The Value Of Cooperation In an SEC Action

The SEC, the DOJ and other regulators frequently encourage self-reporting and cooperation with law enforcement. Taking those steps will result in “cooperation” credit that will be reflected in the charging process or when sanctions are imposed. While there are cases where the value of that cooperation is evident, in many it is not. That is the case with the recent action in which Bank of America Corporation was sanctioned for violations in connection with its regulatory capital stemming from its acquisition of Merrill Lynch during the financial crisis. In the Matter of Bank of America Corporation, Adm. Proc. File No. 3-16177 (September 29, 2014).

In the proceeding Bank of America was charged with violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B). Those violations are the result of not properly calculating its regulatory capital since 2009.

In the acquisition of Merrill in 2009 the Bank acquired Notes with a par value of $52.5 billion. The notes had a fair value at the time which was below par stemming from a decline in Merrill’s creditworthiness. Thus, in accord with GAAP, Bank of America booked the notes at fair value which was a $5.9 billion discount to par. At the same time the Bank assumed the liability at par.

In calculating regulatory capital Bank of America was required to include the realized losses that were recognized in GAAP equity. Yet in calculating regulatory capital from the time of the acquisition until 2013, the Bank failed to include the losses. As more notes matured, or were repurchased by Bank of America, additional losses resulted. Failing to book those losses resulted in overstatements of its regulatory capital. During the period 15 Form 10-Qs contained an overstatement of regulatory capital. In addition, 5 Form 10-K Filings contained overstatements.

The overstatements trace to the time of the acquisition and a list crafted by the transition team that worked on the deal. That team created a schedule that tracked cumulative gains and losses on certain liabilities. In creating the list the Bank correctly recognized that pre-acquisition declines in fair value of the Notes relating to Merrill’s creditworthiness should not be included as an adjustment to its regulatory capital. What the schedule did not take into account was the fact that the notes would mature or otherwise be redeemed.

The Bank used the schedule each quarter and correctly excluded the difference in value of the Notes at par and their fair value at acquisition. The flaw is that it continued to make the adjustment to regulatory capital even after some Notes had matured or were otherwise redeemed. This resulted in a continuing overstatement of regulatory capital.

In April 2014 the Bank discovered the flaw in its process and issued a press release announcing a downward revision to its disclosed regulatory capital amounts and rations. A Form 8-K was also filed. The firm self-reported, instituted remedial steps and developed improved documentation and spreadsheet controls and enhanced internal controls.

Bank of America resolved the proceeding, consenting to the entry of a cease and desist order based on the Sections cited in the Order. It also agreed to pay a civil penalty of $7,650,000.

The Order states that the Bank “provided substantial cooperation to the Commission staff . . . [and] has voluntarily undertaken steps to remediate and address, among other things, the inadequate books and records and internal accounting control deficiencies that are the subject of this proceeding.” The Commission’s press release states that the Bank self-reported and cooperated. This permitted the staff to efficiently and effectively conduct its investigation. The cooperation credit is reflected in the penalty, according to the Commission.

There is no indication of the value of that credit. Yet when considering the question of cooperation, an important consideration is the value of the potential credit. The SEC does not give any indication of the value. In contrast others do. For example, in criminal cases the amount of the credit can frequently be seen in the sentencing guideline calculations and/or from the percentage by which the fine is under the bottom of the range. In the UK the FSA specifies the percentage discount in the fine that reflects cooperation credit. More certainty about the value of cooperation can encourage it. If the SEC wants to encourage cooperation, the agency should consider providing more disclosure of its value.