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.

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.

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.

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.

The Settlement in SEC v. Bank of America Under Attack: Judge Rakoff v. the Attorney-Client Privilege

The SEC and Bank of America confronted a skeptical audience in the form of Judge Rakoff when they presented to him their settlement for approval on August 10, 2009. The Judge asked for further background on the settlement by written submissions (filed on August 24, 2009), which are to be followed by further written submissions (each party responding to the other’s initial submissions) on September 9, 2009. Following the initial submissions on August 24, the Judge issued an order the following day, requesting responses to questions he had that were prompted by the initial submissions.

The Commission filed its complaint and announced its settlement with BofA on the same day — August 3, 2009. The complaint names the Bank only, asserting that, by its October 31, 2008 proxy statement distributed to its stockholders in connection with the Bank’s proposed merger with Merrill Lynch & Co., Inc., the Bank had made materially false and misleading statements concerning its agreement with Merrill for the payment of year-end discretionary bonuses to Merrill’s officers and employees. By the settlement, the Bank agreed to a permanent injunction from violating Section 14(a) of the Exchange Act and the SEC’s Rule 14a-9 (both governing proxy statements), and agreed to pay a penalty of $33 million.

What clearly is troubling the Judge is the SEC’s failure to name in its complaint any of the Bank’s officers. As the Judge observes in his August 25th follow-up order, the burden of the payment of the penalty of $33 million will fall upon the stockholders of BofA (and possibly U.S. taxpayers, given the $45 billion that the Government has invested in the Bank and Merrill). And yet, observed the Judge, “the gravamen of the violation asserted in the [SEC’s August 3d] Complaint is that Bank of America, through its management, effectively lied to its own shareholders.” August 25th Order at 2. Quoting from the SEC’s own guidelines concerning the imposition of financial penalties, the Judge noted that the SEC’s historical position is that:

“Where shareholders have been victimized by the violative conduct, or by the resulting negative effect on the entity following its discovery, the Commission is expected to seek penalties from culpable individual offenders acting for the corporation.”

Id.
So why did the Commission not name Ken Lewis (BofA’s CEO) or any of the other senior officers of the Bank for the alleged false statements in the Bank’s proxy statement?

A. The Alleged False Statements

As is typical, the BofA/Merrill merger agreement contains a series of restrictions on the conduct of Merrill’s business between the date of signing (September 15, 2008) and the close of the merger. These restrictions, referred to as “forbearances,” numbered some 18 in the BofA/Merrill merger agreement. The section containing the forbearances (§ 5.2) is prefaced by this qualification: “… except as set forth in this [sic] Section 5.2 of the Company Disclosure Schedule …, [the] Company shall not … without the prior written consent of [BofA]….” The disclosure schedule, as is customary, is not attached to the merger agreement that was distributed to BofA’s stockholders or otherwise made publicly available, and was not filed with the SEC.

One of the “forbearances” Merrill agreed to was that it would not pay any discretionary bonuses to its directors, officers, or employees. However, in the disclosure schedule Merrill disclosed, and BofA thereby consented to, the payment of discretionary bonuses for 2008 to Merrill’s officers and employees in an amount not to exceed $5.8 billion (further limited to an amount not to exceed an accounting expense of $4.5 billion (the difference due to timing differences required under GAAP)).

The proxy statement, in describing the terms of the merger agreement (ad nauseum), repeats the language of the merger agreement in its description of the “forbearances” agreed to by Merrill, but also does not disclose the contents of the disclosure schedule reflecting the parties’ understanding and agreement to the payment of bonuses not to exceed $5.8 billion.
This discrepancy constitutes the nub of the SEC’s complaint against BofA, as summarized by the Commission in its August 24th filing with the Court:

“Bank of America’s statement was materially false and misleading because it indicated to shareholders that Merrill would only make ‘required’ payments to its employees, such as salary and benefits, but would not pay discretionary year-end bonuses. In fact, Bank of America expressly had agreed to allow Merrill to pay up to $5.8 billion in discretionary year-end bonuses. A shareholder could not have known from reading the proxy statement that Bank of America had already authorized Merrill to do precisely that which the proxy statement indicated Merrill could not do, i.e., pay discretionary year-end bonuses. The statements in the merger agreement regarding the non-payment of bonuses were thus false and misleading without the information set forth in the omitted disclosure schedule.”

Commission’s Memorandum of August 24, 2009 (“SEC Memo”), at 20.

In support of the materiality of the Bank’s failure to disclose its agreement for the payment of up to $5.8 billion in year-end discretionary bonuses to Merrill’s employees, the Commission points to the fact that the $5.8 billion constituted nearly 12% of the $50 billion that the Bank agreed to pay to acquire Merrill and 30% of Merrill’s total stockholders’ equity. SEC Memo at 22.

B. How to Explain the Discrepancy Between the Negative Covenant on the Payment of Bonuses and the Agreement Reflected in the Disclosure Schedule

What was BofA’s explanation for the discrepancy? Answer: No answer.

