NEWS ANALYSIS : Merrill’s Responsibilities Key to Orange County Suit : Crisis: Brokerage’s culpability hinges on how savvy treasurer was and if he or county was the client.
Merrill Lynch & Co. warned former Orange County Treasurer Robert L. Citron in the fall of 1993: Higher interest rates are on the horizon. Think twice about securities such as “inverse floaters,” whose value falls as interest rates climb. Be defensive.
But what--according to public documents--did the Wall Street powerhouse do that same fall? It sold Orange County $277 million in inverse floaters.
And in January and February, 1994, even as Merrill Lynch prepared a 29-page report advising Citron, in writing, to reconsider investments adversely linked to higher interest rates, the company sold him another $855 million of precisely those types of securities, records show.
Just six days after the firm’s officials met with Citron on Feb. 23, 1994, to share their increasing concerns about rising rates, the county was issued another $125 million in inverse floaters underwritten by Merrill.
All told, between October, 1992--when Merrill first admonished Orange County about the number of interest-rate sensitive securities in its ill-fated $7.4-billion portfolio--and the pool’s collapse last month, the firm underwrote for the county at least $2.8 billion in investments whose value would plunge with every ratcheting up of interest rates.
As state and federal probes into the propriety of Merrill’s and the county’s dealings continue, the Wall Street giant’s acknowledgment last week that it sold the risky investments to Citron even after identifying the potential harm to the fund has raised new questions about culpability in the largest municipal bankruptcy filing in U.S. history.
The issue of Merrill’s legal responsibilities in marketing exotic securities and dicey strategies to a public fund--particularly one it knew could be headed for trouble--also will play a central role in the $2.4-billion lawsuit filed against Merrill last week by Orange County.
The lawsuit charged the brokerage with “wantonly and callously” selling the county highly risky investments in violation of state and federal laws.
Merrill officials have insisted the firm acted properly in all its dealings with the county, reacting angrily to the county’s finger-pointing. Merrill officials pointed out that county officials for years have enjoyed healthy returns on their investments without protesting, though they knew all along--or should have known, Merrill officials said--that Citron was using “reverse repurchase agreements,” “derivatives” and other riskier-than-average investments.
But Merrill officials “have now admitted that they knew full well what was going on in the portfolio,” said one municipal bond regulatory official who requested anonymity. “It’s almost like the liquor store selling Ripple to the local drunk.”
By law, Merrill must ensure that what it sells the county is “suitable” for its portfolio. But the definition of “suitability” is vague. It often hinges on the level of sophistication of the investor, and the size and purpose of the investment fund.
Merrill contends that Citron was a savvy, experienced institutional money manager, and that the firm met its legal obligations by repeatedly warning him of the potential danger of his investment strategy.
In 1993, the firm disclosed last week, it even offered to purchase all of the derivatives--securities linked to some underlying benchmark, such as interest rates--it had sold to Citron.
Once he was cautioned, it was Citron’s decision whether to carry on with his tactics and continue to purchase the risky securities, Merrill officials said.
“You explain the risks and he makes the decisions. That’s how the institutional investment business works,” said Paul W. Critchlow, Merrill’s senior vice president for marketing and communications.
Some experts agreed. “The law,” said John C. Coffee Jr., a securities law professor at Columbia University, “is not so paternalistic that it says you can’t sell to a client after a client is warned.
“If the client wants to be greedy . . . this is a country that lets people take risks.”
Yet, Coffee and other securities law experts acknowledged, Merrill may have been responsible for warning someone else within the county if it believed Citron was not operating in the fund’s best interest.
“A broker-dealer is supposed to advise the client if it thinks something is unsuitable,” Coffee said. “Citron is not the client; the client is Orange County.
“Merrill is dealing with Orange County through Mr. Citron.”
Merrill officials disagreed, contending that Citron himself was their client and that it was the county’s responsibility to oversee Citron.
“Citron was the duly elected, independent treasurer of the county,” Critchlow said. “He had the fiduciary responsibility to manage the portfolio.
“We would not see it as our place to go over and around him.”
The fund’s collapse was triggered, in part, because it was stocked with billions of dollars in securities--most of them sold to the county by Merrill--that lost value as interest rates spiked in 1994. Those losses were multiplied because many of the fund’s investments had been pledged as collateral for loans used to make additional investments.
When asked whether Merrill should have stopped selling the risky securities to Citron once its own analysis identified the potential problem, Merrill’s Critchlow replied, “Well, that’s a legitimate question.”
Critchlow suggested that the firm had no right to refuse to sell Citron what it said he wanted--a position several experts in the industry also agreed with. But one broker who requested anonymity said, “You can’t just say because the client understood it, you do it. They (Merrill) have the perfect right not to sell it to him.”
