As Investors Win Arbitrations, Brokerage Houses Keep Paying

Wall Street's Big Houses Find Small Investors Get Payback

With a Blizzard of Arbitrations

The Wall Street Journal
March 17, 2004

The pain isn't over for Wall Street's big brokerage houses.

Last year, 10 big brokerage firms, including Merrill Lynch & Co. and Morgan Stanley, agreed to pay $1.4 billion to settle allegations that they issued overly optimistic research in an attempt to win more-lucrative investment-banking business.

But very little of this money has trickled down to the small investors who actually bought these stocks, prompting clients of these firms to take their beefs into arbitration, the main forum for customer complaints.

Now, some investors are winning cases, and while many of these awards are relatively small, in some cases less than $10,000, the trend could end up costing these firms millions of dollars more than they already have paid.

"There are certainly some people who will say this could be death by a thousand cuts, but I think the greatest damage is to short-term brand image of these firms and not their long-term economic viability," says Samuel Hayes, a professor of investment banking at Harvard Business School.

Take the case of Mark Summers, a Florida dentist who bought stock in Internet Capital Group Inc. after a phone call from Merrill Lynch stockbroker Cary Rosen, who liked the stock because Henry Blodget, the firm's star Internet analyst insisted it was a great buy. "His call was so enthusiastic and confident that I called Dr. Summers to discuss," the broker recently wrote in an affidavit, adding he was so impressed by Mr. Blodget's salesmanship that in addition to buying 5,000 shares for Dr. Summers, he bought some stock for his family.

Last week, a three-person National Association of Securities Dealers arbitration panel ordered Merrill Lynch to pay Dr. Summers $57,920, 75% of the value of the ICG shares he bought. As is often the case, the arbitrators didn't give a reason for issuing the award. (Mr. Rosen didn't return a call for comment. Dr. Summers remains a client of his.)

Mr. Blodget, who left Merrill at the end of 2001, agreed last April to pay $4 million in fines and penalties and to be banned permanently from the securities industry to settle regulators' charges against him for alleged conflicts of interest in his research. He, like the firms involved, neither admitted nor denied wrongdoing. This fine was part of the broader industry sanction. As part of that, Merrill Lynch was charged by securities regulators with civil fraud for its research in two stocks and regulators alleged it issued misleading research in other stocks, including Internet Capital Group, the stock Dr. Summers bought.

To be sure, a number of customers have lost their battle to recoup losses. Last year federal Judge Milton Pollack handed a victory to Merrill Lynch by dismissing several class-action investor lawsuits over allegedly tainted stock research. In one case he said the investors who brought the suits, some of whom were not even clients of the firms in questions, were "high-risk speculators," who knew or should have known better.

Merrill says it has had victories in arbitration as well. "We are prevailing in the majority of these cases," Merrill spokesman Mark Herr said, citing a recent case in which the claimant alleged $1 million in losses from stocks covered by Mr. Blodget and the panel awarded nothing. "The claimants simply cannot produce evidence to sustain their claims."

As for Mr. Summers's award, Mr. Herr said it is "an isolated case in which the panel ignored the fact that the stock was what Henry Blodget said it was, volatile, and that the claimant rode that volatility despite Blodget's warnings about it."

The number of individual cases filed against brokers or brokerage firms with the National Association of Securities Dealers, which handles about 90% of all customer complaints filed, jumped 16.1% in 2003 to a record 8,945. The NASD doesn't track cases by category and doesn't know how many investors have filed cases arguing they were duped by faulty research. In fact, most investors with a complaint against a brokerage house are now arguing that faulty research, in addition to issues such as account churning, contributed to their losses. But some lawyers have filed dozens, in some cases hundreds, of cases against the big firms arguing their clients lost money solely because of bad research.

Win or lose, there is little if any precedential value in these decisions. An investor with a complaint against a U.S. brokerage firm is almost guaranteed to end up in arbitration, as brokerage contracts generally require customers go that route. But unlike court decisions, arbitration cases don't create precedents; each case is argued on its own merits. Arbitrators may look to other decisions for guidance, but aren't required to.

In Dr. Summers's case, his lawyer Darren Blum showed, through the affidavit from Dr. Summers's broker, that his client bought Internet Capital Group because of Mr. Blodget's recommendation. He also submitted as evidence Mr. Blodget's compensation, which soared to $8.1 million in 2001 from $2.5 million in 1999, according to Merrill Lynch documents and tax returns, despite the fact many of the stocks he recommended had dropped in value. "If he made this much money in a year where the stock tanked there is no way they were paying him for his stellar research," says Mr. Blum. Mr. Blodget declined to comment.

There have been other cases won by investors in arbitration. Robert Weiss and James Hooper, both personal-injury-turned-securities lawyers, have filed about 300 cases against Citigroup Global Markets Inc., formerly Salomon Smith Barney, charging the firm issued fraudulent research on WorldCom Inc., the former telecommunications highflier that filed for bankruptcy in 2002. So far, they have won four of 12 cases decided.

Unlike Mr. Blum, they haven't demonstrated that investors relied on the research, leaning instead on state "blue-sky laws," which require brokerage firms to fairly disclose material facts to investors. The term stemmed from the belief that if investors weren't adequately protected, they could be sold anything -- including the "blue sky" itself. "We used the same argument in every case; the only thing that was different was the arbitrator, proving this process is arbitrary," said Mr. Weiss, who has 540 claims against various securities firms outstanding, including the 300 or so against the former Smith Barney.

In regards to Mr. Weiss, his cases all involved claims under $25,000 and, as a result, were decided by one arbitrator. In one recent case, filed by Mr. Weiss against Citigroup, the arbitrator dismissed the case and took the unusual step of writing a decision. "To the extent of his analysis of WorldCom financial performance and financial prospects, I do not find any knowing misstatement of a fact, an indication that Mr. Grubman's private views diverged from his public views, or any departure from reasonable performance standards an analyst should follow," arbitrator Langfred W. White concluded in a seven-page decision. Jack Grubman was an analyst at the former Salomon Smith Barney. A Smith Barney spokeswoman declined to comment.

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