Amegy V Merrill

DISPUTE RESOLUTION BEFORE THE FINANCIAL INDUSTRY REGULATORY AUTHORITY AMEGY INVESTMENTS, INC. and AMEGY BANK NA, Claimants, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC. and MERRILL LYNCH & CO., Inc. Respondents.

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09-00332 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 conservative’s conservative” investment, Merrill said -- it knew, but did not disclose to Amegy and the public, that there was no sustainable

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market for the securities and, without Merrill’s 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 Merrill’s 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, Merrill’s 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 Merrill’s “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.

Merrill’s 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 SEC’s Enforcement Division, because broker-dealer firms that underwrote, marketed and sold auction rate securities (ARS) misled their customers. Through their sales forces, marketing materials, and account statements, firms misrepresented to their customers that ARS were safe, highly liquid investments that were equivalent to cash or money market funds. As a result, numerous customers invested in ARS their savings and other funds they needed to have available on a short-term basis. These firms failed to disclose the increasing risks associated with ARS, including their reduced ability to support the auctions. By engaging in this conduct, those firms violated the Federal securities laws, including the broker-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 Merrill’s

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direct retail customers and then sold them to Amegy clients, causing significant and continuing harm to Amegy’s 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 Amegy’s repeated requests for recompense for itself and its clients, claiming that Amegy is a “sophisticated investor” not entitled to relief from Merrill’s misconduct, it is clear that no amount of due diligence by even the most sophisticated investor could have uncovered Merrill’s 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 Merrill’s misconduct must include payment of Amegy’s losses and rescission of the $140 million in ARS sales that Merrill made to Amegy.1 Summary of Claims 8.

Merrill’s 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 securities from Merrill, which Amegy then sold to its clients, redemptions and refinancings have restored liquidity to approximately $100 million of the purchases, leaving the 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 Texas’s 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 Merrill’s 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 Merrill’s actions. An award of exemplary damages is warranted due to the egregious nature of Merrill’s 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 world’s 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 world’s 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 longterm 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 Merrill’s 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.

Merrill’s 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. Merrill’s 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 Merrill’s 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 [Merrill’s] material auction practices and procedures[; and] . . . at or before the completion of the applicable transaction, provide all customers who are first-time purchasers, and all broker-dealers who are purchasers, of auction rate securities from [Merrill] (“Purchasers”) with a written description of [Merrill’s] 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 written notification with the trade confirmation, that a written description of [Merrill’s] material auction practices and procedures is available on a specified web page of [Merrill’s] website accessible to such Holders and Purchasers. 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 [Merrill’s] 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 participating through [Merrill] in an auction of auction rate securities on the portion of its website that is accessible to such customers and broker-dealers and is related to such auction and (2) the general public on another portion of its website accessible 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.

Merrill’s ARS Business Was Admittedly Both Lucrative and Rigged. (i)

It reaped significant fees and profits from its ARS business.

28.

As of early 2008, Merrill had the world’s 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.

Merrill’s 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 Merrill’s concern about the market.

31.

Beginning in July 2007, certain market influences began to

negatively impact Merrill’s 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, Merrill’s 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, Merrill’s 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 are climbing as well as investors expressing concern about muni [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 to move 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] 11/21/2007 was reflective of a double auction day when the market conducted over 1400 auctions, a scarcity of investors to snap up cheaply priced inventory and the ongoing negative perception of securities that populate the auction market and the behavior of the dealer participants. Any combination of a negative Bloomberg article about auction illiquidity, the ongoing downdraft of press about the monoline insurers that guarantee the entire municipal space in our market, equity prices of the dealer community and the GESs undergoing a death spiral undermining retail investors confidence in our ability to support the auction business and two times the number of daily auctions might have been deadly but we got them all today. The most positive thing that can be said is that we did not fail the two DRD repacks we sole manage for GS and MER today, albeit, we went long roughtly [sic] half of each. . . . 38.

Also in the fall of 2007, Merrill’s 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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lenders became uncomfortable with the liquidity of ARS, however, and they stopped accepting them as collateral. Merrill never told its customers or the public, to whom it was marketing the securities as cash-like instruments, that entities that financed its ARS inventory no longer accepted certain of the securities as collateral. 39.

Inventory remained at the forefront of people’s minds

through the end of the year. On December 4, 2007, Price, Merrill’s head of Credit and Trading, internally stressed its snowballing ARS inventory problem in an email:

“TRADING -- WE NEED TO REDUCE BALANCE SHEET INTO

YEAR END. THE DESK IS OVER IT’S [sic] TARGET BY $3BLN AND WE NEED TO GET IT DOWN.” He privately reiterated the “harsh” impact of the ARS “contagion” to higher-level management of Merrill on December 19: Please be aware that the contagion that has engulfed all has been especially harsh on the [auction market preferred security] product. Previously it was the business that used very little Balance Sheet with a high ROA [return on assets]. . . . Inventory higher yesterday. Fighting hard to get it down, Munis $1.3 bln, AMPS $1.8 bln. 40.

