On Friday, March 26, 2010, hedge funds managed by Pentwater Capital Management, L.P. (“Pentwater”) sought a temporary restraining order from Vice Chancellor Strine (i) restraining The Talbots, Inc. (“Talbots”) from closing a pending exchange offer made to the warrant holders of BPW Acquisition Corp. (“BPW”) and (ii) restraining BPW from proceeding with soliciting consents for amendments to the Warrant Agreement governing the outstanding BPW warrants. The Vice Chancellor rejected Pentwater’s application, concluding that Pentwater’s application should have been brought in New York, not Delaware, that its coercion and contract claims were not colorable, that it had not identified irreparable harm that it would suffer if the court failed to restrain Talbots and BPW, and that the balance of the equities weighed against granting any relief.
Talbots’ exchange offer — for 90% of the outstanding BPW warrants — was a condition to a pending merger of Talbots and BPW. The exchange offer crossed the requisite threshold on April 6 and the merger closed on April 7. Following its defeat at the hands of the Vice Chancellor on March 26th, Pentwater voluntarily dismissed its complaint.
The focus in this post is on the contractual claims asserted by Pentwater, including its claim for violation of the implied covenant of good faith and fair dealing inherent in all contracts. While the Vice Chancellor found Pentwater’s contractual claims not colorable, I think the better argument is that they have merit. (Full disclosure: I represented a group of hedge funds that had a position in the BPW warrants but, after Pentwater’s defeat, folded their tent and participated in the exchange offer.)
Pentwater pursued a risky strategy, namely, seeking to enjoin not only BPW’s consent solicitation but also Talbots’ exchange offer. It also confronted substantial questions as to its selection of venue (Delaware v. New York), the question of whether damages were an adequate remedy, and on the balance of the equities. Had these factors not been present, Pentwater’s contractual claims might very well have received a more receptive audience. Perhaps they may still be, by Pentwater (if it retained any BPW warrants) or by those holders of the BPW warrants who did not participate in the exchange offer.
A. Background
BPW was a poor man’s hedge fund, a so called “SPAC” or special purpose acquisition company. The idea of SPACs was to marry money with smart deal finders. The money was raised with no specific investment in mind, other than in a general industry. Once the smart guys found a good investment opportunity (and they had a limited amount of time to do so) they would present it to the shareholders of the SPAC for approval. If a sufficient number of the shareholders did not approve the acquisition, electing instead for a return of their cash, then the company would liquidate and return the offering proceeds (minus expenses) to the shareholders. Needless to say, with the Great Recession and its impact on hedge funds, the bloom is off SPACs.
BPW conducted its offering in February 2008, raising $350 million through the sale of 35 million units (“Units”), consisting of one share of BPW common stock and one warrant. The warrants were designed to trade separately from the common shortly. BPW was sponsored by Perella Weinberg Partners Acquisition LP (“Perella Weinberg”) and BNYH BPW Holdings, LLC (the investment vehicle of the Lerner family of New York). BPW was to focus on one or more deals in the financial services or business services industries but, of course, the prospectus, having been drafted by lawyers, allowed BPW to pick a deal with any business (the consummation of which would require shareholder approval).
The BPW warrants would not be exercisable unless and until BPW did a deal, and would be exercisable from and after that point until six years from the date of the IPO prospectus (or until February 26, 2014). The warrants were exercisable for one share of BPW common at $7.50 per share.
Talbots, the women’s apparel company, had been suffering from declining sales and heavy debt. Its Japanese majority shareholder and primary lender, AEON Co., Ltd. (“AEON”) was chafing. Talbots retained Perella Weinberg in early 2009 to advise it on refinancing its debt. In the fall of 2009, AEON notified Talbots that it wanted to divest its Talbots debt and its equity interest in Talbots. This, of course, meant that Talbots was in play, so Talbots broadened Perella Weinberg’s portfolio to include “alternative strategic transactions” as well as refinancing transactions that would address Talbots’ upcoming debt maturities.
Surprise! Perella Weinberg, at the instruction of Talbots’ audit committee, sought out several SPACs, including BPW, for a potential deal with Talbots, since SPACs had what Talbots needed — cash. BPW emerged as Talbots’ merger partner, no doubt in no small part because of Perella Weinberg’s sponsorship of BPW and continued significant influence over it (Joseph Perella himself served as Vice Chairman of the BPW board and other Perella officers served in BPW’s management, including Gary Barancik, BPW’s CEO and a partner of Perella Weinberg).
So Talbots and BPW entered into a merger agreement in December 2009 pursuant to which a wholly-owned subsidiary of Talbots would merge with and into BPW, with BPW as the surviving entity and a wholly-owned subsidiary of Talbots. (For reasons not entirely apparent, on April 6, the day before the merger closed, the parties amended the merger agreement to provide that, immediately following the merger, by a short-form merger, BPW would merge with and into Talbots.) Each BPW shareholder would receive Talbots’ shares, in accordance with a formula, designed to deliver to them Talbots’ shares with a value of approximately $11.25 (BPW’s Units were sold in its IPO at $10 per Unit). (As consummated, the exchange ratio was 0.9853 Talbots’ shares for each common share of BPW.)
What to do with the BPW warrants? The BPW warrants, if simply assumed by Talbots in a merger, would be dilutive to the shareholders of Talbots (a warrant with an exercise price of $7.50 is in-the-money for Talbots’ shares trading at $11.25) but the BPW warrant holders could be muscled since the warrants would expire worthless if BPW did not do a deal by its deal deadline — February 26, 2010 (which was extended by the shareholders of BPW to April 26, 2010 in connection with their approval of the Talbots merger). The upshot was a condition to Talbots’ obligation to proceed with the merger, namely, that at least 90% of the holders of the BPW warrants accept Talbots’ common shares or newly-issued Talbots’ warrants. The Talbots warrants would carry an exercise price greater than the $7.50 exercise price of the BPW warrants (adjusted for the exchange ratio of the Talbots/BPW shares in the merger) — the Talbots warrants were priced to be some 30% out-of-the-money based upon Talbots’ common share price used to determine the exchange ratio. Talbots launched its exchange offer to implement this condition to the merger on March 1, 2010, with the definitive version of the exchange offer prospectus dated March 11, 2010.
Talbots stated in the exchange offer prospectus that those BPW warrant holders who did not participate in the offer would “in accordance with the terms of the existing warrant agreement governing the BPW Warrants, be converted into warrants to purchase the number of shares of Talbots’ common stock that such warrant holder would have received in the merger had the BPW warrants been converted to shares of BPW common stock immediately prior to the completion of the merger.” Exchange Offer Prospectus at p. 46. So, based on an exchange ratio of 0.9853 share of Talbots’ common for each share of BPW’s common, BPW warrant holders who held their warrants would be able to purchase Talbots’ common at $7.61. The holders of such warrants, instead of being out-of-the-money by some 30% if they exchanged for Talbots’ warrants, would be in-the-money by some $3.64 (assuming a Talbots’ common price of $11.25). (Talbots closed on March 14 at $15.17.)
This presented an arbitrage opportunity — buy BPW warrants (perhaps combined with some short selling of Talbots’ common). Undergirding this strategy was the assumption that capturing BPW’s $350 million in cash was simply too attractive to Talbots and its majority shareholder, AEON, so that, when push came to shove, Talbots would waive the 90% condition, purchase whatever number of warrants were tendered into the exchange offer, and close the merger with BPW.
Clearly such arbitrage occurred, to the chagrin of Talbots and its advisors, so they come up with a strategy to “persuade” the holdouts to participate in the exchange offer.
B. The March 16 Consent Solicitation
Some two weeks after Talbots launched its exchange offer, BPW filed its preliminary proxy statement with the SEC seeking the consent of the BPW warrant holders for amendments to the Warrant Agreement. The amendments clearly were not in the interest of those warrant holders who had elected or would elect not to participate in the exchange offer, as they would (i) defer the exercise period of the BPW warrants for one year after consummation of the merger between Talbots and BPW, and (ii) remove all anti-dilution protection from the BPW Warrant Agreement for post-merger stock splits and like events involving Talbots’ common stock.
Why would any BPW warrant holder in his, her or its right mind consent to these proposed amendments? Answer: Those who had already tendered or who had decided to tender into the exchange offer, believing that Talbots meant it when it conditioned the BPW merger upon satisfaction of the condition that at least 90% of the BPW warrant holders participate in the exchange offer, or those who also owned BPW common stock and wanted the deal done as holders of BPW common, and/or hedge funds and institutional investors who responded to the entreaties of Perella Weinberg. Whatever their motivations, BPW announced, on March 25, that it had received (non-binding) statements of support for the proposed amendments from over 50% of the warrant holders, thereby virtually clinching its proposal to amend the Warrant Agreement and putting significant pressure on the holdouts to tender into the exchange offer.
C. Pentwater Objects
Pentwater was one of the holdouts. It filed suit in Delaware Chancery Court objecting to the consent solicitation, claiming it was coercive and a violation of the Warrant Agreement and BPW’s implied covenant of good faith and fair dealing, inherent in all contracts. At least in hindsight, Pentwater’s decision to seek immediate injunctive relief, including an order enjoining consummation of the exchange offer (scheduled to expire the evening of the hearing) was a mistake. BPW’s able counsel (Wachtell Lipton & Morris Nichols) set the stage well in their brief (prepared in some 24 hours) opposing Pentwater’s application for a TRO:
“Plaintiffs are a group of hedge funds and warrantholders of BPW who seek to extract hold-up value by blocking the proposed merger of BPW and Talbots . . . .
Plaintiffs . . . recently accumulated about 9% of the outstanding BPW warrants. Plaintiffs have explicitly stated that they intend to hold their warrants out from the Exchange Offer. If plaintiffs follow through on that threat and are joined by holders of a relatively small number of additional warrants, then all 35 million public BPW warrants, including plaintiffs’ 3.3 million warrants, will expire worthless. Of course, plaintiffs do not seek that economically irrational result. What plaintiffs want instead is to walk away with a better deal than the other warrantholders — to capture for themselves all ten percent of the warrants that need not be exchanged and to extract still further benefits. As a result, plaintiffs are now playing a game of ‘chicken,’ in which they risk to drive the entire body of warrantholders over the cliff. To use the more familiar law-and-economics metaphor, the case presents a ‘hold up’ problem, in which a single resisting investor seeks to take a value-maximizing deal hostage in order to extract end-gain benefits for itself.”
Defendants’ Corrected Opposition, dated March 25, 2010 (“Opposition”) at pages 1, 3.
To further isolate Pentwater, counsel advised the court that if the merger were to fall apart, “BPW will liquidate according to the terms of its charter on April 26 and Talbots may well be doomed to bankruptcy.” Id. at 2.
It was downhill from there for Pentwater, whose counsel, John Reed of Edwards Angell Plummer & Dodge LLP, faced a decidedly skeptical audience for his claims in Vice Chancellor Strine.
But Pentwater’s contractual claims, and one other that it did not raise, are, to this commentator, persuasive. So let me now address these.
D. The Minority Protection Provisions of BPW’s Warrant Agreement
The BPW Warrant Agreement is amendable by the holders of warrants exercisable for a majority of BPW’s common shares subject to the outstanding warrants. But the amendment provision of the Warrant Agreement (Section 18) does not stop there. It states that approval must be obtained by a majority of the holders whose warrants “would be affected by such amendment; . . .” (emphasis added.)
What can this limitation mean? It must mean, at a minimum, that not all amendments to the Warrant Agreement are subject to approval by a majority in interest of all warrant holders. The question is how to separate those warrant holders who would be “affected” by a proposed amendment and those who would not. Black’s Law Dictionary (8th edition) defines “affect” as “[m]ost generally to produce an effect on; to influence in some way.”
BPW launched its consent solicitation, seeking approval of the warrant holders to amend the Warrant Agreement, after Talbots commenced its exchange offer (on March 1): How would the warrants of warrant holders who had tendered their warrants to Talbots be “affected” by any amendment of the Warrant Agreement? As warrant holders, tendering warrant holders no longer had any interest in the old warrants, so arguably they could not be “affected” by any amendment of the Warrant Agreement (the consent solicitation was conditional upon occurrence of the merger, so no amendments would be made to the Warrant Agreement if the Talbots/BPW deal fell apart.)
Should the word “adversely” be read into “affected” by the amendment? Assume only two warrant holders, one whose surname begins with the letter “A” and a second whose surname begins with the letter “B.” Assume A owns a majority of the outstanding warrants. What an amendment that deferred the exercise period of the warrants of all warrant holders whose surname begins with a “B” by one year (but adding a year of exercise to the back-end of the warrant exercise period) be valid if approved by “A”?
It strikes this observer that a good argument can be made, based solely on the text of the BPW Warrant Agreement requiring approval for amendments from a majority in interest of those warrant holders “affected” by the amendment, that the BPW warrant holders who tendered into the Talbots exchange offer were not within that class of warrant holders “affected” by the proposed amendments and that therefore the proposed amendments to the BPW Warrant Agreement should only have been decided by the warrant holders who elected not to tender, since they were the only warrant holders, qua warrant holders, who would be affected by the proposed amendments.
Vice Chancellor Strine himself, during the hearing on March 26th on Pentwater’s application for a TRO, highlighted this very issue, although not in the context of an argument that this observer makes here (since Pentwater did not make the argument):
“. . . I guess what they’re saying [Pentwater’s counsel] is, that people are voting [on the amendments to the Warrant Agreement] without any interest in being subject themselves to the contractual change that they’re making.”
Transcript at 60:5-8.
Pentwater did not make the “affected” argument, perhaps because it would not have supported a TRO, but, to this observer, the argument is a good one, and, if made, would have focused the court’s attention on the fact that, by the very provisions of Section 18 of the Warrant Agreement, governing amendments, not all BPW warrant holders are to vote on all proposed amendments to the Warrant Agreement.
But there is more. Section 18 of the BPW Warrant Agreement prohibits any amendment without the consent of the “affected” warrant holders that would, among other things, “reduce” the warrant exercise period or “reduce” the number of BPW common shares issuable upon exercise of a warrant.
Under the Warrant Agreement, the exercise period of the BPW warrants was to commence upon the consummation of any deal and terminate on the earlier of February 26, 2014 or any earlier redemption of the warrants. (The BPW warrants were redeemable at $0.01 per warrant (thus forcing exercise of the warrants) when the share price of BPW’s common equaled or exceeded $13.25 per share for 20 trading days.)
BPW proposed, by its amendments to the Warrant Agreement, to delay the warrant exercise period for 12 months and to add a year to the back-end of the warrant exercise period, thus preserving the length of the warrant exercise period. So, naturally, it argued before Vice Chancellor Strine that there had been no “reduction” in the length of the warrant exercise period, citing the definition of “reduce” in Merriam Webster’s Collegiate Dictionary, as meaning “to diminish in size, amount, extent, or number.” Opposition Brief at 14.
Pentwater responded by arguing that “to remove a particular year from a defined term of years is to ‘reduce’ or ‘diminish’ that term of years by one year.” Pentwater’s Reply Brief at 3. Moreover, as Pentwater noted, BPW’s position would lead to the absurd conclusion that it could have proposed amending the warrant exercise period to delay its commencement for several decades and not, under this interpretation of reduction, run afoul of Section 18 of the Warrant Agreement.
Neither BPW’s counsel nor Vice Chancellor Strine addressed this “reductio ad absurdum” claim, but it should have been addressed. An interpretation of “reduce” in Section 18 of the Warrant Agreement is not tenable if it does not foreclose the possibility that a delay in the warrant exercise period for years (as long as coupled with an extension of the back-end of the warrant exercise period by a like amount) would be permitted by Section 18. The only way to eliminate this absurd possibility is to define reduce by reference to the back-end of the warrant exercise period, namely, that “reduce” should refer to any shortening of the termination date to a date earlier than February 26, 2014.
One reply might be that the condition that amendments be approved by a majority in interest of the warrant holders is sufficient protection against amendments that would lead to an absurd result such as that posited by Pentwater, e.g., a delay in the warrant exercise period for decades. But then that confronts the provision of Section 18 of the Warrant Agreement that stipulates that only “affected” warrant holders are to vote on proposed amendments — a “majority” of the warrant holders who are not affected by a proposed amendment should not be permitted to vote on the amendment. In the above example of “A” and “B,” just as “A” should not be allowed to vote on an amendment that would further its interest at the expense of “B,” so those warrant holders who tendered into the Talbots exchange offer should not have been permitted to vote on an amendment that would have absolutely no effect on them, as warrant holders.
Similarly, it strikes this observer that Pentwater had the better argument that Section 18’s prohibition on amendments that would reduce the number of shares issuable upon exercise of the BPW warrants prohibited BPW’s proposed elimination of the anti-dilution protections of Section 11 of the Warrant Agreement. BPW argued that any amendments to Section 11 were not within the scope of Section 18’s protective provisions: “Nothing in section 18 of the Warrant Agreement prevents modification of the anti-dilution provisions in section 11.” Opposition at 15.
