HP's Acquisition of 3Com: Another Case of Relying Upon Fears of Competitive Harm to Avoid a Pre-Signing Market Check

On January 26, 2010 the stockholders of 3Com Corporation (“3Com”) (Symbol: COMS) will meet to consider a merger of 3Com into a wholly-owned subsidiary of the Hewlett-Packard Company (“HP”) (Symbol: HPQ) for $7.90 in cash per share. In my post of January 13, 2010, I discussed the reliance by Starent Networks (Symbol: STAR) of fears of competitive harm to avoid any pre-signing market check. While a lawsuit was filed challenging the Starent merger with Cisco, it was promptly settled, and therefore the Delaware Chancery Court had no opportunity to pass upon Starent’s explanation for avoiding a pre-signing market check.

This avoidance rationale is expanding. 3Com voiced similar concerns in avoiding any pre-signing market check of its proposed merger with HP. But in this instance Chancellor Chandler of the Delaware Chancery Court did have an opportunity to address the issue. He did so, albeit obliquely, in rejecting plaintiffs’ request for expedited discovery, concluding, in passing, that 3Com’s failure to solicit other buyers before entering into the merger agreement with HP did not “support a colorable claim that fiduciary duties were breached.” (Letter Opinion of December 18, 2009, at page 12.)

A. Background of the HP Merger

This is the second time to the altar for 3Com. In September 2007 3Com agreed to merge with affiliates of financial buyer Bain Capital, a deal that would have delivered to 3Com’s stockholders $5.30 in cash per share. That deal ran into problems, including with the Committee on Foreign Investment in the United States (CFIUS) and was abandoned in April 2008. The abandonment of the merger let to a shakeup in the senior executive ranks of 3Com, including the appointment of a new CEO and COO.

The proposed marriage with HP began in a familiar fashion, with discussions at a trade show in Las Vegas in May 2009 “concerning a possible commercial relationship.” 3Com’s December 15, 2009 Proxy Statement at 18. Discussions continued over the next few months, during which 3Com reports it was also considering “other strategic initiatives” with “other large technology companies.”

The discussions over a “commercial relationship” ripened into deal talks on July 30, 2009, when HP broached the topic of acquiring 3Com in lieu of establishing a commercial relationship. The next day, July 31, 3Com conferred with its long-time banker, Goldman Sachs, to “discuss the strategic landscape of, and the potential for consolidation in, the networking industry.” Proxy Statement at 19.

HP began the dance on August 5, 2009 with a non-binding indication of interest in the range of $4.80 to $5.15 per share in cash. It requested exclusivity for a 60-day period.

3Com’s board of directors met to consider HP’s indication of interest on August 10, 2009.

I commented in my post on the Cisco/Starent merger that Starent’s description of the background of the transaction was notable for the apparent absence of counsel and Goldman, also Starent’s financial advisors, from key board meetings. Not so with 3Com. At this very first board meeting to consider HP’s interest in acquiring 3Com, 3Com’s counsel, Wilson Sonsini, attended the meeting and “advised the board regarding its fiduciary duties in connection with its consideration of HP’s August 5th indication of interest.” Proxy Statement at 19. The board also decided to engage Goldman to act as its financial advisor in evaluating the HP proposal, “including strategic alternatives to a potential acquisition by HP.”

Also at this first meeting on August 10, Messrs. Mao (CEO) and Sege (COO) discussed for the board management’s “ongoing evaluation and discussions with other companies concerning potential strategic and commercial partnerships.” Proxy Statement at 19.

Goldman joined the board at its August 10th meeting. The board naturally rejected HP’s preliminary indication of interest, “but authorized our senior management team and financial advisor to continue discussions with HP regarding a potential acquisition by HP and to provide additional information to HP to support a higher purchase price for 3Com.” Proxy Statement at 20.

3Com, like Starent, concluded that seeking alternative indications of interest at this stage was not prudent:

“After discussion among the board members, the board determined not to seek alternative indications of interest to acquire 3Com from other companies at this time due to the preliminary nature of HP’s indication of interest, the relatively wide divergence in views between the board and HP over 3Com’s valuation, and the significant risks of harm to 3Com’s business and of employee dislocation if speculation arose that 3Com was considering a transaction with potential acquirors.”

Proxy Statement at 20.

This explanation has a familiar ring, although one might ask how 3Com’s competitors and interested parties could not know that 3Com was in play given that it had spent seven months, over the period September 2007 through April 2008, trying to consummate a merger with Bain Capital?

