Experts Question Broker’s Silence on Bonds, Disclosure

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 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% hike 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 the firm recognized the risks as far back as 1992 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 stating that interest rates would likely rise in 1994--as they did--proffering ways to alter his strategies to make the fund less susceptible 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 floated by Orange County governments 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, then 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 state in official statements any “material” 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% hike 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,” agreed 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 who bought millions of dollars of Orange County bonds directly from their brokers, have filed lawsuits against Merrill, contending that 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 could 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 Merrill came in before the deal closed and offered to handle the transaction 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 the 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,” said the executive.

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--and 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--a week before a state Senate hearing on the Orange County matter--and the purity of Merrill’s motives.

Despite its warnings to Citron, the firm continued to sell him the same kind of risky securities, Wiechert noted, only offering to buy them back in 1993, when interest rates were still low and the bonds were more valuable.

“So I don’t know how altruistic Merrill Lynch is being,” Wiechert said.