amegy v merrill

8/14/2019 Amegy v Merrill

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DISPUTE RESOLUTIONBEFORE THE FINANCIAL INDUSTRY

REGULATORY AUTHORITY

AMEGY INVESTMENTS, INC. andAMEGY BANK NA,

Claimants,

v.

MERRILL LYNCH, PIERCE,FENNER & SMITH, INC. andMERRILL LYNCH & CO., Inc.

Respondents.

Arbitration No. ________

STATEMENT OF CLAIM

Claimants Amegy Investments, Inc. and Amegy Bank NA, through

their counsel, respectfully present and prosecute this Statement of Claim, based

on actual knowledge as to themselves and their own actions and upon information

and belief as to all other persons and events.

Introduction and Overview

1. This action has become necessary due to materially false

and misleading representations and omissions by Merrill Lynch, Pierce, Fenner &

Smith, Inc. (Merrill) in its sale to Amegy of over $140 million of auction

market preferred securities. While marketing these securities as safe and liquid

investments -- the conservatives conservative investment, Merrill said -- it

knew, but did not disclose to Amegy and the public, that there was no sustainable

09-00332


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market for the securities and, without Merrills pervasive support, the auctions

used to provide liquidity to holders of the securities would and eventually did fail.

2. Merrill cultivated a widespread belief that auction rate

securities (ARS) were liquid and offered a safe return higher than money

market funds. To secure its position in the lucrative ARS market, it used its own

capital to ensure that auctions did not fail and touted the 20-year track record of

rare failures, thus creating and maintaining the reasonable belief among innocent

purchasers that there was a highly liquid market for these securities. Due to the

practice of Merrill and other banks placing support bids for decades prior to mid

2007, there had been only a handful of failed ARS auctions that prevented

investors from accessing their principal; from 1984 until the end of August 2007,

there were only 44 failed auctions -- an average of less than two per year.

3. After recent disclosures, there now can be no mistake about

the extent of Merrills secret propping up of the ARS market. For the period

January 3, 2006 through May 27, 2008, nearly 6000 ARS auctions for which

Merrill was the sole lead dealer would have failed but for its support. The

apocalyptic events that led to market-wide auction failures in early 2008,

rendering the securities illiquid, were no surprise to Merrill, as it internally feared

just such a meltdown. According to the SEC, Merrill continued to tout the

purported liquidity of ARS to customers despite its awareness of the escalating

liquidity risks in the weeks and months preceding the collapse of the ARS


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market. Even worse, Merrills aggressive marketing of the securities as safe,

liquid investments continued as it debated and began withdrawing from the ARS

market, which it knew would lead to widespread auction failures.

4. A particularly egregious aspect of this long-running scheme

is the role of Merrills independent research department. Merrill permitted its

sales managers, including on its auction desk, routinely to influence and pressure

its research group, including through improper sharing of sensitive private data.

This resulted in biased published research that endorsed the safety and quality of

auction rate securities and urged investors to buy the securities, even though

Merrill knew that the securities were liquid only as long as it decided they would

be so. When sales personnel, including on its auction desk, did not agree with the

tone of a published research piece, Merrill allowed them to insist that the report

be retracted and replaced with a sales-friendly piece. Merrill permitted its sales

team to convey to its research group sensitive data concerning inventory levels,

marketing initiatives, and sales incentives offered to financial advisors to sell

auction rate securities. Merrill even involved its research team in efforts to reduce

its own ARS inventory when problems in the market arose.

5. Merrills massive ARS deception and then abandonment of

the ARS market has not gone unnoticed by government authorities. Among other

agencies, the U.S. Securities and Exchange Commission, New York Attorney

General, and Massachusetts Secretary of State initiated investigations into the


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ARS practices of Merrill and others. These actions were necessary, according

to the Director of the SECs Enforcement Division, because

broker-dealer firms that underwrote, marketed and soldauction rate securities (ARS) misled their customers.Through their sales forces, marketing materials, andaccount statements, firms misrepresented to their customersthat ARS were safe, highly liquid investments that wereequivalent to cash or money market funds. As a result,numerous customers invested in ARS their savings andother funds they needed to have available on a short-term basis. These firms failed to disclose the increasing risksassociated with ARS, including their reduced ability to

support the auctions. By engaging in this conduct, thosefirms violated the Federal securities laws, including thebroker-dealer antifraud provisions.

Merrill settled with government regulators after damning facts emerged about the

improper interactions of its research and sales groups -- disclosures that prompted

the Massachusetts Secretary of State to file suit for violations of securities laws.

In the settlement, Merrill agreed to take certain steps to remedy the harm caused

by its actions, including to repurchase at par $12 billion in auction rate securities

held by its retail customers, to participate in arbitrations with institutional and

other large investors, and to pay a $125 million penalty for its misconduct (the

second largest penalty imposed thus far on any auction market participant).

6. The repurchase program by Merrill has begun, and will

continue through early 2010, but it is materially incomplete. Excluded from the

buy-back settlement are innocent downstream brokers like Amegy, who bought

the securities from Merrill at the same informational disadvantage as Merrills


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direct retail customers and then sold them to Amegy clients, causing significant

and continuing harm to Amegys reputation and goodwill. Amegy continues to

incur losses from its attempts to ameliorate its clients liquidity problems through

such means as below-market rate loans and legal counsel related to the auction

market collapse. And while Merrill has rejected Amegys repeated requests for

recompense for itself and its clients, claiming that Amegy is a sophisticated

investor not entitled to relief from Merrills misconduct, it is clear that no

amount of due diligence by even the most sophisticated investor could have

uncovered Merrills secret and pervasive manipulations and deceptions.

