UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7566 / August 24, 1998 SECURITIES EXCHANGE ACT OF 1934 Release No. 40352 / August 24, 1998 ADMINISTRATIVE PROCEEDING File No. 3-9683 _______________________________ : In the Matter of: : : Merrill Lynch, Pierce, Fenner : & Smith Incorporated, : : Respondent. : _______________________________: ORDER INSTITUTING A PUBLIC ADMINISTRATIVE AND CEASE-AND- DESIST PROCEEDING PURSUANT TO SECTION 8A OF THE SECURITIES ACT OF 1933 AND SECTIONS 15(b) AND 21C OF THE SECURITIES EXCHANGE ACT OF 1934, MAKING FINDINGS, AND IMPOSING SANCTIONS AND CEASE-AND-DESIST ORDER I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that a public administrative and cease-and-desist proceeding be and hereby is instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b) and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch"). II. In anticipation of the institution of this proceeding, Merrill Lynch has submitted an Offer of Settlement, which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and without admitting or denying the findings contained herein, except that Merrill Lynch admits the jurisdiction of the Commission over it and over the subject matter of this proceeding, Merrill Lynch, by its Offer of Settlement, consents to the entry of this Order Instituting a Public Administrative and Cease-And-Desist Proceeding Pursuant to Section 8A of the Securities Act of 1933 and Sections 15(b) and 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing Sanctions and Cease-and- Desist Order ("Order") and to the entry of the findings, sanctions, and cease-and-desist order set forth below. Accordingly, IT IS HEREBY ORDERED that a proceeding pursuant to Section 8A of the Securities Act and Sections 15(b) and 21C of the Exchange Act be, and hereby is, instituted. III. On the basis of this Order and the Offer of Settlement submitted by Merrill Lynch, the Commission finds that:[1] A. RESPONDENT Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch") is a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act [15 U.S.C.  78o(b)] and is headquartered in New York, New York. Merrill Lynch was the underwriter or co-manager of $875 million in notes (the "Notes") issued through four offerings (the "Note Offerings") by the County of Orange, California ("Orange County" or the "County") and the Orange County Flood Control District (the "Flood Control District") in July and August 1994. B. FACTS 1. Introduction Merrill Lynch was the underwriter or co-manager of the Note Offerings conducted by Orange County and the Flood Control District in July and August 1994.[2] Merrill Lynch sold the Notes to institutional investors through Official Statements that omitted material facts about the Orange County Investment Pools' (the "Pools") investment strategy, the risks of that strategy, and the Pools' investment losses. Accurate and complete disclosure about the Pools was material to investors because, in all four offerings, the funds pledged to repay the notes were invested in the Pools and, in two of the offerings, the Pools guaranteed repayment of the notes in that the Orange County Treasurer- Tax Collector ("Treasurer"), on behalf of the Pools, agreed that, if the funds pledged to repay the notes were insufficient, the Treasurer would purchase the notes at maturity at face value plus interest. The Official Statements for three of the Note Offerings also omitted to disclose that the variable interest rate paid on the Notes was statutorily capped at 12%. This information was material to investors that had adopted policies against investing in securities with an interest rate cap. As a result of a business relationship with the County, certain Merrill Lynch personnel knew substantial information about the Pools. The firm, however, unreasonably failed to assure that such information was conveyed to the Merrill Lynch employees who were responsible for reviewing and approving the Official Statements. The Merrill Lynch employees who were responsible for reviewing the Official Statements also knew or should have known material information about the Pools and the interest rate cap. These employees, from a reasonable review of the Official Statements, knew or should have known that the Official Statements omitted such information. 2. The Orange County Investment Pools The Pools operated as an investment fund managed by the Treasurer, in which the County and various local governments or districts (the "Participants") deposited public funds. As of December 6, 1994, the Pools held approximately $7.6 billion in Participant deposits, which the County had leveraged to an investment portfolio with a book value of over $20.6 billion. a. The Pools' Investment Strategy From at least April 1992 until December 1994, the Treasurer's investment strategy for the Pools involved: (1) using a high degree of leverage by obtaining funds through reverse repurchase agreements on a short-term basis (less than 180 days); and (2) investing the Participants' deposits and funds obtained through reverse repurchase agreements in debt securities (issued by the United States Treasury, United States government sponsored enterprises, and highly- rated banks and corporations) with a maturity of two to five years, many of which were derivative securities. The Pools' investment return was to result principally from the interest received on the securities in the Pools. Leverage enabled the Pools to purchase more securities with the anticipation of increasing interest income. This strategy was profitable as long as the Pools