The parties’ decision to proceed to trial rather than appeal Judge Rakoff’s rejection of their settlement on September 14 surprised this observer. I had speculated in my post of September 15 that the parties would appeal. That they have not may be due to technical issues involving the rejection (it did not constitute a final decision) or it may be that the parties’ submissions and Judge Rakoff’s comments so stirred them up that they have concluded it’s time to strap on their holsters and enter the ring. Whatever is the explanation, the case is now headed for trial, scheduled to commence March 1, 2010. Each party will have many interesting decisions to make over the next few months, including:
A. Will the SEC Sue Additional Parties?
Judge Rakoff has set October 19, 2009 as the date by which the SEC, without leave of court, may amend its pleadings or add additional parties. Given Judge Rakoff’s severe criticism of the Commission for failing to pursue any individual officers of BofA or its counsel for the alleged misstatements and omissions in BofA’s October 31, 2008 proxy statement, will the Commission add as parties defendant any of BofA’s executive officers, BofA’s in-house counsel who worked on the proxy statement, or the Wachtell firm, which acted as BofA’s outside counsel?
I would be surprised if the Commission did so. The Commission has made clear in its filings in support of the settlement that it had developed no evidence establishing the requisite “scienter” or knowledge of wrongdoing by any of the executive officers of BofA or its counsel so as to justify adding any of them to the complaint. The Commission cannot simply run away from these assertions and now do what it said only weeks ago that it could not do:
“… the Commission investigated the relevant roles played by various senior officials and other individuals in the events surrounding Merrill’s payment of year-end bonuses and the related proxy disclosures. The Commission duly considered whether to allege additional charges against Bank of America and charges against individuals but determined that such charges were not sufficiently supported by the investigative record.”
SEC’s Memo of August 24, 2009 at 23.
“… there is an insufficient evidentiary basis to establish a prima facie case of the requisite scienter with respect to the lawyers for purposes of alleging secondary liability under the securities laws.”
SEC Reply Memorandum of September 9, 2009, at 14 (footnote omitted).
B. Will the Parties Request a Jury Trial?
Each of the SEC and BofA may request that the trial be held before a jury. Will they do so?
My guess is that the Commission would be satisfied with Judge Rakoff as trier of fact, whereas the Bank may be more inclined to present its case to a jury. The Bank’s strategy will clearly be to parade expert witness after expert witness (to the extent Judge Rakoff will allow them) and possibly fact witnesses to establish that all the world knew that Merrill intended to pay year-end bonuses in a substantial amount and at least equal to what it in fact did pay — $3.6 billion, a pittance by Wall Street standards (the SEC’s charge is that BofA did not disclose its prior agreement with Merrill that Merrill could pay up to $5.8 billion in fourth-quarter bonuses). The challenge is whether the Bank really wants a group of New Yorkers to dwell over the course of a trial upon the payment of billions in bonuses to Wall Street suits.
C. Will the Parties “Re-Settle” the Case Before Trial?
There is nothing to prevent the Commission and BofA to revise their settlement and present the revised settlement to Judge Rakoff for approval. What would that revision consist of?
The Commission could agree to eliminate the civil fine of $33 million, leaving only the permanent injunction against BofA’s commission of future proxy violations. Presumably BofA would not object to this, and on what grounds could Judge Rakoff object to it, given his outrage over the fact that the civil fine in the original settlement was to be borne by the victims of the alleged “lies” (Judge Rakoff’s words) — BofA’s shareholders?
On the other hand, as an astute colleague of mine has observed, how would the SEC look if it agreed to a settlement eliminating the fine agreed to by BofA? Better to try the case and let the judge decide upon the appropriate monetary remedy (and take whatever heat comes from doing so).
D. Will BofA Waive the Attorney-Client Privilege?
In my post of September 15, 2009, I speculated on this question, concluding that it is unlikely that the Bank would respond affirmatively to any Commission request that it waive the privilege so as to allow everyone to come clean on what was discussed between the Bank and its lawyers concerning the proxy statement’s disclosure of Merrill’s year-end bonuses.
In my initial post on this case of September 3, 2009, I speculated on the possible explanations for the proxy statement’s omission of the Bank’s agreement with Merrill that Merrill could pay up to $5.8 billion in year-end bonuses, ranging from a deliberate omission to the explanation that it was simply an inadvertent omission, due to the incredible time pressures under which this deal and the proxy statement were cobbled together. If I am correct, why not waive the privilege and frankly admit that yes, the agreement set forth in the disclosure schedule was not included in the proxy statement, the explanation being that the team responsible for preparing the disclosure schedule did not adequately communicate with the team drafting the proxy statement — the failure was therefore simply a boot?
The problem with waiving the privilege, however, is that it can have other consequences, including in related litigation. And if BofA waived the privilege here, how could it avoid doing so in any future litigation or dispute? Moreover, the SEC has made clear that the record to date does not provide any evidence of the requisite scienter to enable the SEC to name as party defendants any officer of BofA or its counsel, so why not let a sleeping dog lie?
E. And Now for Judge Rakoff
What remedies would he impose upon BofA if it is found liable for having violated the proxy rules?
Judge Rakoff as judge has to be a neutral arbiter. He cannot force the SEC to name defendants, develop theories of liability, or examine witnesses (as a litigant). So let’s assume the Commission tries the case solely against the Bank, and Judge Rakoff (or a jury) finds the Bank liable for a proxy violation in failing to disclose its agreement with Merrill to allow Merrill to pay billions in-year 2008 bonuses. What sanctions does Judge Rakoff then impose upon the Bank?
The Commission in its complaint seeks monetary damages against the Bank pursuant to the provisions of Section 21(d)(3) of the Exchange Act. The “money penalties” available to the Commission under this provision are a function of the “tier” in which a violation falls. Assuming the BofA finder of fact does not conclude that BofA committed an act of fraud, deceit, manipulation, or a deliberate or reckless disregard of the proxy rules, which appears to be the state of the record based upon what the SEC asserts in its briefs filed in support of the settlement, then the relevant tier to which any probable violation found against the Bank would fall is the “first” tier. For corporations, the amount of a first tier penalty is, for “each violation,” $50,000 or, if the defendant has realized “pecuniary gain,” then the gross amount of such gain.
How does one get to a penalty in the millions of dollars under such provision? One way is to find numerous violations, e.g., 50 different misleading statements in a proxy statement. The law in this area is unclear. One mechanism of truly expanding the penalty would be to find a separate violation based upon the number of shareholders to whom the BofA proxy statement was sent — which numbered 283,000. 283,000 times $50,000 is real money. But the point is that even if the Court finds the Bank to have violated the proxy rules, getting to a fine in the range of $33 million (the fine BofA agreed to pay in the settlement) takes some work. Given Judge Rakoff’s express concerns about the burden of any civil fine, it would be surprising if he imposed one of any material significance against the Bank.
How about an injunction, identical to the one secured by the SEC in its settlement? Here, the Bank will inevitably argue that the odds of its repeating a proxy violation are nil, and therefore even the imposition of an injunction is inappropriate. So, while the imposition of an injunction as a remedy for any finding of a proxy violation by the Bank would not surprising, there could be a real fight over even its appropriateness given relevant case law about the standards governing the entry of injunctions.