7. To secure substantial financial benefits, Merrill knowingly

hid from the public, including Amegy, the truth about its role in the ARS market

and auction process. Having profited greatly, Merrill then abandoned the market

when it became a financial burden, leaving innocent purchasers of the securities

with their money frozen in illiquid investments. For that reason, an equitable

resolution of Merrills misconduct must include payment of Amegys losses and

rescission of the $140 million in ARS sales that Merrill made to Amegy.1

Summary of Claims

8. Merrills deceptions about the true nature of auction rate

securities and its true role in the ARS market violated state and federal securities

1 While Amegy purchased over $240 million of auction market preferred securitiesfrom Merrill, which Amegy then sold to its clients, redemptions and refinancingshave restored liquidity to approximately $100 million of the purchases, leavingthe remaining $140 million in ARS purchases at issue in this matter.


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laws and Texas common law. Its conduct violated the prohibition against

manipulative and deceptive practices with regard to sales of a security, under the

Securities Exchange Act of 1934 and Texas Securities Act. Its misrepresentations

and omissions, which were intended to induce Amegy to enter into contracts to

purchase auction rate securities, also constitute common law misrepresentation,

both negligent and knowing, and violations of Texass statutory fraud provision

under the Texas Business Code. As a controlling person under the 1934 Act and

the Texas Securities Act, Merrill Lynch & Co. is jointly and severally liable for

the misconduct of and harm caused by its subsidiary Merrill.

9. As a result of Merrills unlawful conduct, Amegy is entitled

to rescission of the Merrill contracts for sale of auction market preferred

securities, as well as damages for harm to its business reputation and customer

goodwill and costs incurred in addressing the consequences of Merrills actions.

An award of exemplary damages is warranted due to the egregious nature of

Merrills misconduct.

Parties

10. Claimant Amegy Bank NA (Amegy Bank) is one of the

fastest growing and most respected banks in Texas, now with more than 85

locations in Houston, Dallas, and San Antonio. With assets in excess of $11

billion, it specializes in small business banking and private financial management,

serving leading Texas companies as a source of capital as well as providing


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investment services. It is ranked among the top Small Business Administration

lenders in the Texas region. Its investment products and services are offered

through its wholly owned subsidiary, Amegy Investments.

11. Claimant Amegy Investments, Inc. (Amegy Investments)

is a registered broker dealer and investment adviser that provides investment

products and services for retail and institutional clients in Texas and other states.

For purposes of the allegations contained in this Statement, Amegy Investments

acted at all times as a downstream broker dealer of auction rate securities; it

played no role in the issuance or underwriting of the securities.

12. Respondent Merrill Lynch & Co., Inc. (Merrill Lynch &

Co.) is among the worlds largest wealth management, capital markets, and

advisory companies, with $1.5 trillion in total client assets. As an investment

bank, it is a global underwriter of securities across a range of asset classes. At all

times relevant to this Statement, Merrill Lynch & Co. directed the management

and policies of Merrill. It also owns 50% of BlackRock, one of the worlds

largest publicly traded investment management companies and an issuer of a large

portion of the auction rate preferred securities sold to Amegy at issue here. On

January 1, 2009, Merrill Lynch & Co. was acquired by Bank of America Corp. in

a $50 billion deal and is now wholly owned by Bank of America.

13. Like Merrill Lynch & Co., respondent Merrill is now a

wholly owned subsidiary of Bank of America. It acts as a broker for corporate,


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institutional, government, and other clients and as a dealer in the purchase and

sale of corporate debt and equity securities.

Operative Facts

A. The ARS Market Grew Quickly, Due to Its Perceived Liquidity

and Safety.

14. The ARS market emerged in 1984 as an alternative to long-

maturity debt for companies, local governments, and other entities needing long-

term funds. The market for the securities expanded significantly during the

current decade, with Merrill and other large investment banks acting as

underwriters, brokers, lead managers, and auction agents.

15. The idea behind an ARS was to create a funding instrument

that behaved like a long-term bond for the issuer but resembled a short-term

security, such as commercial paper, for the investor. Specifically, auction rate

securities were long-term securities, typically 20 years or longer, but with interest

rates that were reset at fixed intervals through so-called Dutch auctions. These

interest rate resets were typically done at intervals of one, four, five, or seven

weeks, although other reset intervals were available. As designed, the periodic

auctions purportedly gave the bonds a high degree of liquidity comparable to very

short-term assets.

16. Historically, the securities were issued by municipalities,

student loan finance authorities, and other government or tax-exempt entities.

Another class of issuers was closed-end mutual funds, which used ARS debt as a


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way to enhance returns via leveraging. At auctions for these securities, rather

than an interest rate reset, the dividend payment was reset. It is these auction

market preferred securities that are at issue here.

17. The interest rate or dividend on an ARS was reset through

an auction process. Securities were supplied to the auctions by existing holders of

the securities issue who wished to sell. Potential purchasers, including existing

holders who wished to reinvest, bid for securities by specifying both the quantity

of securities they wished to buy and the minimum interest rate they would accept.

The lowest rate that cleared the market was the clearing rate. The entire supply

of securities was allocated to those bidders who specified a minimum acceptable

interest rate at or below this clearing rate. If the auction process worked correctly,

it gave these securities a high degree of liquidity for investors, who could choose

to redeem their ARS holdings at par at the next scheduled auction.

