His main concern, as it had been all along, was with the failure to charge the individuals responsible for any false disclosure.  He essentially found that the omitted information (on the bonuses to Merrill employees and the broker's large losses) were material.  As he stated:

• Despite the Bank’s somewhat coy refusal to concede the materiality of these nondisclosures, it seems obvious that a prudent Bank shareholder, if informed of the aforementioned facts, would have thought twice about approving the merger or might have sought its renegotiation.

But when it came to assigning blame to specific officials inside the company or lawyers on the outside, he was in a tough bind.  First, the materials provided by the Commission on why the agency chose not to charge individuals were convincing enough.  The Commission submitted a memorandum that discussed in some detail the role played by the assorted parties in the process.  While one can argue over the conclusions reached, a clear finger of blame did not point to any single person. 

Moreover, Judge Rakoff used different accusations by the Attorney General of New York (who is charging individuals in the case) to show that there was in fact a different interpretation that could arise from the same facts.  Yet the language quoted from state officials was full of hyperbole (that “Bank of America’s management thought of itself as too big to play by the rules and, just as disturbingly, too big to tell the truth”) rather than legal analysis. 

Indeed, in the one instance where the Judge made findings over the disparate positions taken by the two regulators (over the dismissal of the general counsel of Bank of America), he sided with the position taken by the SEC ("Upon review of the underlying materials provided by the parties here and by the Attorney General, the Court concludes that none of the evidence directly contradicts the Bank’s assertion that [the general counsel's] termination was unrelated to the nondisclosures or to his increasing knowledge of Merrill’s losses.").  

There was a more fundamental issue here.  Other than perhaps require some modifications to the governance provisions (which he did), or seek a bigger penalty (as he described, "it is still very modest in light of the fact that it now covers both cases"), there was little to be gained by not approving the settlement.  The Judge could not force the SEC to bring actions against individuals so causing the matter to go to trial would not have changed that.  

In the end, his refusal to approve the first settlement resulted in a much improved second settlement.  It may not be perfect but all things considered it is a good one.  

The judge's opinion is posted on the DU Corporate Governance web site. 

As the SEC notes in its complaint, the two parties negotiated, approved and announced the deal terms over a three day period in September 2008.  As a result of the terms of the agreement, BofA needed to issue new shares of common stock to provide to Merrill shareholders.  To register the shares that were to be exchanged in the merger, BofA filed a Form S-4 in October 2008 that incorporated a proxy statement jointly prepared by BofA and Merrill.  BofA and Merrill filed that same joint proxy statement in November 2008 and each mailed copies of the proxy statement to their respective shareholders.

The SEC claims that this proxy statement is false and misleading, in part, because BofA failed to disclose Merrill’s fourth quarter losses.  The proxy statement and registration statement described Merrill’s financial condition as of the end of September 2008.  The SEC argues, however, that in November 2008 BofA had become aware of $4.5 billion in losses that Merrill had incurred in October 2008.   Moreover, in early December 2008, two days before the shareholder vote, BofA received a report from Merrill estimating that Merrill lost $6.4 billion total during October and November.  

The SEC’s complaint includes details from discussions beginning in early November 2008 among BofA’s management, in-house counsel and outside counsel.  The parties discussed the company’s disclosure obligations with respect to the losses sustained by Merrill.  According to the complaint, BofA’s lawyers concluded that “no disclosure was necessary because the projected quarterly loss was within the range of losses that Merrill had sustained in the preceding five quarters” and that the “proxy statement and incorporated filings describing the challenging market environment provided adequate warning to shareholders.”  As a result, BofA did not disclose the losses.  

Sometime after the shareholder vote, management learned that Merrill’s fourth-quarter net losses would exceed $12 billion.  The SEC alleges that at this point, BofA management “considered terminating the merger agreement on the ground that a material change in Merrill’s financial condition had accrued.”  Nevertheless, the company continued with the merger without disclosing any of Merrill’s losses.  On January 16, 2009, over six weeks past the shareholder vote and two weeks after the merger closed, BofA finally disclosed Merrill’s fourth-quarter performance.  Merrill suffered a $15.3 billion net loss in that quarter alone.  Consequently, Bank of America’s stock price fell 30% the next day.

The primary materials, including the original complaint and the proposed settlement, can be found on the DU Corporate Governance website.

The addition to the Commission staff of someone with expertise in Delaware law is particularly timely.  The SEC has been delving more and more into issues that intersect with state law (see Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure).  The SEC's access proposal is the best recent example, a delicate balancing act that preempts state law in some but not all circumstances.  Professor Hamermesh will unquestionably provide useful insight into how that should be accomplished.   

What the staff of the Commission must make clear, however, is that the expertise is only going to be used to ensure a more effective SEC rule that does not raise unintended concerns under state law.  It cannot be used because the Commission wants to engage in a deferential approach towards Delaware law.  An example of how the SEC did this was in its decision under the prior Chairman to certify a question to the Delaware Supreme Court on the validity of bylaws that require the company to sometimes repay the costs of an insurgent's proxy contest.  The Supreme Court took the issue in apparent violation of its own rules.  The result was a disasterous decision for shareholders that made it easier for companies to exclude some proxy proposals under Rule 14a-8.  It is authority that we recommended the Commission affirmatively disavow. 

