ORANGE COUNTY IN BANKRUPTCY : Citron Defense May Focus on Risk Warnings

In April, 1993, then-Orange County Treasurer-Tax Collector Robert L. Citron warned a county official--in writing--of the risks of doing a complicated parlay in Treasury notes.

Citron was advising the Orange County Sanitation District official of the pros and cons of a deal the district had asked him to handle: a reverse-repurchase in which the district would put up as collateral some of its government securities in order to borrow money for further investing.

If interest rates happened to rise, Citron warned, the district might have to put up millions of dollars to buy back the bond or might have to sell it at a loss.

That was an accurate warning, as far as it went. But Citron then added: “The likelihood of this happening is minimal.”

In fact, by the end of the year, rates began their steepest rise in a quarter of a century, devastating a county investment portfolio filled with transactions of the kind whose dangers Citron had carefully laid out for the district.

Yet from Citron’s standpoint, the important thing is not the assurances he made that rates would stay low, but the warning he gave of what might happen if they did not.

For as prosecutors, regulators and lawyers begin considering whether the management of the Orange County investment pool warrants civil or even criminal charges, the outlines of Citron’s legal defense are becoming clear: Not only did all his investments comply with rules laid down by state legislation, he will contend, but in document after document, including annual statements to the Orange County Board of Supervisors, he made full disclosure of the risks of his investment strategy.

Citron’s warnings of market risk to participants in the pool are certain to end up in the center ring of the legal circus that is about to pitch a tent over the pool’s wreckage.

A 10-page questionnaire sent by the Securities and Exchange Commission to the pool’s 187 municipal investors, for example, focuses on what and by whom the investors were told about the risk of loss of investment principal, the pool’s sensitivity to changes in interest rates, and its strategies.

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Regulators are also believed to be looking into whether Citron as treasurer used the proceeds of county bond issues to make cash distributions to pool participants who thought they were receiving interest--a maneuver to mask a cash crisis in the pool that could become the core of a civil case against officials involved in arranging the bond issue, Citron included.

Beyond that, at least 12 civil suits to recover lost money have been filed and scores more are sure to materialize, naming the former county treasurer, his investment advisers and others as defendants.

Citron’s management is also being investigated by county, state and federal agencies with the power to bring criminal charges, although none have yet been brought and no evidence of illicit personal enrichment by Citron has surfaced.

“Our position is that there were no material omissions” of fact in disclosure statements made to investors in the county pool or buyers of county bonds backed by funds in the pool, said Citron’s lawyer, David Wiechert, in an interview.

Whatever inadequacies appear, he added, should be blamed on the information Citron received from such professional advisers as Merrill Lynch & Co., the investment firm that underwrote a large amount of the riskiest securities he purchased for the portfolio.

“Bob was relying in good faith on professionals,” Wiechert said.

Moreover, he said, the municipal finance officers who were placing their public funds under Citron’s management in the county pool--many of them voluntarily--should have been sufficiently well-versed in market economics to know that the pool’s above-market yield came packaged with higher risk.

“The question that should be asked of the investors is why did they think they were getting 200 basis points (2 percentage points) or more higher than they would if they invested in 90-day Treasuries?”

Still, lawyers experienced in securities and criminal defense law say that Citron faces a long ordeal in fending off prosecutors and plaintiffs’ lawyers. Orange County’s collapse into bankruptcy is so spectacular that the entire spectrum of law enforcement agencies is constrained to at least investigate Citron’s investment management.

“Because he’s in the middle of a political cyclone, they’re under enormous political pressure to do something,” said Stanley Arkin, a prominent securities counsel.

Wiechert agrees that the political environment may represent Citron’s biggest hazard.

“Criminal exposure is a possibility because it’s not difficult to get an indictment,” he said. But obtaining a conviction would be much harder because it would require “proof beyond a reasonable doubt that Bob Citron intended to defraud investors,” and no evidence of that has appeared.

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The chance of civil charges is greater because the standard of proof is lower than in criminal proceedings and the cases might revolve around the murky issue of what facts Citron was required to disclose to his investors and which of his statements they relied upon when deciding to place their funds in his care. Case law is far from clear on how much information public officials must disclose when they invest money or borrow it in the bond market.

In fact, as Wiechert suggests, Citron in his public statements generally did note that his investment strategy carried higher risks than normal for a public fund. But documents show he usually counterweighted such statements with wishful, if not willful, expressions of market opinion that would turn out to be misguided.

