Finance

BURNED BY MERRILL

Hey. Wanna buy a stake in a high-risk real estate limited partnership? Half your money will go into raw land in Orange County, Calif., and a fifth into a troubled Florida residential development. We're projecting a 13% annual payout for three years, but much of that will be a return of your original money to you. And by the way, 17% of your dough will disappear right away in fees and commissions.

Of course, that wasn't the pitch made by Merrill Lynch & Co. brokers when they were selling Arvida/JMB Partners LP II in late 1989. But it was far closer to reality than the rosy spiel used by Merrill to persuade 15,700 of its retail clients to invest in the partnership. Put bluntly, Arvida II has been one of the poorest-performing LP investments ever sold. Hammered by the real estate slump, it stopped sending checks within months of being formed. And its investors, many of them retirees, have since been told they're unlikely to see another penny of their $234

million.

A two-month investigation by BUSINESS WEEK found that a substantial number of Merrill brokers who sold Arvida II and Arvida I, an earlier deal, sold the partnerships to many clients, including retirees of modest means, for whom risky investments were inappropriate. Materials and oral presentations given to brokers played down the partnerships' risk, exaggerated prior investment performance, and fudged key facts. All told, Arvida investors have lost close to $440 million.

HEFTY FEES. Although it has received little publicity, the Arvida II disaster has turned into a huge legal headache for Merrill, the fund's sole underwriter and broker. In recent months, hundreds of angry investors have filed arbitration claims and other actions against the company. Most contend that such speculative partnerships were unsuitable for them and that the risks were concealed. "The broker said it was a good, safe investment and I would get 13%," recalls Mary O'Donnell DeSimone, a 76-year-old retired nurse in Tamarac, Fla. Although hardly poor, DeSimone was a conservative investor with less than $100,000 in Merrill investments, mostly municipal bonds. Her broker sold some munis so she could buy $12,000 worth of Arvida II. A Merrill spokesman says DeSimone lost an arbitration dispute with Merrill over her IRA account and "had a motive to badmouth Merrill Lynch."

Merrill also faces scores of other partnership arbitration cases, including many focusing on Arvida I. The $400 million partnership, sold in 1987, is troubled, but not as disastrously as Arvida II. Both were created by JMB Realty Corp. and Florida land developer Arvida. Merrill won the first round of legal skirmishing: In early April, a federal judge in Chicago approved a settlement of an Arvida II class action. Merrill and JMB settled for $6 million, or less than two cents on the dollar, with holders of 72% of Arvida II units.

The class action, though, focused narrowly on whether the Arvida II prospectus was inaccurate, which it was unable to prove. The case didn't deal with the much broader issue of Merrill's sales practices, which investors who rejected the class action settlement are now raising in arbitration claims. Says Samantha B. Rabin, managing editor of Securities Arbitration Commentator, an industry newsletter: "Merrill's getting off the hook cheaply, and a lot of people with good claims will be forever stayed from pursuing their claims."

Yet Merrill's legal woes range beyond court action. BUSINESS WEEK has learned that state securities regulators are meeting on Apr. 16 in Washington and will likely decide to set up a nationwide task force to probe Merrill's limited partnership marketing practices. Several states, including New Mexico and Florida, are conducting preliminary inquiries.

REVELATIONS. So far, no one is accusing Merrill of the allegedly systemic sales abuses that plagued Prudential Securities Inc., which had to set up a $330 million fund to settle claims with LP investors. Unlike Prudential, Merrill kept a relatively tight control on its limited partnership activities. Nor does Merrill appear to have followed some of Pru's most unsavory practices, such as allegedly making false guarantees or telling customers that limited partnerships were as safe as certificates of deposit.

Still, revelations of any wrongdoing at all could tarnish a firm that has carefully cultivated a reputation for probity. Merrill has always claimed to hold itself to a higher ethical standard than most rivals. While Pru has always been viewed as a scrappy second-tier firm, Merrill's 13,000-strong broker network makes it the flag bearer for Wall Street on Main Street.