So it’s entirely possible that even if the Bank is found liable for proxy violations as alleged by the SEC, the remedies Judge Rakoff would enter will not be as stringent as those set out in the settlement to which BofA was prepared to accept. How will that look? And who would suffer if that were the case? If the answer is Judge Rakoff, then perhaps there are grounds for one or both of the parties to ask him to recuse himself from the case.
The twists and turns this case has taken are not yet over.
Friday, September 25, 2009
Tuesday, September 15, 2009
The Settlement in SEC v. Bank of America Corp: Judge Rakoff As Populist---Settlement Rejected
While he telegraphed his displeasure with the settlement both at the hearing held on August 10, 2009 on the settlement and in his order requesting clarification of the parties’ initial submissions on August 25, Judge Rakoff’s rejection of the settlement by his order of yesterday was nevertheless surprising. As he himself admits, settlements of this nature, by an agency that is as generally respected by the courts as the SEC, are rarely set aside. This one has been, to the general acclaim of the populace, if the reactions in the press, ranging from The New York Times to The Wall Street Journal, are any indication. The comments on The Times’ website to its report of the settlement yesterday were overwhelmingly favorable. Here’s a sample, from some of the 385 readers’ comments (as of September 15) from The Times’ website:
“Thank you your Honor!”
“Such fundamental reasoning was sorely missing from all the prior bailout efforts.”
“Well, what do you know? A judge does the right thing.”
“Yes, there is justice in this world.”
“Good to see the light of Justice exposing and rejecting the ‘insider’ deal between the SEC and BOA!”
“I like this judge! Nominate him for Stevens’ seat on SCOTUS!”
“A judge with some intelligence and integrity. Faith renewed, at least temporarily….”
A. Judge Rakoff, Populist
The Judge’s September 14th order rejecting the settlement is a refreshing read. He disdains the technical language of securities lawyers, and says it plain and simple. Where the Commission refers to BofA’s proxy statement as containing a “proxy violation” and “false” and “misleading” statements, the Judge refers to BofA’s conduct as allegedly “lying” to its shareholders. Thus Judge Rakoff begins his order:
“In the Complaint in this case, … the Securities and Exchange Commission … alleges, in stark terms, that defendant Bank of America Corporation materially lied to its shareholders….”
What particularly frosts the Judge is that the effect of the settlement is to impose upon the victims of the Bank’s alleged lies — BofA’s shareholders — the burden of paying the settlement’s fine of $33 million:
“In other words, the parties were proposing [by the settlement] that the management of Bank of America — having allegedly hidden from the Bank’s shareholders that as much as $5.8 billion of their money would be given as bonuses to the executives of Merrill who had run that company nearly into bankruptcy — would now settle the legal consequences of their lying by paying the S.E.C. $33 million more of the shareholders’ money.”
September 14th Order at 2.
The Judge blasts the settlement as none of “fair, nor reasonable, nor adequate.” Not content to rely solely on law and notions of justice, the Judge finds that the proposed settlement violates fundamental norms of morality:
“It is not fair, first and foremost, because it does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for that misconduct.”
September 14th Order at 4.
Not the prose one typically reads in legal opinions!
In response to the SEC’s argument that the penalty against the corporate entity — the Bank — is justified because it would send “a strong signal to shareholders that unsatisfactory corporate conduct has occurred [and would allow] shareholders to better assess the quality and performance of management,” the Judge is aghast:
“This hypothesis, however, makes no sense when applied to the facts here: for the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion-dollar purchase of a huge, nearly-bankrupt company, need to lose another $33 million of their money in order to ‘better assess the quality and performance of management’ is absurd.”
September 14th Order at 4.
And in response to the Bank’s claims that its investigation indicated that it was the Bank’s lawyers who drafted the proxy statement, the Judge offers the obvious rejoinder: “But if that is the case, why are penalties not then sought from the lawyers?” Id. at 5.
The Judge blasts BofA for, on the one hand, claiming its innocence of the charges of distributing a misleading proxy statement while at the same time agreeing to fork over $33 million of its shareholders’ money. Not only does the Judge question the decision as a business matter, but he points to the obvious, namely, that management of the Bank may not be disinterested parties:
“It is one thing for management to exercise its business judgment to determine how much of its shareholders money should be used to settle a case brought by former shareholders or third parties. It is quite something else for the very management that is accused of having lied to its shareholders to determine how much of those victims’ money should be used to make the case against the management go away.”
September 14th Order at 7 (footnote omitted).
In what must particularly sting the Commission, particularly under its new head Mary Schapiro, the Judge characterizes the settlement at a “contrivance” designed to provide cover to the SEC:
“Overall, indeed, the parties’ submissions, when carefully read, leave the distinct impression that the proposed Consent Judgment was a contrivance designed to provide the S.E.C. with the façade of enforcement and the management of the Bank with a quick resolution of an embarrassing inquiry — all at the expense of the sole alleged victims, the shareholders.”
Id. at 8.
In a final call to arms, the Judge throws down the gauntlet:
“Yet the truth may still emerge. The Bank of America states unequivocally that if the Court disapproves the Consent Judgment, it is prepared to litigate the charges. … The S.E.C., having brought the charges, presumably is not about to drop them. Accordingly, the Court, having hereby disapproved the Consent Judgment, directs the parties to file with the Court, no later than one week from today, a jointly proposed Case Management Plan that will have this case ready to be tried on February 1, 2010.”
Id. at 12 (footnote omitted).
B. Now What?
The first question for the parties is whether to appeal Judge Rakoff’s rejection of their settlement. (Not being a litigator, I assume each can do so.) While the Judge’s comments undoubtedly rub both parties raw, I assume cooler heads will prevail and one or both of the SEC and the Bank will appeal. From the SEC’s standpoint, none of the arguments it advanced to Judge Rakoff for approving the settlement go away. The Judge’s comments about the burden of the $33 million fine being borne by the innocent shareholders of BofA will hurt, because they are true, but I doubt the SEC is ready to forego its policy of imposing corporate fines altogether. Plus the Commission has its institutional prerogatives to protect, namely, its discretion in investigating, prosecuting, and settling cases. Plus Judge Rakoff is known as a maverick, so the Commission will undoubtedly assume it would receive a more receptive audience at the Second Circuit.
From the Bank’s standpoint, before pursuing any appeal it will have to swallow the bravado of its briefs that if the case were tried, the Bank would undoubtedly prevail. The Bank would be foolish to submit to Judge Rakoff and/or to a jury a case involving, at its core, the payment of billions of dollars in bonuses to Wall Street executives. Testifying in court and before a jury of your average New Yorkers is not something Ken Lewis and the other executives of the Bank will relish. So I would expect the Bank to conclude that a deal is a deal and that this deal should be approved.
