You don't have much leverage when you're trying to sell a failing bank during a financial crisis. Just ask Robert Steel, CEO of Wachovia Corp.

Threatened with a federal takeover if he didn't sell, Steel spent the first week of October doing exactly what regulators and his would-be buyers told him to do.

He ended up in court anyway.

Citigroup Inc. sued Wachovia and Wells Fargo & Co. last week for "tortious interference" and breach of contract after Wells made a surprise bid for the Charlotte, N.C. bank, beating out Citi's previous offer. Citi's CEO, Vikram Pandit, thought he had a done deal.

The legal wrangle, put on hold last week while Citi, Wachovia, Wells Fargo and regulators haggled over a new deal for Wachovia's operations, was a byproduct of the federal government's panicked attempts to prevent the country's biggest financial firms from collapsing and to keep an expanding safety net from ripping. Aside from trying to help the warring suitors divide Wachovia amicably -- an effort that failed Thursday when Citi walked -- Washington announced plans to pump hundreds of billions into the economy (on top of the $700 billion already committed by Congress) by buying commercial paper, investing in banks and cutting interest rates. None of this reassured markets, which spiraled downward.

As the meltdown among financial firms leads to more government-brokered marriages, the legal mess over Wachovia is a reminder to financial executives that regulators' priorities are often different than their own. The Federal Deposit Insurance Corp.'s and other banking agencies' first obligation is to limit taxpayers' exposure to the industry's problems. So if Washington offers a sweet deal, get it signed as soon as possible rather than dicker over details.

The drama over Wachovia kicked into high gear the evening of Oct. 2, when Pandit received a call from Steel, who told him their $2.2 billion merger, announced four days earlier, was off. Instead, Wachovia's board had accepted a last-minute offer from San Francisco-based Wells Fargo. Unlike the plan with Citi, which was only an agreement in principle, Wachovia and Wells Fargo had a signed merger agreement, and there was no going back. Pandit sued.

Pandit's legal foundations appeared unsteady. Despite his complaint that Citi's exclusivity agreement had been violated, Steel argues in an affidavit filed in response to Citi's suit that there had been no negotiation at all between Wells and his bank -- and thus no breach of the exclusivity agreement. Instead, FDIC Chairman Sheila Bair had stayed in touch with Wells Fargo, and when that bank decided it could make an offer far superior to Citi's -- both for taxpayers and Wachovia shareholders -- she enthusiastically urged him to make an offer. He portrays the FDIC chief as determined to have Wachovia taken over as soon as possible.

Steel's characterization of comments by Wells Fargo chairman Richard Kovacevich indicate at least one of his company's suitors felt rushed by the regulators. On Sept. 28, Steel said Kovacevich, who had been considering a bid that would not require government financial assistance, told him Wells was not prepared to make an offer under the FDIC's "compressed timetable" without substantial government assistance.

Later that day, Bair informed Steel that the FDIC's view was that Wachovia's condition posed a systemic risk to the banking system and the agency was prepared to arrange a takeover, and she "directed Wachovia to commence negotiations with Citi." A deal with Citi was announced the next morning.

Citi agreed in principle to acquire all of Wachovia's $500 billion in deposits and would receive unprecedented government protection against loan losses from the acquired institution. The unorthodox agreement left Citi exposed to only $54 billion in losses from a $312 billion pool of mortgages and other assets it was acquiring from Wachovia. Citi would be responsible for the first $42 billion in losses from the mortgage pool and would provide the FDIC $12 billion in Citi preferred stock as further protection. The FDIC would remain exposed to losses on the remaining $258 billion. Also, Citi would not acquire Wachovia's holding company or its AG Edwards & Sons Inc. and Evergreen Investment Management Co. LLC investment and asset management businesses.

The only thing left was to iron out a few details and sign a merger contract-but the talks with Citi were "extremely complicated and difficult," Steel says. The FDIC was applying "tremendous pressure" to get the deal inked by Oct. 6. "On multiple occasions I and our advisers attempted to persuade Citi to structure a whole-company transaction because of its substantially reduced completion risk, but Citi refused."

Early Oct. 3, five days after Wachovia announced its deal with Citi, it surprised the markets by unveiling a $15.1 billion agreement to sell to Wells Fargo instead. In addition to a far higher purchase price, Wells wouldn't need an FDIC backstop and would acquire the whole company.