18. An auction failed when there were insufficient bidders to

cover the number of securities offered for sale. In such a case, the securities were

priced at a specified penalty rate. Failed auctions resulted in the investors not

being able to redeem their money.

19. While ARS were long-term instruments, periodic auctions

allowed holders to treat them as short-term securities. Merrill actively marketed

ARS as vehicles to park short-term cash, and investors viewed them as such. One

of the keys to the rapid growth of this market was the belief on the part of


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investors and innocent downstream brokers like Amegy, fostered by Merrills

aggressive promotion efforts, that these instruments were the equivalent of a

money market fund.

20. By early 2008 the ARS market was enormous, estimated at

$330 billion. This represented one of the single largest investment markets in the

United States. It proved to be a lucrative business for Merrill, which reportedly

reaped tens of millions of dollars in annual profits from its ARS roles as broker,

underwriter, manager, and auction agent.

B. Merrills Misconduct in the ARS Market Prompts an SEC

Settlement.

21. In recent years, the pressure to exploit and maintain its

profitable roles in the ARS market prompted Merrill routinely to breach internal,

industry, regulatory, and legal restrictions on its practices in this fast growing and

significant area.

22. In May 2006, the SEC announced a settlement with fifteen

major broker dealers, including Merrill, that had engaged in improper conduct

with regard to the ARS market for the period January 2003 through June 2004.

The SEC had concluded that Merrill and the others engaged in practices that were

not properly disclosed to the public and which violated the federal securities laws.

The core of the improprieties centered on the ARS auction process, including

intervening in auctions, asking customers to make change orders to prevent failed


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auctions, allowing customers to submit or change orders after auction deadlines,

favoring certain customers over others, and favoring issuers over customers.

23. Among other steps, the SEC issued an order directing that

Merrill and other violators change their conduct (2006 SEC Order). It required

the firms to cease and desist from continuing violations of the Securities Act of

1933, to pay a substantial penalty, and to provide mandatory disclosures of their

material and current auction practices and procedures. Merrills penalty was the

highest ordered by the SEC.

24. Of particular relevance here are the express requirements in

the 2006 SEC Order regarding detailed ongoing disclosures about Merrills ARS

practices and procedures. Specifically, Merrill was ordered to provide within six

months -- and continuing thereafter -- two critical disclosures:

provide all of its customers who hold auction rate securities

(Holders) and the issuers of such securities (Issuers)with a written description of [Merrills] material auctionpractices and procedures[; and] . . .

at or before the completion of the applicable transaction,provide all customers who are first-time purchasers, and allbroker-dealers who are purchasers, of auction rate securitiesfrom [Merrill] (Purchasers) with a written description of[Merrills] material auction practices and procedures.

25. Merrill was directed by the 2006 SEC Order to fulfill its

mandatory ARS disclosure requirements to customers and broker-dealers in

certain specified ways:

by sending a written notification (e.g., via e-mail . . .) or,


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with respect to Purchasers, by including a writtennotification with the trade confirmation, that a writtendescription of [Merrills] material auction practices and

procedures is available on a specified web page of[Merrills] website accessible to such Holders andPurchasers.

Its written notification was required to be set forth prominently in such a manner

as to call it to the attention of the reader and also state that a written description of

[Merrills] material auction practices and procedures will be sent to the Holder or

Purchaser upon request.

26. In addition, within three months after the 2006 SEC Order

and continuing thereafter, Merrill was required to at all times make a description

of its then-current material auction practices and procedures available to:

(1) all customers and broker-dealers who are participatingthrough [Merrill] in an auction of auction rate securities onthe portion of its website that is accessible to suchcustomers and broker-dealers and is related to such auction

and

(2) the general public on another portion of its websiteaccessible to the general public.

27. Merrill failed to comply with its notice obligations under

the 2006 SEC Order with respect to Amegy. Specifically, Merrill failed timely to

provide Amegy with a written description of its material auction practices and

procedures at or before the completion of the applicable transaction in the

manner required.


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C. Merrills ARS Business Was Admittedly Both Lucrative and

Rigged.

(i) It reaped significant fees and profits from its ARSbusiness.

28. As of early 2008, Merrill had the worlds largest auction

market preferred securities business of any brokerage house, acting as lead

manager on $24.6 billion or 42% of the total market. Merrill operated its ARS

program through four units: an investment bank to underwrite the securities; an

auction rate desk (Auction Desk) to act as a remarketing agent for the

securities; a sales force (Sales and Trading) to sell ARS to retail customers,

broker-dealers like Amegy, and other clients; and a research division (Research

Department) to assist the Auction Desk in marketing and placing the securities.

29. Merrills ARS program was funded by issuers of the

securities, who paid Merrill fees to underwrite and market the securities. As an

investment bank, Merrill generated significant fees from underwriting new ARS

issuances. Since 2001, Merrill underwrote $13 billion of auction rate preferred

securities, earning $130 million of underwriting fees. In 2006-07 alone, it reaped

about $90 million in profit from its ARS business.

30. What Merrill underwrote and then sold to customers and

broker-dealers were auction market preferred securities with perpetual maturity

and dividends that reset each 7 to 35 days at auction, as well as long-term debt


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instruments, issued by municipalities and student loan organizations with

maturities of 20-40 years and interest rates that also reset at auction.

(ii) As its ARS inventory grew, so did Merrills concern

about the market.

31. Beginning in July 2007, certain market influences began to

negatively impact Merrills ARS business. As investors began selling the

securities due to concerns about their credit quality, Merrill purchased them into

its own inventory to make sure the auctions did not fail and to preserve its

lucrative ARS business.

