Merrill's Board Trouble

As the brokerage giant's stock gets pummeled, outsiders question how the company's board has handled the problems

Merrill Lynch (MER) shares were under furious assault on Nov. 2, as the company, which last week forced out its CEO in the wake of huge losses, faced more questions about the scope of its exposure to investment pools that own subprime mortgage debt.

The selling was triggered initially by a story in The Wall Street Journal, which said the company has engaged in deals with hedge funds that "may have been designed" to "delay the day of reckoning" on losses in mortgage-backed securities. The story, citing an unnamed source, said the transactions are "likely" to be examined by the Securities & Exchange Commission.

The story led Merrill to issue a statement: "The story is nonspecific and relies on unidentified sources. We have no reason to believe that any such inappropriate transactions occurred. Such transactions would clearly violate Merrill Lynch policy," the company said. An SEC spokesman declined comment, saying the commission has a policy of not confirming or denying the existence of an investigation.

Merrill Shares Take a Beating

The statement failed to stem the wave of selling of Merrill's stock, which was down as much as 12% on Nov. 2. "The wording of the release doesn't inspire confidence," says Adam Compton, an analyst with RCM Capital Management, which owned 800,000 shares of Merrill as of June.

A downgrade on Nov. 2 from Mike Mayo, a bank analyst at Deutsche Bank (DB), also contributed to the stock's decline. He lowered his rating on Merrill from buy to hold, citing the possibility of more writedowns after the company took charges of $8.4 billion in the third quarter for losses in the credit and leveraged loan markets.

Merrill stock, which was already down 30% for the year, ended down 7.9% for the day, at 57.28. The shares are down 42% from their 52-week high reached in early January, when the company was riding the late stages of the boom in collateralized debt obligations (CDOs), which are investment pools with heavy exposure to mortgage-backed debt. The price of insurance on Merrill bonds has risen, too, suggesting traders believe the company's debt will be downgraded to "junk," according to Tim Backshall, senior credit strategist with Credit Derivatives Research, an investment adviser in Walnut Creek, Calif.

Investor Confidence Shaken

It was also a bad day for other financial companies such as Citigroup (C) (, 11/1/07). Citi's board has called a special board meeting for the weekend of Nov. 3rd, raising questions about the future of CEO Charles Prince (, 11/2/07).

At Merrill, the big worry is exposure to the CDO market (, 10/26/07). Mayo said Merrill reduced its net exposure to $15 billion in the third quarter from $32 billion in the second quarter, but only wrote down $6 billion worth of CDO exposure, "leaving a question as to how it reduced the 'missing' $11 billion." The allegation is that Merrill may have sold some debt to a hedge fund, with an understanding that the hedge fund could later sell the debt back to Merrill at a minimum price. "Trust is an issue…we have increasingly lost confidence in the financials of Merrill," Mayo wrote.

Bad Timing for a Company in Search of a Chief

The new questions about Merrill could complicate its search for a successor to former CEO Stanley O'Neal (, 10/31/07). O'Neal was pressured to resign last week, because the company's writedown was much larger than the $4.5 billion it predicted in early October and because the chief executive had investigated the prospect of a merger with Wachovia (WB) without first getting the board's consent. O'Neal is leaving with $161.5 million in back pay and retirement benefits.

"If there is any truth to what was published today, it's going to be a higher risk proposition to come in and manage this company back to health. It doesn't mean that it can't be done," says Compton of RCM Capital.

Corporate Governance Issues

The mounting questions about Merrill have led some corporate governance experts to question the board's role over the last few years. The board is responsible for overseeing the committee that manages the firm's risk. "I would not be happy with the board as my representative. There was a lack of oversight," says Paul Hodgson, a senior research associate at the Corporate Library, a corporate governance watchdog. Merrill declined to comment on the performance of the board. An e-mail and call to board member and Acting Chairman Alberto Cribiore, who's leading the CEO search, went unanswered.

Hodgson and other governance experts say the board fell down in other important respects. They say it structured a compensation package that allowed O'Neal to lock in a huge pay package of $48 million in 2006, even though the fixed-income profits that drove much of his compensation turned out to be fleeting. "There was unlimited upside and very little downside in the compensation," says Patrick McGurn, special counsel for the ISS governance services unit at RiskMetrics Group.

McGurn also faults the Merrill board for insufficient succession planning. While it was clearly grooming Merrill Co-President Gregory Fleming, 44, to succeed O'Neal at some point, it had no one ready to step in and take over as CEO in the event of a crisis.

In early October, Merrill's problems appeared to be large but manageable. Now they appear much more serious. Mayo said the company could be forced to strengthen its balance sheet by finding a partner if it reports more significant writedowns. RCM's Compton agrees the firm's fortunes have taken a dramatic turn for the worse: "Pretty much everything is lining up against them now."

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