Municipal Finance Will Merrill Take A Hit In Orange County?

The similarities are striking. Back in 1984, the city of San Jose, Calif., sued several major brokerages it blamed for some $60 million in investment losses. Faced with a weak legal position and the prospect of millions in litigation costs, all but two of the brokers settled for a total of $24 million without admitting or denying guilt. Among those who mailed in their checks was securities giant Merrill Lynch & Co., which ponied up $750,000.

Merrill could be stuck with a vastly larger tab when the dust settles on a similar dispute with Orange County, Calif., which filed for bankruptcy on Dec. 6 because of $1.7 billion in losses from risky derivatives investments. Merrill, in effect, lent the county's investment pool more than $1 billion to leverage up its portfolio. On Jan. 12, the county sued Merrill, seeking upwards of $2 billion in restitution for transactions the firm allegedly knew exceeded the county's authority and were part of an unwise investment strategy. Merrill blames County Treasurer Robert L. Citron, who ran the investment pool.

BEYOND THE PALE? The case, though, is likely to turn on some arcane legal issues that put Merrill at a distinct disadvantage. Several lawyers contacted by BUSINESS WEEK bet that Merrill will agree to take a big hit to avoid protracted litigation. "My instinct is that Merrill Lynch will have to settle this case," says University of Southern California law professor Jennifer H. Arlen. Some guess Merrill could end up paying more than $100 million.

No way, says Merrill. "I think we will win this case on a motion long before you'll see a trial," says Dennis J. Block, a partner with Weil, Gotshal & Manges, which is representing Merrill. "We believe this case will be dismissed based on law and facts."

The crux of both the San Jose and Orange County cases is what are termed ultra vires actions--beyond the scope of a particular entity's legal power or authority. Orange County claims that Citron borrowed considerably more money, via repurchase agreements with Merrill and others, than was allowable under the state's constitutionally mandated limits on county debt. Repurchase agreements are a form of collateralized lending where one party sells securities and agrees to buy them back in the future at a higher price. Because Citron exceeded his authority, the county claims, the loan transactions were invalid, and Merrill should return to the county all collateral and interest. A Merrill court filing says the debt limits don't apply to the county's investment pool.

Although Citron almost single-handedly managed the pool for years, Merrill could have trouble arguing that he should take the blame for his actions. County lawyers, led by James Mercer and J. Michael Hennigan, assert that California requires contractors dealing with the state to know the intricacies of state law. Thus, Merrill should have known that Citron acted beyond his legal authority. Says Hennigan: "[Merrill Lynch's] investment scheme was illegal and contrary to California's statutes and constitution."

PRECEDENTS. The San Jose case could be a troublesome precedent for Merrill, say attorneys. The U.S. district court judge ruled that the city's repurchase agreements--by which San Jose leveraged up its investment portfolio--were ultra vires because they were outside state investment guidelines. The jury ruled against the brokers who refused to settle. Weil Gotshal's Block argues the case is not a precedent because of factual differences.

A circuit court judge in West Virginia ruled against Morgan Stanley & Co. in an earlier ultra vires case. In 1987, a state investment pool suffered $225 million in losses. Morgan Stanley was one of many dealers who sold Treasury securities to the state. According to the judge, the transactions were inherently speculative and thus beyond the manager's authority. Most dealers settled and paid $28 million. The judge levied a $56 million judgment on Morgan Stanley, which is appealing the ruling.

"If Orange County were to win an ultra vires argument, they would be 75% of the way home to a large judgment," says Columbia University law professor John C. Coffee. Yet a victory for either Orange County or Merrill on narrow legal technicalities still won't answer the larger question of who is to blame.

The Blame Game


Treasurer Robert Citron was misled by Merrill, his financial adviser, which lent more than $1 billion to the county. Merrill should have known that Citron's leveraging of the county's investments exceeded the state-mandated ceiling on county debt. Thus, the firm should not have lent him money beyond that ceiling.


The suit is entirely without merit and will be dismissed. Merrill was not Citron's financial adviser and did not mislead him. Investment strategy, including leveraging the portfolio, was Citron's responsibility. The county debt limit does not apply to the investment pool that Citron managed.


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