Merrill Stumbles In Orange County -- Role In Calamity Under Scrutiny

SANTA ANA, Calif. - Merrill Lynch & Co., which navigated Wall Street's "decade of greed" unscratched by a major scandal, has run aground in Orange County.

The nation's largest brokerage, known by millions for its bull logo and upbeat TV ads about America's future, now faces scrutiny by the Securities and Exchange Commission and the National Association of Securities Dealers over its role in the financial calamity of the year, a $2.02 billion loss that sent one of the wealthiest counties into bankruptcy court.

At least two federal class-action lawsuits name Merrill, former county treasurer Robert Citron and others, seeking to recover money for investors injured by the collapse of Orange County's investment fund.

Also on Merrill's back is the Teamsters Union. Members occupied the firm's North Santa Ana office recently to decry what they called Merrill's complicity in the failed fund.

Merrill replied that the county's investment strategy was well-known and "applauded by numerous public officials" when the fund was a cash cow that brought above-market returns for many years.

"Any suggestion that Merrill Lynch failed to disclose the risks associated with investments purchased from us is utterly preposterous," the firm said.

The key issue is that Merrill was an active participant with the county, particularly during the time when its fund was experiencing substantial losses and when the fund was widely criticized for assuming excessive risk. Merrill served both as underwriter for county municipal bonds and sold it some of the complex securities known as derivatives.

Merrill's dilemma can be viewed two ways. One is that Merrill simply took orders from Citron, once regarded as one of the nation's savviest public finance officers. The other is that Merrill and one of its California salesmen, Michael Stamenson, concocted the investment scheme that failed.

San Francisco attorney Joseph Cotchett, who successfully sued professionals in the Lincoln thrift collapse and now represents investors suing Merrill, said the brokerage and Stamenson were "the primary architects of the investment pools' investment scheme and earned many tens of millions of dollars as a result."

Joan Gallo, city attorney for San Jose, Calif., said she sees frightening parallels between the Orange County debacle and the city's experience a decade ago.

In 1985, San Jose lost $60 million because of what it said were inappropriate activities by Merrill and a dozen other brokerages.

"From my perspective, it is absolutely shocking that after the San Jose case, with the knowledge of what happened to this city, that Merrill would continue this same conduct," said Gallo.

David Wiechert, Citron's attorney, said Merrill was Citron's primary financial adviser and during the last year he extensively "relied on their financial expertise."

Merrill rejects such criticism, stating "at no time did Merrill Lynch act as Orange County's investment adviser."

Merrill also said the intense scrutiny is unfair since it was one of about a dozen firms providing financial services to the county. Merrill "acted properly and professionally" during its 20-year relationship with Orange County, said Daniel Tully, chairman and chief executive, in a statement.

The stakes are enormous for Merrill, considered by many regulators to have a strong ethical backbone that kept it above the insider trading scandals of the '80s.

The SEC's subpoena earlier this month of Merrill, along with other revelations about the Orange County investigation, could damage the firm's muni-bond business.

For example, the Los Angeles Metropolitan Transit Authority has temporarily removed Merrill from its list of underwriters, The Los Angeles Times reported recently.

Warning signs flashed earlier this year that all was not right with the Orange County investment fund, a pool of money from 186 school districts, cities and other local agencies.

The fund borrowed heavily and invested in bonds and complex securities that tumbled in value as interest rates climbed this year, evaporating at least one-quarter of the $8 billion in the fund.

County officials asked the SEC to review the fund in April following charges Citron engaged in excessive risk, said SEC Enforcement Director William McLucas.

John Moorlach, Citron's opponent in the spring election, accurately predicted the fund's demise. His comments were widely reported.

"By May 31, I estimated it was down by $1.3 billion," Moorlach said in a recent interview. "And I was conservative."

The SEC didn't bring enforcement action then because it didn't discover fraud at the time, McLucas said.

Another warning sign came in Aug. 5, 1993, when the Orange County Board of Supervisors reviewed an audit of the treasurer's office that raised questions about its dealings with Merrill.

The audit said that on June 28, 1991, the treasurer's office sold $25 million in notes to Merrill, only to repurchase those notes less than a week later.

"We were told the department head (Citron) entered into these transactions at the request of the broker, Merrill Lynch, to help the broker meet financial statement ratios required by the Securities and Exchange Commission," according to the audit, signed by county chief of audits John Nakane. It cited similar transactions at the end of the fourth quarter in December 1990 and early 1991. Nakane declined to comment about the audit.

Investment analysts found this passage curious, particularly because a $25 million trade would have little effect on the massive balance sheet of Merrill, which earned more than $1 billion last year.

"To buy securities and buy them back simply to meet regulatory requirements is a red flag that ought to be investigated," said Nick Betzold, a specialist in complex securities and partner at the firm Betzold, Berg and Nussbaum in Itasca, Ill.

"Merrill Lynch has written policies prohibiting inappropriate trading," company spokesman Richard Silverman said. "We have just received a copy of the auditor's report and we are reviewing it."