The Battle of Bull Run

Last week, we may have found our answer to that mystery, after the release of a series of damaging internal email messages between Blodget and other Merrill employees. The emails, made public by New York State Attorney General Eliot Spitzer, reveal that while Blodget and other Merrill analysts were pumping up Internet stocks in research reports and in television appearances, they were saying something quite different in private — in some instances referring to highly recommended stocks as "crap" and "junk."

Spitzer says the emails are proof that Merrill's analysts maintained high ratings on many companies simply to help the firm secure more investment-banking work. Armed with those emails, he convinced a New York state judge to order Merrill to begin disclosing more information about its investment-banking ties to corporate clients and other potential conflicts of interest in its equity research reports. Merrill has been given until April 19 to comply with the judge's order. Spitzer, meanwhile, is pressing ahead with his 10-month investigation by serving subpoenas for similar email communications at other big brokerages such as Citigroup (C) and Credit Suisse First Boston — and he's hinting that he may even pursue criminal fraud charges in certain cases.

Securities lawyers say Merrill and other Wall Street firms have another headache to deal with: the threat of being inundated with arbitration claims brought by investors who lost a bundle in the dot-com meltdown. Lawyers say the Merrill emails seriously undermine what had been one of the securities industry's standard defenses in arbitration cases: that a firm isn't liable for an investor's losses if a broker recommends a stock based on the research done by one of the firm's analysts. Lawyers say the arbitrators deciding future disputes will view that defense with great skepticism. "[The new evidence] basically throws that kind of defense out of the window," says Jonathan Kord Lagemann, an attorney who represents investors in securities arbitrations. "They have knowingly misled the public."

Indeed, some lawyers are licking their chops following Spitzer's action. Morgan Bentley, a New Jersey attorney, says he's been trying for months to force Merrill to turn over some email communications related to a securities arbitration case he's brought on behalf of a Merrill customer. Up until this point, Merrill has refused to do so, but Bentley says Spitzer's action will give him more leverage to push his claim. Bentley says his client lost $1 million by investing in Internet and technology stocks recommended by Merrill analysts and brokers. "Every other client of Merrill Lynch who relied on these ratings now has a very viable case."

The fear of a tidal wave of arbitration may be one reason Merrill is talking to Spitzer's office about setting up a restitution fund in the "tens of millions of dollars" for customers who lost money in the tech wreck, according to Monday's Wall Street Journal. A Merrill spokesman wouldn't comment on the talks and reiterated that the emails released by Spitzer had been taken out of context. Blodget, who left Merrill in December, referred all inquiries to his former employer.

Of course, it's not just Merrill that has to worry about an onslaught of arbitrations from disgruntled investors. If Spitzer's expanding investigation uncovers similar kinds of damaging evidence at other Wall Street firms, it could expose those firms to litigation as well. Indeed, some lawyers — obviously emboldened by the preliminary findings in the Merrill investigation — are already targeting high-profile analysts at other Wall Street firms. Last Friday, for instance, New York attorney Jacob Zamansky filed an arbitration claim against star telecom analyst Jack Grubman, of Citi's Salomon Smith Barney. Zamanksy claims his client, George Zicarelli, lost $455,000 on shares of Global Crossing (GBLXQ), the now bankrupt telecommunications company. Grubman had been one of Wall Street's biggest boosters of Global Crossing, and Zicarelli allegedly purchased the stock based on Grubman's recommendation. A Citigroup spokesman had no comment on the arbitration.

Zamansky is the same lawyer who pursued the initial arbitration claim against Blodget that ended with Merrill agreeing to pay $400,000 to New York pediatrician Debasis Kanjilal. The doctor claimed to have lost $500,000 on shares of InfoSpace (INSP), a shooting star of a stock that Kanjilal allegedly bought because of Blodget's strong recommendation. In one of the emails released by Spitzer's office, Blodget refers to InfoSpace as a "piece of junk," even though the stock was listed at the time as one of Merrill's favorite picks. In retrospect, Zamansky says, it's "fair to surmise" that Merrill settled the case in an attempt to prevent emails like the one regarding InfoSpace from surfacing.

But what Merrill didn't know was that its quick settlement with Kanjilal would pique Spitzer's interest and ultimately lead to last week's court order and release of damaging emails. Shortly after the settlement, Zamansky says Spitzer's office came to him seeking information about the dispute. From a strategic standpoint, it seems Merrill's quick settlement with Kanjilal — ostensibly to put the matter to rest — might have made things worse for the firm in the end.