Fund Crisis Puts Merrill Lynch’s Image on Line

While scandals rocked one Wall Street giant after another in recent years, the biggest securities firm of them all, Merrill Lynch, came through it all without suffering any major damage.

It dodged such traumas as the insider trading junk bond debacle that destroyed Drexel Burnham Lambert, the Treasury bond crisis that nearly sank Salomon Bros. and the disastrous high-risk limited partnerships that have cost Prudential Securities more than $1 billion.

Merrill Lynch, in fact, has boasted of having one of the biggest and toughest compliance divisions on Wall Street. That unit is credited with discovering and turning over to the Securities and Exchange Commission the initial key evidence that broke open the big 1980s insider trading scandals.

But these days, Merrill Lynch finds itself under uncharacteristic scrutiny. As regulators explore its involvement in the Orange County bankruptcy, and while separate federal probes investigate Merrill Lynch’s municipal finance dealings in Massachusetts and New Jersey, the firm’s envied reputation is on the line.

So far, securities industry veterans express confidence that the Wall Street powerhouse will continue to play a dominant role in the nation’s municipal finance business, as well as in other key securities markets. During the first nine months of 1994, it was the No. 1 municipal bond underwriter with volume totaling $14 billion. The experts reason that Merrill Lynch will keep on rolling because of its enormous financial muscle, unparalleled sales network and expertise.

Yet some in the industry also question privately whether Merrill was too aggressive in pushing the rapid growth of its municipal finance business over the last decade.

Merrill Lynch has not been charged with any crime in the Orange County bond crisis or in the East Coast cases. Company spokesman James R. Wiggins said Merrill Lynch denies any wrongdoing and has responded promptly to “any questions that arise.”

What may be at stake for Merrill Lynch is the lucrative estimated 5% to 10% of its annual revenues coming from municipal finance. In addition to underwriting bonds, that area includes such activities as trading securities, managing investment funds and making loans for local government agencies.

Although Merrill Lynch now leads Wall Street in municipal finance underwriting, it has plenty of tough competition in a business exceeding $175 billion this year. Goldman, Sachs & Co. was right behind in municipal underwriting during the first three quarters of 1994, with volume totaling $13.1 billion. Lehman Brothers and Smith Barney together accounted for nearly $20 billion more.

A large part of Merrill Lynch’s success stems from the firm’s size and diversity. The firm easily sells off the municipal bonds it underwrites through its own bond mutual funds and its vast network of retail stockbrokers.

“They are able to move bonds on a larger scale than any of their competitors,” said Robert Lamb, a New York University professor who has written six books on municipal finance.

Meanwhile, investigators are looking into whether Merrill Lynch also built up its municipal finance business by breaking securities laws.

In connection with Orange County’s financial collapse, the National Assn. of Securities Dealers, an industry regulatory group, is exploring whether three Merrill Lynch brokers made improper campaign contributions to former County Treasurer-Tax Collector Robert L. Citron. The Securities and Exchange Commission is seeking to determine whether the firm provided kickbacks or campaign contributions in exchange for securities trading business, although it is unclear whether Merrill Lynch is an official target of that investigation.

Orange County also is widely expected to sue Merrill Lynch, the county’s top bond underwriter, to recover at least some of the more than $2 billion in losses absorbed by its investment pool.

Merrill spokesman Wiggins said the company has always responded swiftly to any sign of trouble.

“When you have 43,000 employees, there’s always the potential for someone to step over the line. The question is, how does management deal with it, and we’re proud of how our management has dealt with it.”

Wiggins cited the company’s actions in New Jersey, where federal authorities are investigating whether Merrill Lynch employees made sweetheart deals to gain underwriting business from the state Turnpike Authority. Merrill Lynch alerted authorities about the issue last year, and put three municipal finance employees on paid leave in connection with the matter.

The firm said it discovered that the employees in question were doing business with a securities firm half-owned by Joseph C. Salema, former chief of staff to then-Gov. Jim Florio. The company also said it found “apparent irregularities” in a joint trading account it maintained with Salema’s firm, but would not elaborate.

However, Merrill Lynch apparently was caught off guard by the other major East Coast controversy, in Massachusetts. Federal investigators are following up on a report released a year ago by the Massachusetts inspector general that found that the firm obtained confidential information enabling it to become lead underwriter for bond issues by the state’s Water Resources Authority.

The report also found that an independent adviser to the state agency, Mark Ferber, turned over the information to Merrill Lynch in exchange for bond business. Merrill Lynch denies receiving any inside information, and called the inspector general’s report “substantially inaccurate.”

If Merrill Lynch is encountering more controversy in municipal finance than its big competitors, it may be a function of the company’s size.

Moreover, a broad swath of the municipal finance industry has been tainted in recent years by the “pay for play” issue, involving investment firms that make political contributions to state and local officials to win government business. The controversy prompted the adoption of tighter campaign contribution rules late last year and early this year.

Despite the controversies in its dealings with states and municipalities, Merrill Lynch has suffered little financial fallout. Many experts believe that the same will hold true in the aftermath of the Orange County bankruptcy. Last week the Los Angeles Metropolitan Transportation Authority removed Merrill Lynch for an indefinite period from its list of underwriters, but that was an isolated action.

Concerns about the company’s legal liability pushed down Merrill Lynch’s stock price from $38 before the Orange County news began breaking on Dec. 1 to a low of $33.25 in mid-December, but it has since bounced back, closing at $36 on Friday.

One securities lawyer who asked not to be identified said that although grandstanding politicians may urge agencies to temporarily hold off dealing with the firm, “the sophisticated investment professionals . . . will do business where you get the best price and execution.”

In Massachusetts, despite the federal investigations, officials have kept Merrill Lynch on their exclusive list of five Wall Street firms that are the only ones allowed to be lead underwriters on state bond issues. The only sanction against Merrill Lynch is that it is barred from being a lead underwriter on bond issues that are not competitively bid.

Even for that mild sanction, state officials are almost apologetic. “We realize that we may be treating the firm unfairly and risk losing its superior capabilities, but we felt there was a higher standard of public trust we had to follow,” said Eric Fehrnstrom, assistant state treasurer.

In Florida, Treasurer Tom Gallagher has decided to continue doing bond business with Merrill Lynch, even though his department is suing the firm over its role in an alleged insurance company fraud. Gallagher said he wanted the state “to have the option of doing business with them when, in fact, they may have the best deals in the marketplace. It wasn’t to our advantage, as large as they are, to not have them . . . available as a vendor to us.”

The story was similar in the city of San Jose, which sued Merrill Lynch and other brokerage firms in the mid-1980s after losing $60 million in securities trading. After reaching a settlement with Merrill Lynch, the city resumed doing business with the firm--although not with its previous broker, Michael G. Stamenson, who also was Merrill Lynch’s lead broker with Orange County.

“People’s memories are short in this country,” said Perrin H. Long Jr., a veteran analyst who has long followed the nation’s big Wall Street firms.

Whether Merrill Lynch’s activities in municipal finance create a lasting stain on its reputation depends on more than just whether in the final analysis it is found that some employees broke the law, said a securities industry official who declined to be identified. The other key issue is whether Merrill Lynch is found to have “a corporate culture” that fosters abuses or whether any possible wrongdoing emerged “only in a couple of places in a far-flung operation,” he said.

Alan Bromberg, a securities law professor at Southern Methodist University in Dallas, said that if damaging revelations emerge from Orange County, it could cost Merrill Lynch some municipal finance business in the short term. But given the firm’s prowess in the field, he said, “if they behave themselves, they’ll get it all back within two or three years.”