Business Didn't See Risk, and Got Stung; Clients Say Investments Were Too Complex, but Merrill

Defends Its Disclosures By Dan Fitzpatrick 1,424 words 11 June 2010 The Wall Street Journal (Online and Print) WSJO Business English Copyright 2010 Dow Jones & Company, Inc. All Rights Reserved. When Merrill Lynch & Co. raced ahead of its rivals to become the king of collateralized-debt obligations last decade, pensions and hedge funds weren't its only targets. The Wall Street firm also used its vaunted network of financial advisers to pitch the risky investment pools to Main Street. Some of these individual investors now say they weren't sophisticated enough, despite their relative wealth, to understand the dangers. "We were just lambs being led to the slaughter," said Michael Slomak, a member of a Cleveland family that he says invested $2.65 million in several Merrill-issued CDOs. He says these structured securities, typically based on a pool of debt such as mortgages, had a level of risk that was never adequately explained. The family lost all but $16,500, according to an arbitration claim the family brought against Merrill before the Financial Industry Regulatory Authority. Merrill, now part of Bank of America Corp., didn't provide its response, but a Merrill spokesman said that a "very small percentage" of its CDO sales were sold to individuals and that these buyers had more money than the average investor. Much of the postmortem debate and legal fights following the financial crisis come down to the question of investor sophistication. Investors say the financial products were so complex that they should never have been offered to individuals not savvy enough to understand them. Banks routinely say buyers burned by these deals were sophisticated enough to know the risks and signed statements acknowledging the possibility of losses. The Merrill spokesman said investors signed a disclosure document stating that the CDO "involves a considerable amount of risk and that some or all of the investment may be lost." Other CDO investors admit they didn't read or overlooked certain risk disclosures spelled out in the prospectuses. The increased scrutiny of Wall Street practices by Congress and the Securities and Exchange Commission has led to a surge in lawsuits from large investors. It isn't known how many claims have been filed by small investors, but some legal experts predict more to come. Congress is keeping the issue of investor sophistication alive. The sweeping financial regulations being finalized include a provision requiring regulatory agencies to adjust their definition of sophistication. Merrill is vulnerable to investor ire because it sold the biggest inventory of CDOs and had the industry's biggest brokerage force to sell them in the years leading up to the financial crisis. It was common practice for Merrill to pitch retail clients the lowest-rated CDO slicesa permissable transaction under SEC ruleswhile it sold the higher-rated tranches to larger institutions, according to people familiar with the matter. On many Merrill CDOs, the lowest-rated slice comprised 0.5% to 4% of the deals, according to Merrill documents. Though not all of that was sold to private clients, even a 0.5% piece could be worth $10 million or more. Question of 'Sophistication' Merrill targeted people with more than $5 million in net worth, said people familiar with the strategy. That threshold helped some investors meet technical definitions of what is considered a "sophisticated investor." Page 1 of 3 2010 Factiva, Inc. All rights reserved.

The SEC's definition, according to the Securities Act of 1933, is one who "has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment." The SEC allows "accredited" investors to dip into higher-risk products, and such a person must have a net worth of $1 million, an annual income of $200,000 or control a trust with assets of $5 million. Some think that is an overly simplistic standard of sophistication. In a 2005 note, Finra, an independent securities regulator overseen by the SEC, said the SEC's "accredited status" is "not necessarily an indicator of sophistication" and added that newer investment products "are often complex or have unique features that may not be fully understood by the retail customers to whom they are frequently offered." Similar notes were issued in 2007 and 2010. The SEC declined to comment. The purpose of these warnings, said Gary Goldsholle, Finra vice president and associate general counsel, was to make sure firms understood their obligations and "not rely too heavily or solely on a customer's status as an accredited investor." "Because you have $5 million doesn't mean you are a sophisticated investor," said Fordham University law professor Constantine Katsoris, who leads a group that makes recommendations to Finra. He expects more Main Street investors to bring CDO lawsuits and arbitration claims if lawsuits from big investors prove successful, helping to lower the cost of legal action for small investors. "You might get a piggyback effect if that happens." Other experts counter that little sympathy for small investors is warranted because risks were clearly explained. "I don't find it excusable that a knowledgeable, intelligent college graduate can sign an instrument that says, 'I understood what this was all about,' and then say, 'Actually, I really didn't,' " said Richard Sandow, president of investment-advisory firm Southlake Capital Advisors, who has testified in arbitration cases involving CDOs. The sophistication dispute is playing out in Cleveland and beyond. Merrill targeted pockets of wealth in cities from New York to as far away as Hong Kong, said a person familiar with Merrill's strategy. Boston area businessman Russell Stephens bought a $400,000 CDO from an adviser in Merrill's Tysons Corner, Va., office. The 56-year-old said he was sold the tranche most vulnerable to losses in the event of default, yet was told the CDO would be an appropriate replacement for a municipal bond. The CDO soured, he was hit with an unexpected tax charge, and the value of his investment has dwindled to $80,000, according to Mr. Stephens. "It's been a nightmare," he said. Mr. Stephens said he considers himself a sophisticated investor. But, he said, the deal "wasn't fully explained to me."Merrill declined to comment on Mr. Stephens's account. The adviser couldn't be reached for comment. Stanley Klein, the owner of a company called Multi-Flow Dispensers of Ohio that makes soft-drink-fountain syrups, says he recalls how "overzealous" Merrill was in its salesmanship, citing a local party hosted by Merrill's Cleveland office where potential investors mingled with CDO managers. He said he has lost about $250,000. "It was a risky investment," he said, "but they didn't portray it as that." Alan Lipson, a Cleveland accountant, lost $20,000 of his own money that he invested in the Merrill CDO. The accountant said he missed a key section of the prospectus describing how banks providing the CDO assets could stop paying interest at any time, thereby undercutting the value of his investment. "I wasn't sophisticated [enough] to pick up" that possibility, he said. Assured of CDOs' Safety Cleveland hair-salon entrepreneur Ralph Cortell, who died in 2008, invested $2.65 million as a nest egg for his four daughters. He and his son-in-law, Mr. Slomak, said in the filing that they were offered the CDOs in late 2004 when they asked two local Merrill brokers for advice on how they should invest proceeds from the sale of 200 hair salons. The two local brokers assured them that the CDOs were "very safe with little or no risk," according to the Cortells' Finra complaint, which is still pending against Merrill. Former Merrill Lynch Vice President Jason Lamin visited from the New York office in spring 2005 and recommended they put even more money in CDOs, saying they had "zero risk," according to the filing. The Merrill vice president told Mr. Cortell and Mr. Slomak, "This was a great chance to participate with the big boys"' and to act fast, Mr. Slomak said. "We felt flattered." One of the two Cleveland-area brokers and Mr. Lamin, who isn't named as a defendant, declined to comment. The other couldn't be reached for comment. All three no longer work for Merrill. The family says it never heard warnings that its investment meant "the minute there was a loss, we would be Page 2 of 3 2010 Factiva, Inc. All rights reserved.

wiped out completely," according to Mr. Slomak. "Because you have a few million dollars doesn't mean you are a sophisticated investor." Serena Ng contributed to this article. Write to Dan Fitzpatrick at dan.fitzpatrick@wsj.com Document WSJO000020100611e66b002gx

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