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June 30, 2003

In re MERRILL LYNCH & CO., INC. Research Reports Securities Litigation In re Merrill Lynch & Co., Inc. 24/7 Real Media, Inc. Research Reports Securities Litigation In re Merrill Lynch & Co., Inc. Interliant, Inc. Research Reports Securities Litigation

The opinion of the court was delivered by: MILTON POLLACK, Senior District Judge.


Defendants Merrill Lynch & Co., Inc. (ML & Co.) and its wholly-owned subsidiary Merrill Lynch, Pierce, Fenner & Smith Inc. (MLPF & S) move to dismiss the amended class action complaints in the 24/7 Real Media, Inc. (24/7) and Interliant, Inc. (Interliant) consolidated actions for, inter alia, (1) failure to state a claim upon which relief can be granted, pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, and (2) failure to plead fraud with particularity, as required by the Private Securities Litigation Reform Act of 1995 (Reform Act) (see 15 U.S.C. § 78u-4(b)) and Rule 9(b) of the Federal Rules of Civil Procedure. Individual defendant Henry Blodget (Blodget) joins the motion.*fn1 For the reasons set forth below, the motion is granted.

  In deciding a motion to dismiss under Rule 12(b)(6), this Court, "accepting all factual allegations in the complaint as true and drawing all reasonable inferences in the plaintiffs' favor,"*fn2 must dismiss the action if "it is clear that no relief could be granted under any set of facts that could be proved consistent with the allegations."*fn3 The Court's role is "to assess the legal feasibility of the complaint, not to assay the weight of the evidence which might be offered in support thereof."*fn4 "General, conclusory allegations need not be credited, however, when they are belied by more specific allegations of the complaint."*fn5

[273 F. Supp.2d 356]


  In the fraud context, plaintiffs do not enjoy a "license to base claims . . . on speculation and conclusory allegations."*fn6 Federal Rule of Civil Procedure 9(b) requires that "[i]n all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity." The Second Circuit has held that, at a minimum, the complaint must identify the statements plaintiff asserts were fraudulent and why, in plaintiff's view, they were fraudulent-specifying who made them and where and when they were made.*fn7 This particularity requirement is reinforced by the Reform Act, in which Congress required that all private securities class action complaints alleging material misrepresentations or omissions "shall specify each statement alleged to have been misleading [and] the reason or reasons why the statement is misleading."*fn8

  In deciding a Rule 12(b)(6) motion, the Court may consider the following materials: (1) facts alleged in the complaint and documents attached to it or incorporated in it by reference,*fn9 (2) documents "integral" to the complaint and relied upon in it, even if not attached or incorporated by reference,*fn10 (3) documents or information contained in defendant's motion papers if plaintiff has knowledge or possession of the material and relied on it in

[273 F. Supp.2d 357]

      framing the complaint,*fn11 (4) public disclosure documents required by law to be, and that have been, filed with the Securities and Exchange Commission,*fn12 and (5) facts of which judicial notice may properly be taken under Rule 201 of the Federal Rules of Evidence.*fn13


  The two cases before the Court are part of a large group assigned to this Court by the Multidistrict Panel for consolidated administration. These cases, and the New York Attorney General's report which precipitated them, brought to specific public attention certain aspects of the internal operations in securities firms that had notoriously and long existed and had been variously publicized but not focused on as undesirable conflicts that should be ameliorated, modified, conceivably controlled or eliminated.

  Securities firms had traditionally employed on their rosters paid professional analysts to furnish their opinions and predictions of future targets of prices for the securities being handled by the firms, in effect "risk advisors." Those opinions and predictions were broadcast extensively and distributed free of charge. No customer relationship with defendants is claimed by the plaintiffs; no fiduciary or contractual relations existed, at least none is claimed.

  Those analyst "seers" and their employers have been faulted in the present cases with having conflicting self-interests which influenced and impaired the publicized advice and opinions by exhortations of "BUY" advice and "Target" expectations to market speculators in the then popular internet field.

