LESSONS FROM SEC v. BANK OF AMERICA

It has been a long time coming. The road has been difficult and very rough. The obstacles were considerable. The end, however, is in sight and may prove very worthwhile. The SEC and Bank of America have almost reached the position they thought they were in weeks ago – settlement.

On Monday, U.S. District Judge Jed Rakoff tentatively approved the latest version of the settlement between the two parties, subject only submission of the final papers modified pursuant to suggestions by the Court. This will resolve the two SEC suits against the bank for not disclosing to shareholders when voting on the acquisition of Merrill Lynch by the bank billions of dollars in approved bonuses for executives of the broker and unprecedented fourth quarter losses which undermined the value of the deal.

After reviewing significant portions of the discovery record to evaluate the conflicting claims between the SEC and the New York Attorney General’s case, the court walked carefully between the conflicting versions. Judge Rakoff had raised questions about the significant differences between the SEC and the bank’s version and that of the New York AG regarding the failure to disclose the huge Merrill bonuses and losses and the reason the bank’s General Counsel was fired. While taking care not to endorse either view, the Court allowed that there was a reasonable basis for the prosecutorial judgments made by the SEC.

Nevertheless, in giving tentative approval to the settlement the Court detailed key principles which the SEC would do well to heed in the future. The proposed settlement consists of a $150 million fine to be distributed back to shareholders through a Fair Fund arrangement and certain corporate governance procedures designed to improve the disclosure process at the bank. Judge Rakoff allowed that these terms were much better than those in the initial settlement which consisted only of a $33 million fine and no corporate governance procedures. If, however, the matter was being considered against a clean slate the Court made it clear that the settlement would not be approved, calling it “far from ideal” at one point and “inadequate and misguided” at another.

Throughout its opinion, the court repeatedly returned to two points. One focused on the culture of Bank of America. In describing the process which produced decisions not to disclose the bonuses and the mounting Merrill losses, the Court noted that there was an “apparent working assumption of the Bank’s decision-makers and lawyers involved in the underlying events at issue here . . . not to disclose information if a rationale could be found for not doing so . . .” In this regard, Judge Rakoff noted that the proposed corporate governance procedures, which focus in large measure on improving the disclosure processes at the bank, “are helpful, so far as they go, and may help to render less likely the kind of piecemeal and mincing approach to public disclosure that led to the Bank’s problems in the instant case.” The proposed modifications by the Court which will be in the final papers are designed to strengthen these procedures.

A second point focused on the penalty. Here, the Court noted that while the penalty is modest for both cases in light of the facts, the “more fundamental problem, however, is that a fine assessed against the Bank, taken by itself, penalizes the shareholders for what was, in effect if not in intent a fraud by management on the shareholders. This was among the major reasons the Court rejected the earlier proposed settlement.” Under the circumstances here, where management deceives its shareholders “a fine most directly serves its deterrent purposes if it is assessed against the persons responsible for the deception. If such persons acted out of negligence, rather than ban faith, that should be a mitigating factor . . .” The fact that the fine will be distributed through the Fair Fund provisions of Sarbanes Oxley does not really change this fact. In the end since neither the fine, nor the remedial measures are directed at the specific individuals involved, meaning that their impact is likely to be “very modest” and results in “half-baked justice . . .”

When the final papers are presented in a few days, the Court made it clear that they will be approved. This is consistent with the Court’s limited role which it described as to “balk” when the bank tries to escape the implications of its conduct and to “protect” when a regulatory agency seeks only modest and misguided sanctions.

In the end, what could have been the SEC’s most prominent market crisis case to date turns out to be otherwise. At the same time, if the principles in the Court’s opinion are followed in future actions, the rough ride will prove more than worthwhile.

