Merrill Lynch: See No Evil?

Investigators wonder if all its Enron dealings kept the firm mum

When Enron Chief Financial Officer Andrew S. Fastow hired Merrill Lynch & Co. (MER ) in 1999 to raise money for one of his now-notorious off-balance-sheet entities, he told the brokerage firm that he hoped to use the partnership, LJM2 Co-Investment LP, to launch his own investment business. Although Fastow was angling to become a competitor and his dual roles as Enron finance chief and LJM2 general partner made some Merrill Lynch officials uncomfortable, Merrill obliged.

Not only did a Merrill private-equity sales team raise $265 million of the partnership's $387 million from its best clients--pension funds, wealthy individuals, and family trust funds--the firm invested $5 million and agreed to loan the partnership $10 million. And 97 Merrill executives personally kicked in $17.6 million. Among them, BusinessWeek has learned, were three members of Merrill's executive management team and at least six investment bankers who worked closely on Enron deals or supervised those who did. Chairman and CEO David H. Komansky and President and Chief Operating Officer E. Stanley O'Neal were not among the 97.

While Merrill's Enron entanglement is not the largest of the big investment banks, investigations into LJM2 are exposing Merrill's tangled web of connections in new detail. The relationship gave Merrill a window into Enron's finances that other investors did not have. Among its many roles: underwriter of stocks and bonds, lender, fund-raiser, investor, and counterparty in energy derivatives deals. Internal documents show that Merrill even helped Enron out of a tight spot by acquiring assets so that Enron could gussy up its yearend earnings.

Even with this information, says Merrill, it was not possible to detect Fastow's deceptions. (A Fastow spokesman would not comment.) A Merrill spokesman says that the firm and its employees who dealt with Enron, invested in LJM2, or sold LJM2 limited partnerships did nothing improper. Had Merrill known then what it knows now, a spokesman adds, it would not have done business with Enron.

But the Securities & Exchange Commission, the Justice Dept., and other LJM2 investors are now asking whether Merrill, with all its access to Enron documents, data, and execs, should have been able to piece together enough of the deception to blow the whistle. The SEC has begun a formal investigation of several Merrill-Enron deals, say sources close to the inquiry, including a series of power swaps that allowed Enron to claim millions in profit in 1999. Justice's ongoing criminal investigation, sources say, is now focusing on the role played by individual Merrill investment bankers, but not the firm itself, in another deal. The big question, says one investigator close to the case: "Did [the Merrill 97] have a motive not to reveal what they knew" once their personal wealth was tied up in LJM2?

What's worse for Merrill's reputation as a guardian of other people's money is that other LJM2 investors are considering suing the firm for leading them into a fatally risky investment. The partnership, which showed handsome returns its first two years, is now in debt and may declare bankruptcy. "We assumed all these conflicts of interest had been properly vetted," one investor says. Now, he adds, "the best asset of the partnership is the ability to sue Merrill Lynch."

Merrill's Enron imbroglio couldn't come at a worse time. Less than four months ago, Merrill paid $100 million to settle charges with New York Attorney General Eliot Spitzer that its Internet analysts issued biased research reports to win investment-banking deals. Merrill's share price still has not recovered from that scandal: Its shares closed at $35.67 on Sept. 4, off 33% since Apr. 8 when Spitzer announced his probe--a $16 billion loss in market value.

Merrill isn't alone in feeling the heat. Citigroup and J.P. Morgan Chase & Co. are also under scrutiny. Their Enron deals involved billions more than Merrill's. But lawyers close to the Merrill case say it is further along and will likely set the standard for penalties. "Lots of very smart people at the top ranks of Wall Street never stepped back to see the broad picture," says one government investigator. "It was a failure of vision at a profound level."

Whether Merrill execs had blinders on or just plain didn't see what Enron was up to, the firm has a lot of explaining to do. At the time Fastow wanted to start LJM2, he was handing out deals left and right. Some Merrill bankers felt they weren't getting a fair share. Such private equity deals, says a former Merrill official, especially personal investments by top officials, were the firm's way of "kissing the CFO's ring."

