State charges Merrill with investor fraud

Firm told analysts to downplay debt risks, Galvin says

Massachusetts regulators yesterday charged Merrill Lynch & Co. with fraud and unethical conduct in the sales of auction-rate securities, alleging that the Wall Street firm pressured research analysts to publish misleading reports on the investments and failed to warn customers about the risks in the market.

The complaint, filed by Secretary of State William F. Galvin's office, cites e-mails from Merrill Lynch management urging research staff to write positive reviews of the securities - which brokers at many firms were selling as safe alternatives to money market funds, right up until the auction-rate market collapsed in mid-February.

The state said Merrill sold about $95 million in auction-rate securities to 165 Commonwealth investors in January and February, even as executives knew the market could fail. "We now find out that research was corrupted and investors were disadvantaged. That's really troubling," Galvin said in an interview.

Merrill defended its research practices and denied wrongdoing. "Our research reflected the honest belief that [auction-rate securities] offered higher returns in exchange for less liquidity and noted that market changes had begun to occur," the firm said in a statement. Analysts, the firm added, called the market "as they saw it, not the way anyone else did."

But last August, as problems in the subprime market were bubbling over to the auction market, a managing director in charge of Merrill's auction desk, Frances Constable, directly e-mailed a fixed-income analyst to say, "Any renewed research focusing on the high quality of [auction-rate securities] . . . would be extremely helpful."

In another instance, the complaint said, Constable objected to a research report pointing out that auction-rate securities could be harder to cash out of than other securities, and asked that it be retracted and rewritten. In an e-mail, she complained that the piece could "single-handedly undermine the auction market." The research department acquiesced, according to the complaint, declaring the securities a "buying opportunity" in a revised report.

Merrill denied any material changes to the report. Constable, the firm said, "was entitled to voice her views, just as the analysts were entitled to ignore them. And her opinions did not change the views of our analysts."

Analysts provide research to brokerage clients and to the brokers themselves, who often rely on that information when they sell stocks, bonds, and other products to investors.

Auction-rate securities offered a way for nonprofits, municipalities, and investment funds to borrow money cheaply, while giving investors slightly better returns than a money market account. But the $330 billion market only worked as long as investment banks attracted buyers to regular auctions.

In November, Constable's internal e-mails were openly discussing the troubles in the auction-rate market, according to the complaint. Yet as late as Feb. 4 - days before the market failed - Merrill Lynch researchers were declaring the investments "the conservative's conservative security." By Feb. 13, the market had shut down, trapping billions of investors' dollars.

Constable declined to comment yesterday.

Brokers at most major firms were kept in the dark about the mounting risks in the market starting last fall, as the Globe has previously reported. The state said it found the same lack of awareness among Merrill brokers. Not only did management fail to inform brokers of the risks, the state alleged, but the research staff allegedly was persuaded to downplay the looming trouble they saw in the market.

Merrill says its brokers did know the risks of auction-rate securities, saying "they believed they were good investments for clients willing to trade some liquidity for higher return."

Conflicts in research have been a problem on Wall Street before. Merrill and other firms paid combined fines of more than $1 billion after investigations in 2002 revealed analysts hyped dot-com stocks to help their investment-banking business and pump up share prices. Galvin said he was dismayed to find new research problems at Merrill.

Merrill is the second Wall Street firm Galvin has targeted in his auction-rate probe. In June he filed fraud charges against UBS Financial Services Inc., alleging the brokerage misled customers about the auction-rate market. The Swiss investment bank also faces charges in New York and Texas. In a separate settlement with Massachusetts Attorney General Martha Coakley, UBS agreed to pay $40 million in restitution and fines for auction-rate securities illegally sold to Massachusetts towns and cities.

Galvin is also investigating Bank of America Corp.'s handling of auction-rate investments.

Yesterday, Massachusetts Representative Barney Frank, chairman of the House Financial Services Committee, said he would hold hearings on auction-rate securities starting on Sept. 18, "to examine the continuing crisis."

Beth Healy can be reached at bhealy@globe.com.