“Lewis, Thain [Merrill’s CEO] and Fleming [Merrill’s President] were all asked by Commission staff why this information was set forth in a disclosure schedule as opposed to the text of the merger agreement itself, but none of them could provide an answer. According to Lewis, Thain, Fleming, Curl [BofA’s Vice Chairman for Corporate Planning and Strategy] and Stingi [BofA’s Global Head of Human Resources] that issue was determined by lawyers at Wachtell [BofA’s counsel], Shearman [Merrill’s counsel] and one or more of several lawyers who worked in Bank of America’s in-house legal department, ….”

SEC Memo at 11.

So why did the lawyers from these two distinguished firms (Wachtell and Shearman) not disclose the agreement as to the payment of year-end bonuses in the proxy statement? What discussions, if any, were held between the lawyers and BofA concerning such a disclosure? We don’t know because BofA asserted the attorney-client privilege with respect to all communications with counsel, and the Commission was powerless to compel the Bank to waive the attorney-client privilege in connection with its investigation:

“The evidence obtained by the Commission in its investigation established that the determination of whether to include the ‘disclosure’ schedule in the proxy statement or otherwise to disclose that Bank of America had authorized Merrill to pay up to $5.8 billion in year-end bonuses was either made by, or at least based on the advice of, in-house and outside counsel for Bank of America and Merrill. All the relevant witnesses stated that the written merger agreement, the ‘disclosure’ schedule, and the proxy statement were negotiated and prepared by counsel for the two companies. The witnesses also stated that they relied entirely on counsel to decide what was or was not disclosed in the proxy statement. The Commission found no evidence to the contrary. Nor did the Commission find any evidence of internal deliberations or discussions, aside from consultations with in-house counsel, concerning the disclosures at issue in this case. Bank of America has not waived the attorney-client privilege. As a result, the investigative record does not include any specific rationale as to why the disclosure schedule or its contents were not disclosed in the proxy statement.”

SEC Memo at 24-25 (footnote omitted).

C. The Use and Misuse of Disclosure Schedules

Disclosure schedules are critical in M&A transactions, as they are used to disclose exceptions and qualifications to a party’s representations and warranties. They are prepared with care because they protect a party from claims of breach of representations and warranties that are typically broad and unqualified. While the SEC’s disclosure rules require the filing of merger and like agreements, the rules permit the omission of disclosure schedules from filings made with the SEC, although with a caveat often overlooked:

“Schedules (or similar attachments) to these exhibits [merger agreements and the like] shall not be filed [with the SEC] unless such schedules contain information which is material to an investment decision and which is not otherwise disclosed in the agreement or the disclosure document.”

Regulation S-K, Item 601(b)(2).

Regulation S-K further requires that the merger agreement that is filed contain a list “briefly” identifying the contents of all omitted schedules, together with an agreement to furnish supplementally a copy of the omitted schedule to the Commission upon its request.

Because schedules to merger agreements need not be filed with the Commission, it is tempting for parties to include in them information not strictly qualifying reps and warranties, side deals, and other miscellany. This case highlights one such example.

D. What Explains the Failure to Disclose the Agreement on Bonuses Set Forth in the Disclosure Schedule?

The short answer is that we don’t know, given the cloak of secrecy thrown over the question by BofA’s assertion of the attorney-client privilege. There are at least three possibilities:

(i) The parties, concerned over the reaction by BofA’s stockholders to any disclosure of the agreement on payment of year-end bonuses, deliberately buried their agreement on the payment of bonuses in the disclosure schedule;

(ii) The parties did not consider the agreement material and therefore concluded that no disclosure of it was necessary; or

(iii) The failure to disclose the agreement was a boot.

Given the nature of these parties and the competence and sophistication of their advisors, I regard the first possibility as remote, the second as unlikely, and the third entirely possible.

The context here is important. This deal, even by Wall Street standards, was a sprint. It was negotiated over a weekend, September 13-14, 2008, in the wake of Lehman Brothers’ rumored bankruptcy earlier that week, and inked on Monday, September 15. One can only imagine the intensity of the negotiations and the amount of work and coordination necessary to negotiate and draft the merger agreement and prepare the disclosure schedule. It would not be a surprise if the team in charge of the disclosure schedule was different from the team responsible for drafting the merger agreement and the team responsible for preparing the proxy statement. Mistakes in such a pressure cooker do happen.

E. Judge Rakoff’s Reaction to the Commission’s Explanation of Its Omission of Any Individuals from Its Complaint

Incredulity:

“This is puzzling. If the responsible officers of the Bank of America, in sworn testimony to the SEC, all stated that ‘they relied entirely on counsel,’ this would seem to be either a flat waiver of privilege or, if privilege is maintained, then entitled to no weight whatever, since the statement cannot be tested. …

"If the SEC is right in this assertion, it would seem that all a corporate officer who has produced a false proxy statement need offer by way of defense is that he or she relied on counsel, and, if the company does not waive the privilege, the assertion will never be tested, and the culpability of both the corporate officer and the company counsel will remain beyond scrutiny. This seems so at war with common sense that the Court will need to be shown more than a single, distinguishable case [John Doe v. United States, 350 F. 3d 299 (2d Cir. 2003)] to be convinced that it is, indeed, the law. It also leaves open the question of whether, if it was actually the lawyers who made the decisions that resulted in a false proxy statement, they should be held legally responsible.”