32. While working feverishly throughout August 2007 to

maintain confidence in the auction market preferred securities product among its

own financial advisors, Merrill knew that the ARS market as a whole inexorably

was failing. On August 9, Frances Constable, Managing Director in charge of the

Merrill Auction Desk, internally wrote, Markets are shutting down bit by bit.

We have 5 failed auctions so far, with three more likely today.

33. As a top Merrill manager, Constable was consistent in

recommending to issuers to hold off on new issues for the closed-end fund

companies, as Merrill understood that the ARS markets could not handle new

supply. On August 20, 2007, she wrote in an internal email, Before we commit

to any new business, lets give people the bad news about the choppiness in the

market and urge a bit of wait and see to gauge ongoing market appetite. By


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August 21, inventory creep as a result of having to submit more and more

support bids to prevent auction failures was a major concern.

34. While its own ARS inventory was rising, the state of the

market was a topic of concern between Merrill and issuers of ARS. In August

2007, closed-end fund managers were writing to Merrill asking whether there was

sufficient demand for successful ARS auctions given the recent market

volatility.

35. In September 2007, Merrills ARS inventory levels rose

significantly and its Auction Desk was fast approaching its internal limit of $1

billion of ARS for its own proprietary account. In an internal September 27 email

to John Price, Merrills head of Americas Credit and Trading, Constable noted

ominously: We are shoveling as fast as we can. . . . Net, net. I think we should

be viewed as under our 1bn target, albeit with a few asterisk.

36. On November 19, 2007, Constable emailed Price with

continuing ARS concerns about climbing rates, a negative market tone, and

specials . . . to move inventory:

AMS desk barraged by issuers asking why their rates areclimbing as well as investors expressing concern aboutmuni [guaranteed] by monolines. Negative tone prevails.Inventory up by 100MM. We are offering discounts as well

as 25 and 50 bp [basis point] credit specials in an effort tomove inventory.


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She assessed the Merrill ARS inventory as surpassing $2.32 billion overall. Price

responded: Thank you . . . we need to get smaller unfortunately -- using any

means possible.

37. On November 21, 2007, Constable reported internally on

the extremely difficult time her Auction Desk had in successfully conducting

auctions for the day. She wrote of investor scarcity, cheaply priced

inventory, and negative market perceptions, making the most positive action

that Merrill had was that we did not fail two key auctions:

Auction Market inventory at [close of business] 11/21/2007was reflective of a double auction day when the marketconducted over 1400 auctions, a scarcity of investors tosnap up cheaply priced inventory and the ongoing negativeperception of securities that populate the auction market andthe behavior of the dealer participants. Any combination ofa negative Bloomberg article about auction illiquidity, theongoing downdraft of press about the monoline insurers thatguarantee the entire municipal space in our market, equity

prices of the dealer community and the GESs undergoing adeath spiral undermining retail investors confidence in ourability to support the auction business and two times thenumber of daily auctions might have been deadly but wegot them all today. The most positive thing that can be saidis that we did not fail the two DRD repacks we sole managefor GS and MER today, albeit, we went long roughtly [sic]half of each. . . .

38. Also in the fall of 2007, Merrills own lenders became

concerned about the ARS market, although the public would not know this until it

was too late. Up until then, certain Merrill lenders that financed its ARS

inventory had accepted the securities as collateral for the loans. Some of the


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(iii) Merrill seeks to reduce ARS inventory through

aggressive marketing.

41. In November 2007, Merrills upper management and risk

management reviewed the Auction Desks growing ARS inventory and instituted

a reduction plan, internally referred to as a Balance Sheet Initiative. Its

approach was two-pronged: first, it sought to motivate its national sales force to

push more auction rate securities to its customers, including broker-dealers like

Amegy; and second, it used its Research Department to provide a distorted picture

of the true state of the ARS market and its role in the contagion.

42. Motivating the Merrill sales force. Its first approach was

to encourage its own financial advisor sales force to sell more ARS to the public.

This was accomplished through providing the Merrill sales team with more

lucrative financial incentives for selling ARS products, as well as by holding

informational sales calls with its national sales force. During the calls, Merrill

finessed the alarming weaknesses of the ARS market by not pointing out the

negatives relative to liquidity that its Research Department had flagged. Instead,

it gave its financial advisors a 180-degree false story to pitch -- that ARS market

conditions have made things that were already attractive even more attractive

and that the closed end fund ARS sector was the conservatives conservative

investment in the auction market.


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43. In its internal sales calls, Merrill avoided mentioning the

then-existing risks of ARS auction failures and other market dislocation that could

result in customer investments becoming illiquid. Nor did it mention the

likelihood that Merrill could and would choose to stop its support of the ARS

auction market -- at any time -- or otherwise withdraw from supporting the

auctions that it managed in order to limit its own financial risk regardless of the

impact on Merrill customers, including broker-dealers like Amegy.

44. It was known within Merrill that its Sales and Trading Desk

was to work in concert with its Research Department to unload ARS. During a

national sales call, Constable told participants that we are working in concert

with research to provide the best ideas and to give assurance as to the solidity and

ongoing endurance of some terrific markets.

45. Manipulating research reports. During the fall of 2007,

Merrills Research Department played a pivotal, and inappropriate, role in

assisting sales of ARS at this critical juncture. On at least two occasions, Sales

and Trading and the Auction Desk made direct, specific requests for the Research

Department to draft favorable research pieces regarding the ARS market to assist

in selling down the huge, risky Merrill ARS inventory.

