Cisco and Starent networks announced their all-cash $2.9 billion merger on October 12, 2009. The deal proceeded apace, with a plaintiffs’ class-action lawsuit dutifully filed in early November, settled within one month, Starent’s stockholders approving the merger on December 11, antitrust clearance obtained on December 16, with the merger closing on December 18. Very efficient. Now on to the next one.
A review of the background of the merger, however, as disclosed in Starent’s definitive proxy statement of November 9, 2009 circulated to its stockholders in connection with the special meeting called to approve the merger, squarely raises the question of the appropriateness of relying upon a fear of competitive harm to avoid any pre-signing market check. Unfortunately for those of us interested in M&A doctrine, as enunciated by the Delaware courts, prompt settlement of the legal challenge to the deal will leave resolution of that question to another day.
A. Background of Cisco’s Acquisition of Starent
This deal had its germination in a June 2009 meeting between Starent’s CEO, Ashraf Dahod, and representatives of Cisco to discuss a potential global reseller arrangement between the parties. Simultaneously, Starent commenced discussions with another firm in its industry concerning a possible strategic alliance with respect to the development and sale of certain products. Starent called upon Goldman Sachs, which underwrote Starent’s IPO in 2007, to impress upon Cisco the need to move quickly on negotiations over a reseller arrangement “in light of other strategic alternatives being considered by Starent.” For reasons not explained, Starent’s formal engagement of Goldman, as its financial advisor in this deal, was not formalized until September 23, 2009.
Cisco got down to business in meetings between the parties on August 9 and 10, expressing an interest to Dahod of exploring a possible business combination with Starent. The Starent board met on August 10 and, according to Starent’s proxy statement, made the ritualistic determination “that for the time being Starent should continue to pursue its business plan as an independent company.” No Revlon trigger here. At this very first board meeting to consider a possible deal, the strategy of avoiding a market check of Starent’s value or any auction of Starent was adopted:
“Our board of directors also discussed the potential harm to our business that might result if current or potential customers or competitors were to become aware that we were considering a possible business combination, and our board of directors concluded that there was a need to maintain the confidentiality of any acquisition discussions in order to avoid the potential for such harm, particularly in view of the uncertainty that Starent and Cisco would ever reach an agreement with respect to a business combination.”
Proxy Statement at 17.
The proxy statement does not state, in its description of this first board meeting on a possible deal, that either Goldman or Starent’s counsel participated in the meeting, which is odd since one would think each might have had a view on the board’s conclusion.
Discussions continued apace between Starent and Cisco in early and mid-August. The board met again on August 19. Clearly anticipating an offer from Cisco, the board “considered the possibility of engaging in discussions with other potentially interested parties.” The board confirmed its decision not to engage in discussions with any other potentially interested party:
“Our directors discussed the likely interest of other potentially interested parties in a business combination, as well as the possible ramifications to Starent if competitors or customers were to become aware of any such discussions. Our directors determined that given the preliminary nature of the discussions with Cisco and the potential competitive harms and risk to the alternative strategic alliance under discussion with Company Y, it was not in the best interests of Starent and its stockholders to initiate such discussions at this time, but that the directors would continue to evaluate the advisability of such actions as the discussions with Cisco evolved.”
Proxy Statement at 18.
Again, no mention of Goldman’s or counsel’s participation in this discussion, and no specification of the “potential competitive harms.”
Six days later, the board met again to review the now obviously intense discussions going on between Starent and Cisco. The board again records its decision not to pursue discussions with any other party about a deal:
“There was also discussion at this meeting as to specific other parties that might be interested in a business combination or strategic transaction with Starent and the business issues that would arise if we were to approach other possibly interested parties as to a business combination or other strategic transaction, including specifically the significant potential business risks to Starent that might arise if competitors or customers were to learn that Starent was exploring a sale of its business. The directors concluded that, given the potential for harm to Starent’s business and the jeopardy to its strategic alliance discussions, other potentially interested parties should not be approached at that time and that the issue would be reconsidered if and when Starent were to receive a business combination proposal from Cisco at a value that our board of directors viewed as sufficient to warrant further exploration.”
Proxy Statement at 18.
Again, no mention of Goldman or counsel, and no detail on the “business risks” feared.
Cisco showed its preliminary hand on September 4, 2009, offering in a telephone conversation a price of $27 per share, subject to further due diligence. (The final deal price was at $35 per share.)
On September 8, 2009, Starent entered into an indemnification letter with Goldman. This too is a bit odd given that the formal engagement letter was not entered into until some 15 days later, on September 23. Why not enter into both agreements at the same time (typically the bankers’ indemnification is set out in or in an exhibit to the engagement letter)?
The Starent board rejected Cisco’s preliminary proposal on September 8. In response, Cisco did the obvious, and invited Starent’s management to Cisco’s offices “to explain why Starent’s business and prospects merited a higher price.” After this dog-and-pony show, Cisco upped the ante on September 21, raising its price to $33 per share.
The Starent board met on September 21, and concluded that $33 was “insufficient.” But obviously the end game was near, so what did the directors decide about conducting a market check? No surprise —
“The directors also discussed other parties that might be potentially interested in a business combination. Our board of directors requested that management and Goldman Sachs prepare an assessment of other potentially interested parties. The directors also discussed possible different sales processes that might be pursued if our board of directors were ultimately to determine to pursue a sale of Starent.”
Proxy Statement at 19.
But why request of management and Goldman Sachs “an assessment” of other potentially interested parties if the board had concluded, on August 25, that engaging other parties in deal discussions would pose “significant potential business risks to Starent”? And what about Company Y?
“Our board of directors also discussed the possibility of contacting Company Y with respect to its interest in a possible business combination transaction. Our board of directors concluded that, at that time, such a contact could reasonably result in termination of discussions with Company Y as to a potential strategic alliance and, given that the potential alliance with Company Y represented a potentially significant business opportunity and continued to be a reasonably likely outcome, such outcome should not be jeopardized, particularly since it was uncertain whether Starent and Cisco would ever reach agreement on terms for a business combination.”
Id.
It is at this meeting, September 21, 2009, that the board resolves “to engage Goldman to act as Starent’s financial advisor …”! The horse had just about left the barn and now Goldman is retained?
Three days later the board met again and, apparently for the first time, reviewed with Goldman parties that might be interested in a business combination with Starent. The board then made this significant conclusion:
“Our board of directors also reviewed the possibility that a financial buyer might be interested in a potential acquisition of Starent and determine that such interest would be unlikely at a price equal to or greater than the price under discussion with Cisco [$33 per share].”
Proxy Statement at 20.
Did Goldman support this view?
With financial buyers off the table, the board next turned to strategic buyers, and reaffirmed its early (and often) conclusion that the competitive harm in talking to such potential buyers outweighed any potential benefit:
“The directors reviewed again the potential harm that could be inflicted on Starent if the possibility of a business combination were made public or otherwise became known to customers or competitors. After this review, the directors and management concluded that, in light of the potential competitive and business risks to Starent from approaching any other potentially interested party, and the relatively low likelihood that other parties [this reference appears to be to both strategic and financial buyers] would be interested or able to pursue a business combination with Starent at a value exceeding that offered by Cisco, it was not in the best interests of Starent or its stockholders to contact other potentially interested parties about a possible business combination.”
Proxy Statement at 20.
On September 25, Cisco increased its acquisition price to $35 per share, subject to satisfactory completion of due diligence. On September 29, the hammer dropped with John Chambers (Cisco’s CEO) informing Dahod that $35 was it: Cisco would not go any higher.
Starent apparently had one last possibility to test the Cisco proposal, by broaching a possible business combination with Company Y. But, again, the board declined to do so out of fear that doing so would jeopardize the negotiations with Company Y over a strategic alliance. (The board subsequently resolved to negotiate a commercial OEM reseller agreement with Cisco to mitigate the loss of the strategic alliance with Company Y that would occur upon the announcement of any Cisco/Starent merger.)
B. Legal Considerations
I reviewed the Delaware Supreme Court’s decision in Lyondell Chemical Company v. Ryan, 970 A. 2d 235 (2009) in my post of March 30, 2009. In Lyondell, the Delaware Supreme Court reversed Vice Chancellor Noble’s refusal to grant the Lyondell board summary judgment against plaintiffs on the board’s approval of the merger of Lyondell and a subsidiary of Basell AF. In Lyondell, the Court made clear that where a board is disinterested, and the target has included in its certificate of incorporation (as all public Delaware companies now do) a limitation on the monetary damages available against its directors (as permitted by Section 102(b)(7) of the Delaware GCL), then director liability is available only for conduct that is not in good faith, which requires a showing that the directors “knew” that they were not discharging their fiduciary obligations.
There is no reason to conclude from Starent’s description of this deal that the Starent board was conflicted and not disinterested, notwithstanding that eight key employees (including Dahod and five other executive officers) of Starent secured employment agreements with Cisco. Accordingly, a post-closing challenge to this deal would be out of the question. But the teaching of Lyondell does not apply to a request for injunctive relief. In any such request, Revlon principles should apply in full force. The challenge for plaintiffs, therefore, would be to establish that the board of directors of Starent was grossly negligent in not discharging its fiduciary duties under Revlon to obtain the highest price reasonably attainable for Starent’s stockholders.
In their complaint challenging the deal, the closest the Starent plaintiffs came to challenging the Starent board’s reliance upon competitive harm to avoid any market check is a somewhat pro forma allegation that the board failed “to adequately consider potential acquirers, ….” Complaint ¶ 94 (November 3, 2009). The board’s resorting to the tent of competitive harm to avoid any pre-signing market check is not developed in the complaint and, because the case has been settled, the issue will not be joined before the Delaware Chancery Court.
If the issue were joined, then clearly the board’s conclusions would be tested, i.e., what were the nature of the competitive harms feared, and how would specific customers and competitors of Starent react to any rumors that Starent was in play? Surely blanket statements of competitive harm cannot excuse a board from exercising its Revlon duties, as a resort to such fear could virtually eliminate the need for any pre-signing market check.
It would also be of interest to explore in further detail the roles of Goldman and counsel in the board’s deliberations on the competitive harm that would ensue were Starent to talk to other parties about a deal. From a review of Starent’s description of the background of the deal, it appears that Goldman and counsel played little role in these deliberations.
While it might be too much to say that the Starent board got away with one ($35 per share was some three times Starent’s IPO price of two years earlier), the public record of this transaction shows that Cisco had the field to itself. And Cisco is a savvy dealmaker.
Wednesday, January 13, 2010
Saturday, November 28, 2009
In Re John Q. Hammons Hotels Inc. Shareholder Litigation: Bringing Coherence to Delware's M&A Law Involving Controlling Shareholders?
Much of the march of corporate governance law, as with civilization generally, is to restrain the excesses of the powerful. An illustration is Chancellor Chandler’s important decision in In Re John Q. Hammons Hotels Inc. Shareholder Litigation, 2009 WL 3165613 (October 2, 2009). The Chancellor’s decision is in response to cross motions for summary judgment, and comes some four years after the challenged merger closed on September 16, 2005. In the course of his decision, the Chancellor articulates standards for “majority of the minority” stockholder votes that in certain circumstances would permit the application of a business judgment rather than an entire fairness standard of review for interested-party mergers, applies strict standards to the disclosure of conflicts involving a special committee’s advisors, and applies a surprisingly expansive standard to an aiding and abetting claim against an unaffiliated buyer.
A. John Q. Hammons and His Eponymous Company
John Q. Hammons controlled John Q. Hammons Hotels, Inc. (the “Company”). The Company, an owner and manager of hotels, when public in 1994. It had two classes of stock, Class A and Class B. Hammons and his affiliates owned 5% of the Class A shares and all of the Class B shares, the latter of which had super voting rights. Through his stock holdings, Hammons controlled 75% of the voting power of the Company.
The hotels were owned and operated by a limited partnership of which the Company was the sole general partner. The Company owned a 28% interest in the limited partnership; Hammons owned the remaining the 72% interest (as a limited partner) in the partnership.
Hammons is obviously old school, regarding the trappings of corporate governance as a nuisance. Thus –
• He “disliked the procedural requirements associated with public stockholders and a board of directors, . . . (Slip Opinion at 6).
