Press Room

March 9, 2003
Caution: This Hybrid Can Sting
By GRETCHEN MORGENSON
The New York Times

Two  months ago, when Merrill Lynch began offering customers checking  and savings accounts, the firm, known for decades as America's stockbroker,  made its vision clear: becoming the nation's banker, too. In announcing the service, called "Beyond Banking," Merrill executives bragged that it would allow clients to tap into "the industry's  broadest array of best-in-class products and services accessible through a single point of contact."

Merrill's  moves to become a financial superstore may well improve the firm's  profitability, making it less vulnerable to the unrelenting bear  market. But some of the new offerings are having the opposite effect on some clients. At least two dozen who have used the loan services  that Merrill began offering several years ago are now bringing arbitration  cases against it. The melding of brokerage and banking services, they argue, left them with bigger losses than they would have incurred had they simply used traditional brokerage accounts.

These  cases may be the first of a raft of complaints involving the hybrid lending-investment vehicles that so many financial services conglomerates  have developed and sold assiduously in recent years. Once the Glass-Steagall Act was  repealed in 1999, wiping away the Depression-era barriers intended to separate brokerage firms from banks, Merrill Lynch, Citigroup, Charles Schwab and others aggressively amassed a wide variety of services under one roof.

MariEsther M. Burnham, 41, a Merrill client, says she is a victim. Ms. Burnham, a former programmer at Microsoft, has filed an arbitration case against Merrill, saying she lost $4.06 million, or 94 percent of  her money, following the advice of Joseph DiDomenico, her broker at the firm, who is now at Salomon Smith Barney. He did not return telephone calls seeking comment.

"I hired Merrill Lynch for financial advice after being solicited on  the Microsoft campus," Ms. Burnham said. "They represented  themselves as experts; I trusted their reputation."

But  Ms. Burnham's lawyer, Lawrence L. Klayman of Klayman & Toskes in Boca Raton, Fla., says Mr. DiDomenico failed to diversify or hedge his client's portfolio, which consisted solely of Microsoft  shares she had earned as stock options. In addition, Mr. Klayman  said, Mr. DiDomenico harmed his client by recommending a bank loan  from Merrill to cover the costs of exercising her options - a loan  backed by her Microsoft shares - rather than a traditional margin  loan. The bank loan, made under Merrill's Portfolio Loan Reserve program, resulted in bigger fees to Merrill but larger losses to Ms. Burnham, her lawyer said.

Mr.  Klayman said he represents two dozen other clients who have similar stories to tell of their dealings with Merrill. All of them have filed arbitration claims against the firm; altogether, Mr. Klayman  said, his clients have lost more than $30 million.

Merrill  Lynch countered that Ms. Burnham was responsible for her losses and that the loan it provided had nothing to do with them. The firm also said it had advised her to diversify her holdings.

But  securities regulators are taking an interest in these cases. The  NASD's enforcement department is reviewing how Merrill handled accounts of Microsoft employees who exercised stock options in the late 1990's.  Last month, Ms. Burnham received a letter from an NASD examiner  asking her to share her experiences as a Merrill customer.

Norman S. Poser, a professor at Brooklyn Law School and the author of "Broker-Dealer  Law and Regulation," said Congress separated banks and brokerage firms in the 1930's because of the potential for conflicts of interest in the various operations that had harmed customers. But in recent  years, he said, a new attitude has arisen, one that has characterized  Glass-Steagall as a deal struck by the nation's large banks and brokerage firms to divide various markets among themselves.

"It  was that kind of intellectual background, including the great push  of the banks to compete with the brokers, that lay behind this total erosion of Glass-Steagall," Mr. Poser said. "Now we're beginning to see that maybe there was something in what Congress did back then and maybe it wasn't just a dividing up of markets, but maybe there were some real problems in the combinations."

Ms.  Burnham's case is complex, of course, as are most customer complaints involving the exercise of stock options. Her tale begins in May  1999, when she began exercising the almost 100,000 Microsoft options she had earned since she joined the company in 1991.

Like many other Microsoft employees, Ms. Burnham had never invested in  the stock market before and held nothing but the company's shares  in her account. She said Mr. DiDomenico, her broker, advised her  to exercise her options and hold on to the shares, predicting that  they would rise in value. Ms. Burnham agreed; after all, Microsoft  shares had been a stock market rocket for a decade, and few people  were willing to bet that their rousing performance would end soon.

But  there were risks to this "exercise and hold" strategy.  Ms. Burnham needed to borrow the $1 million to buy the shares and  pay the income taxes due.

Microsoft  stock peaked at a split-adjusted $59.97 during trading on Dec. 30,  1999. Ms. Burnham exercised options through July 2000, when Microsoft  was trading at around $40. She left Microsoft in June 2000, hoping to start a family with her husband, Eric. Adding up the options  she exercised over a period of months gave her Microsoft shares worth roughly $5.5 million, net after taxes and borrowing costs.