3Com provided additional due diligence information to HP in August and September of 2009. HP bided its time. On September 23, the board held a regularly scheduled meeting. Representatives of Goldman attended and, in the context of a review of the discussions with HP, “discussed other strategic opportunities that could be under consideration by HP as potential alternatives to an acquisition of 3Com.” Proxy Statement at 20. Goldman also discussed the “potential interest of other technology companies in acquiring 3Com.” Id. at 21. Wilson Sonsini advised the board “regarding its fiduciary duties in connection with its evaluation of strategic alternatives, including a possible acquisition by HP or any other acquirer.” Id.

With HP’s eyes apparently wandering, now was the time for the 3Com board to put out feelers to other technology companies, assuming 3Com had an interest in pursuing a deal. But it did not do so, even after learning, on October 5 from published reports, that HP might be interested in acquiring one of 3Com’s competitors.

But the only suitor 3Com had an interest in was HP, and finally that desire bore fruit, for on October 19, HP upped its proposed purchase price to $6.75 per share. The board met to consider this offer the following day, and conducted the standard reviews, including of remaining independent. The board resolved to reject HP’s indication of interest, but instructed Mao to advise HP to consider increasing its proposed purchase price to between $8.00 and $8.50 per share, and to inform HP that 3Com “would consider a brief period of exclusive negotiations at a price in this range.” Proxy Statement at 22. At this meeting the board appointed a transaction committee to oversee discussions with HP “or potentially other parties” and to report regularly to the board.

HP edged closer to the altar on October 25, upping the ante to $7.80 per share (the final deal price was $7.90 per share). The board met the following day, October 26, to consider HP’s offer. The board concluded that HP’s offer was “attractive” but instructed management to make one more try.

Quite obviously at this stage it would be a bit late to seek third-party indications of interest. Rather than rely upon concerns of competitive harm to avoid doing so, however, the board now concluded that “very few” companies with the financial resources to acquire 3Com would have an interest in doing so!

“After this discussion [whereby Goldman Sachs discussed other large technology companies that would be reasonably likely to have an interest in 3Com], the board determined that there were few companies that would likely have a strategic interest and sufficient financial resources to consider an acquisition of 3Com. The board further noted that 3Com had been engaged in ongoing discussions with certain of these companies regarding commercial relationships for some time, but none of them had expressed any interest in discussing an acquisition of 3Com at this time. Moreover, the board noted that the press had extensively reported on acquisition trends and likely targets of consolidation in the networking industry (including one of our primary competitors and 3Com itself), but that no companies had approached 3Com to discuss a potential acquisition in light of such press reports.”

Proxy Statement at 23.

Accordingly, the board resolved not to pursue any other potential acquirors and to enter into an exclusivity agreement with HP for a limited duration. HP made its final and best offer of $7.90 per share on October 26. This price, and the definitive merger agreement, were approved by the board on November 11.

B. The Plaintiffs’ Challenge of the Deal

The primary focus of plaintiffs’ complaint against 3Com is on purported disclosure violations, which is understandable since a disclosure violation automatically constitutes irreparable harm entitling plaintiffs to injunctive relief. The plaintiffs spent considerable effort in trying to establish material omissions in the proxy statement involving Goldman’s valuation and the description thereof. Plaintiffs also alleged that the process followed by 3Com in agreeing to the HP merger was flawed and constituted a breach of the board’s fiduciary duties to 3Com’s stockholders. And while plaintiffs do not allege that the reasons given by 3Com’s board to pass on conducting a market check prior to the signing of the HP merger agreement were pretense, plaintiffs allege, repeatedly, that “3Com negotiated exclusively with HP and never contacted any other potential bidder.” Consolidated Amended Complaint ¶ 46 (dated December 11, 2009). Plaintiffs make similar charges in paragraphs 47, 73, 74, and 80(a) of the Complaint. They allege in paragraph 73:

“. . . the terms of the Merger were not the result of an auction process or active market check; they were arrived at without a full and thorough investigation by the Individual Defendants [the executive officers and directors of 3Com] of strategic alternatives; . . .”

So the Chancellor, in ruling on plaintiffs’ request for expedited discovery, clearly had before him the charge that the 3Com board did nothing to conduct a pre-signing market check before agreeing to a deal with HP at $7.90 per share.

