Massachusetts Says Merrill Defrauded ARS Clients

It just keeps getting worse for big named Wall Street firms. Today, William Galvin, secretary of the Commonwealth, announced that he is suing Merrill Lynch for fraudulent auction-rate securities (ARS) sales.

It just keeps getting worse for big named Wall Street firms. Today, William Galvin, secretary of the Commonwealth, announced that he is suing Merrill Lynch for fraudulent auction-rate securities (ARS) sales.

(No doubt allegations of ARS fraud will hit other firms, too. New York Attorney General, Andrew Cuomo, and Galvin are also currently suing UBS regarding ARS sales. UBS, the poster child for horrible risk control, settled a related matter with the Massachusetts’ attorney general yesterday, ponying up $4.4 million for misleading auction-rate securities sales. That’s right: UBS was sued by two Massachusetts officials. UBS did not admit any wrong doing in settling with the Mass AG.)

Let’s presume that Merrill is innocent of Galvin’s charges. After all, Merrill is entitled to defend itself in a court of law. Still, the allegations in the complaint, if true, are damning. They are sure to make a lot of Merrill retail clients—and their financial advisors—angry. Among the sensational claims: Merrill management censored otherwise gloomy fixed income research in order to move volatile inventory out of company inventory and into client portfolios. Oy.

Read the full complaint here. Here’s a snippet of the censorship allegation from Galvin’s complaint:

“Specifically, Merrill Lynch permitted its Sales and Trading, including Auction Desk, managers to unduly influence and pressure the Research Department in a number of ways. First, it allowed Sales and Trading to directly request and advocate for written research to be published endorsing the safety and high quality of nearly all types of ARS and recommending investors buy ARS.”

It continues:

“In one instance, a managing director in charge of Merrill’s auction desk, Frances Constable, directly emailed Martin Mauro, a fixed income analyst in the research department, with the following:

“Any renewed research focusing on the high quality of closed end fund preferreds of ALL tax status, auction municipal bonds and student loan backed bonds, wrapped around the value added proposition of today’s rates would be extremely helpful.”

One of those research reports, published February 4th by Martin Mauro and Kevin Conery, (a copy was obtained by Registered Rep. and excerpted in our May cover story) has been referenced by many angry Merrill Lynch FAs who trusted its findings: namely, that ARS were the “conservative’s conservative security.” Of course, eight days later Merrill and several other firms pulled out of the ARS marketplace, stranding ARS retail investors with illiquid, long-term debt.

Constable is also quoted later in the complaint instructing another fixed income research analyst, Kevin Conery, to “shut down” a Merrill Lynch financial advisor who called in during a conference call on ARS, to express his concern. “Shut this guy down,” she said, according to the complaint. “Suggest he call outside the call. He is focusing attention away from your positive message.”

A Merrill Lynch spokesman issued the following statement:

“We are disappointed that Massachusetts filed this action because it ignores the only reason our advisors sold auction rate securities: They believed they were good investments for clients willing to trade some liquidity for higher return.
The inarguable fact is the number of auctions that had failed in nearly two decades of ARS sales was small. In 2007 there were no failed auctions of securities sold to retail clients and, in fact, none to these clients until late January 2008.”

As for the allegations regarding research, the spokesman said: “Our research reflected the honest belief that ARS offered higher returns in exchange for less liquidity and noted that market changes had begun to occur.”

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