O.C. Scores Biggest Win Yet Over Merrill Lynch : Suit: Judge rules county can pursue claim against broker and try case in Bankruptcy Court. Recovery plan boosted.

Orange County won its biggest victory yet in its $2-billion lawsuit against Merrill Lynch & Co. when a judge ruled Friday that the county was the proper party to sue the Wall Street brokerage and could pursue its claim in U.S. Bankruptcy Court.

The decision is crucial because it means the bankrupt county is on a speedier track to possibly recover damages it claims Merrill Lynch caused by selling the county billions of dollars in high-risk securities.

The ruling also paves the way for final approval of the county’s fragile bankruptcy recovery plan by pool investors reluctant to sign on without a clear indication that the county had filed a viable lawsuit from which they might recover some of the county’s $1.7-billion investment losses.

Orange County’s lawyers were jubilant after U.S. Bankruptcy Judge John E. Ryan ruled in their favor following a two-hour hearing, held on the eve of the anniversary of county leaders’ stunning announcement that their investment portfolio had suffered unprecedented losses.

“This is a big day for us,” said J. Michael Hennigan, a Los Angeles lawyer who argued Orange County’s case.

Ronald L. Olson, Merrill Lynch’s lead attorney, said he was “disappointed by the preliminary but very important decision.”

The brokerage has denied any culpability in the county’s financial collapse, and Olson told the judge Friday that Merrill Lynch would consider appealing.

With billions of dollars at stake, Friday’s hearing involving the largest municipal bankruptcy ever and the world’s biggest brokerage was closely followed in the legal and financial community. The normally empty Bankruptcy Court was packed to capacity with lawyers, accountants and financial advisers as court personnel crammed in extra chairs in the aisles to accommodate spectators.

The hearing involved a request by Merrill Lynch to have the county’s lawsuit thrown out of court.

Olson contended the securities Merrill Lynch sold to the pool belonged to nearly 200 government agencies--cities, school districts, water districts and others--and not just the county, so any lawsuit for damages must be filed on behalf of all the agencies. In addition, California law prohibits counties from claiming ownership of funds in county-run investment pools, the attorney argued.

“It’s time for Orange County to face up to the reality,” Olson said. “Depositors’ monies are not the property of Orange County.”

Olson said the county should file its lawsuit in U.S. District Court and that Merrill Lynch “would defend that case if it should.”

But Ryan rejected those arguments. The judge agreed with Hennigan that funds in the investment pool had been so commingled that the proceeds were untraceable to any specific agency.

Ryan also agreed that Orange County could not claim ownership of the funds under state law, but noted that federal bankruptcy law holds that the remaining money does belong to the county, which can sue in Bankruptcy Court to recover it.

The county’s suit alleges that Merrill Lynch duped former Orange County Treasurer-Tax Collector Robert L. Citron into purchasing risky securities in violation of state law. It also contends that the transactions, particularly those involving complex reverse repurchase agreements, forced the county to exceed the amount of debt it could legally incur under the state’s Constitution.

According to the county’s lawsuit, Merrill Lynch sold Orange County 68% of the securities in the $21-billion investment portfolio, which included $14 billion worth purchased with borrowed money. The county used virtually all of this borrowed money to buy reverse repurchase agreements, a transaction in which the seller often provides both the credit and securities being purchased.

Merrill Lynch officials have repeatedly stated that Citron made his own investment decisions and that he was supported by the county’s Board of Supervisors.

Friday’s hearing was pivotal for the county because Ryan tossed out a similar lawsuit against Merrill Lynch six weeks ago and asked county lawyers to prove that it was the proper party to bring a claim.

If the lawsuit were thrown out a second time, the county would have been forced to file the case in U.S. District Court, meaning that the county would have started from scratch and that hopes for a speedy resolution would have been dashed.

Hennigan told the judge Friday the county was hoping for a resolution to key issues in the case by next June 30, the end of the county’s budget year. The county eventually wants Ryan to rule on the legality of the transactions between Merrill Lynch and Citron.

Bruce Bennett, the bankruptcy lawyer who is crafting the county’s recovery plan, said the ruling would have an immediate effect. Pool investors, he said, would now feel comfortable approving the county’s complicated plan to emerge from bankruptcy.

Under the county’s bankruptcy recovery plan, the county will mortgage property, divert transportation and park taxes, raise dump fees and import trash from neighboring counties. But the plan’s key element is to have pool investors agree to let the county repay about $800 million of their losses with litigation proceeds.

Because so much is riding on the success of the county’s lawsuit, pool investors have been reluctant to embrace the recovery plan until the county had a solid lawsuit in Bankruptcy Court.

Patrick C. Shea, the lead attorney for the pool participants, said the judge’s ruling went a long way in relieving his clients’ concerns.

“It’s an important decision,” Shea said. “It bodes very well for the county’s case.”

Although there are several issues still standing in the way of the pool participants’ final approval of the recovery plan, Shea said he expects those hurdles to be cleared shortly. He predicted the recovery plan would be ratified by his clients within the next two weeks.

County Chief Executive Officer Jan Mittermeier applauded the judge’s decision. She also was hopeful the recovery plan would be quickly ratified by the pool investors.

“I was told by a number of cities that as soon as they saw what happened on Dec 1 . . . that they would be ready to take the agreement to their city councils,” Mittermeier said. “We’re hopeful that that can start happening now.”

Supervisor Marian Bergeson said the ruling may cause Merrill Lynch to consider settling the case.

“I’m sure it gives them a great deal of concern,” she said. “It’s a very severe setback for Merrill Lynch.”

Jon Schotz, a financial adviser to the pool investors, said the hearing’s outcome was a significant victory for both the county and the pool investors.

“It’s the first game of a long season. It’s a great win, but there is a long way to go before we get a victory at the Super Bowl,” he said.

And Chris Vareles, the county’s financial adviser, also likened Friday’s hearing to a sporting victory in which the county “covered the spread by a significant margin.”

James Spiotto, a Chicago lawyer who is an expert on municipal bankruptcy law, cautioned that the judge’s decision was “just the beginning” of the county’s battle against the giant brokerage.

“There are many steps ahead,” he said.

* BAD NEWS Bs: Option B agencies’ weeklong losing streak continues. A18

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

What’s Next?

Judge John E. Ryan’s ruling in U.S. Bankruptcy Court against Merrill Lynch on Friday sets the stage for several possible follow-up scenarios:

* Merrill Lynch & Co. is likely to file an appeal in U.S. District Court challenging Ryan’s ruling allowing the county’s lawsuit to remain in Bankruptcy Court.

* An unsuccessful appeal leaves Merrill lawyers 20 days to file a response to Orange County’s $2-billion lawsuit, which blames the brokerage for the county’s financial losses and bankruptcy.

* Orange County attorneys have until Dec. 6 to resubmit a motion to accelerate the case by having the judge rule on some key matters that would “simplify the issues.”

* Merrill Lynch attorneys then have until Dec. 11 to respond to the county’s motion, which would be argued before Ryan on Dec. 12.

* Cities, school districts, special districts and other agencies that lost money in the county’s failed investment pool are now expected to approve the county bankruptcy recovery plan. That plan must be submitted to Bankruptcy Court by Jan. 1.

Sources: U.S. Bankruptcy Court and county officials

Researched by MATT LAIT / Los Angeles Times