August 25th Order at 3-4.

The Judge’s puzzlement is understandable, but I think the SEC got it right, as long as we have an attorney-client privilege. The BofA officers who were involved in the negotiations with Merrill and the supervision of the documentation all testified, according to the SEC, that they could not explain why the agreement on bonuses set out on the disclosure schedule was not included in the merger agreement itself or in the proxy statement. And, as the Commission points out in its August 24th brief, the Commission found no other evidence associating any representative of BofA (other than counsel) with the proxy statement’s disclosures concerning the payment of bonuses. Given that proxy statements are not signed by any representative of the issuer (unlike registration statements), the Commission had to find some evidence of scienter or culpable participation by an officer to the challenged disclosures in the proxy statement to pursue that individual for a disclosure violation. And, with respect to counsel, to establish “aiding and abetting” exposure, the Commission must also establish knowing participation in the alleged material misstatements or omissions. Given the attorney-client privilege, and the absence of any other evidence tying individuals to the misleading disclosures in the BofA proxy statement, the Commission simply did not have the firepower to go after the officers of BofA or its counsel. And, given the severe criticism the Government has received for its efforts post-Enron to curb defendants’ reliance upon the attorney-client privilege (see, e.g., United States v. Stein, 541 F.3d 130 (2d Cir. 2008) (indictments dismissed against former partners and employees of KPMG, LLP for the Government’s actions depriving defendants of their right to counsel), and S. 445, the Attorney-Client Protection Act of 2009, 111th Cong. 1st Sess.) it was simply not in the cards for the Commission to lean on BofA to waive the privilege as to its communications with counsel.

___________________
In support of the settlement, BofA, in its August 24th submission to the Court, mounts a vigorous defense of the settlement, primarily by arguing that the SEC was lucky it got what it did because if the case were tried, BofA could defeat the charges. I will discuss BofA’s arguments, and the points made by its two experts, in a subsequent post.

A Walk Down Memory Lane: Macmillan 20 Years Later

One of the seminal Delaware decisions from the hectic takeover decade of the 1980s is Mills Acquisition Co. v. Macmillan, Inc., decided 20 years ago, 559 A. 2d 1261 (Del. 1989) (the lower court decision, by Vice Chancellor Jacobs, is reported at 1988 WL 108332, 14 Del. J. Corp. L. 772 (Del. Ch. 1988)). The decision makes for fascinating reading. The practices followed by the Macmillan board and its advisors strike one as prehistoric by today’s standards.

Macmillan’s ineptitude certainly cannot be attributed to any lack of competent advisors, as it and its adversaries retained the best and the brightest: Macmillan retained First Boston and then its notable spinoff, Wasserstein Perella (Bruce Wasserstein); the Special Committee of Macmillan’s board retained Lazard Freres & Co. (Steven Golub) and, as its special counsel, the Wachtell firm. So Macmillan’s wayward behavior cannot be attributed to the quality of its advisors but to its domination by a determined CEO and perhaps to the lack of clarity in the applicable corporate governance standards of that time.

A. The Context

Macmillan was a large publishing, educational and informational services company. The Delaware Supreme Court’s decision in Macmillan was the culmination of a determined effort by Edward P. Evans, Macmillan’s Chairman and CEO, to avoid takeover attempts first by Robert M. Bass and then by Robert Maxwell, both “stars” of many 1980s takeover contests. (Maxwell, a Rupert Murdoch rival, had a colorful career, as a youngster escaping the Nazis from Czechoslovakia, serving, with distinction, in the British Army and later as a member of England’s Parliament, and then building a media empire from England. He died in November 1991, at the age of 68, presumably from falling overboard from his luxury yacht off the Canary Islands. The official verdict was accidental drowning, although some commentators have surmised that he may have committed suicide, and others that he was murdered.)

B. Management’s Restructuring Plan

Even before Bass and Maxwell appeared on the scene, Evans had moved preemptively to assume control of Macmillan in 1987 in response to Maxwell’s hostile bid for a Macmillan competitor, Harcourt Brace Jovanovich. Evans developed a restructuring plan comparable to that adopted by HBJ that would have transferred control of Macmillan to him and his management team through the grant of options and restricted stock, the leveraging of Macmillan to pay a special dividend to its shareholders, the breakup of the company in two, and the issuance of two classes of stock, one to management with super voting rights. The restructuring plan was enjoined by Vice Chancellor Jacobs on July 14, 1988 in Robert M. Bass Group, Inc. v. Evans, 552 A. 2d 1227 (Del. Ch. 1988) (“Macmillan I”). Promptly thereafter, Evans and his management team pursued a management buyout of Macmillan (“Macmillan II”) that ultimately led to this decision of the Delaware Supreme Court, in which Evans and his team were dealt their second defeat. Among other notable features of the restructuring plan struck down by Vice Chancellor Jacobs were the following:

• The Macmillan board granted management several hundred thousand restricted Macmillan shares and stock options, to be exchanged for several million shares of the recapitalized company; and

• Macmillan’s ESOP would purchase, with funds borrowed from Macmillan, a large block of Macmillan shares, and the then-existing independent ESOP trustee (CitiBank) would be replaced by management designees, giving them control over all of the ESOP’s unallocated Macmillan shares.