46. On August 14, 2007, William Kubeck, a Merrill manager in

its Financial Products Group, requested that Fran Faulkner in Research prepare a


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published special edition research report on the ARS market, to have a better

impact on the Merrill sales effort:

Calls are helpful, however, attendance is usually not great.Something published instead of or in addition to a callwould have a better impact. Perhaps this could be releasedas a special edition Fixed Income Digest report outliningcurrent events as they relate to this market and what FAsshould be telling clients.

47. On August 20, 2007, Merrill Auction Desk employee

Robert Tomeny requested from Kevin Conery, a senior director in the Research

Department, a published research piece on certain ARS that had auction failures:

any chance you guys can update that old Centaur research pieces Bess and Stuart

Rosmiller published to include the auction rate series. Tomeny wanted

something from Research to give to potential customers, that he could send out

to auction investors that describe[d] the structure in its entirety.

48. On November 30, 2007, Constable, the Merrill manager of

the Auction Desk, emailed a Merrill research analyst, to update him on the lack of

confidence in the ARS market and to request that he be extremely helpful by

publishing a positive research piece, to reassure investors that ARS are safe by

focusing on the high quality of the securities:

As you know, rates across our market have been backing

up, due to a combination of a renewed crumbling ofconfidence on the part of investors as they absorb the recentspate of bad headlines about monoline insurerers [sic], bankand dealer exposure to subprime and their hits to earningsand a general lack of understanding of all our short term


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cash management alternatives. In the old flight to T-Bills, the recurring conversation here on the AMS desk is aline out of Marathon Man -- Is it safe? Any renewed

research focusing on the high quality of closed end fundpreferreds of ALL tax status, auction municipal bonds andstudent loan banked bonds, wrapped around the value addedproposition with todays rates would be extremely helpful.

49. On other occasions, the Auction Desk appears to have had

advance notice of research to be published about the ARS market. For example,

early on August 9, 2007, Constable emailed Conery, the senior Merrill research

director, with a simple one-line query: Research today? Shortly after 7:30pm

that evening, after apparently not receiving a response, she followed up with

another email to Conery with four lines of question marks -- indicating the

urgency of her need to know about the upcoming research piece. As Constable

later admitted, Merrills Auction Desk should have been told about research only

after it was published.

50. In fact, on August 10, 2007, the Research Department (by

Conery) issued a major piece on the ARS market, titled Turmoil and Opportunity

in the Auction Market. His report took pains to distinguish recent private-

placement auction failures involving institutional buyers from individual investors

who were relatively unharmed as they have been largely active in the more

conservative and public sectors. He downplayed recent ARS failures by

suggesting they were limited to obscure ARS issues, and openly endorsed buying


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auction rate securities as a way to take advantage of their good value and yet

avoid liquidity risk:

We believe there could be many opportunities to takeadvantage of relative value situations without taking onundue or excessive amounts of credit or liquidity risk.

Over the following weeks, the Merrill Auction Desk distributed the Conery report

to customers, including broker-dealers, seeking clarity of recent ARS events.

51. The scheming between the Research and Sales/Trading

Department went beyond discussion of research pieces. The groups began

sharing information that was supposed to be limited to their own internal use. In

fact, Conery had ongoing communications with Price, head of the Credit/Trading

group, and with top managers of the Auction Desk.

52. Their interactions were contrary to Merrills Policy and

Procedures Manual (Policies Manual). It employs a so-called Chinese Wall to

prevent the misuse of material non-public information and to prevent even the

appearance of impropriety. The wall is designed to restrict and monitor the

flow of information between the various areas of [Merrill] such as Global

Research, Sales [and] Trading, among others, to avoid the misuse of such

information and the appearance of impropriety as well as to manage potential

conflicts of interest. The Research Department is on the public side of the

wall, while departments that receive inside information -- such as the Auction

Desk -- are on the private side of the wall. Among the private data not to be


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discussed between Sales/Trading and Research is the level or amounts of ARS

inventory that Merrill maintained for its own account.

53. Nevertheless, Price and Conery exchanged sensitive ARS

data during this period. According to Conerys work notebook, Price gave him

embargoed information, including that Merrill had reached $1 billion in ARS

inventory in October 2007 and that its finance[s] are challenged. On November

20, the day after the Auction Desk was directed to reduce ARS inventory, Conery

had a detailed discussion with Price about the specific breakdown of Merrills

ARS inventory position and its reduction plans. Moreover, from at least August

2007 through February 2008, Conery regularly was given Merrills daily sales

listings, which contained significant non-public information such as its inventory

positions and the credits available to financial advisors selling the ARS products.

Despite its improper knowledge of private-side information, including Merrills

inventory problems and urgency to reduce it, the Research group continued to tout

publicly the safety and liquidity of the securities.

54. In addition to these improprieties, Merrill permitted its

Sales/Trading group and Auction Desk to influence the Research Departments

coverage of the ARS market.

55. On August 21, 2007, Constable, as Auction Desk manager,

demanded a retraction of Research work that could single handedly undermine

the Auction Market. The piece in question was published that day by Mauro and


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Fisher in Merrills Research Department. In comparing auction rate preferred

securities to another product, the piece noted that these securities had no hard

puts (a demand feature that assures investors of getting back par value at the

reset date), and therefore holders needed to rely on other buyers in the market to

redeem the securities at par. Upon reading the piece, Constable called Mauro to

demand a retraction and clarification, claiming that it was misleading to speak

about failures in a municipal market research piece when ARS failures at that

time were limited to securities backed by collateralized debt or loan obligations.

