A former

Merrill Lynch

(MER)

broker was arrested last week in conjunction with a federal investigation into allegations that daytraders were permitted to eavesdrop on the internal communication systems of some of Wall Street's biggest brokerages.

The arrest is the first directly tied to the so-called squawk box investigation being conducted by federal prosecutors in New York and the

Securities and Exchange Commission

. Federal authorities confirmed the arrest, the details of which were revealed in a copy of the criminal complaint obtained by

TheStreet.com

Federal prosecutors last Friday charged Timothy O'Connell, who had worked in Merrill's Garden City, N.Y., branch office up until February, with using "intimidation" to threaten and encourage a witness to lie to a federal grand jury about O'Connell's alleged role in the affair. The witness is identified in court papers as O'Connell's former broker assistant.

O'Connell was arraigned on the charges and released after posting $500,000 bail. His attorney Lee Richards could not be reached for comment.

A Merrill Lynch spokesman had no comment.

To date, prosecutors in the Eastern District of New York and the SEC have not officially commented on the squawk box investigation, which was

first reported last month by

TheStreet.com

. But the 14-page criminal complaint in the case against O'Connell reveals some of the scope of the inquiry.

The complaint says that the investigation began last May and is being aided by two cooperating witnesses, who are former employees of separate daytrading shops. The former daytraders have told authorities that O'Connell permitted daytraders to listen in on the squawk box communications in order to gather information about large block trades.

The informants claim O'Connell enabled the daytraders to eavesdrop on the internal communications "through a telephone line that remained open between the Garden City branch and the daytrading firms throughout the course of the trading day." In return, the daytraders compensated O'Connell by making trades in a Merrill brokerage account and "generating substantial commissions" for the broker.

The complaint does not identify the daytrading firms that allegedly had access to Merrill's squawk box system. But

TheStreet.com

has

reported that

AB Watley

(ABWG)

is one of the daytrading firms caught in the cross hairs of the investigation.

Former Watley CEO John Amore, indicted last summer by federal prosecutors on an unrelated securities offense, is believed to be cooperating with the investigation. Sources familiar with Watley say the brokerage, at various times, offered elite daytraders access to squawk box communications from Merrill,

Lehman Brothers

(LEH)

and

Citigroup's

(C) - Get Report

Smith Barney brokerage group.

Lehman, sources say, recently received a subpoena from federal authorities in conjunction with the probe. People familiar with the inquiry say investigators are focusing on the activities of at least one former Lehman broker. A Lehman spokeswoman declined to comment.

Get a Leg Up

Getting unauthorized access to a brokerage's squawk box system would give a daytrader a big leg up over other traders. That's because getting a tip about a block trade, a single trade of 10,000 or more shares, can be advantageous to traders trying to cash in on sudden price movement in a stock. Such tips could have permitted daytraders to engage in front-running, an illegal practice in which a person buys or sell shares ahead of a trade he suspects will move a stock's price.

In the criminal case involving O'Connell, investigators contend that the SEC has analyzed trading records from the two daytrading firms and "discovered numerous instances" in which daytraders "purchased and sold securities in front of large orders that were subsequently executed by Merrill Lynch's institutional customers," according to the complaint.

For his part, O'Connell, in an interview with federal investigators last June, denied providing daytraders with access to Merrill's squawk box system.

But O'Connell's former assistant, who is not identified by name in the complaint, told authorities earlier this month that O'Connell had indeed provided the daytrading firms with squawk box access.

Back in December, the assistant testified before a grand jury that O'Connell had not provided squawk box access to any daytraders. But in April, the assistant told investigators that the earlier testimony was a lie and that O'Connell had encouraged the assistant to lie to the grand jury.

The assistant said O'Connell said they needed to keep their stories "consistent," according to the complaint. When the assistant questioned the plan, O'Connell allegedly got angry and "slammed his hand against a wall."

The complaint claims the assistant agreed to permit investigators to tape record several phone calls with O'Connell, in which the broker appears to encourage the assistant to keep lying to investigators.

"If they think I lied about this, then they would know I knew about the front-running," O'Connell allegedly told the assistant. In another recorded conversation, O'Connell allegedly said, "If you just stay the course nothing happens. It's over. The only way something happens now is if you change."