. Are you sure you can be true to yourself when you are in such position?