District May Sue Over Investment Loss

After revealing that the Three Valleys Municipal Water District had lost the entire $1.5 million it invested with E. F. Hutton & Co. Inc., the district’s board of directors voted last week to take legal action against the investment firm.

The board voted 4 to 1 to have the district’s attorneys study the legal options available to Three Valleys in seeking recovery of the lost money. The board is expected to approve a specific legal strategy at its next meeting Wednesday.

The water district may join a cooperative legal effort with the cities of San Marino, Lawndale and Palmdale, which together lost more than $9.5 million in public funds after making investments last year with William Parodi, an account representative with E. F. Hutton’s office in Universal City.

Parodi used money from the four public agencies to purchase government bonds on margin, a practice whereby investors borrow money to buy securities, said attorney David Aleshire of Rutan and Tucker, a law firm that represents both the water district and the City of Lawndale.

In the case of Three Valleys, margin trading enabled Parodi to buy $37 million in bonds with an initial investment of $1.5 million, the district reported. But when the value of the bonds fell, the agencies received margin calls--requests to either sell off bonds or invest more cash to cover the loans.

After an initial investment of $300,000, the City of Lawndale deposited an additional $1.6 million to cover margin calls, Aleshire said. The Three Valleys water district refused to deposit additional money, so its account was liquidated in September to satisfy the margin calls, said Arthur Kidman, an attorney for the district.

In March, Parodi was “permitted to resign” from E. F. Hutton, said Steve Nelson, a spokesman with the investment firm’s headquarters in New York. When a registered broker leaves a firm, the firm must report whether the broker left voluntarily, was discharged or was “permitted to resign.”

After leaving Hutton, Parodi went to First Investments Inc., an Arkansas-based firm, where he continued to handle investments for the three Southern California cities, Aleshire said.

“When Mr. Parodi left the firm, he took those accounts with him,” said Nelson of E. F. Hutton.

However, the Three Valleys account remained with E. F. Hutton and was assigned to another account representative. Therefore, any legal action by the district would be directed solely against E. F. Hutton, while the cities could also name First Investments in lawsuits, Aleshire said. Parodi could not be reached for comment.

Kidman said legal action by the water district will assert that the investments made by E. F. Hutton were not legally permissible under the California Government Code, which forbids the use of public funds in speculative investments. Three Valleys will also claim that E. F. Hutton engaged in margin trading without the authorization of the water district, Kidman said.

‘Question of Suitability’

“Even if Three Valleys were to lose on the first two (legal grounds), there’s still the question of suitability,” Kidman said. “Brokers are required to know their customers. Some types of investments are just too risky for some customers.”

Nelson refused to comment on the water district’s investments with E. F. Hutton because the matter is the subject of pending litigation. In previous interviews, Nelson has said that Hutton made regular reports to the district about the status of its investments.

Kidman said he recommended legal action to the Three Valleys board of directors after E. F. Hutton offered a cash settlement that “was considerably less than what the water district had in mind.” A lawsuit by the district will be settled through either arbitration or a jury trial, Kidman said.

According to a chronology prepared by the water district, the board of directors authorized the investment of $1.5 million with E. F. Hutton in November. Three Valleys officials said they repeatedly informed E. F. Hutton of its investment policy, which states that safety should be the top priority in making investments with the district’s money.

In an April 7 meeting between representatives of the water district and the investment firm, the district was informed that its money had been used to buy bonds on margin, the chronology stated.

Richard W. Hansen, general manager of the Three Valleys water district, said he was surprised to learn that district money had been invested on margin, but he did not realize at the time that the district’s entire investment was in jeopardy.

‘Not Informed’

“They did not inform us of the significance of a margin account and what its risks are,” Hansen said. “They said, ‘Don’t worry about it.’ ”

At the same time, account representatives with E. F. Hutton told the district that the value of its portfolio had fallen to $1.2 million, Hansen said.

“We were told, ‘Don’t worry, (the loss) is only on paper,’ ” Hansen said. “If we had been told the real picture in April, we would have done something different.” On April 9, the district sent a letter to E. F. Hutton reiterating its investment policy and notifying the firm to cease margin trading with the district’s funds. However, an audit of the district’s investments has revealed that further margin trading was conducted after the letter was sent, Hansen said.

In September, the district began receiving margin calls to deposit more money in its account. At that point, Hansen informed the board of directors that the district had lost $900,000, a revelation that was made public by board member William Koch.

The board voted Sept. 21 to withdraw its remaining funds--believed at the time to be about $600,000--from E. F. Hutton. On Sept. 22, Hutton liquidated the account to cover a margin call, Kidman said.

“It’s quite possible that even in one day the additional $600,000 was lost,” Kidman said. “There was so much leverage on that account that even a small movement in the market” could have caused the account be depleted.

Hansen stressed that even with the $1.5-million loss, the district has $11.7 million in reserves.

Koch has accused Hansen of hiding the investment loss from the district’s board of directors. However, Hansen said he was kept in the dark by E. F. Hutton.

“We felt as though we were on top of the situation,” Hansen said. “We were asking questions of our account executive. The answers we got back were misleading.”

Serving as a water broker, the Three Valleys Municipal Water District buys water from the Los Angeles Metropolitan Water District and distributes it to water companies in Azusa, Claremont, Covina, Diamond Bar, La Verne, Pomona, Rowland Heights, San Dimas, Walnut and West Covina.