They're Off! Merrill's CEO Horse Race

CEO Komansky is signaling that Stanley O'Neal is no longer a shoo-in to run the company

It sounded like a sure thing. When Merrill Lynch & Co. (MER ) Chairman and Chief Executive David H. Komansky promoted then-Chief Financial Officer E. Stanley O'Neal in February, 2000, to succeed John "Launny" Steffens as president of the company's army of 15,000 brokers in the U.S., the popular perception was that unless something went horribly wrong, O'Neal would be named next in line to run America's No. 1 retail brokerage.

And why not? For generations, Merrill has picked its leaders from among executives who proved their mettle by leading its thundering herd. Komansky, who plans to recommend his successor to the board by January, 2002, before retiring in 2004, got his start as a broker. So did his predecessor, Daniel P. Tully. If he gets the job, O'Neal would be the first African American CEO of a Wall Street brokerage giant.

Now, however, O'Neal's ascension to the throne is in serious doubt. Both inside and outside the company, there is a growing perception that O'Neal, 49, faces serious rivals. Jeffrey M. Peek, 54, head of asset management, is said to be coming on strong after resurrecting the firm's asset management division. Rumors are also swirling inside Merrill of two other possible candidates: the head of investment banking, Thomas W. Davis, 47, as well as the head of global private client services, Winthrop H. Smith Jr., 51, son of the first chairman of Merrill Lynch, Pierce, Fenner & Smith, as the firm was called when it was incorporated in 1959. "Stanley O'Neal is no longer a shoo-in," says Amy S. Butte, securities-industry analyst at Bear, Stearns & Co. "Jeffrey Peek is a serious contender."

Komansky has been sending conflicting signals of late. In an interview on CNBC on May 11, he said there are "at least three" contenders. And in other recent public appearances, he has praised businesses run by O'Neal, Peek, and Davis. Yet one senior industry insider says he heard Komansky say in private that although many names are being floated, there is really only one truly suitable successor. Some close associates say of late Komansky has made favorable comments about Peek, suggesting he may be pulling ahead.

Since the CNBC interview, the succession issue has become so sensitive that Komansky and the contenders declined to be interviewed by BusinessWeek. "We have a management succession process in place. David Komansky has said that he intends to make a recommendation to the board by the end of this year, and when a decision is made, it will be announced," says company spokesman Paul W. Critchlow.

The growing uncertainty about Komansky's successor couldn't come at a worse time. Although Komansky has vehemently denied that any deal with British private bank HSBC Holdings PLC (HBC ) is in the works, renewed rumors of a potential merger have sparked speculation that Komansky is having trouble finding a successor from inside Merrill that the board will accept. Senior executives on Wall Street, who ask not to be named, predict that Merrill may very soon look outside for a chief executive, and could even draft Morgan Stanley's former president, John J. Mack. Mack declines to comment on the rumors. "We have a number of very talented people inside the organization," insists Critchlow.

TOO AGGRESSIVE? O'Neal's path to the top might have been smoother had he been less aggressive of late in pursuing ambitious goals. Through cost-cutting, he managed to dull the impact of rough markets and boost his division's pretax margin by 2%, even though the U.S. private client group's pretax earnings slid 2% in the first quarter. But it has cost him the loyalty of some of his troops. One of O'Neal's first moves was to announce 1,800 layoffs of support staff. More recently, he has encouraged financial consultants to shuffle off clients with $100,000 or less in investable assets to call centers. He wants brokers to focus on clients with $1 million or more in assets. That had brokers located in areas where there are few millionaires to chase squealing in protest. Some brokers are leaving. "The rate of defections among Merrill brokers has accelerated recently," says Mark Elzweig, head of New York headhunters Mark Elzweig Co. "This has been a welcome surprise to other wire houses. Merrill brokers were only rarely recruitable."

By contrast, Peek has been winning friends. He has spent the last three years transforming a major embarrassment for the firm into an asset. Since becoming head in 1997, he has revamped the asset management division and dramatically improved the overall performance of Merrill's own mutual funds. Now, 70% of Merrill's funds measured by assets are in the top quarter of their category, up from 40% over a year ago. Consequently, despite difficult market conditions, the division's pretax earnings declined by only 5% in the first quarter, and it experienced only $73 million in net redemptions in equity and fixed-income funds, compared with $1.5 billion during the same period of 2000. Rival Morgan Stanley Dean Witter & Co. had $444 million worth of net redemptions in the first quarter. "It's a real success story over the last year," says Whitney Dow, an analyst at Financial Research Corp., which monitors mutual funds.

More important, with improved product, Peek has been able to win the trust of many Merrill brokers. "In the past, some consultants would have been reluctant to use [Merrill's] products because of their performance," says Dow. But in the past year, Merrill funds have climbed to an estimated 35% of Merrill brokers' sales, up from 20% in 2000. "Stanley O'Neal has been and probably remains the leading candidate, but Jeff has made the decision tougher than it otherwise would have been," says Mark L. Constant, securities-industry analyst at Lehman Brothers Inc., who used to work for Peek at Merrill Lynch.

REMARKABLE RECOVERY. The other candidates have not had to prove their worth on rescue missions. But Davis has demonstrated his ability to lead investment banking, a business that accounts for 66% of Merrill's $874 million in earnings in the first quarter. On his watch, the investment bank recovered from roughly $1 billion in bond losses in 1998 to become the firm's biggest earner. "I wouldn't count him out," says James F. Mitchell, securities-industry analyst at Putnam Lovell Securities Inc.

Although Smith, 52, is more of a long shot, he has built up a great deal of credibility within the ranks since starting with the company as an investment banker in 1974. He has also developed strong relationships with governments, institutions, and individuals everywhere from Tokyo to London as the chairman of Merrill Lynch International and president of its global private-client group.

For now, Komansky isn't under pressure from shareholders to rush to judgement. "We don't have a problem with any of the candidates," says Tom Goggins, portfolio manager at John Hancock Financial Industries Fund. But the longer the contest continues, the greater the risk that Merrill could be damaged by embittered losers.

By Emily Thornton in New York

Before it's here, it's on the Bloomberg Terminal.