The board also granted Evans and his management team generous golden parachute agreements, and adopted a poison pill, from which the ESOP was exempted.

In approving the restructuring plan, the Chancery Court found that the Macmillan board was dominated by Evans and his management team.

C. The Bass Group

Bass appeared on the scene in October 1997, acquiring 7.5% of Macmillan’s outstanding shares. Management inaccurately characterized Bass to the Macmillan board as a greenmailer. Vice Chancellor Jacobs concluded in Macmillan I that the factual data relied upon by management to criticize Bass was false. As Vice Chancellor Jacobs concluded:

“[t]here is … no evidence that Macmillan management made any effort to accurately inform the board of [the true] facts. On the present record, I must conclude (preliminarily) that management’s pejorative characterization of the Bass Group, even if honestly believed, served more to propagandize the board than to enlighten it.”

Macmillan I, 552 A. 2d at 1232.

In the course of implementing the restructuring plan (before it was enjoined in July 1988), the board, among other things, adopted the Macmillan Non-Employee Director Retirement Plan, which provided lifetime benefits to seven of the Macmillan directors (including three of the five members on its Special Committee considering the restructuring) equal to the director’s fees being paid at the time of termination. (The plan was later amended to pay such benefits to the surviving spouses of board members.)

Almost as an afterthought, management decided in February or March of 1988 to appoint a Special Committee of the board to evaluate the restructuring plan. The members of the Special Committee were hand-picked by Evans. The Special Committee was not actually formed until May 1988, after management had conducted intensive discussions and negotiations over the restructuring plan with the “Committee’s” investment bank, Lazard. Representatives of Lazard spent over 500 hours with management on the proposed restructuring before the Special Committee came into existence and retained Lazard.

The annual meeting of Macmillan shareholders was held May 18, 1988. The day before the meeting, the Bass Group offered a friendly deal for all of Macmillan, at $64 per share, in cash, in an offer left open for further negotiation. The offer was publicly disclosed by the Bass Group in an SEC filing, although it was not mentioned by management at the annual meeting of shareholders the following day.

The Bass Group’s offer was disclosed to the board following the annual meeting. It was at this meeting of the board that the Special Committee was selected (one of whose members never attended a single committee meeting). Evans presented the restructuring proposal to the Special Committee, but the Committee was not given any negotiating authority regarding the terms of the restructuring. The board deferred discussion of the Bass Group proposal.

The Special Committee met for the first time on May 24, 1988. Evans selected the Wachtell firm to represent the Committee. None of the members of the Special Committee had met with either Lazard or Wachtell before the meeting at which they were appointed as the Committee’s advisors, and the Committee was not advised of management’s extensive contact with Lazard on the restructuring proposal over the preceding months. The Committee directed Lazard to evaluate management’s restructuring plan, along with the Bass Group’s offer.

Evans subsequently directed another member of management to meet with the Bass Group, but the officer was directed to tell the Bass Group to go away. No further substantive negotiations were conducted between Macmillan and the Bass Group, and the Special Committee did not press for negotiations between Macmillan and the Bass Group.

The Special Committee met on May 28, 1988 to hear Lazard’s presentation on management’s restructuring plan. By this point Macmillan had hired its own financial advisor, Wasserstein Perella. (In the small world department, Bruce Wasserstein is now Chairman and CEO of Lazard (NYSE: LAZ).) The restructuring plan was valued at $64.15 per share, which Lazard advised the Committee was fair, notwithstanding its valuation of Macmillan at $72.57 per share. Lazard recommended rejection of the Bass Group’s $64 all-cash “fully-negotiable” offer, as “inadequate.” Wasserstein Perella valued management’s restructuring proposal at between $63 and $68 per share, and made the same recommendation as Lazard concerning the Bass offer.

The Special Committee recommended that the board adopt management’s restructuring proposal and reject the Bass offer. The Special Committee had not negotiated any aspect of the restructuring with management.

Following the public announcement of the restructuring, on May 31, 1988, the Bass Group made a second offer for all of Macmillan’s stock at $73 per share. Alternatively, the Bass Group proposed a restructuring similar to the restructuring approved by the Macmillan board, differing only in that it would offer $5.65 in cash per share more to the stockholders of Macmillan.

On June 7, 1988, at a joint meeting of the Special Committee and the Macmillan board, Lazard advised the board that the Bass Group’s $73 cash offer was inadequate, given its previous evaluation of Macmillan at between $72 and $80 per share. Wasserstein Perella agreed, and so the board again rejected the revised Bass offer and reaffirmed its approval of management’s restructuring plan.