According to sources close to both government probes, investigators have reviewed a Merrill videotape in which Fastow tells a dozen or so Merrill bankers that the LJM2 partnership will invest mostly in Enron assets and investors can expect around 30% returns. Fastow boasts that no one can price Enron assets as well as he "since I will have better information than anyone else." The remark drew snickers from the bankers. After assuring the group that he would always be on the LJM2 side of transactions with Enron, he then said: "Do I know everything that's going on? Do I have to sign off on every deal that goes in there? Yes. I'm in the unique position of not having the responsibility to sell the assets, but I know everything about them, and I've been involved in their approval and maybe their structuring."

Although it didn't stop the firm from doing business with him, Fastow's conflicts did raise a few eyebrows. Robert S. Furst and Schuyler M. Tilney, two Texas-based investment bankers who had day-to-day contact with Enron, questioned then-Enron President Jeffrey K. Skilling about the issue. He reassured them that Enron would put in place internal controls to oversee Fastow.

That wasn't the only time Merrill execs got that queasy feeling. James Brown, a Merrill banker who structured complex financial deals, fretted over a transaction in which Merrill agreed to pay Enron $28 million for an interest in three power-generating barges off the coast of Nigeria. On Dec. 21, 1999, he wrote: "Reputational risk i.e. aid/abet Enron income [statement] manipulation" on the cover sheet of a memo from Furst. The sale allowed Enron to book a $12 million profit.

What was so risky about that? Documents released by the Senate's Permanent Subcommittee on Investigations, headed by Democrat Carl Levin of Michigan, show that it was not a straightforward sale. In an oral side deal, Enron promised to find a buyer for the barges in six months. It also guaranteed Merrill a total return of 22.5%. But under SEC rules, a company cannot recognize revenue from a sale if it is obliged to take the product off the buyer's hands in the future or if the risk of ownership does not pass from seller to buyer. If Enron violated such accounting rules, then Merrill may have aided in the coverup, say legal experts. Merrill says it did bear the risk of ownership and had no guarantees it could sell in six months.

Merrill officials started to get antsy in June, 2000, about whether Enron would find a buyer. But Fastow came through. The buyer was...LJM2. That put Merrill and some of its top execs, including Furst, Brown, and Tilney, who had all invested in LJM2, at the center of the conflict. Together, the execs gave Fastow $1 million, with Tilney putting up $750,000. One Merrill official, in an e-mail released by the Senate panel, noted the irony: To take Merrill out of the shaky barge deal, Enron used the partnership that Merrill and its execs invested in, for which Merrill had raised most of the funds.

The conflicts don't end there. Around the same time, Merrill was asked to kick in $10 million of a $65 million syndicated loan to LJM2. When a Merrill credit committee rejected the request, Tilney, Furst, and Benjamin Sullivan, who oversaw the sales team for LJM2, appealed. "Andy Fastow is in an influential position to direct business to Merrill Lynch," they said in a memo to Thomas W. Davis, head of Merrill's corporate and institutional client group, urging him to "capitalize on successful momentum with Enron."

Merrill ultimately lent Fastow the $10 million. Davis' role in clinching the loan is unclear, but he and Sullivan both had $150,000 in LJM2. The Merrill spokesman says that the 97 were "qualified" investors with at least $5 million in investable assets (required under the Investment Company Act of 1940 definition) and that, as passive investors, they played no management role. Furst, who left the firm at the end of last year, and Tilney invoked their right not to testify before Levin's panel about their roles in the barge deal once they learned that Justice was conducting a criminal probe. Their lawyers say they did nothing improper. Merrill put Tilney on paid leave for not cooperating with the Senate.

