Securities Dealers Offer New Rules in Wake of O.C. Fiasco

The National Assn. of Securities Dealers proposed new rules Monday to ensure that brokerages not sell unsuitably risky securities to large government agencies previously viewed as sophisticated investors--a move that one expert said might have prevented Orange County’s financial fiasco.

The Government Finance Officers’ Assn. in Washington pressed for the change in so-called “suitability” rules because of a series of incidents in which local governments suffered major losses after brokerage firms sold them government securities or related derivatives. Derivatives are complex financial instruments whose value is derived from an underlying stock, bond, commodity or financial index.

Betsy Dotson, an official with the finance officers’ organization, contended that the proposed rules might have headed off Orange County’s recent debacle. The county filed for bankruptcy in December after suffering $1.7 billion in losses from a strategy that involved heavy investments in derivatives tied to government securities.

The county is suing Merrill Lynch, from which it bought many of the securities. Merrill Lynch denies any wrongdoing and says it warned the county that its strategy was faulty.

Dotson said the new rules would have set a higher standard for determining “what was a suitable investment for Orange County.”

A Merrill Lynch official Monday reiterated the firm’s contention that the securities weren’t to blame for Orange County’s bankruptcy filing.

“The problem with the portfolio was not the securities, the problem was the leverage,” said Tim Gilles, a spokesman for Merrill Lynch in New York.

“We welcome the NASD’s effort to bring greater clarity to suitability issues in relation to institutional clients,” Gilles said. “But Merrill Lynch’s actions were proper at all times in relations to its dealings with the Orange County treasurer’s office under the rules that existed at the time and under these proposed rules had they been in effect.”

Lawyers for Orange County said that they did not think the newly proposed rules would affect their pending lawsuit against the nation’s largest brokerage firm.

County lawyer James Mercer argued that Merrill Lynch, at the time it sold securities to Orange County, was already subject to suitability rules of the New York Stock Exchange and state government codes.

“It sounds like it will supplement existing rules, and that’s good,” Mercer said

The proposed rules change must be approved by the Securities and Exchange Commission.

The impetus for new NASD rules came from a 1993 change in federal law, for the first time authorizing organizations such as the NASD to draw up suitability rules for government securities. Suitability rules already were in effect for stocks and corporate bonds, although they were applied mainly to small investors.

The new proposal, however, makes clear that suitability rules will apply to institutional investors for stocks as well as government securities.

Wall Street traditionally has regarded institutional investors as fair game for virtually all stocks and bonds. The philosophy has been that institutional investors are big, sophisticated players who are well equipped to evaluate risk on their own.

But Dotson said many small cities and counties don’t have the financial expertise to evaluate complicated investments. And she added, “Quite frankly, if you look at some of the so-called experts in this field (employed by some larger cities and counties), many of them have been off the mark.”

The suitability rules would require brokerage firms to consider such factors as an investors’ assets.

The NASD last summer proposed much milder rule changes, freeing brokerage firms from having to assess suitability for any investor that had at least $50 million in assets. Dotson said that exemption would have covered nearly every state and local government in the country. She also said the report of a congressional committee that drafted the 1993 law stated explicitly that Congress didn’t want rules written that would exempt customers based only on the size of their assets.

The NASD said that as a result of comments it received from the finance officers and others, it changed the proposed rules to cover all investors, regardless of size.

The NASD said the key factor in deciding how much responsibility a brokerage firm has to assess the suitability of a particular security is whether the customer is buying it because the brokerage firm recommended it. Brokerage firms would have less responsibility for securities institutional investors decided to buy on their own without prompting from the brokerage firm.

Paltrow reported from New York and Vrana from Orange County.