  At the times here involved, the stock markets were in the throes of a colossal "bubble" of panic proportions. Speculators abounded to capitalize on the opportunities presented by this bubble.

  The market "bubble" burst intervened before plaintiffs got out of their holdings and their holdings lost value. The plaintiffs, learning of the subsequent actions of the regulators concerning the conflicts mentioned above, rushed to the courts in these cases seeking to recover the losses they experienced due to the intervening cause, the burst of the bubble.

[273 F. Supp.2d 358]


  The companies involved herein were duly registered with the SEC. Their assets, liabilities and economics were there disclosed for any holder or purchaser including these plaintiffs to evaluate at his own risk. What was missing, was what a willing buyer would pay to a willing seller to own the stock-with all the relevant information of the fully published underlying corporate values there for everyone to see and evaluate.

  In the euphoric early phase of the bubble experienced by the market-buyers of stock traded in the optimistic expectation of finding someone who valued acquiring and possessing the stock at a level higher than the holder did-even if some of the risk analysts of the stock privately had doubts from time to time, on price, future market value, but not underlying assets.

  The risk manager's forecasts on future price were both correct and incorrect-depending on the timing of the mercury level in the market thermometer. "Buy" or "accumulate" opinion was an appraisal of the direction of the unsteady market fever. Those who listened to those prognostications were rewarded with huge paper profits if they cashed in — depending on the cycle of the bubble. Others missed out with the collapse of the fever.


  The record clearly reveals that plaintiffs were among the high-risk speculators who, knowing full well or being properly chargeable with appreciation of the unjustifiable risks they were undertaking in the extremely volatile and highly untested stocks at issue, now hope to twist the federal securities laws into a scheme of cost-free speculators' insurance. Seeking to lay the blame for the enormous Internet Bubble solely at the feet of a single actor, Merrill Lynch, plaintiffs would have this Court conclude that the federal securities laws were meant to underwrite, subsidize, and encourage their rash speculation in joining a freewheeling casino that lured thousands obsessed with the fantasy of Olympian riches, but which delivered such riches to only a scant handful of lucky winners. Those few lucky winners, who are not before the Court, now hold the monies that the unlucky plaintiffs have lost-fair and square-and they will never return those monies to plaintiffs. Had plaintiffs themselves won the game instead of losing, they would have owed not a single penny of their winnings to those they left to hold the bag (or to defendants).

  Notwithstanding this — the federal securities laws at issue here only fault those who, with intent to defraud, make a material misrepresentation or omission of fact (not opinion) in connection with the purchase or sale of securities that causes a plaintiff's losses. Considering all of the facts and circumstances of the cases at bar, and accepting all of plaintiffs' voluminous, inflammatory and improperly generalized allegations as true, this Court is utterly unconvinced that the misrepresentations and omissions alleged in the complaints have been sufficiently alleged to be cognizable misrepresentations and omissions made with the intent to defraud. Plaintiffs have failed to adequately plead that defendant and its former chief internet analyst caused their losses. The facts and circumstances fully within this Court's proper province to consider on a motion to dismiss show beyond doubt that plaintiffs brought their own losses upon themselves when they knowingly spun an extremely high-risk, high-stakes wheel of fortune.

  Defendant ML & Co. is a holding company through which defendant MLPF & S provides research, brokerage, and investment banking services. From February

[273 F. Supp.2d 359]

      1999 through December 2001, defendant Blodget was a first vice president of Merrill Lynch and its primary analyst for companies in the internet sector. During the putative class periods, Merrill Lynch issued research reports on a number of different internet companies, including 24/7 and Interliant. Many of these reports included analysts' opinions on whether investors should buy the stocks at issue.