Merrill strongly defends its limited partnership sales practices and track record. John L. Steffens, the executive vice-president in charge of Merrill's retail brokerage network, declined BUSINESS WEEK'S request for comment. Steffens hasn't been directly linked to Arvida's problems. Richard Ruffine, head of marketing for Merrill's special-investments unit, says the firm's performance on the 63 limited partnerships it sold between 1983 and 1993 was good. He says investors lost money on only 23. Half of the losses came from three partnerships, including the two Arvida deals.

Ruffine concedes that a "few hundred" Arvida II investors "may have a significant beef." But he insists that only a small number of brokers sold partnerships to unsuitable investors. Ruffine attributes the Arvida partnerships' poor performance to the unpredictable severity of the real estate crash. He also says that Merrill brokers were fully informed about the risks involved in Arvida and other partnerships and the vast majority of brokers told clients about the risks. And even though a judge ruled in Merrill's favor in April, Merrill will make a fair settlement with any clients that have legitimate grievances. Says Ruffine: "We don't see any correlation between Merrill and Prudential. This is not a system that broke down."

Nevertheless, the BUSINESS WEEK investigation, which involved interviews with more than 125 people, including many Merrill customers and over a dozen current and former Merrill branch managers and brokers, found that the problems were more widespread than Merrill admits. Among the findings:

--Possible misrepresentation of facts.

Merrill may have failed to convey adequately the risks of the two Arvida deals to its brokers and clients. Arvida II "was largely a land transaction, and land is the highest risk in real estate," says John E. Neal, who heads Kemper Corp.'s real estate department. In 1990, he was head of Continental Bank Corp.'s real estate lending group when the bank made a big loan to help Arvida II develop land into residential communities.

But those risks were glossed over in internal Merrill presentations, according to Merrill brokers that BUSINESS WEEK contacted. The 24-page Arvida I brochure, for example, devotes only one boilerplate paragraph to risks. One internal Merrill promotional document says Arvida I entailed only "moderate risk." Ex-brokers recall that risks were never mentioned in oral presentations for the funds. Instead, Merrill brokers were regaled with statistics about the unsullied track record of JMB, the Arvida partnerships' sponsor, which had sold many successful limited partnerships through Merrill.

Many brokers didn't understand or explain to clients that JMB's past successes in more dependable, income-producing commercial real estate deals were very different from Arvida's riskier, residential land development projects. In fact, Arvida was JMB's first residential foray. Says Ruffine: "JMB had delivered in the past, and there was no reason to believe they wouldn't deliver in the future. I can understand how a few brokers might ignore the risks and dwell more on the proven record [of JMB]."

The internal presentations also focused on expected cash flows: 15% to 20% annually for Arvida I in its first five or six years and 13% for Arvida II's first three years. Arvida I "sounded terrific" when it was unveiled at a meeting in Boca Raton, Fla., in 1987, recalls James R. Ottesen, a former Vero Beach (Fla.) Merrill broker. "There was a boom in housing, and they painted it as though the boom could go on for a long, long time." Ottesen maintains that he wasn't fooled: He read the prospectus, decided it was chancy, and sold very few units. Merrill says it successfully sued Ottesen after he voluntarily left Merrill to prevent him from soliciting his Merrill clients.

Some Merrill brokers weren't so diligent--or so smart. A former Georgia broker, who sold Arvida II units to several risk-averse clients, swears that his office manager told him Arvida II "was like a municipal bond with an upside kicker." Merrill says the description would have been inappropriate, but two other former brokers from the same branch confirm the account. "If that's true, it's pretty alarming," says one state securities regulator. "It's almost a replay of Pru. Per se, most limited partnerships were risky, speculative investments."

-- Potential unsuitability.

Merrill appears to have made little attempt to restrict sales to risk-tolerant clients. Current and former Merrill brokers say a large portion of buyers, many of them Florida residents, were retirees looking for income. Merrill instructed brokers they could sell the two Arvida funds to any prospect with $30,000 in income and a $30,000 net worth, or a $75,000 net worth. "I was told there isn't a client mn your books this isn't suitable for," recalls one ex-Merrill broker in Georgia about Arvida II. "This was supposed to be a conservative investment."