were able to maintain a positive spread between the long-term interest rate received on the securities and the short-term interest rate paid on the funds obtained through reverse repurchase agreements. b. The Pools' Portfolio During 1993 and 1994, the Treasurer, using reverse repurchase agreements, leveraged the Participants' deposits to amounts ranging from 158% to over 292%. As of the end of June 1994, the Pools held $19.8 billion in securities, with approximately $7.2 billion in Participant deposits and about $12.6 billion in reverse repurchase agreements, resulting in leverage of about 274%. During 1993 and 1994, the amount of derivatives in the Pools' portfolio ranged from 27.6% to 42.2% of the portfolio. As of the end of June 1994, 38.2% of the Pools' securities were derivatives. Most of the Pools' derivative securities were inverse floaters, which paid interest rates inversely related to the prevailing interest rate. From January 1993 through November 1994, 24.89% to 39.84% of the Pools' portfolio consisted of inverse floaters. As of the end of June 1994, 35% of the Pools' portfolio was invested in inverse floaters. From January 1993 through November 1994, only 1.84% to 5.59% of the Pools' portfolio consisted of securities that paid interest rates directly related to the prevailing interest rate (variable rate securities) or securities that paid interest rates that rose at certain stated intervals to certain stated rates (step-up securities). As of the end of June 1994, about 3.17% of the Pools' portfolio was invested in variable and step-up securities. c. The Pools' Sensitivity To Interest Rate Changes And The Rise In Interest Rates During 1994 The composition of the Pools' portfolio made it sensitive to interest rate changes. As interest rates rose, the market value of the Pools' securities fell, and the interest received on the Pools' inverse floaters also declined. Thus, the Treasurer's investment strategy was profitable so long as interest rates, including the cost of obtaining funds through reverse repurchase agreements, remained low, the market value of the Pools' securities did not decline, and the Pools had the ability to hold securities to maturity. From April 1992 through 1993, U.S. interest rates remained low and relatively stable. Due to the low interest rates and the Pools' investment strategy, the Pools earned a relatively high yield of approximately 8%. Beginning in February 1994, interest rates began to rise. This rise in interest rates resulted in: (1) an increase in the cost of obtaining funds under reverse repurchase agreements; (2) a decrease in the interest income on inverse floaters; (3) a decrease in the market value of the Pools' debt securities; (4) collateral calls and reductions in amounts obtained under reverse repurchase agreements; and (5) a decrease in the Pools' yield. d. Orange County's Bankruptcy By early December 1994, the Pools had an unrealized decline in market value of about $1.5 billion. Shortly thereafter, on December 6, 1994, Orange County filed Chapter 9 bankruptcy petitions on behalf of itself and the Pools (the petition filed on behalf of the Pools was later dismissed). Between early December 1994 and January 20, 1995, the Pools' securities portfolio was liquidated, incurring a loss of almost $1.7 billion on the Participants' deposits of $7.6 billion, a 22.3% loss. **FOOTNOTES** [1]:/ The findings herein are made pursuant to the Offer of Settlement of Merrill Lynch and are not binding on any other person or entity named as a respondent in this or any other proceeding. [2]:/ Orange County and the Flood Control District were charged with disclosure violations concerning these offerings in a settled cease-and-desist proceeding. See In re County of Orange, California, Securities Act Release No. 7260 (Jan. 24, 1996). 3. The Note Offerings a. The Taxable Note Offerings In July and August 1994, Merrill Lynch underwrote or co-managed the underwriting of municipal securities offerings for Orange County and the Flood Control District. The issuers conducted these offerings (the "Taxable Note Offerings") for the purpose of generating an anticipated profit by reinvesting the proceeds (together with funds equal to the estimated interest on the notes) in the Pools to earn an investment return that would be higher than the rate of interest payable to the Taxable Note investors. The issuers pledged these invested funds to secure repayment of the Taxable Notes, and, if the pledged funds were insufficient to pay principal and interest, the issuers would satisfy any deficiency with other moneys lawfully available to repay the notes in the respective issuer's general fund attributable to the fiscal year in which the notes were issued. The County issued $600 million in notes (the "$600 Million Taxable Notes") on July 8, 1994, described in an Official Statement dated July 1, 1994. These notes earned a variable interest rate reset monthly at the one-month London Interbank Offered Rate ("LIBOR") not to exceed 12% per annum. The $600 Million Taxable Notes were originally due on July 10, 1995. On June 27, 1995, the County and the noteholders entered into Rollover Agreements under which the maturity of the notes was extended from July 10, 1995, to June 30, 1996, and the interest rate paid on the notes was increased. On June 12, 1996, as part of its emergence from bankruptcy, the County repaid the notes with a portion of the proceeds from another County municipal securities offering. On August 2, 1994, the Flood Control District issued $100 million in