ORANGE COUNTY IN BANKRUPTCY : NEWS ANALYSIS : Merrill’s Disclosure Questioned : Crisis: Bond experts are asking whether the Wall Street giant sufficiently informed investors of risks.
Merrill Lynch & Co.’s acknowledgment that it knew of the precarious nature of Orange County’s investment portfolio raised questions Wednesday about why the Wall Street giant continued to underwrite Orange County bonds if it believed the county fund could be in jeopardy.
Most troubling, municipal bond experts say, is whether there was sufficient disclosure of the county investment pool’s condition when Merrill underwrote a $600-million issue of taxable county notes last July.
The county was borrowing the money to invest it in the pool, but by that time Merrill--which continued to maintain Wednesday that it had acted properly in all its dealings with Orange County--had warned then-Treasurer Robert L. Citron repeatedly about the risks of his investment strategy.
“The question here is whether those same warnings and concerns Merrill made to Citron in 1994 and earlier should have been made to bondholders,” said Sam Gruenbaum, a securities lawyer in Los Angeles. “If they were material facts, they should have been disclosed.”
In particular, Merrill’s admission this week that it had estimated last February that the troubled fund would lose $270 million in market value for each 1% increase in interest rates could be considered a “material fact” that investors would want to know, Gruenbaum said.
“These documents show that Merrill knew just what the risks were and quantified them,” said Gruenbaum, a former Securities and Exchange Commission enforcement agent. “But they didn’t quantify them for bondholders.”
After going weeks with having little to say about the $2.02-billion plunge in the investment pool and the county’s subsequent bankruptcy, Merrill this week released an internal report and a series of letters to Citron indicating that as far back as 1992, the firm recognized the risks of the ex-treasurer’s strategy of using leverage and derivatives and betting that interest rates would remain low.
Just four months before the sale of the $600 million in taxable notes, the firm gave Citron a 29-page report saying that interest rates would probably rise in 1994--as they did--and suggesting ways to make the fund less vulnerable to interest rate spikes.
On Wednesday, Merrill reiterated that it did nothing improper in the deal, which has drawn scrutiny from the SEC and the state Department of Corporations.
Merrill, which made millions annually from its dealings with Orange County, both underwrote and marketed many of the bonds that county governments floated in recent years, and also sold Citron many of the investment pool’s riskiest securities.
While the firm’s intent in releasing the documents this week was to answer charges of wrongdoing leveled at Merrill since the crisis began last month, it also spawned more questions:
* If the firm was aware of the fund’s risks, experts said, why did it agree to underwrite the $600-million note in the first place?
* Why did it not include in its official statements for the note the type of warning it had sent to Citron?
* And why did the firm not note such risks in other bonds it underwrote for the county? By law, Merrill was required to list in official statements any facts that could affect the decision-making process of a potential bond buyer.
“The letters certainly raise disclosure issues, not only about the county’s vulnerability to interest rates (but) about the extent the county was borrowing the money to cover liquidity losses,” said John Coffee, a securities law professor at Columbia University in New York. “A reasonable fact finder might conclude that some of these factual risks should have been disclosed.”
Bond experts were especially troubled to learn that Merrill had put a dollar figure--$270 million per 1% increase in interest rates--on the investment pool’s exposure to rising rates, but then did not disclose that information to potential investors in county notes.
“Those statements could come back to haunt them,” said Lew Feldman, a bond attorney in Los Angeles. “It shows they knew things they didn’t disclose to investors in the $600-million note. Given that, maybe they shouldn’t have sold it in the first place.”
Other bond experts were critical of Merrill as well.
“These communications show that Merrill clearly knew there was a danger here and they were aware this money was being raised to supplement a dangerous investment strategy--one that they themselves didn’t agree to,” said Richard Lehmann, president of the Bond Investors Assn.
Angry individual investors, some of whom bought millions of dollars of Orange County bonds directly from their brokers, have filed lawsuits against Merrill, claiming the firm did not provide adequate disclosure. However, large institutional investors--mostly mutual funds--that purchased the bulk of Orange County bonds have not publicly complained about disclosure or filed suit.
Lehmann said the litigation would be precedent-setting in terms of defining an underwriter’s disclosure duties.
Paul W. Critchlow, Merrill’s senior vice president for marketing and communications, insisted Wednesday that the firm followed disclosure laws to the letter on the $600-million deal. Merrill officials pointed out that liability for disclosure to investors also falls on the shoulders of the municipality issuing the bonds and its financial adviser--in this case, Leifer Capital of Santa Monica.
Merrill pointed out that, originally, PaineWebber Inc. was to underwrite the $600-million bond issue but that Merrill came in before the deal closed and offered to handle it at less cost to the county. Critchlow said that while Merrill looked over the offering documents with bond attorneys after the deal was put together, the bulk of the work was done by the county and Leifer. One PaineWebber executive who spoke on condition that he not be identified said he thought the disclosure on the issue was sufficient and that the bulk of responsibility falls on the county.
“We really dodged a bullet, though,” the executive said.
Merrill has repeatedly asserted that it never acted as Citron’s financial adviser, though the documents released by the firm this week reveal that it offered plenty of advice.
Some Orange County officials suggested Wednesday that the firm should have alerted someone else in the county, perhaps the Board of Supervisors, to its concerns. But Critchlow said Merrill did not have the responsibility--in fact, did not have the right--to alert anyone other than Citron to the fund’s potential risk.
“Our responsibility was to go to him and say, ‘Here are the risks of what you’re doing.’ It was his responsibility to go to them,” Critchlow said.
After reviewing the Merrill documents for the first time Wednesday, Citron’s attorney, David Wiechert, questioned the timing of their release and the purity of Merrill’s motives.
* FUND-RAISING CRUNCH
County officials may impose new fees and charges for services. A1
* IN THE SPOTLIGHT
Merrill Lynch’s chief investment strategist undergoes scrutiny. D2
* LIFE-AND-DEATH STRUGGLE
Woes of small firms dependent on county as a major customer. D2