  Plaintiffs are those investors in 24/7 and Interliant stocks who, during the putative class periods, purchased shares in the respective companies and subsequently lost money.*fn14 Suing to recoup these losses, they allege that the predictions expressed in Merrill Lynch research reports caused their losses. Reliance is alleged through the fraud-on-the-market theory. None of the plaintiffs alleges actually to have seen or read the analyst reports themselves. Indeed, none of the plaintiffs claims to have been a customer of Merrill Lynch or to have purchased the securities through Merrill Lynch; all concede that they were non-client purchasers.*fn15

  Plaintiffs allege that the analyst opinions expressed in the research reports were materially misleading and violated Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 promulgated thereunder by the Securities and Exchange Commission. In support of the fraud allegations, plaintiffs rely almost exclusively on, and quote heavily from, an affidavit prepared by Eric Dinallo of the New York State Attorney General's Office (Dinallo affidavit).*fn16 The affidavit, filed April 8, 2002-more than a year after the close of the two class periods-detailed the efforts of the New York Attorney General to investigate defendants' internet research group.

  The Dinallo affidavit was offered in support of an application before the New York state courts for an order, pursuant to New York state law, requiring Merrill Lynch employees to turn over documents and give testimony in the Attorney General's continuing investigation into whether defendants violated New York state law. Soon after the affidavit became public, plaintiffs filed these federal class action suits (now consolidated before this Court) against defendants alleging violations of the federal securities laws, including the federal provisions mentioned above. The Dinallo affidavit notes that the state regulations pursuant to which the Attorney General proceeded impose entirely different legal requirements. "Unlike the federal securities laws," the affidavit states, "no purchase or sale of stock is required, nor are intent, reliance, or damages required elements of a violation."*fn17

 The research reports

  The internet research group at Merrill Lynch prepared two main kinds of reports on the companies that they followed: (1) quarterly Sector Reports (or "Quarterly Handbooks") containing in-depth analyses of the industry and each company in the

[273 F. Supp.2d 360]

      sector covered by Merrill Lynch, and (2) reports focusing on one particular company that took the form of comments, bulletins and notes, which were generally issued in response to news from the issuer or new developments or trends affecting the company that was the subject of the report (hereinafter Company Reports).*fn18 These reports were sometimes just a few letter-sized, single-spaced pages in length, and other times were several pages or more in length.

  The reports show that the internet issuer companies were the primary sources of information for the Merrill Lynch analysts in forming their opinions. Plaintiffs make no allegation that any of the company-related information relied on by the analysts in preparing the reports was in any way false, nor do they allege that the analysts made up facts or misrepresented facts about any of the companies in any of the reports. Rather, plaintiffs allege in the main that the analysts misrepresented their true opinions in the reports (viz., opinions as to whether the stocks should or should not be purchased at the relevant times) and did not disclose certain alleged conflicts of interest within the Merrill Lynch brokerage house. In their brief, plaintiffs also claim-as they must, if they are to have any hope of satisfying federal securities fraud pleading requirements-that their complaints adequately show that these alleged misrepresentations and non-disclosures were material, were made with scienter, were relied upon by them in making their purchases, and ultimately resulted in their losses.

  There were approximately forty-four Company Reports issued (at irregular intervals) with respect to 24/7 Real Media, Inc. during the alleged 24/7 class period, which stretches from May 12, 1999 through November 9, 2000. There were approximately thirty-four Company Reports issued (also at irregular intervals) with respect to Interliant, Inc. during the alleged Interliant class period, which stretches from August 4, 1999 through February 20, 2001.

  The analyst reports discussed the companies' financial reports and revenue information, their respective business models and strategy, and the issuers' own estimates of future performance.*fn19 The reports frequently contained a description of the analysts' opinions as to the company's competitive position in the industry, including evaluations of comparable companies. In addition, the reports included the analysts' financial models and projections for the companies, evaluations of past company performance against such models and projections, as well as discussion of estimates and projections by other analysts. All told, these evaluations-none of which are alleged to be false or misleading in their factual underpinnings or in their methodology-provided background and support for the analysts' opinions on whether the individual stocks might be considered for purchases or for sales.