That may be true, but it should be irrelevant. Any amendment that would reduce the number of shares issuable upon exercise of the BPW warrants should fall within the scope of the protective provisions of Section 18 whether by amendment to Section 11 of the Warrant Agreement or to any other provision of the Warrant Agreement. BPW made clear in its consent solicitation that the effect of removing anti-dilution protection from the BPW Warrant Agreement would be to permit, among other things, stock splits of the common stock of Talbots (into which warrants not tendered to Talbots would be exercisable after the completion of the merger) with “no corresponding increase to the number of shares . . . issuable on exercise of unexchanged BPW Warrants . . .” Consent Solicitation Statement, dated March 16, 2010, Barancik’s cover letter, page 1.
E. BPW’s Alleged Violation of the Covenant of Good Faith and Fair Dealing
Pentwater asserted in its complaint that the proposed amendments to the Warrant Agreement not only breached its explicit terms but also BPW’s implied covenant of good faith and fair dealing, inherent in all contracts. By proposing to reduce the warrant exercise period and the number of shares issuable upon exercise of the warrants, without the consent of all “affected” warrant holders, BPW would be frustrating the “reasonable commercial expectations” of the warrant holders and the intended purpose of the Warrant Agreement. In support of its assertion, Pentwater pointed to, among other provisions, Section 11(g) of the Warrant Agreement. This provision, the last subsection of Section 11 of the Warrant Agreement addressing the circumstances in which adjustments to the terms of the warrants were to be adjusted to protect the warrant holders, states:
“(g) Other Events. If any event occurs as to which the foregoing provisions of this Section 11 are not strictly applicable or, if strictly applicable, would not, in the good faith judgment of the Board, fairly and adequately protect the purchase rights of the registered holders of the Warrants in accordance with the essential intent and principles of such provisions, then the Board shall make such adjustments in the application of such provisions, in accordance with such essential intent and principles, as shall be reasonably necessary, in the good faith opinion of the Board, to protect such purchase rights as aforesaid and shall give written notice to the Warrant Agent [Mellon Investor Services LLC] with respect to such determinations.”
(Emphasis added.)
Talbots and BPW, in their opposition to Pentwater’s application for a TRO, mocked Pentwater’s covenant claims as the “last refuge of the contractually unprotected,” Opposition at 5, asserting that, since Pentwater’s claims did not fit within the “narrow language” of Section 18 requiring individual warrant holder consent for amendments to the Agreement, Pentwater was seeking to “re-write” the Warrant Agreement. Opposition at 16-17.
The Warrant Agreement is governed by New York law, and BPW heavily relied upon the New York Court of Appeals’ (New York’s highest court) decision in Reiss v. Financial Performance Corp., 97 N.Y.2d 195, 64 N.E.2d 958 (2001) in support of its position. Reiss involved an objection by an issuer to the attempted exercise of warrants following the issuer’s one-for-five reverse stock split. Unfortunately for the issuer, the warrant agreement did not provide for any adjustment in the number of shares issuable upon exercise of the warrants upon a reverse (or forward) stock split; the reverse stock split therefore made the warrants more valuable. Making matters more difficult for the issuer, it had, before entering into the warrant agreement in question, issued a warrant with provisions addressing stock splits.
The New York Court of Appeals essentially concluded that the issuer had made its bed and now must lie in it. An omission or mistake, observed the Court, “does not constitute an ambiguity,” and courts may not, by construction, “add or excise terms,” or “make a new contract for the parties under the guise of interpreting the writing . . . .” 97 N.Y.2d at 199.
But Reiss is not the solid foundation BPW cites it to be. Somewhat surprisingly, the New York Court of Appeals observed, at the end of its decision, that, had the tables been reversed, and the warrant holder were before the court objecting to a forward stock split, the warrant holder might be entitled to a remedy “if Financial [the issuer] performed a forward stock split, on the theory that he [the warrant holder] ‘did not intend to acquire nothing.’” Reiss, 97 N.Y.2d at 201. “We should not assume,” observed the Court, “that one party intended to be placed at the mercy of the other . . . .” Id.
Delaware most recently articulated the content of the implied covenant of good faith and fair dealing in the Supreme Court’s April 6, 2010 decision in Nemec v. Shrader, 2010 WL 1320918, a 3-2 decision affirming Chancellor Chandler’s rejection of a covenant claim brought by two former stockholders of Booz Allen. As explained by the majority of the Supreme Court:
“The implied covenant of good faith and fair dealing involves a ‘cautious enterprise,’ inferring contractual terms to handle developments or contractual gaps that the asserting party pleads neither party anticipated. ‘[O]ne generally cannot base a claim for breach of the implied covenant on conduct authorized by the agreement.’ We will only imply contract terms when the party asserting the implied covenant proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected. When conducting this analysis, we must assess the parties’ reasonable expectations at the time of contracting and not rewrite the contract to appease a party who later wishes to rewrite a contract he now believes to have been a bad deal. Parties have a right to enter into good and bad contracts, the law enforces both.”
Slip Opinion at 10 (footnotes and citation omitted).
The best guidance on Pentwater’s covenant claim is that provided by one of the most celebrated jurists who have sat on the Delaware Chancery Court, Chancellor Allen, in his decision in Katz v. Oak Industries Inc., 508 A.2d 873 (Del. Ch. 1986). The facts of Katz were similar to those challenged by Pentwater: Oak Industries, in financial distress, proposed an exchange offer to its debt holders offering to exchange outstanding debentures for newly-issued notes, stock and warrants. At the same time, Oak arranged the sale of one of its businesses to Allied Signal and an equity investment by Allied Signal, contingent upon successful completion of the exchange offer.
Those noteholders who wish to participate in the exchange offer were required, as a condition to the exchange, to consent to amendments to the underlying indentures that would remove many of Oak’s financial covenants. Katz, a holdout, objected to this feature of the exchange offer as coercive, a violation of the contractual provisions of the indentures, and a violation of the implied covenant of good faith and fair dealing.
In his analysis, Chancellor Allen viewed the dispute as one of contract, not as a question of fairness or breach of fiduciary duty: “The terms of the contractual relationship agreed to and not broad concepts such as fairness define the corporation’s obligations to its bondholders.” 508 A.2d at 879 (footnote omitted). (The same test applies to relations between an issuer and holders of its outstanding warrants and options.)
Moreover, that the Oak board proposed the exchange offer to benefit Oak’s common stockholders at the possible expense of its bondholders “does not itself appear to allege a cognizable legal wrong.”
“It is the obligation of directors to attempt, within the law, to maximize the long-run interests of the corporation’s stockholders; that they may sometimes do so ‘at the expense’ of others . . . does not for that reason constitute a breach of duty.”
508 A.2d at 879.
In addressing Katz’s allegations of “coercion,” Chancellor Allen tied the concept to the specific allegations of breach of contract made by Katz and not to any stand alone concept of “coercion,” that is to say, the “relevant legal norm that will support the judgment whether such ‘coercion’ is wrongful or not will . . . be derived from the law of contacts.” Id. at 880.
Chancellor Allen viewed the implied covenant as follows:
“Modern contract law has generally recognized an implied covenant to the effect that each party to a contract will act with good faith towards the other with respect to the subject matter of the contract.”
For him, the appropriate legal test was the following:
“ . . . is it clear from what was expressly agreed upon that the parties who negotiated the express terms of the contract would have agreed to proscribe the act later complained of as a breach of the implied covenant of good faith — had they thought to negotiate with respect to the matter. If the answer to this question is yes, then, in my opinion, a court is justified in concluding that such act constitutes a breach of the implied covenant of good faith.”
508 A.2d at 880.
If this is the test, it is hard to see how it would not apply to a claim by a BPW warrant holder who did not participate in the Talbots exchange offer that delaying by one year the commencement of his or her warrant exercise period or eliminating the anti-dilution protections of the BPW Warrant Agreement, without that warrant holder’s consent, is not a breach of the covenant. The whole purpose of the BPW warrants, which were designed to trade separately from BPW’s common stock, was to grant the warrant holders an upside kicker once BPW did a deal. To delay the exercise period for one year is fundamentally at odds with the investment appeal of the warrants in the first place. It is hardly conceivable that any rational warrant holder would have agreed to such provision back in February 2008 when the warrants were issued. The same argument holds true for the amendment eliminating anti-dilution protections.
F. The Stronger Case
Pentwater’s challenge to BPW’s consent solicitation was weighted with too much baggage to succeed. In seeking a TRO enjoining not only the consent solicitation but Talbots’ exchange offer, Pentwater sought to hold up a merger that had been approved by the shareholders of both Talbots and BPW. Had Pentwater had the courage of its convictions (and a lot of money to spend on litigation), it would have voted against the consent solicitation, awaited the merger’s close, and then sued for contractual damages. Since Pentwater, like all hedge funds, is in the business of making money and not litigating, it would be entirely understandable if, having suffered defeat at the hands of Vice Chancellor Strine, it tendered into Talbots’ exchange offer and moved on.
But not all warrant holders did so. That may well be explained by inertia, uninformed warrant holders, etc. But any warrant holder who might challenge the amendments approved by (a bare majority) of the warrant holders would have a stronger case than Pentwater, since that case would focus solely on the contractual provisions of the Warrant Agreement and the covenant of good faith and fair dealing.
Otherwise, the lessons for hedge funds and arbitrageurs seeking to exploit opportunities involving warrants is clear: buyer beware.
Thursday, April 15, 2010
Wednesday, March 10, 2010
Selectica, Inc. v. Versata Enterprises, Inc.: The Court's Treatment of Director Independence & the Preclusivity of Defensive Measures
In my post of March 4 I noted that Vice Chancellor Noble addressed certain important doctrinal issues that I passed on to address how Trilogy’s negotiating posture with Selectica heavily influenced the Vice Chancellor’s decision to affirm the Selectica board’s adoption and triggering of a NOL pill. In this post I address two of those other issues addressed by Vice Chancellor Noble.
A. “Inside” Directors Treated as Independent
The Vice Chancellor had to review the Selectica board’s actions in light of the Unocal standard that applies enhanced scrutiny to a defensive measure adopted to thwart or impede a takeover to ensure that the action is motivated by a good faith concern for the welfare of the corporation and its stockholders and to ensure that the board did not act solely or primarily out of the desire to perpetuate themselves in office. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985). A board must also demonstrate that its defensive response was reasonable in relation to the threat posed. As clarified by the Court in Unitrin, a defensive measure is disproportionate, or unreasonable, if it is either “coercive” or “preclusive.” Unitrin, Inc. v. American General Corp., 651 A.2d 1361, 1387 (Del. 1995).
A board’s conduct is viewed more favorably by the Delaware courts if the defensive actions are taken by a majority of independent directors. So the initial fight before Vice Chancellor Noble between Selectica and Trilogy was over the independence of the four directors sitting on the Selectica board that adopted and triggered the NOL poison pill. The Vice Chancellor’s treatment of two of them attracted my attention. Directors Zawatski and Thanos both were appointed Co-Chairs of the board in August 2008 after the board terminated the CEO and elected not to replace him. (After August 19, 2009, Zawatski became the sole Chair of the board and “continued to handle the Company’s daily operations.” Slip Opinion at 5, note 10.)
Delaware law distinguishes between an “outside” director and an “independent” director. An outside director is a non-employee and a non-management director who receives no income other than usual directors’ fees. Slip Opinion at 35. Delaware applies a subjective person standard, however, in considering the question of director independence, examining the relevant facts to determine whether the director is one whose decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences, and whether the director is dominated or otherwise controlled by an individual or entity interested in the transaction.
There is little question that Zawatski and Thanos did not qualify as “outside” directors under either Delaware law or the applicable standards of the SEC and the stock exchanges. As Co-Chairs of the board, they performed duties comparable to those of the CEO, a disqualification by itself under the independence standards of the SEC and the exchanges. Moreover, while each claimed their compensation was not material to them, as Co-Chairs Thanos was paid $164,125 and Zawatski $274,273 in addition to their compensation as directors, another basis for disqualifying them as independent under SEC and stock exchange standards.
Nevertheless, Vice Chancellor Noble concluded that each, based on the record before him, were independent. As he noted:
“Both Thanos and Zawatski were retired and took on the Co-Chair position following successful careers in the private sector. Both serve on multiple boards and both have testified that the income they receive in these roles is not personally material to them, and that they hope to be able to resign these positions in the near term.”
Slip Opinion at 39 (footnote omitted).
While the Vice Chancellor could not conclude that Selectica’s board’s actions in adopting and triggering the NOL poison pill against Trilogy were entitled to “material enhancement” by reason of the independence of the board, in effect he granted the board that presumption, clearly influenced by their conduct in the situation the board found itself following the CEO’s termination. He rejected as groundless the concern that the board’s actions stemmed from a desire for entrenchment. As he noted:
“Both Zawatski and Thanos had previously been outside directors before taking over management duties and had only temporarily assumed these duties in lieu of hiring a new CEO in anticipation of the Company’s proximate sale. Further, one may readily presume that, given the financial plight of the Company, attracting additional independent and qualified directors might be difficult.”
Id. at 40.
B. Did Selectica’s Five Percent Trigger Make Its NOL Pill Preclusive?
The second topic of interest in Vice Chancellor Noble’s application of Unocal to Selectica’s board’s adoption and triggering of its NOL pill is his treatment of Trilogy’s claim that adoption of the pill was unreasonable because it was “preclusive.” A defensive measure is preclusive under Delaware law where it operates to unreasonably preclude a takeover or precludes effective stockholder action, including where a measure makes a bidder’s ability to wage a successful proxy contest and gain control either mathematically impossible or realistically unattainable. Slip Opinion at 54.
The Vice Chancellor’s treatment of Trilogy’s claim of preclusion makes clear that defensive measures must be extreme before they will be invalidated by the Delaware courts. Defensive measures that make it more difficult for an acquirer to obtain control of a board are not preclusive; preclusive measures are those that are “insurmountable” or “impossible to outflank.” Id. at 55, citing tionIn re Gaylord Container Corporation Shareholders Litigation, 753 A.2d 462, 481-482 (Del. Ch. 2000). Trilogy’s primary claim of preclusivity focused on the NOL trigger — 4.99% of Selectica’s outstanding common shares. Trilogy argued that this low trigger “renders the possibility of an effective proxy contest realistically unattainable.” Slip Opinion at 56. With such a low trigger, argued Trilogy, a challenger could not establish a sufficient foothold in the securities of the target to establish a credible threat to incumbent management. Moreover, the low trigger combined with a staggered board (such as characterized the Selectica board), further rendered a potential takeover unrealistic since a proxy contest would have to be sustained over multiple years to gain control of the board.
Selectica effectively countered by pointing to the adoption by more than 50 publicly-held companies of NOL pills with triggers of roughly 5%, and to some 15 proxy contests occurring over a three-year period where the challenger controlled less than 5.49% of the outstanding shares, with the challenger successfully obtaining board seats in ten of such contests, including five involving companies with classified boards.
Vice Chancellor Noble granted Trilogy the point that the low trigger of a NOL poison pill “has a substantial preclusive effect,” Slip Opinion at 59, but concluded that the effects were not “draconian,” and therefore not preclusive under the Unocal/Unitrin standards:
“It is not enough that a defensive measure would make proxy contests more difficult — even considerably more difficult. To find a measure preclusive (and avoid the reasonableness inquiry altogether), the measure must render a successful proxy contest a near impossibility or else utterly moot, given the specific facts at hand.”
Slip Opinion at 60 (footnote omitted).
What are examples of preclusive defensive measures? Vice Chancellor Noble cites two examples, those condemned by the Delaware Supreme Court in Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003) — a no-shop, submit the agreement to the stockholders even if the board changes its recommendation, and shareholder lock-ups of more than 50% of the outstanding shares — and that condemned by Vice Chancellor Jacobs in Carmody v. Toll Brothers, Inc., 723 A.2d 1180 (Del. Ch. 1998) where the Vice Chancellor found the adoption of a “dead-hand” poison pill preclusive (the pill in Carmody could only be redeemed by the directors who adopted it or their designated successors).
The question that naturally arises from Vice Chancellor Noble’s conclusion on preclusion is whether a creative board could justify a 5% or so trigger for reasons other than preserving NOLs. If it can, then Selectica is authority for the proposition that a low-trigger pill, even when adopted by a board with staggered terms, will not be considered preclusive under Delaware law.
A. “Inside” Directors Treated as Independent
The Vice Chancellor had to review the Selectica board’s actions in light of the Unocal standard that applies enhanced scrutiny to a defensive measure adopted to thwart or impede a takeover to ensure that the action is motivated by a good faith concern for the welfare of the corporation and its stockholders and to ensure that the board did not act solely or primarily out of the desire to perpetuate themselves in office. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985). A board must also demonstrate that its defensive response was reasonable in relation to the threat posed. As clarified by the Court in Unitrin, a defensive measure is disproportionate, or unreasonable, if it is either “coercive” or “preclusive.” Unitrin, Inc. v. American General Corp., 651 A.2d 1361, 1387 (Del. 1995).
A board’s conduct is viewed more favorably by the Delaware courts if the defensive actions are taken by a majority of independent directors. So the initial fight before Vice Chancellor Noble between Selectica and Trilogy was over the independence of the four directors sitting on the Selectica board that adopted and triggered the NOL poison pill. The Vice Chancellor’s treatment of two of them attracted my attention. Directors Zawatski and Thanos both were appointed Co-Chairs of the board in August 2008 after the board terminated the CEO and elected not to replace him. (After August 19, 2009, Zawatski became the sole Chair of the board and “continued to handle the Company’s daily operations.” Slip Opinion at 5, note 10.)
