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Lynch Pinned
Crawling out of the Merrill mess.


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Larry Kudlow

Merrill Lynch is once again in a heap of trouble. But this time the Wall Street monolith is feeling the heat from Congress, the SEC, and the Justice Department.

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In May, Merrill paid $100 million in conflict-of-interest charges to New York Attorney General Elliot Spitzer after it was found that research analysts at the firm had shilled for investment bankers. This time it’s the investment bankers who shilled for Enron. They provided loans for a sham transaction designed to avoid proper debt scoring and to inflate profits.

Now all hell is descending on the fine old firm of Merrill Lynch. It may turn out that Merrill is charged with willful fraud. Individuals may well go to jail. Undoubtedly, the reputation of this great company will be badly besmirched. And the sad fact is, the folks at Merrill knew better.

You can call it another case of moral amnesia in the financial world. Yet so much of life is a tug-of-war; you’re pulling on one end of the rope while somebody else is pulling on the other. In Merrill’s case, bankers knew full well that big fees could accrue from the Enron transactions. But these very same bankers also knew they would get big bonuses from those fat transaction fees. This, of course, is the age-old dance of seduction.

Who seduced whom? It really doesn’t matter. Both sides were wrong. The off-the-books Enron partnership was part of Enron’s pump-and-dump corporate scam. And the structured finance loan from Merrill Lynch should have never been made to Enron in the first place. Merrill financial chief James Brown made this clear in hand-written notes that labeled the transaction a “reputational risk that aided and abetted Enron income statement manipulation.”

Plenty of Wall Street’s big investment houses have been offered transactions structured around various tax and accounting benefits. But those firms who have maintained their ethical compass have always asked the key questions raised by the IRS and the SEC. Namely, they ask if a transaction has any material economic value or benefit.

Of course, many accounting issues are neither black nor white; there’s a gray area that will ultimately be vetted by accounting or law-enforcement agencies. Honest disagreements are possible. People do not go to jail if their intent was good — if they were creating something of economic value that would benefit the public.

Grown-up banking houses, however, set up numerous management controls to separate the wheat from the chaff, the ethical from the unethical, the legal from the illegal. Well-managed firms force their staffs to jump through numerous hoops before final sign-offs are made on unusual deals. One firm I know of recently created a special investment-banking committee to rule on structured-finance transactions. This same firm also forces its executives to get clearance from a commitment committee, a tax committee, a compliance function, and a credit panel. I’d call this a grown-up, well-managed firm.

Sure, that sounds like a corporate bureaucracy. But the well-run houses know full well that their reputations are on the line, and that business has been very good to them. So they work hard to preserve what they have built over time.

Still, this system broke down somewhere in the Merrill Lynch line of command. Clearly there weren’t enough managerial hoops to jump through and clearly too many senior execs looked the other way. Merrill Lynch will have to replace senior management in order to change its badly-battered and much-abused culture. Shareholders will demand no less.

The firm can survive this, the jobs of the thousands and thousands of honest employees can be maintained, and its equity value can prosper in a new world. In the aftermath of the new securities and accounting legislation recently passed by Congress and signed into law by the president, American business can be revived through more honest accounting, greater information disclosure, and independent corporate governance. Adam Smith’s ethical epicenter that is required of a free market system will be resurrected. Along the way, however, those who chose the wrong path will bear the responsibility for that miscreant decision. Perhaps they too may rise again.



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