notes (the "$100 Million Taxable Notes") described in an Official Statement dated July 27, 1994. These notes earned a variable interest rate reset monthly at the one-month LIBOR plus .03% not to exceed 12% per annum. The notes matured, and were repaid, on August 1, 1995. b. The Teeter Note Offerings In July and August 1994, Merrill Lynch underwrote two Orange County offerings of Teeter Notes (the "Teeter Note Offerings"). The purpose of the Teeter Note Offerings was to fund the County's Teeter Plan, an alternate method of property tax distribution whereby the County pays local taxing entities (such as school districts) their share of property taxes upon levy rather than actual collection and the County then retains all property taxes, and the penalties and interest thereon, upon collection. The first Teeter Note Offering was conducted on July 20, 1994, for $111 million (the "$111 Million Teeter Notes"). These notes were described in an Official Statement dated July 13, 1994. These notes earned a variable interest rate reset monthly at one-month LIBOR not to exceed 12% per annum. The second Teeter Note Offering was conducted on August 18, 1994, for $64 million (the "$64 Million Teeter Notes"). These notes were described in an Official Statement dated August 12, 1994. These notes earned a variable interest rate reset monthly at 70% of one- month LIBOR not to exceed 12% per annum. The $111 Million and $64 Million Teeter Notes matured, and were repaid, in part with proceeds from a June 30, 1995 Teeter bond offering. The Official Statements for the Teeter Note Offerings represented that the County planned to deposit certain delinquent tax payments, penalties, and interest collections in accounts pledged to repay the Teeter Notes and to then invest those funds in the Pools. The Official Statements for the Teeter Note Offerings represented that the County anticipated that the funds in the repayment account would not be sufficient to pay the principal and interest on the Teeter Notes at maturity and that the County estimated that, at maturity of the Teeter Notes, approximately $70 million would be available in the repayment account to pay the principal and interest on the $175 million in Teeter Notes. The Official Statements further represented that this anticipated deficiency in the repayment account would be satisfied from moneys received under Standby Note Purchase Agreements, which agreements obligated the Treasurer (as "fund manager" of the Pools) to purchase the Teeter Notes, and from other moneys lawfully available to the County for repayment from revenues received or attributable to the fiscal year in which the notes were issued. 4. Omissions Of Material Facts In The Official Statements Merrill Lynch offered and sold the Notes through Official Statements that omitted material facts regarding the Pools. The Official Statements for three of the Note Offerings also omitted to disclose the statutory 12% cap on the interest rate payable to noteholders. a. Omissions Of Material Facts Regarding The Pools i. The Pools' Investment Strategy The disclosure in the Official Statements for the Note Offerings regarding the Pools' investment strategy was misleading because it failed to disclose material information, including: (1) the Pools' investment strategy was predicated upon the assumption that prevailing interest rates would remain at relatively low levels; (2) the Pools' use of leverage through reverse repurchase agreements was constant, high, and a major part of the Pools' investment strategy; and (3) the Pools had a substantial investment in derivative securities, particularly inverse floaters. ii. The Risks Of The Pools' Investment Strategy The disclosure in the Official Statements regarding the risks of the Pools' investment strategy was misleading because it omitted material information about the Pools' sensitivity to rises in interest rates. Specifically, the Official Statements failed to disclose that because of the Pools' high degree of leverage and substantial investment in inverse floaters, rising interest rates would have a negative effect on the Pools, including: (1) the Pools' cost of obtaining funds under reverse repurchase agreements would increase; (2) the Pools' interest income on the inverse floaters would decrease; (3) the Pools' securities would decline in market value; (4) as the value of the securities fell, the Pools would be subject to collateral calls and reductions in amounts obtained under reverse repurchase agreements; (5) the Pools' earnings would decrease; (6) the Pools would suffer losses of principal at certain interest rate levels; and (7) if the Pools' began to suffer lower earnings or losses of principal, certain Participants may withdraw their invested funds, leaving the County and other Participants such as the Flood Control District who were required to deposit their funds with the Treasurer to absorb any losses. iii. The Pools' Investment Results The disclosure in the Official Statements regarding the Pools' historic investment results was misleading because it omitted material information regarding the Pools' investment results during the first half of 1994 when interest rates were rising. Specifically, the Official Statements omitted to disclose that as a result of rising interest rates in 1994, the market value of the Pools' securities was declining, the Pools were subject to collateral calls and reductions in amounts obtained under reverse repurchase agreements, and the Pools' costs of obtaining funds under reverse repurchase agreements were