The Wall Street Journal-20080202-Merrill Faces Fraud Allegations

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Merrill Faces Fraud Allegations

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Massachusetts state authorities accused Merrill Lynch & Co. on Friday of fraud and misrepresentation related to the firm's sale of debt securities that rapidly collapsed during the credit crisis.

The allegations come just a day after Merrill bought back the securities, known as collateralized debt obligations, from Springfield, Mass. Merrill repurchased the CDOs at the same price of $13.9 million that the firm initially sold them to the city last spring.

These CDOs, which are pools of debt that included subprime mortgages, had plunged in value to $1.2 million, according to a recent Merrill account statement for Springfield.

In the Massachusetts complaint, the secretary of state alleges that Merrill acted in a way that was "inappropriate and illegal." The complaint said "these highly-risky and esoteric CDOs were unsuitable for the City of Springfield [and] Merrill Lynch did not properly disclose to the City the risks of owning these CDOs."

The allegations are civil and could result in fines and other penalties, but the secretary's office doesn't have criminal authority.

Merrill Lynch spokesman Mark Herr said, "We are puzzled by this suit. We have been cooperating with [Secretary of State William] Galvin's office in its inquiry."

Observers say the Massachusetts complaint will be closely watched across the brokerage community. "This is a big deal," said Mark Flessner, a partner at Sonnenschein Nath & Rosenthal in Chicago and a former federal prosecutor. "This looks to be the first case of its kind to bring charges based on the subprime crisis, and it is going to cause brokerage firms a lot of concern."

Separately, the Massachusetts Attorney General's office is also investigating Merrill CDO sales in the state. The attorney general is considering whether the firm should pay additional penalties to Springfield for not informing the city of the risky nature of the securities, according to people familiar with the investigation.

That office is also investigating whether the Merrill Lynch brokers who sold Springfield the securities were being pressured by other Merrill officials to unload the risky CDOs just as the credit crisis was reaching a boil.

Mr. Galvin said his office is continuing to investigate Merrill's activities statewide.