• He hired the Company’s President in 2001 “without consulting the Board . . .” Id.
• The Company had numerous related party transactions with Hammons: he owned a hotel management company that provided accounting and other administrative services to the Company; owned a 50% interest in the entity from which the Company leased its corporate headquarters; utilized the Company for administrative and other services for his outside business interests (for which he reimbursed the Company); utilized the services of Company employees in his personal enterprises; and owned real estate underlying one of the Company’s hotels that the Company leased from him.
• He threatened legal action against the Board to prevent it from pursuing the sale of certain hotels that the Board concluded were no longer “core assets” of the Company.
• He entered into a side agreement with a broker retained to sell one of the Company’s properties, which granted Hammons a right of first refusal, without disclosing the agreement to the Board.
B. Merger of the Company
Consistent with his style, in early 2004 Hammons informed the Board that he had begun discussions with a third party regarding a sale of the Company and/or his interest in the Company. Hammons’ hand-picked suitor offered $13 per share for all of the outstanding Class A shares. The deal included extensive agreements with Hammons to accommodate his desires to avoid taxation of the disposition of his interest in the Company, to provide him with financing to continue his development of hotels, and to grant to him, by distribution from the buyer, one of the Company’s premier properties.
The deal with the initial suitor eventually went away. The deal that was done, and is the subject of this litigation, was done with affiliates of Jonathan Eilian, an unaffiliated third party. Eilian eventually negotiated a deal whereby his acquisition vehicles would pay $24 in cash per share to the Class A stockholders and accommodate Hammons’ tax, line of credit, and property desires. The deal was negotiated by a special committee of the Company’s board, comprised of independent directors, who retained Lehman Brothers as its financial advisor and the Katten Muchin firm as its legal advisor.
C. Critical Facts
The special committee negotiated with Eilian a not uncommon protection for the minority stockholders, namely, that the deal be approved by a majority of the Class A shareholders of the Company other than Hammons and his affiliates, but, as it turns out, the agreement was deficient in two respects: the condition was to secure the approval of a majority of the Class A shares voting on the merger, and the condition was waivable by the special committee.
As an illustration of why principals should restrain their deal analysis in public, the record in this case included Eilian’s description, in an email sent during the negotiations, of his observation that Hammons practiced a “liberal” mixing of private and personal expenses and competitive interests; and, in one of his early letters to the special committee, his recognition of the “perceived conflicts of interest with the controlling Class B shareholder [Hammons]” as one explanation for the underperformance of the Company’s shares. Further, in an early presentation of his proposal for acquiring the Company, Eilian cited “unique issues of [the] controlling shareholder” as one source of the Company’s trading discount. Slip Opinion at 45. (Prior to merger rumors, the Company’s shares traded in the $4 to $7 range. It went public at $16.50 per share in 1994).
Two facts of interest here turned out to be relevant to the plaintiffs’ claims of nondisclosure: Katten Muchin represented the lender that provided the financing for Eilian to do the deal, and Lehman sought to play a role in Eilian’s planned refinancing of the Company’s debt. Neither alleged conflict was disclosed in the Company’s proxy statement, although Katten Muchin did secure a waiver from the special committee for its joint representation of the board and the buyer’s lender (the deal team and the loan team at Katten Muchin were separate). (Lehman did not get Eilian’s business, and asserted that the group at Lehman that solicited Eilian’s business was different from the group that worked for the Company.)
D. The Stockholder Vote
In a special meeting of stockholders held September 15, 2005, 72% of the outstanding Class A shares voted to approve the merger (with 89% of the Class A shares that voted voting to approve the merger).
E. Standard of Review: Entire Fairness or Business Judgment?
This was the threshold issue the Chancellor confronted in considering the cross motions for summary judgment. Looming over the decision was the Delaware Supreme Court’s decision in Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994), which mandates the application of an entire fairness standard of review to an interested cash-out merger by a controlling or dominating shareholder. The Chancellor concluded that Lynch did not mandate entire fairness review here because the buyer, Jonathan Eilian, “had no prior relationship with the Company or with Hammons” Slip Opinion at 25. No matter that Hammons secured separate benefits for himself from Eilian:
“The rights Hammons retained after the Merger – the 2% interest in the surviving LP, the preferred interest with a $335 million liquidation preference, and various other contractual rights and obligations – do not change that Eilian made an offer to the minority stockholders, who were represented by the disinterested and independent special committee. Put simply, this case is not one in which Hammons stood ‘on both sides of the transaction.’”
Slip Opinion at 25 (citing Lynch).
So the Chancellor moves on to a business judgment standard of review, correct? Incorrect. While Lynch does not mandate entire fairness review, the Chancellor nevertheless applied that standard of review here because of “deficiencies” in the procedures employed by the special committee in this deal. How so?
“In this case – which, again, I have determined is not governed by Lynch – business judgment would be the applicable standard of review if the transaction were (1) recommended by a disinterested and independent special committee, and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.”
Slip Opinion at 29 (footnote omitted).
In an important footnote to this observation, the Chancellor emphasizes that the special committee cannot be just any special committee:
“Rather, the committee must be given sufficient authority and opportunity to bargain on behalf of the minority stockholders, including the ability to hire independent legal and financial advisors. Moreover, neither special committee approval nor a stockholder vote would be effective if the controlling stockholder engaged in threats, coercion, or fraud.”
Id. at 29 n. 38.
But why not apply the business judgment standard given that Hammons did not stand “on both sides” over the transaction? Because, observed the Chancellor, Hammons, by reason of his blocking position as controlling shareholder, and bargaining power, competed with the minority stockholders “for portions of the consideration Eilian was willing to pay to acquire” the Company. Id. at 30. Because of this fact, it was imperative that there be “robust procedural protections in place to ensure that the minority stockholders have sufficient bargaining power and the ability to make an informed choice of whether to accept the third-party’s offer for their shares.” Id.
F. The Chancellor’s Categorical Voting Rules
In explaining his conclusion that, to assure business judgment review (at least in interested party mergers not controlled by Lynch), namely, that the majority-of-the-minority vote be of all minority shares, and that the condition be non-waivable, even by the special committee, the Chancellor displays an appreciation for the pressures confronting special committees:
“To give maximum effect to these procedural protections, they must be preconditions to the transaction. In other words, the lack of such requirements cannot be ‘cured’ by the fact that they would have been satisfied if they were in place. This increases the likelihood that those seeking the approval of the minority stockholders will propose a transaction that they believe will generate the support of an actual majority of the minority stockholders. Moreover, a clear explanation of the pre-conditions to the Merger is necessary to ensure that the minority stockholders are aware of the importance of their votes and their ability to block a transaction they do not believe is fair.”
Slip Opinion at 31-32.
G. Hammons’ Veto Power and Unfair Dealing
Plaintiffs argued that by reason of Hammons’ veto power over any deal, the special committee was by definition “coerced” into accepting any Hammons-approved deal because, absent any such approval, the Company’s shares would sink back to their pre-merger trading level ($4 to $7 per share). The Chancellor rejected this structural coercion claim, primarily because of the proposition that, at law, Hammons, as a controlling shareholder, had no obligation to sell his shares or to agree to any transaction that would have adverse tax implications for him:
“The mere possibility that the situation would return to the status quo, something Hammons could have chosen to do by never considering selling his shares, is not, standing alone, sufficient ‘coercion’ to render a special committee ineffective for purposes of evaluating fair dealing.”
Slip Opinion at 35.
H. Self-Dealing and Share Price Depression
The Chancellor concluded that a trial is necessary to resolve the parties’ claims on fair dealing. And, in what surprised this observer, the Chancellor concludes that the plaintiffs could prevail at trial on their claim of unfair dealing “if they were able to establish that the price of the minority shares was depressed as a result of Hammons’ improper self-dealing conduct.” Slip Opinion at 35. If the pre-merger price of the Class A shares was depressed by such conduct, “then the special committee and the stockholders could have been subject to improper coercion, meaning they would have been coerced into accepting any deal, whether fair or not, to avoid remaining as stockholders.”
I. Disclosure Claims
As noted above, the Chancellor concluded that the Company’s failure to include in its proxy statement the potential conflicts to which Katten Muchin and Lehman were subject precluded summary judgment on plaintiffs’ disclosure claims, thus necessitating that the claims be tried. In rejecting the defendants’ motion on these disclosure claims, the Chancellor places heavy reliance on the importance of disclosure of potential conflicts of interest to which advisors may be subject:
“This Court, however, has stressed the importance of disclosure of potential conflicts of interest of financial advisors. Such disclosure is particularly important where there was no public auction of the Company and ‘shareholders may be forced to place heavy weight upon the opinion of such an expert.’ It is imperative that stockholders be able to decide for themselves what weight to place on a conflict faced by the financial advisor.”
Slip Opinion at 40 (footnotes omitted).
Similar concerns apply to the disclosure of conflicts to which legal advisors may be subject:
“Again, the compensation and potential conflicts of interest of the special committee’s advisors are important facts that generally must be disclosed to stockholders before a vote. This is particularly true, where, as here, the minority stockholders are relying on the special committee to negotiate on their behalf in a transaction where they will receive cash for their minority shares. Although the waiver of the conflict by the special committee may have resolved any ethical violation, the special committee’s waiver of the conflict would likely be important to stockholders in evaluating the Merger and in assessing the efforts of the special committee and its advisors.”
Slip Opinion at 42.
J. Aiding and Abetting
An aiding and abetting claim requires, among other things, knowing participation in a breach of fiduciary duty by the alleged aider and abettor. In another surprise for this observer, the Chancellor concluded that, by reason of Eilian’s “awareness” of Hammons’ conflicts of interest and alleged improper self-dealing, he was not entitled to summary judgment on plaintiffs’ aiding and abetting claim: “There remains,” concluded the Chancellor, “a material issue of fact as to whether Eilian was aware that [the Company’s] stock price was depressed as a result of Hammons’ improper self-dealing.” Slip Opinion at 45.
_____________________
So this case is headed for trial. While the parties attempted mediation prior to the filing of their summary judgment motions, unsuccessfully, one would assume that settlement discussions may resume in earnest now that Chancellor has teed this case up for a full-blown trial.
A. John Q. Hammons and His Eponymous Company
John Q. Hammons controlled John Q. Hammons Hotels, Inc. (the “Company”). The Company, an owner and manager of hotels, when public in 1994. It had two classes of stock, Class A and Class B. Hammons and his affiliates owned 5% of the Class A shares and all of the Class B shares, the latter of which had super voting rights. Through his stock holdings, Hammons controlled 75% of the voting power of the Company.
The hotels were owned and operated by a limited partnership of which the Company was the sole general partner. The Company owned a 28% interest in the limited partnership; Hammons owned the remaining the 72% interest (as a limited partner) in the partnership.
Hammons is obviously old school, regarding the trappings of corporate governance as a nuisance. Thus –
• He “disliked the procedural requirements associated with public stockholders and a board of directors, . . . (Slip Opinion at 6).
• He hired the Company’s President in 2001 “without consulting the Board . . .” Id.
• The Company had numerous related party transactions with Hammons: he owned a hotel management company that provided accounting and other administrative services to the Company; owned a 50% interest in the entity from which the Company leased its corporate headquarters; utilized the Company for administrative and other services for his outside business interests (for which he reimbursed the Company); utilized the services of Company employees in his personal enterprises; and owned real estate underlying one of the Company’s hotels that the Company leased from him.
• He threatened legal action against the Board to prevent it from pursuing the sale of certain hotels that the Board concluded were no longer “core assets” of the Company.
• He entered into a side agreement with a broker retained to sell one of the Company’s properties, which granted Hammons a right of first refusal, without disclosing the agreement to the Board.
B. Merger of the Company
Consistent with his style, in early 2004 Hammons informed the Board that he had begun discussions with a third party regarding a sale of the Company and/or his interest in the Company. Hammons’ hand-picked suitor offered $13 per share for all of the outstanding Class A shares. The deal included extensive agreements with Hammons to accommodate his desires to avoid taxation of the disposition of his interest in the Company, to provide him with financing to continue his development of hotels, and to grant to him, by distribution from the buyer, one of the Company’s premier properties.