SETTLING BANK OF AMERICA: THE SEC HAS THE RIGHT FORMULA

The Wall Street Journal, in a Saturday editorial, claims SEC Chairman Mary Schapiro is some how inconsistent or perhaps disingenuous because of certain corporate governance procedures in the Commission’s proposed settlements with Bank of America. Somehow, the Journal cobbles those together with the Commission’s rule making agenda and a claimed lack of similar procedures at FINRA while Ms. Schapiro was there. Whatever the validity of this far fetched syllogism – and that is far from clear – it is readily apparent that the WSJ has totally missed the mark. Not only does the editorial neglect to discuss the underlying securities law violations and their impact on the shareholders, but perhaps more importantly, it fails to link those issues to the corporate governance which is, after all, the whole point.

The two SEC enforcement actions against Bank of America are about what shareholders were told and what they should have been told when they voted on whether to approve the acquisition of financially troubled Merrill Lynch by the bank. Two points in those cases are beyond dispute: First, the shareholders were not told that the bank and Merrill had agreed executives of the broker could be paid billions of dollars in bonuses. Thus shareholders did not know that in voting for the deal they were also approving huge bonuses for executives who steered the firm historic losses and near collapse. The fact that at the time of the shareholder vote there was wide spread concern and discontent about huge Wall Street bonuses might suggest that shareholder would have wanted to know those facts.

Second, shareholders were not given updated financial information about the brokerage firm’s fourth quarter performance. That information would have told shareholders that Merrill was piling up losses of historic proportions, running into the billions of dollars. Thus, shareholders did not know that in voting for the deal the value of the investment they were approving was plummeting precipitously compared to the financial information in the materials they were furnished. Again, investors may have found this information important when spending their money.

The SEC suits claim that shareholders should have been given the information about the bonuses and the financial condition of Merrill. Judge Rakoff’s inquires have sought to unravel who may have been responsible for these disclosure decisions and the basis for the different conclusions on individual liability reached by the SEC and the New York Attorney General in his suit. Regardless of the outcome of the court’s inquiries, any settlement of the two SEC enforcement actions should address the specific disclosure issues in the case and make sure that the wrongful conduct is not repeated.

For the SEC, charged by Congress with bringing a new ethics to the marketplace, the question should be how to make sure that the shareholders it claims were lied to in the Merrill acquisition get the information they need in the future. The huge fine proposed is supposed to address this question based on the notion that monetary sanctions equal deterrence in the future. This theory is dubious at best. The $30 million penalty in the initial settlement rejected by the court did nothing to halt the bank from insisting that its conduct was absolutely correct, a position which virtually ensured a replication of the claimed wrongful conduct in the future. There is little reason to believe that multiplying the size of the penalty for a huge financial institution like Bank of America will change its stance. The deterrence through big money payments theory, while perhaps appropriate in some cases, is best left to the criminal prosecutors who more typically invoke it.

What can protect shareholders in the future is the installation of procedures which focus on the key problems in the cases. Here, that is what shareholders were told when voting. While there are many ways to fashion appropriate remedial procedures to address this point, those contained in the proposed SEC settlement are keyed to these issues. They include:

• The retention of an independent auditor to review the Bank’s internal disclosure controls;

• New CEO and CFO certifications regarding the annual and merger proxy statement;

• Retention of disclosure counsel who will report to the Audit Committee;

• Adoption of a super-independence standard for all members of the Board’s compensation committee;

• Retaining a consultant to the compensation committee;

• Providing shareholders with a “say on pay;” and

• Implementing incentive compensation principles that will be disclosed on the bank’s web site.

To be sure there no set of procedures designed after the fact which can undo the harm caused. No set of procedures can take the shareholders back in time and tell them about the huge bonuses or the rapidly deteriorating financial condition of Merrill before the December 2008 meeting. At the same time, the procedures in the proposed consent decree do focus on the key issues disclosure and compensation issues in the case to make sure that in the future shareholders are given the proper information when they are required to vote. This is how the securities laws envision bringing a new ethics to the marketplace. Unfortunately the Journal, in an apparent spat of free market anti-regulatory zeal which seems to overlook what happened in these cases and the origins of the current market crisis, missed this critical point. Fortunately for shareholders, Ms. Shapiro and the SEC did not.