, the nation's largest brokerage firm,
recently settled an arbitration lawsuit brought by a former client who claimed he was misled by technology analyst Henry Blodget. The plaintiff argued that Blodget maintained a buy rating on broadband services provider
in order to facilitate a lucrative financial deal for Merrill. The firm agreed to pay $400,000 to Debases Kanjilal, a 46-year-old physician who said he lost $500,000 after choosing to hold on to the stock based on Blodget's bullish call.
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In today's Daily Interview, Jack Coffee, a law professor at
, discusses the settlement and its implications for other brokerages, which have come under increasing scrutiny lately on conflict of interest issues. Coffee previously worked as a corporate lawyer with Cravath Swaine & Moore and serves as a member of the
Securities and Exchange Commission's
Advisory Committee on the Capital Formation and Regulatory Processes and of the Legal Advisory Board to the
National Association of Securities Dealers
TSC: In light of the Merrill Lynch settlement, what do you see happening in terms of analysts' coverage of companies that might be investment banking clients of their firms?
Well, I think the safest prediction is that litigation is always subject to a copycat phenomenon and that imitation is the sincerest form of flattery. So I expect there will be other attorneys, and other claimants represented by the same attorney, who will raise similar claims involving both Merrill and Mr. Blodget, and a variety of other investment banking houses and well-known analysts.
TSC: What sort of impact will the settlement have on the credibility of sell-side analysts as a whole?
I think it's probably more a product of their declining credibility, than a new blow. I want to emphasize, though, that the fact that there will be other arbitration proceedings does not mean that they're likely to be highly successful. I would predict very inconsistent outcomes. Arbitration is never bounded by rules and precedents the way a court is, and, moreover, I think that if the same action had been brought in federal court, it would probably have been dismissed because the plaintiff would have lacked standing under what's called the Purchaser's Seller Doctrine to assert a rule of 10B-5 violation.
TSC: Can you elaborate on that?
The essential claim, as we understand it, in this case is that
the plaintiff continued to hold the stock based on a strong buy recommendation put out by Mr. Blodget and that buy recommendation was materially misleading because it failed to disclose Mr. Blodget's alleged conflict of interest.
Now, in general, a plaintiff cannot sue in federal court unless they purchased or sold the security based on materially false or misleading information. Here we're talking about someone who is continuing to hold. Under a
decision or line of decisions that begins with the Blue Chip case 25 years ago, a person who simply says they continued to hold cannot sue under 10B-5. The Supreme Court was concerned that merely allowing holders to sue because they continued to hold would invite a lot of fabricated litigation.
TSC: Merrill Lynch recently said that it has implemented a policy under which it restricts analysts from owning any of the stocks they are covering. Do you think this policy of policing themselves will work in eliminating conflicts of interest?
I don't mean to criticize Merrill for introducing that fairly strong, fairly prophylactic constraint, but I don't think that's the principal conflict of interest. This case tends to illustrate what the more typical conflict is, namely, that analysts are really employed by, report to, or are closely associated with the underwriting side of the business.
And that the underwriting side of the business is deal-driven, and thus the analyst is aware, and sometimes he is made painfully aware, that a particular issuer is a client and that an adverse rating or an adverse comment by the analyst will hurt a client and reduce revenue to the firm. That produces the real conflict.
What's happened, frankly, over the last 10 years is we've moved from a world in which securities analysts were formerly principally compensated based on brokerage commissions paid by institutional investors, to a new world in which their compensation is increasingly derived from investment banking revenues, thus coming from issuers. Over the last 10 years, we've seen the ratio of buy recommendations to sell recommendations move from 6 to 1 to something closer to 100 to 1. I think that reflects a change in where the revenue is coming from. It's coming less from brokerage commissions because of competition and more from underwriting revenues, and that makes the analyst much more closely aligned with the underwriting side of the business.
TSC: Arbitration cases typically do not set a precedent. Does that hold true for this particular case?
There's clearly no precedent when dealing with arbitration. There is, however, a recovery and incentives for other lawyers and for other clients to raise these claims. Arbitration is always a little unpredictable, always a bit of rolling the dice. Again, I think there will be very inconsistent outcomes.
For the individual investor who sustained large losses, there is very little downside in bringing an arbitration proceeding. You won't be held liable for costs, and if you can get an attorney to take it on a contingent fee basis, you basically have little at risk.
Now, what will not happen is that we will not see a class action, or at least a successful class action, because I don't think such a case can be easily certified as a class. Secondly, small claimants will not be able to assert any legal remedy because they're not willing to pay the cost of an attorney on an hourly basis, and most plaintiff's counsels are not interested in getting one-third of a $10,000 recovery. They have to see a much larger recovery before they're going to seriously invest in the case and prepare for it.
So the people that come out of the woodwork, if they do, will be large claimants that have $100,000 losses or greater -- that's sort of the break point for the claims being asserted.