If, surprise of surprises, the case does head to trial, then one of the first issues the parties will have to address is the Bank’s invocation of the attorney-client privilege. Fundamental to the Commission’s defense of the settlement and its failure to include any individual officers of BofA is the fact that the Bank invoked the privilege, thereby preventing the Commission from investigating communications between the Bank and counsel regarding the proxy statement’s disclosures concerning the payment of discretionary year-end bonuses to Merrill’s executives and employees. Somewhat surprisingly, the Bank, in its reply memorandum of September 9, 2009, appears to take the position that it did not invoke the attorney-client privilege: “It [the Bank] did not prevent any witnesses from testifying or ever invoke the attorney-client privilege in testimony regarding the subject of whether or how to disclose Merrill Lynch’s incentive compensation.” Reply Memo at 1. While this statement is hedged, undoubtedly the first question the Commission would put to the Bank, if the parties proceed to trial, is whether the Bank will now waive the privilege as to all communications between the Bank and counsel regarding the disclosures in the proxy statement concerning bonus compensation to Merrill’s officers and employees. While the Bank may squirm at that question, I would anticipate the response would be a firm “No.”
If the case proceeds to trial, would the Commission add as party defendants any officers of the Bank? Any lawyers of its counsel, the Wachtell firm? It would seem, given a trial date of February 1, 2010, that it is a bit late to add party defendants. Moreover, the Commission has made plain in its briefs filed with the Court that it was not able to develop any evidence establishing scienter on behalf of the Bank’s officers or counsel, and so, how could it name any such individuals as party defendants now?
And, if the case proceeds to trial, and the Commission does not add to the case any individual party defendants, what is the point of proceeding? It would appear that hell will freeze over before Judge Rakoff would impose a penalty on the Bank when no individuals stand before him as defendants, so what would the Commission seek in any trial against the Bank only?
So, upon reflection, the odds of the parties taking up Judge Rakoff’s command to proceed to trial appear nil. Next up: the Second Circuit.
Wednesday, September 9, 2009
The Settlement in SEC v. Bank of America Corp. Under Attack: Bank of America's Defense of the Settlement
In my post of September 3, 2009, I addressed the settlement entered into on August 3, 2009 between the SEC and Bank of America in which the Bank, settling the SEC’s complaint of the same day alleging material misstatements and omissions in the Bank’s October 31, 2008 proxy statement, agreed to a permanent injunction against future violations of the proxy rules and agreed to pay a $33 million fine. I reviewed the SEC’s support of the settlement and Judge Raikoff’s concerns over the settlement. In this post I discuss the Bank’s defense of the settlement, set forth in its memorandum filed August 24, and the submissions of its two experts, Morton Pierce, chairman of Dewey & LeBoeuf’s mergers and acquisitions group, and Joe Grundfest, professor of law at Stanford.
A. The Best Defense is a Powerful Offense
It is clear that what bothers Judge Raikoff about the settlement is the SEC’s failure to name, and include in the settlement, any of the Bank’s officers. In its defense of the settlement, the Bank chooses not to defend this specific omission, but to assert that the SEC’s complaint itself is subject to powerful defenses and that, if the case were tried, the Bank would likely prevail. The thrust of the Bank’s position, therefore, is that the settlement should be approved because the SEC is fortunate to have secured the terms that it did — never mind that one or more individual officers of the Bank was not named as a defendant in the SEC’s complaint.
In support of its position, the Bank makes two arguments: first, that its proxy statement contained no false or misleading statement and no material omission, and second, that even if the proxy statement can be faulted for not specifically flagging Merrill’s and the Bank’s agreement that Merrill could pay year-end incentive bonuses of up to $5.8 billion, the omission was immaterial, given that Merrill’s intent to pay year-end bonuses in approximately this amount was well known to the market prior to the stockholder vote on the merger, via Merrill’s SEC filings and in extensive press reports concerning Merrill.
B. No Misstatement or Omission
The crux of the SEC’s complaint against BofA is that the Bank failed to disclose in the proxy statement distributed to the Bank’s stockholders in connection with the Merrill merger its agreement with Merrill that Merrill could pay up to $5.8 billion in discretionary year-end performance bonuses to Merrill’s officers and employees. In the merger agreement, summarized in the joint proxy statement, the Bank and Merrill agreed that Merrill would not pay discretionary bonuses to its directors, officers, and employees between the date of the merger agreement (September 15, 2008) and the close of the merger, except as set forth in Merrill’s disclosure schedule, without the prior written consent of the Bank. The disclosure schedule, which was not filed with the merger agreement or otherwise made publicly available, reflected the parties’ understanding and agreement that Merrill could pay discretionary year-end bonuses in an amount not to exceed $5.8 billion in the aggregate (and $4.5 billion in the aggregate as an accounting expense).
In defending the proxy statement disclosure, the Bank distorts what the SEC alleges in its complaint, asserting that the Commission alleges that Merrill “was prohibited from making [year-end] bonus payments.” Bank’s Memorandum of August 24, 2009 (“BofA Memo”), at 1. The charge is picked up by Professor Grundfest in his affidavit in support of the Bank’s submission: “The Complaint alleges that Bank of America made ‘representations that Merrill was prohibited from making [year-end bonus] payments.’” Grundfest Affidavit, dated August 21, 2009, ¶ 34. But it wasn’t Merrill’s negative covenant not to pay year-end discretionary bonuses that the Commission attacked, but the proxy statement’s failure to disclose the deal that the Bank and Merrill had already struck by the time they signed the merger agreement:
“The omission of Bank of America’s agreement authorizing Merrill to pay discretionary year-end bonuses made the statements to the contrary in the joint proxy statement and its several subsequent amendments materially false and misleading. Bank of America’s representations that Merrill was prohibited from making such payments were materially false and misleading because the contractual prohibition on such payments was nullified by the undisclosed contractual provision expressly permitting them.”
SEC Complaint, dated August 3, 2009, ¶ 3.
Morton Pierce, one of the Bank’s experts, testifies in his affidavit that the inclusion of compensation-related information in disclosure statements and the non-disclosure of the contents of disclosure statements is customary practice in M&A transactions. That may very well be true, but it does not respond to the question of whether non-disclosure of BofA’s and Merrill’s agreement on the payment of year-end bonuses in this disclosure statement made the Bank’s statement in its proxy statement that no such bonuses would be paid without the Bank’s written consent misleading. (And, on that point, Mr. Pierce is careful to “express no view.”). And, while maintaining the confidentiality of disclosure statement disclosures is customary, neither the Bank nor its experts respond to the point, made by the SEC in its August 24th memorandum, that the very Reg. S-K instructions that permit the nondisclosure of disclosure statements requires disclosure of their contents if “such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document [transmitted to the shareholders and/or investors].” Reg. S-K, Item 601(b)(2).
So I don’t find persuasive the Bank’s claim that its proxy statement disclosure concerning its agreement with Merrill over the payment of discretionary year-end bonuses is not misleading.
C. The Omission of the Agreement on Payment of Year-End Bonuses Was Immaterial
The Bank has a stronger argument on this point. The Bank does not claim that the amount of the permitted year-end bonuses — up to $5.8 billion — is not material, but that the fact and probable amount of Merrill’s intent to pay such bonuses was widely known, both through Merrill’s 10-Q filings with the SEC and in press reports. The Bank cites Merrill’s first two 2008 quarterly reports for the proposition that Merrill had made known to the market its intent to pay compensation and bonuses in an amount comparable to those paid in 2007, and continued with that disclosure in its 10-Q filed after announcement of the merger agreement on September 15, 2008 (for the third calendar quarter ended September 30, 2008). And the Bank, primarily through Professor Grundfest, cites, ad nauseum, media reports that detailed Merrill’s claims to pay compensation and bonuses, including reports from The New York Times, Bloomberg News, and The Today Show, to the effect that Merrill was setting aside some $6.7 billion for officer and employee bonuses.