Delaware law distinguishes between an “outside” director and an “independent” director. An outside director is a non-employee and a non-management director who receives no income other than usual directors’ fees. Slip Opinion at 35. Delaware applies a subjective person standard, however, in considering the question of director independence, examining the relevant facts to determine whether the director is one whose decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences, and whether the director is dominated or otherwise controlled by an individual or entity interested in the transaction.
There is little question that Zawatski and Thanos did not qualify as “outside” directors under either Delaware law or the applicable standards of the SEC and the stock exchanges. As Co-Chairs of the board, they performed duties comparable to those of the CEO, a disqualification by itself under the independence standards of the SEC and the exchanges. Moreover, while each claimed their compensation was not material to them, as Co-Chairs Thanos was paid $164,125 and Zawatski $274,273 in addition to their compensation as directors, another basis for disqualifying them as independent under SEC and stock exchange standards.
Nevertheless, Vice Chancellor Noble concluded that each, based on the record before him, were independent. As he noted:
“Both Thanos and Zawatski were retired and took on the Co-Chair position following successful careers in the private sector. Both serve on multiple boards and both have testified that the income they receive in these roles is not personally material to them, and that they hope to be able to resign these positions in the near term.”
Slip Opinion at 39 (footnote omitted).
While the Vice Chancellor could not conclude that Selectica’s board’s actions in adopting and triggering the NOL poison pill against Trilogy were entitled to “material enhancement” by reason of the independence of the board, in effect he granted the board that presumption, clearly influenced by their conduct in the situation the board found itself following the CEO’s termination. He rejected as groundless the concern that the board’s actions stemmed from a desire for entrenchment. As he noted:
“Both Zawatski and Thanos had previously been outside directors before taking over management duties and had only temporarily assumed these duties in lieu of hiring a new CEO in anticipation of the Company’s proximate sale. Further, one may readily presume that, given the financial plight of the Company, attracting additional independent and qualified directors might be difficult.”
Id. at 40.
B. Did Selectica’s Five Percent Trigger Make Its NOL Pill Preclusive?
The second topic of interest in Vice Chancellor Noble’s application of Unocal to Selectica’s board’s adoption and triggering of its NOL pill is his treatment of Trilogy’s claim that adoption of the pill was unreasonable because it was “preclusive.” A defensive measure is preclusive under Delaware law where it operates to unreasonably preclude a takeover or precludes effective stockholder action, including where a measure makes a bidder’s ability to wage a successful proxy contest and gain control either mathematically impossible or realistically unattainable. Slip Opinion at 54.
The Vice Chancellor’s treatment of Trilogy’s claim of preclusion makes clear that defensive measures must be extreme before they will be invalidated by the Delaware courts. Defensive measures that make it more difficult for an acquirer to obtain control of a board are not preclusive; preclusive measures are those that are “insurmountable” or “impossible to outflank.” Id. at 55, citing tionIn re Gaylord Container Corporation Shareholders Litigation, 753 A.2d 462, 481-482 (Del. Ch. 2000). Trilogy’s primary claim of preclusivity focused on the NOL trigger — 4.99% of Selectica’s outstanding common shares. Trilogy argued that this low trigger “renders the possibility of an effective proxy contest realistically unattainable.” Slip Opinion at 56. With such a low trigger, argued Trilogy, a challenger could not establish a sufficient foothold in the securities of the target to establish a credible threat to incumbent management. Moreover, the low trigger combined with a staggered board (such as characterized the Selectica board), further rendered a potential takeover unrealistic since a proxy contest would have to be sustained over multiple years to gain control of the board.
Selectica effectively countered by pointing to the adoption by more than 50 publicly-held companies of NOL pills with triggers of roughly 5%, and to some 15 proxy contests occurring over a three-year period where the challenger controlled less than 5.49% of the outstanding shares, with the challenger successfully obtaining board seats in ten of such contests, including five involving companies with classified boards.
Vice Chancellor Noble granted Trilogy the point that the low trigger of a NOL poison pill “has a substantial preclusive effect,” Slip Opinion at 59, but concluded that the effects were not “draconian,” and therefore not preclusive under the Unocal/Unitrin standards:
“It is not enough that a defensive measure would make proxy contests more difficult — even considerably more difficult. To find a measure preclusive (and avoid the reasonableness inquiry altogether), the measure must render a successful proxy contest a near impossibility or else utterly moot, given the specific facts at hand.”
Slip Opinion at 60 (footnote omitted).
What are examples of preclusive defensive measures? Vice Chancellor Noble cites two examples, those condemned by the Delaware Supreme Court in Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003) — a no-shop, submit the agreement to the stockholders even if the board changes its recommendation, and shareholder lock-ups of more than 50% of the outstanding shares — and that condemned by Vice Chancellor Jacobs in Carmody v. Toll Brothers, Inc., 723 A.2d 1180 (Del. Ch. 1998) where the Vice Chancellor found the adoption of a “dead-hand” poison pill preclusive (the pill in Carmody could only be redeemed by the directors who adopted it or their designated successors).
The question that naturally arises from Vice Chancellor Noble’s conclusion on preclusion is whether a creative board could justify a 5% or so trigger for reasons other than preserving NOLs. If it can, then Selectica is authority for the proposition that a low-trigger pill, even when adopted by a board with staggered terms, will not be considered preclusive under Delaware law.
Thursday, March 4, 2010
Selectica, Inc. v. Versata Enterprises, Inc.: Delaware Chancery Court Upholds Trigger of Poison Pill
This case has already gotten lots of attention, as the first instance of the triggering of a poison pill. In his decision of February 26, 2010, 2010 WL 703062, Vice Chancellor Noble concluded that Selectica’s board acted reasonably in adopting a low-threshold (4.99%) poison pill to protect the company’s NOL. His careful decision illustrates why participants in contests for control should always ask themselves “how will this look before the Delaware Chancery Court?”
A. Bad Blood Between Selectica and Trilogy, Inc.
Both Selectica and Trilogy, Inc. provide enterprise software solutions for contract management and sales configuration systems, whatever that means. Trilogy, a private company, is controlled by Joseph Liemandt, its founder and over 85% stockholder. Trilogy had been successful in two patent infringement lawsuits against Selectica, securing a judgment in one of $7.5 million and a settlement in the other of up to $17.5 million, of which some $7.5 million was deferred. Trilogy had also made several unsuccessful runs at acquiring Selectica, which Selectica’s board rebuffed. By the end of 2006, Trilogy had disposed of its Selectica shares.
B. Selectica’s NOL
Since Selectica went public in March 2000, it had never turned a profit. By the time of the dispute before Vice Chancellor Noble in the spring of 2009, it was trading below $1 per share, and it had incurred operating losses of some $160 million. Fewer than 25 investors held some two-thirds of its outstanding stock.
Selectica’s NOL drew the attention of Steel Partners, a private equity fund specializing in smaller cap companies. Steel Partners saw an opportunity in marrying Selectica with a profitable company to exploit Selectica’s NOL. As a result of pressure from Steel Partners, Selectica retained specialists to analyze its NOL and the complicated provisions governing the loss of NOLs if a company undergoes an “ownership change” as defined in IRC Code §382, generally defined as an ownership change of more than 50 percentage points by one or more 5% shareholders within a period of three years. If such an ownership change occurs, then a substantial portion of the NOL is lost.
C. Exploration of Strategic Alternatives
By July of 2008 Selectica concluded it had to explore strategic alternatives. It retained Needham & Company to evaluate its alternatives. The evaluation included reaching out to potential buyers. By February 2009, at least half a dozen parties were seriously interested in Selectica. By April 2009, Selectica had signed a letter of intent and entered into exclusive negotiations with a potential buyer.
D. Trilogy Butts In
Trilogy resumed its interest in Selectica in the summer of 2008. Trilogy made a couple of lowball offers for Selectica, which were rejected by its board. It was invited to engage in the sale process being overseen by Needham, but it declined, apparently out of unwillingness to sign a non-disclosure agreement. Trilogy and its founder, Liemandt, commenced buying Selectica’s stock in the open market. The buying crossed the 5% threshold in November 2008, prompting Trilogy to file a Schedule 13D, in which it stated that it had acquired the Selectica shares “for investment purposes.”
E. Selectica’s Adoption of the NOL Pill
The Selectica board, concerned about the effect of Trilogy’s purchases on its NOL, arguably Selectica’s major asset, engaged its accounting and tax advisors to evaluate its NOL and its potential loss through an “ownership change.” They concluded, after extensive analysis and consultation with the board, that the NOL was valuable and that Trilogy’s actions in acquiring Selectica shares threatened it. On November 16, 2008, the board amended its previous shareholder rights plan, adopted in February 2003, with a view to protecting its NOL. The trigger was dropped from 15% to 4.99%, with existing 5% stockholders grandfathered to permit them to acquire up to an additional 0.5% of Selectica’s shares (subject to the original 15% cap) without triggering the pill. The board established a committee of independent directors to periodically review the pill to determine whether it would continue to be in the best interest of Selectica and its stockholders.
F. Trilogy Buys Through the Trigger
Adoption of the NOL poison pill apparently outraged Trilogy and its controlling stockholder, Liemandt. Liemandt promptly inquired of two of Trilogy’s officers how many shares of Selectica Trilogy and Liemandt would need to purchase “to ruin the tax attributes” of the NOL. Slip Opinion at 20. Trilogy then promptly notified Selectica that a contract it had known about for some four months between Selectica and Sun Microsystems breached the terms of the prior patent infringement settlement between Selectica and Trilogy.
By December 19, 2008, Trilogy had blown through the NOL trigger, attaining 6.7% ownership of Selectica’s outstanding common stock. Selectica then had 10 days, under the terms of the plan, to determine whether Trilogy would qualify as an “exempt person” under the plan, thus avoiding triggering the pill. What was Liemandt’s motive in blowing through the trigger?
“Liemandt testified that the rationale behind triggering the pill was to ‘bring accountability’ to the Board and ‘expose’ what Liemandt characterized as ‘illegal behavior’ by the Board in adopting a pill with such a low trigger.”
Slip Opinion at 21 (footnote omitted).
And what was Trilogy’s proposal to Selectica?
“He [an officer of Trilogy] then proposed that Selectica agree to purchase Trilogy’s shares back, accelerate the payment of its [$7 million] debt, terminate its license with Sun, and make a payment to Trilogy of $5 million ‘for settlement of basically all outstanding issues between our companies.’”
Slip Opinion at 22 (footnote omitted).
This is what one might term an “unvarnished” proposal. One suspects it was not vetted with experienced counsel.
Needless to say, the Selectica board rejected Trilogy’s settlement demands as “highly unreasonable” and “lacking any reasonable basis in fact.” No kidding.
G. After Trilogy Repeatedly Rejects Requests for a Standstill, Selectica Triggers the Pill
Selectica repeatedly requested that Trilogy agree to a standstill and not purchase any additional shares of Selectica stock. Trilogy rejected the demands. Accordingly, after extensive consultation with its tax and legal advisors, the board, on January 2, 2009, implemented the pill and authorized an exchange of rights of common stock and a reloading of the pill. As a result of the exchange, the number of outstanding shares of Selectica’s common stock was doubled, other than for Trilogy and its affiliates, whose ownership of Selectica stock dropped from 6.7% to 3.3%.
H. The Court’s View of Trilogy’s Conduct
Vice Chancellor Noble’s discussion of poison pills, Selectica’s NOL poison pill, and the standards governing the adoption and exercise of a poison pill are important and deserve attention, but not in this post. What I want to focus on is how Trilogy’s ill-advised and, frankly, off the wall conduct in negotiations (or the lack thereof) with Selectica influenced the Vice Chancellor.
At trial and in post-trial argument, Trilogy and its counsel mounted an impressive challenge to all aspects of Selectica’s board’s conduct, including the justification for any NOL pill, the processes followed by the Selectica board in adopting and implementing the pill, the board’s reliance upon experts, and the failure of the Selectica board to meet the Unocal tests for application of the business judgment rule to the adoption of a defensive measure such as a poison pill. All of these objections were carefully rejected by Vice Chancellor Noble. Trilogy’s arguments have a distinct ex post flavor. One cannot escape the conclusion that this case was decided by Trilogy’s opportunistic behavior in making a run at Selectica to coerce it into meeting demands of Trilogy that had nothing to do with Selectica’s governance or its control. As the Vice Chancellor notes at the end of his extensive opinion:
“Here, the record demonstrates that a longtime competitor sought to employ the shareholder franchise intentionally to impair corporate assets [of Selectica], or else to coerce the Company into meeting certain business demands under the threat of such impairment.”
. . . .
In this instance, Trilogy, a competitor with a contentious history, recognized that harm would befall its rival if it purchased sufficient shares of Selectica stock, and Trilogy proceeded to act accordingly.”
Slip Opinion at 65, 69.
______________________
Kudos to the Selectica directors. They served on the board of a small company that had never made money and had been pushed around by an aggressive competitor. They did something no other board had ever done, trigger a poison pill. In a risk averse world, that took courage. Their judgment and determination have been rewarded by Vice Chancellor Noble’s decision in this case.
A. Bad Blood Between Selectica and Trilogy, Inc.
Both Selectica and Trilogy, Inc. provide enterprise software solutions for contract management and sales configuration systems, whatever that means. Trilogy, a private company, is controlled by Joseph Liemandt, its founder and over 85% stockholder. Trilogy had been successful in two patent infringement lawsuits against Selectica, securing a judgment in one of $7.5 million and a settlement in the other of up to $17.5 million, of which some $7.5 million was deferred. Trilogy had also made several unsuccessful runs at acquiring Selectica, which Selectica’s board rebuffed. By the end of 2006, Trilogy had disposed of its Selectica shares.
B. Selectica’s NOL
Since Selectica went public in March 2000, it had never turned a profit. By the time of the dispute before Vice Chancellor Noble in the spring of 2009, it was trading below $1 per share, and it had incurred operating losses of some $160 million. Fewer than 25 investors held some two-thirds of its outstanding stock.
Selectica’s NOL drew the attention of Steel Partners, a private equity fund specializing in smaller cap companies. Steel Partners saw an opportunity in marrying Selectica with a profitable company to exploit Selectica’s NOL. As a result of pressure from Steel Partners, Selectica retained specialists to analyze its NOL and the complicated provisions governing the loss of NOLs if a company undergoes an “ownership change” as defined in IRC Code §382, generally defined as an ownership change of more than 50 percentage points by one or more 5% shareholders within a period of three years. If such an ownership change occurs, then a substantial portion of the NOL is lost.
C. Exploration of Strategic Alternatives
By July of 2008 Selectica concluded it had to explore strategic alternatives. It retained Needham & Company to evaluate its alternatives. The evaluation included reaching out to potential buyers. By February 2009, at least half a dozen parties were seriously interested in Selectica. By April 2009, Selectica had signed a letter of intent and entered into exclusive negotiations with a potential buyer.
D. Trilogy Butts In
Trilogy resumed its interest in Selectica in the summer of 2008. Trilogy made a couple of lowball offers for Selectica, which were rejected by its board. It was invited to engage in the sale process being overseen by Needham, but it declined, apparently out of unwillingness to sign a non-disclosure agreement. Trilogy and its founder, Liemandt, commenced buying Selectica’s stock in the open market. The buying crossed the 5% threshold in November 2008, prompting Trilogy to file a Schedule 13D, in which it stated that it had acquired the Selectica shares “for investment purposes.”
E. Selectica’s Adoption of the NOL Pill
The Selectica board, concerned about the effect of Trilogy’s purchases on its NOL, arguably Selectica’s major asset, engaged its accounting and tax advisors to evaluate its NOL and its potential loss through an “ownership change.” They concluded, after extensive analysis and consultation with the board, that the NOL was valuable and that Trilogy’s actions in acquiring Selectica shares threatened it. On November 16, 2008, the board amended its previous shareholder rights plan, adopted in February 2003, with a view to protecting its NOL. The trigger was dropped from 15% to 4.99%, with existing 5% stockholders grandfathered to permit them to acquire up to an additional 0.5% of Selectica’s shares (subject to the original 15% cap) without triggering the pill. The board established a committee of independent directors to periodically review the pill to determine whether it would continue to be in the best interest of Selectica and its stockholders.
F. Trilogy Buys Through the Trigger
Adoption of the NOL poison pill apparently outraged Trilogy and its controlling stockholder, Liemandt. Liemandt promptly inquired of two of Trilogy’s officers how many shares of Selectica Trilogy and Liemandt would need to purchase “to ruin the tax attributes” of the NOL. Slip Opinion at 20. Trilogy then promptly notified Selectica that a contract it had known about for some four months between Selectica and Sun Microsystems breached the terms of the prior patent infringement settlement between Selectica and Trilogy.
By December 19, 2008, Trilogy had blown through the NOL trigger, attaining 6.7% ownership of Selectica’s outstanding common stock. Selectica then had 10 days, under the terms of the plan, to determine whether Trilogy would qualify as an “exempt person” under the plan, thus avoiding triggering the pill. What was Liemandt’s motive in blowing through the trigger?
