WALL STREET: WHERE IT REALLY HURTS

WALL Street for years has escaped what it dreads most: a serious attack on its integrity. Last week, when just such a blow fell, it landed where it really hurt. The staff of the Securities and Exchange Commission accused Merrill Lynch, Pierce, Fenner & Smith, Inc., the world's largest and best-known brokerage house, of practicing fraud and deceit by misusing inside information. Even though Merrill Lynch immediately protested its innocence, the charges by their very nature can only tarnish Wall Street's zealously nurtured image. That image is of a market where 24 million investors can trade with confidence that they are not being cheated.

The commission ordered public hearings into charges that Merrill Lynch illegally fed corporate secrets to 15 of its largest customers--even while withholding the same information from thousands of little investors. The tipoffs, according to the SEC staff, led the 15 big outfits to unload shares of Douglas Aircraft Co. stock just before it plunged in value during June 1966. At the same time, said the SEC, Merrill Lynch kept on buying Douglas stock for less favored customers without telling them it had inside knowledge that Douglas' earnings were falling sharply.

That charge struck at the heart of the brokerage firm's cherished reputation for encouraging and instructing small investors. In essence, it accused Merrill Lynch of doing the very opposite: favoring big institutions at the expense of the rank and file.

Before the Public. The SEC filed fraud charges against Merrill Lynch and 14 of its officers and salesmen, including Executive Vice President Winthrop C. Lenz. For the first time, the agency also brought fraud charges against the recipients of the information. All are large institutional investors, including the Dreyfus Corp., the Madison Fund and Investors Management Co. All were accused of violating SEC regulations, issued under the 1933 Securities Act and the 1934 Securities Exchange Act, that prohibit insiders from acting on information before it becomes public knowledge.

According to the SEC staff, Merrill Lynch learned of Douglas' financial troubles while underwriting a $75 million offering of the company's convertible debentures. On June 7, 1966, the planemaker reported profits of 85-c- a share for the five months that ended the previous April 30. But by then Douglas, now a part of the McDonnell Douglas Corp., was running into production snags and unexpected cost increases. In its underwriter's role, said the SEC, Merrill Lynch discovered that the aircraft company's earnings outlook had worsened, and passed that fact on to some of its big institutional customers. On June 24, the company publicly disclosed that its profits for the six months through May 31 had fallen to a mere 12-c- a share, and predicted that its earnings for the entire year would be paltry at best. The bad news caused Douglas shares to plummet in a week from 90 1/2 to 64 3/8 on the New York Stock Exchange. Forewarned by Merrill Lynch, said the SEC staff, the big traders lightened their holdings in time to save an estimated $4,500,000.

Raising Doubts. The accusations hit Wall Street at a time when it is already awash in problems. The stock exchanges are battling the Government in defense of their lucrative but controversial system of fixed minimum commissions. As part of an eight-month effort to unsnarl the paperwork jam that has slowed brokers' back-office operations, the exchanges and over-the-counter market last week decided to remain on a four-day trading week throughout September. Beyond all that, the Merrill Lynch case is clearly Wall Street's newest, worst nightmare, if only because it is bound to raise doubts about the habits and methods of brokers everywhere.

Merrill Lynch expressed "surprise" at the SEC action. "We are convinced that none of our people acted wrongfully, and we will defend our position vigorously," said a spokesman. For its own sake, the firm can afford to do no less. Merrill Lynch owes both its eminence and fortune to its success in wooing the small investor. To back the well-justified boast that it brought Wall Street to Main Street, the company points to its 1,400,000 individual customers, nearly one-third more than any other stockbroker has. Their trading, along with that of 3,000 institutional customers, last year helped Merrill Lynch to gross $369 million and net a record $54.6 million.

Beyond Conventions. Merrill Lynch is fond of noting that it imposes on its employees a set of ethics that goes well beyond the requirements of law or the conventions of Wall Street. For example, no employee is allowed to obtain a bank loan by using securities as collateral. Unless he is about to retire, no officer is permitted to become a director of another company. Alone among big brokers, Merrill Lynch has refused to promote the sale of mutual-fund shares, reasoning that such dealings could lead to a conflict of interest in serving its big and little customers.

It was therefore all the more shocking that the SEC complaint accused Merrill Lynch of accepting a payoff for its stock tip to big investors. This consisted in part of "give-ups" on shares subsequently traded by the 15 institutions, the SEC charged. A give-up is a practice by which a large investor orders the broker executing a transaction to split his commission with other brokers, in this case with Merrill Lynch. Give-ups have long been under SEC fire. The agency contends that such fee splitting means that brokers' commissions are unduly large on big-volume deals. In their battle to fend off more drastic changes in fee structures, the New York and American stock exchanges recently agreed to outlaw give-ups as part of an overall cut in commissions on big trades.

Stretching the Rule. The SEC's current effort to force the exchanges to pare their commissions began only this year, but the drive to erase insiders' advantages in the stock market started long ago. The agency established in 1961, in the Cady, Roberts case, that a broker who buys or sells stock on the basis of inside information commits fraud. Such police work intensified after Lawyer Manuel F. Cohen, an austere career civil servant, took over as SEC chairman in 1964. In the Merrill Lynch case, the SEC contends that not only the inside-tip giver is acting illegally, but also--and it is a word that was heard all over the Street last week --the "tippee."

The use of inside knowledge has long been common in the securities industry. Indeed, such investment guidance is so prized that an army of more than 11,000 securities analysts strive constantly to uncover it. Investment-company managers, in particular, feel obliged to use whatever they learn to improve their handling of other people's money. Thus, some mutual funds were indignant at the SEC's charges. President Edward Merkle of the Mad ison Fund called them "ridiculous."

Unless granted more time, Merrill Lynch and the other respondents have 15 days to file formal answers to the SEC charges. Then an SEC examiner will conduct the public hearings, probably in Manhattan. If he and the commission uphold the accusations, Merrill Lynch could face penalties ranging from a wrist-tap censure to permanent revocation of its license to do business. The institutions would be subject to milder punishment. They could, for example, be barred from operating as broker-dealers, or lose their registration as investment advisers. But, except for Dreyfus Corp., which operates the well-known Dreyfus & Co. brokerage firm, almost none of them engage in such activities. In any case, the SEC's verdict can be appealed all the way to the U.S. Supreme Court. Considering the magnitude of the issues at stake, such an outcome seems likely.

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