Human Chess Made Endgame for O.C., Merrill

The gap between them seemed unbridgeable: hundreds of millions of dollars that for years separated Wall Street’s No. 1 brokerage and one of America’s wealthiest counties.

Then, out of the blue Tuesday, came word of a deal between Orange County and Merrill Lynch & Co., its former lead investment house. To settle lawsuits over $1.64 billion in losses from the county’s 1994 bankruptcy, Merrill would pay the county $400 million, return $20 million in frozen funds and pay $17 million more to a water district.

Public victory, private pressures. Behind years of posturing and finger-pointing, both sides knew they faced plenty of damning evidence against them. What might a jury make of it?

Besides that, a hearing on a key legal point was rapidly approaching--a point so important that losing it could devastate either side.

And all this might have yielded nothing if not for a judge’s not-so-subtle prodding--and a human bond that was forged by weeks of enforced separation followed by enforced closeness.

This is the story of those two months.

It began with lunch for two at the exclusive California Club, a downtown Los Angeles power center.

One party was J. Michael Hennigan, a highly paid lawyer battling to recover Orange County’s bankruptcy loss. The other was Merrill defense lawyer Ronald L. Olson.

On the menu: Rule 23 of Southern California’s federal court system. Parties in a civil action must try to settle the dispute before trial.

The two quickly agreed on mediation by a federal judge. They spent the next two weeks debating names before picking John G. Davies.

The Australian-born Davies, a 1952 Olympic gold medalist in the breaststroke, had overturned the swindling convictions of Lincoln Savings & Loan boss Charles H. Keating Jr. And his sentencing of two former LAPD officers in the beating of motorist Rodney G. King had been condemned as too lenient.

But Davies was highly regarded by the lawyers. He is a business law specialist with keen instincts for complex financial issues.

He would need them. During meetings that often stretched from morning to 8 p.m. over the next three weeks, Davies helped both sides see the strengths--and, more important, the weaknesses--of their cases.

The mediation began Tuesday, May 12, in Davies’ marble and dark-wood courtroom on the eighth floor of the new federal courts building in downtown Los Angeles. Arrayed around the judge were the high-profile legal teams.

Merrill brought in-house attorneys, its bankruptcy lawyers, courtroom litigators hired just for the trial, and the staff to support them all. Most important, it brought the firm’s vice chairman, Stephen L. Hammerman, a former top official of the U.S. Securities and Exchange Commission--the man with the power to approve any deal should one emerge.

The county team was smaller. There was Hennigan, with partners James W. Mercer and Bruce Bennett. Patrick Shea represented the 200 investors in the county’s pool. And, most important, Thomas W. Hayes, the litigation czar approved by the bankruptcy court to recover as much as possible of the county treasury’s $1.64 billion in losses.

As though a jury were looking on, Olson and Hennigan laid out their starkly conflicting versions of what had caused the largest municipal bankruptcy in American history, and who was responsible.

Hennigan went first, straightening his trademark bow tie and launching into his opening statement, blaming Merrill for the umpteenth time for Orange County’s debacle.

The county’s case was simple, he told the judge: Merrill had duped former county Treasurer Robert L. Citron into making massive bets with borrowed money on interest rates remaining low.

It had done so to generate enormous fees for the firm and lucrative bonuses and commissions, especially for Citron’s daily contact, Michael G. Stamenson, who made millions.

Orange County was Merrill’s single most profitable client, Hennigan told Davies, and Stamenson was the firm’s No. 1 salesman worldwide--a fact underscored by an astonishing Merrill training video.

Caught on that hourlong tape, portions of which were played that day in court, Stamenson lifts an expression from author Tom Wolfe’s satiric take on bond traders, the best-selling “Bonfire of the Vanities.” Some sales people are merely successful, Stamenson says, but those who really seek to conquer their worlds should emulate him and become “masters of the universe.”

But there was a problem with how exactly Stamenson had come to master Orange County, a big problem for Merrill, Hennigan told the judge:

The investment strategy Stamenson had foisted on an unwitting Citron was absurdly risky and illegal under California law. As an expert in government finance, Merrill had to know this and should now be forced to compensate the county with $2 billion.

When Merrill’s turn came, lead lawyer Ronald Olson shook his head. He’d heard all this before.

Orange County knew what it was doing, Olson asserted. Citron was not only the elected treasurer but a savvy investor widely praised for his consistently high returns.

In fact, there had been no scheme at all, and Citron had fully disclosed how his alchemy worked, Olson argued. Citron, he said, was not speculating. Instead, he was consciously taking higher--but not inordinately higher--risks to earn more money for the county.

Besides, however risky Citron’s tactics may have been, the county supervisors had deliberately looked the other way, because they wanted the extra money he brought in and didn’t want to make the hard choice of cutting programs.

The county’s claim that Merrill had led Citron into an illegal investment scheme was nonsense, Olson said. California law permits treasurers to borrow and invest as Citron had.

