Probers Ask if Citron Borrowed to Cover Losses

Federal and state regulators are investigating whether former Orange County Treasurer Robert L. Citron plunged the county an additional $600 million into debt during the summer to cover mounting losses in his investment pool--and then misled investors about the fund’s stability, sources disclosed Tuesday.

One source close to the inquiries said investigators are trying to determine whether the operation of the now-bankrupt county fund effectively deteriorated into a “Ponzi scheme,” in which new investor funds were used to cover earlier losses.

The federal Securities and Exchange Commission and the state Department of Corporations want to know whether Citron and a team of financial consultants failed to fully disclose the fund’s shaky condition, sources said.

Specifically, they hope to determine if the $600 million borrowed through a note sold in July was used to cover losses in the investment pool, the sources said.

Merrill Lynch, the giant Wall Street investment firm, underwrote the bond offering, and Santa Monica-based Leifer Capital served as the county’s financial adviser. Both firms have been subpoenaed by the SEC as part of its investigation into Orange County’s fiscal disaster.

Documents describing the offering to potential investors made no mention of the tremendous financial strain the county portfolio was facing as its big bets that interest rates would fall proved wrong. If serious enough, non-disclosure of crucial information could violate federal securities laws that require municipalities to provide investors with a full picture of the risks they face.

Citron could not be reached for comment Tuesday. A Merrill Lynch spokesman reiterated late Tuesday that the firm’s conduct in underwriting the note was proper.

“We have made it quite clear that all the disclosure with regards to the $600-million underwriting is complete and all material facts were provided to investors,” spokesman Jim Wiggins said.

Leifer officials have refused comment. LeBoeuf, Lamb, Greene & MacRae--a Los Angeles law firm that served as bond counsel on the bond issue--also has refused to comment.

In a brief interview last week, acting county Treasurer Matthew R. Raabe refused to discuss how the proceeds from the bond sale were used, saying he was spending his time “looking ahead, not back.” But Raabe insisted that the money was never used to cover losses and added: “I don’t think I can be much clearer on that.”

At its peak, the fund borrowed $16 billion, aiming to reinvest the proceeds at higher interest rates to boost the pool’s return to its investors.

But some observers of the county’s financial dealings said they have concluded that the $600 million in bonds issued July 8 was intended to cover losses caused by Citron’s ill-fated belief that interest rates would decline.

“If you look at it knowing what we know now,” one high-ranking county official said, “no reasonable person could come to any other conclusion. . . . You’d have to assume the treasurer was using money from the fund to cover the losses. But no one knew it at the time.”

Sam Gruenbaum, a former SEC enforcement officer, said he believes Citron sold the $600 million in bonds specifically to meet anticipated “collateral calls”--demands by creditors to pay off a portion of their loans.

“If they hadn’t sold (the bonds), they would have had to sell securities and post losses,” said Gruenbaum, now a private securities attorney in Los Angeles. “It would be astonishing if the SEC wasn’t looking into disclosure issues here. It is a red flag. It’s an issue and it calls for close examination.”

County officials and the bankers who worked on recent bond issues refused to release documents concerning recent collateral calls made against the county.

Liability for disclosures to investors falls not only on the municipality issuing bonds, but on the financial consultants who help prepare the offering.

Federal regulations require municipal dealers preparing bonds for public sale to fully disclose any economic trends, marketing strategies or financial risks that could affect the bonds.

Underwriters also must generally disclose in the prospectus any financial relationships with the issuer--such as political donations. Merrill Lynch has donated $15,000 to Orange County elected officials since 1986. That includes $4,000 donated by its employees to Citron’s campaign June 13--the day before the $600-million bond issue was approved by the County Board of Supervisors.

But those contributions were not mentioned in the bond disclosures circulated to potential investors.

“Issuers in the municipal market routinely make public statements and issue reports that can affect the market for their securities,” the SEC said in a March report on the need for better disclosure regulations. “Without a mechanism for providing ongoing disclosures to investors, these disclosures may cause the issuer to violate the anti-fraud provisions.”

Documents for the bond issue do include several sections on risk. But they do not mention that the fund already was in trouble, and the only detailed discussion of negative economic trends blames Sacramento for raiding county coffers during 1993-94 budget cutting.

In a three-sentence section called “Investment Risk,” investors were told: “If the county investment pool suffers an overall investment loss on the portfolio, pledged monies may be insufficient to pay the principal of and interest on the notes.”

In a passage on “The Orange County Investment Pool,” investors were told: “From time to time, a significant portion of these securities are pledged with respect to reverse repurchase agreements authorized by law.”

An SEC staff member in Washington, who asked not to be identified, said any precipitous drop in the value of a fund would normally be something that potential investors should know in considering a bond.

Because underwriters are often allowed discretion to decide what is “relevant,” the staff member said, “it’s hard to say anything absolutely under the anti-fraud regulations. But that sounds like something that should be disclosed. I would say so.”

By June 1, there were reports that the Orange County investment fund had lost $1.2 billion in value in five months and that the county had been forced to post more than $300 million in extra collateral because the value of the securities used to borrow from brokerages had declined as interest rates climbed.

“With rates rising steadily, by July of 1994 the pool would have already lost money,” said Gruenbaum. Long-term bond yields “had already gone way up, so they were losing, losing, losing. The question is whether these losses in the pool were fully disclosed to investors.”

Buyers of the $600 million in bonds were simply told in the offering documents that as of March 31, the fund’s value totaled $7.61 billion, climbing by June 16 to $7.71 billion, according to bond documents.

“What happens is that you’ve got lawyers at the table looking at the deal trying to decide what is really important to the investors buying these taxable notes,” said Andrew Kintzinger, president of the National Assn. of Bond Lawyers, a group of 3,000 attorneys. “And it’s a judgment call. Ultimately, it’s the county’s decision.”

Kintzinger questioned whether investors in the Orange County fund knew what they were getting into.

“Not every market downturn or adverse trend is always material, so it doesn’t need to be told to investors,” Kintzinger said. “But looking back at Orange County, this clearly does not appear to be one of those cases.”

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