“Liemandt testified that the rationale behind triggering the pill was to ‘bring accountability’ to the Board and ‘expose’ what Liemandt characterized as ‘illegal behavior’ by the Board in adopting a pill with such a low trigger.”
Slip Opinion at 21 (footnote omitted).
And what was Trilogy’s proposal to Selectica?
“He [an officer of Trilogy] then proposed that Selectica agree to purchase Trilogy’s shares back, accelerate the payment of its [$7 million] debt, terminate its license with Sun, and make a payment to Trilogy of $5 million ‘for settlement of basically all outstanding issues between our companies.’”
Slip Opinion at 22 (footnote omitted).
This is what one might term an “unvarnished” proposal. One suspects it was not vetted with experienced counsel.
Needless to say, the Selectica board rejected Trilogy’s settlement demands as “highly unreasonable” and “lacking any reasonable basis in fact.” No kidding.
G. After Trilogy Repeatedly Rejects Requests for a Standstill, Selectica Triggers the Pill
Selectica repeatedly requested that Trilogy agree to a standstill and not purchase any additional shares of Selectica stock. Trilogy rejected the demands. Accordingly, after extensive consultation with its tax and legal advisors, the board, on January 2, 2009, implemented the pill and authorized an exchange of rights of common stock and a reloading of the pill. As a result of the exchange, the number of outstanding shares of Selectica’s common stock was doubled, other than for Trilogy and its affiliates, whose ownership of Selectica stock dropped from 6.7% to 3.3%.
H. The Court’s View of Trilogy’s Conduct
Vice Chancellor Noble’s discussion of poison pills, Selectica’s NOL poison pill, and the standards governing the adoption and exercise of a poison pill are important and deserve attention, but not in this post. What I want to focus on is how Trilogy’s ill-advised and, frankly, off the wall conduct in negotiations (or the lack thereof) with Selectica influenced the Vice Chancellor.
At trial and in post-trial argument, Trilogy and its counsel mounted an impressive challenge to all aspects of Selectica’s board’s conduct, including the justification for any NOL pill, the processes followed by the Selectica board in adopting and implementing the pill, the board’s reliance upon experts, and the failure of the Selectica board to meet the Unocal tests for application of the business judgment rule to the adoption of a defensive measure such as a poison pill. All of these objections were carefully rejected by Vice Chancellor Noble. Trilogy’s arguments have a distinct ex post flavor. One cannot escape the conclusion that this case was decided by Trilogy’s opportunistic behavior in making a run at Selectica to coerce it into meeting demands of Trilogy that had nothing to do with Selectica’s governance or its control. As the Vice Chancellor notes at the end of his extensive opinion:
“Here, the record demonstrates that a longtime competitor sought to employ the shareholder franchise intentionally to impair corporate assets [of Selectica], or else to coerce the Company into meeting certain business demands under the threat of such impairment.”
. . . .
In this instance, Trilogy, a competitor with a contentious history, recognized that harm would befall its rival if it purchased sufficient shares of Selectica stock, and Trilogy proceeded to act accordingly.”
Slip Opinion at 65, 69.
______________________
Kudos to the Selectica directors. They served on the board of a small company that had never made money and had been pushed around by an aggressive competitor. They did something no other board had ever done, trigger a poison pill. In a risk averse world, that took courage. Their judgment and determination have been rewarded by Vice Chancellor Noble’s decision in this case.
Monday, February 22, 2010
SEC v. Bank of America Corp.: Judge Rakoff Approves the Second Settlement, Damming It With No Praise
Judge Rakoff held his nose today and approved the second settlement submitted to him by the SEC and BofA. Channeling popular rage over Wall Street, bank bailouts, and excessive executive compensation, the Judge, deferring to the SEC’s judgment that the settlement is fair, reasonable, adequate, and in the public interest, and exercising judicial restraint, approves the settlement while “praising” it as “better than nothing,” and representing “half-baked justice at best.” Opinion and Order of February 22, 2009 (“Opinion”) at 14.
A. Not One for Framing
In light of Judge Rakoff’s treatment of their settlement of this case, it is unlikely that the Commission or its enforcement staff will highlight SEC v. Bank of America Corp. in their accomplishments for 2010. Judge Rakoff is not hesitant to express his views of the Commission’s work product. He announces at the beginning of his opinion that he “reluctantly” grants the Commission’s motion to approve the settlement. He makes clear up front that, based upon his review of the evidence developed by the Commission since his rejection of the first settlement presented to him in the summer of 2009, that BofA’s proxy statement sent to its shareholders in connection with the December 5, 2008 meeting called to approve the Merrill merger failed to adequately disclose the Bank’s agreement to pay Merrill executives up to $5.8 billion in bonuses and failed to adequately disclose the huge losses Merrill suffered during the fourth quarter of 2008. He belittles the Bank’s defense that the nondisclosures were not material:
“Despite the Bank’s somewhat coy refusal to concede the materiality of these nondisclosures, it seems obvious that a prudent bank shareholder, if informed of the aforementioned facts, would have thought twice about approving the merger or might have sought its renegotiation.”
Opinion at 3-4.
As I have noted in previous posts, the Judge was clearly influenced by the allegations of New York’s Attorney General, Andrew Cuomo, in his action against the Bank, Lewis, and Price, filed the day before the Commission presented its second settlement for Judge Rakoff’s approval. The Judge sought and received transcripts of Cuomo’s office’s examination of BofA General Counsel Mayopoulos and others, receiving it ex parte due to that office’s objection to making public the transcripts of such testimony (on the grounds that it would prejudice the office’s prosecution of the case against the Bank and its two former principal officers were the transcripts shared with the Bank).
The Judge rejects the Bank’s objection to his consideration of evidence from Cuomo’s case as “frivolous,” asserting that it would have been a “dereliction” of his duty to ignore evidence of Cuomo’s claims of willful misconduct to test the factual assumptions underlying the settlement presented by the Commission to him for approval. On the other hand, the Judge concedes, in a footnote, that his decision to accept the materials “ex parte” was “problematic,” acknowledging the Bank’s “legitimate concern that the Court’s determinations be made on a record fully available for [its] scrutiny.” Opinion at 6, note 3.
B. Mayopoulos’ Firing
After reviewing the evidence submitted to him, the Judge “concludes that none of the evidence directly contradicts the Bank’s assertion that Mayopoulos’ termination was unrelated to the nondisclosures or to his increasing knowledge of Merrill’s losses.” Opinion at 7. Nevertheless, the Judge is careful to note that “contrary inferences might be drawn” from the evidence, including the fact that the Bank terminated Mayopoulos on such short notice and “asked [him] to leave the premises immediately.” Id.
C. Officers of BofA Acted Negligently
Perhaps the most crucial conclusion reached by the Judge is that the evidence supports the Commission’s conclusion “that the Bank and its officers acted negligently, rather than intentionally, in causing the nondisclosures that are the predicates to the settlement here proffered, …” Id. at 8. This conclusion was “reasonable” by the SEC, supported by “substantial evidence,” and one that a “reasonable regulator could draw.” Id. It is highly unlikely the Bank will cite any language from this Opinion, but if it does it will be this text.
D. The Settlement’s Prophylactic Measures
The Judge accepts the prophylactic measures exacted from the Bank by the SEC, including the modifications to two of them that he requested, and accepts the Bank’s rejection of the suggestion that the SEC and the Court play a role in the selection of an independent compensation consultant to the Board’s compensation committee. In doing so, the Judge cannot help getting in his digs on the Bank’s officers and lawyers:
“Given that the apparent working assumption of the Bank’s decision-makers and lawyers involved in the underlying events at issue here was not to disclose information if a rationale could be found for not doing so, the proposed remedial steps should help foster a healthier attitude of ‘when in doubt, disclose.’”
Opinion at 9.
E. The Settlement’s $150 Million Fine
The Judge’s strongest criticism is for the $150 million fine agreed to by the Bank in the second settlement. Accepting the Bank’s and the Commission’s agreement to explicitly provide that distribution of the fine will not be made to Merrill “legacy” shareholders of BofA or to Bank officers or directors who had access to the undisclosed information, Judge Rakoff continues to express his outrage that innocent shareholders, including innocent Merrill legacy shareholders of BofA, are bearing the cost of the fine and not the culpable officers of Bank, even if they were guilty only of negligence:
“… the effect [of the exclusion of Merrill legacy shareholders] is very modest, amounting perhaps to no more than a few pennies per share. Moreover, while the ‘legacy’ Merrill shareholders may have received something of a windfall as a result of the nondisclosures, they were not responsible for those nondisclosures. Rather, the responsibility was that of the Bank’s executives, who, although barred from receiving any part of the $150 million fine, are not contributing to its payment in any material respect.”
Opinion at 13.
So, all in all, while the settlement, concludes Judge Rakoff, is “better than nothing, this is half-baked justice at best.” Opinion at 14.
In fact, the Judge goes as far as to state that if this proposed settlement were first presented to him, he would reject it as “inadequate and misguided.” Id. So why is he approving it? Because, explains the Judge, he would “fail in [his] duty if [he] did not give considerable weight to the S.E.C.’s position.” And, even more importantly to the Judge, he has to take into account “considerations of judicial restraint,” meaning that, having made his preferences clear, he cannot act upon them!
So, realizing that he is a judge and not an enforcement god, Judge Rakoff “while shaking [his] head,” approves the settlement.
It is safe to say that the Bank and the Commission are more than pleased to close the door on Judge Rakoff’s courtroom and exit Foley Square as quickly as possible.
A. Not One for Framing
In light of Judge Rakoff’s treatment of their settlement of this case, it is unlikely that the Commission or its enforcement staff will highlight SEC v. Bank of America Corp. in their accomplishments for 2010. Judge Rakoff is not hesitant to express his views of the Commission’s work product. He announces at the beginning of his opinion that he “reluctantly” grants the Commission’s motion to approve the settlement. He makes clear up front that, based upon his review of the evidence developed by the Commission since his rejection of the first settlement presented to him in the summer of 2009, that BofA’s proxy statement sent to its shareholders in connection with the December 5, 2008 meeting called to approve the Merrill merger failed to adequately disclose the Bank’s agreement to pay Merrill executives up to $5.8 billion in bonuses and failed to adequately disclose the huge losses Merrill suffered during the fourth quarter of 2008. He belittles the Bank’s defense that the nondisclosures were not material:
“Despite the Bank’s somewhat coy refusal to concede the materiality of these nondisclosures, it seems obvious that a prudent bank shareholder, if informed of the aforementioned facts, would have thought twice about approving the merger or might have sought its renegotiation.”
Opinion at 3-4.
As I have noted in previous posts, the Judge was clearly influenced by the allegations of New York’s Attorney General, Andrew Cuomo, in his action against the Bank, Lewis, and Price, filed the day before the Commission presented its second settlement for Judge Rakoff’s approval. The Judge sought and received transcripts of Cuomo’s office’s examination of BofA General Counsel Mayopoulos and others, receiving it ex parte due to that office’s objection to making public the transcripts of such testimony (on the grounds that it would prejudice the office’s prosecution of the case against the Bank and its two former principal officers were the transcripts shared with the Bank).
The Judge rejects the Bank’s objection to his consideration of evidence from Cuomo’s case as “frivolous,” asserting that it would have been a “dereliction” of his duty to ignore evidence of Cuomo’s claims of willful misconduct to test the factual assumptions underlying the settlement presented by the Commission to him for approval. On the other hand, the Judge concedes, in a footnote, that his decision to accept the materials “ex parte” was “problematic,” acknowledging the Bank’s “legitimate concern that the Court’s determinations be made on a record fully available for [its] scrutiny.” Opinion at 6, note 3.
B. Mayopoulos’ Firing
After reviewing the evidence submitted to him, the Judge “concludes that none of the evidence directly contradicts the Bank’s assertion that Mayopoulos’ termination was unrelated to the nondisclosures or to his increasing knowledge of Merrill’s losses.” Opinion at 7. Nevertheless, the Judge is careful to note that “contrary inferences might be drawn” from the evidence, including the fact that the Bank terminated Mayopoulos on such short notice and “asked [him] to leave the premises immediately.” Id.
C. Officers of BofA Acted Negligently
Perhaps the most crucial conclusion reached by the Judge is that the evidence supports the Commission’s conclusion “that the Bank and its officers acted negligently, rather than intentionally, in causing the nondisclosures that are the predicates to the settlement here proffered, …” Id. at 8. This conclusion was “reasonable” by the SEC, supported by “substantial evidence,” and one that a “reasonable regulator could draw.” Id. It is highly unlikely the Bank will cite any language from this Opinion, but if it does it will be this text.
D. The Settlement’s Prophylactic Measures
The Judge accepts the prophylactic measures exacted from the Bank by the SEC, including the modifications to two of them that he requested, and accepts the Bank’s rejection of the suggestion that the SEC and the Court play a role in the selection of an independent compensation consultant to the Board’s compensation committee. In doing so, the Judge cannot help getting in his digs on the Bank’s officers and lawyers:
“Given that the apparent working assumption of the Bank’s decision-makers and lawyers involved in the underlying events at issue here was not to disclose information if a rationale could be found for not doing so, the proposed remedial steps should help foster a healthier attitude of ‘when in doubt, disclose.’”
Opinion at 9.
E. The Settlement’s $150 Million Fine
The Judge’s strongest criticism is for the $150 million fine agreed to by the Bank in the second settlement. Accepting the Bank’s and the Commission’s agreement to explicitly provide that distribution of the fine will not be made to Merrill “legacy” shareholders of BofA or to Bank officers or directors who had access to the undisclosed information, Judge Rakoff continues to express his outrage that innocent shareholders, including innocent Merrill legacy shareholders of BofA, are bearing the cost of the fine and not the culpable officers of Bank, even if they were guilty only of negligence:
“… the effect [of the exclusion of Merrill legacy shareholders] is very modest, amounting perhaps to no more than a few pennies per share. Moreover, while the ‘legacy’ Merrill shareholders may have received something of a windfall as a result of the nondisclosures, they were not responsible for those nondisclosures. Rather, the responsibility was that of the Bank’s executives, who, although barred from receiving any part of the $150 million fine, are not contributing to its payment in any material respect.”
Opinion at 13.
So, all in all, while the settlement, concludes Judge Rakoff, is “better than nothing, this is half-baked justice at best.” Opinion at 14.
In fact, the Judge goes as far as to state that if this proposed settlement were first presented to him, he would reject it as “inadequate and misguided.” Id. So why is he approving it? Because, explains the Judge, he would “fail in [his] duty if [he] did not give considerable weight to the S.E.C.’s position.” And, even more importantly to the Judge, he has to take into account “considerations of judicial restraint,” meaning that, having made his preferences clear, he cannot act upon them!
So, realizing that he is a judge and not an enforcement god, Judge Rakoff “while shaking [his] head,” approves the settlement.
It is safe to say that the Bank and the Commission are more than pleased to close the door on Judge Rakoff’s courtroom and exit Foley Square as quickly as possible.
Saturday, February 20, 2010
SEC v. Bank of America Corp.: Ruling on Second Settlement Imminent; Judge Rakoff: Bull in a China Shop
Judge Rakoff is scheduled to rule on the second settlement submitted by the SEC and BofA for Court approval this coming Monday, February 22. It is apparent from the submissions made by the parties since my post of February 12 that both the SEC and the Bank are saying to the Judge “Enough, Already,” and want him to get on with it and approve the settlement. I still believe he will do so, but lifetime tenure does something for federal judges – it makes them very, very independent.
A. The SEC’s Supplemental Statement of Facts
In response to the Judge’s February 11 order, both the SEC and the Bank have, through counsel, corresponded with Judge Rakoff, jointly submitted the evidentiary record on issues requested by the Judge, and the SEC has submitted a Supplemental Statement of Facts (the “Statement”) summarizing the evidentiary record. By the Statement, the SEC confirms its conclusions that:
• General Counsel Timothy Mayopoulos advised management of the Bank, after conferring with the Wachtell firm, that the Bank was not required to make additional disclosure to its shareholders concerning Merrill’s forecasted fourth-quarter losses before the shareholder meeting held on December 5, 2008;
• Wachtell supported Mayopoulos’s advice; and
• Mayopoulos’s firing on December 10, 2008 was “for reasons which had no connection to his legal advice or any other aspect of his job performance.” Statement ¶2.
The Commission does not provide any argument in the Statement. By its detail, however, the Commission reinforces its conclusion that there is no basis for a finding of bad faith or scienter by Mayopoulos or Wachtell in the legal advice they gave the Bank.
While the evidence cited by the Commission on Mayopoulos’s firing supports the Commission’s conclusion on the absence of any motive to terminate Mayopoulos for any legal advice he gave, the termination does illustrate the brutality of corporate politics. According to the evidence developed by the Commission, Mayopoulos was fired to make room for Brian Moynihan, then BofA’s head of its investment banking division (and now CEO of the Bank).
