ORANGE COUNTY IN BANKRUPTCY : County Suffers Small Setback in Lawsuit Against Merrill Lynch : Courts: A bankruptcy judge rules that a county request to separate the two major issues in the litigation is premature.

SANTA ANA — Orange County suffered a small setback in its $2-billion lawsuit against Merrill Lynch & Co. Friday when a U.S. bankruptcy judge ruled it was too soon to say whether the Wall Street giant knowingly extended the county more credit than the state Constitution allows, thereby voiding the deals.

U.S. Bankruptcy Judge John E. Ryan said it was “premature” to entertain a request by county bankruptcy lawyers to speed up the litigation by separating two major issues in the lawsuit against the brokerage firm.

The suit accuses Merrill Lynch of fraud and also alleges that the firm extended credit to former Orange County Treasurer-Tax Collector Robert L. Citron in excess of California’s legal limits.

Earlier this week, county bankruptcy lawyer J. Michael Hennigan filed a request to “bifurcate” the issues, so that the county could get a quick ruling that Merrill was obliged under state laws to know that Citron did not have the authority to borrow billions of dollars and to gamble public funds on unsuitable investments.

But Ryan said he could not grant the county’s request--at least not yet. “I would like to take one step a time,” the judge said, following an hourlong hearing.

Ryan noted that Merrill Lynch still needed to file a response to the county’s amended lawsuit and that he had not yet ruled on the brokerage firm’s motion to dismiss the entire complaint.

“I would like to take the issue of bifurcation through that process,” the judge said.

Responding to Ryan’s ruling, county bankruptcy lawyer Bruce Bennett said: “We would have liked it better if the motion was granted. We want to go to trial but obviously they don’t. That may tell you something about where this lawsuit is at.”

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Daniel J. Bussel, a professor and expert in commercial law at UCLA School of Law, said the judge’s ruling was reasonable. “The judge is simply managing the case before him,” Bussel said. “He has decided he’ll take it in this order rather than the order which the county prefers.”

Another law professor, Christopher B. Cameron of Southwestern University School of Law, said the decision was not unusual. “The judge has made a decision that there’s no leverage to be gained in promoting a settlement now,” Cameron said. “If he thought that [separating the issues] would speed up a settlement, he would have allowed it.”

After voters last month overwhelmingly rejected Measure R, the proposal to raise the sales tax from 7.75% to 8.25%, the county’s recovery plans have come to hinge on a big payoff from its lawsuit against Merrill Lynch.

The county is seeking $2.4 billion in damages from the Wall Street brokerage firm, which sold the county most of the securities in the county-run investment pool that plunged $1.7 billion in value last December, triggering the county’s unprecedented bankruptcy.

Outgoing County Chief Executive Officer William J. Popejoy indicated last month that the county would settle for $1.2 billion to avoid protracted litigation. But Merrill Lynch Chairman Daniel P. Tully has flatly rejected the offer.

Merrill Lynch spokesmen have repeatedly stated that the company has done nothing wrong. They have argued that Citron was a knowledgeable investor who was solely responsible for the county’s investment strategy.

The firm’s lawyers said the county legal arguments are without foundation because the Board of Supervisors “championed those investments when it was to their advantage to do so . . . when they were able to receive the above-market investment return that Citron provided to them.”

In court Friday, Ronald L. Olson, a lawyer for Merrill Lynch, told the bankruptcy judge that client pressure was probably responsible for “this obviously premature” motion to bifurcate the trial.

“It would appear that Plan A has evaporated [because] the tax increase was not approved,” Olson said. “There appears to be enormous political pressure to do something.”

But Hennigan, the county’s lawyer, responded that Merrill Lynch’s lawyers have served notice that they needed 400 days to take depositions of potential witnesses for the trial.

Separating the issues, Hennigan said, would guarantee a “trial in our lifetime and this year.” If the issues were not separated, a trial of the county’s lawsuit “would eclipse the O.J. Simpson case,” he said.

Bennett said the county may ask the judge to consider a similar motion in two months.