Instead  of recommending a traditional margin loan to pay for the shares,  which would have been backed by Microsoft stock in her account,  Mr. DiDomenico suggested that she take out a Portfolio Reserve Loan from a banking subsidiary of Merrill,  backed by her Microsoft shares. The loan's interest rate floated,  with periodic adjustments based on the London Interbank Offered Rate plus 1.5 percentage points; it was 7.47 percent when she began borrowing. According to Merrill,  the rate was lower than what was available in a margin account.

Ms.  Burnham was persuaded. Since she also wanted to refinance a $208,000  loan that she and her husband carried on their home in Seattle,  she agreed to borrow $1.2 million from Merrill's bank subsidiary.

At no time did Mr. DiDomenico advise her to diversify her holdings or to hedge what was a dangerously imbalanced portfolio, Ms. Burnham  said. And, she said, he did not tell her what could happen to her holdings if Microsoft stock fell.

Merrill  stood to make more money selling a Portfolio Reserve Loan. It carried origination costs of up to 1 percent; margin accounts do not impose  such fees. And some of the firm's Portfolio Reserve Loans carry a prepayment penalty of up to 5 percent, although Merrill said Ms. Burnham's did not.

Mr.  Klayman said a more significant problem was this: According to Ms.  Burnham, Mr. DiDomenico did not advise her that by using a Portfolio  Loan Reserve, her risk was greater than it would have been with a margin loan. Because Ms. Burnham held only Microsoft stock, her loan should never have reached 30 percent of her portfolio's assets,  according to Merrill's guidelines.

When Merrill clients have concentrated portfolios - holdings that are dominated by a few stocks - the firm limits the amount they can borrow on those holdings. For example, a client with 75,001 to 100,000  shares of a single stock can borrow only 25 percent of those securities'  value. If the assets fall so much that the loan is more than 25 percent, the client must put more money or assets into the account or the loan will be closed out.

But  Ms. Burnham's bank loan was not closed out even as the Microsoft  shares that backed it fell. Had  Ms. Burnham sold her Microsoft shares each time she exercised her options and paid the taxes she owed on the gains, she would have ended up with $4.3 million, her lawyer said. But because she followed Mr. DiDomenico's advice, leveraging her assets greatly, she wound  up with an account worth $281,000 when she closed it in 2000. Now  living in Las Cruces, N.M., Ms. Burnham is seeking $4.06 million  from Merrill to cover her losses.

"The last couple of years have been filled with stress and anxiety,"  she said. "It was devastating to see my lifetime of work and savings melt away. This affects my family's future; the worst part was finding out it could have been prevented."

Of course, many brokers - and their clients - made investment mistakes  as the bull market was roaring. But Mr. Klayman argues that Ms.  Burnham's losses show an incongruity between Merrill's bank-lending practices and its approach to margin lending that imperils its clients. "The failure of Merrill Lynch to integrate its affiliated bank's lending practices in compliance with its own heightened margin lending practices has levied a huge price on the unknowing Microsoft stock option plan participants," he said.

In a statement released by Mark Herr, a Merrill spokesman, the firm said: "Ms. Burnham came to Merrill Lynch already concentrated in Microsoft through her ownership of Microsoft options. Merrill Lynch did not increase her concentration.

"The strategy she selected sought to realize the value in the options but also to preserve her position in Microsoft because she was unwilling to sell. As the price of Microsoft shares dropped, Ms. Burnham rejected Merrill Lynch's advice to diversify her holdings. The source of  the loan she used to finance the exercise of her options has nothing  to do with her alleged loss. In fact, she realized well over a half-million dollars in value from her options."

The  dispute is now before arbitrators.

Merrill's  moves to grab more of its customers' financial transactions appear  to be working. The firm's global private client business, where  its one-stop-shopping thrust is greatest, attracted $10 billion  of new money in the last quarter of 2002, Merrill said, and total  private client assets held at the firm totaled $1.14 trillion in  the period. That business generated pretax operating earnings of  $1.2 billion in 2002, up 31 percent from the previous year.

One  of the firm's strongest pushes has been in mortgage lending. Since  it entered the business a decade ago, Merrill has originated more than $20 billion in jumbo mortgages - those over $250,000 - making it the nation's seventh-largest mortgage originator. "By working  with a financial adviser who looks at your mortgage and other liabilities within the context of your whole financial picture, you have the  opportunity to make all of your money work to its fullest potential,"  Merrill's Web site states.

A  popular product at Merrill is Mortgage 100, which allows a customer to finance 100 percent of a home's value by pledging eligible securities  like stocks or bonds. According to Mr. Klayman, some of his clients  have lost their homes when the shares backing the loans were decimated.

Banking is big business," Mr. Klayman said. "Because the Glass-Steagall walls came down, Merrill had an opportunity to take advantage of that. But their internal controls did not work. The  barriers established by the Glass-Steagall Act that were removed  to better serve Americans have been eclipsed by the corporate ethos of profits."