As a result of the pending merger with Merrill, Moynihan’s position was going to be eliminated, and John Thain, Merrill’s CEO, was to take over the combined entity’s investment banking operations. The BofA board of directors balked at Moynihan’s pending departure, urging Ken Lewis to find a suitable position for him. Lewis decided to place Moynihan in Mayopoulos’s position as General Counsel of the Bank, even though Moynihan had not practiced for years and his bar membership was not then even active.
So, according to the evidence developed by the SEC, Mayopoulos was fired not by reason of his performance, loyalty, or competence, but simply to make room for an officer that Lewis was prepared to lose but the Board of Directors of the Bank wanted to retain.
B. Cuomo’s Office’s Response
By its letter dated February 16, 2010 to the SEC, Cuomo’s office rejected the Commission’s request to turn over transcripts of the testimony of Mayopoulos and others given by them to Coumo’s office. Coumo's office stated that turning over such materials would adversely affect that office’s prosecution of its case against the Bank, Lewis, and Joe Price, the Bank’s former CFO.
In response to this letter, Judge Rakoff jumped in with his Order of February 17, stating his desire to see the requested materials to enable him to determine “whether the conclusions on which the S.E.C. premises its proposed settlement have an adequate basis in fact or are materially at variance with other sworn testimony.” Order at 2. Given the time constraints, the Judge simply requested that Cuomo’s office “voluntarily” produce the materials to the Court, suggesting that if Cuomo’s office deemed it necessary, the production could be made “ex parte,” meaning to the Court alone, without copying the SEC or BofA.
Cuomo’s office took up the suggestion and submitted the materials ex parte to the Court by its letter dated February 19.
C. BofA’s Response
BofA initially responded to Judge Rakoff’s Order of February 11 by its letter to the Court of February 16. Barely disguising its irritation, the Bank “respectfully” pointed out to Judge Rakoff that the second proposed settlement “was the result of arm’s length negotiations” between BofA and the Commission and, in the opinion of the Bank, “no changes” were necessary to the proposed consent judgment submitted by the Commission and the Bank to the Court. Nevertheless, the Bank stated its agreement to the Judge’s request for Commission and, possibly, Court involvement in the appointment of an independent auditor to assess the Bank’s disclosure controls and procedures and the retention of disclosure counsel for BofA’s audit committee.
But the Bank balked at Judge Rakoff’s request that the Commission and the Court participate in the selection of an independent compensation consultant for the Board’s compensation committee. The consent judgment submitted by the SEC and the Bank provides for the retention of an independent compensation consultant by the compensation committee, to be selected solely by the compensation committee. The Judge requested in his February 11 order that the consultant be acceptable to both the SEC and the Court and that, if the Bank and the SEC could not agree on the consultant, the Court would make that choice. That request irritated the Bank:
“. . . we do not believe that the third proposed change to the Consent Judgment is necessary to achieve or tailored to the remedial objectives of the settlement, and we further believe that this proposed change would impose on the SEC a substantive role that the SEC expressly does not seek and that is outside the province of the SEC and the Court.”
BofA letter of February 16, at 3 (footnote omitted).
In response to Cuomo’s office’s turning over materials, ex parte, to the Court, the Bank submitted its letter of February 18 in protest. The Bank’s position is that evidence developed in other forums and not in the pending actions against the Bank before Judge Rakoff should not be considered by the Court. This is not a frivolous complaint, and could serve as the basis for any appeal by the Bank to Judge Rakoff’s decision on the settlement, assuming he does not approve it.
____________________
If Judge Rakoff does not approve the second settlement, he will certainly confirm his reputation as a maverick. Without familiarity with the procedural hurdles that might confront the Commission or the Bank in challenging any rejection of the settlement by the Judge, one would think that if he rejects the settlement one or both of the parties will seek review of his decision by the Second Circuit and/or seek to disqualify Judge Rakoff from presiding over the trial of this case. It is not too much to ask how Judge Rakoff could maintain his impartiality if, as a result of his detailed review of deposition transcripts and other evidence, he concludes that the settlement should be rejected because the Commission has failed to name officers of the Bank and/or its counsel for securities law violations.
A. The SEC’s Supplemental Statement of Facts
In response to the Judge’s February 11 order, both the SEC and the Bank have, through counsel, corresponded with Judge Rakoff, jointly submitted the evidentiary record on issues requested by the Judge, and the SEC has submitted a Supplemental Statement of Facts (the “Statement”) summarizing the evidentiary record. By the Statement, the SEC confirms its conclusions that:
• General Counsel Timothy Mayopoulos advised management of the Bank, after conferring with the Wachtell firm, that the Bank was not required to make additional disclosure to its shareholders concerning Merrill’s forecasted fourth-quarter losses before the shareholder meeting held on December 5, 2008;
• Wachtell supported Mayopoulos’s advice; and
• Mayopoulos’s firing on December 10, 2008 was “for reasons which had no connection to his legal advice or any other aspect of his job performance.” Statement ¶2.
The Commission does not provide any argument in the Statement. By its detail, however, the Commission reinforces its conclusion that there is no basis for a finding of bad faith or scienter by Mayopoulos or Wachtell in the legal advice they gave the Bank.
While the evidence cited by the Commission on Mayopoulos’s firing supports the Commission’s conclusion on the absence of any motive to terminate Mayopoulos for any legal advice he gave, the termination does illustrate the brutality of corporate politics. According to the evidence developed by the Commission, Mayopoulos was fired to make room for Brian Moynihan, then BofA’s head of its investment banking division (and now CEO of the Bank).
As a result of the pending merger with Merrill, Moynihan’s position was going to be eliminated, and John Thain, Merrill’s CEO, was to take over the combined entity’s investment banking operations. The BofA board of directors balked at Moynihan’s pending departure, urging Ken Lewis to find a suitable position for him. Lewis decided to place Moynihan in Mayopoulos’s position as General Counsel of the Bank, even though Moynihan had not practiced for years and his bar membership was not then even active.
So, according to the evidence developed by the SEC, Mayopoulos was fired not by reason of his performance, loyalty, or competence, but simply to make room for an officer that Lewis was prepared to lose but the Board of Directors of the Bank wanted to retain.
B. Cuomo’s Office’s Response
By its letter dated February 16, 2010 to the SEC, Cuomo’s office rejected the Commission’s request to turn over transcripts of the testimony of Mayopoulos and others given by them to Coumo’s office. Coumo's office stated that turning over such materials would adversely affect that office’s prosecution of its case against the Bank, Lewis, and Joe Price, the Bank’s former CFO.
In response to this letter, Judge Rakoff jumped in with his Order of February 17, stating his desire to see the requested materials to enable him to determine “whether the conclusions on which the S.E.C. premises its proposed settlement have an adequate basis in fact or are materially at variance with other sworn testimony.” Order at 2. Given the time constraints, the Judge simply requested that Cuomo’s office “voluntarily” produce the materials to the Court, suggesting that if Cuomo’s office deemed it necessary, the production could be made “ex parte,” meaning to the Court alone, without copying the SEC or BofA.
Cuomo’s office took up the suggestion and submitted the materials ex parte to the Court by its letter dated February 19.
C. BofA’s Response
BofA initially responded to Judge Rakoff’s Order of February 11 by its letter to the Court of February 16. Barely disguising its irritation, the Bank “respectfully” pointed out to Judge Rakoff that the second proposed settlement “was the result of arm’s length negotiations” between BofA and the Commission and, in the opinion of the Bank, “no changes” were necessary to the proposed consent judgment submitted by the Commission and the Bank to the Court. Nevertheless, the Bank stated its agreement to the Judge’s request for Commission and, possibly, Court involvement in the appointment of an independent auditor to assess the Bank’s disclosure controls and procedures and the retention of disclosure counsel for BofA’s audit committee.
But the Bank balked at Judge Rakoff’s request that the Commission and the Court participate in the selection of an independent compensation consultant for the Board’s compensation committee. The consent judgment submitted by the SEC and the Bank provides for the retention of an independent compensation consultant by the compensation committee, to be selected solely by the compensation committee. The Judge requested in his February 11 order that the consultant be acceptable to both the SEC and the Court and that, if the Bank and the SEC could not agree on the consultant, the Court would make that choice. That request irritated the Bank:
“. . . we do not believe that the third proposed change to the Consent Judgment is necessary to achieve or tailored to the remedial objectives of the settlement, and we further believe that this proposed change would impose on the SEC a substantive role that the SEC expressly does not seek and that is outside the province of the SEC and the Court.”
BofA letter of February 16, at 3 (footnote omitted).
In response to Cuomo’s office’s turning over materials, ex parte, to the Court, the Bank submitted its letter of February 18 in protest. The Bank’s position is that evidence developed in other forums and not in the pending actions against the Bank before Judge Rakoff should not be considered by the Court. This is not a frivolous complaint, and could serve as the basis for any appeal by the Bank to Judge Rakoff’s decision on the settlement, assuming he does not approve it.
____________________
If Judge Rakoff does not approve the second settlement, he will certainly confirm his reputation as a maverick. Without familiarity with the procedural hurdles that might confront the Commission or the Bank in challenging any rejection of the settlement by the Judge, one would think that if he rejects the settlement one or both of the parties will seek review of his decision by the Second Circuit and/or seek to disqualify Judge Rakoff from presiding over the trial of this case. It is not too much to ask how Judge Rakoff could maintain his impartiality if, as a result of his detailed review of deposition transcripts and other evidence, he concludes that the settlement should be rejected because the Commission has failed to name officers of the Bank and/or its counsel for securities law violations.
Friday, February 12, 2010
SEC v. Bank of America Corp.; The SEC and BofA Enter Into a Second Settlement; The Cuomo NY State Action
The Commission and BofA are headed back to Judge Rakoff for approval of a second settlement after their first settlement was rejected by the Judge on September 14, 2009. From my initial reading of the terms of the settlement and the supporting papers filed by the SEC in support of the settlement, I concluded that it was highly likely the Judge would approve it on this second go-round. Then I read Attorney General Cuomo’s complaint of February 4, 2010 filed against BofA and its two principal officers, Ken Lewis (CEO) and Joe Price (CFO), in New York State Supreme Court (New York’s trial court) and I am not so sure. Cuomo’s complaint, which reads more like a brief for summary judgment than a complaint, contains extensive quotations and summaries of testimony and emails and gets the blood flowing. Judge Rakoff obviously has read it, because, as was apparent from the preliminary hearing he held on Monday, February 8, 2010, the Judge commented to counsel for the Commission and BofA that he found the $150 million civil penalty “still quite small,” questioned whether there should be court supervision of certain prophylactic aspects of the settlement, and questioned the Commission’s summary of evidence in support of the settlement in light of the even more extensive recitation of facts (albeit in the form of allegations) in Cuomo’s complaint. See New York Times, Tuesday, February 9, 2010, page B7, col. 2.
So while I still would hazard that Judge Rakoff is likely to approve the second settlement, the fireworks on this one are not over, and Cuomo’s allegations are often stunning and sure to prove discomforting to many of BofA’s senior officers and its counsel.
A. The Second Settlement
The civil penalty of $150 million agreed to by BofA in the second settlement is some five times the fine of $33 million in the August 2009 settlement rejected by the Judge. This is real money, particularly in light of the relevant statutory standards I addressed in my post of September 25, 2009, but a relative pittance compared to BofA’s historical earnings: for the five years ended December 31, 2008, BofA reported average annual net income, after taxes, of $14.1 billion, of which $150 million represents a scant 1.1%.
BofA also agrees to implement, for a period of three years, prophylactic measures designed to enhance its financial reporting and its compensation practices, and to grant shareholders a say in its compensation policies. These measures include auditor certification of the Bank’s disclosure controls and procedures in addition to the attestation now required by SOX § 404 for the Bank’s internal controls and procedures for financial reporting; CEO and CFO certifications of its proxy statements comparable to those now required of the Bank’s 10-Ks and 10-Qs; appointment of separate disclosure counsel for the audit committee of its board of directors; adoption of independence requirements for the members of its compensation committee comparable to those that apply to its audit committee; retention of an independent compensation consultant to be engaged by and to report solely to the compensation committee; institution and implementation of formal written incentive compensation principles and processes, to be amended only after seeking a separate advisory shareholder vote; and provision of a separate advisory shareholder vote at each annual meeting involving the election of directors regarding the Bank’s compensation of its executives. These measures would push BofA to the forefront of “best practices” in its shareholder reporting and provide gainful, and the emphasis is on “gainful,” employment for scores of lawyers, accountants, and compensation consultants.
To address Judge Rakoff’s concern that the $33 million fine imposed by the August 2009 settlement would be borne by the “innocent” victims of BofA’s failure to disclose its agreement with Merrill in its merger proxy statement to allow Merrill to pay up to $5.8 billion in incentive bonuses to its employees for 2008, this second settlement provides for the distribution of the penalty “solely” to the “harmed” BofA shareholders. The fund is to be distributed pursuant to a plan to be subsequently proposed by the Commission and approved by the Court under the provisions of Section 308(a) of SOX. Presumably those shareholders “harmed” by the Bank’s disclosure failures will not include any Merrill shareholders who received BofA stock in the merger.
In support of the settlement, the Commission has filed a 35-page “Statement of Facts” detailing relevant facts established by the evidence obtained by the Commission in discovery after Judge Rakoff’s September 14, 2009 rejection of the first settlement. In a written consent filed with the supporting papers, the Bank “acknowledges that there is an evidentiary basis for the statements in the Statement of Facts ….” Consent of Bank of America Corporation, dated February 1, 2010, ¶ 14. The Bank has further agreed “not to take any action or to make or permit to be made any public statement denying, directly or indirectly, the statements in the Statement of Facts or any allegation in the complaints filed in the Actions or creating the impression that the statements in the Statement of Facts or the allegations in the complaints are without factual basis.” Id. The SEC’s Statement is meticulous in its citation to the sources for each of the statements of fact made. It is safe to say that the Statement reflects the input of BofA’s counsel, as it includes statements (often in footnotes) that this commentator considers reflective of BofA’s defenses.
1. No “Bad Boy” Taint
In the August 2009 settlement rejected by Judge Rakoff, the Bank agreed not only to the payment of a civil penalty in the amount of $33 million, but also to the inclusion in the final judgment of a permanent injunction enjoining the Bank from violating Section 14(a) of the Exchange Act and Rule 14a 9 promulgated by the SEC thereunder, the proxy statement anti-fraud prohibition.
Presumably in exchange for the prophylactic covenants the Bank has agreed to in this settlement, the Commission sets forth no such injunction in this second settlement. That omission is a significant victory for the Bank. Under the SEC’s rules, an “ineligible issuer” is not entitled to use certain procedures and forms that allow it to access the capital markets quickly and efficiently. An institution such as BofA uses these procedures and forms every day. An ineligible issuer includes any issuer that, within the past three years, has been the subject of any judicial or administrative decree or order arising out of a governmental action that, among other things, “[r]equires that the person cease and desist from violating the anti-fraud provisions of the federal securities laws ….” SEC Rule 405 (definition of “ineligible issuer”). The omission of any injunction in this second settlement prohibiting the Bank from violating the proxy statement anti-fraud provisions of the Exchange Act is a significant win for the Bank.
2. Why BofA Excluded Mention of its Agreement for the Payment of Merrill’s Q4 2008 Bonuses from its Proxy Statement
Several of my earlier posts focused on the likely explanation for BofA’s omission from its proxy statement of its agreement with Merrill (contained in a schedule to the merger agreement) that Merrill could pay up to $5.8 billion in year-end bonuses to Merrill’s officers and employees. The SEC’s Statement of Facts discloses that the language of the schedule, permitting the payment of up to $5.8 billion in discretionary year-end bonuses, continued to be negotiated “through October 21, 2008,” Statement ¶ 39, over a month after the merger was announced and the merger agreement filed with the SEC (the schedule is an attachment, albeit not publicly filed, to the merger agreement).
Why was the agreement set out in the schedule with respect to the payment of year-end bonuses not mentioned in the merger proxy statement? The Commission summarizes the deposition testimony of Jeannemarie O’Brien, the Wachtell partner who was responsible for the employee benefits provisions of the merger agreement and their disclosure in the proxy statement, who provided this answer:
“According to O’Brien, the provision in the Schedule did not have to be disclosed because, she believed, the [bonus] awards that Merrill was authorized to pay under Section 5.2 to the Schedule were not special transactional bonuses and were regular year-end bonuses consistent with the prior year.”
Statement ¶ 40.
This explanation doesn’t make sense in the context of the actual language of the forbearance provision of the merger contract, which provided that Merrill would not, without the prior written consent of the Bank, “pay any amount to [directors, officers or employees] not required by any current plan or agreement (other than base salary in the ordinary course of business).” Merger Agreement § 5.2(c). Nevertheless, what the Commission obviously found persuasive is the uniform testimony of the Bank’s executives “that they generally relied on Wachtell Lipton for the accuracy, completeness, and legal compliance of the Bank’s proxy disclosures.” Statement ¶ 40.
The Commission’s Statement concludes in rather stark fashion, highlighting the bonuses actually paid by Merrill in December 2008, after the shareholders of BofA had approved the merger. These bonuses totaled $3.62 billion, paid by a company, Merrill, that reported a net loss of $15.3 billion for the fourth quarter of 2008 and a net loss of $27 billion for all of 2008:
“Approximately 39,400 employees at Merrill Lynch received [bonus] awards. . . . Merrill paid year-end bonuses for 2008 of $1 million or more to nearly 700 employees, $5 million or more to over 50 employees, and $10 million or more to over 10 employees. . . . Among those who received year-end bonuses for 2008 at Merrill were employees who were not retained after the closing of the merger.”