Both the Bank and Merrill, in their joint proxy statement, as is typical, incorporated by reference their recent SEC filings, including their 2008 10-Qs, and the SEC filings they would make prior to the stockholder meeting of December 5, 2008. So the Bank could clearly raise as a defense that the very information the Commission alleges it omitted from its proxy statement could be found in the Bank’s SEC filings. While media reports are not incorporated by reference in SEC filings, the Bank could argue that the information on Merrill’s expected bonuses was so widely available that the “market” and therefore BofA’s stockholders must be considered to have been aware of it.
The SEC, in its initial August 24 filing, anticipated these claims, and responded by pointing out that Merrill’s SEC filings do not break out bonuses from compensation accruals generally, and that BofA’s stockholders should not be expected to conduct a treasure hunt to ascertain information material to their vote on whether to approve the Bank’s merger with Merrill:
“Although tidbits of information relevant to the issue of year-end compensation at Merrill were available to the public at the time that the proxy materials were disseminated, none of that information disclosed Merrill’s plan to pay billions of dollars in discretionary bonuses and, more importantly, Bank of America’s consent to that plan in connection with the proposed merger. Merrill’s quarterly filings disclosing accruals for “compensation and benefits” did not provide any breakdown for the components of that aggregate accrual. An investor could not have known what portion was being accrued for year-end bonuses as opposed to salaries, benefits, or other expenses. In any event, investors are entitled to full disclosure of material facts within the four corners of the proxy statement and are not required to puzzle through reams of other data from which they may or may not be able to infer those material facts. ….
"While Merrill’s plan to pay bonuses was discussed to some extent in the media before the December 5, 2008 shareholders’ meetings, these reports do not negate Bank of America’s liability for its misleading proxy statement. As an initial matter, the media reports consisted of speculation and some of the reports were based on anonymous sources. Moreover, none of the reports stated that Bank of America had contractually consented to the payment of the Merrill bonuses before the merger closed. In any event, investors were not required to ignore Bank of America’s express representations in its proxy materials and rely instead on sporadic media speculation that was inconsistent with those representations.”
SEC August 24 Memo at 22-23 (emphasis in original).
The Bank’s reliance upon the claim that Merrill’s intent to pay year-end bonuses in the range of $5.8 billion (the actual bonuses paid were some $3.6 billion) was so widely known as to make the failure to expressly refer to that intent in the proxy statement immaterial raises an obvious question: if so widely known, why not include the Bank’s agreement with Merrill that it could pay bonuses of up to $5.8 billion in the proxy statement? Why the need to maintain in confidence information that was known, among others, by the viewers of The Today Show?
The Bank’s claim that the omission of its agreement with Merrill over the payment of year-end bonuses from the text of the proxy statement was immaterial should give Judge Raikoff pause, and could very well establish the bona fides of the settlement to his satisfaction. But if not, and the tone of his August 25 Order reflects considerable skepticism about the merits of the settlement, then the Bank will be forced to emphasize that while it may have exposure for the omission, none of its officers should have as there is no evidence that any of them had the slightest awareness of the omission and therefore no evidence to establish the necessary scienter that would have justified the SEC’s naming any of the Bank’s officers as defendants in the complaint.
The parties have today filed their replies, including to the issues raised in Judge Rakoff's August 25th order. I will address any points I find of interest in their briefs in a subsequent post.
A. The Best Defense is a Powerful Offense
It is clear that what bothers Judge Raikoff about the settlement is the SEC’s failure to name, and include in the settlement, any of the Bank’s officers. In its defense of the settlement, the Bank chooses not to defend this specific omission, but to assert that the SEC’s complaint itself is subject to powerful defenses and that, if the case were tried, the Bank would likely prevail. The thrust of the Bank’s position, therefore, is that the settlement should be approved because the SEC is fortunate to have secured the terms that it did — never mind that one or more individual officers of the Bank was not named as a defendant in the SEC’s complaint.
In support of its position, the Bank makes two arguments: first, that its proxy statement contained no false or misleading statement and no material omission, and second, that even if the proxy statement can be faulted for not specifically flagging Merrill’s and the Bank’s agreement that Merrill could pay year-end incentive bonuses of up to $5.8 billion, the omission was immaterial, given that Merrill’s intent to pay year-end bonuses in approximately this amount was well known to the market prior to the stockholder vote on the merger, via Merrill’s SEC filings and in extensive press reports concerning Merrill.
B. No Misstatement or Omission
The crux of the SEC’s complaint against BofA is that the Bank failed to disclose in the proxy statement distributed to the Bank’s stockholders in connection with the Merrill merger its agreement with Merrill that Merrill could pay up to $5.8 billion in discretionary year-end performance bonuses to Merrill’s officers and employees. In the merger agreement, summarized in the joint proxy statement, the Bank and Merrill agreed that Merrill would not pay discretionary bonuses to its directors, officers, and employees between the date of the merger agreement (September 15, 2008) and the close of the merger, except as set forth in Merrill’s disclosure schedule, without the prior written consent of the Bank. The disclosure schedule, which was not filed with the merger agreement or otherwise made publicly available, reflected the parties’ understanding and agreement that Merrill could pay discretionary year-end bonuses in an amount not to exceed $5.8 billion in the aggregate (and $4.5 billion in the aggregate as an accounting expense).
In defending the proxy statement disclosure, the Bank distorts what the SEC alleges in its complaint, asserting that the Commission alleges that Merrill “was prohibited from making [year-end] bonus payments.” Bank’s Memorandum of August 24, 2009 (“BofA Memo”), at 1. The charge is picked up by Professor Grundfest in his affidavit in support of the Bank’s submission: “The Complaint alleges that Bank of America made ‘representations that Merrill was prohibited from making [year-end bonus] payments.’” Grundfest Affidavit, dated August 21, 2009, ¶ 34. But it wasn’t Merrill’s negative covenant not to pay year-end discretionary bonuses that the Commission attacked, but the proxy statement’s failure to disclose the deal that the Bank and Merrill had already struck by the time they signed the merger agreement:
“The omission of Bank of America’s agreement authorizing Merrill to pay discretionary year-end bonuses made the statements to the contrary in the joint proxy statement and its several subsequent amendments materially false and misleading. Bank of America’s representations that Merrill was prohibited from making such payments were materially false and misleading because the contractual prohibition on such payments was nullified by the undisclosed contractual provision expressly permitting them.”
SEC Complaint, dated August 3, 2009, ¶ 3.