What’s more, if the county was to be believed, only Citron and his top aide, Matthew Raabe, really knew what had occurred between Citron and Merrill Lynch.

But who could believe them? Both were now felons, convicted of looting some $100 million from schools, cities and local agencies for the county’s benefit.

Finally, it was preposterous for a county that had enjoyed an extra $800 million in interest earnings in the three years before its bankruptcy to now demand from Merrill the entire $1.64 billion lost when Citron’s house of cards collapsed.

Judge Acted as Go-Between

The morning-long arguments were familiar to all that day. But because they were listening to attorneys for the other side for the first time, Hayes and Hammerman, the only participants empowered to end the 42-month legal fight, had never heard the cases against them presented so forcefully.

Then, the similarity to a real trial ended.

Davies dispatched each camp to separate rooms: Merrill to the jury room, Orange County to his courtroom. And apart from an occasional stroll down the hallways outside, murmuring into cellular phones, those were their bases for weeks of shuttle diplomacy.

Each side alternately went to Davies’ chambers to hear the other’s latest position from the judge and present its own, never knowing the nuances of what the other had said, never having the chance to read an expression on an opponent’s face.

If mediation failed, the soundness of their cases would be determined at a final pretrial hearing. There, U.S. District Judge Gary L. Taylor, the Santa Ana-based judge presiding over the lawsuit, would decide a core issue--whether Merrill had illegally extended Citron more credit than the law allows to fund more purchases of risky securities.

The stakes were enormous, for both adversaries.

If the county lost, it could still go to trial against Merrill, but with a far weaker case. And it would have no case left at all against most of the 20 other brokerages it had sued.

If Merrill lost, it could be found liable at trial for all of the county’s losses and perhaps far more. And the county’s cases against the other brokerages that also had extended it credit would be strengthened immensely.

Merrill almost immediately offered to settle for $100 million, an amount the county regarded as laughably low. For its part, the county initially demanded full repayment--an insistence that could only lead to a full-blown trial.

“They were as far apart as two parties can be and still be in the same state,” said Shea, the attorney for cities, schools and agencies.

Hayes turned down the $100 million, then $200 million, $250 million, $275 million.

“We spent a lot of time getting Tom Hayes ready” to resist the initial offers, Hennigan said. “He looked into the mouth of the dragon many times before he said yes.”

The amounts would have been harder to resist had the county not already secured nearly $200 million in settlements from other lawsuit defendants.

Yet even with that strengthened hand, Hayes was keenly aware of what his team called “the food fight” elements of the case--the abundant facts that made the county look bad, from the convictions of Citron and Raabe to the profound lack of oversight by the county supervisors and auditor.

“We’d known for quite some time that the county was not blameless in this,” Hayes said.

The magnitude of Merrill’s offers was not lost on Davies. One morning not long after India tested an atomic weapon, the judge displayed a newspaper with a story on the announcement of U.S. sanctions that would cost India $144 million.

“And [Davies] told us, ‘You’ve turned down more money than we were going to give to the government of India,’ ” one participant recalled.

Slowly the offers rose to $300 million then $331 million during the second week. “That’s a lot of money,” Davies said repeatedly.

Then he changed the rules. On Wednesday, May 20, he called Hayes and Hammerman into his chambers for a nearly two-hour meeting. It was time for them to cut a deal face to face, without help from their legal teams.

Hayes and Hammerman bear an uncanny resemblance, each with light hair, fair complexion and an almost military bearing. And right off the bat, they established an almost brotherly bond.

That afternoon they left the court and took a walk together. The next day, Thursday, May 21, they met for breakfast. And the settlement figure rose to $375 million.

That afternoon, they headed back for a private session with the judge, who had made clear he especially liked Merrill’s argument that the county’s losses were actually less than $1 billion because of the extraordinary earnings it had gained on its high-risk investments in previous years. It was an argument whose strength had begun to sink in with the county team.

The meeting lasted nearly two hours.

“And then they come out. And Hayes tells us, ‘It’s going to be $400 million,’ ” Hennigan said.

The next week was spent ironing out details. The Irvine Ranch Water District, which had filed a separate suit against Merrill, finally accepted a $17-million settlement. Merrill agreed to make that a separate payment--not part of the $400 million.

On Tuesday, June 2, Hammerman briefed Merrill’s board on the settlement and the county Board of Supervisors signed off on the last details. Later that day, video rolled and cameras flashed as Hayes and the lawyers revealed the historic deal to reporters.

They had just obtained one of the largest settlements ever paid by a Wall Street firm. Yet the county lawyers had mixed emotions over the compromise.

“We’re trial lawyers,” said Hennigan. “Imagine you work your whole life to make it to the Super Bowl.

“And just before the game starts, it’s called off--but they give you the ring anyway. It’s just not the same.”

No one had come out of this deal a master of the universe.