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Orange County Sues Merrill Lynch for $2 Billion Loss

January 13, 1995

SANTA ANA, Calif. (AP) _ The supervisors of bankruptcy-stricken Orange County sued Merrill Lynch & Co. on Thursday for more than $2 billion in damages, contending the brokerage sold the county unsuitable investments.

Merrill ``abused the trust and confidence of the people by permitting and encouraging″ investments by the county fund that were ``neither authorized by law or suitable for taxpayers,″ Board of Supervisors Chairman Gaddi H. Vasquez said.

The brokerage firm replied that the investment risks were fully disclosed to the county by former Treasurer Robert L. Citron, and that the Board of Supervisors applauded his efforts, which had for years brought high returns, and urged him to continue.

``For the Board of Supervisors to now accuse Merrill Lynch is disingenuous at best, and an abdication of their own responsibilities in this matter,″ Merrill Lynch said in a statement.

In a related development, the supervisors voted to pay Citron’s defense costs in a Securities and Exchange Commission investigation of the debacle.

Having Citron work with the county will save it the expense of researching reams of documents and will enable Citron to recall more completely what happened over years of complicated transactions, said Terry Andrus, the county’s lawyer.

The county will also pay SEC-related costs for assistant Treasurer Matthew Raabe and auditor Steven Lewis. No criminal defense costs will be paid, Andrus said.

The Orange County lawsuit filed in federal bankruptcy court is the latest of more than a dozen already filed against Merrill Lynch, the county’s lead broker and underwriter of municipal bonds. Michael Stamenson, a wealthy San Francisco-based Merrill Lynch broker who was the county’s chief contact, has been named a defendant in earlier suits.

Some of the litigation says Merrill Lynch earned more than $100 million doing business with Orange County, providing it a motive for supplying the county with investments it knew were unsuitable for tax dollars.

The lawsuit also accuses the brokerage of violating a state constitutional provision requiring counties and other local entities to get two-thirds approval from voters before borrowing more than their annual revenue.

It alleges, too, that state law bans the extreme combination of borrowing and investing in risky derivative securities, which the county investment pool used.

The suits says Merrill Lynch devised an investment program under which the county investment pool borrowed more than $13 billion, while knowing the state Constitution set a $1.6 billion limit.

Orange County sought bankruptcy protection last month, the biggest municipal bankruptcy in history, because of disastrous investments that soured when interest rates began rising last year.

The county’s travails have focused national attention on how local governments raise money in the financial markets, whether they put taxpayer money at risk, and whether Wall Street brokers bear responsibility for leading municipal treasury managers into investments they don’t understand.

Earlier this week, Merrill Lynch released documents showing it warned Citron several times of the high risks of his bets that interest rates would stay stable or fall. It said it decided not to sever a 20-year relationship with a ``sophisticated institutional investor″ when he refused.

At the time of the county’s bankruptcy filing, Citron’s fund managed about $7.4 billion for Orange County and 186 school districts, cities and local government agencies. Losses so far total about $2.02 billion _ a 27 percent decline.

The losses resulted from Citron’s strategy of obtaining short-term loans from brokerages and re-investing the money in medium-term securities, including many interest-rate-sensitive derivative securities.

In effect, it was a huge bet on stable or lower interest rates. And as the Federal Reserve increased short-term rates six times last year to head off inflation, it proved disastrous.

In another case involving derivatives and borrowing, the West Virginia State Investment Pool has won more than $85 million in settlements and judgments from brokers. The pool had lost about $160 million, according to Michael Mayer, a financial consultant and witness for West Virginia.

Mayer said the West Virginia official who made the purchases was, like Citron, headstrong in pursuing her strategies. Nevertheless, the judge and jury found the broker-dealers violated the New York Stock Exchange’s ``know your customer″ rule requiring that investments be suitable ones.

Merrill Lynch spokesman Timothy Gilles said the two cases are not similar because the West Virginia case turned on a determination that the investment manager had no authority to make the investments. Citron was clearly authorized under state law to borrow and invest in derivatives, he said.

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