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Protect investors from brokers' stock scams: when analysts issue bogus stock recommendations, attorneys can hold them liable for clients' lost savings.

On May 21, 2002, Merrill Lynch, one of the world's largest brokerage firms, agreed to settle a case brought by New York Attorney General Eliot Spitzer alleging that the company defrauded retail brokerage customers.

According to Spitzer, Merrill Lynch issued misleading "buy" recommendations on over two dozen stocks that were followed by its Internet analyst group. (1) The company's goal was to curry favor with the stocks' issuers, in hopes of securing lucrative investment-banking business in the future. (2)

Secretly, however, Merrill Lynch analysts disparaged those stocks in internal e-mails, describing the same stocks they recommended to their customers as "dogs" and "pieces of crap," among other less-than-flattering references. (3) Internally, it was a poorly kept secret that analyst recommendations were little more than a tool to gain investment-banking business and that they bore no relation to the truth about the stocks. (4) In fact, the company makes more money through stock-and-bond underwriting and merger deals than it does selling stocks to its retail customers. (5) Merrill Lynch and other brokerage firms purportedly pay their analysts substantial year-end bonuses based on their success in securing that more lucrative business. (6)

Retail investors have no way of knowing about this inherent conflict of interest. Merrill Lynch mounts slick advertising campaigns touting its "tradition of trust." It makes the following promises, among others, to investors:

* "At Merrill Lynch, the interests of our clients always come first."

* "Your relationship with Merrill Lynch is serviced by professionals committed to the highest standards of integrity."

* "The cornerstone of the Merrill Lynch client relationship is accountability and open communication." (7)

While the "highest standards of integrity" in the securities industry have always fallen well short of any objective measure of the term, investors are only now waking up to how low those "high standards" really are. Unfortunately, the only real value of the New York attorney general's settlement with Merrill Lynch is that it alerts the investing public to how deep the chasm is between reality and the perception of integrity generated by Wall Street advertising campaigns.

The $100 million Merrill Lynch paid to settle the New York case represents only a fraction of its $2.4 billion operating profit--and not a single penny will go to investors who believed the company's recommendations and lost their savings as a result. (8)

In the settlement, Merrill Lynch denied any wrongdoing and yet expressed "regret" that the disparaging e-mails "may have appeared inconsistent with Merrill Lynch's published recommendations." (9) The only way investors who were injured by this conduct will recover is by bringing private actions, which in most cases are restricted to arbitration.

Besides redefining the "highest standards of integrity," Merrill Lynch has likewise redefined "accountability": It has stated that it will "vigorously defend" any actions brought by individual customers to recover the losses they sustained because they took the company at its word. (10) The firm initially responded to the New York attorney general's action in the same fashion, declaring that "there is no basis for [his] allegations. His conclusions are just plain wrong." (11)

Claims against Merrill Lynch and other firms that issue bogus stock recommendations can succeed. Understanding the law will help you reveal the charades brokers use.


The duties owed by those who offer investment advice differ according to the title of the person offering the advice, the type of account the customer has, and the jurisdiction. These distinctions--though largely unknown to the investing public and lawyers who do not practice securities law--can mean the difference between succeeding and failing in an action to recover losses.

Investment advisers. By definition, an investment adviser is "any person who, for compensation, engages in the business of advising others ... as to the value of securities or as to the advisability of investing in, purchasing, or selling securities...." (12) Investment advisers must be registered with either the Securities and Exchange Commission (SEC) or the securities commissioner of the state they are located in, depending on the total amount of assets they manage. (13)

The Supreme Court held 40 years ago that investment advisers are fiduciaries. (14) In that ruling, the Court noted that the committee reports on the Investment Advisers Act of 1940 "indicate a desire to preserve 'the personalized character of the services of investments advisers,' and to eliminate conflicts of interest between the investment adviser and the clients as safeguards both to unsophisticated investors and to bona fide investment counsel." (15)

Many brokerage firms, including Merrill Lynch, offer customers programs that give them access to the firm's professional "money managers"--as the company calls them--who are registered as investment advisers. Such programs establish fiduciary obligations. Enrolled customers should have no trouble convincing a court or arbitration panel that the firm owed a duty to avoid or disclose conflicts of interest like those revealed in the internal Merrill Lynch documents.

Brokers. Federal and state securities statutes define a "broker" as "any person engaged in the business of effecting transactions in securities for the account[s] of others...." (16) But because brokers are expressly excluded from the definition of "investment adviser," (17) the federal laws that establish the fiduciary obligations of investment advisers do not create the same duty for brokers.

Some states, including Georgia (18) and New York, (19) hold that stockbrokers owe a fiduciary duty to their customers. Federal courts have reached the same conclusion. (20) Many jurisdictions, however, have no black-letter rule and instead decide the issue case by case. (21) Perhaps the most significant factor for courts in those jurisdictions is whether the brokerage account was discretionary or nondiscretionary.