Merrill, the county’s primary brokerage, has repeatedly declined to say how much money it has earned in its dealings with the county. However, a review by The Times of Merrill’s transactions with the county suggests that on one $600-million note underwritten by Merrill in October, the firm’s fee was $2 per $1,000, or $1.2 million.
In a $60-million issue of Student Loan Marketing Assn., or Sallie Mae, notes underwritten by Merrill in 1992, the firm’s fee was $300,000, or $5 per $1,000, records show.
In its two-decades-long relationship with the county, the brokerage has handled hundreds of similar deals. Orange County’s lawsuit indicated that Merrill made “nearly $100 million in fees during 1993 and 1994” from its dealings with the county.
The Times’ review also raises questions about individual investments sold by Merrill for reasons other than risk.
On March 15, 1994, for example, the county was issued tens of millions of dollars in Federal Home Loan Bank notes underwritten by Merrill, records show. While the three-year note paid 4.3%, comparable U.S. Treasury notes, which are less risky, were paying about 5.3%.
In October, 1994--just weeks before the pool’s unraveling--Merrill sold the county a $600-million Sallie Mae note with an unusual structure, given the market conditions at the time.
If rates fell, Sallie Mae likely would “call,” or buy back, the notes. If rates rose--as they did throughout 1994 and are expected by some to do in 1995--the county would not be able to “put,” or sell, them back to Sallie Mae. Instead the county would have to hold on to them and face the possibility of earning less than market returns.
Asked about the transaction, Merrill officials said Citron specifically requested the terms of that deal. “That was a perfect example of a reverse inquiry,” one Merrill official said, referring to the industry’s term for an investment suggested by a client instead of a broker.
Although the law in the area of broker-client responsibilities is vague and largely uncharted territory, the actions taken against Merrill, if any, will hinge on several key issues:
* How sophisticated an investor was Citron?
The 24-year veteran treasurer had managed billions of dollars, helped draft investment legislation and scolded those who criticized him, claiming that he was not a “Johnny-come-lately” to the investment world. But Citron’s attorney, David Wiechert, maintains that Citron took the vast majority of his advice from Merrill, especially its longtime broker Michael G. Stamenson.
If Citron was that sophisticated, the argument goes, why would he approve deals that were not good for the county?
Legally, the more sophisticated the investor, experts say, the less burden there is on any brokerage to ensure that the investment is right for the investor, assuming it has disclosed any potential risks.
“The suitability law was designed to protect widows and orphans,” said Coffee, the securities law professor. At least on the surface, Citron appeared to be a “big boy,” an eminently qualified investor who could make his own decisions, Coffee said.
* Who actually was the client?
If it was the county--as many securities experts suggested--then Merrill indeed may have had an obligation to alert a county official other than Citron of its concerns, especially if it believed Citron’s tactics were “reckless.”
If it was Citron--as Merrill maintains--then the firm’s repeated warnings to Citron may have been enough to relieve the firm of responsibility for the fund’s fate, experts said.
“The client is the person or the agency for whom the securities are being bought. And I don’t think any of the securities were being bought in Citron’s name,” said Sam Gruenbaum, a securities lawyer in Los Angeles and former enforcement agent for the Securities and Exchange Commission.
* Did Merrill act as the county’s financial adviser?
“If the broker is recommending investments, then they have a higher burden of making sure the investment is suitable,” Gruenbaum said.
Merrill has strongly denied that it operated as Citron’s financial adviser. And Citron himself has said he employed Leifer Associates in Santa Monica as his adviser. However, a series of letters between Merrill and Citron and Merrill’s Feb. 23, 1994, report, all released last week, indicate that Merrill did offer Citron plenty of advice.
Merrill’s admission that it knew the fund was risky and sensitive to interest rate hikes also has ramifications for a $600-million taxable note issue that it underwrote for the county in July, 1994.
None of the information Merrill had about Orange County’s troubled fund--including an estimate that the fund would lose $270 million for every 1% rise in interest rates--was disclosed in its offering statement for the note, the proceeds of which were supposed to go back into the fund.
Around the time the note was issued, Thomas Sowanick, Merrill’s chief fixed-income strategist, wrote in a report disseminated to clients: “We believe that the rise in rates has yet to run its course.”
Of the February report in which Merrill warned Citron, the bond regulatory official said, “If you admit there’s a problem on Feb. 23, and you say nothing about it in the offering statement” for the $600-million issue last summer, “that’s a problem.”
At a minimum, securities experts noted the irony in the firm’s continuing to supply Citron with risky securities in the face of its own finding of the fund’s precariousness, and its own experts’ forecasts that interest rates would continue to inch up.
“The big question on suitability,” said Gruenbaum, “is: Was this right for the pool? Was this kind of strategy appropriate for this fund in this county?”
* THE BEST COURSE? Experts are tying to figure out if a Chapter 9 filing was the best strategy for Orange County. D1
Orange County’s Bankruptcy
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