Fort Walton Beach Council agenda — 02-09-2010 Special-BRP, Merrill Lynch lawsuit — reading text

in the process knowingly caused significant financial harm to the Fund. They then hid from the Fund the material facts related to their violations including the full extent and financial consequences of their conflicts, the fact that their recommendations decreased the Fund' s returns while increasing Merrill' s profits, the true costs of their recommendations and the true method by which they vetted money managers for the Fund. In so doing, Merrill and Callaway placed their own interests above those of the Fund and failed to fairly deal with the. Fund. In an independent review of Merrill' s pension fund consulting practices, the SEC concluded that Merrill' s conduct constituted " a fraud and deceit" on its clients, and that Callaway " willfully aided and abetted and caused Merrill Lynch' s violation ..." The SEC's orders concerning Merrill and Callaway are attached to this complaint as Composite Exhibit `B" and " C" respectively. THE DIRECTED BROKERAGE PROGRAM 9. The primary mechanism by which Merrill and Callaway increased their own income while reducing that of the Fund was their " directed brokerage" program ( " Directed Brokerage Program "). Merrill and Callaway encouraged all of their pension fund clients in Florida, including the Fund, to use the Directed Brokerage Program as a cost saving measure. Under the Directed Brokerage Program the Fund would, with Merrill' s and Callaway' s assistance, direct its money managers to conduct its trades through Merrill. Merrill would then give the Fund credit for a portion of the commission Merrill earned on those trades against its annual consulting fee. As presented by Merrill and Callaway, using directed brokerage would, at 44-  In no additional costs, allow the Fund to reduce or eliminate the cost of Merrill' s consulting fee. truth, and as Merrill and Callaway well knew, the result of directed brokerage was very different. It dramatically increased Merrill' s and Callaway' s income and significantly reduced the Fund' s return on its investment. It did so by creating incentives for both Merrill and the fund managers to trade in ways that increased Merrill "s profits and increased the Fund' s costs, thus reducing its returns. It also created incentives for Merrill and Callaway to encourage the retention of those The incentives poorer performing managers who brought their trading business to Merrill. described above constituted conflicts of interest which Merrill and Callaway never fully disclosed to the Fund. Because under the ,Directed Brokerage Program Merrill and Callaway As a made money from the Fund' s trading, it ways in their financial interest to increase trading. result Merrill and Callaway consistently advocated active trading by the managers even though less active index trading was more productive for the Fund.. With the adoption of directed brokerage, Merrill and Callaway were placed in the position of negotiating on their own behalf with the same managers they were hired by' the Fund to monitor. Those negotiations included among other things how much of the Fund' s assets would be paid to Merrill as commissions and costs as well as the terms and conditions on which the trades would be executed. 10. As a result of the Directed Brokerage Program, both Merrill, Callaway, and the managers with whom they negotiated were Iconflicted. Merrill and Callaway, in their capacities as fiduciaries to the Fund, were now negotiating with a third party how much of the Fund' s money would be transferred to Merrill as trading costs. The managers were negotiating with the people who reviewed their performance to Oetermine how much of the Fund' s money would be transferred to them in the form of trading ' costs. - They could therefore curry favor with their reviewer by using the Fund' s assets. They could also put more money in their reviewer' s pocket 45- by increasing the number of trades. Unsurprisingly, these conflicted relationships consistently resulted in higher commissions, higher execution costs ( i.e. an absence of best execution) and more trading than was necessary. Moreover, the worse the manager' s actual performance the greater its incentive became to please Merrill by increasing its trading profits. Thus the conflicts resulted in the retention of those poorer performing managers who curried Merrill' s favor by providing it with payments taken from the Fund' s assets. Although Merrill and Callaway had presented this program to the Fund as cost neutral, it was not. The inevitable result was that the Fund' s performance was negatively affected by the conflicts that Merrill and Callaway created. The performance drag created by the excess trading cost significantly affected the Fund' s performance. The effect of -the conflicts described above was aggravated by Merrill' s and Callaway' s manager selection process. FAILURE TO-INDEX 11. Merrill and Callaway were committed to a policy of active only management of the Fund's investment portfolio. Because active only management results in increased trading, Merrill and Callaway profited from their recommendation while the Fund suffered. The failure to index even a portion of the portfolio cost the Fund significant, unnecessary money manager fees and more importantly, it cost the Fund significant losses in underperformance. 12. Moreover, in furtherance of Merrill's and Callaway' s scheme to maximize commissions rather than to maximize returns for the Fund, a disproportionate percentage of the money managers recommended by Merrill and Callaway were " active" money managers. Many pension funds invest some portion of their investment portfolio with " index" or " passive" money managers. This is especially true of domestic large capitalization equities since this segment of the market is very efficient and outperforming a relevant index, such as the Russell 1000 Stock 46-