Discretionary versus nondiscretionary accounts. Discretionary accounts allow the broker to make trades in a customer's account without obtaining prior approval. Industry rules require that the customer sign paperwork that gives the broker discretionary control over the account. (22) Brokers who exercise discretion without the approval paperwork are subject to discipline by the National Association of Securities Dealers, Inc. (NASD), a private, non-profit organization that regulates this country's securities firms.

All jurisdictions recognize the fiduciary obligations of a broker who has discretionary control over a client's account. (23) Because brokerage firms recognize that discretionary authority increases liability exposure, many prohibit their salespeople from accepting it. Most brokerage accounts are nondiscretionary, meaning that the salesperson must obtain prior approval for every transaction.

In practice, many securities salespeople exercise discretion without the proper paperwork. Many customers, not appreciating the difference between the two types of accounts, informally allow their brokers to exercise discretion, trusting that the broker will use his or her expertise to make good decisions about what to buy and sell, and when. Only when a dispute arises and the broker denies exercising discretionary control does the customer realize that his or her trust was misplaced and that the law may not hold the broker accountable for the breach.

Plaintiff lawyers facing brokerage firms in stock-analyst cases should argue that the most basic of legal duties--the duty of due care--requires full disclosure of material facts and prohibits a firm from lying to its customers. A lie establishes the breach of a duty to tell the truth. Merrill Lynch's e-mails and other internal documents directly contradict some of the company's public "buy" recommendations and, therefore, establish that the firm lied to its customers.

In its investigations of Merrill Lynch and other brokerage firms, the New York attorney general's office subpoenaed "self-evaluation" memos prepared by research analysts in connection with annual reviews used to determine bonuses.

Media reports indicate that in those memos, analysts admitted a direct connection between their recommendations and the amount of investment-banking fees their firms earned. (24)


For customers with discretionary accounts, causation is clear because the brokerage firm, not the customer, decided what stocks to buy and when. The mere purchase of disparaged securities in a customer's discretionary account may establish liability.

Causation is not as obvious for customers with nondiscretionary accounts. However, the Uniform Securities Act--the basis of 36 states' blue-sky laws regulating the sale of securities (25)--does not require that the customer prove reliance on an analyst's bogus recommendation. (26) The only causal connection needed is privity between the customer and the brokerage firm that issued the recommendation. Therefore, customers bringing liability claims against Merrill Lynch under most states' blue-sky laws can prove causation simply by showing that they bought the stocks in question from the firm while the sham recommendation was in effect.

Customers pursuing common law fraud claims and claims under federal securities laws, however, must prove reliance on the analysts' recommendations. To do this, the client should gather every piece of paper he or she received from the brokerage firm.

The company may have sent the customer a hard copy of the analysts' reports. Monthly account statements at many firms, including Merrill Lynch, note analysts' recommendations on all stocks in the customer's account. While ratings on stocks already in the customer's account obviously could not have led to the initial purchase, the customer may have relied on them in deciding to make subsequent purchases and to keep the stocks after their prices declined.

Finally, trade confirmations, sent to customers after every trade, are to be marked "solicited" for trades recommended by the stockbroker. (27) The confirmation of a "solicited" trade might be all a customer needs to prove reliance. Though it is not uncommon for brokers to deliberately mismark trades to cover up inappropriate recommendations, an order marked "solicited" will defeat the firm's defense that the customer ordered the purchase without any input from the company.


Most state securities acts provide for rescissory damages when a sale involves fraud, deceit, or a material misrepresentation or omission of fact. For example, the Georgia Securities Act provides that
 damages are the amount which equals the
 difference between the fair value of the consideration
 the buyer gave for the security and
 the fair value of the security at the time the
 buyer disposed of it, plus interest thereon
 from the date of payment down to the date of
 repayment.... (28)

The statute also provides for recovery of "taxable court costs and reasonable attorney's fees." (29)

When a brokerage firm elevates its own financial interests above those of its customers, this breach of fiduciary duty warrants punitive damages. Arbitration panels can impose punitive damages, though they award them less often than juries do. Appellate courts have affirmed these awards. (30)


Virtually every brokerage firm includes a predispute arbitration clause in the documents it uses for opening client accounts, and the courts--including the U.S. Supreme Court--have uniformly enforced them. (31) Therefore, most customers will be forced to pursue their claims in arbitration. Depending on the terms of the agreement, these proceedings are usually conducted by self-regulatory organizations (such as the NASD and the New York Stock Exchange) or by the American Arbitration Association. (32)

While arbitration proceedings generally are less formal than trials, customers must have experienced counsel to succeed. The three arbitrators who will decide the case--including one from the securities industry (33)--typically are educated professionals, often attorneys.