As noted, on July 14, 1988, Vice Chancellor Jacobs preliminarily enjoined the management restructuring and held that both of the Bass offers were “clearly superior” to the restructuring proposal.

The following day, management set in motion a course of action that led to the opinion of the Delaware Supreme Court in Macmillan II.

D. A Management Buyout; Maxwell Enters the Fray

Once Vice Chancellor Jacobs opened the field for the Bass Group’s offer, management immediately pursued defensive measures to thwart it, focusing primarily on a management buyout sponsored by the granddaddy of all buyout firms, Kohlberg Kravis Roberts & Co. The effort was launched by Evans without prior consultation or approval by the Macmillan board. Evans and his COO, William Reilly, directed Macmillan’s financial advisors to pursue a possible sale of the company. As characterized by the Delaware Supreme Court, the process was motivated by two primary objectives:

• To repel any third-party suitors unacceptable to Evans and Reilly; and

• To transfer an enhanced equity position in a restructured Macmillan to Evans and his management group.

559 A. 2d at 1272.

On July 20, 1988, the Bass Group was eclipsed when Maxwell entered the scene, proposing to Evans a consensual merger in a buyout offer of $80 per share. Maxwell indicated he was prepared to retain Macmillan’s management.

Macmillan did not respond to Maxwell’s overture for five weeks. Instead, management accelerated its discussions with KKR over a management buyout, which included, after execution of a confidentiality agreement with KKR, the provision of substantial non-public financial and other information to KKR.

Maxwell was not prepared to wait, so, after three weeks, on August 12, 1988, he made an $80 per share, all-cash tender offer to Macmillan’s stockholders. That same day, Maxwell sent another letter to Evans confirming the making of the tender offer and reiterating his desire to reach a friendly accord with Macmillan. “Significantly,” observed the Delaware Supreme Court, “no Macmillan representative ever attempted to negotiate with Maxwell on any of these matters.” 559 A. 2d at 1272.

Notwithstanding their earlier opinions that management’s restructuring, which would have delivered $64.15 per share to the stockholders of Macmillan (as determined by Lazard) (in a combination of cash and debt securities) was fair to the Macmillan stockholders and that Macmillan had a maximum breakup value of $80 per share, both Wasserstein Perella and Lazard issued new opinions on August 25 that Maxwell’s $80 per share offer “was unfair and inadequate.” Id. at 1273. Accordingly, the Macmillan board rejected Maxwell’s offer.
Evans and Maxwell met on August 30, 1988. Evans informed Maxwell that “he was an unwelcome bidder for the whole company….” Id.

Management continued its negotiations with KKR, and committed to KKR, on September 6, 1988, to a management buyout in which they would, of course, participate, even though KKR had not yet disclosed to Evans and his group the amount of its bid! KKR did commit to making a firm offer by the end of the week — September 9, 1988. And so Evans instructed Macmillan’s financial advisors to notify all remaining interested parties, including Maxwell, that final bids for Macmillan were due by the afternoon of September 9. The day before the deadline, Evans informed Maxwell that management would recommend the KKR leveraged buyout to the Macmillan board, and that he, Evans, “would not consider Maxwell’s outstanding offer [of $80 per share] despite Maxwell’s stated claim that he would pay ‘top dollar’ for the entire company.” Id. Evans also informed Maxwell that “senior management” would leave the company if any bidder other than KKR prevailed over a management-sponsored buyout offer. Maxwell repeated his offer to negotiate the purchase price.

During this period of time, Macmillan continued to drag its feet on providing complete information to Maxwell, notwithstanding that it had already been provided to KKR.

By the deadline, September 9, 1998, Maxwell sent another letter to Evans offering to increase his all-cash bid for the company to $84 per share.

Notwithstanding the deadline, Macmillan’s representatives continued to negotiate overnight with KKR until its offer was reduced to writing the next day, September 10. KKR offered to acquire 94% of Macmillan’s shares through a complicated, highly-leveraged, two-tiered transaction, with a “face value” of $85 per share, payable in a mix of cash and subordinated debt securities. It included a requirement that Macmillan pay KKR’s expenses and an additional $29.3 million breakup fee if its deal were busted up by virtue of a higher bid for the company.

The Macmillan board then met to consider the two remaining offers — Maxwell’s and the KKR/management proposal — on September 10 and 11, 1988. The financial advisors opined that KKR’s offer was both higher than Maxwell’s bid and fair to Macmillan’s stockholders from a financial point of view. The board thereupon approved the KKR offer and agreed to recommend it to Macmillan’s shareholders. A public announcement of the acceptance soon followed.

But Maxwell was not done. On September 15, 1988, Maxwell announced that he was increasing his all-cash offer to $86.60 per share. In the light of this move, the Macmillan board withdrew its recommendation of the KKR offer, and instructed Macmillan’s investment advisors to attempt to solicit higher bids from Maxwell, KKR, and any others.