[273 F. Supp.2d 361]


  Each of the company-specific research reports about which the 24/7 and Interliant plaintiffs complain carried a rating consisting of a two-part designation: (1) a letter (either A, B, C, or D) representing the analysts' opinion of the stock's "Investment Risk Rating," coupled with (2) a pair of numbers (each a numeral between 1 and 5) designating the analysts' opinion of the "Appreciation Potential" of the stock over time.

  An Investment Risk Rating of "A" denoted the lowest level of risk. A stock with an "A" rating was expected to exhibit "modest price volatility," and typically represented a company with strong balance sheets, demonstrated long-term profitability, and "stable to rising dividends." A "B" rating meant that the stock was "expected to entail price risk similar to the market as a whole," and represented a company that had "demonstrated the ability to produce above-average sales, profits and other measures of leadership within its industry." A "C" rating indicated "above average risk," and represented companies with balance sheets that were average or below average for their respective industries. The "C" companies in many cases were new to the industry or had erratic earnings.

  A "D" rating, which the analysts assigned to all Internet companies including 24/7 and Interliant, denoted the highest level of risk. In addition to having all of the characteristics of a "C" issuer, "D" companies were so designated because of the analysts' opinion that the company's stock had a "high potential for price volatility." One or more of the following factors, among others, could have led to a company's receiving a "D" rating: untested management, lack of earnings history, or heavy dependence upon one product or service.

  As noted above, the Investment Risk Rating for each stock was coupled with a pair of numbers. The two numbers, each a single digit between one and five, represented the analysts' opinions of the stock's Appreciation Potential. The first digit reflected the analyst's prediction of how the stock would perform over the short term, i.e., within 0-12 months, and the second digit represented the analyst's prediction of performance over the intermediate term, i.e., 12-24 months. The digits signified the following estimates:
1 BUY: Issue was considered to have particularly attractive potential for appreciation and was estimated to appreciate by 20% or more within the given time frame.
2 ACCUMULATE: Issue was considered to have attractive potential for appreciation and was estimated to appreciate by 10-20% within the given time frame.
3 NEUTRAL: Issue was considered to have limited potential for appreciation and was estimated to appreciate/decline by 10% or less within the given time frame.
4 REDUCE: Issue was considered too unattractive for appreciation and was estimated to decline by 10%-20% within the given time frame.
5 SELL: Issue was considered to be particularly unattractive for appreciation and was estimated to decline by 20% or more within the given time frame.
Thus, a rating of D-1-2 meant that the stock at issue was highly volatile and estimated to appreciate by 20% or more within the immediately following 12 months and 10-20% for the 12 months following that (i.e. the period stretching 12-24 months after issuance of the report).


  To recover damages in a private cause of action under Rule 10b-5, a plaintiff

[273 F. Supp.2d 362]

      must plead and prove-among other elements-loss causation. "To establish loss causation a plaintiff must show[ ] that the economic harm that it suffered occurred as a result of the alleged misrepresentations." Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1495 (2d Cir. 1992) (emphasis in original).

 1. Loss causation is missing from plaintiffs' pleadings

  "Loss causation developed exclusively out of case law and was never expressly recognized by the Supreme Court."*fn20 In the Private Securities Litigation Reform Act of 1995 (Reform Act),*fn21 however, Congress codified a uniform loss causation standard and made it applicable to all securities fraud suits of the kind presently before the Court. To cope with the the scandals associated with such class suits, Congress enacted the so-called "Loss Causation" provision:
(4) Loss causation
In any private action arising under this chapter, the plaintiff shall have the burden of proving that the act or omission of the defendant alleged to violate this chapter caused the loss for which the plaintiff seeks to recover damages.*fn22
This was necessary in the Reform Act for the goal entitled in the legislation:
sec.101. private securities litigation reform.
  Plaintiffs were explicitly reminded in this Court's Case Management Order No. 3, well prior to framing the allegations in the consolidated amended complaints, that they should give careful attention to pleading loss causation:
Consolidated amended complaints should also be carefully framed in order that they may fully comply with all applicable law regarding the pleading of loss causation.
Plaintiffs have failed to heed this reminder.