As Professor Hamermesh mentioned in the press release from Widener announcing the appointment:  “This is a significant step not just for me, but for both the SEC and the State of Delaware in particular."  Hopefully the last clause simply refers to the benefit that will accrue to Delaware because of a rule that does not have unintended consequences under its law and not because Delaware (and those who are a proponent of the Delaware model of corporate governance) see this appointment as an avenue to excersise influence over SEC rulemaking and policies. 

First, of course, it is, to some degree, a clear victory for the judge.  He rejected a $33 million dollar settlement that did not address the failure to disclose the mounting losses by Merrill in connection with shareholder approval of the acquisition.  Moreover, the original settlement harmed existing shareholders by imposing a penalty without providing them with any benefits.  This settlement not only involves a substantially increased penalty ($150 million) but contains corporate governance provisions that ought to benefit existing shareholders.  It is a much improved deal.

Second, Bank of America strenuously argued that it had done absolutely nothing wrong in connection with the first settlement.  The settlement therefore looked like government extortion, the price Bank of America had to pay for getting rid of an overbearing government.   BofA has not admitted the allegations in the settlement (it merely acknowledged "having been served with the Amended Complaint", entered a general appearance and "admits the Court's jurisdiction over it and over the subject matter of the
Actions.").  Nonetheless, the rougher settlement provides greater assurance that the matter was resolved on the merits and not as a result of government coercion.

Third, the failure of the SEC to address the losses by Merrill Lynch in the first case (the complaint only involved issues around the representation that the bank had not approved the bonuses for Merrill when, it was alleged, they in fact had) and the confusion of the reliance on counsel argument suggested that the Agency had not been thorough in its investigation, lending credence to the suggestion by BofA that this case was best explained through government coercion.  The SEC has now added in claims about the losses and conducted extensive discovery, including taking depositions of officers and lawyers involved in the matter.  The increased thoroughness provides greater assurance that the matter is being decided on the merits and is not a product of government coercion. 

In rejecting the first settlement, Judge Rakoff indicated a number of concerns, including the failure to charge individuals.  While the Judge may be disappointed in this failure (although the individuals have now been charged by the New York Attorney General), it will not be enough to stop the settlement.  The SEC provided its reasons for not charging the individuals and, given the greater effort and thoroughness of the Agency, not to mention the depositions taken of counsel, the Judge will not hold up the settlement on this basis. 

These include enhanced auditor review of disclosure procedures and expanded certification requirements for the CEO and CFO (now applicable to the proxy statement).  The undertakings require greater involvement of the audit committee of the board in the disclosure process (through the requirement to hire special counsel). 

A series of undertakings are also designed to affect the compensation process.  The independence requirement for members of the compensation committee have been enhanced (subjecting them to the same standards as the audit committee independence requirement that was adopted in SOX), as has the requirement for the compensation consultants.  Shareholders are to receive an advisory vote on compensation (say on pay) and on changes in compensation policies. 

The description of the undertakings below comes from the memorandum filed by the SEC (and which will be posted eventually at the DU Corporate Governance web site).   We'll venture a prediction on what Judge Rakoff will do in the next post.

• Audit of Internal Disclosure Controls.  Under Section 404 of the Sarbanes-Oxley Act, 15 U.S.C. § 7262, Bank of America must establish internal controls and procedures for financial reporting and have its outside auditor attest to, and report, on management’s assessment of their effectiveness. Although Bank of America is also required to establish controls and procedures for disclosure-related matters and evaluate their effectiveness each quarter, see 17 C.F.R. § 240.13a-15, such disclosure controls and procedures are not required to be audited by an external auditor. This undertaking requires Bank of America to retain an independent auditor to perform an annual assessment and attestation of the Bank’s internal disclosure controls, similar to a Section 404 audit, and to include the attestation report in its annual report to shareholders and filings on Form 10-K.

• Certifications of Annual and Merger Proxy Statements.  Pursuant to the Sarbanes-Oxley Act, Bank of America’s Chief Executive Officer and Chief Financial Officer are required to certify the accuracy of the Bank’s quarterly and annual reports under the Exchange Act. See 17 C.F.R. §§ 240.13a-14(a), 240.15d-14(a). No certification is required, however, with respect to proxy statements. This undertaking requires Bank of America’s CEO and CFO to provide certifications of all annual and merger proxy statements similar in form to the certifications required for quarterly and annual reports under theSarbanes-Oxley Act.

• Special Counsel to Audit Committee. This undertaking requires the Audit Committee of the Bank’s Board of Directors to retain special counsel with expertise in disclosure issues who will report to the Committee and review the Bank’s public disclosures. The disclosure counsel is required to confer with members of the Bank’s Audit Committee in executive session at all regularly scheduled meetings, separate and apart from the non-independent Board members, to discuss the adequacy of Bank of America’s public disclosures.