The deal with the initial suitor eventually went away. The deal that was done, and is the subject of this litigation, was done with affiliates of Jonathan Eilian, an unaffiliated third party. Eilian eventually negotiated a deal whereby his acquisition vehicles would pay $24 in cash per share to the Class A stockholders and accommodate Hammons’ tax, line of credit, and property desires. The deal was negotiated by a special committee of the Company’s board, comprised of independent directors, who retained Lehman Brothers as its financial advisor and the Katten Muchin firm as its legal advisor.
C. Critical Facts
The special committee negotiated with Eilian a not uncommon protection for the minority stockholders, namely, that the deal be approved by a majority of the Class A shareholders of the Company other than Hammons and his affiliates, but, as it turns out, the agreement was deficient in two respects: the condition was to secure the approval of a majority of the Class A shares voting on the merger, and the condition was waivable by the special committee.
As an illustration of why principals should restrain their deal analysis in public, the record in this case included Eilian’s description, in an email sent during the negotiations, of his observation that Hammons practiced a “liberal” mixing of private and personal expenses and competitive interests; and, in one of his early letters to the special committee, his recognition of the “perceived conflicts of interest with the controlling Class B shareholder [Hammons]” as one explanation for the underperformance of the Company’s shares. Further, in an early presentation of his proposal for acquiring the Company, Eilian cited “unique issues of [the] controlling shareholder” as one source of the Company’s trading discount. Slip Opinion at 45. (Prior to merger rumors, the Company’s shares traded in the $4 to $7 range. It went public at $16.50 per share in 1994).
Two facts of interest here turned out to be relevant to the plaintiffs’ claims of nondisclosure: Katten Muchin represented the lender that provided the financing for Eilian to do the deal, and Lehman sought to play a role in Eilian’s planned refinancing of the Company’s debt. Neither alleged conflict was disclosed in the Company’s proxy statement, although Katten Muchin did secure a waiver from the special committee for its joint representation of the board and the buyer’s lender (the deal team and the loan team at Katten Muchin were separate). (Lehman did not get Eilian’s business, and asserted that the group at Lehman that solicited Eilian’s business was different from the group that worked for the Company.)
D. The Stockholder Vote
In a special meeting of stockholders held September 15, 2005, 72% of the outstanding Class A shares voted to approve the merger (with 89% of the Class A shares that voted voting to approve the merger).
E. Standard of Review: Entire Fairness or Business Judgment?
This was the threshold issue the Chancellor confronted in considering the cross motions for summary judgment. Looming over the decision was the Delaware Supreme Court’s decision in Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994), which mandates the application of an entire fairness standard of review to an interested cash-out merger by a controlling or dominating shareholder. The Chancellor concluded that Lynch did not mandate entire fairness review here because the buyer, Jonathan Eilian, “had no prior relationship with the Company or with Hammons” Slip Opinion at 25. No matter that Hammons secured separate benefits for himself from Eilian:
“The rights Hammons retained after the Merger – the 2% interest in the surviving LP, the preferred interest with a $335 million liquidation preference, and various other contractual rights and obligations – do not change that Eilian made an offer to the minority stockholders, who were represented by the disinterested and independent special committee. Put simply, this case is not one in which Hammons stood ‘on both sides of the transaction.’”
Slip Opinion at 25 (citing Lynch).
So the Chancellor moves on to a business judgment standard of review, correct? Incorrect. While Lynch does not mandate entire fairness review, the Chancellor nevertheless applied that standard of review here because of “deficiencies” in the procedures employed by the special committee in this deal. How so?
“In this case – which, again, I have determined is not governed by Lynch – business judgment would be the applicable standard of review if the transaction were (1) recommended by a disinterested and independent special committee, and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.”
Slip Opinion at 29 (footnote omitted).
In an important footnote to this observation, the Chancellor emphasizes that the special committee cannot be just any special committee:
“Rather, the committee must be given sufficient authority and opportunity to bargain on behalf of the minority stockholders, including the ability to hire independent legal and financial advisors. Moreover, neither special committee approval nor a stockholder vote would be effective if the controlling stockholder engaged in threats, coercion, or fraud.”
Id. at 29 n. 38.
But why not apply the business judgment standard given that Hammons did not stand “on both sides” over the transaction? Because, observed the Chancellor, Hammons, by reason of his blocking position as controlling shareholder, and bargaining power, competed with the minority stockholders “for portions of the consideration Eilian was willing to pay to acquire” the Company. Id. at 30. Because of this fact, it was imperative that there be “robust procedural protections in place to ensure that the minority stockholders have sufficient bargaining power and the ability to make an informed choice of whether to accept the third-party’s offer for their shares.” Id.
F. The Chancellor’s Categorical Voting Rules
In explaining his conclusion that, to assure business judgment review (at least in interested party mergers not controlled by Lynch), namely, that the majority-of-the-minority vote be of all minority shares, and that the condition be non-waivable, even by the special committee, the Chancellor displays an appreciation for the pressures confronting special committees:
“To give maximum effect to these procedural protections, they must be preconditions to the transaction. In other words, the lack of such requirements cannot be ‘cured’ by the fact that they would have been satisfied if they were in place. This increases the likelihood that those seeking the approval of the minority stockholders will propose a transaction that they believe will generate the support of an actual majority of the minority stockholders. Moreover, a clear explanation of the pre-conditions to the Merger is necessary to ensure that the minority stockholders are aware of the importance of their votes and their ability to block a transaction they do not believe is fair.”
Slip Opinion at 31-32.
G. Hammons’ Veto Power and Unfair Dealing
Plaintiffs argued that by reason of Hammons’ veto power over any deal, the special committee was by definition “coerced” into accepting any Hammons-approved deal because, absent any such approval, the Company’s shares would sink back to their pre-merger trading level ($4 to $7 per share). The Chancellor rejected this structural coercion claim, primarily because of the proposition that, at law, Hammons, as a controlling shareholder, had no obligation to sell his shares or to agree to any transaction that would have adverse tax implications for him:
“The mere possibility that the situation would return to the status quo, something Hammons could have chosen to do by never considering selling his shares, is not, standing alone, sufficient ‘coercion’ to render a special committee ineffective for purposes of evaluating fair dealing.”
Slip Opinion at 35.
H. Self-Dealing and Share Price Depression
The Chancellor concluded that a trial is necessary to resolve the parties’ claims on fair dealing. And, in what surprised this observer, the Chancellor concludes that the plaintiffs could prevail at trial on their claim of unfair dealing “if they were able to establish that the price of the minority shares was depressed as a result of Hammons’ improper self-dealing conduct.” Slip Opinion at 35. If the pre-merger price of the Class A shares was depressed by such conduct, “then the special committee and the stockholders could have been subject to improper coercion, meaning they would have been coerced into accepting any deal, whether fair or not, to avoid remaining as stockholders.”
I. Disclosure Claims
As noted above, the Chancellor concluded that the Company’s failure to include in its proxy statement the potential conflicts to which Katten Muchin and Lehman were subject precluded summary judgment on plaintiffs’ disclosure claims, thus necessitating that the claims be tried. In rejecting the defendants’ motion on these disclosure claims, the Chancellor places heavy reliance on the importance of disclosure of potential conflicts of interest to which advisors may be subject:
“This Court, however, has stressed the importance of disclosure of potential conflicts of interest of financial advisors. Such disclosure is particularly important where there was no public auction of the Company and ‘shareholders may be forced to place heavy weight upon the opinion of such an expert.’ It is imperative that stockholders be able to decide for themselves what weight to place on a conflict faced by the financial advisor.”
Slip Opinion at 40 (footnotes omitted).
Similar concerns apply to the disclosure of conflicts to which legal advisors may be subject:
“Again, the compensation and potential conflicts of interest of the special committee’s advisors are important facts that generally must be disclosed to stockholders before a vote. This is particularly true, where, as here, the minority stockholders are relying on the special committee to negotiate on their behalf in a transaction where they will receive cash for their minority shares. Although the waiver of the conflict by the special committee may have resolved any ethical violation, the special committee’s waiver of the conflict would likely be important to stockholders in evaluating the Merger and in assessing the efforts of the special committee and its advisors.”
Slip Opinion at 42.
J. Aiding and Abetting
An aiding and abetting claim requires, among other things, knowing participation in a breach of fiduciary duty by the alleged aider and abettor. In another surprise for this observer, the Chancellor concluded that, by reason of Eilian’s “awareness” of Hammons’ conflicts of interest and alleged improper self-dealing, he was not entitled to summary judgment on plaintiffs’ aiding and abetting claim: “There remains,” concluded the Chancellor, “a material issue of fact as to whether Eilian was aware that [the Company’s] stock price was depressed as a result of Hammons’ improper self-dealing.” Slip Opinion at 45.
_____________________
So this case is headed for trial. While the parties attempted mediation prior to the filing of their summary judgment motions, unsuccessfully, one would assume that settlement discussions may resume in earnest now that Chancellor has teed this case up for a full-blown trial.
Wednesday, November 11, 2009
SEC v. Bank of America Corp.: Bank of America Asserts the Advice of Counsel Defense
Following its October 12, 2009 decision to waive the attorney-client privilege as to communications between it (and Merrill Lynch) and their counsel regarding the disclosures concerning the payment of year-end 2008 discretionary bonuses, Bank of America took the next logical step and, in its answer to the SEC’s amended complaint, dated October 30, 2009, has now asserted, as an affirmative defense, that the Bank “reasonably and in good faith relied on counsel with respect to the matters alleged in the [SEC’s] Amended Complaint.”
So the Bank has come full circle, from taking the position, during the SEC’s investigation of its proxy statement disclosures, that it would not waive the attorney-client privilege while at the same time not formally asserting the advice of counsel defense, to now waiving the privilege and formally asserting the defense. The Bank was emphatic on these points in its briefs filed with the Court in support of its settlement with the SEC (now rejected by Judge Rakoff):
“In the August 25 Order, the Court also asked whether Bank of America had waived the attorney-client privilege by allegedly asserting that it relied on counsel. The answer is indisputably no for at least three reasons. First, no Bank of America or Merrill Lynch witnesses told the SEC that they relied on the advice of counsel with respect to the matter at issue here. At most, when asked, Bank of America and Merrill Lynch witnesses answered that they delegated to counsel the responsibility for preparing the Proxy Statement, including the section at issue here. Second, no Bank of America or Merrill Lynch witnesses revealed the content of any confidential communication with counsel. Third, neither Bank of America nor Merrill Lynch has ever invoked reliance on advice of counsel as a defense to a claim by the SEC in litigation.”
Bank’s Reply Memorandum, dated September 9, 2009, at 2 (footnote omitted).
A. So Why Assert the Defense Now?
I speculated in my post of October 15, 2009 that the Bank may have waived privilege in this case because of pressure it was receiving from other quarters, including Congress and New York Attorney General Andrew Cuomo. I also speculated, given that the decision on waiver went to the highest level at the Bank — its Board of Directors — that it would be surprising indeed if any of the privileged materials now to be disclosed would prejudice the Bank’s defense. In all events, once the Bank made the decision to waive the privilege as to communications between it (and Merrill) and their counsel — Wachtell (counsel to the Bank) and Shearman & Sterling (counsel to Merrill), why not assert an advice of counsel defense? After all, the Bank has consistently asserted that the drafting of the November 3, 2008 proxy statement was done by the lawyers and disclosure decisions were made by the lawyers. So why not let the lawyers defend the disclosures (and omissions) in the proxy statement?
But, as a technical matter, it’s not clear what the advice of counsel defense will do for the Bank. The SEC, in its amended complaint, which sharpens its allegations against the Bank, does not name any additional parties, including any officers of the Bank or any of the Bank’s or Merrill’s lawyers. “Scienter” is not an element of the SEC’s claim of proxy violations against the Bank. The SEC need not establish that the Bank, in omitting to disclose publicly its agreement with Merrill on the payment of year-end 2008 discretionary bonuses, was “conscious” of the violation or reckless in not disclosing the agreement in light of the requirements of the proxy rules. As the SEC explained in its initial brief in support of its settlement with the Bank:
“There is no scienter requirement for a violation of Section 14(a) of the Exchange Act and Rule 14a-9. A misleading proxy statement violates these provisions even if the company filing the statement ‘believed in perfect good faith that there was nothing misleading in the proxy materials.’ . . . Liability may be imposed based on negligent conduct. . . . (misstatements need not have ‘resulted from knowing conduct’ and ‘[l]iability can be imposed for negligently drafting a proxy statement’). As the Seventh Circuit explained in a recent case, negligence in this context simply describes the issuer’s failure to comply with the law: ‘Section 14(a) requires proof only that the proxy solicitation was misleading, implying at worst negligence by the issuer. And negligence is not a state of mind; it is a failure, whether conscious or even unavoidable . . . to come up to the specified standard of care.’”
