SEC Sues First Boston Over Sale of O.C. Bonds

In its first strike against one of Orange County’s financial advisors, the Securities and Exchange Commission on Wednesday sued CS First Boston, accusing it of fraud and deceptive practices that hastened the county’s fiscal downfall two years ago.

The federal regulator charged that First Boston and two of its investment bankers misrepresented or omitted crucial information about the county’s shaky financial condition in documents offering to sell $110 million in county bonds. The company and the bankers denied any wrongdoing.

The bonds were sold only months before the county collapsed into the nation’s worst municipal bankruptcy.

The agency’s action, filed in federal court in Santa Ana, raises the specter of other lawsuits, including one against the nation’s largest investment banker, Merrill Lynch & Co., the county’s main investment advisor.

The agency’s investigation is “wide-ranging” and “continuing,” said Elaine Cacheris, the SEC regional director in Los Angeles, but she wouldn’t elaborate.

Even so, county officials see the First Boston lawsuit as a signal that the SEC is reaching the end of its negotiating rope with the county’s outside advisors over their roles in the county’s financial fiasco.

Over the last year, the agency has sent numerous notices to investment bankers, lawyers and others saying that they are targets of possible lawsuits stemming from the county’s bankruptcy. The SEC entered into talks with them to settle possible charges before suits are filed. Neither the agency nor the targets will discuss such matters.

Earlier this year, the SEC filed enforcement actions against former County Treasurer-Tax Collector Robert L. Citron and his former assistant, Matthew Raabe. Separately, the agency ordered Orange County and its Board of Supervisors to halt future fraudulent conduct in the offer and sale of securities.

The lawsuit against First Boston and its two former brokers--Douglas S. Montague, 39, of La Canada and Jerry L. Nowlin, 53, of Park City, Utah--seeks an unspecified amount in penalties. The firm is liable for $500,000 per violation and each individual faces a penalty of $100,000 per violation, but the SEC would not detail how many violations occurred.

The agency alleges that while preparing documents for the bond sale, the defendants “knew, or were reckless in not knowing, significant negative information” about the county’s beleaguered investment pools. They either misrepresented the information or omitted it from the official offering statement, the suit alleges.

It accused the firm and the former employees of fraud and “deceptive, dishonest and unfair practices.”

First Boston asserted that “there is no basis for a fraud charge” and that it will defend its position “vigorously.”

“The county provided CS First Boston with misleading information,” said Andrew MacMillan, a spokesman for the brokerage. First Boston, he said, was “clearly victimized” by Citron, who was sentenced Tuesday to a year in jail for his role in the collapse.

The individual defendants also blamed Citron and the county.

“Mr. Nowlin denies the charges and expects to be cleared at trial,” said his lawyer, Jan Lawrence Handzlik. “He played by the rules and did his job properly at all times. Even the SEC was hoodwinked by certain officials in Orange County.”

Montague said through his lawyer, Robert S. Brewer Jr., that he maintained the “highest” ethical standards and complied with all laws and rules. “I am confident it ultimately will be demonstrated that my conduct in this transaction was above reproach,” he said.

The bonds were issued in September 1994 to help fund the county’s obligation to the Orange County Employees Retirement System.

But the sale came as the county-run investment pool was teetering under the weight of repeated hikes in the interest rate, which was gutting the value of some highly risky securities it held. The $20.6-billion investment pool crashed, losing $1.64 billion, and the county went into bankruptcy in December 1994.

The SEC charges that First Boston and its brokers couldn’t help but know that increases in the interest rate through 1994 had been destroying about a third of the county’s portfolio.

“From a variety of sources, they knew of the risks in the Orange County investment pools,” Cacheris said. “They knew from the transactions they engaged in, from news reports and from other sources that there was substantial risk. None of this was disclosed.

“The disclosure that investors got cast the pools in a false light,” she said. “It gave a false sense of safety and security.”

What made the offering particularly worrisome to county officials was that it offered short-term notes that investors could cash in with only seven days’ notice.

The seven-day feature hastened the county’s collapse, officials have said. Already losing $1.5 billion, the pools couldn’t withstand a call by bondholders for refunds. But news leaked out, and they demanded their money. The county responded by filing for bankruptcy, making the $110-million bond issue the only one to default and adding to the county’s problems.

First Boston pointed out that it had nothing to do with the securities that the county bought for its investment pools, in which numerous cities and agencies also participated.

In fact, many of those investments, as well as the strategy for buying high-risk securities, came from Merrill Lynch, the county charges in its $2.4-billion lawsuit against Merrill and others.

In selling county pension bonds to the public, however, First Boston had a duty to examine the county’s financial condition, including the investment pools, and disclose any risks to potential investors. That, the SEC charges, is what the brokerage failed to do.

“I’m glad to see the SEC stepping up to the plate,” said John M.W. Moorlach, who first warned about the county’s risky holdings and eventually took over as county treasurer.

Moorlach said the debt offering didn’t even make economic sense because the interest rate benefit the county was supposed to get by selling debt to the public vanished by the time the offering was ready.

“The county should have backed out of the deal in September [1994],” he said. “There was no gain in going forward, except for CS First Boston making a profit on the deal. Greed has a funny way of biting back.”