Morton Pierce, one of the Bank’s experts, testifies in his affidavit that the inclusion of compensation-related information in disclosure statements and the non-disclosure of the contents of disclosure statements is customary practice in M&A transactions. That may very well be true, but it does not respond to the question of whether non-disclosure of BofA’s and Merrill’s agreement on the payment of year-end bonuses in this disclosure statement made the Bank’s statement in its proxy statement that no such bonuses would be paid without the Bank’s written consent misleading. (And, on that point, Mr. Pierce is careful to “express no view.”). And, while maintaining the confidentiality of disclosure statement disclosures is customary, neither the Bank nor its experts respond to the point, made by the SEC in its August 24th memorandum, that the very Reg. S-K instructions that permit the nondisclosure of disclosure statements requires disclosure of their contents if “such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document [transmitted to the shareholders and/or investors].” Reg. S-K, Item 601(b)(2).
So I don’t find persuasive the Bank’s claim that its proxy statement disclosure concerning its agreement with Merrill over the payment of discretionary year-end bonuses is not misleading.
C. The Omission of the Agreement on Payment of Year-End Bonuses Was Immaterial
The Bank has a stronger argument on this point. The Bank does not claim that the amount of the permitted year-end bonuses — up to $5.8 billion — is not material, but that the fact and probable amount of Merrill’s intent to pay such bonuses was widely known, both through Merrill’s 10-Q filings with the SEC and in press reports. The Bank cites Merrill’s first two 2008 quarterly reports for the proposition that Merrill had made known to the market its intent to pay compensation and bonuses in an amount comparable to those paid in 2007, and continued with that disclosure in its 10-Q filed after announcement of the merger agreement on September 15, 2008 (for the third calendar quarter ended September 30, 2008). And the Bank, primarily through Professor Grundfest, cites, ad nauseum, media reports that detailed Merrill’s claims to pay compensation and bonuses, including reports from The New York Times, Bloomberg News, and The Today Show, to the effect that Merrill was setting aside some $6.7 billion for officer and employee bonuses.
Both the Bank and Merrill, in their joint proxy statement, as is typical, incorporated by reference their recent SEC filings, including their 2008 10-Qs, and the SEC filings they would make prior to the stockholder meeting of December 5, 2008. So the Bank could clearly raise as a defense that the very information the Commission alleges it omitted from its proxy statement could be found in the Bank’s SEC filings. While media reports are not incorporated by reference in SEC filings, the Bank could argue that the information on Merrill’s expected bonuses was so widely available that the “market” and therefore BofA’s stockholders must be considered to have been aware of it.
The SEC, in its initial August 24 filing, anticipated these claims, and responded by pointing out that Merrill’s SEC filings do not break out bonuses from compensation accruals generally, and that BofA’s stockholders should not be expected to conduct a treasure hunt to ascertain information material to their vote on whether to approve the Bank’s merger with Merrill:
“Although tidbits of information relevant to the issue of year-end compensation at Merrill were available to the public at the time that the proxy materials were disseminated, none of that information disclosed Merrill’s plan to pay billions of dollars in discretionary bonuses and, more importantly, Bank of America’s consent to that plan in connection with the proposed merger. Merrill’s quarterly filings disclosing accruals for “compensation and benefits” did not provide any breakdown for the components of that aggregate accrual. An investor could not have known what portion was being accrued for year-end bonuses as opposed to salaries, benefits, or other expenses. In any event, investors are entitled to full disclosure of material facts within the four corners of the proxy statement and are not required to puzzle through reams of other data from which they may or may not be able to infer those material facts. ….
"While Merrill’s plan to pay bonuses was discussed to some extent in the media before the December 5, 2008 shareholders’ meetings, these reports do not negate Bank of America’s liability for its misleading proxy statement. As an initial matter, the media reports consisted of speculation and some of the reports were based on anonymous sources. Moreover, none of the reports stated that Bank of America had contractually consented to the payment of the Merrill bonuses before the merger closed. In any event, investors were not required to ignore Bank of America’s express representations in its proxy materials and rely instead on sporadic media speculation that was inconsistent with those representations.”
SEC August 24 Memo at 22-23 (emphasis in original).
The Bank’s reliance upon the claim that Merrill’s intent to pay year-end bonuses in the range of $5.8 billion (the actual bonuses paid were some $3.6 billion) was so widely known as to make the failure to expressly refer to that intent in the proxy statement immaterial raises an obvious question: if so widely known, why not include the Bank’s agreement with Merrill that it could pay bonuses of up to $5.8 billion in the proxy statement? Why the need to maintain in confidence information that was known, among others, by the viewers of The Today Show?
The Bank’s claim that the omission of its agreement with Merrill over the payment of year-end bonuses from the text of the proxy statement was immaterial should give Judge Raikoff pause, and could very well establish the bona fides of the settlement to his satisfaction. But if not, and the tone of his August 25 Order reflects considerable skepticism about the merits of the settlement, then the Bank will be forced to emphasize that while it may have exposure for the omission, none of its officers should have as there is no evidence that any of them had the slightest awareness of the omission and therefore no evidence to establish the necessary scienter that would have justified the SEC’s naming any of the Bank’s officers as defendants in the complaint.
The parties have today filed their replies, including to the issues raised in Judge Rakoff's August 25th order. I will address any points I find of interest in their briefs in a subsequent post.
Thursday, September 3, 2009
The Settlement in SEC v. Bank of America Under Attack: Judge Rakoff v. the Attorney-Client Privilege
The SEC and Bank of America confronted a skeptical audience in the form of Judge Rakoff when they presented to him their settlement for approval on August 10, 2009. The Judge asked for further background on the settlement by written submissions (filed on August 24, 2009), which are to be followed by further written submissions (each party responding to the other’s initial submissions) on September 9, 2009. Following the initial submissions on August 24, the Judge issued an order the following day, requesting responses to questions he had that were prompted by the initial submissions.
The Commission filed its complaint and announced its settlement with BofA on the same day — August 3, 2009. The complaint names the Bank only, asserting that, by its October 31, 2008 proxy statement distributed to its stockholders in connection with the Bank’s proposed merger with Merrill Lynch & Co., Inc., the Bank had made materially false and misleading statements concerning its agreement with Merrill for the payment of year-end discretionary bonuses to Merrill’s officers and employees. By the settlement, the Bank agreed to a permanent injunction from violating Section 14(a) of the Exchange Act and the SEC’s Rule 14a-9 (both governing proxy statements), and agreed to pay a penalty of $33 million.
What clearly is troubling the Judge is the SEC’s failure to name in its complaint any of the Bank’s officers. As the Judge observes in his August 25th follow-up order, the burden of the payment of the penalty of $33 million will fall upon the stockholders of BofA (and possibly U.S. taxpayers, given the $45 billion that the Government has invested in the Bank and Merrill). And yet, observed the Judge, “the gravamen of the violation asserted in the [SEC’s August 3d] Complaint is that Bank of America, through its management, effectively lied to its own shareholders.” August 25th Order at 2. Quoting from the SEC’s own guidelines concerning the imposition of financial penalties, the Judge noted that the SEC’s historical position is that:
“Where shareholders have been victimized by the violative conduct, or by the resulting negative effect on the entity following its discovery, the Commission is expected to seek penalties from culpable individual offenders acting for the corporation.”
Id.
So why did the Commission not name Ken Lewis (BofA’s CEO) or any of the other senior officers of the Bank for the alleged false statements in the Bank’s proxy statement?
