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.
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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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