increasing. b. Omission Of The Interest Rate Cap The Official Statements for the Taxable Notes and the $111 Million Teeter Notes each represented that the notes paid a variable interest rate connected to one-month LIBOR. These Official Statements were misleading because they omitted to disclose the material information that the notes contained a statutory 12% cap on the maximum variable interest rate. 5. Merrill Lynch's Knowledge About The Pools a. Merrill Lynch's Securities Business With Orange County Merrill Lynch engaged in significant securities business with Orange County in the years prior to the Note Offerings. From 1992 to December 1994, Orange County was one of Merrill Lynch's largest accounts. As of June 1994, just prior to the Note Offerings, approximately two-thirds of the securities in the Pools' portfolio, including inverse floaters, had been purchased from Merrill Lynch and almost one-fifth of the Pools' reverse repurchase agreements were entered into with Merrill Lynch. Merrill Lynch conducted this securities business with Orange County through trading and sales personnel, who as a result knew substantial information about the Pools. b. Merrill Lynch's Receipt Of Information Concerning The Pools From Orange County Merrill Lynch, through trading and sales personnel, received from the County several documents that provided detailed information about the Pools, including the Pools' Annual Financial Statements (the "Annual Reports") for fiscal years 1991-1992 and 1992-1993. The 1991-1992 Annual Report stated that: the Pools' investment strategy was to obtain funds through reverse repurchase agreements and reinvest the proceeds in securities that paid an interest rate higher than the interest paid on those funds; the Pools would "vigorously continue" this reverse investment policy; the Pools invested in derivative securities; and the Treasurer "expected interest rates to stay in or near these [low] levels for at least the next two or three years." The 1992-1993 Annual Report stated that: the Pools' investment strategy utilized leverage through reverse repurchase agreements and derivative securities, particularly inverse floaters; the Pools' leverage ratio was approximately 2 to 1; the Pools' leverage strategy had "been predicated on interest earning rates to continue to remain low for a minimum of the next three years"; and if interest rates were to rise materially, it would be "reasonable to expect that the overall performance of the portfolio would decline." c. Merrill Lynch's Derivatives Pricing Reports From 1992 to late 1994, Merrill Lynch, through trading and sales personnel, provided Orange County with a monthly report, called the Derivatives Pricing Report, that marked to market the derivatives that Merrill Lynch had sold to Orange County. The Derivatives Pricing Reports for March through June 1994 priced about $3.7 billion to $4.2 billion in derivative securities, which constituted 17% to 21% of the Pools' total portfolio and 47% to 56% of the Pools' derivative securities. During March through July 1994, a period of rising interest rates, the Derivatives Pricing Reports showed that these derivative securities, marked to market, had declined by between 7.59% and 8.36%. d. Merrill Lynch's Mid-1992 Review Of The Pools In mid-1992, Merrill Lynch conducted a review of the Pools' securities, leverage position, and sensitivity to interest rate changes. The review showed that as of mid- 1992, the Pools had a $6.15 billion portfolio, including $4 billion in derivative securities, which was purchased with $3.5 billion in deposits and $2.5 billion in funds borrowed under reverse repurchase agreements (indicating leverage of 175%) and that, for each 1% increase (or decrease) in the interest rate, the equity in the Pools would decrease (or increase) by 7%. The review noted that the duration of the Pools' portfolio was relatively long and was more typical of a portfolio with a maturity of ten to twenty years. The review suggested that the account representative responsible for the Orange County account ("account representative") ensure that the County was aware of how sensitive the portfolio was to changes in interest rates and explore with the County ways of reducing its overall leverage by limiting its amount of reverse repurchase agreements. In an October 1992 letter, Merrill Lynch advised the Treasurer of the results of its mid-1992 review. This letter stated that the Pools' duration indicated more price volatility than would be expected from a portfolio with such a short average maturity of 1.4 years and that the Pools' use of leverage through reverse repurchase agreements and investment in inverse floaters made maturity of the portfolio a less reliable indicator of the price sensitivity of the portfolio. Merrill Lynch trading and sales personnel knew the results of this review and participated in communicating the results to the Treasurer. e. Merrill Lynch Discussions In November 1992 Regarding The Risks Of The Pools In November 1992, the Merrill Lynch account representative reported to the Treasurer that a number of Merrill Lynch trading and sales personnel and other officials had met to discuss the Pools. The account representative reported to the Treasurer that these officials had discussed: (1) the fact that the Pools already owned about $3 billion in inverse floaters and was planning on investing another $1 billion in these derivatives; (2) the belief of these Merrill Lynch officials that the Treasurer was too concentrated in inverse floaters and that a significant