By  on November 23, 2008

The strained relationship between high-profile jeweler Fred Leighton andits major creditor, Merrill Lynch, has reached new levels of friction.

Merrill Lynch Mortgage Capital Inc. filed a motion in U.S.Bankruptcy Court, Southern District, on Friday citing the possibility of a Chapter 7 liquidation by the famed jeweler. Merrill said the firm could run out ofoperating cash by the end of the year and called for its owner, Ralph Esmerian, tobe replaced by a "disinterested Chapter 11 trustee."

In the court papers, obtained by WWD, Merrill charged Esmerian with concealinginventory records, failure to take the necessary steps to improve the businessand pay down debt, as well as cost overruns at the construction of a new BeverlyHills store that exceed $1 million.

Merrill said Esmerian "used the debtor's estate as his personal candy store."The papers also raised questions about what happened to a "special collection"of jewelry items that were collateral.

According to a source familiar with the case, Merrill conducted an investigationinto the inventory, and then decided to go public for the first time withallegations about missing inventory by filing the motion.

"Esmerian systematically sold significant portions of Merrill Lynch's collateraland diverted the proceeds for purposes other than the repayment of MerrillLynch," the court papers said.

If Leighton runs out of operating funds, the company could be forced to sell. A hearing has been set for Dec. 2. Merrill Lynch Mortgage Capital Inc. isrepresented by Cadwalader, Wickersham & Taft. Esmerian is represented by PhilipNizer. Esmerian's attorneys have until Friday to file an objection.

Merrill loaned Esmerian about $180 million to buy the company, which was putinto bankruptcy last April. Esmerian, an art dealer, hired Peter Bacanovic, whodid a five-month jail term for insider trading in the Martha Stewart case, aspresident of Fred Leighton. Bacanovic has instituted several strategies to tryto grow and get the jeweler back on track. Fred Leighton is knownfor providing red carpet celebrities with its expensive estate pieces. Last March, sought repayment of its loans to Esmerian and a Christie's auctionof the most prized pieces was set. The auction was abruptly halted when Esmerianthrew Fred Leighton into bankruptcy.

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