FORTUNE MAGAZINE Luxury Report

Diamonds are a banker's worst friend

When Merrill Lynch agreed to bankroll Fred Leighton's effort to become the next great luxury jeweler, the bank had no idea it would soon find itself entangled in a glittering strand of litigation.

By Suzanne Kapner, writer

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Ralph Esmerian with 24-karat horses made for the heiress Barbara Hutton with jewels supplied by his father.
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As part of his agreement with Merrill Lynch, Esmerian was supposed to hire a seasoned CEO for Fred Leighton. He hired Peter Bacanovic, above, Martha Stewart's socialite stockbroker.

(Fortune Magazine) -- On the morning of Sept. 27, 2007, two Merrill Lynch bankers arrived at the Rockefeller Center office of Ralph Esmerian, a jewelry dealer and art collector, and boxed up tens of millions of dollars of rare jewelry. Armed guards loaded the jewels - including a 14-carat pink diamond ring worth roughly $15 million - into a Brink's truck idling outside. Within hours the gems, some of which had been in Esmerian's family for generations, had been carted away - seized as collateral for a loan gone bad.

Esmerian had borrowed the money two years earlier to finance the acquisition of Fred Leighton, known as the jeweler to the stars. Back then Fred Leighton consisted of a store on New York City's Madison Avenue and a second boutique in Las Vegas, but Esmerian envisioned turning Leighton into an international brand with stores around the world.

It was a plan that tantalized a group of Merrill Lynch bankers. Heretofore, these bankers had made money collateralizing real estate, machinery, and other hard assets. But lately they had been making some less traditional plays: They had provided $500 million of financing to United Artists, which used the money in part to produce the Tom Cruise movie "Valkyrie." The bankers also lent money to the Ranch, a custom-crush winery in Napa Valley.

For the Merrill bankers the deal with Esmerian was their introduction to the byzantine world of jewelry - a world they would regret entering. Jewels are funny things. Most people's first brush with them is when they get engaged. It's arguably the most idealistic and least objective moment in a relationship. Business deals - specifically ones consummated when credit is loose - are not all that different. And back in 2006, when Merrill Lynch and Esmerian hooked up, they were blind to each other's faults. In Merrill, Esmerian (pronounced ess-mary-ann) thought he had found a partner who would stick by him in good times and bad. Instead, he says, he ended up with a bunch of "cowboys" who cared more about generating fees than building a business.

Similarly, Merrill felt comfortable with Esmerian because the deal was backed by millions of dollars of jewelry. In addition to Fred Leighton's inventory, Esmerian had pledged his family's cache of 101 jewels, known as the Special Collection, with an appraised value of $89 million. In a deal code-named Project Nile, the bankers agreed to lend Esmerian $176 million, payable over three years. What the bankers failed to detect was that they were funding a serial borrower who already had multimillion-dollar loans from Sotheby's and Christie's, and who would soon be accused by his siblings of playing fast and loose with, that's right, the family jewels.

As with so many overheated romances, Esmerian and his bankers now find themselves in court. Merrill Lynch is suing Esmerian in an attempt to recover its money, an amount that the bank claims has ballooned, with unpaid interest, to $192 million. "We are in a dispute with Mr. Esmerian for one simple reason," says Bill Halldin, a Merrill spokesman. "He failed to make monthly interest payments that he agreed to when he borrowed money."

Esmerian, 68, is suing Merrill Lynch, contesting the bank's ownership of the collateral and claiming the loan was faulty from the outset. "Merrill Lynch didn't understand what they were getting into," Esmerian says. "But I didn't understand what I was getting into either. In my business, if you're late making a payment it's no big deal."

Regardless of whose side you come down on, one thing is sure: The company is the real casualty. Fred Leighton has been operating under Chapter 11 bankruptcy protection since April 2008 and is running out of cash. In December the court stripped Esmerian of his powers and appointed a restructuring officer, who is evaluating bids for all or part of the company. Interested parties include Robert Pressman of Barneys New York fame and Michael Steinhardt, the hedge fund honcho, who is a longtime friend and supporter of Esmerian's. Neither would comment.

The goal is to find an investor who will satisfy the various legal claims and fund the company's operations until it can emerge from bankruptcy. But given the state of the economy, there is also the possibility that Fred Leighton will cease to exist. The whole sad saga - which features a cameo appearance by Martha Stewart's former stockbroker - is a cautionary tale in the perils of trying to build a luxury brand from little more than a name. For every success like Burberry there is an Asprey, the jeweler to the British Crown that flamed out a few years ago.

Humble beginnings

Unlike Asprey, Fred Leighton never had an aristocratic pedigree. Instead the jewelry shop was the creation of a New York City cabdriver's son named Murray Mondschein, who bought a store in 1959 that sold Mexican wedding dresses and artifacts. The store, located in Greenwich Village, was named Fred Leighton after its late owner. Believing that people would be more apt to buy from someone whose name was on the door, Mondschein changed his name to Fred Leighton.

Before long the store began stocking vintage jewelry, and by the 1970s, Leighton was fast becoming a legend in the business. At the time, estate jewelry was not as fashionable as it is today, but Leighton cultivated a celebrity clientele. "People went to Fred Leighton to buy from Murray's hands," says François Curiel, Christie's jewelry specialist and the chairman of the auction house's European operations.

Meanwhile Esmerian was cutting his teeth in the family business of jewelry wholesaling. Unmarried and without children, he is the last of four generations of jewelers. His great-grandfather was a lapidary in Constantinople in the late 1800s. His father, Raphael, was a respected jeweler and gem dealer in Paris and later New York City. Raphael designed one of the first fine jewelry lines for Neiman Marcus. After Raphael's death in 1976, Esmerian, who grew up in Paris and New York, took over the family trade.

When Ralph talks about jewels he sounds like a boy showing off his baseball cards. A favorite piece is a pair of horse heads sculpted by Herbert Haseltine for the heiress Barbara Hutton out of 24-karat gold and embedded with diamonds, rubies, sapphires, and emeralds. The horses held a mythical place in Ralph's childhood. His father supplied Haseltine with the stones. Esmerian bought the horse heads from a private dealer about eight years ago.

Esmerian first met Leighton at an auction in the early 1970s, and the two became friendly. Esmerian would drop by the New York store on Saturday mornings to sip coffee with Leighton. Before long he was loaning the store pieces on consignment. By 2005, Leighton was looking to retire, and Esmerian jumped at the chance to buy his company. Through a friend Esmerian had met a Merrill Lynch broker, who put him in touch with Josh Green and Ryan Bell, two young bankers who worked for a division called Merrill Lynch Mortgage Capital, which specialized in collateralizing loans against hard assets. (Green and Bell would not comment for this article.)

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