Bank of America Corp.'s decision to buy Merrill Lynch & Co. was made with desperate speed, during one of the most extraordinary weekends in U.S. financial history. Lehman Brothers Holdings Inc. was collapsing. At the New York Federal Reserve, senior executives of America's largest financial institutions gathered in a futile attempt to save it. By Saturday, it became clear that Lehman would fail and that markets would rampage on. Fearing for his firm, Merrill chief executive John Thain turned to BofA chief executive Kenneth Lewis, who had long wanted a larger Wall Street presence. A deal was struck, cursory due diligence begun and lawyers summoned to draw up the merger agreement before markets opened on Monday.
On Sunday night, the two CEOs signed a merger agreement. Merrill was no Bear Stearns Cos. or Lehman. It was still standing, and the proposed deal put it under the protective cloak of BofA. Despite panic in the markets, and a looming recession, the merger agreement anticipated a standard process. No one could foresee the stresses BofA, Merrill, Wall Street and the world would face before the deal's Jan. 1 close.
Execution of that merger agreement has bedeviled the players in this drama -- Lewis, who recently announced his retirement, Thain, then-Secretary of the Treasury Henry Paulson, Federal Reserve Chief Ben Bernanke, the Securities and Exchange Commission, the outside attorneys -- ever since. Controversy, testimony, charges and countercharges have erupted over the deal. Thain has been fired; Lewis, Bernanke and Paulson have been pummeled by Congress and the press. Questions over the deal were effectively revived and reframed by U.S. District Court Judge Jed Rakoff, who in September brusquely rejected the SEC's proposed settlement of a suit against BofA for disclosure violations. Rakoff instead scheduled a Feb. 1 trial date for the case.
The disclosure issue -- charges that BofA failed to reveal to shareholders before their vote on the deal that Merrill could pay up to $5.8 billion in bonuses -- returns us to the desperation of last year. Regulators wanted BofA to complete the deal. When Merrill began to absorb huge losses in the fourth quarter -- some $9 billion -- Bernanke and Paulson pressured (or forced, depending on the perspective) a backtracking Lewis to go through with the transaction and eventually offered another bailout. In hustling the deal through, regulators may have cued bank executives and their advisers to limit disclosure of Merrill's losses and payment of bonuses. The SEC's settlement with BofA further incited charges that individuals in Charlotte, N.C., New York and Washington were being shielded from scrutiny.
Those exigencies collide with Rakoff and his insistence that shareholders and the public have a right to know. Rakoff is demanding that the SEC and BofA reveal which individuals decided not to disclose bonus payments. He is furious at the lack of disclosure by a bank that's received billions of dollars of taxpayer money. His concerns clash not only with the expedience demanded by a financial emergency, but with traditional merger disclosure practices and with the SEC's preference for settling rather than litigating cases.
In his Sept. 14 order rejecting the SEC settlement, Rakoff called it "a contrivance designed to provide the SEC with the façade of enforcement and the management of the bank with a quick resolution of an embarrassing inquiry at the expense of the sole alleged victims, the shareholders."
The judge is concerned with larger issues, says David Skeel, a professor at the University of Pennsylvania Law School who studied Rakoff's role in the SEC's securities fraud suit against WorldCom Inc. "I personally think that he sort of sees himself as a voice for public rage, as an outlet for it. I think he's responding to the general sense of outrage at what happened in that merger. I also feel as though he sees these cases as teaching moments."
Who's right? There's little consensus on the situation among the few lawyers who will even discuss it. But the case raises many questions and reveals flaws in regulatory responses to extraordinary situations. How closely did disclosure in the case follow accepted practices? To the extent it didn't, did the divergence stem from calculated decisions at BofA or the government, from a failure to fully grasp the deal's political nature, or even from sloppy drafting? Why is the SEC settling the case rather than litigating it? And is Rakoff courageously challenging dubious, if long-accepted, practices or self-indulgently second-guessing from the comfort of his chambers?
