ORANGE COUNTY IN BANKRUPTCY : Investors Weigh Their Options : Legal Action Against Brokers Is Inevitable, Experts Predict
For Merrill Lynch and several other Wall Street firms, Orange County’s bankruptcy filing may presage a lull before a legal storm that securities law experts say is all but inevitable.
Merrill, the nation’s largest brokerage firm, played by far the biggest role in selling risky derivatives to the county’s ill-starred investment fund. Losses led to the county’s bankruptcy filing on Tuesday. Merrill reportedly earned $80 million in fees and commissions from its dealings with the fund. Merrill and other Wall Street brokerages also helped the county borrow huge sums to buy still more of the securities that plummeted in value as interest rates rose.
As far as is known, neither the county nor any of the other investors in the fund have filed suit against the firms. The identities of some of them still haven’t been made public. Merrill strongly denies any liability and says the county was sophisticated enough to make its own investment decisions.
But John C. Coffee Jr., an expert on securities law at Columbia University Law School, and others say suits seeking to force the firms to reimburse the county for its losses are extremely likely. They say much will depend on facts that have yet to be made public. But they say settlements and decisions in other cases suggest that, if sued, the brokerage firms face a significant risk of being forced to make good on at least part of losses now estimated to be well in excess of $1.5 billion.
Concern about possible suits comes amid new disclosures about Merrill’s role in the Orange County fund. Sources close to Merrill told The Times on Wednesday that last May, senior executives from Merrill Lynch’s headquarters in New York flew to Orange County to meet with county Treasurer Robert L. Citron to go over concerns about the fund and its investment strategy. The county’s account with Merrill until then had been handled almost exclusively by Merrill’s San Francisco office. The meeting came as Citron was running for reelection against John M.W. Moorlach, who had leveled major criticisms about the risks the fund was taking.
The sources declined to give details of the May meeting, or say what the outcome was. After the meeting, the fund made no major changes in its strategy, and Citron won reelection. Paul Critchlow, Merrill’s chief spokesman, said he wouldn’t confirm or deny that the meeting took place.
In a statement read by Critchlow, Merrill said the county was sophisticated enough to make its own evaluation of interest rates, and said “Merrill Lynch is confident that in all of its activities with and on behalf of Orange County our company acted properly and professionally at all times.” The firm also said it believed the bankruptcy filing was “unnecessary.”
Wall Street already has begun factoring in potential legal liability for Merrill: The firm’s shares on the New York Stock Exchange have declined $3.375 since the fund’s losses were first disclosed on Dec. 1. It closed down $1.25 Wednesday, at $35. Wednesday a Smith Barney analyst lowered her rating of the stock because of potential exposure to lawsuits.
Michael Stamenson, a veteran institutional salesman in Merrill’s San Francisco office, was the lead broker on the Orange County account. Stamenson, who reportedly earned over $5 million in annual commissions in recent years, has declined to comment.
But Orange County was one of Merrill’s leading customers for buying interest rate-sensitive derivatives, sometimes buying the entire amount Merrill had to sell. The fund bought nearly $4 billion of Fannie Mae securities from Merrill in 1993, including an entire $800-million issue in July of that year, sources confirmed.
And Merrill helped “leverage up” the fund, along with other Wall Street firms enabling it to borrow large sums of money so that it could buy still more derivatives. The fund borrowed $12 billion, adding to the $7.8 billion in public money invested in it. Merrill, for example, underwrote new bonds for the county, the proceeds of which were immediately used to buy more than $1 billion in higher risk derivatives from Merrill.
Even though courts might consider the county to be a sophisticated investor, there are still plenty of legal theories about Wall Street firms’ potential liability. Citron, who resigned Sunday, had a fiduciary duty to the fund and to the cities and agencies that invested in it; the firms could be accused of helping him breach his fiduciary duties by selling him risky securities and enabling him to worsen the situation by using borrowed money. Citron has declined comment about the losses.
According to Coffee, the most chilling scenario for Wall Street is what happened in England four years ago, when 130 small cities speculated heavily in a type of derivative known as interest rate swaps. Britain’s House of Lords ruled that the cities had no authority to buy such risky securities and therefore weren’t responsible for the losses. That left the banks and investment firms that sold the securities to absorb over $700 million in losses.
A case with striking parallels to Orange County occurred in West Virginia in the late 1980s. A state investment fund, which invested money of state agencies as well as other government entities that voluntarily invested, speculated heavily in treasury put-options, financed with “reverse repos” similar to those used by Orange County. The fund ended up losing over $100 million. The state sued the brokerages that sold the securities. Mary L. Wolff, a Memphis lawyer who represented the state, said the fund recovered about $28 million in settlements from Salomon Bros., Goldman Sachs, and several other firms, and won a judgment of $58 million against Morgan Stanley, which is currently being appealed.
In addition, Bankers Trust was recently sued by two corporate clients for selling them derivatives that caused big losses. Gibson Greeting Cards and Procter & Gamble both filed suit. Bankers Trust agreed to settle with Gibson Greetings, absorbing about 70% of its losses, even though it contended that the company was a sophisticated investor that should have been fully aware of the risks.
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Merrill Lynch Stock Prices
Daily closes since Nov. 28:
Wednesday: $35, down $1.25
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