Orange County Can Sue Merrill Lynch, Judge Rules

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 in its effort to recover damages that 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. The investors have been reluctant to sign on without a clear indication that the county had filed a viable lawsuit from which investors might recover some of the county’s $1.7-billion in investment losses.

Orange County’s lawyers were jubilant after Bankruptcy Judge John E. Ryan ruled in their favor after a two-hour hearing, which was held exactly a year after county leaders announced 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, the hearing involving the largest municipal bankruptcy ever and the world’s biggest brokerage was closely followed in the legal and financial community. The usually empty Bankruptcy Court was packed to capacity with lawyers, accountants and financial advisers.

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

Olson contended that the securities Merrill Lynch sold to the pool belonged to nearly 200 government agencies--cities, school districts, water districts--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 the federal bankruptcy law holds that money does belong to the county, which can sue in Bankruptcy Court to recover it.

The county’s lawsuit alleges that Merrill Lynch duped former Orange County Treasurer 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 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 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 decisions and that he was supported by the county Board of Supervisors.

Bruce Bennett, the bankruptcy lawyer who is crafting the county’s recovery plan, said pool investors would now feel comfortable approving the county’s complicated plan to emerge from bankruptcy.