Sept. 15 (Bloomberg) -- The U.S. Securities and Exchange Commission is left with few options as it weighs how to proceed in a lawsuit against Bank of America Corp. after a judge rejected a $33 million settlement.

Yesterday, U.S. District Judge Jed Rakoff in New York refused to accept a settlement that would have resolved the SEC’s claim that the bank deceived investors in November about bonuses to be paid executives at Merrill Lynch & Co., which the bank was buying. Rakoff said the accord appeared to be a “contrivance” between the SEC and Bank of America and wondered why bank executives or their lawyers weren’t sued.

Now the SEC is in a jam, said Peter Henning, a former SEC attorney who teaches law at Wayne State University in Detroit. Regulators could dismiss a case in which the bank is accused of breaking the law. They could try the case and risk that the bank has strong defenses. Or they could file a new lawsuit against individual executives or lawyers after saying earlier that they lacked sufficient evidence to do so.

“In a sense, the SEC has painted itself into a corner,” Henning said in an interview.

Tamar Frankel, a professor at Boston University School of Law, said a settlement with different terms may eventually be acceptable to Rakoff. One possibility is that Bank of America could agree to recover all or part of the bonuses paid Merrill Lynch executives, she said.

“It’s very unusual,” Frankel said of Rakoff’s refusal to accept the $33 million settlement.

‘Quick Resolution’

In a 12-page order yesterday, Rakoff said he wouldn’t accept a settlement that required shareholders to pay $33 million for the alleged wrongdoing of bank executives. He ordered the case to go to trial on Feb. 1.

“The parties’ submissions, when carefully read, leave the distinct impression that the proposed consent judgment was a contrivance designed to provide the SEC with the façade of enforcement and the management of the bank with a quick resolution of an embarrassing inquiry,” Rakoff wrote.

The proposed settlement followed the Aug. 3 lawsuit in which the SEC said the bank misled investors about bonus payments while buying Merrill Lynch.

Bank of America said in a proxy statement in November that Merrill had agreed not to pay year-end bonuses before the acquisition closed without the bank’s consent, the SEC said. Instead, the bank said Merrill could pay as much as $5.8 billion in bonuses, the SEC alleged.

The bank, the biggest U.S. commercial lender, said later in court papers that it had done nothing wrong and agreed to settle to avoid unwanted litigation with an important regulator. The Charlotte, North Carolina-based bank also said shareholders knew bonuses would be paid.

‘Implicit Message’

Rakoff rejected the bank’s arguments yesterday, saying he still doesn’t know why executives or their lawyers weren’t sued. He said a trial in the case, which neither side wants, would start on Feb. 1.

“The judge’s not-so-implicit message is that he wants people named and he wants those people to pay the penalties,” Anthony Sabino, a business-law professor at St. John’s University in New York, said in an interview. “The bottom line is that there have been very pertinent and important questions asked and the answers have not been very forthcoming.”

John Nester, an SEC spokesman, said the settlement “properly balanced all the relevant considerations.” The agency is reviewing Rakoff’s order, he said.

“Proper disclosure was made to shareholders,” Scott Silvestri, a Bank of America spokesman, said in a statement. The bank is “prepared to prove that through litigation,” he said.

Few Options

Henning said the SEC’s options are limited. It may file a new lawsuit against bank executives after saying earlier in a court filing that there was insufficient evidence to charge individuals, he said.

“It will be hard for the SEC to charge individuals now unless it wants to admit it did a very bad job” on the original investigation of the bank, Henning said, adding that the SEC is still smarting over accusations of incompetence in its probes of con man Bernard Madoff. “After the Madoff debacle, I don’t think they want to do that,” he said.

The SEC may push the case to trial and risk that the bank presses a potential defense that U.S. regulators pressured them into closing the Merrill deal, Henning said. Another option is for the SEC to dismiss the case and file an administrative claim that wouldn’t be heard in federal court.

“I think they’ll look for some way to bail out of Judge Rakoff’s court,” Henning said.

February Trial

A Feb. 1 trial is unlikely, Henning said, as lawyers investigate what is likely to be a complicated case.

There may also be pre-trial litigation over Bank of America’s reliance on its outside lawyers. According to the SEC, the bank has said it relied on its lawyers’ advice before issuing its November proxy statement.

Rakoff has questioned whether the bank may assert that defense without waiving its attorney-client privilege, which keeps communications with counsel confidential.

For now, said Boston University’s Frankel, “the SEC can either continue and go to trial, or say, ‘I give up.’”

The case is Securities and Exchange Commission v. Bank of America Corp., 09-cv-06829, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporters on this story: David Glovin in New York federal court at dglovin@bloomberg.net; David Scheer at David Scheer in New York at dscheer@bloomberg.net.

Last Updated: September 15, 2009 09:39 EDT