Another ex-Merrill broker, David G. Deacon, says his office in Delray Beach, Fla., did a brisk business in both Arvida funds, even though 95% of its clients were retirees. Most were seeking income and security of principal. Deacon says he sold $270,000 worth of Arvida I and $500,000 of Arvida II. "We were selling Arvida II to people like a bond," he recalls. "I feel I wasn't adequately told the risks, and I didn't adequately convey the risks to my clients."

One of Deacon's clients was Dorothea Heyl, an 89-year-old widow who says she lives off the income from her modest portfolio. Heyl, who was 85 when she bought $15,000 worth of Arvida II, says: "I was told it was an excellent investment, that I would have good income from it."

Merrill says it fired Deacon for operating a customer's account under an assumed name. Deacon says the customer was entitled to use that name. Merrill also says it settled a complaint against Deacon for selling a client an unsuitable limited partnership. Merrill says the vast majority of Arvida purchasers were suitable for the funds. It says the funds were moderate-risk investments, aimed at clients with a desire for current cash-flow but who didn't need to conserve principal because the funds were self-liquidating.

--Allegedly misleading return forecasts.

Current and former Merrill brokers say it was never made clear to them that the handsome cash-flow forecasts for both Arvida funds would, in the early years, be largely a return of capital, not on capital. Indeed, the internal marketing brochure for Arvida II highlights the 13% payout from Arvida I in 1988 as a key selling point but fails to inform brokers how that was achieved.

Some brokers seem to have been confused about the issue. BUSINESS WEEK has seen copies of two form letters to clients, mailed by Merrill branches in Florida, that use the word "return" instead of "cash-flow" in marketing pitches. In a Nov. 9, 1989, letter for Arvida II from a Merrill branch in Tampa, broker Maureen S. Ayral wrote to one of her clients who owned Arvida I: "As you know, since our purchase, these units (Arvida I) have generated greater than the 12% return projected...." She made no reference to the fact that a major portion of that included payback of original capital. Merrill says its internal documents and presentations clearly explained the Arvida payments, and says Ayral's client hasn't complained.

The current acrimony is a far cry from the successful start of Arvida, which stands for ARthur VIning DAvis, the legendary former chairman of Alcoa, who bought huge tracts of Florida land in the 1940s and 1950s. In 1962, after Penn Central Corp. bought it, Arvida grew into a pioneering builder of lavishly landscaped, planned residential communities. Chicago-based JMB, one of the largest real estate syndicators, bought Arvida for over $400 million in 1986.

At the time, many Arvida executives wondered if JMB had paid too much, since previous owners had sold off some prime properties. "This cow had been milked pretty good," says a former high-level Arvida executive. "The [Arvida I] deal was underwater to start with," says former Arvida President John W. Temple. "The best management in the world can't make money out of overpriced real estate."

JMB and Merrill, though, were able to skim off some of the remaining cream. Up-front fees and commissions to Merrill and JMB ate up 14% of investors' funds in Arvida I and 17% of Arvida II. JMB got $20 million from Arvida I and $15 million from Arvida II. Although typical of other partnerships, the payments made it harder to attain the Arvida funds' lofty projections.

Arvida's top management didn't stick around to see how the deals worked out. In the months before JMB sold Arvida I to Merrill customers, eight of the nine top executives left, including its chairman and president Temple, most voluntarily. Yet Merrill's sales material didn't mention the management changes. Under the heading Superior Professional Management, one circular to brokers read: "...retaining Arvida's experienced personnel is a great advantage for the partnership." Not a single broker BUSINESS WEEK contacted recalls knowing about the management changes. The Arvida I prospectus only said the chairman and president were new. Merrill's Ruffine says: "If seven or eight of the top executives left before the deal, we probably should have said that."

MUSICAL CHAIRS. JMB argues that Arvida's management was strong. JMB promoted a high-level Arvida executive, Roger E. Hall, who became chairman, and rehired Ernest M. Miller Jr., a former senior executive, as chief financial officer. Says Gary Nickele, JMB's general counsel: "What's material [in the prospectus] is who the management was going to be, not who left."