Statement ¶ 49.
B. Cuomo’s Complaint
While the papers filed by the Commission in support of its second settlement with the Bank have the tenor one would expect from a Commission filing, particularly one negotiated with the defendant — staid, measured, and largely colorless — Attorney General Cuomo’s complaint filed against the Bank and its two principal officers, Ken Lewis and Joe Price, is anything but: it is hard-hitting, colorful, and dramatically lays out facts it alleges justify a finding of fraudulent practices engaged in by the defendants. From the Commission’s papers we get firmness but civility; from Cuomo we get a Bronx cheer. And one thing is for certain, Cuomo’s complaint has caused and will cause the Commission and the Bank massive heartburn.
1. Treatment of the Bank’s Failure to Disclose Merrill’s Fourth Quarter Losses
A good illustration of the dramatically different pictures painted by the Commission and Cuomo’s office from the same facts is their treatment of BofA’s failure to disclose Merrill’s fourth quarter losses prior to the special meeting of the Bank’s shareholders held on December 5, 2008 to approve the Merrill merger. For the third quarter of 2008, ended September 30, Merrill reported net losses of $5.2 billion. This figure was publicly reported and incorporated by reference into the proxy statement distributed to the Bank’s shareholders in connection with the merger. Between the third quarter and the date of the meeting, December 5, Merrill incurred net losses of in excess of $7.5 billion, which were not disclosed by the Bank to its shareholders even though the Bank was well aware of them. It was this failure that triggered the Commission to file its second complaint against the Bank, on January 12, 2010, which complaint is also being resolved by the second settlement.
After announcement of the proposed merger on September 15, 2008, the Bank sent hundreds of employees to Merrill’s offices in New York to facilitate the anticipated merger. BofA’s Chief Accounting Officer, Neil Cotty, even moved into an office at Merrill’s headquarters. The Bank received daily reports of Merrill’s financial results. It learned shortly after October 31, 2008 that Merrill had incurred losses before taxes of $6.1 billion for October (and net losses of $4.5 billion). The $4.5 billion monthly net loss almost equaled the $5.2 billion loss that Merrill had reported for the entire third quarter of 2008. When Cotty learned of this loss, he forwarded an email to Joe Price that noted: “Read and weep.” SEC Statement ¶ 15.
After learning of the October 2008 loss, Price sought the advice of the Bank’s general counsel, Timothy Mayopoulos, on the Bank’s disclosure obligations. Here is how the SEC describes the deliberations conducted by Mayopoulos with the Bank’s outside counsel, Wachtell Lipton, and Bank executives (the Bank waived the attorney-client privilege thereby permitting such inquiries on October 12, 2009):
“Over the next several days, Mayopoulos, Price, and other executives and in-house attorneys at Bank of America conferred amongst themselves as well as with Edward Herlihy, Nicholas Demmo and other attorneys at Wachtell Lipton to determine whether a disclosure was required in light of the forecasted $5 billion quarterly loss at Merrill. . . . Notes of a Wachtell Lipton attorney reflect that the initial view of the lawyers on November 13 was that there should be some additional disclosure. . . . Thereafter, the attorneys and executives reviewed and analyzed, among other materials, Merrill’s results in the preceding six quarters, analyst estimates for Merrill’s results in the fourth quarter, as well as the Proxy Statement and other recent Bank of America and Merrill public filings that were available to shareholders. . . . On November 20, the lawyers concluded that no additional disclosure was required. . . . Price informed Lewis of the conclusion reached by the lawyers.”
Statement ¶ 18 (record citations and footnote omitted).
Contrast this rather antiseptic description with the recitation found in Cuomo’s complaint. Cuomo alleges that Mayopoulos’ initial reaction was that the Merrill losses ought to be disclosed: ‘[m]y reaction was that $5 billion is a lot of money, and I believe my initial reaction was that a disclosure was likely warranted.’” Complaint ¶ 75. The Complaint details the conversations Mayopoulos had with Wachtell partners concerning disclosure of the anticipated fourth quarter losses, including reciting from counsel’s notes (Wachtell obviously joined BofA and waived its attorney work product privilege). At a November 13, 2008 conference call that Mayopoulos held with Ed Herlihy, Eric Roth, and Nick Demmo of Wachtell, the Complaint alleges that “[d]uring this meeting, the parties agreed disclosure was the proper course, and they discussed both the disclosure’s content and the date of disclosure.” Complaint ¶ 82.
After the November 13th meeting, Mayopoulos reconsidered his conclusion on the disclosure of the anticipated fourth quarter 2008 Merrill losses. He concluded, based upon Merrill’s reported quarterly losses since the fourth quarter of 2007, ranging from $2 billion to $10 billion, that disclosure of the anticipated $5 billion fourth quarter loss (Mayopoulos, based on his conversations with other Bank executives, had concluded that November 2008 would be flat for Merrill) was not necessary, as it would “be well within the range of prior experience at Merrill Lynch, and that investors, based on that, would not be surprised by that result.” Complaint ¶ 86. He reached this conclusion notwithstanding that, as the SEC recounts, analysts covering Merrill issued reports after Merrill’s reported Q3 2008 net loss of $5.2 billion that projected that Merrill’s fourth-quarter performance would be an improvement over the third quarter, with some projecting that Merrill would report income and others reporting much more modest losses. Statement ¶ 13. Indeed, even Ken Lewis and Joe Price expected Merrill to break even in the fourth quarter. Id.
The last that Mayopoulos conferred with Wachtell about disclosure was November 20, 2008. Here is what Cuomo alleges about that conference call:
“Significantly, Wachtell played a limited role on the question by this time. After their original conclusion [from November 13] was disregarded, Wachtell lawyers took themselves out of the equation, doing no substantive work, and in fact simply agreeing with Mayopoulos. They issued no memoranda or work product and they did no further research. Herlihy testified that Mayopoulos ‘had done a lot of homework and thought it through and so had come to some conclusion with respect to the disclosure.’
Neither Wachtell nor the Bank ever consulted Roth [a Wachtell partner] again on the question. Roth was the lawyer closest to the issues involved in disclosure. He was the lawyer most involved in the analysis of the question, as the only one who had done any research in the area or talked to other lawyers about the litigation of such questions. He was left to think that disclosure would be made:
Question: So what was your understanding of what was going to happen on November 13, 2008 when that conversation ended?
Roth: My sense was that as of the close of that meeting the view was that some kind of trend disclosure would be made — or at least that was the recommendation that was being made to the business people. I have no reason to believe the business people wouldn’t agree with the lawyers’ advice — and that Price would go talk to the senior executives of Merrill about the concept.
But after November 13, he was no longer involved, except to hear that the trend disclosure was never made:
Question: What is the next thing that happened with respect to the disclosure of the Merrill Lynch loss issue after November 13, 2008?
Roth: In terms of what I did [on disclosure], I had no involvement in the consideration or discussion of this issue after November 13 and prior to January 15 with the client. [...] I believe that at some point prior to January 16 I had a conversation with Ed Herlihy where I inquired after the trend disclosure and what had happened. [ ... ]
Question: What did Mr. Herlihy say?
Roth: He told me […] that the client had decided that it was not necessary for the companies to make that disclosure.”
Complaint ¶¶ 92-93.
The contrast between the Commission’s treatment of BofA’s solicitation of Merrill’s advice on the disclosure of Merrill’s fourth-quarter losses was also dramatic. After the November 13, 2008 conference call Mayopoulos had with the Wachtell lawyers, it was agreed that Price would contact Merrill’s CEO, Thain, concerning disclosure of Merrill’s fourth-quarter losses. As described by the SEC: “Price also approached Thain and Nelson Chai, Merrill’s then-Chief Financial Officer, to suggest that a disclosure may be required. Thain and Chai rejected the suggestion, suggesting that Merrill ordinarily did not provide shareholders with interim disclosure in the middle of a quarterly period.” Statement ¶ 17.
Here is how Cuomo describes Price’s approach to Thain and Chai:
“Although, as Roth’s notes reflect, Price was to ‘engage’ Merrill Lynch, instead he [Price] avoided the issue by watering it down to a mere question. On November 14, Price met with Thain, Cotty [BofA’s Chief Accounting Officer], Chai and Hayward [Merrill’s Finance Director] at Merrill’s New York offices to analyze Merrill’s assets and financial condition. Price did not act on Mayopoulos’ advice to tell Thain that Bank of America would be disclosing Merrill losses. Rather, he merely asked Thain and Chai if Merrill would be making any disclosures regarding Merrill’s fourth quarter losses. Price recalled that he ‘asked that they assess any potential need to early disclose financial results and we would do the same, it would come back together.’
Hayward explained that there was only ‘a very short comment from Joe Price to the effect — not verbatim, but to the effect — does Merrill plan to do any intra-quarter disclosure, and John [Thain] responded, No, we don’t provide intra-quarter guidance, had not been doing that all year and didn’t plan to.’”
Complaint ¶¶ 83-84.
On December 3, 2008, just two days before the shareholder vote on the merger, by which time the fourth quarter loss was projected to be $8.9 billion, the SEC, in a footnote in its Statement, notes that Jeffrey Brown, the Bank’s Treasurer, raised with Price “the possibility of disclosing Merrill’s fourth quarter losses; after Price advised Brown that he had consulted the Bank’s attorneys on the issue, Brown suggested that, as a practical matter, disclosure may be advisable.” Statement ¶ 18, note 5.
Cuomo’s description of the interaction is more dramatic:
“Corporate treasurer Jeffrey Brown became concerned about the mounting losses at Merrill and the devastating effect they would have on the Bank of America shares he and others held. As he put it,
Associates are shareholders, as well. We had paid a lot for Merrill Lynch, and we were also watching before our eyes their financial condition deteriorate. You knew that there was likely to be adverse impacts to the share price, and that wasn’t necessarily a good thing as a shareholder.
Brown voiced this concern to Price before the shareholder vote, saying that he believed the losses ought to be disclosed to shareholders. Brown told Price that ‘I felt that we should disclose; that the losses were meaningful enough.’ He explained that ‘at this point it’s about a $9 billion after tax number. That’s a fairly significant loss for a corporation to experience in one quarter, and withholding that could potentially result in items like we’re discussing today [in his deposition].’ After Price dismissed Brown’s concerns, Brown offered an unforgettable warning: ‘I stated to Mr. Price that I didn’t want to be talking through a glass wall over a telephone.’”
Complaint ¶¶ 137-138.
2. Mayopoulos’ Firing
One of the areas Judge Rakoff showed an interest in at the hearing on the second settlement held February 8, as reported by the New York Times, was the firing of general counsel Mayopoulos. The SEC does not mention the firing at all in its Statement of Facts or its supporting papers. While its relevance is not clear, the recitation of the firing in Cuomo’s complaint adds to the drama of the tale it relates. As indicated above, Mayopoulos played the good trooper in his revised conclusion that disclosing Merrill’s anticipated fourth quarter losses in the Bank’s proxy statement was not necessary since they were within the range (as he then understood the actual losses after September 30, 2008) of Merrill’s quarterly losses reported since the fourth quarter of 2007. Mayopoulos had also been consulted by Price and Greg Curl, the Bank’s Vice Chairman of Corporate Development (and lead negotiator for the Bank on the Merrill merger) on whether, in light of Merrill’s fourth quarter losses, the Bank might invoke the “MAC” (material adverse change) clause of the merger agreement and back out of the merger. Mayopoulos advised that successfully invoking the MAC clause was unlikely.
After the merger, the Bank’s board met on December 9, 2008. Price reported to the board that Merrill’s projected net loss for the fourth quarter of 2008 was now $9 billion, some $2 billion higher than Price had previously told Mayopoulos was the expected fourth quarter loss. Right after the December 9 board meeting, Mayopoulos sought out Price to discuss the higher figure. Price was unavailable, so Mayopoulos planned to talk to him the following day with his question. Here is how Cuomo details Mayopoulos’ firing:
“Thus on the evening of December 9, Mayopoulos knew too much: first, that he had been approached before the shareholder meeting about the MAC; second, that on December 3, prior to the shareholder vote, he was told losses were only $7 billion after tax, and third, he now knew that by that time the losses had been at least $9 billion.
The next day, December 10, without any warning, Mayopoulos was told his employment had been terminated, and he was immediately escorted from the premises by an HR executive. He was not permitted to remove any belongings, even personal effects.
. . . .
Bank of America thus fired its General Counsel in the middle of a historic financial crisis, and in the course of the most significant acquisition in its corporate life. As Mayopoulos recalled in his congressional testimony,
I was stunned. I had never been fired from any job, and I had never heard of the general counsel of a major company being summarily dismissed for no apparent reason and with no explanation.
[…]
Finally, I could not understand why I was dismissed so abruptly. I was surprised that I was given no opportunity to say goodbye to my colleagues and staff, and why there was no orderly transition of my work to Mr. Moynihan. [Brian Moynihan, then head of the Bank’s Global Corporate Investment Bank and now CEO of the Bank.] No one, including Mr. Moynihan, ever contacted me to discuss what I had been working on. Nearly a year later, I still do not know why I was terminated, who was involved in the decision to do so, or what their reasons or motivations were.”
Complaint ¶¶ 156-157, 161.
3. The Bank Extracts $20 Billion from the Government
A good portion of Cuomo’s complaint is devoted to the Bank’s allegedly fraudulent extraction of $20 billion from the Government to support the Merrill merger. The thrust of the allegations is that the Bank, Lewis, and Price falsely claimed to Treasury Secretary Paulson and Fed Chairman Bernanke that the Bank could back out of the merger by reason of the MAC clause, due to the unanticipated losses suffered by Merrill during the fourth quarter of 2008, and that it could only proceed with the merger with taxpayer assistance. The detailed allegations make for fascinating reading, and certainly do not cast a favorable light on Lewis, Price, or counsel, but the relevance of the allegations is not entirely clear, given that neither Paulson nor Bernanke was fooled — they saw the argument as a negotiating tactic and probably without foundation — and, as we now know, the Bank in December 2009 repaid not only the $20 billion the Government invested in the Bank to assist with the Merrill merger but also the other $25 billion in TARP monies invested by the Government in the Bank.
But here is some of the gory detail.
The thrust of Cuomo’s allegations, which do serve to emphasize the weakness of the Bank’s position in failing to disclose Merrill’s fourth quarter losses to its shareholders prior to the shareholder vote, is that the Bank tried to use the very same losses that it concluded were not necessary to disclose to its shareholders as grounds for claiming Merrill had suffered a “material adverse change” and therefore would be justified in backing out of the merger! As Cuomo alleges:
“Thus, only the remaining $1.4 billion represented losses incurred after the shareholder vote but prior to December 12 [when the Bank embarked on MAC discussions with the Government]. In other words, BoA management sought taxpayer aid to save the Bank on a figure that was in reality only $1.4 billion worse than the losses they concealed from shareholders voting on the Merrill acquisition. Their action demonstrates, perhaps more clearly than any other fact, the materiality of the pre-vote losses, and BoA management’s obligations to disclose them.”
Complaint ¶¶ 167 (emphasis in original).
Moreover, both the Bank’s general counsel, Mayopoulos (by now having been fired), and the Wachtell firm advised the Bank against invoking the MAC clause. In another illustration of why it is never a good idea to waive the attorney-client or attorney work product privileges, Cuomo details Wachtell’s advice on the MAC clause to the Bank:
“Wachtell concluded right away that invoking the MAC clause would likely fail, and worse, could put the Bank at huge risk of being forced to purchase a bankrupted Merrill Lynch. On December 14, Roth took notes of a conversation with Demmo [another Wachtell partner] in which he noted ‘If we call the MAC company = bankrupt damage = huge,’ which he testified meant that ‘given the state of the financial markets, just the assertion that Merrill had suffered a MAC would probably result in counterparties refusing to deal with Merrill, and, as we saw with Lehman, it may not survive a day.’ The notes also reflect that the initial thinking included government aid: ‘Go to gov’t to share pain? Get addl cap.’ Roth testified that this note reflected Demmo’s thinking ‘that one possible course of action to consider would be the prospect of going to the government and getting some form of assistance.’ Moynihan likewise testified that going into the meetings with the federal officials, a potential solution to the situation was obtaining government aid.”
Complaint ¶ 182.
Demonstrating the dexterity lawyers are capable of, Wachtell’s advice to its client did not prevent it from forcibly arguing to the Government that the Bank could successfully invoke the MAC clause with Merrill and back out of the deal:
“The very lawyers who concluded that a MAC claim would be futile and disastrous argued forcefully to federal officials that a MAC case would be successful. Brenner [the Bank’s Associate General Counsel] described the December 19 meeting [with Paulson and Bernanke] to Moynihan as follows:
Eric [Roth] made a very strong case as to why there is a MAC. All questions (other than one) came from Tom Baxter at the NY Fed and focused on the case law around MAC. Since Eric or Peter [Hein] [of Wachtell] were involved in each case Tom cited, no line of questioning evolved very well for Tom. Tom observed there had never been a successful MAC case before, and Eric responded that all cases are factually based, and this one essentially could be the first due to magnitude and duration of future lost earnings.