The complexity and sensitivity of these issues begins with the circumstances under which Merrill agreed to sell. The panic caused by Lehman's collapse imperiled Merrill. Unlike Bear Stearns at the time of its sale to J.P. Morgan Chase & Co. in March 2008, Merrill wasn't done for, but its near-term health was highly uncertain. The sale to BofA took pressure off Merrill's stock and reduced the risk of counterparty defections even if it didn't address its massive losses on mortgage assets.
However difficult the problems at Merrill were to assess, many of the ways in which a troubled financial institution and the government might deal with distress weren't available when it threw itself into BofA's arms. Merrill wasn't a commercial bank or a savings and loan, so the Federal Deposit Insurance Corp. couldn't seize it and auction it. Nor could the Federal Housing Finance Agency, as it had with Fannie Mae and Freddie Mac a few weeks before Lehman collapsed. And though the Fed provided American International Group Inc. with an $85 billion line of credit in exchange for an 80% stake last Sept. 16, just two days after Lehman failed, the political will for such a solution with Merrill was clearly lacking.
J.P. Morgan's acquisition of Bear Stearns was one model for the Merrill purchase, since both deals were purchases of troubled public companies. Wachtell, Lipton, Rosen & Katz advised both buyers, and the two merger agreements are similar. But the differences between them illustrate the challenges BofA, Merrill and regulators faced in shepherding their deal to closing.
J.P. Morgan agreed to acquire Bear over a weekend when it was the only failing institution whose fate Treasury and the Fed had to resolve; by September, the government had many firms to worry about, and, therefore, less leeway in addressing Merrill. The government provided a $30 billion backstop to J.P. Morgan for assuming Bear's liabilities, and the buyer agreed to pay $10 in stock per share of Bear, or a little more than $1 billion. J.P. Morgan got an option on Bear stock that made the deal's completion inevitable. J.P. Morgan shareholders did not have a vote on the deal.
In exchange, the bank got the extraordinary right to operate Bear between signing and closing. As the merger agreement states, "[J.P. Morgan] shall be entitled to direct the business, operations and management of [Bear] in its reasonable discretion." It was an exceptional concession analogous to the FDIC's seizure of a troubled bank.
BofA did not gain that level of control over Merrill. Instead, the BofA-Merrill deal employed standard language that allowed each party to run its business in the ordinary course, which included "using reasonable best efforts to ... retain the services of its key officers and key employees." In other words, pay bonuses. As in most agreements, that right was qualified, though the precise nature of those limitations is a central issue in the SEC's suit against BofA.
In short, the J.P. Morgan-Bear Stearns contract acknowledged the exceptional circumstances under which it was struck, as did the deal's modest price and significant discount to Bear's value even a week earlier.
The Merrill contract and deal terms did not. BofA offered $50 billion in stock for Merrill, or $29 per share, a 70% premium to Merrill's Sept. 12, 2008, closing price. The government did not provide the buyer with a backstop, and BofA shareholders had the right to kill the deal.
The crisis deepened in the weeks after Lewis and Thain signed the agreement. In October, BofA took $25 billion in funds from the Troubled Asset Relief Program. By the end of November, BofA knew Merrill expected pretax losses of almost $9 billion in the fourth quarter, but Lewis went through with a Dec. 5 vote at which BofA shareholders approved the deal without knowing of the loss.
In the days thereafter, Lewis considered declaring that Merrill had suffered a material adverse effect that would allow BofA to walk from the deal. But Paulson and Bernanke threatened to remove him and the board if they did so, the CEO said in February to a lawyer from the office of New York Attorney General Andrew Cuomo, who's been conducting an investigation into bonuses since last year. Lewis backed down, and the Merrill deal closed at year's end. By that point, the $50 billion in stock that BofA had agreed to pay for Merrill in September was worth $20 billion — the amount of additional TARP funds that the U.S. government invested in BofA in January. The government ended up backstopping the transaction after all.
More than seven months after the deal closed, the SEC brought suit against BofA for violating proxy disclosure rules and simultaneously announced a proposed $33 million settlement — a typical course of action for the agency, says Michael Klausner, a professor at Stanford Law School. But in an Aug. 5 order, Rakoff declined to approve the settlement because, he wrote, "[it] in no way specifies the basis for the $33 million figure or whether any of this money is derived directly or indirectly from the $20 billion" in bailout money BofA received. The judge reiterated that position at an Aug. 10 hearing, and the parties thereafter submitted two sets of briefs to him in support of their agreement.