Citigroup responded instantly in a statement charging that Wachovia's decision was a "clear breach" of their agreement to hold exclusive negotiations.

According to Steel's affidavit, the only contact he had with Wells Fargo after they broke off negotiations Sept. 28 was a congratulatory call from Kovacevich after the Citi agreement was announced. Bair, who had not signed the exclusivity agreement, however, and was not bound by it, had been talking to Wells Fargo. On Oct. 2, Steel says, he received an "unexpected call" from Bair advising him that Kovacevich would be calling to propose a merger "and encouraged me to give serious consideration to that offer."

Citi officials haven't explicitly criticized the FDIC, but it's clear they feel blind-sided. They say Citi did the FDIC a big favor when it agreed to buy Wachovia. "Citi has been providing liquidity and market support to Wachovia since the day of the announcement," says an official. Had Citi not stepped in, "Wachovia would have failed the following day and the debt issued by its holding company would have collapsed, with potentially devastating implications for the stability and security of the financial markets."

Pandit, who had begun raising the $10 billion Citi needed to complete the deal, says his bank should be compensated for the stability it brought to Wachovia. Citi's breach of contract suit, filed in New York Supreme Court, seeks $20 billion in compensatory damages and $40 billion in punitive damages.

That Bair so aggressively lobbied to supplant a deal she had brokered should not be a surprise. Regulators' primary responsibility is to minimize the cost a troubled institution imposes on taxpayers and protect the health of the banking system. Besides requiring no financing assistance, a takeover by Wells would ensure that the U.S. has four remaining banking giants rather than three -- Citigroup, Wells, J.P. Morgan Chase & Co. and Bank of America Corp.

The huge disparity between the two offers for Wachovia was partially explained by passage of the $700 billion Treasury Department plan to buy bad assets from banks and other financial institutions. The plan passed five days after Citi's offer, and there was no guarantee the bill would be enacted. By the time Wells' offer was penned, the vote count suggested passage was fairly certain.

The FDIC says Bair played no role in persuading Kovacevich to come up with a new offer, yet Bair's actions, combined with curiously timed legal and regulatory changes that played in Wells' favor, fueled speculation that Citi's bid was viewed as little more than a placeholder to give its rival more time to draw up a bid that put the FDIC less at risk.

Individuals tracking the merger battle also say the FDIC was responsible for inserting an unnoticed provision into the $700 billion financial rescue package that was enacted Oct. 3. The act's clause relaxes restrictions on takeover talks between banks. The provision could make it tougher for Citi to enforce the exclusive negotiation agreement.

The provision caught the industry by surprise, leading many to suspect it was inserted at the FDIC's request to boost Wells' chances. One lawyer, however, says the change was really aimed at a problem that commonly arises when any bank's condition is deteriorating and the FDIC starts seking a buyer.

Typically, a struggling bank will look for buyers on its own and will require interested parties to enter standstill agreements barring them from using the information they pick up during due diligence to make hostile bids.

The FDIC wanted the change in law, he says, to clarify that potential buyers aren't prevented from participating in government-assisted takeovers because of standstill agreements they might have signed.

Many say another Washington action also might have nudged Wells to rethink its bid, a Sept. 30 Internal Revenue Service notice that will help banks cut their tax bills after making acquisitions. The IRS said unrealized losses from loan portfolios acquired from a target bank can be used as tax-loss carry-forwards that offset the acquirer's net income.

Because of the change, losses embedded in Wachovia's portfolio could be worth roughly 30 cents on the dollar to Wells. "That's powerful," says an attorney. The tax ruling was worth less to Citi's initial offer because of the huge backstop against losses.

A Treasury spokesman, however, insists Wachovia played no role in the IRS action. "Internally, there was recognition that there were questions regarding how we view losses during a change in ownership," he says. "This notice has been in the works for many, many weeks. It was issued not to affect any particular transaction or taxpayer."

Given the turmoil and risks to the deposit insurance fund, one banking expert says it's hard to find fault with the FDIC, beyond tweaking the agency for rushing to announce the Citi offer. "Why didn't they wait until they had contracts in hand and the deal was done?"