Experienced management was especially important for Arvida. Planned communities of the sort Arvida was building need big up-front infrastructure investments and depend on a steady stream of homebuyers. If the real estate cycle turns down before many lots or houses have been sold, the developer can incur big losses. "Planned communities tend to be among the riskiest of real estate investments," explains Lawrence Bacow, professor at Massachusetts Institute of Technology's Center for Real Estate. JMB and Arvida executives say the partnerships hedged their risks by including multiple properties in different stages of development, including more mature properties designed to throw off cash.

For a while, investors in Arvida I thought they had latched on to a winner. Sales at the Arvida properties were strong. In early 1989, says Ira J. Schulman, the JMB executive in charge of Arvida deals, Merrill approached JMB about a second Arvida partnership that would include 2,300 acres of undeveloped land in and near San Clemente, Calif., known as Talega Valley. For balance, JMB and Merrill decided to include eight smaller properties, including some that were partly developed.

Still, Arvida II plunked 47% of its assets in Talega Valley, compared with no more than 17% in a single property in Arvida I. Shortly thereafter, the bottom fell out of the real estate market. "The length and depth of the depression far exceeded what anybody expected," says Miller, now Arvida's CEO.

Sales screeched to a halt in both Arvida partnerships. Arvida I's revenues dropped from $307 million in 1989, to $151 million in 1991. It posted a $30.7 million loss in 1991, followed by a $44 million loss the following year. JMB executives halted the quarterly distributions in late 1990.

That was rosy c in 1991, followed by a $44 million loss the following year. JMB executives halted the quarterly distributions in late 1990.

That was rosy compared with the debacle at Arvida II, which lost $215 million from 1990 to 1992, and sent out just one check to investors. The problem: Talega. Before Arvida and JMB executives stopped the project in early 1992, they had poured in $150 million, with $70 million of it borrowed. Not a single lot has been sold.

Arvida I's fortunes rebounded in late 1993, thanks to a recovering economy and heavy cost-cutting at Arvida. The fund earned $19.8 million (before

an extraordinary gain) on sales that were up 42%, to $247 million. It even eked out a small distribution of $6.35 per $1,000 unit. Miller says that this year is looking bright.

But Arvida II seems headed into a death spiral. It is dependent on its bankers to stay out of bankruptcy and lacks the cash to meet a June Talega-related bond payment. JMB and Arvida executives seem resigned to its demise.

Merrill, for its part, is litigating nearly every Arvida complaint, even dragging most Arvida I arbitration cases into New York courts in hopes of using the six-year time limit on these cases to quash them. Merrill has prevailed in some New York cases but judges have ordered that others should be arbitrated. Merrill brokers say that they have received a memo telling them not to discuss the matter with outsiders. "We can't even get any information to tell our clients," says one broker in the Southeast. "Everybody knows it's a bad situation, but we've got our heads in the sand, hoping it'll go away."

Merrill's 42,000 clients who bought into the Arvida deals, though, are not likely to forget the experience. Several brokers recall a tumultuous conference call in late 1990, during which JMB executives told Merrill brokers that Arvida I and II distributions were being suspended. When opened for brokers' questions, "the phone lines were jammed, especially from Florida," recalls one ex-broker. "You could hear the venom being spit into the phone line." One ex-broker says the common refrain went like this: "This was

marketed and represented to fixed-income accounts. What am I going to tell my folks that need that income?"

It's a question many Merrill brokers are facing these days.TABLE: PALTRY PERFORMANCE

Arvida I Arvida II

1987-1993 1989-III, 1993

ORIGINAL PRICE PER UNIT $1,000 $1,000

MERRILL'S FEE AND COSTS $88 $105

JMB'S FEE $50 $64

PAYOUTS TO INVESTORS* $326 $39

CURRENT VALUE ( 1993-IV) $125 $6

DECLINE IN VALUE $549 $955

*Arvida I stopped distributions in late 1990 and resumed in first-quarter 1994. Arvida II stopped distributions in late1990

DATA: COMPANY REPORTS, THE STANGER REPORT

Mark Maremont in Boca Raton