56. The next day, August 22, 2007, after Constable complained

to Price, Conery, and others, the Research Department retracted the report and

issued a replacement. The new report changed the overall emphasis of the piece,

from distinguishing between liquidity of different instruments to recommending

that investors buy ARS. The Auction Desk had gotten just what it wanted -- more

vital marketing fodder. As Constable later noted, the new report and other

research have been essential tools in our sales arsenal.

57. This incident had a lasting impact on ARS reports from the

Research Department. Going forward, the reports consistently understated

negative market events and known risks, and highlighted the supposed ARS

benefits, all in order to minimize the potential adverse consequences to Merrills

marketing and sales of the securities.


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58. In December 2007, the Research group endorsed buying

ARS. The piece argued that credit fears are largely misplaced in the auction

market and expressed conviction that auction market preferred securities of

closed-end funds are a conservatives conservative security.

59. The ties between the Research Department and Auction

Desk were no secret within the firm. In fact, some members of the groups touted

the relationship to their superiors in year-end performance reviews. Conery

described his service to the Auction Desk as integral and well coordinated,

including a large number of conference[s]. The ongoing close coordination, in

his view, helped to significantly improve liquidity and lower inventory levels.

His self-review sums up the upside-down role that the Research Department had

undertaken -- it became a sales tool, and instead of providing independent

reports about the true state of the ARS market, it issued reports intended to

manipulate and confuse investors.

(iv) Merrill decides to stop supporting its auction program,

to cut its risk.

60. Merrills concerns about the ARS market grew in early

2008. On January 9, a senior Auction Desk trader internally raised concerns

about downgrades of firms that insure ARS issues: We anticipate that if this

happens there will be a wave of selling in these issues that we will be unable to

support causing the auction to fail. If any of these issues fail one can make the


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assumption that it will spread to the other sectors of our market regardless of the

insurer or ratings.

61. Two days later, Constable gave her colleagues on the

Auction Desk an internal risk management analysis of options to reduce Merrills

risk associated with certain auction market preferred inventory. One part of the

analysis dealing with the risky preferred ARS provided an Option #3: Fail

future auctions:

OPTIONS TO REDUCE RISK

. . . Option #3: Fail future auctionsPros: ML balance sheet will be capped at levels today.Cons: ML cannot fail our own paper and may be forced totake that back.

62. At the same time, ARS inventory concerns continued. In a

January 18, 2008 email, Constable internally emphasized, we are about to get

shellacked from terrified investors and we HAVE TO SELL INVENTORY!!

No one at Merrill conveyed this coming shellack[ing] to ensure that terrified

investors in the marketplace do not buy these securities.

63. On January 23, 2008, word began circulating that Lehman

Brothers had a number of ARS auctions fail the day before. In response to an

internal question from a Merrill banker with an issuer client who had concerns

about the ARS market, a Merrill colleague wrote:

Lehman failed 5 auctions yesterday -- this is unprecedented.I am not sure what to tell [the issuer client] but, in my


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opinion, we have to let [the client] know that we feel theauction market is going to get worse not better and theywould be best served exiting the market.

Merrill did not disclose its concerns that the ARS market is going to get worse,

and participants would be best served exiting the market, with its customers,

like Amegy, or with the investing public.

64. Despite knowing this information, the Research

Department continued to issue positive ARS research pieces, minimizing the

negative aspects of the securities. Between February 1 and 8, 2008, while Merrill

was considering abandoning the auction process, Conery wrote or contributed to

three published research pieces that advised investors to be confident in the ARS

market. Indeed, his February 1 piece opined, For funds that investors need to

keep liquid, we continue to find the best value in auction market securities.

65. On February 8, just days before Merrill abandoned the ARS

market and left buyers with frozen investments, Conery wrote that he found ARS

rates to be attractive and was impressed by the auction markets resiliency in

the face of challenging times.

66. On the evening of February 12, 2008, Merrill decided to

stop supporting its ARS program and to allow the vast majority of their auctions

to fail the next day. Its decision to stop supporting ARS auctions was made solely

to cut its own perceived risk, not out of any consideration or analysis of the effect

on customers holding the securities.


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67. Merrills decision to withdraw entirely from the ARS

market coincided with the decision of other major auction rate banks to do the

same, causing a catastrophic collapse of the ARS market as a whole. As a result,

the funds of holders of ARS became frozen, and a liquidity crisis ensued.

68. As holders of auction market preferred securities became

increasingly panicked about the state of the market and their ability to access their

money, many sought to sell their shares, further increasing the imbalance between

purchases and sales, making it difficult for the markets to resume functioning.

69. Months after Merrills decision to abandon the ARS market

and the holders of the securities, auctions continued to fail on a widespread basis,

prompting the District of Columbia Department of Insurance, Securities and

Banking to report that the ARS market remains largely frozen and investors are

unable to access the funds they had put into securities that they thought would act

like cash.

70. Holders of auction market preferred securities have been at

a particular disadvantage relative to holders of other ARS when it comes to

chances of redemption by the issuer. While ARS issued by municipalities, for

example, have high penalty rates for failed auctions encouraging redemption,

the same is not true of the auction market preferred products. Those securities

tend to have a significantly lower penalty rate for failed auctions, giving issuers

less incentive to redeem the securities.


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71. And while holders of auction market preferred securities

and innocent downstream brokers like Amegy continue to be injured by Merrills

deceptions and withdrawal from the market, banks like Merrill apparently

continue to get paid for their ARS services, as issuers reportedly pay fees for each

year of an auction rate issues life.

D. Amegy Purchased Auction Rate Preferred Securities from

Merrill.