rise in interest rates would have a negative effect on the Pools' investment performance; and (3) that Merrill Lynch intended to review the derivative structures that Merrill Lynch could offer to Orange County that might serve as a hedge against changes in interest rates. In late 1992, Merrill Lynch established a mechanism by which a separate department would consult with trading personnel regarding the purchase of certain derivatives by the County. f. Merrill Lynch Urges The Treasurer To Provide The County Board Of Supervisors With Additional Disclosure About The Pools Also in November 1992, Merrill Lynch urged the Treasurer to make greater disclosure to the County Board of Supervisors regarding the Pools' investment strategy and the risks of that strategy. Subsequently, in an April 1993 letter, Merrill Lynch provided to the Treasurer bullet points to include in the Treasurer's next Annual Report regarding the Pools. These bullet points included: the Pools' investment strategy used leverage; the Pools' use of reverse repurchase agreements and purchase of derivative securities resulted in a leverage ratio of 2 to 1; if interest rates were to rise, it was reasonable to expect that the overall performance of the portfolio would decline; and if a sudden rise in interest rates were to recur, there could be an erosion of principal. Merrill Lynch trading and sales personnel knew that Merrill Lynch was urging the Treasurer to make such greater disclosure and participated in communicating the bullet points to the Treasurer. g. Merrill Lynch's January 1993 Meeting With The Treasurer Regarding The Pools In January 1993, Merrill Lynch trading and sales personnel discussed the Pools with the Treasurer. At this meeting, the Merrill Lynch trading and sales personnel discussed with the Treasurer: the Pools' "distinct" investment strategy; the amount of leverage in the Pools; the risks associated with the strategy; and that, at certain interest rate levels, the Pools would lose principal because the Pools' financing costs would exceed the yield. The Merrill Lynch trading and sales personnel also suggested at this meeting that the Treasurer should report to the County Board of Supervisors about these matters and that the Pools should reduce the leverage ratio to no more than 2 to 1 and should not invest in derivatives in excess of the Pools' long-term deposits. h. The February 1993 Memorandum Regarding Certain Risks Of The Pools In February 1993, a Merrill Lynch trader distributed to certain other Merrill Lynch trading personnel a memorandum in which he expressed certain concerns about the Pools' risks and made specific recommendations concerning Merrill Lynch's ongoing relationship with the Orange County account. The memorandum explained that a substantial amount in the Pools had been voluntarily deposited by Participants seeking the Pools' higher return and stated the trader's views that these voluntary Participants could withdraw their funds at par with little restriction and were, therefore, not bearing any of the risks accompanying the high yields and that the County and other long term investors were bearing that risk associated with higher yields. The memorandum then stated that if interest rates rose and the Pools' yield decreased, these voluntary Participants would withdraw their funds, causing adverse consequences for Orange County. i. Merrill Lynch's Offer To Repurchase Derivatives Sold To The Pools In March 1993, Merrill Lynch made an offer to the Treasurer to repurchase certain securities that it had sold to the Pools. These securities had a book value of $4.09 billion (36% of the portfolio) and were comprised of $3.8 billion in inverse floaters (34% of the portfolio), $175 million in floating rate securities (2% of the portfolio), and $100 million in fixed rate securities (1% of the portfolio). In March 1993, Merrill Lynch told the Treasurer that it was making the offer to assist the Treasurer in reducing the Pools' risk profile in the event of changes in interest rates. In a June 1993 letter, Merrill Lynch reiterated its position, stating that it had made the offer to allow the County the opportunity to lower its risk profile in derivative securities and to reduce leverage so that the Pools would be better positioned to perform in the event of interest rate changes. In April 1993, the Treasurer refused Merrill Lynch's offer, stating that he believed that because of future low interest rates, the securities may be even more valuable in the future. Merrill Lynch trading and sales personnel knew of this offer and the Treasurer's rejection of the offer and participated in these communications with the Treasurer. j. Merrill Lynch's February 1994 Review Of The Pools In February 1994, Merrill Lynch trading and sales personnel presented to the Treasurer their review of certain of the Pools' securities as of late 1993-early 1994. This review presented information showing that the Pools held $5 billion in inverse floaters and $6.8 billion in fixed rate securities, and found that the Pools' aggregate derivative portfolio had declined in value to a price of 99.50. The review further specifically discussed the sensitivity of the portfolio to changes in interest rates, noting that: (1) the Pools' performance was dependent upon continued low interest rates; (2) each basis point (.01%) change in the interest rates would result in a change in the market value of the derivatives in the portfolio of $2.7 million; (3) the portfolio held approximately $5.3 billion in derivative securities with an average duration of about five years; (4) if interest rates were to rise, the inverse floaters would pay lower coupons; (5) rising interest rates would result in significant movements in the market value of the portfolio due to the Pools' investment in inverse floaters; and (6) continued rising rates could have a severe impact on the market value of the Pools' securities. The review also discussed future interest rates, stating that it was difficult to predict future interest rates but that historically initial increases by the Federal Reserve Bank of interest rates led to further increases. Finally, the review presented certain recommendations that the Treasurer could implement in light of the interest rate environment. 