  Plaintiffs claim in their brief that "[s]ome, and perhaps much, of the `Internet bubble' was a classic stock market manipulation engineered by Wall Street's investment bankers and research analysts."*fn23 There is no factual predicate or legitimate inference from facts alleged in the consolidated complaint for plaintiffs' semantic invention of a stock market manipulation for internet company securities engineered by Wall Street's investment bankers and research analysts. Not even the freewheeling investigation and report make any such assertion or suggestion as a prop for its criticisms.

  The cited alleged omissions of conflicts of interest could not have caused the loss of market value. The alleged omissions are not the `legal cause' of the plaintiff's losses. There was no causal connection between the burst of the bubble and the alleged omissions; it was the burst which caused the market drop and the resultant losses a considerable time thereafter when plaintiffs decided it was time to sell. A defendant does not become an insurer against an intervening cause unrelated to the acquisition, e.g., a precipitous price decline caused by a market crash. The plaintiffs controlled their ultimate exit from the stocks after waiting no doubt for a market reversal.

[273 F. Supp.2d 363]


  There are simply no allegations in the complaints, much less particularized allegations of fact, from which this Court could conclude that it was foreseeable that the alleged non-disclosures of conflicts would cause the harm allegedly suffered by plaintiffs as a result of the bursting of the Internet bubble. Plaintiffs have also failed to allege facts which, if accepted as true, would establish that the decline in the prices of 24/7 and Interliant stock (their claimed losses) was caused by any or all of the alleged omissions from the analyst reports.

  Moreover, none of the Second Circuit cases upon which plaintiffs rely have applied the so-called "disparity of investment quality" or "price inflation" theory of pleading loss causation to a putative securities class action in which the plaintiffs sought to utilize the fraud on the market theory. Rather, each involved a face-toface transaction in which the identified plaintiffs alleged that they actually detrimentally relied on defendants' misrepresentations and that they were harmed as a result. For sound policy reasons discussed below, plaintiffs' theory on loss causation should not be expanded to fraud on the market cases, where reliance is presumed (if certain criteria are met) based upon the assumption that in an efficient market "most publicly available information is reflected in market price, [and] an investor's reliance on any public material misrepresentation, therefore, may be presumed." Basic v. Levinson, 485 U.S. 224, 241-42, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988).*fn24 In the circumstances here presented, the sound reasoning of the Eleventh Circuit Court of Appeals in Robbins v. Koger Props., Inc., 116 F.3d 1441 (11th Cir. 1997), should be applied. There, the court observed that in a fraud on the market putative class action, price inflation is typically used as a surrogate for reliance and the closely related concept of transaction causation. After examining the concept of proximate causation carefully, the court reasoned that price inflation should not be extended to satisfy the independent requirement to plead loss causation:
Our cases have not utilized the [fraud on the market] theory to alter the loss causation requirement, and we refuse to do so here. Our decisions explicitly require proof of a causal connection between the misrepresentation and the investment's subsequent decline in value.
Robbins, 116 F.3d at 1448 (emphasis added).

  Accordingly, the court stated that in the circumstances presented, the "showing of price inflation, however, does not satisfy the loss causation requirement" and would otherwise collapse transaction and loss causation, see id., a result which even plaintiffs acknowledge would be at odds with Second Circuit law.

  Even if there was a claim that the misconduct caused the purchase price of the stocks to be artificially inflated, plaintiffs have failed to allege facts (as opposed to legal conclusions) from which to infer that the alleged omissions were a substantial cause of any inflation. In their memorandum, plaintiffs refer to only eight of the over eighty research reports issued by Merrill Lynch on 24/7 and Interliant during the putative class periods and allege that the respective stock prices rose in the days following the issuance of the research reports. Yet despite instances thereafter when prices dropped following reports, plaintiffs make no attempt in their pleadings to allege facts that would support their conclusion that any minor increases were caused by an analyst's rating as opposed

[273 F. Supp.2d 364]

      to the numerous other factors, including previously non-public internal financial information released at virtually the same time by the companies themselves (or elsewhere in the analysts' reports), or even the effect of reports issued by other analysts.