A. The Alleged False Statements
As is typical, the BofA/Merrill merger agreement contains a series of restrictions on the conduct of Merrill’s business between the date of signing (September 15, 2008) and the close of the merger. These restrictions, referred to as “forbearances,” numbered some 18 in the BofA/Merrill merger agreement. The section containing the forbearances (§ 5.2) is prefaced by this qualification: “… except as set forth in this [sic] Section 5.2 of the Company Disclosure Schedule …, [the] Company shall not … without the prior written consent of [BofA]….” The disclosure schedule, as is customary, is not attached to the merger agreement that was distributed to BofA’s stockholders or otherwise made publicly available, and was not filed with the SEC.
One of the “forbearances” Merrill agreed to was that it would not pay any discretionary bonuses to its directors, officers, or employees. However, in the disclosure schedule Merrill disclosed, and BofA thereby consented to, the payment of discretionary bonuses for 2008 to Merrill’s officers and employees in an amount not to exceed $5.8 billion (further limited to an amount not to exceed an accounting expense of $4.5 billion (the difference due to timing differences required under GAAP)).
The proxy statement, in describing the terms of the merger agreement (ad nauseum), repeats the language of the merger agreement in its description of the “forbearances” agreed to by Merrill, but also does not disclose the contents of the disclosure schedule reflecting the parties’ understanding and agreement to the payment of bonuses not to exceed $5.8 billion.
This discrepancy constitutes the nub of the SEC’s complaint against BofA, as summarized by the Commission in its August 24th filing with the Court:
“Bank of America’s statement was materially false and misleading because it indicated to shareholders that Merrill would only make ‘required’ payments to its employees, such as salary and benefits, but would not pay discretionary year-end bonuses. In fact, Bank of America expressly had agreed to allow Merrill to pay up to $5.8 billion in discretionary year-end bonuses. A shareholder could not have known from reading the proxy statement that Bank of America had already authorized Merrill to do precisely that which the proxy statement indicated Merrill could not do, i.e., pay discretionary year-end bonuses. The statements in the merger agreement regarding the non-payment of bonuses were thus false and misleading without the information set forth in the omitted disclosure schedule.”
Commission’s Memorandum of August 24, 2009 (“SEC Memo”), at 20.
In support of the materiality of the Bank’s failure to disclose its agreement for the payment of up to $5.8 billion in year-end discretionary bonuses to Merrill’s employees, the Commission points to the fact that the $5.8 billion constituted nearly 12% of the $50 billion that the Bank agreed to pay to acquire Merrill and 30% of Merrill’s total stockholders’ equity. SEC Memo at 22.
B. How to Explain the Discrepancy Between the Negative Covenant on the Payment of Bonuses and the Agreement Reflected in the Disclosure Schedule
What was BofA’s explanation for the discrepancy? Answer: No answer.
“Lewis, Thain [Merrill’s CEO] and Fleming [Merrill’s President] were all asked by Commission staff why this information was set forth in a disclosure schedule as opposed to the text of the merger agreement itself, but none of them could provide an answer. According to Lewis, Thain, Fleming, Curl [BofA’s Vice Chairman for Corporate Planning and Strategy] and Stingi [BofA’s Global Head of Human Resources] that issue was determined by lawyers at Wachtell [BofA’s counsel], Shearman [Merrill’s counsel] and one or more of several lawyers who worked in Bank of America’s in-house legal department, ….”
SEC Memo at 11.
So why did the lawyers from these two distinguished firms (Wachtell and Shearman) not disclose the agreement as to the payment of year-end bonuses in the proxy statement? What discussions, if any, were held between the lawyers and BofA concerning such a disclosure? We don’t know because BofA asserted the attorney-client privilege with respect to all communications with counsel, and the Commission was powerless to compel the Bank to waive the attorney-client privilege in connection with its investigation:
“The evidence obtained by the Commission in its investigation established that the determination of whether to include the ‘disclosure’ schedule in the proxy statement or otherwise to disclose that Bank of America had authorized Merrill to pay up to $5.8 billion in year-end bonuses was either made by, or at least based on the advice of, in-house and outside counsel for Bank of America and Merrill. All the relevant witnesses stated that the written merger agreement, the ‘disclosure’ schedule, and the proxy statement were negotiated and prepared by counsel for the two companies. The witnesses also stated that they relied entirely on counsel to decide what was or was not disclosed in the proxy statement. The Commission found no evidence to the contrary. Nor did the Commission find any evidence of internal deliberations or discussions, aside from consultations with in-house counsel, concerning the disclosures at issue in this case. Bank of America has not waived the attorney-client privilege. As a result, the investigative record does not include any specific rationale as to why the disclosure schedule or its contents were not disclosed in the proxy statement.”
SEC Memo at 24-25 (footnote omitted).
C. The Use and Misuse of Disclosure Schedules
Disclosure schedules are critical in M&A transactions, as they are used to disclose exceptions and qualifications to a party’s representations and warranties. They are prepared with care because they protect a party from claims of breach of representations and warranties that are typically broad and unqualified. While the SEC’s disclosure rules require the filing of merger and like agreements, the rules permit the omission of disclosure schedules from filings made with the SEC, although with a caveat often overlooked:
“Schedules (or similar attachments) to these exhibits [merger agreements and the like] shall not be filed [with the SEC] unless such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document.”
Regulation S-K, Item 601(b)(2).
Regulation S-K further requires that the merger agreement that is filed contain a list “briefly” identifying the contents of all omitted schedules, together with an agreement to furnish supplementally a copy of the omitted schedule to the Commission upon its request.
Because schedules to merger agreements need not be filed with the Commission, it is tempting for parties to include in them information not strictly qualifying reps and warranties, side deals, and other miscellany. This case highlights one such example.
D. What Explains the Failure to Disclose the Agreement on Bonuses Set Forth in the Disclosure Schedule?
The short answer is that we don’t know, given the cloak of secrecy thrown over the question by BofA’s assertion of the attorney-client privilege. There are at least three possibilities:
(i) The parties, concerned over the reaction by BofA’s stockholders to any disclosure of the agreement on payment of year-end bonuses, deliberately buried their agreement on the payment of bonuses in the disclosure schedule;
(ii) The parties did not consider the agreement material and therefore concluded that no disclosure of it was necessary; or
(iii) The failure to disclose the agreement was a boot.
Given the nature of these parties and the competence and sophistication of their advisors, I regard the first possibility as remote, the second as unlikely, and the third entirely possible.
The context here is important. This deal, even by Wall Street standards, was a sprint. It was negotiated over a weekend, September 13-14, 2008, in the wake of Lehman Brothers’ rumored bankruptcy earlier that week, and inked on Monday, September 15. One can only imagine the intensity of the negotiations and the amount of work and coordination necessary to negotiate and draft the merger agreement and prepare the disclosure schedule. It would not be a surprise if the team in charge of the disclosure schedule was different from the team responsible for drafting the merger agreement and the team responsible for preparing the proxy statement. Mistakes in such a pressure cooker do happen.