6. Merrill Lynch's Underwriting Of The Notes Merrill Lynch trading personnel were principally responsible for Merrill Lynch's obtaining the underwriting of the first Note Offering, the $600 Million Taxable Note Offering. The Merrill Lynch trading personnel referred the underwriting to Merrill Lynch investment bankers. The account representative knew that Merrill Lynch obtained the underwriting. These Merrill Lynch trading and sales personnel knew much of the information about the Pools stated above, but Merrill Lynch failed to assure that such information was conveyed to the investment bankers. Merrill Lynch participated in the review and approval of the Official Statements for the Note Offerings through the investment bankers. As stated below, the investment bankers knew or reasonably should have known information about the Pools and/or about the interest rate cap and that such information was omitted from the Official Statements. a. The Investment Bankers' Knowledge As stated below, the investment bankers knew or reasonably should have known information about the Pools from media coverage in the first half of 1994 and from Merrill Lynch's business relationship with Orange County. As a result of participating in Merrill Lynch's underwriting of a large taxable note offering conducted in 1993 by another local government located in Southern California (the "Prior Offering"), one of the investment bankers also knew or reasonably should have known of disclosure issues relating to the Pools. One of the investment bankers also knew or reasonably should have known of the interest rate cap on the Taxable Notes and the $111 Million Teeter Notes. i. Media Coverage Regarding The Pools From January 31 through June 30, 1994, articles appeared in the media regarding the Pools. The articles reported that the Treasurer stated that: he used reverse repurchase agreements to leverage the Pools' $7.5 billion in deposits to $19.5 billion in investments; 20% of the $19.5 billion portfolio was invested in derivative securities; his strategy was to obtain funds through short-term reverse repurchase agreements and invest in medium-term securities; the value of the Pools' portfolio had "been hit by rising interest rates"; and as a result of rising interest rates and the declining market value of the Pools' securities, the County had recently experienced up to $300 million in collateral calls under reverse repurchase agreements. These articles also reported that the County's portfolio had incurred a decline in market value of "an estimated $1.2 billion" and that many believed that the investment strategy was too risky for public funds and exposed the Pools to the risk of very large losses. The investment bankers knew that there were a number of articles published in the first half of 1994 regarding the Pools and read at least some of these articles. In addition, in late April 1994, one of the investment bankers received a memorandum from Merrill Lynch municipal research personnel about recent municipal securities offerings by issuers located in Southern California. The memorandum attached an article about the Pools that was published on April 15, 1994. In referring to the article, the memorandum stated that, although the research personnel had no additional information about the Pools and the article was perhaps one-sided, it implied there may be a great potential for losses in the fund due to recent market trends. The memorandum further stated this development may have implications for how Merrill Lynch addressed future note underwritings, in particular during the upcoming California note season. ii. Merrill Lynch's Business Relationship With Orange County The investment bankers knew that Orange County was a client of Merrill Lynch and, therefore, should have known that the firm had information about Orange County. The investment bankers further knew the account representative was responsible for the Orange County account and that the account representative had information regarding the Pools. In the Spring of 1994, even though Merrill Lynch did not have an underwriting relationship with the County at that time, one of the investment bankers contacted the account representative to ascertain the validity of the concerns about the Pools raised in the media reports. The account representative told the investment banker that the Pools were okay and taking a more defensive posture and that the County was selling securities to increase the cash position. iii. The Prior Offering The Merrill Lynch investment bankers also knew of the Prior Offering; one of the investment bankers had even participated in the underwriting. The preliminary official statement for the offering stated that the proceeds would be invested in the issuer's investment pool (the "Prior Pool") and contained disclosure about the