The SEC initially blamed the companies' outside lawyers for the alleged failure to disclose the Merrill bonuses. In its first brief, filed on Aug. 24, the agency named the senior lawyers on the deal: Edward Herlihy, Nicholas Demmo, Jeannemarie O'Brien and Matthew Guest of Wachtell Lipton, which advised BofA, and John Madden, John Marzulli Jr., Scott Petepiece and Linda Rappaport at Shearman & Sterling LLP, Merrill's outside counsel.
In its second brief, filed Sept. 9, the SEC quoted public materials produced by Wachtell and Shearman that the firms issued in response to a 2005 report in which the SEC warned issuers that they needed to disclose facts that would modify or contradict a representation made in a publicly filed contract, such as the language in the Merrill agreement about the payment of bonuses.
Laying the blame on outside lawyers allowed the SEC to argue that executives did not know about the disclosure violation and thus did not intend to deceive shareholders. Therefore the SEC would have a hard time making a case against the executives, which meant that a settlement with the company looked like an attractive option.
By calling out two Wall Street law firms, the SEC tried to show that it would be more aggressive in demanding disclosure than the agency had been under a Republican administration. But the SEC could have asked for more information about the treatment of bonuses in the Merrill merger agreement; it didn't. Nor did it ask Merrill to be completely clear about whether it intended to pay bonuses before BofA purchased it. Such regulatory forbearance is typical, a fact the agency probably doesn't want to see publicized in a trial. Better to settle and send a message to corporate America and its lawyers.
Settlements are also very typical. But Rakoff has now put that system of regulation by settlement on trial. This must come as a shock to Mary Schapiro's new Democratic SEC that has promised aggressive reforms after a deregulatory era; after all, the problems, fiscal and regulatory, festered under the Bush administration. "The Bush administration starved the SEC financially, making it difficult for the SEC to do its job.," says Hillary Sale, a professor at Washington University School of Law in St. Louis. "SEC commissioners in that era were interested in managing enforcement actions in ways that were not true previously."
And settlements are a cost-effective litigation practice for both regulators and private parties. "I think this case is unusual in a number of ways," says Klausner. "The economics of settlement have been the same since the beginning of time and always will be, and it would be really unwise on the part of the courts or the SEC to change their attitude toward settlement."
As a result, Schapiro's SEC finds itself trapped between Rakoff and BofA. As Skeel says, "BofA makes the argument that the SEC doesn't have a great case, and you don't have to read between the lines much to make the argument that that's driving the SEC. Their mistake in this was treating it as a normal case. They defend what they did by comparing it to what they did in other cases, which isn't the best argument in these circumstances."
Adds Skeel: "The SEC has egg on its face. They have to defend what they've done. If this settlement gets undone, it undermines the SEC's authority a bit. At some point, the SEC is going to have to start looking tough."
BofA's motives are less byzantine: The company simply wants to avoid a trial. In briefs, BofA argues that its shareholders had ample knowledge of the bonuses to be paid to Merrill employees, and thus it did not break the law. One reading of the agreement suggests that Merrill could pay bonuses; after all, each party was allowed to use "reasonable best efforts to ... retain the services of key officers and key employees." The bank also pointed to an Oct. 16 earnings release in which Merrill "announced compensation and benefits expenses of $3.5 billion for the third quarter of 2008." Merrill CFO Nelson Chai repeated that on a conference call.
Moreover, BofA said, both it and Merrill "repeatedly warned shareholders not to read the merger agreement or the proxy statement's description thereof as a source of factual information," since both were "subject to important qualifications and limitations" agreed to by the parties.
Such was the case in the section of the agreement where Merrill promises not to pay employees "any amount not required by any current plan or agreement (other than base salary in the ordinary course of business)" — that is, no bonuses, in apparent contradiction to the clause allowing Merrill to run its business as it usually would. But the clause that bars bonuses is specifically qualified, or modified, by an addendum to the agreement known as a "disclosure schedule" that shareholders never saw. This was common practice, though it has become a key issue in the SEC's suit.