E. Judge Rakoff’s Reaction to the Commission’s Explanation of Its Omission of Any Individuals from Its Complaint
Incredulity:
“This is puzzling. If the responsible officers of the Bank of America, in sworn testimony to the SEC, all stated that ‘they relied entirely on counsel,’ this would seem to be either a flat waiver of privilege or, if privilege is maintained, then entitled to no weight whatever, since the statement cannot be tested. …
"If the SEC is right in this assertion, it would seem that all a corporate officer who has produced a false proxy statement need offer by way of defense is that he or she relied on counsel, and, if the company does not waive the privilege, the assertion will never be tested, and the culpability of both the corporate officer and the company counsel will remain beyond scrutiny. This seems so at war with common sense that the Court will need to be shown more than a single, distinguishable case [John Doe v. United States, 350 F. 3d 299 (2d Cir. 2003)] to be convinced that it is, indeed, the law. It also leaves open the question of whether, if it was actually the lawyers who made the decisions that resulted in a false proxy statement, they should be held legally responsible.”
August 25th Order at 3-4.
The Judge’s puzzlement is understandable, but I think the SEC got it right, as long as we have an attorney-client privilege. The BofA officers who were involved in the negotiations with Merrill and the supervision of the documentation all testified, according to the SEC, that they could not explain why the agreement on bonuses set out on the disclosure schedule was not included in the merger agreement itself or in the proxy statement. And, as the Commission points out in its August 24th brief, the Commission found no other evidence associating any representative of BofA (other than counsel) with the proxy statement’s disclosures concerning the payment of bonuses. Given that proxy statements are not signed by any representative of the issuer (unlike registration statements), the Commission had to find some evidence of scienter or culpable participation by an officer to the challenged disclosures in the proxy statement to pursue that individual for a disclosure violation. And, with respect to counsel, to establish “aiding and abetting” exposure, the Commission must also establish knowing participation in the alleged material misstatements or omissions. Given the attorney-client privilege, and the absence of any other evidence tying individuals to the misleading disclosures in the BofA proxy statement, the Commission simply did not have the firepower to go after the officers of BofA or its counsel. And, given the severe criticism the Government has received for its efforts post-Enron to curb defendants’ reliance upon the attorney-client privilege (see, e.g., United States v. Stein, 541 F.3d 130 (2d Cir. 2008) (indictments dismissed against former partners and employees of KPMG, LLP for the Government’s actions depriving defendants of their right to counsel), and S. 445, the Attorney-Client Protection Act of 2009, 111th Cong. 1st Sess.) it was simply not in the cards for the Commission to lean on BofA to waive the privilege as to its communications with counsel.
___________________
In support of the settlement, BofA, in its August 24th submission to the Court, mounts a vigorous defense of the settlement, primarily by arguing that the SEC was lucky it got what it did because if the case were tried, BofA could defeat the charges. I will discuss BofA’s arguments, and the points made by its two experts, in a subsequent post.
The Commission filed its complaint and announced its settlement with BofA on the same day — August 3, 2009. The complaint names the Bank only, asserting that, by its October 31, 2008 proxy statement distributed to its stockholders in connection with the Bank’s proposed merger with Merrill Lynch & Co., Inc., the Bank had made materially false and misleading statements concerning its agreement with Merrill for the payment of year-end discretionary bonuses to Merrill’s officers and employees. By the settlement, the Bank agreed to a permanent injunction from violating Section 14(a) of the Exchange Act and the SEC’s Rule 14a-9 (both governing proxy statements), and agreed to pay a penalty of $33 million.
What clearly is troubling the Judge is the SEC’s failure to name in its complaint any of the Bank’s officers. As the Judge observes in his August 25th follow-up order, the burden of the payment of the penalty of $33 million will fall upon the stockholders of BofA (and possibly U.S. taxpayers, given the $45 billion that the Government has invested in the Bank and Merrill). And yet, observed the Judge, “the gravamen of the violation asserted in the [SEC’s August 3d] Complaint is that Bank of America, through its management, effectively lied to its own shareholders.” August 25th Order at 2. Quoting from the SEC’s own guidelines concerning the imposition of financial penalties, the Judge noted that the SEC’s historical position is that:
“Where shareholders have been victimized by the violative conduct, or by the resulting negative effect on the entity following its discovery, the Commission is expected to seek penalties from culpable individual offenders acting for the corporation.”
Id.
So why did the Commission not name Ken Lewis (BofA’s CEO) or any of the other senior officers of the Bank for the alleged false statements in the Bank’s proxy statement?
A. The Alleged False Statements
As is typical, the BofA/Merrill merger agreement contains a series of restrictions on the conduct of Merrill’s business between the date of signing (September 15, 2008) and the close of the merger. These restrictions, referred to as “forbearances,” numbered some 18 in the BofA/Merrill merger agreement. The section containing the forbearances (§ 5.2) is prefaced by this qualification: “… except as set forth in this [sic] Section 5.2 of the Company Disclosure Schedule …, [the] Company shall not … without the prior written consent of [BofA]….” The disclosure schedule, as is customary, is not attached to the merger agreement that was distributed to BofA’s stockholders or otherwise made publicly available, and was not filed with the SEC.
One of the “forbearances” Merrill agreed to was that it would not pay any discretionary bonuses to its directors, officers, or employees. However, in the disclosure schedule Merrill disclosed, and BofA thereby consented to, the payment of discretionary bonuses for 2008 to Merrill’s officers and employees in an amount not to exceed $5.8 billion (further limited to an amount not to exceed an accounting expense of $4.5 billion (the difference due to timing differences required under GAAP)).
The proxy statement, in describing the terms of the merger agreement (ad nauseum), repeats the language of the merger agreement in its description of the “forbearances” agreed to by Merrill, but also does not disclose the contents of the disclosure schedule reflecting the parties’ understanding and agreement to the payment of bonuses not to exceed $5.8 billion.
This discrepancy constitutes the nub of the SEC’s complaint against BofA, as summarized by the Commission in its August 24th filing with the Court:
“Bank of America’s statement was materially false and misleading because it indicated to shareholders that Merrill would only make ‘required’ payments to its employees, such as salary and benefits, but would not pay discretionary year-end bonuses. In fact, Bank of America expressly had agreed to allow Merrill to pay up to $5.8 billion in discretionary year-end bonuses. A shareholder could not have known from reading the proxy statement that Bank of America had already authorized Merrill to do precisely that which the proxy statement indicated Merrill could not do, i.e., pay discretionary year-end bonuses. The statements in the merger agreement regarding the non-payment of bonuses were thus false and misleading without the information set forth in the omitted disclosure schedule.”
Commission’s Memorandum of August 24, 2009 (“SEC Memo”), at 20.
In support of the materiality of the Bank’s failure to disclose its agreement for the payment of up to $5.8 billion in year-end discretionary bonuses to Merrill’s employees, the Commission points to the fact that the $5.8 billion constituted nearly 12% of the $50 billion that the Bank agreed to pay to acquire Merrill and 30% of Merrill’s total stockholders’ equity. SEC Memo at 22.
B. How to Explain the Discrepancy Between the Negative Covenant on the Payment of Bonuses and the Agreement Reflected in the Disclosure Schedule
What was BofA’s explanation for the discrepancy? Answer: No answer.