SEC’s Memorandum, dated August 24, 2009, at 19 (citations omitted).
If the SEC need not establish scienter by the Bank to make out its claims of proxy rule violations by the Bank, then it is not clear what purpose the advice of counsel defense serves. You can’t justify driving 60 miles an hour in a 25-mile school zone on the ground that your lawyer told you it was OK. Similarly, even if Wachtell rendered a written opinion to the Bank that the omission of the year-end bonuses agreement articulated in the Disclosure Schedule to the Bank/Merrill Merger Agreement from the proxy statement was permissible under the proxy rules, that opinion would not exonerate the Bank from liability if Judge Rakoff finds that the proxy rules required disclosure of the agreement in the proxy statement.
The Bank’s position is that a violation of the proxy rules requires a finding of negligence, and that there was no negligence in the drafting of the BofA/Merrill proxy statement:
“The Proxy Statement was drafted by expert counsel for both Bank of America and Merrill Lynch. It followed the state-of-the-art custom and practice in the legal industry.”
Bank’s Memorandum, dated August 24, 2009, at 27.
Perhaps the Bank intends to rely on the advice of Wachtell to establish that it was not negligent in omitting to disclose the agreement on payment of year-end 2008 discretionary bonuses from the proxy statement. But, as the Seventh Circuit observed in Beck v. Dobrowski, 559 F.3d 680, 682 (7th Cir. 2009), “Section 14(a) requires proof only that the proxy solicitation was misleading, ….” What BofA’s or Merrill’s counsel may have opined on that question should be irrelevant to this question.
B. What Proffering the Defense Will Do
Make life uncomfortable for a lot of lawyers. With the Bank’s waiver of the privilege, the SEC will be reviewing a lot of documents and emails by Wachtell and Shearman & Sterling (as well as in-house counsel) relevant to the proxy statement disclosures. One or more of these lawyers may be called to testify at trial, if a trial occurs. Such scrutiny cannot be welcome to transaction lawyers. And, of course, there is the risk that, if counsel consciously addressed the question of disclosing the agreement on payment of year-end 2008 discretionary bonuses, set forth in the Disclosure Statement to the Merger Agreement, in the proxy statement, and consciously decided not to do so, then such counsel could find themselves named as parties defendant to the SEC’s lawsuit against the Bank or brought up on separate administrative or civil proceedings by the Commission.
So the Bank’s waiver of the attorney-client privilege and its assertion of the advice of counsel defense cannot have sat well with the managing partners of Wachtell or Shearman & Sterling.
So the Bank has come full circle, from taking the position, during the SEC’s investigation of its proxy statement disclosures, that it would not waive the attorney-client privilege while at the same time not formally asserting the advice of counsel defense, to now waiving the privilege and formally asserting the defense. The Bank was emphatic on these points in its briefs filed with the Court in support of its settlement with the SEC (now rejected by Judge Rakoff):
“In the August 25 Order, the Court also asked whether Bank of America had waived the attorney-client privilege by allegedly asserting that it relied on counsel. The answer is indisputably no for at least three reasons. First, no Bank of America or Merrill Lynch witnesses told the SEC that they relied on the advice of counsel with respect to the matter at issue here. At most, when asked, Bank of America and Merrill Lynch witnesses answered that they delegated to counsel the responsibility for preparing the Proxy Statement, including the section at issue here. Second, no Bank of America or Merrill Lynch witnesses revealed the content of any confidential communication with counsel. Third, neither Bank of America nor Merrill Lynch has ever invoked reliance on advice of counsel as a defense to a claim by the SEC in litigation.”
Bank’s Reply Memorandum, dated September 9, 2009, at 2 (footnote omitted).
A. So Why Assert the Defense Now?
I speculated in my post of October 15, 2009 that the Bank may have waived privilege in this case because of pressure it was receiving from other quarters, including Congress and New York Attorney General Andrew Cuomo. I also speculated, given that the decision on waiver went to the highest level at the Bank — its Board of Directors — that it would be surprising indeed if any of the privileged materials now to be disclosed would prejudice the Bank’s defense. In all events, once the Bank made the decision to waive the privilege as to communications between it (and Merrill) and their counsel — Wachtell (counsel to the Bank) and Shearman & Sterling (counsel to Merrill), why not assert an advice of counsel defense? After all, the Bank has consistently asserted that the drafting of the November 3, 2008 proxy statement was done by the lawyers and disclosure decisions were made by the lawyers. So why not let the lawyers defend the disclosures (and omissions) in the proxy statement?
But, as a technical matter, it’s not clear what the advice of counsel defense will do for the Bank. The SEC, in its amended complaint, which sharpens its allegations against the Bank, does not name any additional parties, including any officers of the Bank or any of the Bank’s or Merrill’s lawyers. “Scienter” is not an element of the SEC’s claim of proxy violations against the Bank. The SEC need not establish that the Bank, in omitting to disclose publicly its agreement with Merrill on the payment of year-end 2008 discretionary bonuses, was “conscious” of the violation or reckless in not disclosing the agreement in light of the requirements of the proxy rules. As the SEC explained in its initial brief in support of its settlement with the Bank:
“There is no scienter requirement for a violation of Section 14(a) of the Exchange Act and Rule 14a-9. A misleading proxy statement violates these provisions even if the company filing the statement ‘believed in perfect good faith that there was nothing misleading in the proxy materials.’ . . . Liability may be imposed based on negligent conduct. . . . (misstatements need not have ‘resulted from knowing conduct’ and ‘[l]iability can be imposed for negligently drafting a proxy statement’). As the Seventh Circuit explained in a recent case, negligence in this context simply describes the issuer’s failure to comply with the law: ‘Section 14(a) requires proof only that the proxy solicitation was misleading, implying at worst negligence by the issuer. And negligence is not a state of mind; it is a failure, whether conscious or even unavoidable . . . to come up to the specified standard of care.’”
SEC’s Memorandum, dated August 24, 2009, at 19 (citations omitted).
If the SEC need not establish scienter by the Bank to make out its claims of proxy rule violations by the Bank, then it is not clear what purpose the advice of counsel defense serves. You can’t justify driving 60 miles an hour in a 25-mile school zone on the ground that your lawyer told you it was OK. Similarly, even if Wachtell rendered a written opinion to the Bank that the omission of the year-end bonuses agreement articulated in the Disclosure Schedule to the Bank/Merrill Merger Agreement from the proxy statement was permissible under the proxy rules, that opinion would not exonerate the Bank from liability if Judge Rakoff finds that the proxy rules required disclosure of the agreement in the proxy statement.
The Bank’s position is that a violation of the proxy rules requires a finding of negligence, and that there was no negligence in the drafting of the BofA/Merrill proxy statement:
“The Proxy Statement was drafted by expert counsel for both Bank of America and Merrill Lynch. It followed the state-of-the-art custom and practice in the legal industry.”
Bank’s Memorandum, dated August 24, 2009, at 27.
Perhaps the Bank intends to rely on the advice of Wachtell to establish that it was not negligent in omitting to disclose the agreement on payment of year-end 2008 discretionary bonuses from the proxy statement. But, as the Seventh Circuit observed in Beck v. Dobrowski, 559 F.3d 680, 682 (7th Cir. 2009), “Section 14(a) requires proof only that the proxy solicitation was misleading, ….” What BofA’s or Merrill’s counsel may have opined on that question should be irrelevant to this question.
B. What Proffering the Defense Will Do
Make life uncomfortable for a lot of lawyers. With the Bank’s waiver of the privilege, the SEC will be reviewing a lot of documents and emails by Wachtell and Shearman & Sterling (as well as in-house counsel) relevant to the proxy statement disclosures. One or more of these lawyers may be called to testify at trial, if a trial occurs. Such scrutiny cannot be welcome to transaction lawyers. And, of course, there is the risk that, if counsel consciously addressed the question of disclosing the agreement on payment of year-end 2008 discretionary bonuses, set forth in the Disclosure Statement to the Merger Agreement, in the proxy statement, and consciously decided not to do so, then such counsel could find themselves named as parties defendant to the SEC’s lawsuit against the Bank or brought up on separate administrative or civil proceedings by the Commission.
So the Bank’s waiver of the attorney-client privilege and its assertion of the advice of counsel defense cannot have sat well with the managing partners of Wachtell or Shearman & Sterling.
Thursday, October 15, 2009
SEC v. Bank of America Corp.; Attorney-Client Communications to be Aired
Two of the questions I posed in my post of September 25, 2009 have now been answered. Both the SEC and Bank of America have demanded trial by jury, and the Bank has decided to waive the attorney-client privilege as to communications relevant to the SEC’s complaint against the Bank.
The SEC was first to file a jury trial demand, followed by the Bank. While presenting a 100-page plus legal document to a jury for review is always a challenge, the fundamental question in this case – whether the Bank should have disclosed its agreement with Merrill to allow the payment of up to $5.8 billion in fourth quarter bonuses to Merrill employees – is straightforward, and it would not surprise this observer if the SEC relishes the prospect of having a panel of ordinary New Yorkers pass upon the compensation mores of Wall Street bankers. Perhaps also factoring into the SEC’s decision, and the Bank’s, is a concern over Judge Rakoff, who has demonstrated that he can be a loose cannon.
The Bank’s decision to waive the attorney-client privilege is more surprising, characterized as a “bombshell reversal” by The American Lawyer. Perhaps if the question of waiving the privilege involved only this case, the Bank would have maintained its position and not waived the privilege, but clearly more is at stake, including Congressional inquiries and the pressure being exerted by New York Attorney General Andrew Cuomo. As the Wall Street Journal reports, the “new more conciliatory legal approach is in part intended to pave the way to a settlement of various investigations, say people familiar with the matter.” WSJ, October 13, 2009 at C1, col. 2.
The Bank’s waiver is set forth in a stipulation with the SEC dated October 12, 2009, and is carefully drafted to limit the waiver only to those communications relevant to the matters at issue in the SEC’s complaint against the Bank. This restricted waiver responds to one of the concerns I expressed in my post of September 25 that any waiver could extend to other litigation. Judge Rakoff has accepted the stipulation, although characteristically he couldn’t resist editorializing, chastising the parties for draping the stipulation in “legalese – with the complete first sentence extending over two-and-a-quarter single-spaced pages and featuring no fewer than nine recitations of the word ‘Whereas’.” Order of October 14, 2009. As the Judge characterizes the stipulation:
“It would allow the Bank of America to waive attorney-client privilege and work-product protection regarding certain categories of information material to this case … without thereby waiving such privilege and protection regarding other information that may be of interest in related private lawsuits.”
The matter was of sufficient importance that it went to the highest decision-making level at the Bank – its Board of Directors. It is hard to believe that the Board would have made this decision without believing that none of the affected communications – emails and the like between the Bank and its lawyers, both in-house and at the Wachtell firm, and communications between Merrill and its in-house and outside counsel at Shearman & Sterling – will cast a bad light on either the Bank or its executives.
It may be a different matter for Wachtell. The New York Times, in its article on the waiver, reported that “Wachtell lobbied to keep its advice protected …” (NY Times, October 13, 2009 at B10, col. 6 (the same article quotes a spokesman for Wachtell as claiming the report of its opposition to a waiver to be “totally erroneous”).
The Bank’s position all along, as detailed in the SEC’s briefs in support of the settlement, now rejected by Judge Rakoff, is that it relied upon Wachtell to draft the October 31, 2008 proxy statement used to solicit the Bank’s shareholders to approve the Merrill merger, and that it was Wachtell that made the determination not to explicitly include the Bank’s agreement to permit the payment of up to $5.8 billion in year-end bonuses in the proxy statement itself rather than just in the disclosure schedule included as part of the merger agreement (but not filed with the SEC or made publicly available). So disclosing all attorney-client communications between the Bank and Wachtell can only create discomfort for the firm, and separate it from the Bank.
