Putting BofA's Merrill Acquisition on Trial

In the corporate world it can be messy negotiating a merger. For Bank of America, it appears the backroom drama behind its deal for Merrill Lynch is going to be aired in public.

The Sept. 14 decision by a federal judge to reject the $33 million fine Bank of America (BAC) agreed to pay to settle government charges that it withheld material information ahead of the shareholders' vote on the deal was a major setback for the Charlotte-based bank. While BofA's management had hoped the settlement with the Securities & Exchange Commission would help end the controversy over the Merrill acquisition, the bank now faces two equally bad outcomes.

At best, the judge's ruling forces the SEC to go public with more of the behind-the-scenes jousting between BofA and regulators. Worse, it could force the SEC to bring charges against any specific BofA executives that it believes decided not to disclose the unreported losses and executive bonuses before shareholders voted. "BofA is in serious, serious trouble now," says Anthony Sabino, a professor of law and business at St. John's University.

The ruling by U.S. District Court Judge Jed S. Rakoff wasn't entirely surprising given that he'd already signaled his uneasiness with the SEC's settlement. On Aug. 10, Rakoff refused to approve the settlement. He further demanded that the SEC provide more details as to whether BofA executives knew about the looming losses and bonus payouts at Merrill—and if so, who made the decision not to disclose this information to shareholders ahead of the December vote on the deal. Rakoff conceded that settlements like this were often in the best interest of all parties, sparing them the cost and distractions of litigation. But in his latest ruling, the judge said the proposed $33 million settlement "suggests a rather cynical relationship between the parties: The SEC gets to claim that it is exposing wrongdoing on the part of Bank of America in a high-profile merger; the bank's management gets to claim that they have been coerced into an onerous settlement by overzealous regulators. And all this is done at the expense not only of the shareholders, but also of the truth."

Both Sides Are on the Defensive As a result, Rakoff wrote that he was "forced to conclude that the proposed consent judgment is neither fair, nor reasonable, nor adequate" to protect the public's interest. He told both sides to prepare for a Feb. 1 trial on the SEC's allegations.

A Bank of America spokesman said: "We disagree with today's ruling. Bank of America believes the facts demonstrate that proper disclosure was made to shareholders about Merrill bonuses. We are prepared to prove that through litigation. We will consider all our legal options over the coming days." At the SEC, officials defended the original settlement. "We believe the proposed settlement properly balanced all of the relevant considerations," spokesman John Nester said. "We will carefully review the court's most recent order."

If Bank of America had little interest in seeing the Merrill deal dissected publicly, the SEC may not have had much more. With the judge refusing to rubber-stamp the settlement, the SEC may have no other choice but to deepen its investigation into why BofA didn't disclose the $3.6 billion in bonuses Merrill was preparing to pay its executives—as well as its failure to alert shareholders to the ballooning losses at Merrill. According to prosecutors in New York, who are conducting a separate probe, Merrill executives privately raised their estimates of pretax losses for the fourth quarter, from $9 billion to $14 billion, in the days before the Dec. 5, 2008, shareholder vote—a change that wasn't disclosed to shareholders.

And then there are the bonuses, which led to an outcry by lawmakers who were outraged that top executives were receiving incentive pay when the bank was being bailed out by taxpayers. While Bank of America and Merrill executives argued that the bonus payouts were a scheduled end-of-year ritual on Wall Street, and that the parties had already issued extensive risk disclosures, some critics have said the $3.6 billion in payouts were unexpectedly large, given Merrill's poor performance, and served to further erode its weakened balance sheet.

Bove: BofA Gained Much from Merrill At this point, some analysts believe the SEC has no good options, regardless of what else it might learn in an expanded Bank of America probe. For one thing, agency officials could try to extract a larger fine from BofA—one the SEC regards as more in keeping with the magnitude of the alleged crime. But Rakoff could well argue that a larger fine only inflicts more harm on the bank's shareholders—or as he wrote, "further victimizes the victims."

Richard X. Bove, a veteran bank analyst now at Rochdale Securities, fears that if the courts decide the merger was consummated fraudulently—because BofA shareholders didn't know the true state of Merrill's finances—it could invalidate the deal and force BofA to spin off the investment bank. For all the bad press over Merrill's disastrous forays into subprime mortgages, Bove says the lush profit stream from Merrill's brokerage business and the old Countrywide mortgage group have kept Bank of America afloat. "Without the earnings being pumped in from Countrywide and Merrill Lynch, Bank of America would be in a truly perilous state," he says.

And while Bove thinks it is conceivable that BofA shareholders might not have approved the $17 billion merger if they'd known about the hefty bonuses and undisclosed losses at Merrill, the bank's shareholders must now realize the degree to which the income produced by Merrill's vast army of 16,000 brokers is providing critical funds. "Nobody who owns shares in BofA would want to see Merrill spun off because it's been a very accretive merger," he says.

But some legal scholars, including John Coffee at Columbia University, believe the judge lacks the authority to unwind the merger. "He can approve the settlement or not approve the settlement," notes Coffee. "But what he can't do is order the SEC to pursue a reversal of the merger." What the SEC can do isn't clear. Given the criticism the SEC has suffered for not detecting the fraud perpetrated by investment manager Bernie Madoff, Coffee thinks the SEC doesn't have the option of simply dropping the case.

How Far Did the Government Push BofA? Given that New York Attorney General Andrew Cuomo is already threatening to file charges against several top executives at Bank of America for failing to disclose the growing problems at Merrill ahead of the shareholder vote, the SEC may have no choice but to train its sights on BofA executives as well. "The SEC is in something of a competition with the New York attorney general," notes Coffee. If they still go after the company while Cuomo pursues any executives who he believes engaged in a cover-up, that doesn't make [the SEC] look like the tough cop."

But bringing charges against top BofA executives could trigger a messy legal battle at a time when the Obama Administration is trying to stabilize the banking system and coax bankers to provide the lending necessary to jump-start the economy. Digging deeper into the drama of who knew what and when at Bank of America could raise uncomfortable questions—not just for BofA, but for the government itself. Already, Bank of America CEO Ken Lewis has claimed that then-Treasury Secretary Henry Paulson and other key Bush Administration officials not only pressured the bank not to disclose Merrill's growing problems but to complete the Merrill deal for fear that if BofA backed out, it could further destabilize the financial markets. Coffee believes that if the SEC tries to make a case against Lewis and other executives for not disclosing enough about Merrill's woes, "it could look contradictory since the government used brass knuckles to make [BofA] close this deal," he says.

By forcing the SEC's hand, Judge Rakoff may believe he is simply acting in the best interests of the public—taxpayers and shareholders alike. That may be true. But the court may have opened a Pandora's box of problems for both the government and the nation's largest bank.

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