The hearing is conducted much like a court trial, following specific rules of procedure issued by the arbitration forum. It often involves complex issues of securities law. Only counsel who understand the rules and regulations governing the securities industry will recognize and obtain the documents necessary to prove his or her client's case. (34) An attorney new to this field may want to recruit cocounsel to help with the arbitration.

W.C. Fields said, "Never give a sucker an even break." Investors are learning the hard way that the securities brokerage industry has been following his advice. Knowledgeable counsel can help investors hold brokerage firms accountable for their misconduct.


(1.) Press Release, Merrill Lynch, Merrill Lynch Announces Agreement with New York State Attorney General (May 21, 2002), available at

(2.) Affidavit of Eric R. Dinallo, Assistant Attorney General of the State of New York, on behalf of Eliot Spitzer, Attorney General of the State of New York (New York County Sup. Ct. Apr. 8, 2002).

(3.) Id. at 10-11.

(4.) Id. at 3-5, 10-22.

(5.) Merrill Lynch 2001 Annual Report to Shareholders, at 19, available at

(6.) Charles Gasparino, Latest Fuel in Analyst Probe: "Bonus" Memos, WALL ST. J., May 30, 2002, at C1.

(7.) See Merrill Lynch Web site at askmerrill.,2603,,00.html.

(8.) Pradnya Joshi, Merrill Lynch Agrees to Pay $100M, Make Reforms, NEWSDAY, May 22, 2002, at A07. Under the terms of the settlement. $48 million will go to New York State and $52 million will go to other stales.

(9.) See Press Release, supra note 1.

(10.) Joshi, supra note 8, quoting Merrill Lynch President and Chief Operating Officer Stan O'Neal.

(11.) Press Release, Merrill Lynch, Merrill Lynch Statement on Action by New York State Attorney General (Apr. 8, 2002k available at

(12.) 15 U.S.C. [section] 80b-2(a)(11) (2000).

(13.) Id. [section] 80b-3.

(14.) Sec.& Exch. Comm'n v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963).

(15.) Id. at 191 (emphasis added).

(16.) 15 U.S.C. [section] 78c(a)(4).

(17.) Id. [section] 80b-2(a)(11).

(18.) See, e.g., Glisson v. Freeman, 532 S.E.2d 442, 449 (Ga. Ct. App. 2000): Minor v. E.F. Hutton & Co., 469 S.E.2d 262, 264 (Ga. Ct. App. 1991).

(19.) See, e.g., Busch v. L.F. Rothschild & Co., 259 N.Y.S.2d 239 (App. Div. 1965).

(20.) See, e.g., Rolf v. Blyth Eastman Dillon & Co., 424 F. Supp. 1021, 1036 (S.D.N.Y. 1977).

(21.) See. e.g., McAdam v. Dean Wirier Reynolds, Inc., 896 F.2d 750. 766-67 (3d Cir. 1990) (New Jersey law); Caravan Mobile Home Sales, Inc. v. Lehman Bros. Kuhn Loeb. Inc., 769 F.2d 561,567 (9th Cir. 1985) (California law).

(22.) Nat'l Ass'n of Sec. Dealers Conduct Rule 2510(b).

(23.) See, e.g., Thropp v. Bache Halsey Stuart Shields, Inc., 650 E2d 817,820 (6th Cir. 1981); Rupert v. Clayton Brokerage Co. of St. Louis. 737 P.2d 1106, 1110 (Colo. 1987); Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Boeck, 377 N.W.2d 605, 608 (Wis. 1985).

(24.) Gasparino, supra note 6.

(25.) Arizona, California, Florida. Georgia, Illinois, Louisiana. Maine, New York, North Dakota, Ohio, Rhode Island, South Dakota. Texas, and Vermont have yet to adopt the Uniform Securities Act.

(26.) Gohler v. Wood, 919 P.2d 561,565-66 (Utah 1996).

(27.) Confirmations marked "unsolicited" indicate trades initiated by the customer.

(28.) GA. CODE ANN. [subsection] 10-5-12, 10-5-14 (1997).

(29.) Id. [subsection] 10-5-14(a).

(30.) See Mastrobuono v. Shearson Lehman Hutton, Inc., 514 U.S. 52 (1995): Sanders v. Gardner, 7 E Supp. 2d 151 (E.D.N.Y. 1998); Greenway Capital Corp. v. Schneider, 494 S.E.2d 287 (Ga. Ct. App. 1997).

(31.) See Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220 (1987).


(33.) Id, [section] 1-10.

(34.) Id. [section] 6-2.

Pat Huddleston II and Jason L. Nohr are partners with Huddleston & Nohr in Marietta, Georgia. Rhon E. Jones is a shareholder with Beasley, Allen, Crow, Methvin, Portis & Miles in Montgomery, Alabama.
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Author:Nohr, Jason L.
Date:Apr 1, 2003
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