“Lewis, Thain [Merrill’s CEO] and Fleming [Merrill’s President] were all asked by Commission staff why this information was set forth in a disclosure schedule as opposed to the text of the merger agreement itself, but none of them could provide an answer. According to Lewis, Thain, Fleming, Curl [BofA’s Vice Chairman for Corporate Planning and Strategy] and Stingi [BofA’s Global Head of Human Resources] that issue was determined by lawyers at Wachtell [BofA’s counsel], Shearman [Merrill’s counsel] and one or more of several lawyers who worked in Bank of America’s in-house legal department, ….”
SEC Memo at 11.
So why did the lawyers from these two distinguished firms (Wachtell and Shearman) not disclose the agreement as to the payment of year-end bonuses in the proxy statement? What discussions, if any, were held between the lawyers and BofA concerning such a disclosure? We don’t know because BofA asserted the attorney-client privilege with respect to all communications with counsel, and the Commission was powerless to compel the Bank to waive the attorney-client privilege in connection with its investigation:
“The evidence obtained by the Commission in its investigation established that the determination of whether to include the ‘disclosure’ schedule in the proxy statement or otherwise to disclose that Bank of America had authorized Merrill to pay up to $5.8 billion in year-end bonuses was either made by, or at least based on the advice of, in-house and outside counsel for Bank of America and Merrill. All the relevant witnesses stated that the written merger agreement, the ‘disclosure’ schedule, and the proxy statement were negotiated and prepared by counsel for the two companies. The witnesses also stated that they relied entirely on counsel to decide what was or was not disclosed in the proxy statement. The Commission found no evidence to the contrary. Nor did the Commission find any evidence of internal deliberations or discussions, aside from consultations with in-house counsel, concerning the disclosures at issue in this case. Bank of America has not waived the attorney-client privilege. As a result, the investigative record does not include any specific rationale as to why the disclosure schedule or its contents were not disclosed in the proxy statement.”
SEC Memo at 24-25 (footnote omitted).
C. The Use and Misuse of Disclosure Schedules
Disclosure schedules are critical in M&A transactions, as they are used to disclose exceptions and qualifications to a party’s representations and warranties. They are prepared with care because they protect a party from claims of breach of representations and warranties that are typically broad and unqualified. While the SEC’s disclosure rules require the filing of merger and like agreements, the rules permit the omission of disclosure schedules from filings made with the SEC, although with a caveat often overlooked:
“Schedules (or similar attachments) to these exhibits [merger agreements and the like] shall not be filed [with the SEC] unless such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document.”
Regulation S-K, Item 601(b)(2).
Regulation S-K further requires that the merger agreement that is filed contain a list “briefly” identifying the contents of all omitted schedules, together with an agreement to furnish supplementally a copy of the omitted schedule to the Commission upon its request.
Because schedules to merger agreements need not be filed with the Commission, it is tempting for parties to include in them information not strictly qualifying reps and warranties, side deals, and other miscellany. This case highlights one such example.
D. What Explains the Failure to Disclose the Agreement on Bonuses Set Forth in the Disclosure Schedule?
The short answer is that we don’t know, given the cloak of secrecy thrown over the question by BofA’s assertion of the attorney-client privilege. There are at least three possibilities:
(i) The parties, concerned over the reaction by BofA’s stockholders to any disclosure of the agreement on payment of year-end bonuses, deliberately buried their agreement on the payment of bonuses in the disclosure schedule;
(ii) The parties did not consider the agreement material and therefore concluded that no disclosure of it was necessary; or
(iii) The failure to disclose the agreement was a boot.
Given the nature of these parties and the competence and sophistication of their advisors, I regard the first possibility as remote, the second as unlikely, and the third entirely possible.
The context here is important. This deal, even by Wall Street standards, was a sprint. It was negotiated over a weekend, September 13-14, 2008, in the wake of Lehman Brothers’ rumored bankruptcy earlier that week, and inked on Monday, September 15. One can only imagine the intensity of the negotiations and the amount of work and coordination necessary to negotiate and draft the merger agreement and prepare the disclosure schedule. It would not be a surprise if the team in charge of the disclosure schedule was different from the team responsible for drafting the merger agreement and the team responsible for preparing the proxy statement. Mistakes in such a pressure cooker do happen.
E. Judge Rakoff’s Reaction to the Commission’s Explanation of Its Omission of Any Individuals from Its Complaint
Incredulity:
“This is puzzling. If the responsible officers of the Bank of America, in sworn testimony to the SEC, all stated that ‘they relied entirely on counsel,’ this would seem to be either a flat waiver of privilege or, if privilege is maintained, then entitled to no weight whatever, since the statement cannot be tested. …
"If the SEC is right in this assertion, it would seem that all a corporate officer who has produced a false proxy statement need offer by way of defense is that he or she relied on counsel, and, if the company does not waive the privilege, the assertion will never be tested, and the culpability of both the corporate officer and the company counsel will remain beyond scrutiny. This seems so at war with common sense that the Court will need to be shown more than a single, distinguishable case [John Doe v. United States, 350 F. 3d 299 (2d Cir. 2003)] to be convinced that it is, indeed, the law. It also leaves open the question of whether, if it was actually the lawyers who made the decisions that resulted in a false proxy statement, they should be held legally responsible.”
August 25th Order at 3-4.
The Judge’s puzzlement is understandable, but I think the SEC got it right, as long as we have an attorney-client privilege. The BofA officers who were involved in the negotiations with Merrill and the supervision of the documentation all testified, according to the SEC, that they could not explain why the agreement on bonuses set out on the disclosure schedule was not included in the merger agreement itself or in the proxy statement. And, as the Commission points out in its August 24th brief, the Commission found no other evidence associating any representative of BofA (other than counsel) with the proxy statement’s disclosures concerning the payment of bonuses. Given that proxy statements are not signed by any representative of the issuer (unlike registration statements), the Commission had to find some evidence of scienter or culpable participation by an officer to the challenged disclosures in the proxy statement to pursue that individual for a disclosure violation. And, with respect to counsel, to establish “aiding and abetting” exposure, the Commission must also establish knowing participation in the alleged material misstatements or omissions. Given the attorney-client privilege, and the absence of any other evidence tying individuals to the misleading disclosures in the BofA proxy statement, the Commission simply did not have the firepower to go after the officers of BofA or its counsel. And, given the severe criticism the Government has received for its efforts post-Enron to curb defendants’ reliance upon the attorney-client privilege (see, e.g., United States v. Stein, 541 F.3d 130 (2d Cir. 2008) (indictments dismissed against former partners and employees of KPMG, LLP for the Government’s actions depriving defendants of their right to counsel), and S. 445, the Attorney-Client Protection Act of 2009, 111th Cong. 1st Sess.) it was simply not in the cards for the Commission to lean on BofA to waive the privilege as to its communications with counsel.
___________________
In support of the settlement, BofA, in its August 24th submission to the Court, mounts a vigorous defense of the settlement, primarily by arguing that the SEC was lucky it got what it did because if the case were tried, BofA could defeat the charges. I will discuss BofA’s arguments, and the points made by its two experts, in a subsequent post.
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