I surmised in my post of September 3, 2009 there are at least three possible explanations for the Bank’s (or, according to the Bank, Wachtell’s) failure to disclose the Bank’s bonus agreement with Merrill in the proxy statement itself:
“(i) The parties, concerned over the reaction by BofA’s stockholders to any disclosure of the agreement on payment of year-end bonuses, deliberately buried their agreement on the payment of bonuses in the disclosure schedule;
(ii) The parties did not consider the agreement material and therefore concluded that no disclosure of it was necessary; or
(iii) The failure to disclose the agreement was a boot.”
If the new material discloses that Wachtell’s lawyers consciously decided not to disclose the bonus agreement in the proxy statement but leave it to the disclosure schedule, then the SEC could very well add the responsible lawyers to its complaint against the Bank as “aiders and abettors” of the Bank’s violations or as parties who “caused” the Bank’s violations. I speculated in my post of September 9 that the third possibility is the likely one, given the time pressures under which this deal was done: the omission of the bonus agreement in the text of the proxy statement was an oversight. It will be interesting to see what the disclosed materials reveal.
But then again, all of the materials may not be revealed. Uncommunicated work product by a lawyer, such as memos to file not distributed to the client, research memos, and internal communications, may not be within the reach of the Bank’s waiver. Generally, a law firm need not disclose uncommunicated work product, since that is a privilege of the firm, not the client, except in disputes between the client and the firm over the competence of the firm’s legal services. So it could very well turn out that Wachtell will resist emptying its files for the SEC, at least to the extent of uncommunicated Wachtell work product relating to the engagement. It is conceivable, therefore, that the mystery of why the Bank’s agreement with Merrill on the payment of year-end bonuses is included in the disclosure schedule but not in the proxy statement will remain a mystery.
What we can anticipate is the type of embarrassing disclosures that inevitably accompany the production of emails. It continues to astound this observer that individuals who should know better treat email communications like they do communications between fellow golfers in the steam room. Witness this email disclosure between otherwise sophisticated directors of the Bank (Charles K. Gifford and Thomas May) on January 15, 2009, made during a conference call among members of the Board and senior management about Merrill’s mounting losses:
[Gifford] “Unfortunately, it’s screw the shareholders !!”
[May] “No trail, ….”
[Gifford, responding to May’s admonition] “The context of a horrible economy !!! will effect everyone.”
[May] “Good comeback, …”
(NY Times, October 14, 2009, at B1, col. 4, and B4, col. 1)
With the production of attorney-client communications by the Bank, we can expect more of such embarrassing disclosures. Whether they prove more than just embarrassing will be the question.
The SEC was first to file a jury trial demand, followed by the Bank. While presenting a 100-page plus legal document to a jury for review is always a challenge, the fundamental question in this case – whether the Bank should have disclosed its agreement with Merrill to allow the payment of up to $5.8 billion in fourth quarter bonuses to Merrill employees – is straightforward, and it would not surprise this observer if the SEC relishes the prospect of having a panel of ordinary New Yorkers pass upon the compensation mores of Wall Street bankers. Perhaps also factoring into the SEC’s decision, and the Bank’s, is a concern over Judge Rakoff, who has demonstrated that he can be a loose cannon.
The Bank’s decision to waive the attorney-client privilege is more surprising, characterized as a “bombshell reversal” by The American Lawyer. Perhaps if the question of waiving the privilege involved only this case, the Bank would have maintained its position and not waived the privilege, but clearly more is at stake, including Congressional inquiries and the pressure being exerted by New York Attorney General Andrew Cuomo. As the Wall Street Journal reports, the “new more conciliatory legal approach is in part intended to pave the way to a settlement of various investigations, say people familiar with the matter.” WSJ, October 13, 2009 at C1, col. 2.
The Bank’s waiver is set forth in a stipulation with the SEC dated October 12, 2009, and is carefully drafted to limit the waiver only to those communications relevant to the matters at issue in the SEC’s complaint against the Bank. This restricted waiver responds to one of the concerns I expressed in my post of September 25 that any waiver could extend to other litigation. Judge Rakoff has accepted the stipulation, although characteristically he couldn’t resist editorializing, chastising the parties for draping the stipulation in “legalese – with the complete first sentence extending over two-and-a-quarter single-spaced pages and featuring no fewer than nine recitations of the word ‘Whereas’.” Order of October 14, 2009. As the Judge characterizes the stipulation:
“It would allow the Bank of America to waive attorney-client privilege and work-product protection regarding certain categories of information material to this case … without thereby waiving such privilege and protection regarding other information that may be of interest in related private lawsuits.”
The matter was of sufficient importance that it went to the highest decision-making level at the Bank – its Board of Directors. It is hard to believe that the Board would have made this decision without believing that none of the affected communications – emails and the like between the Bank and its lawyers, both in-house and at the Wachtell firm, and communications between Merrill and its in-house and outside counsel at Shearman & Sterling – will cast a bad light on either the Bank or its executives.
It may be a different matter for Wachtell. The New York Times, in its article on the waiver, reported that “Wachtell lobbied to keep its advice protected …” (NY Times, October 13, 2009 at B10, col. 6 (the same article quotes a spokesman for Wachtell as claiming the report of its opposition to a waiver to be “totally erroneous”).
The Bank’s position all along, as detailed in the SEC’s briefs in support of the settlement, now rejected by Judge Rakoff, is that it relied upon Wachtell to draft the October 31, 2008 proxy statement used to solicit the Bank’s shareholders to approve the Merrill merger, and that it was Wachtell that made the determination not to explicitly include the Bank’s agreement to permit the payment of up to $5.8 billion in year-end bonuses in the proxy statement itself rather than just in the disclosure schedule included as part of the merger agreement (but not filed with the SEC or made publicly available). So disclosing all attorney-client communications between the Bank and Wachtell can only create discomfort for the firm, and separate it from the Bank.
I surmised in my post of September 3, 2009 there are at least three possible explanations for the Bank’s (or, according to the Bank, Wachtell’s) failure to disclose the Bank’s bonus agreement with Merrill in the proxy statement itself:
“(i) The parties, concerned over the reaction by BofA’s stockholders to any disclosure of the agreement on payment of year-end bonuses, deliberately buried their agreement on the payment of bonuses in the disclosure schedule;
(ii) The parties did not consider the agreement material and therefore concluded that no disclosure of it was necessary; or
(iii) The failure to disclose the agreement was a boot.”
If the new material discloses that Wachtell’s lawyers consciously decided not to disclose the bonus agreement in the proxy statement but leave it to the disclosure schedule, then the SEC could very well add the responsible lawyers to its complaint against the Bank as “aiders and abettors” of the Bank’s violations or as parties who “caused” the Bank’s violations. I speculated in my post of September 9 that the third possibility is the likely one, given the time pressures under which this deal was done: the omission of the bonus agreement in the text of the proxy statement was an oversight. It will be interesting to see what the disclosed materials reveal.
But then again, all of the materials may not be revealed. Uncommunicated work product by a lawyer, such as memos to file not distributed to the client, research memos, and internal communications, may not be within the reach of the Bank’s waiver. Generally, a law firm need not disclose uncommunicated work product, since that is a privilege of the firm, not the client, except in disputes between the client and the firm over the competence of the firm’s legal services. So it could very well turn out that Wachtell will resist emptying its files for the SEC, at least to the extent of uncommunicated Wachtell work product relating to the engagement. It is conceivable, therefore, that the mystery of why the Bank’s agreement with Merrill on the payment of year-end bonuses is included in the disclosure schedule but not in the proxy statement will remain a mystery.
What we can anticipate is the type of embarrassing disclosures that inevitably accompany the production of emails. It continues to astound this observer that individuals who should know better treat email communications like they do communications between fellow golfers in the steam room. Witness this email disclosure between otherwise sophisticated directors of the Bank (Charles K. Gifford and Thomas May) on January 15, 2009, made during a conference call among members of the Board and senior management about Merrill’s mounting losses:
[Gifford] “Unfortunately, it’s screw the shareholders !!”
[May] “No trail, ….”
[Gifford, responding to May’s admonition] “The context of a horrible economy !!! will effect everyone.”
[May] “Good comeback, …”
(NY Times, October 14, 2009, at B1, col. 4, and B4, col. 1)
With the production of attorney-client communications by the Bank, we can expect more of such embarrassing disclosures. Whether they prove more than just embarrassing will be the question.
Friday, September 25, 2009
SEC v. Bank of America Corp.: The Parties Head for Trial
The parties’ decision to proceed to trial rather than appeal Judge Rakoff’s rejection of their settlement on September 14 surprised this observer. I had speculated in my post of September 15 that the parties would appeal. That they have not may be due to technical issues involving the rejection (it did not constitute a final decision) or it may be that the parties’ submissions and Judge Rakoff’s comments so stirred them up that they have concluded it’s time to strap on their holsters and enter the ring. Whatever is the explanation, the case is now headed for trial, scheduled to commence March 1, 2010. Each party will have many interesting decisions to make over the next few months, including:
A. Will the SEC Sue Additional Parties?
Judge Rakoff has set October 19, 2009 as the date by which the SEC, without leave of court, may amend its pleadings or add additional parties. Given Judge Rakoff’s severe criticism of the Commission for failing to pursue any individual officers of BofA or its counsel for the alleged misstatements and omissions in BofA’s October 31, 2008 proxy statement, will the Commission add as parties defendant any of BofA’s executive officers, BofA’s in-house counsel who worked on the proxy statement, or the Wachtell firm, which acted as BofA’s outside counsel?
I would be surprised if the Commission did so. The Commission has made clear in its filings in support of the settlement that it had developed no evidence establishing the requisite “scienter” or knowledge of wrongdoing by any of the executive officers of BofA or its counsel so as to justify adding any of them to the complaint. The Commission cannot simply run away from these assertions and now do what it said only weeks ago that it could not do:
“… the Commission investigated the relevant roles played by various senior officials and other individuals in the events surrounding Merrill’s payment of year-end bonuses and the related proxy disclosures. The Commission duly considered whether to allege additional charges against Bank of America and charges against individuals but determined that such charges were not sufficiently supported by the investigative record.”
SEC’s Memo of August 24, 2009 at 23.
“… there is an insufficient evidentiary basis to establish a prima facie case of the requisite scienter with respect to the lawyers for purposes of alleging secondary liability under the securities laws.”
SEC Reply Memorandum of September 9, 2009, at 14 (footnote omitted).
B. Will the Parties Request a Jury Trial?
Each of the SEC and BofA may request that the trial be held before a jury. Will they do so?
My guess is that the Commission would be satisfied with Judge Rakoff as trier of fact, whereas the Bank may be more inclined to present its case to a jury. The Bank’s strategy will clearly be to parade expert witness after expert witness (to the extent Judge Rakoff will allow them) and possibly fact witnesses to establish that all the world knew that Merrill intended to pay year-end bonuses in a substantial amount and at least equal to what it in fact did pay — $3.6 billion, a pittance by Wall Street standards (the SEC’s charge is that BofA did not disclose its prior agreement with Merrill that Merrill could pay up to $5.8 billion in fourth-quarter bonuses). The challenge is whether the Bank really wants a group of New Yorkers to dwell over the course of a trial upon the payment of billions in bonuses to Wall Street suits.
C. Will the Parties “Re-Settle” the Case Before Trial?
There is nothing to prevent the Commission and BofA to revise their settlement and present the revised settlement to Judge Rakoff for approval. What would that revision consist of?
The Commission could agree to eliminate the civil fine of $33 million, leaving only the permanent injunction against BofA’s commission of future proxy violations. Presumably BofA would not object to this, and on what grounds could Judge Rakoff object to it, given his outrage over the fact that the civil fine in the original settlement was to be borne by the victims of the alleged “lies” (Judge Rakoff’s words) — BofA’s shareholders?
On the other hand, as an astute colleague of mine has observed, how would the SEC look if it agreed to a settlement eliminating the fine agreed to by BofA? Better to try the case and let the judge decide upon the appropriate monetary remedy (and take whatever heat comes from doing so).
