The rash of securities crimes over the last several years has touched most of the major investment firms. A notable exception is Merrill Lynch & Co., whose well-regarded compliance department has kept the country's largest brokerage house virtually free of serious taint.
That could change soon. BUSINESS WEEK has learned that the Securities & Exchange Commission and the U.S. Attorney's Office for New York's Southern District are investigating Merrill's junk sales and trading department, looking into such possible violations as "front-running," or trading ahead of customers; "scalping," promoting issues after acquiring positions; and parking.
Last September, Merrill fired two vice-presidents on the junk desk, Edward N. Scherer and Richard Kursman. Merrill said they were terminated for "mishandling a customer account," an "isolated incident." Yet according to BUSINESS WEEK's sources, who have knowledge of the inquiry, wrongdoing may have been more systematic. The firm has made changes in compliance procedures. On Feb. 26, Merrill announced the retirement of Brian M. Barefoot, the managing director who headed the junk desk. "Merrill enjoys the best reputation for compliance, but not in junk bonds," says a source familiar with the probes. "The firm has some serious issues to confront with the junk-bond desk."
LEGAL FRONTIER. Merrill says its own review found no evidence that anyone other than Scherer and Kursman, who are said to be cooperating with prosecutors, were involved in wrongdoing. "We are the victim and hopefully won't be blamed for what has happened, because we have acted promptly," says a Merrill spokesman. Lawyers for Scherer and Kursman had no comment. Barefoot couldn't be reached. The SEC and the Justice Dept. declined to comment.
Even if the government's suspicions are true, it's far from certain that such conduct violates the law. Front-running, scalping, and parking can be illegal when stocks are involved, but the law is murky when applied to junk.
The possible front-running infractions, according to BUSINESS WEEK's sources, involve evidence that Merrill junk employees may have routinely purchased junk bonds for their own accounts shortly before the distribution of internal analyses of junk issues, which sometimes are circulated to outsiders. Sources say the trading could have involved Interco, Federated Department Stores, Greyhound, and MCorp. Scherer and Kursman are said to have made some 20 such trades over a 10-month period. In one instance, Merrill junk employees purchased $5 million of Interco's 13.75% senior subordinated debentures at about 11 3/4 last July, a few days before the release of the favorable analysis on Interco's debt. After it circulated, the bonds more than doubled, to 24.
Merrill says that after it fired Scherer and Kursman, it found other high-yield employees had bought Interco debt "in approved transactions." But because of Interco's quick runup, the firm "adjusted downward" the price paid by nine institutional customers "to avoid any appearance of impropriety." The firm says it found no trading by junk employees in Greyhound or Federated bonds, and that the only employee who bought MCorp. debt was one of the two who were fired. Sources say Scherer and Kurzman did not secure approval for their trading and traded through an outside accomplice.
EARLY BIRDS? Prosecutors are also looking into whether Merrill's junk employees engaged in scalping. According to sources, the employees bought junk bonds, then promoted them to customers based on positive reports. They sold after customer purchases pushed up prices. John C. Coffee, a securities-law professor at Columbia University's law school, says such conduct could be considered illegal if the reports or the employees' characterization of them to customers were overly optimistic or false.
Elsewhere, the SEC is said to be probing whether Merrill junk employees helped a now-insolvent Florida insurer, Guarantee Security Life Insurance Co., to disguise its deteriorating condition by engaging in illegal securities parking. Last Dec. 20, the Florida Insurance Dept., Guarantee's receiver, sued Merrill, Richard Allerton, a managing director in its junk department, and others. The suit details some of the transactions said to be under scrutiny by the SEC and Justice. On Mar. 18, a Senate subcommitte probing insurance fraud is set to hold hearings on Guarantee. Merrill denies any illegal or unethical activity and is cooperating with the SEC.
The Florida suit alleges that Merrill helped prop up Guarantee with "phantom" yearend transactions in 1984, 1985, 1986, and 1988 that looked on the books like sales of junk bonds by Guarantee to Merrill in exchange for U.S. Treasuries. The purported trades removed the junk--which required the insurer to set aside a reserve totalling 20% of the junk bond's value--from Guarantee's balance sheets. In its place: Treasuries that required no such reserve. The transactions were reversed early the following January, the suit alleges. Allerton, it asserts, issued confirmation slips to fit the bogus trades. Allerton left the firm on Dec. 31.
Merrill and Allerton are fighting the suit. The firm and Allerton's lawyer, Charles A. Stillman, insist that Allerton's departure was voluntary and unrelated to Guarantee.
Even if Merrill avoids charges relating to Guarantee and really was a victim of two rogue employees, its sterling compliance reputation will still need some polishing.
PROBING MERRILL'S JUNK DESK The SEC and the Justice Dept. are said to be looking into several areas of possible wrongdoing: FRONT-RUNNING Merrill employees may have acquired junk bonds before the distribution to outsiders of bullish internal junk analysis reports. Merrill denies any wrongdoing SCALPING Merrill employees may have acquired junk positions, promoted the junk to customers, and then sold out after prices rose. Merrill says an internal review found no evidence of such wrongdoing PARKING Merrill may have helped Guarantee Security Life Insurance, a Florida insurer, hide its deteriorating financial position through prearranged "parking," or sale and repurchase deals, of junk from 1984 to 1988. Merrill denies any illegal or unethical activity and is cooperating with the SEC