At this point, Wasserstein Perella took over the bidding process, notwithstanding that Lazard, not Wasserstein Perella, served as the Special Committee’s financial advisor. The remaining bidders were instructed that final bids were due by the close of business on September 26, 1988. By the deadline, Maxwell made an all-cash offer of $89 per share. KKR submitted another “blended” offer of $89.50 per share, consisting of $82 in cash and the balance in subordinated securities. KKR’s offer included three conditions designed to end the auction: (i) the imposition of a “no-shop” covenant, (ii) the grant to KKR of a lockup option to purchase eight Macmillan subsidiaries for $950 million, and (iii) the execution of a definitive merger agreement by noon the following day, September 27, 1988.

Given the closeness of the offers, and the nature of KKR’s offer, Macmillan’s advisors concluded it was a toss-up and that the auction should therefore continue.

Notwithstanding their obvious interest in the process, Macmillan’s financial advisors (the exact culprit is not identified) advised Evans and Reilly of the state of play, informing them of both bids. Evans promptly tipped KKR to Maxwell’s bid. In addition, Bruce Wasserstein varied his instructions as to the final round of bidding, impressing upon KKR (but not Maxwell) “the need to go as high as [KKR] could go” in terms of price, and discouraging a lockup or advising care in the character of any lockup KKR should propose. 559 A. 2d at 1275-1276.

Shortly before the deadline, KKR submitted a final revised offer with a face value of $90 per share, again conditioned, but with a revised lockup reduced to the grant of an option on four subsidiaries for a purchase price of $775 million.

Macmillan’s advisors negotiated overnight with both Maxwell and KKR over the terms of their merger agreements. No representative suggested to Maxwell that it increase its bid (from $89 per share). “On the other hand, for almost eight hours Macmillan and KKR negotiated to increase KKR’s offer.” Id. at 1277. KKR did so, by five cents (!), to $90.05, but KKR extracted concessions for the increase.

On the morning of September 27, 1988, the Macmillan board met to consider the competing bids. The meeting was chaired by Evans. Wasserstein spoke for the financial advisors. The board was assured that the advisors had run a level playing field for the two bidders. Evans did not disclose to the board that he had tipped KKR to Maxwell’s bid. Wasserstein, management’s financial advisor, opined that the KKR offer was the higher of the two bids. The Lazard representative concurred in Wasserstein’s assessment.

The Macmillan board accepted the KKR proposal, and granted KKR the lockup option.

Showing that he was not a quitter, Maxwell, on September 29, 1988, the very day that KKR filed documents with the SEC amending its tender offer to reflect the final deal, announced that he had amended his cash tender offer to $90.25 per share. But this was too late: the Macmillan board rejected it, and the focus turned to the litigation.

E. The Supreme Court’s Decision

It should come as no surprise that the Delaware Supreme Court came down like a ton of bricks on Macmillan and its advisors. The condemnatory language of the Court is as strong as one gets from what are normally staid jurists.

The Court begins with a statement of the relevant decisional framework:

“We have held that when a court reviews a board action, challenged as a breach of duty, it should decline to evaluate the wisdom and merits of a business decision unless sufficient facts are alleged with particularity, or the record otherwise demonstrates, that the decision was not the product of an informed, disinterested, and independent board. …. Yet, this judicial reluctance to assess the merits of a business decision ends in the face of illicit manipulation of a board’s deliberative process by self-interested corporate fiduciaries. Here, not only was there such deception, but the board’s own lack of oversight in structuring and directing the auction afforded management the opportunity to indulge in the misconduct which occurred. In such a context, the challenged transaction must withstand rigorous judicial scrutiny under the exacting standards of entire fairness. …. What occurred here cannot survive that analysis.”

559 A. 2d at 1279 (footnote and citations omitted).

The Court smoked Evans and Reilly, condemning their conduct as “resolutely intended to deliver the company to themselves in Macmillan I, and to their favored bidder, KKR, and thus to themselves, in Macmillan II.” Id. at 1279-1280. On the record, it is no surprise that the Court found the board to be “torpid, if not supine, in its efforts to establish a truly independent auction, free of Evans’ interference and access to confidential data.”

“By placing the entire process in the hands of Evans, through his own chosen financial advisors, with little or no board oversight, the board materially contributed to the unprincipled conduct of those upon whom it looked with a blind eye.”

Id. at 1280.

The Court condemned Macmillan’s conduct as failing “all basic standards of fairness.” Id. Indeed, one can catalog major errors made by the Macmillan board from the record, errors it is safe to say no competently counseled board of directors of a public company would make today:

• Macmillan’s management met with KKR to discuss a management-sponsored buyout, without prior notice to or approval of the Macmillan board;

• The Special Committee’s financial and legal advisors were chosen by management, not by the Special Committee of the board appointed to review management’s restructuring proposal and oversee the auction;

• The Special Committee delegated the creation and administration of the auction to Evans’ advisors, not to those of the Committee; and

• The Special Committee and the board as a whole conducted minimal oversight of the auction.