In a Sept. 10, 1993, report to the pool investors, for instance, he wrote that the pool’s high yield was produced by reverse repurchase agreements and “inverse floaters”--securities designed to produce a higher yield when market interest rates remain low or decline.

“If rates were to rise materially, it is reasonable to expect that the overall performance of the portfolio would decline,” he wrote. Furthermore, he said he had stopped buying inverse floaters over the previous six months precisely to hedge against the possibility of higher rates.

But he then assured his investors: “Interest rates could rise 100 basis points (1%) tomorrow, because of some temporary phenomena happening in the world. But higher interest rates are not at all sustainable.”

As it happened, rates rose more than 2 percentage points in the year following his prognostication and remained high throughout 1994.

Moreover, he did not stay out of the inverse-floater market for long. Beginning in January and February, 1994--just before the Federal Reserve Board signaled its determination to push rates up with three quarter-point rate hikes in three months--Citron bought hundreds of million of dollars in such exotic securities, all of which have since been heavily discounted in value.

Some were so complex that they resembled the creation of alchemists. The interest payout of a $25-million purchase on Jan. 10, for instance, was based on the interrelationship of trading in German marks, Italian lira, Swedish krona and British pounds. (It was a bad bet: Between the purchase date and the end of 1994, the payout dropped by half, to 2.31% from 4.72%.)

Citron also overstated to investors his ability to unwind his complicated transactions once market conditions rendered them unprofitable.

“The Orange County treasury currently has over $900 million (in) securities reversed against themselves,” he told the sanitation district in April, 1993, “so we are well versed in monitoring this kind of investment.” However, the reverse transactions could not be unwound without a loss when rates rose.

Yet securities and defense lawyers note that Citron may be able to defend his own judgment by showing that he had plenty of company among the nation’s biggest and most sophisticated investors in suffering derivatives-based losses in 1994.

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He could also plead that the securities he bought were issued by agencies sponsored by the federal government--as such they were safe to the extent that their risk of default was almost nil, although the way Citron invested magnified their exposure to adverse changes in rates.

Citron may also contend that he was simply not responsible for the fund’s estimated $2.02-billion loss.

Although some analysts say the paper losses were becoming so great that a cash crunch would eventually have forced Citron to sell some holdings at a loss, “the question is to what extent does he avoid exposure, because the damages were really created by the precipitate selloff (by his successors) and not holding to maturity,” said one securities lawyer.

Others say Citron might successfully deflect civil liability onto other defendants, such as his professional advisers. As Arkin put it: “Going after Merrill Lynch is going to be one of the great games in town.”

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Citron’s Disclosures

Former Orange County Treasurer Robert L. Citron maintains that he made adequate disclosures about the nature and risks of his strategy in managing the county’s now bankrupt investment pool. The following are examples of what he said--and what actually occurred.

* From an Apr. 12, 1993, letter to the Orange County Sanitation Districts (which wanted to purchase $50 million in reverse repurchase agreements):

(text of graphic:) The negative side of this transaction is that if interest rates rise, it is possible not to have a “positive carry.” Where the bid or the interest rate paid for borrowing the money would be more than the coupon on the treasury note. In this event the District would need to come up with $50 million to buy outright these securities, or what would likely happen is to sell them at a price that is lower than originally paid for the securities. A principal loss would occur. The likelihood of this happening is minimal; particularly if the investment is closely monitored. If interest rates start rising the security could be sold and/or swapped for a like security with a higher coupon. The Orange County Treasury currently has over $900 million securities reversed against themselves, so we are well versed in monitoring this type of investment.

WHAT HAPPENED

What Citron termed an unlikely scenario is exactly what occurred. Rising rates reduced the value of the collateral he put up for loans in the county’s investment portfolio, eventually forcing the county to take losses and spurring its bankruptcy filing.

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From a Sept. 10, 1993, annual report to the county Board of Supervisors:

(text of graphic:) If rates were to rise materially, it is reasonable to expect that the overall performance of the portfolio would decline. Athough we strongly believe that future interest rates will remain low, to insure against the eventuality of materially rising interest rates, for the last six months we have not been buying structured/floating interest rate instruments but have been purchasing fixed interest rate coupon instruments.