72. From 2004 through February 2008, Amegy purchased over

$140 million in auction market preferred securities from Merrill on a riskless

principal basis based upon the false and misleading representations Merrill made

to Amegy and others. Those ARS, which Amegy sold to its clients, have yet to be

redeemed or refinanced. At no time during this period did Merrill disclose to

Amegy that Merrills own proprietary inventory had reached or exceeded its limit;

that for years it had been placing supporting bids in thousands of auctions that

would have failed without Merrills bids; that it was taking steps to rid itself of its

inventory; or that it was considering abandoning the ARS market entirely,

rendering illiquid the ARS being bought by Amegy.

73. In the summer and fall of 2007, as the nations credit

markets deteriorated, Amegy performed an exhaustive analysis of the quality of

the securities underlying the auction market preferreds it purchased from Merrill

and then sold to its clients. That analysis reassured Amegy that the securities


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were of good credit quality. But no amount of research or analysis could have led

Amegy to learn of Merrills deceptive marketing and support of the ARS market

and the truly illiquid nature of the securities.

74. In late 2007 and early 2008, consistent with its deceptive

marketing and sales approach to rid itself of its increasingly burdensome ARS

inventory, Merrill had its traders contact Amegy more frequently to point out the

attractive rates being offered on auction market preferred securities available in

Merrills auctions. The traders did not disclose that Merrills own proprietary

inventory had reached or exceeded its limit; that for years it had been placing

supporting bids in thousands of auctions that would have failed without Merrills

bids; that it was taking steps to rid itself of its inventory; or that it was considering

abandoning the ARS market entirely, rendering the securities illiquid.

75. Merrills decision to abandon the ARS market left Amegy

clients with illiquid ARS and significantly damaged its reputation and goodwill

by virtue of its association with the illiquid securities Merrill misleadingly

marketed and sold. While Merrill has refused to repurchase the ARS bought by

Amegy and then sold to its clients, Amegy has taken steps to provide needed

liquidity to its clients. For example, Amegy Bank has provided below-market rate

loans to its clients who hold these illiquid ARS. It also has incurred legal

expenses as it works with its clients to right the wrong done by Merrill.


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E. Merrills Disclosures to Amegy Did Not Comply with the 2006

SEC Order.

76. Merrill failed to comply procedurally and substantively

with the 2006 SEC Order that resulted from its deceptions in the ARS market.

77. Specifically, the 2006 SEC Order first required Merrill to

provide not later than 6 months after the entry of this Order a written

description of [Merrills] material auction practices and procedures to all of its

customers who hold auction rate securities . . . and the issuers of such securities.

78. After a diligent search of its files and consultation with its

personnel who handled Merrill transactions, Amegy has found no indication that

it received the mandated written description of practices and procedures, nor has

Merrill confirmed that it sent a written description to Amegy.

79. The 2006 SEC Order required that Merrill, at or before the

completion of the applicable transaction, provide . . . all broker dealers who are

purchasers . . . of auction rate securities from [Merrill] (Purchasers) with a

written description of [Merrills] material auction practices and procedures. The

Order demanded that Merrill provide a written notification with the trade

confirmation, that a written description of [Merrills] material auction practices

and procedures is available on a specified web page of [Merrills] website

accessible to such . . . Purchasers. The Order mandated how notification must be


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disclaim responsibility for its misleading and deceptive conduct. It also claims

that Amegy is a sophisticated investor that should have known the secret risks

in buying ARS from Merrill. Neither argument holds water, and both are belied

by Merrills agreement to repurchase ARS at par from its clients, regardless of

their sophistication and despite the availability of the disclosures to the public.

82. In truth, no reasonable outside investor could have known

the extent to which Merrill was propping-up the ARS market through bidding for

its own account. Time and again, Merrill emphasized the opposite to the public,

including Amegy, using the Research Department to paint a picture of a highly

(and legitimately) liquid market for a conservatives conservative investment.

83. At best, the Merrill Lynch & Co. website conveyed that

Merrill may submit a bid in an auction to keep it from failing, but it is not

obligated to do so and that there may not always be enough bidders to prevent

an auction from failing in the absence of Merrill Lynch bidding in the auction for

its own account. This is not a truthful disclosure, considering that Merrill knew

the ARS market existed only because of its bids. The fact that 6000 auctions

would have failed over a period of thirty months without the support of Merrill

exposes the distortion in its website disclosure. In truth, Merrill was almost

always submitting bids to keep auctions from failing, and there almost never were

enough other bidders to prevent a failure in the absence of Merrills bids.


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First Claim

Violation of the Federal Securities Laws

(Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10-b(5))

84. A violation of Section 10(b) occurs when, in connection

with the purchase or sale of securities, a party uses the instrumentalities of

interstate commerce or the mails, directly or indirectly, to make untrue statements

of material facts or omissions of material facts causing financial loss.

85. In connection with its sale to Amegy of over $140 million

in auction market preferred securities, Merrill made untrue statements regarding

the liquidity of ARS and the true nature of Merrills participation in the auction

market. Merrill failed to disclose, despite misleading representations to the

contrary, that the ARS markets existed solely as a result of Merrills support bids,

and that the securities would be illiquid without the bids.

Second Claim

Controlling Person Liability under the Federal Securities Laws(Section 20(a) of the Securities Exchange Act of 1934)

86. A person who controls a person liable under the Securities

Exchange Act of 1934 is liable jointly and severally with and to the same extent

as the primary violator to any person to whom the primary violator is liable,

unless the control person acted in good faith and did not directly or indirectly

induce the act or acts constituting the violation or cause of action.