 (a) Merely Alleging "Artificial Inflation" is Not Sufficient To Satisfy Loss Causation

  Causation under federal securities laws "is two pronged: a plaintiff must allege both transaction causation . . . and loss causation. . . ." Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87, 95 (2d Cir. 2001) (emphasis added). The loss causation inquiry must examine "how directly the subject of the fraudulent statement caused the loss, and whether the resulting loss was a foreseeable outcome of the fraudulent statement." Id. at 96 (citing First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994)). As explained in AUSA Life Insurance Co. v. Ernst & Young, the "foreseeability query" is whether the defendant could have reasonably foreseen that its alleged misconduct could lead to the financial decline of the investments which led to the harm to the investors. See AUSA, 206 F.3d 202, 217 (2d Cir. 2000) ("The foreseeability query is whether E & Y could have reasonably foreseen that their certification of false financial information could lead to the demise of JWP, by enabling JWP to make an acquisition that otherwise would have been subjected to higher scrutiny, which led to harm to the investors.").

  Here, to the contrary, plaintiffs have not alleged that there was any link between the allegedly overly optimistic ratings and the financial troubles of 24/7 or Interliant that led to their financial demise in the wake of the bursting bubble, nor any facts demonstrating that they were the cause.*fn25 Nor do plaintiffs allege facts demonstrating that it was foreseeable that the allegedly overly optimistic ratings would lead to the financial demise of 24/7 or Interliant.

 (b) The Burst of the Bubble — Intervening Cause

  The Second Circuit has also continued to stress the need to examine whether intervening causes are present and the lapse of time between the fraudulent statement and the loss. Both of these elements focus on conduct occurring after the investment decision and after the purchase of shares at the allegedly inflated price. For example, the Second Circuit reiterated in Castellano v. Young & Rubicam, Inc. that "`when factors other than the defendant's fraud are an intervening direct cause of a plaintiff's injury, that same injury cannot be said to have occurred by reason of the defendant's actions.'" 257 F.3d 171, 189

[273 F. Supp.2d 365]

      (2d Cir. 2001) (citing First Nationwide, 27 F.3d at 769); see also Suez Equity, 250 F.3d at 96. As the Second Circuit explained:
The cases where we have held that intervening direct causes preclude a finding of loss causation present facts sharply different from those at issue here [in Castellano]. See Powers [v. British Vita, 57 F.3d 176, 189 (2d Cir. 1995)] (market value of stock fell as a result of recession); [First Nationwide], 27 F.3d at 772 (investor's loss caused by marketwide real estate crash); Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1495 (2d Cir. 1992) (loss to plaintiff from loans made on the basis of fraudulent misrepresentation were the result of a decline in value of collateral unrelated to the fraud); Bloor v. Carro, Spanbock, Londin, Rodman & Fass, 754 F.2d 57, 62 (2d Cir. 1985) (loss caused not by misrepresentations in various documents used to attract investments but by looting and mismanagement of these funds by controlling stockholders).
Castellano, 257 F.3d at 189-90. These cases distinguished by Castellano are plainly applicable to the facts here where the overall Internet market had collapsed — causing the price of 24/7 and Interliant to decline dramatically — and where plaintiffs cannot allege a factual link between that decline and defendants' conduct. Yet if merely alleging artificial inflation was sufficient, then there would be no need for any of these cases to discuss the importance of considering whether there was the presence of any intervening factors.

  Indeed, the Second Circuit has held that "when the plaintiff's loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that the plaintiff's loss was caused by the fraud decreases." First Nationwide, 27 F.3d at 772 (citing Bastian v. Petren Res. Corp., 892 F.2d 680, 684 (7th Cir. 1990)). Yet, plaintiffs' allegations ...

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