C. The Chancellor’s Decision

Chancellor Chandler ruled on plaintiffs’ request for expedited discovery by his letter opinion of December 18, 2009. The test, as stated by the Chancellor, in resolving plaintiffs’ request was whether they had alleged in their complaint “a sufficiently colorable claim [and have shown] a sufficient possibility of threatened irreparable injury, as would justify imposing on the defendants and the public the extra (and sometimes substantial) costs of an expedited preliminary injunction proceeding.” Letter Opinion at 1-2.

The Chancellor concludes that plaintiffs had not met this test. With respect to their disclosure claims, he essentially concludes that the plaintiffs were nit picking, and that 3Com had done all that Delaware law requires to explain the basis for the board’s decision to proceed with the merger with HP and had accurately summarized Goldman’s valuation analysis and its limitations. As the Chancellor observed in responding to plaintiffs’ claim that Goldman’s fairness opinion deviated from conventional practice and that such deviations should have been disclosed:

“Under Delaware law, the valuation work performed by an investment banker must be accurately described and appropriately qualified. So long as that is done, there is no need to disclose any discrepancy between the financial advisor’s methodology and the Delaware fair value standard under Section 262 (or any other standard for that matter).”

Letter Opinion at 10 (footnotes omitted).

In conclusion, observed the Chancellor, the plaintiffs’ “quibbles with Goldman’s methodologies (and inputs into those methodologies), if they are serious, can be resolved via an appraisal action.” Id. at 11.

The bulk of the Chancellor’s decision is devoted to plaintiffs’ disclosure claims (11 of 12 pages) — he gives short shrift to plaintiffs’ breach of fiduciary duty claims, and groups them together: Plaintiffs, he observes, have alleged that the 3Com directors breached their fiduciary duties by —

“(a) including a no-solicitation and matching rights provision in the Merger agreement, (b) including a $99 million termination fee, that, along with a $10 million expense reimbursement fee represents over 4% of the equity value of the Merger, and (c) failing to make an effort to solicit other buyers before entering the Merger agreement.”

The Chancellor concluded that “none” of these allegations “support a colorable claim that fiduciary duties were breached.” Letter Opinion at 12.

While the Chancellor cites authority for his conclusion as to plaintiffs’ “deal protection” allegations, he cites none for the proposition that a target need not solicit other buyers before entering into a merger agreement. Perhaps it was obvious to him.

D. Whither Pre-Signing Market Checks?

Perhaps in passing upon pre-signing market checks, Starent and 3Com took their cue from the Delaware Supreme Court’s decision in Lyondell Chemical Co. v. Ryan, 970 A.2d 235 (2009), which I discussed in my post of March 30, 2009. The board of Lyondell did not conduct a pre-signing market check before agreeing to a deal with Basell AF at $48 per share, a number Lyondell’s banker, Deutsche Bank, concluded was “an absolute home run.” But Vice Chancellor Noble was clearly bothered by the Lyondell board’s failure to conduct any pre-signing market check, and the speed with which the board approved the deal, in denying defendants’ motion for summary judgment.

The Delaware Supreme Court reversed the Vice Chancellor and directed entry of summary judgment for the defendants. One of the key findings of the Court was that Vice Chancellor Noble had selected too early a date for the invocation of Revlon duties — the announcement of the filing of a Schedule 13D by Basell rather than the later point in time at which the board resolved to seriously consider a sale of the company. Because Lyondell involved a post-closing challenge to a merger, and Lyondell had an exculpatory provision in its certificate of incorporation, plaintiffs had to establish a lack of good faith by the directors (which is non-exculpatory) to prevail. The Court in Lyondell confirmed that to establish a lack of good faith requires establishing that the directors knew that they were not discharging their fiduciary obligations.

In reversing Vice Chancellor Noble, the Delaware Supreme Court noted that the Lyondell directors were active, sophisticated, and generally aware of the value of the company and the conditions of the markets in which the company operated (970 A.2d at 241, and that they “had reason to believe that no other bidders would emerge, given the price Basell had offered and the limited universe of companies that might be interested in acquiring Lyondell’s unique assets.” Id. Moreover, Lyondell’s CEO negotiated Basell’s offer from an initial price of $40 to $48 per share, a 20% increase. And, noted the Court, “no other acquiror expressed interest during the four months between the merger announcement and the stockholder vote.” Id.

Crucial to its analysis, the Court noted that Revlon duties (to obtain the highest price reasonably available) “applies only when a company embarks on a transaction — on its own initiative or in response to an unsolicited offer — that will result in a change in control.” Id. at 242.