D. Will BofA Waive the Attorney-Client Privilege?
In my post of September 15, 2009, I speculated on this question, concluding that it is unlikely that the Bank would respond affirmatively to any Commission request that it waive the privilege so as to allow everyone to come clean on what was discussed between the Bank and its lawyers concerning the proxy statement’s disclosure of Merrill’s year-end bonuses.
In my initial post on this case of September 3, 2009, I speculated on the possible explanations for the proxy statement’s omission of the Bank’s agreement with Merrill that Merrill could pay up to $5.8 billion in year-end bonuses, ranging from a deliberate omission to the explanation that it was simply an inadvertent omission, due to the incredible time pressures under which this deal and the proxy statement were cobbled together. If I am correct, why not waive the privilege and frankly admit that yes, the agreement set forth in the disclosure schedule was not included in the proxy statement, the explanation being that the team responsible for preparing the disclosure schedule did not adequately communicate with the team drafting the proxy statement — the failure was therefore simply a boot?
The problem with waiving the privilege, however, is that it can have other consequences, including in related litigation. And if BofA waived the privilege here, how could it avoid doing so in any future litigation or dispute? Moreover, the SEC has made clear that the record to date does not provide any evidence of the requisite scienter to enable the SEC to name as party defendants any officer of BofA or its counsel, so why not let a sleeping dog lie?
E. And Now for Judge Rakoff
What remedies would he impose upon BofA if it is found liable for having violated the proxy rules?
Judge Rakoff as judge has to be a neutral arbiter. He cannot force the SEC to name defendants, develop theories of liability, or examine witnesses (as a litigant). So let’s assume the Commission tries the case solely against the Bank, and Judge Rakoff (or a jury) finds the Bank liable for a proxy violation in failing to disclose its agreement with Merrill to allow Merrill to pay billions in-year 2008 bonuses. What sanctions does Judge Rakoff then impose upon the Bank?
The Commission in its complaint seeks monetary damages against the Bank pursuant to the provisions of Section 21(d)(3) of the Exchange Act. The “money penalties” available to the Commission under this provision are a function of the “tier” in which a violation falls. Assuming the BofA finder of fact does not conclude that BofA committed an act of fraud, deceit, manipulation, or a deliberate or reckless disregard of the proxy rules, which appears to be the state of the record based upon what the SEC asserts in its briefs filed in support of the settlement, then the relevant tier to which any probable violation found against the Bank would fall is the “first” tier. For corporations, the amount of a first tier penalty is, for “each violation,” $50,000 or, if the defendant has realized “pecuniary gain,” then the gross amount of such gain.
How does one get to a penalty in the millions of dollars under such provision? One way is to find numerous violations, e.g., 50 different misleading statements in a proxy statement. The law in this area is unclear. One mechanism of truly expanding the penalty would be to find a separate violation based upon the number of shareholders to whom the BofA proxy statement was sent — which numbered 283,000. 283,000 times $50,000 is real money. But the point is that even if the Court finds the Bank to have violated the proxy rules, getting to a fine in the range of $33 million (the fine BofA agreed to pay in the settlement) takes some work. Given Judge Rakoff’s express concerns about the burden of any civil fine, it would be surprising if he imposed one of any material significance against the Bank.
How about an injunction, identical to the one secured by the SEC in its settlement? Here, the Bank will inevitably argue that the odds of its repeating a proxy violation are nil, and therefore even the imposition of an injunction is inappropriate. So, while the imposition of an injunction as a remedy for any finding of a proxy violation by the Bank would not surprising, there could be a real fight over even its appropriateness given relevant case law about the standards governing the entry of injunctions.
So it’s entirely possible that even if the Bank is found liable for proxy violations as alleged by the SEC, the remedies Judge Rakoff would enter will not be as stringent as those set out in the settlement to which BofA was prepared to accept. How will that look? And who would suffer if that were the case? If the answer is Judge Rakoff, then perhaps there are grounds for one or both of the parties to ask him to recuse himself from the case.
The twists and turns this case has taken are not yet over.
A. Will the SEC Sue Additional Parties?
Judge Rakoff has set October 19, 2009 as the date by which the SEC, without leave of court, may amend its pleadings or add additional parties. Given Judge Rakoff’s severe criticism of the Commission for failing to pursue any individual officers of BofA or its counsel for the alleged misstatements and omissions in BofA’s October 31, 2008 proxy statement, will the Commission add as parties defendant any of BofA’s executive officers, BofA’s in-house counsel who worked on the proxy statement, or the Wachtell firm, which acted as BofA’s outside counsel?
I would be surprised if the Commission did so. The Commission has made clear in its filings in support of the settlement that it had developed no evidence establishing the requisite “scienter” or knowledge of wrongdoing by any of the executive officers of BofA or its counsel so as to justify adding any of them to the complaint. The Commission cannot simply run away from these assertions and now do what it said only weeks ago that it could not do:
“… the Commission investigated the relevant roles played by various senior officials and other individuals in the events surrounding Merrill’s payment of year-end bonuses and the related proxy disclosures. The Commission duly considered whether to allege additional charges against Bank of America and charges against individuals but determined that such charges were not sufficiently supported by the investigative record.”
SEC’s Memo of August 24, 2009 at 23.
“… there is an insufficient evidentiary basis to establish a prima facie case of the requisite scienter with respect to the lawyers for purposes of alleging secondary liability under the securities laws.”
SEC Reply Memorandum of September 9, 2009, at 14 (footnote omitted).
B. Will the Parties Request a Jury Trial?
Each of the SEC and BofA may request that the trial be held before a jury. Will they do so?
My guess is that the Commission would be satisfied with Judge Rakoff as trier of fact, whereas the Bank may be more inclined to present its case to a jury. The Bank’s strategy will clearly be to parade expert witness after expert witness (to the extent Judge Rakoff will allow them) and possibly fact witnesses to establish that all the world knew that Merrill intended to pay year-end bonuses in a substantial amount and at least equal to what it in fact did pay — $3.6 billion, a pittance by Wall Street standards (the SEC’s charge is that BofA did not disclose its prior agreement with Merrill that Merrill could pay up to $5.8 billion in fourth-quarter bonuses). The challenge is whether the Bank really wants a group of New Yorkers to dwell over the course of a trial upon the payment of billions in bonuses to Wall Street suits.
C. Will the Parties “Re-Settle” the Case Before Trial?
There is nothing to prevent the Commission and BofA to revise their settlement and present the revised settlement to Judge Rakoff for approval. What would that revision consist of?
The Commission could agree to eliminate the civil fine of $33 million, leaving only the permanent injunction against BofA’s commission of future proxy violations. Presumably BofA would not object to this, and on what grounds could Judge Rakoff object to it, given his outrage over the fact that the civil fine in the original settlement was to be borne by the victims of the alleged “lies” (Judge Rakoff’s words) — BofA’s shareholders?
On the other hand, as an astute colleague of mine has observed, how would the SEC look if it agreed to a settlement eliminating the fine agreed to by BofA? Better to try the case and let the judge decide upon the appropriate monetary remedy (and take whatever heat comes from doing so).
D. Will BofA Waive the Attorney-Client Privilege?
In my post of September 15, 2009, I speculated on this question, concluding that it is unlikely that the Bank would respond affirmatively to any Commission request that it waive the privilege so as to allow everyone to come clean on what was discussed between the Bank and its lawyers concerning the proxy statement’s disclosure of Merrill’s year-end bonuses.
In my initial post on this case of September 3, 2009, I speculated on the possible explanations for the proxy statement’s omission of the Bank’s agreement with Merrill that Merrill could pay up to $5.8 billion in year-end bonuses, ranging from a deliberate omission to the explanation that it was simply an inadvertent omission, due to the incredible time pressures under which this deal and the proxy statement were cobbled together. If I am correct, why not waive the privilege and frankly admit that yes, the agreement set forth in the disclosure schedule was not included in the proxy statement, the explanation being that the team responsible for preparing the disclosure schedule did not adequately communicate with the team drafting the proxy statement — the failure was therefore simply a boot?
The problem with waiving the privilege, however, is that it can have other consequences, including in related litigation. And if BofA waived the privilege here, how could it avoid doing so in any future litigation or dispute? Moreover, the SEC has made clear that the record to date does not provide any evidence of the requisite scienter to enable the SEC to name as party defendants any officer of BofA or its counsel, so why not let a sleeping dog lie?
E. And Now for Judge Rakoff
What remedies would he impose upon BofA if it is found liable for having violated the proxy rules?
Judge Rakoff as judge has to be a neutral arbiter. He cannot force the SEC to name defendants, develop theories of liability, or examine witnesses (as a litigant). So let’s assume the Commission tries the case solely against the Bank, and Judge Rakoff (or a jury) finds the Bank liable for a proxy violation in failing to disclose its agreement with Merrill to allow Merrill to pay billions in-year 2008 bonuses. What sanctions does Judge Rakoff then impose upon the Bank?
The Commission in its complaint seeks monetary damages against the Bank pursuant to the provisions of Section 21(d)(3) of the Exchange Act. The “money penalties” available to the Commission under this provision are a function of the “tier” in which a violation falls. Assuming the BofA finder of fact does not conclude that BofA committed an act of fraud, deceit, manipulation, or a deliberate or reckless disregard of the proxy rules, which appears to be the state of the record based upon what the SEC asserts in its briefs filed in support of the settlement, then the relevant tier to which any probable violation found against the Bank would fall is the “first” tier. For corporations, the amount of a first tier penalty is, for “each violation,” $50,000 or, if the defendant has realized “pecuniary gain,” then the gross amount of such gain.
How does one get to a penalty in the millions of dollars under such provision? One way is to find numerous violations, e.g., 50 different misleading statements in a proxy statement. The law in this area is unclear. One mechanism of truly expanding the penalty would be to find a separate violation based upon the number of shareholders to whom the BofA proxy statement was sent — which numbered 283,000. 283,000 times $50,000 is real money. But the point is that even if the Court finds the Bank to have violated the proxy rules, getting to a fine in the range of $33 million (the fine BofA agreed to pay in the settlement) takes some work. Given Judge Rakoff’s express concerns about the burden of any civil fine, it would be surprising if he imposed one of any material significance against the Bank.
How about an injunction, identical to the one secured by the SEC in its settlement? Here, the Bank will inevitably argue that the odds of its repeating a proxy violation are nil, and therefore even the imposition of an injunction is inappropriate. So, while the imposition of an injunction as a remedy for any finding of a proxy violation by the Bank would not surprising, there could be a real fight over even its appropriateness given relevant case law about the standards governing the entry of injunctions.
So it’s entirely possible that even if the Bank is found liable for proxy violations as alleged by the SEC, the remedies Judge Rakoff would enter will not be as stringent as those set out in the settlement to which BofA was prepared to accept. How will that look? And who would suffer if that were the case? If the answer is Judge Rakoff, then perhaps there are grounds for one or both of the parties to ask him to recuse himself from the case.
The twists and turns this case has taken are not yet over.
Tuesday, September 15, 2009
The Settlement in SEC v. Bank of America Corp: Judge Rakoff As Populist---Settlement Rejected
While he telegraphed his displeasure with the settlement both at the hearing held on August 10, 2009 on the settlement and in his order requesting clarification of the parties’ initial submissions on August 25, Judge Rakoff’s rejection of the settlement by his order of yesterday was nevertheless surprising. As he himself admits, settlements of this nature, by an agency that is as generally respected by the courts as the SEC, are rarely set aside. This one has been, to the general acclaim of the populace, if the reactions in the press, ranging from The New York Times to The Wall Street Journal, are any indication. The comments on The Times’ website to its report of the settlement yesterday were overwhelmingly favorable. Here’s a sample, from some of the 385 readers’ comments (as of September 15) from The Times’ website:
“Thank you your Honor!”
“Such fundamental reasoning was sorely missing from all the prior bailout efforts.”
“Well, what do you know? A judge does the right thing.”
“Yes, there is justice in this world.”
“Good to see the light of Justice exposing and rejecting the ‘insider’ deal between the SEC and BOA!”
“I like this judge! Nominate him for Stevens’ seat on SCOTUS!”
“A judge with some intelligence and integrity. Faith renewed, at least temporarily….”
