Merrill Lynch

(MER)

suspected a broker was providing daytraders with access to confidential stock information months before federal authorities began investigating the matter last spring, according to a criminal complaint unsealed earlier this week.

The complaint says Merrill, in December 2003, conducted an internal investigation into reports that a broker in the firm's Garden City, N.Y., branch office let daytraders eavesdrop on Merrill's internal communications system.

The firm's inquiry ended with Merrill deciding to remove a so-called "squawk box'' communications system from the broker's office. The device was a conduit for Merrill traders to discuss block trades by the brokerage's institutional customers.

Two weeks ago, federal prosecutors charged the broker, Timothy O'Connell, with trying to intimidate a witness into lying to a federal grand jury about his alleged role in the squawk box investigation. The witness, whose identity hasn't been disclosed, was O'Connell's former assistant.

Prosecutors contend that O'Connell enabled traders at two daytrading shops to eavesdrop on Merrill's internal communication system by leaving a phone off the hook for the entire day. In return, the daytraders compensated O'Connell by making trades in a Merrill brokerage account and "generating substantial commissions" for the broker.

Sources say one of the daytrading firms to have listened in to Merrill's internal squawk box system is

AB Watley

(ABWG)

, a small brokerage that confirmed receiving subpoenas from the

Securities and Exchange Commission

.

O'Connell left Merrill's Garden City branch in early February. He has pleaded innocent to the witness-tampering charges.

A Merrill spokesman declined to comment on the complaint's claim that the firm conducted an internal investigation into the matter some five months before federal authorities began their own investigation.

If true, the complaint's contention could raise questions about O'Connell, who was permitted to remain in his job unpenalized, according to a copy of O'Connell's broker registration statement.

The account of Merrill's internal investigation comes from the criminal complaint filed by federal prosecutors against Benjamin Grimaldi, the senior compliance officer for the Garden City office. Grimaldi also was charged with witness-tampering and instructing O'Connell's assistant to lie to the grand jury.

Grimaldi, who has been suspended by Merrill, pleaded innocent to charges during a Monday arraignment.

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has learned that the squawk box removed from O'Connell's office was different from the standard squawk box that many retail brokers use. O'Connell's device was only used to communicate information about big block trades by institutions.

Wall Street brokers usually have access to squawk box intercoms that are used by research analysts to discuss stocks. Historically, "analyst'' squawk boxes have been a source of scorn amongst brokers, with many considering the analyst comments of minimal value.

But the squawk box O'Connell had access to, carrying tips about block trades, is a valuable commodity on Wall Street. Since such trades usually cause price fluctuations in the underlying stock, advance knowledge of them is a major advantage to a market participant who's willing to buy or sell beforehand.

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."

The complaint filed against Grimaldi makes it clear that not all brokers at Merrill had access to a "trading desk'' squawk box. The complaint notes that only O'Connell and "certain brokers'' in the Garden City office, which is one of Merrill's largest branches on Long Island, had access to them.

A broker with another Wall Street firm says it's rare for retail brokers to have access to anything other than an "analyst'' squawk box. The broker said it could even be a conflict of interest for a firm's traders to be sharing information about impending institutional trades with a retail broker.

It's believed that when Merrill pulled the trading squawk box from O'Connell's office, it also removed similar boxes from the offices of other retail brokers. The number of Merrill brokers who had access to the trading boxes is not known.

Meanwhile, Merrill is not the only big brokerage in the cross hairs of investigators. Sources familiar with Watley say the brokerage also offered elite daytraders access to squawk box communications from

Lehman Brothers

(LEH)

and

Citigroup's

(C) - Get Report

Smith Barney brokerage group.

TheStreet.com

previously reported that a person familiar with Watley's operation said the firm worked with at least two Smith Barney brokers to gain access to the big brokerage's squawk box system. In addition, at least one former Lehman broker is being scrutinized.

The identities of the brokers under investigation are not known. But a person familiar with the investigation said the Lehman broker has since moved on to Smith Barney.