Orange County sued Merrill Lynch & Co. on Thursday, alleging that the giant Wall Street brokerage concocted an exotic investment scheme that broke state law and led to the collapse of the county's finances.
The county is seeking to recover $2.4 billion in damages--the entire amount the brokerage handled in reverse repurchase agreements, investments that produced high yields when interest rates were low but tumbled when rates rose.
Gaddi H. Vasquez, chairman of the County Board of Supervisors, accused the brokerage of trampling the rights of local taxpayers and breaking state law in helping drive one of America's most affluent counties into bankruptcy.
"Merrill Lynch abused the trust and the confidence of the people of the county by permitting and encouraging the investment of public funds in volatile financial instruments that were neither authorized by law nor suitable for the investment of taxpayers' dollars," Vasquez said.
The county has been wracked by the financial crisis as employees have been laid off and contracts have been canceled. Thursday, the county's chief administrative officer called for 5% pay cuts for all employees.
In its lawsuit against Merrill Lynch, the county contends that all investments and bond sales involving the brokerage from June 30, 1993, to last Dec. 4--the day former Treasurer Robert L. Citron resigned--should be declared void because they violated several state laws, including a provision in the California Constitution requiring that any substantial debt the county incurred be approved by two-thirds of the voters.
County officials indicated for the first time Thursday that they do not intend to sue Citron. They have talked about suing Merrill, the nation's biggest investment house, since the first days of the financial crisis, but the specifics of the lawsuit caught officials of the brokerage firm by surprise.
"Our initial reaction is one of incredulity," said Merrill spokesman James R. Wiggins.
Wiggins denied that the brokerage was the architect of the county's investment strategy, instead blaming Citron and the Board of Supervisors for approving a series of investments that relied on heavy borrowing.
"If this was illegal, then everybody was party to that illegality who was in a position of authority in Orange County, because it was widely known and disclosed," Wiggins said. "This (lawsuit) reminds me a little bit of that old line in Casablanca: 'There was gambling going on here? I'm shocked!' "
After the lawsuit was filed, county officials rushed to U.S. Bankruptcy Court in response to reports that the brokerage had sold most of the $1 billion in collateral it held on behalf of the county. County attorneys sought a restraining order to halt any sales, and a judge ordered that no sales be made before another hearing Tuesday.
In other developments Thursday:
* The county grand jury began issuing subpoenas to several aides of county supervisors as part of the district attorney's criminal probe into Orange County's financial collapse, two aides confirmed.
Prosecutors have already seized records from Citron and county Auditor Steve Lewis.
* County Administrative Officer Ernie Schneider unveiled his "plan for recovery," which would include 5% salary cuts for the county's 18,000-member work force and would halt the county's contribution into its employee retirement fund. The county has announced layoffs of more than 400 workers.
"We need to demonstrate to the public that the county can weather this storm," Schneider said, "that we have the ability to continue operation, to provide essential services and to plan for the future."
* Since imposing a hiring freeze Dec. 8, the county has hired nearly 150 new employees--including 97 full-time workers--a move that has angered workers being laid off and surprised top officials desperately trying to cut the county budget. Union officials are angry that the new jobs were not filled with laid-off workers or transfers from other departments.
* The county agreed to release $215 million in local property tax money collected before it filed for bankruptcy Dec. 6. The county simply administers the money for local governments, which invested in the county pool and have battled to get the tax money back through Bankruptcy Court.
* United Way of Orange County announced that it has put together an emergency loan fund to help nonprofit organizations crippled by delays in obtaining government funding. The $450,000 fund, made up of contributions from United Way and seven businesses, will offer interest-free loans to nonprofit health and human-service organizations.
* Investors in the county's pool, which include 186 school districts, cities and special districts, said they will draft resolutions formally demanding the return of 100% of their money, which has been frozen since the county filed for bankruptcy.
* In Sacramento, state Treasurer Matt Fong called for changes in state law to require public agencies to issue more frequent reports detailing the current value of investments.
Fong, in the first of three hearings on government investment practices, said more frequent reporting would have allowed elected officials and investors in Orange County to have learned "months earlier than they did that the county's investment strategy was flawed and that losses were building up."
* In Washington, Securities and Exchange Commission Chairman Arthur Levitt Jr. and representatives of the securities industry testified at a congressional hearing that tightening laws on municipal investing is unnecessary because governments throughout the county have learned from Orange County's mistakes.