A. Judge Rakoff, Populist
The Judge’s September 14th order rejecting the settlement is a refreshing read. He disdains the technical language of securities lawyers, and says it plain and simple. Where the Commission refers to BofA’s proxy statement as containing a “proxy violation” and “false” and “misleading” statements, the Judge refers to BofA’s conduct as allegedly “lying” to its shareholders. Thus Judge Rakoff begins his order:
“In the Complaint in this case, … the Securities and Exchange Commission … alleges, in stark terms, that defendant Bank of America Corporation materially lied to its shareholders….”
What particularly frosts the Judge is that the effect of the settlement is to impose upon the victims of the Bank’s alleged lies — BofA’s shareholders — the burden of paying the settlement’s fine of $33 million:
“In other words, the parties were proposing [by the settlement] that the management of Bank of America — having allegedly hidden from the Bank’s shareholders that as much as $5.8 billion of their money would be given as bonuses to the executives of Merrill who had run that company nearly into bankruptcy — would now settle the legal consequences of their lying by paying the S.E.C. $33 million more of the shareholders’ money.”
September 14th Order at 2.
The Judge blasts the settlement as none of “fair, nor reasonable, nor adequate.” Not content to rely solely on law and notions of justice, the Judge finds that the proposed settlement violates fundamental norms of morality:
“It is not fair, first and foremost, because it does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for that misconduct.”
September 14th Order at 4.
Not the prose one typically reads in legal opinions!
In response to the SEC’s argument that the penalty against the corporate entity — the Bank — is justified because it would send “a strong signal to shareholders that unsatisfactory corporate conduct has occurred [and would allow] shareholders to better assess the quality and performance of management,” the Judge is aghast:
“This hypothesis, however, makes no sense when applied to the facts here: for the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion-dollar purchase of a huge, nearly-bankrupt company, need to lose another $33 million of their money in order to ‘better assess the quality and performance of management’ is absurd.”
September 14th Order at 4.
And in response to the Bank’s claims that its investigation indicated that it was the Bank’s lawyers who drafted the proxy statement, the Judge offers the obvious rejoinder: “But if that is the case, why are penalties not then sought from the lawyers?” Id. at 5.
The Judge blasts BofA for, on the one hand, claiming its innocence of the charges of distributing a misleading proxy statement while at the same time agreeing to fork over $33 million of its shareholders’ money. Not only does the Judge question the decision as a business matter, but he points to the obvious, namely, that management of the Bank may not be disinterested parties:
“It is one thing for management to exercise its business judgment to determine how much of its shareholders money should be used to settle a case brought by former shareholders or third parties. It is quite something else for the very management that is accused of having lied to its shareholders to determine how much of those victims’ money should be used to make the case against the management go away.”
September 14th Order at 7 (footnote omitted).
In what must particularly sting the Commission, particularly under its new head Mary Schapiro, the Judge characterizes the settlement at a “contrivance” designed to provide cover to the SEC:
“Overall, indeed, the parties’ submissions, when carefully read, leave the distinct impression that the proposed Consent Judgment was a contrivance designed to provide the S.E.C. with the façade of enforcement and the management of the Bank with a quick resolution of an embarrassing inquiry — all at the expense of the sole alleged victims, the shareholders.”
Id. at 8.
In a final call to arms, the Judge throws down the gauntlet:
“Yet the truth may still emerge. The Bank of America states unequivocally that if the Court disapproves the Consent Judgment, it is prepared to litigate the charges. … The S.E.C., having brought the charges, presumably is not about to drop them. Accordingly, the Court, having hereby disapproved the Consent Judgment, directs the parties to file with the Court, no later than one week from today, a jointly proposed Case Management Plan that will have this case ready to be tried on February 1, 2010.”
Id. at 12 (footnote omitted).
B. Now What?
The first question for the parties is whether to appeal Judge Rakoff’s rejection of their settlement. (Not being a litigator, I assume each can do so.) While the Judge’s comments undoubtedly rub both parties raw, I assume cooler heads will prevail and one or both of the SEC and the Bank will appeal. From the SEC’s standpoint, none of the arguments it advanced to Judge Rakoff for approving the settlement go away. The Judge’s comments about the burden of the $33 million fine being borne by the innocent shareholders of BofA will hurt, because they are true, but I doubt the SEC is ready to forego its policy of imposing corporate fines altogether. Plus the Commission has its institutional prerogatives to protect, namely, its discretion in investigating, prosecuting, and settling cases. Plus Judge Rakoff is known as a maverick, so the Commission will undoubtedly assume it would receive a more receptive audience at the Second Circuit.
From the Bank’s standpoint, before pursuing any appeal it will have to swallow the bravado of its briefs that if the case were tried, the Bank would undoubtedly prevail. The Bank would be foolish to submit to Judge Rakoff and/or to a jury a case involving, at its core, the payment of billions of dollars in bonuses to Wall Street executives. Testifying in court and before a jury of your average New Yorkers is not something Ken Lewis and the other executives of the Bank will relish. So I would expect the Bank to conclude that a deal is a deal and that this deal should be approved.
If, surprise of surprises, the case does head to trial, then one of the first issues the parties will have to address is the Bank’s invocation of the attorney-client privilege. Fundamental to the Commission’s defense of the settlement and its failure to include any individual officers of BofA is the fact that the Bank invoked the privilege, thereby preventing the Commission from investigating communications between the Bank and counsel regarding the proxy statement’s disclosures concerning the payment of discretionary year-end bonuses to Merrill’s executives and employees. Somewhat surprisingly, the Bank, in its reply memorandum of September 9, 2009, appears to take the position that it did not invoke the attorney-client privilege: “It [the Bank] did not prevent any witnesses from testifying or ever invoke the attorney-client privilege in testimony regarding the subject of whether or how to disclose Merrill Lynch’s incentive compensation.” Reply Memo at 1. While this statement is hedged, undoubtedly the first question the Commission would put to the Bank, if the parties proceed to trial, is whether the Bank will now waive the privilege as to all communications between the Bank and counsel regarding the disclosures in the proxy statement concerning bonus compensation to Merrill’s officers and employees. While the Bank may squirm at that question, I would anticipate the response would be a firm “No.”
If the case proceeds to trial, would the Commission add as party defendants any officers of the Bank? Any lawyers of its counsel, the Wachtell firm? It would seem, given a trial date of February 1, 2010, that it is a bit late to add party defendants. Moreover, the Commission has made plain in its briefs filed with the Court that it was not able to develop any evidence establishing scienter on behalf of the Bank’s officers or counsel, and so, how could it name any such individuals as party defendants now?
And, if the case proceeds to trial, and the Commission does not add to the case any individual party defendants, what is the point of proceeding? It would appear that hell will freeze over before Judge Rakoff would impose a penalty on the Bank when no individuals stand before him as defendants, so what would the Commission seek in any trial against the Bank only?
So, upon reflection, the odds of the parties taking up Judge Rakoff’s command to proceed to trial appear nil. Next up: the Second Circuit.
Wednesday, September 9, 2009
The Settlement in SEC v. Bank of America Corp. Under Attack: Bank of America's Defense of the Settlement
In my post of September 3, 2009, I addressed the settlement entered into on August 3, 2009 between the SEC and Bank of America in which the Bank, settling the SEC’s complaint of the same day alleging material misstatements and omissions in the Bank’s October 31, 2008 proxy statement, agreed to a permanent injunction against future violations of the proxy rules and agreed to pay a $33 million fine. I reviewed the SEC’s support of the settlement and Judge Raikoff’s concerns over the settlement. In this post I discuss the Bank’s defense of the settlement, set forth in its memorandum filed August 24, and the submissions of its two experts, Morton Pierce, chairman of Dewey & LeBoeuf’s mergers and acquisitions group, and Joe Grundfest, professor of law at Stanford.
A. The Best Defense is a Powerful Offense
It is clear that what bothers Judge Raikoff about the settlement is the SEC’s failure to name, and include in the settlement, any of the Bank’s officers. In its defense of the settlement, the Bank chooses not to defend this specific omission, but to assert that the SEC’s complaint itself is subject to powerful defenses and that, if the case were tried, the Bank would likely prevail. The thrust of the Bank’s position, therefore, is that the settlement should be approved because the SEC is fortunate to have secured the terms that it did — never mind that one or more individual officers of the Bank was not named as a defendant in the SEC’s complaint.
In support of its position, the Bank makes two arguments: first, that its proxy statement contained no false or misleading statement and no material omission, and second, that even if the proxy statement can be faulted for not specifically flagging Merrill’s and the Bank’s agreement that Merrill could pay year-end incentive bonuses of up to $5.8 billion, the omission was immaterial, given that Merrill’s intent to pay year-end bonuses in approximately this amount was well known to the market prior to the stockholder vote on the merger, via Merrill’s SEC filings and in extensive press reports concerning Merrill.
B. No Misstatement or Omission
The crux of the SEC’s complaint against BofA is that the Bank failed to disclose in the proxy statement distributed to the Bank’s stockholders in connection with the Merrill merger its agreement with Merrill that Merrill could pay up to $5.8 billion in discretionary year-end performance bonuses to Merrill’s officers and employees. In the merger agreement, summarized in the joint proxy statement, the Bank and Merrill agreed that Merrill would not pay discretionary bonuses to its directors, officers, and employees between the date of the merger agreement (September 15, 2008) and the close of the merger, except as set forth in Merrill’s disclosure schedule, without the prior written consent of the Bank. The disclosure schedule, which was not filed with the merger agreement or otherwise made publicly available, reflected the parties’ understanding and agreement that Merrill could pay discretionary year-end bonuses in an amount not to exceed $5.8 billion in the aggregate (and $4.5 billion in the aggregate as an accounting expense).
In defending the proxy statement disclosure, the Bank distorts what the SEC alleges in its complaint, asserting that the Commission alleges that Merrill “was prohibited from making [year-end] bonus payments.” Bank’s Memorandum of August 24, 2009 (“BofA Memo”), at 1. The charge is picked up by Professor Grundfest in his affidavit in support of the Bank’s submission: “The Complaint alleges that Bank of America made ‘representations that Merrill was prohibited from making [year-end bonus] payments.’” Grundfest Affidavit, dated August 21, 2009, ¶ 34. But it wasn’t Merrill’s negative covenant not to pay year-end discretionary bonuses that the Commission attacked, but the proxy statement’s failure to disclose the deal that the Bank and Merrill had already struck by the time they signed the merger agreement:
“The omission of Bank of America’s agreement authorizing Merrill to pay discretionary year-end bonuses made the statements to the contrary in the joint proxy statement and its several subsequent amendments materially false and misleading. Bank of America’s representations that Merrill was prohibited from making such payments were materially false and misleading because the contractual prohibition on such payments was nullified by the undisclosed contractual provision expressly permitting them.”
SEC Complaint, dated August 3, 2009, ¶ 3.
Morton Pierce, one of the Bank’s experts, testifies in his affidavit that the inclusion of compensation-related information in disclosure statements and the non-disclosure of the contents of disclosure statements is customary practice in M&A transactions. That may very well be true, but it does not respond to the question of whether non-disclosure of BofA’s and Merrill’s agreement on the payment of year-end bonuses in this disclosure statement made the Bank’s statement in its proxy statement that no such bonuses would be paid without the Bank’s written consent misleading. (And, on that point, Mr. Pierce is careful to “express no view.”). And, while maintaining the confidentiality of disclosure statement disclosures is customary, neither the Bank nor its experts respond to the point, made by the SEC in its August 24th memorandum, that the very Reg. S-K instructions that permit the nondisclosure of disclosure statements requires disclosure of their contents if “such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document [transmitted to the shareholders and/or investors].” Reg. S-K, Item 601(b)(2).
So I don’t find persuasive the Bank’s claim that its proxy statement disclosure concerning its agreement with Merrill over the payment of discretionary year-end bonuses is not misleading.