87. Merrill Lynch & Co. acted as a control person of Merrill

within the meaning of Section 20(a) of the Exchange Act. By virtue of its 100%


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ownership of Merrill, Merrill Lynch & Co. had the power to and did influence and

control Merrills conduct, including the content and dissemination of false and

misleading statements, among them Merrills misleading ARS practices and

procedures contained on the Merrill Lynch & Co. website.

Third Claim

Violation of the Texas Securities Act

(Tex. Civ. Stat. Ann. Art. 581-33)

88. A person who offers or sells a security by means of an

untrue statement of a material fact, or an omission to state a material fact

necessary in order to make statements made not misleading, is liable to the person

buying the security, who may seek rescission.

89. In connection with its sale to Amegy of $140 million in

auction market preferred securities, Merrill made untrue statements regarding the

liquidity of ARS and the true nature of Merrills participation in the market.

Merrill failed to disclose, and made misleading representations to the contrary,

that the ARS markets existed solely as a result of Merrills support bids, and that

the securities would be illiquid without the bids.

Fourth Claim

Controlling Person Liability under the Texas Securities Act

(Tex. Civ. Stat. Ann. Art. 581-33)

90. A person who directly or indirectly controls a person liable

under the Texas Securities Act is liable jointly and severally with and to the same

extent as the primary violator to any person to whom the primary violator is


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liable, unless the controlling person sustains the burden of proof that he did not

know, and in the exercise of reasonable care could not have known, of the

existence of the acts by reason of which the liability is alleged to exist.

91. Merrill Lynch & Co. acted as a control person of Merrill

within the meaning of the Texas Securities Act. By virtue of its 100% ownership

of Merrill, Merrill Lynch & Co. had the power to and did influence and control

Merrills conduct, including the content and dissemination of false and misleading

statements, among them Merrills misleading ARS practices and procedures

contained on the Merrill Lynch & Co. website.

Fifth Claim

Statutory Fraud

(Tex. Bus. & Comm. Code 27.01)

92. A claim for statutory fraud lies where a party makes false

representations of past or existing material facts for the purpose of inducing

another party to enter into a contract for the purchase of securities, and the party

relies upon the false representations when entering into the contract. It does not

require proof of knowledge or recklessness as a prerequisite to recover actual

damages, but such proof warrants an award of exemplary damages.

93. Merrill made repeated false representations about the

liquidity of the ARS market, while fully aware that the markets were liquid only

because of Merrills participation. Merrill made these false representations with

the specific purpose of inducing Amegy and others to enter into contracts to


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purchase ARS. Amegy, like others, relied upon Merrills misrepresentations

about the liquidity of the market when entering into the contracts. Had Amegy

been aware of the true nature of the ARS market, as known to Merrill, it would

not have purchased over $140 million in auction market preferred securities.

Sixth Claim

Common Law Fraudulent Inducement

94. The elements of a fraudulent inducement claim are a

material misrepresentation, which was false, which was either known to be false

when made or was asserted without knowledge of the truth, which was intended

to be acted upon, which was relied upon, and which caused injury.

95. Merrill made repeated false representations about the

liquidity of the ARS market, while fully aware that the markets were liquid only

because of Merrills participation. It made these false representations with the

specific purpose of inducing Amegy and others to enter into contracts to purchase

ARS. Amegy, like others, relied upon Merrills misrepresentations about the

liquidity of the market when entering into the contracts. Indeed, had it been

aware of the true nature of the ARS market, as known to Merrill, Amegy would

not have purchased over $140 million in auction market preferred securities.

Seventh Claim

Common Law Negligent Misrepresentation

96. The elements of a negligent misrepresentation claim are

that respondent made a statement of fact in the course of its business, the


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statement was false, respondent knew or should have known of the statements

falsity, claimant relied on the statement, and reliance on the statement caused

injury to the claimant.

97. Merrill represented to Amegy and the public that auction

market preferred securities were conservative and liquid investments, knowing

that they were not truly liquid, and that without Merrills constant supporting bids

in the auctions, thousands of auctions would have failed. Amegy relied upon

Merrills representations about these securities when it purchased over $140

million of them from Merrill, and that reliance caused harm to Amegy.

Prayer for Relief

For these reasons, and so that equity may be done, Claimants

respectfully request that, after a full and final evidentiary hearing, they be

awarded rescission of the challenged sales, all of their damages, and interest,

attorney fees, and costs, as follows:

a. Rescission of $140 million in auction market preferredsecurities bought from Merrill, for which Amegy willtender back the securities;

b. Actual damages, including Amegys costs related toameliorating losses and inconvenience to its clients, such asby providing investment liquidity, as well as fees paid byAmegy for legal and other advice related to Merrills

abandonment of the ARS market;

c. Damages for harm to Amegys reputation and goodwill;

d. Exemplary or enhanced damages as warranted by theevidence and law;


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e. Reasonable and necessary attorney fees for this arbitration;

f. Costs and expenses of arbitration; and

g. Pre- and post-award interest at the highest lawful rate.

Claimants reserve their right to amend and supplement this Statement of Claim, as

additional facts and evidence becomes known.

Dated: January 20, 2009 Respectfully submitted,

R. Paul YetterKimberly L. McMullanYetter, Warden & Coleman, L.L.P.909 Fannin, Suite 3600Houston, Texas 77010(713) 632-8000(713) 632-8002 (Fax)[email protected]@yetterwarden.com

Attorneys for Claimants

Amegy Investments, Inc. andAmegy Bank NA

amegy v merrill

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