WHAT HAPPENED

Rates would not remain low indefinitely. In fact, they began rising two months later. Moreover, Citron again started buying structured notes in January, 1994, as the rise picked up steam.

What the SEC Wants to Know

As part of its investigation into dealings by the Orange County treasurer’s office, the Securities and Exchange Commission has sent the following list of questions to cities, school districts and other agencies that invested in the Orange County Investment Pools:

1. As of Dec. 1, 1994, how much money did your municipality (or district) have invested in the Orange County Investment Pools?

$ Bond Pool $ Commingled Investment Pool $ Other Pools $ Total 2. How did you first hear about the Orange County Investment Pools? What did you hear? 3. On what date did your municipality (or district) make its first investment in the Orange County Investment Pools? 4. Was your municipality (or district) required by California law to invest its funds in the Orange County Investment Pools? Yes No 5. Who made the decision to invest your municipality’s (or district’s) funds in the Orange County Investment Pools? 6. Why did your municipality decide to invest in the Orange County Investment Pools? 7. What were you told about the safety of your investment with the Orange County Investment Pools? Who told you this? When? 8. What were you told about the objective of the Orange County Investment Pools? Who told you this? When? 9. What were you told about the investment strategy of the Orange County Investment Pools? Who told you this? When? 10. What were you told about the risk of loss of your investment principal? Who told you? When? 11. What were you told about the sensitivity of the Orange County Investment Pools and its investments to changes in the interest rate? Who told you? When? 12. What were you told about whether or not the Orange County Investment Pools would hold the investments in its portfolio to maturity? Who told you this? When? 13. What were you told about the Orange County Investment Pools’ “exit strategies”? Who told you? When? 14. What were you told about the Orange County Investment Pools cash or other liquid assets? Who told you this? When? 15. What did you understand was the nature of the investments to be made by the Orange County Investment Pools? 16. What were you told about how the yield on the Orange County Investment Pools would be determined? Who told you this? When? 17. What were you told about the Orange County Investment Pools’ use of reverse repurchase agreements? Who told you this? When? 18. What were you told about the Orange County Investment Pools investing in derivatives? Who told you this? When? 19. What were you told about the Orange County Investment Pools’ use of leverage and/or the extent of leverage in its portfolio? Who told you this? When? 20. When did the Orange County treasurer’s office tell you that the Orange County Investment Pools had suffered a loss in principal? What were you told? Who told you this? 21. What kinds of documents did you receive from the Orange County treasurer’s office? When did you receive these documents? 22. Did anyone from Orange County treasurer’s office ever guarantee your municipality’s investments against losses? Who? Do you have any such guarantees in writing? Before Dec. 1, 1994, had the Orange County treasurer’s office ever paid off losses incurred by your municipality or district? If so when and how much was the loss? 23. Have you ever heard of a municipality or district receiving guarantees against losses in an investment from the Orange County treasurer’s office? Which municipality or district did you hear received such guarantees? Who did you hear made such guarantees? When? 24. Has anyone at the Orange County treasurer’s office ever managed or structured other investments on behalf of your municipality or district in addition to the Orange County Investment Pools? Who? When? 25. Has anyone ever recommended to you that your municipality or district issue taxable debt or otherwise raise money for the sole purpose of investing the proceeds in the Orange County Investment Pools? Who made such a recommendation? When? Did you do so? 26. Have you ever heard that the investments made by the Orange County Investment Pools were high-risk investments? Who told you this? When? 27. Did you ever ask anyone at the Orange County treasurer’s office if the Orange County Investment Pools invested in high-risk securities? Who did you ask? When? What did they say in response? 28. Did anyone at the Orange County treasurer’s office ever promise you a certain return? Who? When? What was the return promised? 29. Did anyone at the Orange County treasurer’s office ever speak to you about “paper losses”? Who spoke to you? When? What did they say? 30. Please list all employees of your municipality (or district) who were involved with your municipality’s (or district’s) investments in the Orange County Investments Pools. 31. Has the Orange County treasurer’s office or Orange County Investment Pools ever purchased securities from your municipality or district? If so, please describe the circumstances. 32. Please discuss anything else pertaining to your investment with the Orange County Investment Pools. 33. Please attach to this questionnaire copies of all documents that you received in connection with your investment with the Orange County Investment Pools. (For example, correspondence, agreements, annual reports, monthly reports.)

Source: Securities and Exchange Commission