C. The Omission of the Agreement on Payment of Year-End Bonuses Was Immaterial
The Bank has a stronger argument on this point. The Bank does not claim that the amount of the permitted year-end bonuses — up to $5.8 billion — is not material, but that the fact and probable amount of Merrill’s intent to pay such bonuses was widely known, both through Merrill’s 10-Q filings with the SEC and in press reports. The Bank cites Merrill’s first two 2008 quarterly reports for the proposition that Merrill had made known to the market its intent to pay compensation and bonuses in an amount comparable to those paid in 2007, and continued with that disclosure in its 10-Q filed after announcement of the merger agreement on September 15, 2008 (for the third calendar quarter ended September 30, 2008). And the Bank, primarily through Professor Grundfest, cites, ad nauseum, media reports that detailed Merrill’s claims to pay compensation and bonuses, including reports from The New York Times, Bloomberg News, and The Today Show, to the effect that Merrill was setting aside some $6.7 billion for officer and employee bonuses.
Both the Bank and Merrill, in their joint proxy statement, as is typical, incorporated by reference their recent SEC filings, including their 2008 10-Qs, and the SEC filings they would make prior to the stockholder meeting of December 5, 2008. So the Bank could clearly raise as a defense that the very information the Commission alleges it omitted from its proxy statement could be found in the Bank’s SEC filings. While media reports are not incorporated by reference in SEC filings, the Bank could argue that the information on Merrill’s expected bonuses was so widely available that the “market” and therefore BofA’s stockholders must be considered to have been aware of it.
The SEC, in its initial August 24 filing, anticipated these claims, and responded by pointing out that Merrill’s SEC filings do not break out bonuses from compensation accruals generally, and that BofA’s stockholders should not be expected to conduct a treasure hunt to ascertain information material to their vote on whether to approve the Bank’s merger with Merrill:
“Although tidbits of information relevant to the issue of year-end compensation at Merrill were available to the public at the time that the proxy materials were disseminated, none of that information disclosed Merrill’s plan to pay billions of dollars in discretionary bonuses and, more importantly, Bank of America’s consent to that plan in connection with the proposed merger. Merrill’s quarterly filings disclosing accruals for “compensation and benefits” did not provide any breakdown for the components of that aggregate accrual. An investor could not have known what portion was being accrued for year-end bonuses as opposed to salaries, benefits, or other expenses. In any event, investors are entitled to full disclosure of material facts within the four corners of the proxy statement and are not required to puzzle through reams of other data from which they may or may not be able to infer those material facts. ….
"While Merrill’s plan to pay bonuses was discussed to some extent in the media before the December 5, 2008 shareholders’ meetings, these reports do not negate Bank of America’s liability for its misleading proxy statement. As an initial matter, the media reports consisted of speculation and some of the reports were based on anonymous sources. Moreover, none of the reports stated that Bank of America had contractually consented to the payment of the Merrill bonuses before the merger closed. In any event, investors were not required to ignore Bank of America’s express representations in its proxy materials and rely instead on sporadic media speculation that was inconsistent with those representations.”
SEC August 24 Memo at 22-23 (emphasis in original).
The Bank’s reliance upon the claim that Merrill’s intent to pay year-end bonuses in the range of $5.8 billion (the actual bonuses paid were some $3.6 billion) was so widely known as to make the failure to expressly refer to that intent in the proxy statement immaterial raises an obvious question: if so widely known, why not include the Bank’s agreement with Merrill that it could pay bonuses of up to $5.8 billion in the proxy statement? Why the need to maintain in confidence information that was known, among others, by the viewers of The Today Show?
The Bank’s claim that the omission of its agreement with Merrill over the payment of year-end bonuses from the text of the proxy statement was immaterial should give Judge Raikoff pause, and could very well establish the bona fides of the settlement to his satisfaction. But if not, and the tone of his August 25 Order reflects considerable skepticism about the merits of the settlement, then the Bank will be forced to emphasize that while it may have exposure for the omission, none of its officers should have as there is no evidence that any of them had the slightest awareness of the omission and therefore no evidence to establish the necessary scienter that would have justified the SEC’s naming any of the Bank’s officers as defendants in the complaint.
The parties have today filed their replies, including to the issues raised in Judge Rakoff's August 25th order. I will address any points I find of interest in their briefs in a subsequent post.
A. The Best Defense is a Powerful Offense
It is clear that what bothers Judge Raikoff about the settlement is the SEC’s failure to name, and include in the settlement, any of the Bank’s officers. In its defense of the settlement, the Bank chooses not to defend this specific omission, but to assert that the SEC’s complaint itself is subject to powerful defenses and that, if the case were tried, the Bank would likely prevail. The thrust of the Bank’s position, therefore, is that the settlement should be approved because the SEC is fortunate to have secured the terms that it did — never mind that one or more individual officers of the Bank was not named as a defendant in the SEC’s complaint.
In support of its position, the Bank makes two arguments: first, that its proxy statement contained no false or misleading statement and no material omission, and second, that even if the proxy statement can be faulted for not specifically flagging Merrill’s and the Bank’s agreement that Merrill could pay year-end incentive bonuses of up to $5.8 billion, the omission was immaterial, given that Merrill’s intent to pay year-end bonuses in approximately this amount was well known to the market prior to the stockholder vote on the merger, via Merrill’s SEC filings and in extensive press reports concerning Merrill.
B. No Misstatement or Omission
The crux of the SEC’s complaint against BofA is that the Bank failed to disclose in the proxy statement distributed to the Bank’s stockholders in connection with the Merrill merger its agreement with Merrill that Merrill could pay up to $5.8 billion in discretionary year-end performance bonuses to Merrill’s officers and employees. In the merger agreement, summarized in the joint proxy statement, the Bank and Merrill agreed that Merrill would not pay discretionary bonuses to its directors, officers, and employees between the date of the merger agreement (September 15, 2008) and the close of the merger, except as set forth in Merrill’s disclosure schedule, without the prior written consent of the Bank. The disclosure schedule, which was not filed with the merger agreement or otherwise made publicly available, reflected the parties’ understanding and agreement that Merrill could pay discretionary year-end bonuses in an amount not to exceed $5.8 billion in the aggregate (and $4.5 billion in the aggregate as an accounting expense).
In defending the proxy statement disclosure, the Bank distorts what the SEC alleges in its complaint, asserting that the Commission alleges that Merrill “was prohibited from making [year-end] bonus payments.” Bank’s Memorandum of August 24, 2009 (“BofA Memo”), at 1. The charge is picked up by Professor Grundfest in his affidavit in support of the Bank’s submission: “The Complaint alleges that Bank of America made ‘representations that Merrill was prohibited from making [year-end bonus] payments.’” Grundfest Affidavit, dated August 21, 2009, ¶ 34. But it wasn’t Merrill’s negative covenant not to pay year-end discretionary bonuses that the Commission attacked, but the proxy statement’s failure to disclose the deal that the Bank and Merrill had already struck by the time they signed the merger agreement:
“The omission of Bank of America’s agreement authorizing Merrill to pay discretionary year-end bonuses made the statements to the contrary in the joint proxy statement and its several subsequent amendments materially false and misleading. Bank of America’s representations that Merrill was prohibited from making such payments were materially false and misleading because the contractual prohibition on such payments was nullified by the undisclosed contractual provision expressly permitting them.”
SEC Complaint, dated August 3, 2009, ¶ 3.
Morton Pierce, one of the Bank’s experts, testifies in his affidavit that the inclusion of compensation-related information in disclosure statements and the non-disclosure of the contents of disclosure statements is customary practice in M&A transactions. That may very well be true, but it does not respond to the question of whether non-disclosure of BofA’s and Merrill’s agreement on the payment of year-end bonuses in this disclosure statement made the Bank’s statement in its proxy statement that no such bonuses would be paid without the Bank’s written consent misleading. (And, on that point, Mr. Pierce is careful to “express no view.”). And, while maintaining the confidentiality of disclosure statement disclosures is customary, neither the Bank nor its experts respond to the point, made by the SEC in its August 24th memorandum, that the very Reg. S-K instructions that permit the nondisclosure of disclosure statements requires disclosure of their contents if “such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document [transmitted to the shareholders and/or investors].” Reg. S-K, Item 601(b)(2).
So I don’t find persuasive the Bank’s claim that its proxy statement disclosure concerning its agreement with Merrill over the payment of discretionary year-end bonuses is not misleading.
C. The Omission of the Agreement on Payment of Year-End Bonuses Was Immaterial
The Bank has a stronger argument on this point. The Bank does not claim that the amount of the permitted year-end bonuses — up to $5.8 billion — is not material, but that the fact and probable amount of Merrill’s intent to pay such bonuses was widely known, both through Merrill’s 10-Q filings with the SEC and in press reports. The Bank cites Merrill’s first two 2008 quarterly reports for the proposition that Merrill had made known to the market its intent to pay compensation and bonuses in an amount comparable to those paid in 2007, and continued with that disclosure in its 10-Q filed after announcement of the merger agreement on September 15, 2008 (for the third calendar quarter ended September 30, 2008). And the Bank, primarily through Professor Grundfest, cites, ad nauseum, media reports that detailed Merrill’s claims to pay compensation and bonuses, including reports from The New York Times, Bloomberg News, and The Today Show, to the effect that Merrill was setting aside some $6.7 billion for officer and employee bonuses.
Both the Bank and Merrill, in their joint proxy statement, as is typical, incorporated by reference their recent SEC filings, including their 2008 10-Qs, and the SEC filings they would make prior to the stockholder meeting of December 5, 2008. So the Bank could clearly raise as a defense that the very information the Commission alleges it omitted from its proxy statement could be found in the Bank’s SEC filings. While media reports are not incorporated by reference in SEC filings, the Bank could argue that the information on Merrill’s expected bonuses was so widely available that the “market” and therefore BofA’s stockholders must be considered to have been aware of it.
The SEC, in its initial August 24 filing, anticipated these claims, and responded by pointing out that Merrill’s SEC filings do not break out bonuses from compensation accruals generally, and that BofA’s stockholders should not be expected to conduct a treasure hunt to ascertain information material to their vote on whether to approve the Bank’s merger with Merrill:
“Although tidbits of information relevant to the issue of year-end compensation at Merrill were available to the public at the time that the proxy materials were disseminated, none of that information disclosed Merrill’s plan to pay billions of dollars in discretionary bonuses and, more importantly, Bank of America’s consent to that plan in connection with the proposed merger. Merrill’s quarterly filings disclosing accruals for “compensation and benefits” did not provide any breakdown for the components of that aggregate accrual. An investor could not have known what portion was being accrued for year-end bonuses as opposed to salaries, benefits, or other expenses. In any event, investors are entitled to full disclosure of material facts within the four corners of the proxy statement and are not required to puzzle through reams of other data from which they may or may not be able to infer those material facts. ….
"While Merrill’s plan to pay bonuses was discussed to some extent in the media before the December 5, 2008 shareholders’ meetings, these reports do not negate Bank of America’s liability for its misleading proxy statement. As an initial matter, the media reports consisted of speculation and some of the reports were based on anonymous sources. Moreover, none of the reports stated that Bank of America had contractually consented to the payment of the Merrill bonuses before the merger closed. In any event, investors were not required to ignore Bank of America’s express representations in its proxy materials and rely instead on sporadic media speculation that was inconsistent with those representations.”
SEC August 24 Memo at 22-23 (emphasis in original).
The Bank’s reliance upon the claim that Merrill’s intent to pay year-end bonuses in the range of $5.8 billion (the actual bonuses paid were some $3.6 billion) was so widely known as to make the failure to expressly refer to that intent in the proxy statement immaterial raises an obvious question: if so widely known, why not include the Bank’s agreement with Merrill that it could pay bonuses of up to $5.8 billion in the proxy statement? Why the need to maintain in confidence information that was known, among others, by the viewers of The Today Show?
The Bank’s claim that the omission of its agreement with Merrill over the payment of year-end bonuses from the text of the proxy statement was immaterial should give Judge Raikoff pause, and could very well establish the bona fides of the settlement to his satisfaction. But if not, and the tone of his August 25 Order reflects considerable skepticism about the merits of the settlement, then the Bank will be forced to emphasize that while it may have exposure for the omission, none of its officers should have as there is no evidence that any of them had the slightest awareness of the omission and therefore no evidence to establish the necessary scienter that would have justified the SEC’s naming any of the Bank’s officers as defendants in the complaint.
The parties have today filed their replies, including to the issues raised in Judge Rakoff's August 25th order. I will address any points I find of interest in their briefs in a subsequent post.
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