Parties to a merger agreement often qualify representations or warranties in disclosure schedules that aren't disclosed to shareholders on the theory that the information is competitively sensitive and immaterial. A company's decision to pay out $5 billion in compensation would be material and would be disclosed in quarterly and annual reports, which proxies to merger agreements refer to. The decision to pay a managing director $4 million would be immaterial and commercially sensitive. (Payments to senior executives and board members are normally disclosed and were here.)
Companies aren't supposed to bury material information in disclosure schedules, but the subtlety of lawyers' debates over correct use conflicts with the harsh focus on bonuses at investment banks over the last year.
Several lawyers at firms not involved in crafting the deal say BofA's failure to explicitly disclose the size of bonuses or the disclosure schedules themselves would have been common practice under normal circumstances.
In that situation, "I don't think that the amount or timing of the bonuses would have occurred to anyone as anything other than ordinary course of business," says a lawyer not involved in the deal. "That's what banks do: They pay out half their revenue as compensation. That's the deal investors signed up for. So what harm was being done to BofA's shareholders by the bonuses being paid? The harm was that the losses were far greater than were disclosed. Only in the context of those losses were those bonuses material."
But, he adds, "the bonuses have been a hot-button issue from day one — the financial system is failing, this bank had to be sold, and they still paid the bonuses. What should have happened that weekend when the deal was being done was to say that there was no banker compensation agreed and they'll figure it out later. Barclays did that when they bought the remnants of Lehman."
Another lawyer says BofA and Merrill should have made clear that the seller planned to pay normal compensation in the ordinary course of business consistent with its accruals, a concept that was implicit in the documents BofA sent to shareholders but never clearly stated.
Still, companies rarely go out of their way to emphasize executive compensation in their disclosures, which is part of the problem. Moreover, "normal practice" jibed nicely with the desire of BofA, Merrill and regulators to avoid a debate about bonuses as they were trying to close an increasingly problematic deal.
It seems at least plausible that Lewis and his regulators talked in November, before the vote, as, according to the BofA CEO, they did the next month. Lewis said there were no lawyers from Wachtell when he met with Paulson and Bernanke at the New York Fed in December. That discussion involved the possibility of a Merrill MAE, which would normally be a legal issue but in this case was a political one. Perhaps the disclosure of Merrill's losses fell into the same category and was treated the same way.
The highly unusual circumstances surrounding the deal may account for a striking feature of the SEC's claim against BofA: The SEC sued only the company rather than any of its executives. According to a study of litigation brought by the SEC since 2000 by Stanford's Klausner and his research associate Jason Hegland, the agency charges only the company and not individual officers in only about 10% of its enforcement actions.
In about 85% of the SEC's cases, Klausner says, the agency imposes "severe sanctions" on officers. Such punishments may include monetary penalties, disgorgement of ill-gotten gains and a temporary or permanent bar against serving as an officer or director of a public company with temporary bars lasting an average of five years.
Rakoff seems to want such sanctions. In his Sept. 14 order rejecting the settlement, he wondered why the SEC didn't sue individuals. Had he approved the settlement, Rakoff wrote, the case would have closed "without the SEC adequately accounting for why it did not pursue charges against either bank management or the lawyers who allegedly were responsible for the false and misleading statements." The judge clearly would like individuals to admit culpability for disclosure violations and pay for it. One lawyer not involved in the BofA transaction believes that such a settlement would appease Rakoff.
Despite his excoriation of the SEC, the judge can't make the agency into defendants. If the case proceeds to trial, Klausner said, "in all likelihood, the company — that is, the shareholders — will pay more, and they will pay litigation costs as well."
But settlements often come on the eve of trial, and there are four months before this one is scheduled to start. That's a lot of time for discovery and the further revelations it may bring in a case that's about the opaque process by which two companies that received billions of dollars in government aid combine, the corners that were cut in the process and the costs to shareholders regardless of the systemic benefits.
Rakoff certainly has gotten everyone's attention.