Prior Pool that was similar to portions of the disclosure regarding the Orange County Pools in the Official Statements for the Note Offerings. Because of certain market rumors about the Prior Pool, Merrill Lynch requested additional information and disclosure about the Prior Pool's derivative investments before pricing the offering. A detailed comparison of the Prior Offering and the Note Offerings and their related disclosure would have shown at least two differences. First, with respect to reverse repurchase agreements, both offerings stated that "[f]rom time to time" the pools engaged in reverse repurchase transactions. The Prior Offering, however, disclosed that the Prior Pool had engaged in no reverse repurchase agreements as of the end of the prior quarter and that the maximum amount of the Prior Pool's portfolio that could be pledged under reverse repurchase agreements was 25%. In contrast, the Note Offerings only disclosed that "a significant portion" of the Pools' securities was pledged under reverse repurchase agreements but did not disclose that the Pools were leveraged by about 274% and that the Pools' investment strategy was based on such leverage. Second, with respect to derivative investments, the Prior Offering specifically disclosed the dollar amount of derivative securities held by the pool and the structure of the derivatives. In contrast, the Note Offering only disclosed the Pools' investment in fixed and floating rate securities but did not disclose the Pools' dollar investment in inverse floaters. iv. The Interest Rate Cap The existence of the interest rate cap on the Taxable Notes and the $111 Million Teeter Notes was stated in three documents relating to the issuance of those Notes: the resolutions of the Boards of Supervisors of Orange County and the Flood Control District authorizing the issuance of the notes; the issuers' certificates stating that the offering amounts complied with state law; and the sample notes. These documents were included in the official transcript of the Taxable Note and $111 Million Teeter Note Offerings, which were provided to all professionals participating in the offering, including one of the Merrill Lynch investment bankers. b. Merrill Lynch's Review Of The Official Statements Merrill Lynch's review of the Official Statements was conducted through the investment bankers. One of the investment bankers reviewed and approved the disclosure for all of the Note Offerings. The only change that this investment banker made to the disclosure related to the interest reset language. Another investment banker also read, and did not object to, the Pool disclosure and directed a third investment banker who was not otherwise assigned to the underwriting to review the Pool disclosure. The investment bankers took no further action to determine whether the disclosure was accurate and complete. At the time of the Note Offerings, Merrill Lynch had a written policy stating that the underwriter cannot ignore the underwriter's "`independent reservoir' of knowledge" about the issuer. After Merrill Lynch obtained the underwriting, the investment bankers did not discuss the Pool disclosure with anyone at Merrill Lynch other than with each other, even though the investment bankers knew that Orange County was a Merrill Lynch client and other Merrill Lynch personnel had been involved in obtaining the underwriting for the firm. The investment bankers also did not make inquiries into the media coverage about the Pools, even though the investment bankers knew of the reports and one of the investment bankers had received a memorandum stating that the Pools' reported losses could have implications for Merrill Lynch's future underwriting of municipal note offerings in California. The investment banker who had previously spoken to the account representative about the media coverage regarding the Pools did not question whether the Treasurer had taken a more defensive position. The investment bankers also did not conduct a detailed comparison between the disclosure in the Note Offerings and the disclosure in the Prior Offering, which would have shown that the Prior Offering had additional disclosure regarding derivatives and leverage. C. LEGAL DISCUSSION 1. Merrill Lynch Violated Sections 17(a)(2) And (3) Of The Securities Act In The Offer and Sale of the Notes Sections 17(a)(2) and (3) of the Securities Act make it unlawful for any person, through the means or instruments of interstate commerce or the mails, in the offer or sale of any security: (2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or (3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser. Scienter is not required to prove violations of Sections 17(a)(2) or (3) of the Securities Act. Aaron v. SEC, 446 U.S. 680, 697 (1980). Violations of these sections may be established by showing negligence. SEC v. Hughes Capital Corp., 124 F.3d 449, 453-54 (3d Cir. 1997); SEC v. Steadman, 967 F.2d 636, 643 n.5 (D.C. Cir. 1992). Accordingly, Merrill Lynch, through negligent conduct, violated Sections 17(a)(2) and (3) of the Securities Act in the offer and sale of the Notes. a. The Omissions Were Material Information about the Pools' investment strategy, the risks of that strategy, and the Pools' declining investment results and about the cap on the Notes' variable interest rates was material to the Note investors. Information is material if there is a substantial likelihood that a reasonable investor in making an investment decision would consider it as having significantly altered the total mix of