In other words, even though it knew a MAC claim was out of the question, the Bank threatened federal officials that it would make one anyway, in order to get taxpayer aid.”
Complaint ¶ 200.
C. Thain’s Reputation Restored?
John Thain should thank Judge Rakoff for his rejection of the August 2009 settlement between the SEC and BofA. As a result of the rejection, the Commission was forced to develop and disclose the record of the deal and the negotiations conducted between the parties in connection with the merger. That record establishes that Merrill (and Thain) did not conceal relevant information concerning the payment of 2008 fourth quarter bonuses to Merrill’s employees or the losses incurred by Merrill for the fourth quarter of 2008.
Lewis fired Thain on January 22, 2009. The firing, widely reported, came in a visit Lewis paid to Thain in New York, and was delivered in a meeting that lasted less than 15 minutes. Officially, all that the Bank stated, in its press release announcing Thain’s departure, was that he was “leaving the company.” Most of the release was devoted to Moynihan’s elevation to President of Global Banking and Global Wealth and Investment Management (replacing Thain). (Moynihan would eventually replace Lewis as CEO of the Bank in December 2009.)
The dirt came in the press reports, which obviously relied upon Bank representatives for their information. Thus, the New York Times, in its report on the termination of January 23, 2009, noted that despite Merrill’s mounting losses over the fourth quarter, it “rushed to pay annual bonuses to its employees before its deal with Bank of America closed on Jan. 1.” While noting that Merrill did alert the Bank in “mid-December” that its losses were ballooning, the Times reported that “Mr. Lewis did not hear the news from Mr. Thain, who around that time left for a skiing trip at his second home in Vail, Colo.” Ouch!
Another reason for the termination, reported the Times, “may have been the decision by Mr. Thain to make an earlier-than-usual bonus payout to Merrill employees, just three days before the merger closed, and before Bank of America could do anything to prevent it.” Thain, following corporate etiquette, “declined through a spokeswoman to comment on whether he had misrepresented Merrill’s risks at the time of the merger.”
But, as the SEC’s Statement of Facts (for which BofA formally acknowledged there was “an evidentiary basis”) and Cuomo’s Complaint make clear, the Bank was well aware of Merrill’s mounting losses during the fourth quarter of 2008 (on a daily basis), agreed with Merrill that it could pay up to $5.8 billion in bonuses for 2008, and was aware of and did not object to the payment of the bonuses actually awarded prior to year end. SEC Statement ¶¶ 33, 39-40, 47; Complaint ¶¶ 236-40.
This is not to say that Thain’s termination was not inevitable. The captain goes down with the sinking ship. With its massive fourth quarter 2008 losses and the outrage that greeted its payment of billions in bonuses, it is no surprise that Lewis “suggested” Thain leave the combined company. What is clear is that the request was not prompted by any failure of disclosure by Merrill or Thain to BofA.
D. What Will Judge Rakoff Do?
As indicated, on Monday, February 8, Judge Rakoff held a preliminary hearing on the second settlement, and, in his fashion, voiced some skepticism. The Judge has now issued his order, on February 11, requesting additional information and certain clarifications concerning this second settlement. This one is not over.
First, for the easy part: the Judge requests the parties to indicate whether they would agree to modifications of the prophylactic provisions of the settlement to permit Court intervention if the parties (the SEC and the Bank) do not agree on the appointment of (i) the independent auditor to conduct the disclosure controls and procedures certification, (ii) disclosure counsel to be retained by the audit committee, or (iii) the independent compensation consultant to be retained by the compensation committee of the BofA board of directors. In any such instance, Judge Rakoff is suggesting the prophylactic provisions be modified to permit the Court to make the choice if the parties are unable to do so. I would anticipate that neither the Commission nor the Bank will have any objection to these suggested revisions to the prophylactic provisions of the settlement.
The Judge also requests clarification that the distribution of the $150 million civil fine not be made to “legacy Merrill Lynch” shareholders of the Bank, meaning those formerly Merrill shareholders who received BofA stock in the merger. No surprise here.
Where things get very dicey is with the Judge’s request for all underlying evidence for his review on the following matters:
• The Mayopoulos termination;
• Wachtell Lipton’s participation, if any, in the “evaluation of the disclosure issues raised by the reports of increased losses at Merrill Lynch & Co.”;
• All recommendations that the Bank disclose Merrill’s fourth quarter 2008 losses, including any from Mayopoulos, Wachtell Lipton, Merrill’s auditors, BofA’s “corporate treasurer,” or anyone else; and
• Similar information as to disclosure of the agreement reached by the Bank and Merrill vis รก vis the payment of 2008 bonuses.
The Judge asks for the underlying evidence relating to the above-referenced matters, requesting that the parties “jointly and severally” arrange the evidence in accordance with the Judge’s listing of the topics he is interested in. He does not call for any argument on the question he is obviously interested in, namely, whether there is any culpability by any individuals for the alleged disclosure violations by the Bank.
The order requires the parties to make their submissions to the Court by no later than 5 p.m. on Tuesday, February 16, 2010. There goes the Presidents’ Day holiday for counsel to the Commission and the Bank. It is safe to say they must all be muttering under their breath about their blown weekend and what Judge Rakoff is up to.
We shall soon see.
So while I still would hazard that Judge Rakoff is likely to approve the second settlement, the fireworks on this one are not over, and Cuomo’s allegations are often stunning and sure to prove discomforting to many of BofA’s senior officers and its counsel.
A. The Second Settlement
The civil penalty of $150 million agreed to by BofA in the second settlement is some five times the fine of $33 million in the August 2009 settlement rejected by the Judge. This is real money, particularly in light of the relevant statutory standards I addressed in my post of September 25, 2009, but a relative pittance compared to BofA’s historical earnings: for the five years ended December 31, 2008, BofA reported average annual net income, after taxes, of $14.1 billion, of which $150 million represents a scant 1.1%.
BofA also agrees to implement, for a period of three years, prophylactic measures designed to enhance its financial reporting and its compensation practices, and to grant shareholders a say in its compensation policies. These measures include auditor certification of the Bank’s disclosure controls and procedures in addition to the attestation now required by SOX § 404 for the Bank’s internal controls and procedures for financial reporting; CEO and CFO certifications of its proxy statements comparable to those now required of the Bank’s 10-Ks and 10-Qs; appointment of separate disclosure counsel for the audit committee of its board of directors; adoption of independence requirements for the members of its compensation committee comparable to those that apply to its audit committee; retention of an independent compensation consultant to be engaged by and to report solely to the compensation committee; institution and implementation of formal written incentive compensation principles and processes, to be amended only after seeking a separate advisory shareholder vote; and provision of a separate advisory shareholder vote at each annual meeting involving the election of directors regarding the Bank’s compensation of its executives. These measures would push BofA to the forefront of “best practices” in its shareholder reporting and provide gainful, and the emphasis is on “gainful,” employment for scores of lawyers, accountants, and compensation consultants.
To address Judge Rakoff’s concern that the $33 million fine imposed by the August 2009 settlement would be borne by the “innocent” victims of BofA’s failure to disclose its agreement with Merrill in its merger proxy statement to allow Merrill to pay up to $5.8 billion in incentive bonuses to its employees for 2008, this second settlement provides for the distribution of the penalty “solely” to the “harmed” BofA shareholders. The fund is to be distributed pursuant to a plan to be subsequently proposed by the Commission and approved by the Court under the provisions of Section 308(a) of SOX. Presumably those shareholders “harmed” by the Bank’s disclosure failures will not include any Merrill shareholders who received BofA stock in the merger.
In support of the settlement, the Commission has filed a 35-page “Statement of Facts” detailing relevant facts established by the evidence obtained by the Commission in discovery after Judge Rakoff’s September 14, 2009 rejection of the first settlement. In a written consent filed with the supporting papers, the Bank “acknowledges that there is an evidentiary basis for the statements in the Statement of Facts ….” Consent of Bank of America Corporation, dated February 1, 2010, ¶ 14. The Bank has further agreed “not to take any action or to make or permit to be made any public statement denying, directly or indirectly, the statements in the Statement of Facts or any allegation in the complaints filed in the Actions or creating the impression that the statements in the Statement of Facts or the allegations in the complaints are without factual basis.” Id. The SEC’s Statement is meticulous in its citation to the sources for each of the statements of fact made. It is safe to say that the Statement reflects the input of BofA’s counsel, as it includes statements (often in footnotes) that this commentator considers reflective of BofA’s defenses.
1. No “Bad Boy” Taint
In the August 2009 settlement rejected by Judge Rakoff, the Bank agreed not only to the payment of a civil penalty in the amount of $33 million, but also to the inclusion in the final judgment of a permanent injunction enjoining the Bank from violating Section 14(a) of the Exchange Act and Rule 14a 9 promulgated by the SEC thereunder, the proxy statement anti-fraud prohibition.
Presumably in exchange for the prophylactic covenants the Bank has agreed to in this settlement, the Commission sets forth no such injunction in this second settlement. That omission is a significant victory for the Bank. Under the SEC’s rules, an “ineligible issuer” is not entitled to use certain procedures and forms that allow it to access the capital markets quickly and efficiently. An institution such as BofA uses these procedures and forms every day. An ineligible issuer includes any issuer that, within the past three years, has been the subject of any judicial or administrative decree or order arising out of a governmental action that, among other things, “[r]equires that the person cease and desist from violating the anti-fraud provisions of the federal securities laws ….” SEC Rule 405 (definition of “ineligible issuer”). The omission of any injunction in this second settlement prohibiting the Bank from violating the proxy statement anti-fraud provisions of the Exchange Act is a significant win for the Bank.
2. Why BofA Excluded Mention of its Agreement for the Payment of Merrill’s Q4 2008 Bonuses from its Proxy Statement
Several of my earlier posts focused on the likely explanation for BofA’s omission from its proxy statement of its agreement with Merrill (contained in a schedule to the merger agreement) that Merrill could pay up to $5.8 billion in year-end bonuses to Merrill’s officers and employees. The SEC’s Statement of Facts discloses that the language of the schedule, permitting the payment of up to $5.8 billion in discretionary year-end bonuses, continued to be negotiated “through October 21, 2008,” Statement ¶ 39, over a month after the merger was announced and the merger agreement filed with the SEC (the schedule is an attachment, albeit not publicly filed, to the merger agreement).
Why was the agreement set out in the schedule with respect to the payment of year-end bonuses not mentioned in the merger proxy statement? The Commission summarizes the deposition testimony of Jeannemarie O’Brien, the Wachtell partner who was responsible for the employee benefits provisions of the merger agreement and their disclosure in the proxy statement, who provided this answer:
“According to O’Brien, the provision in the Schedule did not have to be disclosed because, she believed, the [bonus] awards that Merrill was authorized to pay under Section 5.2 to the Schedule were not special transactional bonuses and were regular year-end bonuses consistent with the prior year.”
Statement ¶ 40.
This explanation doesn’t make sense in the context of the actual language of the forbearance provision of the merger contract, which provided that Merrill would not, without the prior written consent of the Bank, “pay any amount to [directors, officers or employees] not required by any current plan or agreement (other than base salary in the ordinary course of business).” Merger Agreement § 5.2(c). Nevertheless, what the Commission obviously found persuasive is the uniform testimony of the Bank’s executives “that they generally relied on Wachtell Lipton for the accuracy, completeness, and legal compliance of the Bank’s proxy disclosures.” Statement ¶ 40.
The Commission’s Statement concludes in rather stark fashion, highlighting the bonuses actually paid by Merrill in December 2008, after the shareholders of BofA had approved the merger. These bonuses totaled $3.62 billion, paid by a company, Merrill, that reported a net loss of $15.3 billion for the fourth quarter of 2008 and a net loss of $27 billion for all of 2008:
“Approximately 39,400 employees at Merrill Lynch received [bonus] awards. . . . Merrill paid year-end bonuses for 2008 of $1 million or more to nearly 700 employees, $5 million or more to over 50 employees, and $10 million or more to over 10 employees. . . . Among those who received year-end bonuses for 2008 at Merrill were employees who were not retained after the closing of the merger.”
Statement ¶ 49.
B. Cuomo’s Complaint
While the papers filed by the Commission in support of its second settlement with the Bank have the tenor one would expect from a Commission filing, particularly one negotiated with the defendant — staid, measured, and largely colorless — Attorney General Cuomo’s complaint filed against the Bank and its two principal officers, Ken Lewis and Joe Price, is anything but: it is hard-hitting, colorful, and dramatically lays out facts it alleges justify a finding of fraudulent practices engaged in by the defendants. From the Commission’s papers we get firmness but civility; from Cuomo we get a Bronx cheer. And one thing is for certain, Cuomo’s complaint has caused and will cause the Commission and the Bank massive heartburn.
1. Treatment of the Bank’s Failure to Disclose Merrill’s Fourth Quarter Losses
A good illustration of the dramatically different pictures painted by the Commission and Cuomo’s office from the same facts is their treatment of BofA’s failure to disclose Merrill’s fourth quarter losses prior to the special meeting of the Bank’s shareholders held on December 5, 2008 to approve the Merrill merger. For the third quarter of 2008, ended September 30, Merrill reported net losses of $5.2 billion. This figure was publicly reported and incorporated by reference into the proxy statement distributed to the Bank’s shareholders in connection with the merger. Between the third quarter and the date of the meeting, December 5, Merrill incurred net losses of in excess of $7.5 billion, which were not disclosed by the Bank to its shareholders even though the Bank was well aware of them. It was this failure that triggered the Commission to file its second complaint against the Bank, on January 12, 2010, which complaint is also being resolved by the second settlement.
After announcement of the proposed merger on September 15, 2008, the Bank sent hundreds of employees to Merrill’s offices in New York to facilitate the anticipated merger. BofA’s Chief Accounting Officer, Neil Cotty, even moved into an office at Merrill’s headquarters. The Bank received daily reports of Merrill’s financial results. It learned shortly after October 31, 2008 that Merrill had incurred losses before taxes of $6.1 billion for October (and net losses of $4.5 billion). The $4.5 billion monthly net loss almost equaled the $5.2 billion loss that Merrill had reported for the entire third quarter of 2008. When Cotty learned of this loss, he forwarded an email to Joe Price that noted: “Read and weep.” SEC Statement ¶ 15.
After learning of the October 2008 loss, Price sought the advice of the Bank’s general counsel, Timothy Mayopoulos, on the Bank’s disclosure obligations. Here is how the SEC describes the deliberations conducted by Mayopoulos with the Bank’s outside counsel, Wachtell Lipton, and Bank executives (the Bank waived the attorney-client privilege thereby permitting such inquiries on October 12, 2009):
“Over the next several days, Mayopoulos, Price, and other executives and in-house attorneys at Bank of America conferred amongst themselves as well as with Edward Herlihy, Nicholas Demmo and other attorneys at Wachtell Lipton to determine whether a disclosure was required in light of the forecasted $5 billion quarterly loss at Merrill. . . . Notes of a Wachtell Lipton attorney reflect that the initial view of the lawyers on November 13 was that there should be some additional disclosure. . . . Thereafter, the attorneys and executives reviewed and analyzed, among other materials, Merrill’s results in the preceding six quarters, analyst estimates for Merrill’s results in the fourth quarter, as well as the Proxy Statement and other recent Bank of America and Merrill public filings that were available to shareholders. . . . On November 20, the lawyers concluded that no additional disclosure was required. . . . Price informed Lewis of the conclusion reached by the lawyers.”
Statement ¶ 18 (record citations and footnote omitted).
Contrast this rather antiseptic description with the recitation found in Cuomo’s complaint. Cuomo alleges that Mayopoulos’ initial reaction was that the Merrill losses ought to be disclosed: ‘[m]y reaction was that $5 billion is a lot of money, and I believe my initial reaction was that a disclosure was likely warranted.’” Complaint ¶ 75. The Complaint details the conversations Mayopoulos had with Wachtell partners concerning disclosure of the anticipated fourth quarter losses, including reciting from counsel’s notes (Wachtell obviously joined BofA and waived its attorney work product privilege). At a November 13, 2008 conference call that Mayopoulos held with Ed Herlihy, Eric Roth, and Nick Demmo of Wachtell, the Complaint alleges that “[d]uring this meeting, the parties agreed disclosure was the proper course, and they discussed both the disclosure’s content and the date of disclosure.” Complaint ¶ 82.
After the November 13th meeting, Mayopoulos reconsidered his conclusion on the disclosure of the anticipated fourth quarter 2008 Merrill losses. He concluded, based upon Merrill’s reported quarterly losses since the fourth quarter of 2007, ranging from $2 billion to $10 billion, that disclosure of the anticipated $5 billion fourth quarter loss (Mayopoulos, based on his conversations with other Bank executives, had concluded that November 2008 would be flat for Merrill) was not necessary, as it would “be well within the range of prior experience at Merrill Lynch, and that investors, based on that, would not be surprised by that result.” Complaint ¶ 86. He reached this conclusion notwithstanding that, as the SEC recounts, analysts covering Merrill issued reports after Merrill’s reported Q3 2008 net loss of $5.2 billion that projected that Merrill’s fourth-quarter performance would be an improvement over the third quarter, with some projecting that Merrill would report income and others reporting much more modest losses. Statement ¶ 13. Indeed, even Ken Lewis and Joe Price expected Merrill to break even in the fourth quarter. Id.
