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. Last Updated: 07/27/2016

Merrill Warned of Fraud Before Sale

LOS ANGELES -- Two weeks before Merrill Lynch & Co. underwrote a $667 million public stock offering for Allegheny Energy Inc. in April 2001, it received a letter from a law firm saying Allegheny's chief energy trader, Daniel Gordon, could be involved in a criminal fraud. Merrill made no public disclosure of the allegation before selling the stock.

The law firm of Davis, Hatley, Haffeman & Tighe PC in Great Falls, Montana, representing K2 Energy Corp., wrote the letter, dated April 13, 2001, to Merrill and Allegheny. A month earlier, Allegheny had purchased Merrill's energy-trading unit, and hired Gordon to run it. The U.S. Justice Department is now investigating Gordon, 27, for embezzling $43 million from Merrill, according to federal documents.

"I wrote a very pointed letter to Merrill and Allegheny warning of possible criminal conduct by Dan Gordon,'' said attorney Max Davis, whose client K2, is a Calgary-based natural gas exploration company that had sought a $7 million investment from Merrill's energy-trading unit.

In the letter, Davis expressed concern about possible fraud by Gordon in arranging that investment. He said K2 had learned that "certain actions'' taken in pursuit of that transaction "are being referred to the appropriate authorities [on an international basis] for investigation of possible criminal charges.''

Merrill, the largest securities firm by capital, had an obligation to investigate Davis's allegations against Gordon before selling the stock to the public, said Constance Bagley, a securities lawyer and associate professor at Harvard Business School.

In the prospectus, Merrill disclosed its previous transaction with Allegheny. Merrill said it had agreed on Jan. 8, 2001, to sell its energy-trading unit to Hagerstown, Maryland-based Allegheny for $490 million and a two percent interest in Allegheny Energy Supply, an Allegheny subsidiary.

Merrill Lynch did not do anything wrong in its handling of the letter from Davis or the underwriting of Allegheny's stock sale, said spokesman Bill Halldin.

"We knew Allegheny was aware of this situation involving their employee and that Allegheny had thoroughly looked into it,'' Halldin said.

Eight days after K2's attorney Davis sent the letter to Merrill and Allegheny, Gordon wrote a $3 million personal check to K2 as a "break-up fee,'' in exchange for K2 withdrawing the letter and agreeing to keep its contents secret, Davis said. The agreement canceled the proposed $7 million investment in K2.

"The scenario makes it seem the money was more likely hush money than a break-up fee,'' said James Cox, a professor of law at Duke University in Durham, North Carolina.

Gordon is being investigated for embezzling $43 million from Merrill Lynch when he worked for the firm in 2000. Gordon disguised the theft as an energy trade. He is also under investigation for allegedly defrauding Allegheny of $2.5 million by funneling Allegheny money to companies controlled by Gordon. Allegheny fired Gordon last September for violating conflict-of-interest rules.

K2 attorney Davis said he was not aware of the embezzlement when he wrote to Merrill in 2001.