The integrity of the process becomes acute when insiders are among the bidders. The Court condemned the skewing of the process in favor of KKR:

“Clearly, this auction was clandestinely and impermissibly skewed in favor of KKR. The record amply demonstrates that KKR repeatedly received significant material advantages to the exclusion and detriment of Maxwell to stymie, rather than enhance, the bidding process.”

559 A. 2d at 1281.

Referring to its Revlon principles (decided in 1986), the Court emphasized that once the Macmillan board decided, in September 1988, to abandon further restructuring attempts and to sell the company, further “discriminatory treatment of a bidder, without any rational benefit to the shareholders, was unwarranted.” Id. at 1282. At that point in time, the Macmillan board’s obligation was to obtain the highest price reasonably available for the company, provided that it was offered by a “reputable and responsible bidder.”

Aside: This qualification is important, as the Court cites factors that a board may consider in evaluating a bidder, including

“… the adequacy and terms of the offer; its fairness and feasibility; the proposed or actual financing for the offer, and the consequences of that financing; questions of illegality; the impact of both the bid and the potential acquisition on other constituencies, provided that it bears some reasonable relationship to general shareholder interests; the risk of non-consummation; the basic stockholder interests at stake; the bidder’s identity, prior background and other business venture experiences; and the bidder’s business plans for the corporation and their effects on stockholder interests.”

559 A. 2d at 1282 n. 29.

The Court was apoplectic over Evans’ tip to KKR of Maxwell’s $89 all-cash offer following the first round of bidding, compounded by Evans’ and Reilly’s “knowing concealment of the tip at the critical board meeting of September 27,” conduct that “utterly destroys their credibility.” Id. at 1282. Indeed, the Court goes so far as to say that the tip and the failure to disclose it “was a fraud upon the [Macmillan] board.” Id. at 1283!

While the grant of a lockup is not a per se violation of a board’s fiduciary duties, and can play a function in a contest for corporate control, in this instance the Court concluded that the lockup granted to KKR “was not necessary to draw any other bidders into the contest.” Accordingly, the Court reversed the Chancery Court and sent the case back down with instructions to enjoin the lockup.
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Macmillan is instructive in illustrating how far corporate practice has evolved in a relatively short period of time. Reading it today makes clear the shift in power over M&A transactions that has occurred in the past 20 years from management to the board and, within the board, to the independent directors. It is inconceivable that any M&A transaction involving a public company would be managed today as the change of control in Macmillan was “managed” in 1988.

Fiduciary Outs for Intervening Events: Are They Necessary?

Fiduciary outs to permit a target board to accept a superior proposal are now virtually universal in public M&A deals, particularly after Omnicare (Omnicare, Inc. v. NCS Healthcare, Inc., 818 A. 2d 914 (Del. 2003)), but how about a fiduciary out that permits a target board to change its recommendation in favor of a deal by reason of “intervening” events? The Committee on Mergers and Acquisitions of the ABA’s Section of Business Law gives an example of such a provision in its 2008 “Target Deal Points Study” (M&A Negotiation Trends Involving Public Targets: Insights from the 2008 Strategic Buyer/Public Company Target Deal Points Study):

“Notwithstanding anything to the contrary contained in Section 5.2(b), at any time prior to the approval of this Agreement by the Required Target Stockholder Vote, the Target Board Recommendation may be withdrawn or modified in a manner adverse to the Buyer if: (A)(i) an unsolicited, bona fide written offer… is made to the Target and is not withdrawn… and the Target’s board of directors determines in good faith (based upon a written opinion of an independent financial advisor of nationally recognized reputation) that such offer constitutes a Superior Offer; or (ii) a material development or change in circumstances occurs or arises after the date of this Agreement [that was not known by the Target’s board of directors as of the date of this Agreement] (such material development or change in circumstances being referred to as an “Intervening Event”), and (B) the Target’s board of directors determines in good faith … that, in light of such Superior Offer or such Intervening Event, the withdrawal or modification of the Target Board Recommendation is required in order for the Target’s board of directors to comply with its fiduciary obligations to the Target’s stockholders under applicable law …”

Slide 50 (emphasis in original).

Based upon a sample of 152 transactions studied (of acquisitions of publicly-traded targets by publicly-traded and other strategic buyers for transactions announced in 2007, excluding acquisitions by private equity buyers), the M&A Committee reports that 52% of the deals permitted the target board to change its recommendation in the exercise of its fiduciary duties (7% based upon the occurrence of an intervening event or superior offer and 45% in the exercise of the board’s fiduciary duties and not limited solely to a superior offer or the occurrence of an intervening event). Deal Points Study, slide 51.

A. What’s the Point?

A deal is a deal. Why permit a target board to change its recommendation (and presumably torpedo stockholder approval of the deal) on such nebulous grounds as the occurrence of a “material development” or a “change in circumstances” since the deal was inked, particularly given the amount of time and effort that goes into negotiating a merger agreement and preparing the necessary disclosures? This out strikes one as bordering on the ridiculous.