The last that Mayopoulos conferred with Wachtell about disclosure was November 20, 2008. Here is what Cuomo alleges about that conference call:
“Significantly, Wachtell played a limited role on the question by this time. After their original conclusion [from November 13] was disregarded, Wachtell lawyers took themselves out of the equation, doing no substantive work, and in fact simply agreeing with Mayopoulos. They issued no memoranda or work product and they did no further research. Herlihy testified that Mayopoulos ‘had done a lot of homework and thought it through and so had come to some conclusion with respect to the disclosure.’
Neither Wachtell nor the Bank ever consulted Roth [a Wachtell partner] again on the question. Roth was the lawyer closest to the issues involved in disclosure. He was the lawyer most involved in the analysis of the question, as the only one who had done any research in the area or talked to other lawyers about the litigation of such questions. He was left to think that disclosure would be made:
Question: So what was your understanding of what was going to happen on November 13, 2008 when that conversation ended?
Roth: My sense was that as of the close of that meeting the view was that some kind of trend disclosure would be made — or at least that was the recommendation that was being made to the business people. I have no reason to believe the business people wouldn’t agree with the lawyers’ advice — and that Price would go talk to the senior executives of Merrill about the concept.
But after November 13, he was no longer involved, except to hear that the trend disclosure was never made:
Question: What is the next thing that happened with respect to the disclosure of the Merrill Lynch loss issue after November 13, 2008?
Roth: In terms of what I did [on disclosure], I had no involvement in the consideration or discussion of this issue after November 13 and prior to January 15 with the client. [...] I believe that at some point prior to January 16 I had a conversation with Ed Herlihy where I inquired after the trend disclosure and what had happened. [ ... ]
Question: What did Mr. Herlihy say?
Roth: He told me […] that the client had decided that it was not necessary for the companies to make that disclosure.”
Complaint ¶¶ 92-93.
The contrast between the Commission’s treatment of BofA’s solicitation of Merrill’s advice on the disclosure of Merrill’s fourth-quarter losses was also dramatic. After the November 13, 2008 conference call Mayopoulos had with the Wachtell lawyers, it was agreed that Price would contact Merrill’s CEO, Thain, concerning disclosure of Merrill’s fourth-quarter losses. As described by the SEC: “Price also approached Thain and Nelson Chai, Merrill’s then-Chief Financial Officer, to suggest that a disclosure may be required. Thain and Chai rejected the suggestion, suggesting that Merrill ordinarily did not provide shareholders with interim disclosure in the middle of a quarterly period.” Statement ¶ 17.
Here is how Cuomo describes Price’s approach to Thain and Chai:
“Although, as Roth’s notes reflect, Price was to ‘engage’ Merrill Lynch, instead he [Price] avoided the issue by watering it down to a mere question. On November 14, Price met with Thain, Cotty [BofA’s Chief Accounting Officer], Chai and Hayward [Merrill’s Finance Director] at Merrill’s New York offices to analyze Merrill’s assets and financial condition. Price did not act on Mayopoulos’ advice to tell Thain that Bank of America would be disclosing Merrill losses. Rather, he merely asked Thain and Chai if Merrill would be making any disclosures regarding Merrill’s fourth quarter losses. Price recalled that he ‘asked that they assess any potential need to early disclose financial results and we would do the same, it would come back together.’
Hayward explained that there was only ‘a very short comment from Joe Price to the effect — not verbatim, but to the effect — does Merrill plan to do any intra-quarter disclosure, and John [Thain] responded, No, we don’t provide intra-quarter guidance, had not been doing that all year and didn’t plan to.’”
Complaint ¶¶ 83-84.
On December 3, 2008, just two days before the shareholder vote on the merger, by which time the fourth quarter loss was projected to be $8.9 billion, the SEC, in a footnote in its Statement, notes that Jeffrey Brown, the Bank’s Treasurer, raised with Price “the possibility of disclosing Merrill’s fourth quarter losses; after Price advised Brown that he had consulted the Bank’s attorneys on the issue, Brown suggested that, as a practical matter, disclosure may be advisable.” Statement ¶ 18, note 5.
Cuomo’s description of the interaction is more dramatic:
“Corporate treasurer Jeffrey Brown became concerned about the mounting losses at Merrill and the devastating effect they would have on the Bank of America shares he and others held. As he put it,
Associates are shareholders, as well. We had paid a lot for Merrill Lynch, and we were also watching before our eyes their financial condition deteriorate. You knew that there was likely to be adverse impacts to the share price, and that wasn’t necessarily a good thing as a shareholder.
Brown voiced this concern to Price before the shareholder vote, saying that he believed the losses ought to be disclosed to shareholders. Brown told Price that ‘I felt that we should disclose; that the losses were meaningful enough.’ He explained that ‘at this point it’s about a $9 billion after tax number. That’s a fairly significant loss for a corporation to experience in one quarter, and withholding that could potentially result in items like we’re discussing today [in his deposition].’ After Price dismissed Brown’s concerns, Brown offered an unforgettable warning: ‘I stated to Mr. Price that I didn’t want to be talking through a glass wall over a telephone.’”
Complaint ¶¶ 137-138.
2. Mayopoulos’ Firing
One of the areas Judge Rakoff showed an interest in at the hearing on the second settlement held February 8, as reported by the New York Times, was the firing of general counsel Mayopoulos. The SEC does not mention the firing at all in its Statement of Facts or its supporting papers. While its relevance is not clear, the recitation of the firing in Cuomo’s complaint adds to the drama of the tale it relates. As indicated above, Mayopoulos played the good trooper in his revised conclusion that disclosing Merrill’s anticipated fourth quarter losses in the Bank’s proxy statement was not necessary since they were within the range (as he then understood the actual losses after September 30, 2008) of Merrill’s quarterly losses reported since the fourth quarter of 2007. Mayopoulos had also been consulted by Price and Greg Curl, the Bank’s Vice Chairman of Corporate Development (and lead negotiator for the Bank on the Merrill merger) on whether, in light of Merrill’s fourth quarter losses, the Bank might invoke the “MAC” (material adverse change) clause of the merger agreement and back out of the merger. Mayopoulos advised that successfully invoking the MAC clause was unlikely.
After the merger, the Bank’s board met on December 9, 2008. Price reported to the board that Merrill’s projected net loss for the fourth quarter of 2008 was now $9 billion, some $2 billion higher than Price had previously told Mayopoulos was the expected fourth quarter loss. Right after the December 9 board meeting, Mayopoulos sought out Price to discuss the higher figure. Price was unavailable, so Mayopoulos planned to talk to him the following day with his question. Here is how Cuomo details Mayopoulos’ firing:
“Thus on the evening of December 9, Mayopoulos knew too much: first, that he had been approached before the shareholder meeting about the MAC; second, that on December 3, prior to the shareholder vote, he was told losses were only $7 billion after tax, and third, he now knew that by that time the losses had been at least $9 billion.
The next day, December 10, without any warning, Mayopoulos was told his employment had been terminated, and he was immediately escorted from the premises by an HR executive. He was not permitted to remove any belongings, even personal effects.
. . . .
Bank of America thus fired its General Counsel in the middle of a historic financial crisis, and in the course of the most significant acquisition in its corporate life. As Mayopoulos recalled in his congressional testimony,
I was stunned. I had never been fired from any job, and I had never heard of the general counsel of a major company being summarily dismissed for no apparent reason and with no explanation.
[…]
Finally, I could not understand why I was dismissed so abruptly. I was surprised that I was given no opportunity to say goodbye to my colleagues and staff, and why there was no orderly transition of my work to Mr. Moynihan. [Brian Moynihan, then head of the Bank’s Global Corporate Investment Bank and now CEO of the Bank.] No one, including Mr. Moynihan, ever contacted me to discuss what I had been working on. Nearly a year later, I still do not know why I was terminated, who was involved in the decision to do so, or what their reasons or motivations were.”
Complaint ¶¶ 156-157, 161.
3. The Bank Extracts $20 Billion from the Government
A good portion of Cuomo’s complaint is devoted to the Bank’s allegedly fraudulent extraction of $20 billion from the Government to support the Merrill merger. The thrust of the allegations is that the Bank, Lewis, and Price falsely claimed to Treasury Secretary Paulson and Fed Chairman Bernanke that the Bank could back out of the merger by reason of the MAC clause, due to the unanticipated losses suffered by Merrill during the fourth quarter of 2008, and that it could only proceed with the merger with taxpayer assistance. The detailed allegations make for fascinating reading, and certainly do not cast a favorable light on Lewis, Price, or counsel, but the relevance of the allegations is not entirely clear, given that neither Paulson nor Bernanke was fooled — they saw the argument as a negotiating tactic and probably without foundation — and, as we now know, the Bank in December 2009 repaid not only the $20 billion the Government invested in the Bank to assist with the Merrill merger but also the other $25 billion in TARP monies invested by the Government in the Bank.
But here is some of the gory detail.
The thrust of Cuomo’s allegations, which do serve to emphasize the weakness of the Bank’s position in failing to disclose Merrill’s fourth quarter losses to its shareholders prior to the shareholder vote, is that the Bank tried to use the very same losses that it concluded were not necessary to disclose to its shareholders as grounds for claiming Merrill had suffered a “material adverse change” and therefore would be justified in backing out of the merger! As Cuomo alleges:
“Thus, only the remaining $1.4 billion represented losses incurred after the shareholder vote but prior to December 12 [when the Bank embarked on MAC discussions with the Government]. In other words, BoA management sought taxpayer aid to save the Bank on a figure that was in reality only $1.4 billion worse than the losses they concealed from shareholders voting on the Merrill acquisition. Their action demonstrates, perhaps more clearly than any other fact, the materiality of the pre-vote losses, and BoA management’s obligations to disclose them.”
Complaint ¶¶ 167 (emphasis in original).
Moreover, both the Bank’s general counsel, Mayopoulos (by now having been fired), and the Wachtell firm advised the Bank against invoking the MAC clause. In another illustration of why it is never a good idea to waive the attorney-client or attorney work product privileges, Cuomo details Wachtell’s advice on the MAC clause to the Bank:
“Wachtell concluded right away that invoking the MAC clause would likely fail, and worse, could put the Bank at huge risk of being forced to purchase a bankrupted Merrill Lynch. On December 14, Roth took notes of a conversation with Demmo [another Wachtell partner] in which he noted ‘If we call the MAC company = bankrupt damage = huge,’ which he testified meant that ‘given the state of the financial markets, just the assertion that Merrill had suffered a MAC would probably result in counterparties refusing to deal with Merrill, and, as we saw with Lehman, it may not survive a day.’ The notes also reflect that the initial thinking included government aid: ‘Go to gov’t to share pain? Get addl cap.’ Roth testified that this note reflected Demmo’s thinking ‘that one possible course of action to consider would be the prospect of going to the government and getting some form of assistance.’ Moynihan likewise testified that going into the meetings with the federal officials, a potential solution to the situation was obtaining government aid.”
Complaint ¶ 182.
Demonstrating the dexterity lawyers are capable of, Wachtell’s advice to its client did not prevent it from forcibly arguing to the Government that the Bank could successfully invoke the MAC clause with Merrill and back out of the deal:
“The very lawyers who concluded that a MAC claim would be futile and disastrous argued forcefully to federal officials that a MAC case would be successful. Brenner [the Bank’s Associate General Counsel] described the December 19 meeting [with Paulson and Bernanke] to Moynihan as follows:
Eric [Roth] made a very strong case as to why there is a MAC. All questions (other than one) came from Tom Baxter at the NY Fed and focused on the case law around MAC. Since Eric or Peter [Hein] [of Wachtell] were involved in each case Tom cited, no line of questioning evolved very well for Tom. Tom observed there had never been a successful MAC case before, and Eric responded that all cases are factually based, and this one essentially could be the first due to magnitude and duration of future lost earnings.
In other words, even though it knew a MAC claim was out of the question, the Bank threatened federal officials that it would make one anyway, in order to get taxpayer aid.”
Complaint ¶ 200.
C. Thain’s Reputation Restored?
John Thain should thank Judge Rakoff for his rejection of the August 2009 settlement between the SEC and BofA. As a result of the rejection, the Commission was forced to develop and disclose the record of the deal and the negotiations conducted between the parties in connection with the merger. That record establishes that Merrill (and Thain) did not conceal relevant information concerning the payment of 2008 fourth quarter bonuses to Merrill’s employees or the losses incurred by Merrill for the fourth quarter of 2008.
Lewis fired Thain on January 22, 2009. The firing, widely reported, came in a visit Lewis paid to Thain in New York, and was delivered in a meeting that lasted less than 15 minutes. Officially, all that the Bank stated, in its press release announcing Thain’s departure, was that he was “leaving the company.” Most of the release was devoted to Moynihan’s elevation to President of Global Banking and Global Wealth and Investment Management (replacing Thain). (Moynihan would eventually replace Lewis as CEO of the Bank in December 2009.)
The dirt came in the press reports, which obviously relied upon Bank representatives for their information. Thus, the New York Times, in its report on the termination of January 23, 2009, noted that despite Merrill’s mounting losses over the fourth quarter, it “rushed to pay annual bonuses to its employees before its deal with Bank of America closed on Jan. 1.” While noting that Merrill did alert the Bank in “mid-December” that its losses were ballooning, the Times reported that “Mr. Lewis did not hear the news from Mr. Thain, who around that time left for a skiing trip at his second home in Vail, Colo.” Ouch!
Another reason for the termination, reported the Times, “may have been the decision by Mr. Thain to make an earlier-than-usual bonus payout to Merrill employees, just three days before the merger closed, and before Bank of America could do anything to prevent it.” Thain, following corporate etiquette, “declined through a spokeswoman to comment on whether he had misrepresented Merrill’s risks at the time of the merger.”
But, as the SEC’s Statement of Facts (for which BofA formally acknowledged there was “an evidentiary basis”) and Cuomo’s Complaint make clear, the Bank was well aware of Merrill’s mounting losses during the fourth quarter of 2008 (on a daily basis), agreed with Merrill that it could pay up to $5.8 billion in bonuses for 2008, and was aware of and did not object to the payment of the bonuses actually awarded prior to year end. SEC Statement ¶¶ 33, 39-40, 47; Complaint ¶¶ 236-40.
This is not to say that Thain’s termination was not inevitable. The captain goes down with the sinking ship. With its massive fourth quarter 2008 losses and the outrage that greeted its payment of billions in bonuses, it is no surprise that Lewis “suggested” Thain leave the combined company. What is clear is that the request was not prompted by any failure of disclosure by Merrill or Thain to BofA.
D. What Will Judge Rakoff Do?
As indicated, on Monday, February 8, Judge Rakoff held a preliminary hearing on the second settlement, and, in his fashion, voiced some skepticism. The Judge has now issued his order, on February 11, requesting additional information and certain clarifications concerning this second settlement. This one is not over.
First, for the easy part: the Judge requests the parties to indicate whether they would agree to modifications of the prophylactic provisions of the settlement to permit Court intervention if the parties (the SEC and the Bank) do not agree on the appointment of (i) the independent auditor to conduct the disclosure controls and procedures certification, (ii) disclosure counsel to be retained by the audit committee, or (iii) the independent compensation consultant to be retained by the compensation committee of the BofA board of directors. In any such instance, Judge Rakoff is suggesting the prophylactic provisions be modified to permit the Court to make the choice if the parties are unable to do so. I would anticipate that neither the Commission nor the Bank will have any objection to these suggested revisions to the prophylactic provisions of the settlement.
The Judge also requests clarification that the distribution of the $150 million civil fine not be made to “legacy Merrill Lynch” shareholders of the Bank, meaning those formerly Merrill shareholders who received BofA stock in the merger. No surprise here.
Where things get very dicey is with the Judge’s request for all underlying evidence for his review on the following matters:
• The Mayopoulos termination;
• Wachtell Lipton’s participation, if any, in the “evaluation of the disclosure issues raised by the reports of increased losses at Merrill Lynch & Co.”;
• All recommendations that the Bank disclose Merrill’s fourth quarter 2008 losses, including any from Mayopoulos, Wachtell Lipton, Merrill’s auditors, BofA’s “corporate treasurer,” or anyone else; and
• Similar information as to disclosure of the agreement reached by the Bank and Merrill vis รก vis the payment of 2008 bonuses.
The Judge asks for the underlying evidence relating to the above-referenced matters, requesting that the parties “jointly and severally” arrange the evidence in accordance with the Judge’s listing of the topics he is interested in. He does not call for any argument on the question he is obviously interested in, namely, whether there is any culpability by any individuals for the alleged disclosure violations by the Bank.
The order requires the parties to make their submissions to the Court by no later than 5 p.m. on Tuesday, February 16, 2010. There goes the Presidents’ Day holiday for counsel to the Commission and the Bank. It is safe to say they must all be muttering under their breath about their blown weekend and what Judge Rakoff is up to.
We shall soon see.
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