information made available. See Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). Accurate and complete disclosure about the Pools was material to investors because it affected the sources of repayment for the Notes. In particular, in all of the Note Offerings, the funds pledged to repay the securities were invested in the Pools, and, in the two Teeter Note Offerings, the Pools guaranteed repayment of the securities. Disclosure of the interest rate cap was material to investors that had adopted policies against investing in securities with an interest rate cap. b. Merrill Lynch Should Have Known That The Official Statements Were Materially Misleading Merrill Lynch, as underwriter of the Note Offerings, had a duty to conduct a professional review of the Official Statements, including an assessment of the information in its possession or reasonably accessible to it, sufficient to form a reasonable basis for believing in the accuracy and completeness of the key representations in the Official Statements. Merrill Lynch, through its trading and sales personnel, knew substantial material information about the Pools. Merrill Lynch, however, unreasonably failed to assure that such information was conveyed to the investment bankers responsible for reviewing and approving the Official Statements for the Note Offerings. In addition, Merrill Lynch, through its investment bankers responsible for reviewing and/or approving the Official Statements for the Note Offerings, also knew or reasonably should have known material information about the Pools and/or the Notes' interest rate. From such a professional review of the Official Statements, Merrill Lynch, through its investment bankers, knew or reasonably should have known that the Official Statements omitted to disclose material information that was in its possession or reasonably accessible to it about the Pools and the Notes' interest rates.[3] 2. Merrill Lynch Violated Section 15B(c)(1) Of The Exchange Act And MSRB Rule G-17 under Section 15B(c)(1) of the Exchange Act, a broker, dealer, or municipal securities dealer is prohibited from using the mails or any instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any municipal security in violation of any rule of the Municipal Securities Rulemaking Board ("MSRB"). As a broker-dealer conducting a municipal securities business, Merrill Lynch was subject to Section 15B(c)(1) of the Exchange Act and the MSRB rules. MSRB Rule G-17 provides that: "In the conduct of its municipal securities business, each broker, dealer, and municipal securities dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice." For the reasons set forth above in Section E.1. with respect to the violations of Sections 17(a)(2) and (3) of the Securities Act, Merrill Lynch violated MSRB Rule G-17. 3. Conclusion Accordingly, based on the foregoing, the Commission finds that Merrill Lynch willfully violated Sections 17(a)(2) and (3) of the Securities Act, Section 15B(c)(1) of the Exchange Act, and MSRB Rule G-17. IV. Merrill Lynch has submitted an Offer of Settlement in which, without admitting or denying the findings herein, it consents to the Commission's entry of this Order, which: (1) makes findings, as set forth above; (2) orders Merrill Lynch to cease and desist from committing or causing any violations and any future violations of Sections 17(a)(2) and (3) of the Securities Act, Section 15B(c)(1) of the Exchange Act, and MSRB Rule G-17; and (3) orders Merrill Lynch to pay a civil penalty in the amount of $2,000,000. V. Prior to the date of this Order, Merrill Lynch revised its policies and procedures relating to municipal securities underwriting. VI. In view of the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer of Settlement submitted by Merrill Lynch. Accordingly, IT IS HEREBY ORDERED that, pursuant to Section 8A of the Securities Act and Sections 15(b) and 21C of the Exchange Act: 1. Merrill Lynch shall, effective immediately, cease and desist from committing or causing any violation and any future violation of Sections 17(a)(2) and (3) of the Securities Act, Section 15B(c)(1) of the Exchange Act, and MSRB Rule G-17. 2. Merrill Lynch shall, within thirty (30) days of the date of this Order, pay a civil money penalty in the amount of $2,000,000 to the United States Treasury. Such payment shall be: (1) made by United States postal money order, certified check, bank cashier's check or bank money order; (2) made payable to the United States Securities and Exchange Commission; (3) hand-delivered or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, Virginia 22312; and (4) submitted under cover letter that identifies Merrill Lynch as a Respondent in these proceedings, and states the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Kelly Bowers, Assistant Regional Director, Pacific Regional Office, Securities and Exchange Commission, 5670 Wilshire Boulevard, 11th Floor, Los Angeles, California 90036. 3. Merrill Lynch shall comply with the undertakings specified in its Offer as follows: Merrill Lynch undertakes to maintain the policies and procedures referred to in Section V above; provided, however, that Merrill Lynch may modify such policies and procedures with alternative policies and procedures designed to achieve the same purposes. By the Commission. Jonathan G. Katz Secretary **FOOTNOTES** [3]:/ For purposes of Merrill Lynch's violations, the conduct of the Merrill Lynch officials and employees may be imputed to the firm. See SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1089 n.3 (2d Cir. 1972).