And the Court went out of its way to emphasize the discretion a board has in discharging its Revlon duties:

“There is only one Revlon duty — to ‘[get] the best price for the stockholders at a sale of the company.’ No court can tell directors exactly how to accomplish that goal, because they will be facing a unique combination of circumstances, many of which will be outside their control. As we noted in Barkan v. Amsted Industries, Inc., ‘there is no single blueprint that a board must follow to fulfill its duties.’ ”

970 A.2d at 242 – 243 (footnotes omitted).

In language that clearly gives comfort to those who believe a pre-signing market check is not necessary under Revlon, the Court responded in this way to Vice Chancellor Noble’s concerns about the failure of the Lyondell board to conduct an auction or market check pre-signing:

“The Lyondell directors did not conduct an auction or a market check, and they did not satisfy the trial court that they had the ‘impeccable’ market knowledge that the court believed was necessary to excuse their failure to pursue one of the first two alternatives [conduct an auction or a market check]. As a result, the Court of Chancery was unable to conclude that the directors had met their burden under Revlon. In evaluating the totality of the circumstances, even on this limited record, we would be inclined to hold otherwise. . . . Where, as here, the issue is whether the directors failed to act in good faith, the analysis is very different, and the existing record mandates the entry of judgment in favor of the directors.”

970 A.2d at 243 (emphasis added).

An evaluation of a board’s discharge of its fiduciary duties, particularly in a deal context, is heavily contextual. But the records of the Cisco/Starent and HP/3Com deals contain facts similar to those involved in the Basell/Lyondell deal: large companies experienced in doing deals, advised by competent and experienced advisors; a final merger price that exceed by a material amount the initial bids (30% in the case of Cisco/Starent and 65% in the case of HP/3Com); and, notably, the failure of any third party to jump in after the deal was announced. While deal protection measures and match rights make the prospect of busting up a deal unattractive, it can be done, as EMC’s snatching of Data Domain from NetApp demonstrated. (See my posts of June 10, 24 and 26, 2009 on the battle for Data Domain).

But this much is clear — a board disinclined to conduct an auction or pre-signing market check to validate a price that it negotiates with a suitor has both precedent and Delaware case law to justify its reluctance. And a board can take some comfort in knowing that if it truly misses the boat, a determined party (e.g., an EMC) may jump in and make the board’s error moot.

SEC v. Bank of America Corp.: Recent Developments

This case is headed for trial on March 1, 2010 before Judge Rakoff. Two recent decisions by the Judge have sharpened the issues for trial. Whether the case actually is tried is problematic, given BofA’s obvious attempts, under new CEO Brian Moynihan, to settle all litigation arising out of BofA’s acquisition of Merrill Lynch.

A. Judge Rakoff’s Evidentiary Ruling of January 4

I have commented extensively on this case in prior posts. As I have observed, BofA’s primary defense was to be that the fact that Merrill would pay substantial 2008 year-end bonuses to its officers and employees was so well known by the market that any failure to disclose BofA’s agreement that Merrill could pay such bonuses (of up to $5.8 billion) was immaterial.

By his January 4, 2010 Opinion and Order (“Order”) Judge Rakoff dealt with the SEC’s motion to exclude from evidence all media reports concerning Merrill’s payment of year-end bonuses. The Judge granted the motion. The ground for the decision was BofA’s own October 31, 2008 proxy statement, used to solicit the consent of its stockholders for the merger. BofA was hoisted on its own petard, as it cautioned its stockholders to rely only on the information set forth in the proxy statement and information specifically incorporated by reference into the proxy statement:

“You should rely only on the information contained or incorporated by reference into this document. No one has been authorized to provide you with information that is different from that contained in, or incorporated by reference into, this document.”

Order at 1-2.

To emphasize the point, BofA repeated this admonition, in even stronger language, in bold face type, at the end of its proxy statement:

“You should rely only on the information contained or incorporated by reference in this document. Neither Bank of America nor Merrill Lynch has authorized anyone to give any information or make any representation about the merger or our companies that is different from, or in addition to, that contained in this document. Therefore, if anyone does give information of this sort, you should not rely on it.”

Order at 2.

These disclosures provided the Judge with all he needed to grant the SEC’s motion to exclude all media reports from evidence, including any reliance on such reports by both the SEC’s and BofA’s experts.

