Merrill Lynch is in the process of settling a class-action lawsuit that was filed on behalf of 300,000 investors who allegedly lost more than $600 million in Merrill's short-term global funds.
The suit was filed in 1993 by lead plaintiffs' attorney Michael Kirby with Post Kirby Noonan & Sweat in San Diego. The claim involved the Merrill Lynch Short Term Global Income Fund, sold to U.S. citizens beginning in August 1990, and the Merrill Lynch Short Term World Income Portfolio, sold to non-U.S. citizens beginning in June 1990.
Details on the settlement were not immediately available, but a representative of the U.S. District Court in Newark, N.J., says the case was settled in early August, and both sides have 60 days in which to sign settlement agreements.
Kirby did not return phone calls.
A Merrill Lynch spokesperson disputes that a settlement has been reached. "You have misinformation. It's not true. We have no further comment on further litigation."
The lawsuit alleged Merrill breached its fiduciary duties and deviated from a "prudent investment management" policy by "speculating in high risk derivatives," according to a summary of Kirby's complaint obtained by this magazine. Kirby also alleged that Merrill made misrepresentations and omissions about the funds in prospectuses and in various marketing materials.
Many of the documents relating to the case are not available from the court, but a number of exhibits filed in the case, and transcripts of depositions--all sent to RR magazine by an anonymous source--indicate that the fund was marketed as an alternative for safe money, and that when the retail fund suffered setbacks, brokers complained en masse to Merrill management.
Kirby initially filed the suit in U.S. District Court in San Diego in 1993 on the behalf of foreign investors who were alleged to have lost more than $86 million in the World fund. The suit was then reported in the media, and according to an amended complaint obtained by RR from the New Jersey court where the case was settled, Kirby claims he was then flooded with phone calls from investors in the Global fund and from former Merrill brokers who were complaining about the way the fund was sold.
Kirby then added the U.S. investors to the suit, and refiled it. In May 1994, the case was transferred from San Diego to the U.S. District Court in Newark, N.J., at Merrill's request.
The retail fund was apparently marketed as a conservative investment that would yield 150 to 200 basis points more than a U.S. six-month CD, according to exhibits in the case. Training slides for brokers emphasized "preservation of principal" and "safety." Brokers also were told the worst-case scenario for the funds would be a 3% fluctuation in NAV.
One former Merrill broker now tells RR that he refused to sell the Global Fund because he couldn't understand how the managers could keep the NAV stable by using "complicated hedging strategies."
Between May and October 1992, the two funds experienced substantially higher volatility. The entire category of short-term global funds suffered losses as these funds' "cross hedging" strategies fell apart. Most invested in high-coupon European paper, and hedged the currency risk. The strategy worked as long as Europe's exchange rate mechanism held together, whereby members agreed to keep their currencies within pre-determined ranges. When Italy and Britain broke out of the system in 1992, global funds' hedging strategies backfired.
On Sept. 24, 1992, Arthur Zeikel, head of Merrill Lynch Asset Management and the Global Fund's chairman, wrote investors a lengthy letter explaining that the fund's losses were caused by the unprecedented European monetary system crisis.
But Kirby alleged that the Merrill funds had another problem--derivatives. On Nov. 7, 1994, Kirby's office received an anonymous phone call informing him that the Global fund had experienced massive losses from speculating in risky derivatives, according to the case documents. One example given was a $70 million derivative that was supposedly purchased for the fund with a leverage factor of 500%. The derivative lost 63% of its value, or $44 million in less than three months, Kirby claims in a memorandum filed in the case.
One institutional fixed-income rep who, at RR's request, looked at the term sheet on the $70 million derivative, says the security couldn't be redeemed for more than par, but could lose value. "It's betting on how the peseta will perform with a leverage factor of five" and appears to be highly risky, the rep says. Details on the issue are sketchy since no CUSIP number was provided on the term sheet.
By early '92, the fund had purchased $1.4 billion of derivatives for the portfolio, which made up almost 25% of assets, Kirby alleged.
On Sept. 8, 1992, Zeikel gave a public address to brokers, admitting that "the volatility of the Global fund is unlimited," according to the depositions given by several brokers.
Merrill management was then apparently bombarded with broker complaints--a total of about 500 phone calls, according to a deposition given by Dennis Reens, a senior MLAM marketing executive.
Five Merrill brokers who wrote complaint letters to Zeikel after his address were deposed for the case.
In one letter, George Georgiades, a Merrill broker from Bryan, Texas (now the College Station office), wrote: "You have stated that the volatility of the fund is 'unlimited' and that if our clients are not comfortable they can 'get out'. This is clearly not the way this fund was sold, and if clients wanted to get out, they'd be hit with a withdrawal fee." Georgiades recommended waiving the CDSC and the management fees and trailers to "send a message to my clients that we care about them."
Merrill did not waive any management fees, but did later waive the CDSC.
Georgiades' standing as a current Merrill employee appears to have put him in a difficult position. In the portions of his deposition in April of this year reviewed by RR, he uses some variation of "I don't recall" 29 times under questioning by Kirby.
Mark Bayliss, a Merrill broker from Bryan, Texas, and Gerard Frigon, a broker in Merrill's San Mateo, Calif., office used the same wording as appears in Georgiades' letter to Zeikel.
In his deposition, Frigon explained: "As a representative of my clients to MLAM, I wrote this letter as a means to express my concern; and hopefully with added strength and terms and words used in the letter, may possibly get some results."
John Ting, another Merrill broker from San Mateo, Calif., wrote to the firm saying, "We had told our clients during the initial offering 2 years ago that there was no such thing as a perfect hedge, but we would minimize the fund's fluctuation to no more than (+-) 3% by utilizing hedging techniques. ... This was not a number I created. This was the 'official' line that MLAM had used. ... Now you tell us that if the client 'cannot take the heat, he should get out of the kitchen.'"
Frank Donnelly, a Merrill broker from San Antonio, also wrote and complained: "For the first time ever I firmly believe that MLAM didn't do its due diligence on a product. I believe that the risks were understated and the process was not thought through. It also could be that we, as FC's, were too eager to place CD money in 'CD substitutes.'... I urge MLAM and Merrill Lynch to address this problem before the media learns about it and forces a solution."
In Donnelly's deposition, Kirby asked whether Donnelly was saying in his letter that Merrill should do something about the losses clients had suffered.
Donnelly responded, "What I meant there was that they needed to change the management."
Merrill did eventually change the management of the Global fund. The fund's NAV is currently around $7.70, down 23% from its initial price of $10.