LJM2's tentacles went deep inside Merrill. Among the 97 investors were Daniel Bayly, New York-based head of Merrill's investment-banking unit ($200,000); Mark McAndrews, former chief operating officer of the unit ($50,000); and Furst's boss, Richard Gordon ($500,000), who was also involved in the barge deal (table). Bayly, named in one document as the Merrill official who would confirm Enron's "commitment to guaranty the ML takeout within six months," has since been promoted to chairman of the unit. McAndrews, who did not return calls, has left the firm. Gordon, who works out of Merrill's Houston office and oversees Tilney, would not comment.

The bankers' involvement makes it all the more surprising that Merrill missed the red flags LJM2 raised. Among them: Fastow promised to set up an advisory committee to review conflicts of interest. But Fastow decided what constituted a conflict and whether to refer it to the committee. LJM2 limited partners were named to the panel, but it apparently never met. Fastow also promised that assets LJM2 acquired from Enron would be subject to competing bids. But investigators say no bidding took place.

Fastow also told Merrill that he and two subordinates in Enron's financial unit had Enron board approval to manage LJM2. In truth, only Fastow did.

Had Merrill officials asked follow-up questions, they might have learned that Fastow was not making good on his pledges. Merrill says that it did not create, structure, or manage LJM2 and that limited partners were under no obligation to ask such questions.

Columbia University law professor John C. Coffee Jr. says that Merrill knew a great deal about Enron's finances through the LJM2 prospectus and annual report, the barge deal, and the electricity swaps. It also knew that Enron in 1998 had pressured the firm for positive analyst reports. But Merrill stood behind Enron's financial statements when it sold the company's debt and lent it money in 2000 and 2001. "When you do a public deal, you can't cordon off information you have, even if you learned it in a private deal," says Coffee. "You have an obligation to see that information gets to the market." Merrill rejects any suggestion that it or the LJM2 investors had access to information that was not in public filings and other publicly available documents.

Withholding data from the public was the crux of the SEC's 1998 case against Merrill Lynch for its role in the Orange County bankruptcy. Without admitting or denying guilt, Merrill paid $2 million to settle civil charges that the firm sold Orange County notes to the investing public but omitted what it knew about the California county's risky investment strategy in offering documents.

That's why corporate-finance expert James Brown's scribbled notation may cause the firm a big legal headache. Brown asked whether the barge deal might help Enron cook the books. While Merrill says that Brown's concerns were satisfied and Merrill's lawyers cleared the transaction, Coffee says the mere fact Brown made a notation means it is "arguable that at least some people at Merrill understood that the transaction was being done to inflate earnings and was not a true risk-transferring event. That's probably the biggest red flag." Brown's lawyer would not comment.

Merrill also may have its hands full with irate clients over LJM2. At the time, it seemed like a good bet. What could go wrong in a fund backed by the world's biggest brokerage and the hot-shot CFO of an innovative company?

That's what Joe Marsh, a 50-year-old producer for magician David Copperfield, thought. When Merrill first approached him in the summer of 1999, Marsh was skeptical. So Merrill hooked him up with Fastow. Marsh says Fastow told him on a conference call that his position at Enron meant he could pick the best deals with the highest returns for LJM2.

Looking back, Marsh says Merrill should have raised more questions with Enron about Fastow's conflict of interest before agreeing to shop LJM2 around to investors. "My whole emphasis was, if Merrill Lynch is selling it, it has to be good because they're the biggest brokerage firm in the world," says Marsh, president of Magic Arts & Entertainment in Aurora, Ohio.

For awhile, at least, LJM2 gave its limited partners what they were expecting: outsize returns thanks to Fastow's inside seat. In October, 2000, LJM2 reported that the fund had a 69% rate of return--twice what Fastow had promised in the prospectus. However, once Enron Corp. sank, LJM2 went down with the ship. For Merrill Lynch, all that's left of its involvement is a slew of investigations and lawsuits--and another struggle to save the firm's reputation.

By Paula Dwyer and Laura Cohn in Washington and Emily Thornton in New York, with Wendy Zellner in Dallas

    Before it's here, it's on the Bloomberg Terminal.