"The message of Orange County has been heard," making it unnecessary to impose new federal restrictions on municipal finance, Levitt told the finance subcommittee of the House Commerce Committee.
An SEC directive earlier this year calling for increased disclosure by municipal bond insurers should be a sufficient reform measure, he said.
"It's good management control that was lacking in Orange County up and down the line," Levitt said, suggesting that someone "has to be looking over the shoulders" of the public officials who make investments. "Are there other Orange counties? I would be surprised if there were not. Is it a calamity of national proportions? I think not."
But Rep. Christopher Cox (R-Newport Beach) renewed his call for federal laws requiring better disclosure of municipal investments.
Cox said he wants to develop legislation requiring the same standards of disclosure for municipalities now required of corporations, without the SEC's formal registration mandate.
"Orange County was a disclosure problem," Cox said. "If the market had known what Citron was up to, he would have been disciplined."
In Santa Ana, county officials alleged that their former treasurer was encouraged to gamble with the public's money by the county's main underwriter, Merrill Lynch.
Employing a novel legal argument, the county's attorneys contend in the lawsuit that the county's investments broke state laws, but say that Merrill Lynch is to blame for pushing through billions of dollars worth of deals.
Bruce Bennett, the county's bankruptcy attorney, said Merrill Lynch had no legal or supervisorial authorization to enter into the agreements it did with Citron.
He said the firm essentially gambled and lost about $5,000 for "each man, woman and child in Orange County. . . . They should have realized that."
Bennett said that the legal action against Merrill Lynch was only a beginning, and that other investment firms that did business with the county will become targets "as soon as we have all the information put together."
In addition to the lawsuit, Bennett went to court Thursday seeking a temporary restraining order to prevent Merrill Lynch from liquidating any county securities the firm now holds as collateral for loans it earlier made to Citron's investment pool.
James W. Mercer, an attorney representing the county against Merrill Lynch, alleged that Citron violated state law when he leveraged the portfolio nearly threefold--from $7.5 billion to $20 billion.
The California Constitution prohibits counties from incurring "any indebtedness or liability . . . exceeding in any year the income and revenue provided for that year" without approval of two-thirds of the voters.
But the county, Mercer said, has decided against suing the former treasurer.
"Our job was to recover money for the county," Mercer said. "How much money are we going to recover from Bob Citron?"
Citron's attorney, David Wiechert, declined to respond to Mercer's suggestion that Citron violated state law. After reviewing the county's lawsuit Thursday afternoon, Wiechert said: "We are obviously in accord that Merrill Lynch was our financial adviser. Whether or not these transactions violated debt limitations based on complex interpretations of state law is something that has to be evaluated."
Citron, who held the elected post for 24 years, is the subject of criminal investigations by local and federal prosecutors.
Although the Board of Supervisors in 1985 authorized Citron to engage in reverse repurchase agreements, Mercer said, it did not allow him to do so in violation of other state laws. The board's authorization allowed Citron to invest "solely to supplement" the county's income. But in making a bet against rising interest rates, the treasurer had no guarantee that he would be making money for the county, Mercer said.
"I am not in any position to say whether the Board of Supervisors did or did not violate the law," Mercer said. "The board probably failed to supervise the treasurer, and so did the county administrative officer."
Merrill Lynch's Wiggins countered that Citron fully disclosed the nature of his reverse repurchase agreements, and, in his annual reports, repeatedly reported that the pool was highly leveraged.
"Mr. Citron made it very clear in press interviews going back a number of years that he was the architect of this investment strategy. Merrill Lynch did not create the strategy," Wiggins said. "To suggest that this was somehow a Merrill Lynch-created dynamic is absurd on its face."
Wiggins also said that Merrill Lynch handled only about 15% of the reverse repurchase agreements in the portfolio and that a dozen other firms were also involved in the leverage strategy. He said everyone who received Citron's annual reports--the County Board of Supervisors as well as officials at the 186 local agencies that were invested in the pool--"is liable as well."
Platte and Lait reported from Orange County, and Rosenblatt reported from Washington. Times staff writers Chris Woodyard, Julie Marquis, Jodi Wilgoren, Lee Romney, Rene Lynch, Susan Marquez Owen and correspondent Shelby Grad in Orange County contributed to this report.