Bankers Grilled About Risk Disclosure : Hearing: Lawmakers ask Wall Street representatives why they didn’t do more to warn officials and bond buyers of their concerns about county investments.

State lawmakers grilled Wall Street investment bankers Thursday, demanding to know why they didn’t more forcefully share their concerns about Orange County’s high-risk investment pool with local officials and the county’s bond buyers.

The members of a special Senate committee impaneled to look into Orange County’s $1.69-billion investment loss were especially angry that investment giant Merrill Lynch & Co. knew of the high stakes involved in former Treasurer-Tax Collector Robert L. Citron’s investment strategy but continued selling him the highly volatile securities he sought.

Merrill bankers, noting that they warned Citron nine times since 1992 that his bets on interest rates might not pan out, said the firm’s officials believed they had no responsibility to stop selling securities to Citron because he was a sophisticated manager whose bets might have paid off if interest rates had not risen sharply.

“In the case of Mr. Citron, we were highly comfortable in the fact that he was an extremely sophisticated financial manager,” said Richard M. Fuscone, 43, a managing director for Merrill Lynch who flew in from Wall Street to defend the firm’s actions. “But you can be an extremely sophisticated financial manager and still be wrong.”

Merrill’s arguments sounded like the “tobacco defense,” said state Sen. Tom Hayden (D-Santa Monica.)

“You sell tobacco to somebody, you warn them that it will kill them,” said Hayden. “They say, ‘Fine, I take the warning.’ You sell them more tobacco.”

Lawmakers said the firm forgot that its clients were the taxpayers of Orange County, not Citron.

The questioning also left some county supervisors convinced that highly paid financial experts should have given clearer warnings about the risk in Citron’s strategy.

“I think Merrill Lynch is in a real pickle,” said Supervisor Roger R. Stanton. “They clearly were dodging and dancing on a lot of these questions.

“The message that comes across is that they regarded Bob Citron, as a person, as their client. Why didn’t they come to the legislative body?” he asked.

Merrill Lynch, which sold Orange County many of the riskiest investments in its collapsed portfolio, has said it earned $62.4 million in 1993 and 1994 from its dealings with the county. In 1994, the firm underwrote and marketed more Orange County bonds than any other firm.

Committee members asked bankers whether there was sufficient disclosure of the county’s investment pool problems when Merrill underwrote a $600-million taxable bond issue sold by the county last July to reap extra returns in the pool.

The note issue has drawn scrutiny from the federal Securities and Exchange Commission and the state Department of Corporations, which are investigating whether that note was issued solely to meet expected collateral calls by brokerage firms.

Lawmakers called the disclosure language in bond documents for that note “rather abstract and oblique” and questioned whether there was enough information for investors to make responsible decisions.

“There actually was” enough disclosure, said Fuscone. “If you look at disclosure statements, it was quite specific and outlines several of the risks associated with the fund. We did not consider it to be abstract. We were confident all the proper questions had been asked and were answered.”

The bond documents for the note issue disclosed that the investment portfolio did not reflect its true market value and that it included derivatives, Fuscone said. But state Sen. Lucy Killea (I-San Diego) asked why more detailed information wasn’t provided on the fund, especially given Merrill’s extensive warnings to Citron.

Appearing with Fuscone were J. Timothy Romer, an investment banker who joined Merrill Lynch in July, 1989, and Elke Cheveney, a Merrill Lynch vice president. Both worked on note financing for the county.

Cheveney pointed out that PaineWebber Inc. was selected to underwrite the $600-million bond issue. But at the last minute, Merrill offered to handle the deal at less cost to the county.

While Merrill looked over the offering documents with the county’s bond attorney, the bulk of the disclosure work was done by PaineWebber, the county and its financial adviser, Leifer Capital of Santa Monica, Fuscone said.

Orange County filed suit against Merrill Jan. 12 for $2.4 billion in damages, alleging that the brokerage developed a complex investment scheme that broke state law and led to the collapse of the county’s finances.

Individual investors, some of whom bought millions of dollars of Orange County bonds, have also filed lawsuits against Merrill, contending that the firm did not provide adequate disclosure.

Much of Thursday’s debate focused on whether Merrill Lynch’s client was Citron or the County of Orange, and whether Merrill should have warned the county Board of Supervisors directly.

Fuscone said the firm dealt with Citron as the county’s authorized representative and had no responsibility to inform other officials.

“We respected Mr. Citron’s authority and his successful management of the fund over many years and the disclosure he had embraced and provided to the board and the pool participants,” Fuscone said.

Fuscone said it would have been an “extraordinary act” for the firm to go over Citron’s head.

“The Board of Supervisors could have had a reaction that there was something very wrong with the portfolio at the time,” he said. “This was not the case.”

But state Sen. John R. Lewis (R-Orange) called Fuscone’s arguments “a dog that just won’t hunt.” And state Sen. Patrick Johnston (D-Stockton) said it was “critical” that at some point Merrill Lynch had a duty to go beyond Citron and contact “the client, the taxpayers of Orange County, but you didn’t do that.”

Under questioning from lawmakers, Doug Montague, a public finance banker for CS First Boston Corp. who helped structure a $110-million Orange County pension bond issue now in default, said he believed there was sufficient disclosure on that deal as well.

First Boston, which underwrote $545 million of Orange County bonds in 1994, was the firm that unloaded $2.6 billion in county bonds in early December, prompting the county’s bankruptcy filing.

After the county said it couldn’t pay $1.2 billion in loans due, CS First Boston decided to sell the $2.6 billion of collateral bonds it held as security for loans to the county.

Hayden said there were “glaring” disclosure differences between the pension bonds and the notes sold by the county last summer. “It seems that disclosure is rather upbeat and makes no reference to risky investments,” he said.

Hayden continued to focus on the lack of disclosure in deals associated with the investment pool during testimony by investment banker Kenneth D. Ough, a senior vice president at Rauscher Pierce Refnes.

Hayden ran down a list that included four Orange County school districts, the county Department of Education and two cities--Irvine and Anaheim--which Ough persuaded to borrow millions to funnel into the county pool.

“There seems to be no disclosure of the risk,” Hayden said. “Why is that?”

Ough said he had retained a “prominent nationally recognized disclosure counsel”--the firm of Jones, Hall, Hill & White--to determine if there was risk to be disclosed.

“Look, everything we heard at that time was very positive with regards to the Orange County investment pool,” Ough said.

Times staff writers Tracy Weber and Lee Romney contributed to this report.