The source of this provision lies in the nature of a merger agreement (including a two-step merger agreement involving first a tender offer and then a back-end merger). A merger agreement requires stockholder approval (unless the target is 90% or more owned by the acquiring corporation). By reason of this requirement, “[t]he directors of [the target are] under continuing fiduciary duties to the shareholders to evaluate the proposed transaction.” Frontier Oil Corporation v. Holly Corporation, 2005 WL 1039027 at * 27 (Del. Ch. 2005). As Vice Chancellor Noble emphasized in this decision:

“Revisiting the commitment to recommend the Merger was not merely something that the Merger Agreement allowed the Holly Board [the target] to do; it was the duty of the Holly Board to review the transaction to confirm that a favorable recommendation would continue to be consistent with its fiduciary duties.”

Id. at * 28. See also id. at * 29 (“They [Holly’s Board], of course, will require, as a matter of fiduciary duty, to continue their assessment of whether to recommend the Merger to Holly’s shareholders.”).

If, then, a target board’s recommendation to stockholders to approve a deal speaks not only as of the date the board met to approve the merger agreement, but also continues to the actual vote of stockholders on the deal, then the board has no choice but to take into account events that have transpired or “intervened” since the date of the meeting at which the board approved the transaction.

B. What Kind of “Intervening Events” Matter?

This observer is not aware of any cases that directly address what kind of “intervening events” (other than a superior proposal) would justify a board in changing its recommendation to stockholders to approve a contractually agreed-upon deal. The Frontier/Holly case itself offers two potential candidates, namely, litigation involving the acquiror (Frontier Oil) which, while the parties were aware was a potential claim on signing, blew up into major litigation after signing, and a discovery, post-signing, that Holly’s assets were much more valuable than understood by the Holly board at the time of signing. Vice Chancellor Noble appears to assume, in his decision, that these two events would have justified the Holly board in withdrawing its recommendation to the Holly stockholders to approve the Frontier/Holly deal. However, he concluded, nevertheless, that neither the blowup of the litigation nor Frontier’s failure to disclose a guaranty of its subsidiary’s lease obligations (thus leading to Frontier’s being named as a defendant in the litigation) constituted a “material adverse effect” or a material rep and warranty breach that would have justified Holly in terminating the merger agreement.

Another potential candidate for an “intervening event” justifying a change in an approval recommendation would be positive news for a drug company conducting clinical trials of a new drug. A good example is Genentech’s Avastin (colon cancer), whose clinical trials clearly motivated the Genentech board in “slow playing” its negotiations with Roche. Once the parties resolved their differences, the final two-step merger agreement between the parties explicitly excluded from the definition of a Genentech “material adverse effect,” “the results of the Avastin … adjuvant colon cancer trial ….”

C. What Difference Does the Board Recommendation Make?

With a truly positive “intervening event” a board recommendation for approval of a deal would be beside the point. If, say, Holly, between signing and the Holly stockholder vote, announced a mega oil discovery, with the result that its stock price quintupled, what difference would a board recommendation to approve the deal with Frontier make? Stockholders would vote the deal down, particularly if, as is typically the case, arbs come to own a significant percentage of the target’s stock. So in this sense a provision allowing a board, in obeisance to its fiduciary duties, to change its approval recommendation by reason of intervening events simply acknowledges the obvious: if the world changes between signing and the stockholder vote, the change will affect the stockholder vote.

C. Interplay of MAE Condition and Fiduciary Out

There is also a sense that the broad-form fiduciary out is simply the converse of allowing an acquiror to withdraw from a deal by reason of the occurrence of a material adverse effect. If by reason of events occurring subsequent to signing (I ignore, for this purpose, breaches of reps and warranties), that materially and adversely affect the target disproportionally the buyer can walk, why not allow the seller to do the same if the opposite occurs, e.g., the wonder drug is approved or the giant oil and/or gas field is proved up?

D. But at What Cost?

A change in board recommendation will typically allow the buyer to terminate the agreement and collect a breakup fee. The typical fee is payable by reason of a termination due to the acceptance of a superior offer, such as just happened with Data Domain and NetApp when EMC busted up their deal. But how about payment of a greater termination fee if a target board changes its recommendation solely based upon an intervening event not involving a superior proposal? That would appear problematic, because it could be viewed as coercive to the stockholders of the target (“approve our deal or else”), and because it might be construed as undercutting the target board’s exercise of its fiduciary duties, as articulated by Vice Chancellor Noble in the Frontier decision.

E. Breaking Up is Easier Said Than Done

As the Frontier case itself demonstrates, and as emphasized by the Delaware Chancery Court’s decisions in Hexion v. Huntsman and IBP, the sensible course to follow in trying to extricate oneself from one of these deals is to let the stockholders do it, i.e., if a target board modifies its recommendation in favor of a deal by reason of an intervening event, the prudent course for the target board (assuming the buyer doesn’t terminate and collect the breakup fee) is to take the deal to the stockholders and let them reject it, if they so choose. Seeking a declaratory judgment from the Delaware Chancery Court permitting a party (buyer or seller) to extricate itself from a fully negotiated contract is, based on the Chancery Court’s decisions to date, an uphill battle.