As Chairman Schapiro and her new team finish their first year at the SEC, their efforts to retool enforcement are well under way. A key early test looms, however, in the ruling that will come shortly in SEC v. Bank of America, discussed here.

Presently, there is no bigger or more significant market crisis case than Bank of America. The facts of the cases arise directly from the collapsing financial markets in 2008, centering on the acquisition of foundering Wall Street titan Merrill Lynch by the bank. Critical to the cases is what shareholders were told or should have been told when they approved the deal as discussed here.

The court rejected the initial effort to settle by the parties. At that time, the claim by the SEC was that Bank of America lied to its shareholders regarding already approved billions of dollars in bonuses for executives of the brokerage which was having its worst year in history. The court rejected that proposed settlement in an opinion which called the Commission’s investigation a sham.

Now, the parties are trying again to settle not just the initial claim, but also a second one filed in a parallel suit. The second complaint alleges that shareholders should have been furnished updated financial information about the brokerage before voting. That information would have told shareholders that the value of the deal had dropped significantly because Merrill was incurring unprecedented billions of dollars in fourth quarter losses.

An order issued Friday by Judge Rakoff on Friday, February 12, 2010 follows an initial hearing on the new settlement proposal. In the order, the court raises a number of questions about the proposed settlement, including the “very different interpretations of the underlying facts proposed by, respectively, the parties in this case and the Attorney General of the State of New York in the parallel case . . .” In view of this, the court is requesting discovery materials centered on four key points while asking if the parties would permit certain modifications to the proposed consent decree. The discovery materials requested concern:

1) The termination in December 2008 of Bank of America general counsel Timothy Mayopoulos;

2) The extent of participation after November 18, 2008 by the bank’s outside counsel Wachtell Lipton in evaluating the disclosure issue regarding the losses at Merrill;

3) Any information showing that anyone recommended pre-merger disclosure of Merrill’s losses; and

4) Any information indicating that at any time after September 2008 that anyone recommended pre-merger disclosure to the bank’s shareholders of the agreement to pay the Merrill bonuses.

These points focus directly on the two key issues in the SEC cases regarding the disclosure of the Merrill’s financial condition and the bonuses. Perhaps more importantly, these points focus directly on a key question of prosecutorial discretion, that is, the SEC’s decision not to prosecute individual in its cases. As the court suggests, the facts presented by the SEC in its case and those alleged by the NY AG diverge significantly on key points about the disclosure decisions as detailed here. At the time the earlier settlement was rejected, the court had expressed concern because the view of the facts offered by the SEC differed significantly from that of the bank.

The court’s proposed modifications to the settlement raise equally significant issues. The requests focus largely on whether the parties will permit the court to resolve any impasse between them on the selection of: the “independent auditor;” the “disclosure counsel;” and the “compensation consultant.” A final point would limit the Fair Fund distribution to Bank of America shareholders who were harmed by the non-disclosures. This would exclude “so-called ‘legacy Merrill Lynch’ shareholders of Bank of America . . . [and] Bank of America officers or directors who had access to the undisclosed information . . .”

For the SEC, the stakes regarding the resolution of these cases could not be higher. The critical issue on trial here is the credibility of the Commission’s efforts to rejuvenate its enforcement program and to fairly and effectively proceed with its heavily touted market crisis investigations. While earlier orders of the court have been critical of SEC enforcement, the current order is in many ways worse. In this order, the court is signaling extreme skepticism of the facts presented to it in the settlement papers and on which the SEC is basing its prosecutorial decisions. It is a rare event when a court requests access to the raw discovery data to evaluate the representations being made in the papers presented to it. The mere fact that the court felt compelled to take this extraordinary step should be of grave concern to the SEC.

Those concerns should be amplified by the requests to modify the consent decree. With the exceptions of the proposed modifications to the Fair Funds distribution, the court has not sought to change the substance of the remedial procedures proposed. Rather, the court has sought to make sure they get implemented. This again is an extraordinary step and should be causing red lights to flash all over the SEC and the Enforcement division about the basis for its judgments and actions in these cases.

This is clearly a crossroads for an agency struggling for a comeback. The first time Judge Rakoff rejected a proposed settlement should have been a wake-up call and an opportunity for the SEC. A wake-up call to make sure that it is pushing forward in the best interest of investors in its market crisis cases and carefully evaluating the evidence and theories on which they are based. An opportunity to make sure that it is being aggressive in fulfilling its statutory mandate in a very high profile case which, if resolved properly, could facilitate its comeback. The answer to whether the Commission seized this opportunity and in fact is rejuvenating its once honored enforcement program is coming soon in the form of a ruling by the court in Bank of America.