“Furthermore, even if the media reports of Merrill’s likelihood of paying bonuses could otherwise somehow be said to bear indirectly on the question of how material was the Bank’s alleged failure to disclose that it had in fact already approved the payment of such bonuses when it purported to represent that it had not given such approval, the warnings in the proxy statement totally changed the relevant mix of information for assessing materiality. Since the test of materiality is whether the undisclosed information, if disclosed, “would have been viewed by a reasonable investor as having significantly altered the ‘total mix’ of information made available,” TSC Indus., 426 U.S. at 438, one must ask what a reasonable investor would reasonably consider the total mix of information in this case. The answer is that since the Bank itself warned investors not to rely on the media, it would be unreasonable for a shareholder to consider the media pronouncements to be a part of the relevant mix of information.”

Order at 5.

As is his want, Judge Rakoff could not resist putting in a final dig at BofA for its position:

In effect, the Bank is arguing that, even though it expressly warned its shareholders to disregard the media, it can now defend itself by asserting that a reasonable shareholder would have disregarded these warnings and, by consulting the media, perceived that the Bank’s alleged lies were immaterial. Even a zealous advocate might perceive that such an argument hints at hypocrisy.”

Order at 6.

B. The Judge Rejects the SEC’s Request to Amend Its Complaint

By his order of January 11, the Judge rejected the SEC’s attempt to amend its Complaint to add an additional alleged omission by the Bank, namely its purported failure to disclose Merrill’s sizeable losses incurred in the fourth quarter of 2008. Apparently the Judge was convinced this new claim was brought too late and would prejudice BofA. For our purposes it is a sideshow; its exclusion from the case doesn’t detract from the drama that is unfolding in Judge Rakoff’s court.

On January 13, the SEC filed a new complaint, also in the Southern District, against BofA repeating its allegations of proxy violations for BofA’s failure to disclose Merrill’s sizeable fourth quarter 2008 losses. While I am not familiar with the Southern District’s assignment procedures, this action could very well be deemed a “related” case to that pending before Judge Rakoff and therefore assigned to him. If so, the SEC’s filing of this second action against BofA may have strategic implications: one or both parties may request a delay in the March 1 trial date of the current action before Judge Rakoff so that both actions, clearly involving similar facts, documents, evidence, and witnesses, be tried at the same time. The SEC may also believe that the second action gives it additional leverage over BofA.

C. Prognosis

I discussed in some detail my prognosis for any trial in this case in my post of September 25, 2009 and concluded, “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 would not be as stringent as those set out in the settlement to which BofA was prepared to accept.” The settlement Judge Rakoff rejected called for payment of a civil fine by BofA of $33 million and entry of a permanent injunction against future violations of the proxy rules.

We now know, after extensive discovery, including of BofA’s lawyers (BofA waived the attorney-client privilege - see my post of October 15, 2009), that the SEC’s initial conclusions based upon the discovery it conducted prior to entering into the settlement, that the record did not establish scienter on the part of any officer of BofA or its counsel, sufficient to allow the SEC to name any such persons, have been confirmed, at least in the SEC’s mind. So the Judge’s outrage at the settlement for its failure to name any individual culprits will not be vindicated at trial. Assuming, as appears likely to this observer, that the Bank will be found liable for a proxy violation for failing to disclose its agreement with Merrill to pay year-end bonuses of up to $5.8 billion, what remedies will Judge Rakoff impose?

Given the sensitivities of the Judge to imposing upon the “victim,” here BofA’s shareholders, any damages for BofA’s proxy violations, it is entirely reasonable to conclude that the most probable remedy Judge Rakoff would impose is an injunction. As I discussed in my post of September 25, even on that remedy the Bank will mount a vigorous defense, namely on the ground that the odds of its repeating a proxy violation are nil.

The Judge is of course very bright, and probably appreciates that this case is headed in that direction so he may be more amenable to accepting the next settlement BofA and the SEC agree to. This leaves open the possibility that BofA will enter into a global settlement with the SEC and New York’s Attorney General Andrew Cuomo that includes the payment of a fine (to the extent demanded by Cuomo) and a consent to injunctive relief against future violations of the proxy rules. Given there’s a new captain of the BofA ship, CEO Moynihan, I am reasonably confident that is a settlement he would gladly accept to get the Merrill litigation behind him.

Cisco/Starent Merger: Relying Upon Fears of Competitive Harm to Avoid a Pre-Signing Market Check

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.

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.

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.

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.