At no point did Merrill convey to Amegy that it had

surpassed its internal ARS inventory ceiling or that it was prepared to take extraordinary steps to “get [its inventory] down.” As inventory concerns grew, so did Merrill’s desperation to push ARS onto the public as safe and liquid investments, which it would do at any cost to save itself.

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(iii)

Merrill seeks to reduce ARS inventory through aggressive marketing.

41.

In November 2007, Merrill’s upper management and risk

management reviewed the Auction Desk’s 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 conservative’s 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,

Merrill’s 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 call would have a better impact. Perhaps this could be released as a special edition Fixed Income Digest report outlining current events as they relate to this market and what FAs should 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 of confidence on the part of investors as they absorb the recent spate of bad headlines about monoline insurerers [sic], bank and dealer exposure to subprime and their hits to earnings and a general lack of understanding of all our short term

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cash management alternatives. In the old “flight to TBills”, the recurring conversation here on the AMS desk is a line out of “Marathon Man” -- “Is it safe?” Any renewed research focusing on the high quality of closed end fund preferreds of ALL tax status, auction municipal bonds and student loan banked bonds, wrapped around the value added proposition with today’s 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, Merrill’s 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 privateplacement 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 take advantage of relative value situations without taking on undue 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 Merrill’s 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 Conery’s 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 Merrill’s ARS inventory position and its reduction plans. Moreover, from at least August 2007 through February 2008, Conery regularly was given Merrill’s 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 Merrill’s 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 Department’s 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 Merrill’s 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 Merrill’s 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.

Merrill’s 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 Merrill’s 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 auctions Pros: ML balance sheet will be capped at levels today. Cons: ML cannot fail our own paper and may be forced to take 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 the auction market is going to get worse not better and they would 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 market’s 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.

Merrill’s 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 Merrill’s 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 Merrill’s 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 issue’s 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 Merrill’s 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 Merrill’s 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 nation’s 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 Merrill’s 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 Merrill’s auctions. The traders did not disclose that Merrill’s 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 Merrill’s 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.

Merrill’s 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.

Merrill’s 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 [Merrill’s] 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 [Merrill’s] material auction practices and procedures.” The Order demanded that Merrill provide a “written notification with the trade confirmation, that a written description of [Merrill’s] material auction practices and procedures is available on a specified web page of [Merrill’s] website accessible to such . . . Purchasers.” The Order mandated how notification must be

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made on an order confirmation: “Such written notification must be set forth prominently in such a manner as to call it to the attention of the reader. . . .” 80.

While Merrill claims to have complied with the trade

confirmation notification, a review of those confirmations that it claims satisfy the 2006 SEC Order demonstrates that the notification was not “set forth prominently in such a manner as to call it to the attention of the reader.” Indeed, Amegy’s ARS traders do not recall seeing such notifications on the trade confirmations, and the trade confirmations themselves make clear why -- the sole reference to Merrill’s practices and procedures was wedged between details of the dividend rate and reset date and a notice that the security was callable. The notice was not set apart by special type or font, nor even separated by punctuation from other parts of the confirmation. This supposed notification fails to comply with the 2006 SEC Order’s delivery requirements. 81.

Merrill’s failure to comply with the 2006 SEC Order’s

specific procedural mandates for providing notice of its ARS policies and procedures is only part of Merrill’s breach of that Order; its actual auction policies and procedures disclosures, which were contained on Merrill Lynch & Co.’s website www.ml.com, were themselves misleading.

Indeed, the SEC

concluded that Merrill “did not make adequate disclosures that the liquidity of these securities was based on Merrill . . . supporting the auctions it managed when there was not enough demand.” Yet Merrill has relied on the website links to

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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 Merrill’s 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 “conservative’s 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 Merrill’s 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 Merrill’s 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 Merrill’s 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 Merrill’s conduct, including the content and dissemination of false and misleading statements, among them Merrill’s 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 Merrill’s 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 Merrill’s 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 Merrill’s conduct, including the content and dissemination of false and misleading statements, among them Merrill’s 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 Merrill’s 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 Merrill’s 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 Merrill’s 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 Merrill’s 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 statement’s 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 Merrill’s constant supporting bids in the auctions, thousands of auctions would have failed. Amegy relied upon Merrill’s 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 preferred securities bought from Merrill, for which Amegy will tender back the securities;

b.

Actual damages, including Amegy’s costs related to ameliorating losses and inconvenience to its clients, such as by providing investment liquidity, as well as fees paid by Amegy for legal and other advice related to Merrill’s abandonment of the ARS market;

c.

Damages for harm to Amegy’s reputation and goodwill;

d.

Exemplary or enhanced damages as warranted by the evidence 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 Yetter Kimberly L. McMullan Yetter, Warden & Coleman, L.L.P. 909 Fannin, Suite 3600 Houston, Texas 77010 (713) 632-8000 (713) 632-8002 (Fax) [email protected] [email protected] Attorneys for Claimants Amegy Investments, Inc. and Amegy Bank NA

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