• “Super-Independence” of Compensation Committee.  The members of Bank of America’s Audit Committee are prohibited, under the Sarbanes-Oxley Act, from accepting consulting, advisory or other compensatory fees from the Bank or its affiliates other than routine compensation for serving as a Board member. See 15 U.S.C. §78j-1(m)(3)(B). This standard of independence, commonly referred to as “super-independence,” is not required for compensation committee members. This undertaking requires Bank of America to adopt a super-independence requirement for members of the Compensation Committee of its Board.

• “Super-Independent” Compensation Consultant.   Pursuant to this undertaking, Bank of America will maintain a consultant to advise the  members of its Compensation Committee, who will also be subject to “super-independence” standards.

• “Say on Pay”.  As a former recipient of funds under the Troubled Asset Relief Program (TARP), Bank of America until recently was required to hold a non-binding shareholder vote to approve executive compensation. See 17 C.F.R. § 240.14a-20. Because the Bank has recently repaid the government the TARP funds it had received, it is no longer subject to this requirement. Thisundertaking requires the Bank to continue holding a non-binding shareholder vote on executive compensation for three years from the entry of judgment.

• Disclosure of Compensation Principles and Advisory Shareholder Vote on Any Changes.  Pursuant to this undertaking, Bank of America will implement and maintain incentive compensation principles and procedures and post a description of them in a prominent place on its website at www.bankofamerica.com. Unless a change in the principles is required by law, Bank of America can change them only after first informing its shareholders and placing any proposed change to the shareholders for an advisory vote.

• There is undoubtedly a constituency that is interested in, and has long pressed the Commission to require, more extensive disclosures on environmental issues in order to drive particular environmental policy objectives. The issuance of this release, however, at a time when the state of the science, law and policy relating to climate change appear to be increasingly in flux, makes little sense.

As for the legal effects of the release, Commissioner Casey oddly opposed it because it reflected a statement of the law as it currently existed.

• Legal requirements and reputational pressures relating to climate change issues are, fundamentally, no different than those that arise in other regulatory contexts, albeit climate change is currently a “hotter” and more controversial political topic than most other regulatory issues.  . . . Nevertheless, the disclosure guidance in this release relating to legal requirements and reputational pressures would apply with equal force to any other legal and regulatory regime affecting public companies.

In other words, she did not object to any of the legal principles in the release, only that it was written in the context of climate change disclosure.  In other words, "there is no credible reason to single out climate change issues for discussion."

Its a strange criticism.  While it is true that the release applies a broad set of requirements to a specific type of disclosure, there is nothing new with that.  Moreover, to the extent it brings all of the existing requirements into a single place, there is a certain convenience factor that results.

Commissioner Casey's real objection seems to be the belief that by restating the requirements, they will in fact put pressure on companies to make more and better disclosure in the area.  As she notes:  "Nevertheless, this guidance assumes that man-made global warming and climate change are occurring as a result of greenhouse gas emissions and are likely to result in physical effects that will affect the businesses of registrants."

That may be true.  But whatever the cause, disclosure only needs to occur, presumably, where the change in the climate will have a material effect on the company's business.  There may be difficulties in quantifying the consequences and in the precise cause of the climate change, but shareholders ought to be informed about the impact of these changes if they will be material.

Paredes objected to several things (including his belief there were more pressing priorities before the Commission and, as a result, "now is not the time for this agency to consider climate change disclosure.").  One of them was this statement in the release:

• Depending on the nature of a registrant's business and its sensitivity to public opinion, a registrant may have to consider whether the public's perception of any publicly available data relating to its greenhouse gas emissions could expose it to potential adverse consequences to its business operations or financial condition resulting from reputational damage.

He contended that the requirement would "foster confusion and uncertainty about a company's required disclosures'"  His main objection?  That "reputational damage . . .  can be quite speculative."  The result will encourage disclosures "that are unlikely to improve investor decision making and may actually distract investors from focusing on more important information."

The claim that disclosure can result in excessive amounts of information has been raised by Commissioner Paredes before.  See Statement by Commissioner Paredes at Open Meeting to Adopt Amendments Regarding Proxy Disclosure Enhancements, Dec. 16, 2009 ("Even as we add new disclosure requirements today, it is important to consider whether other mandated disclosures should be more narrowly focused or otherwise scaled back if they are no longer sufficiently useful to investor decision making").  Moreover, the risk that new requirements will result in boilerplate is always present. 

But the substance of the claim is misplaced.  Without the benefit of the entire release, there may be more to the statement than is in the remarks by Commissioner Paredes.  Yet it looks to be nothing more than an application of qualitative materiality.  Moreover, while the statement refers to reputational damage, it specifically indicates that this will only be important where it will have an adverse effect on business operations or finances.  In other words, this is about reputational harm that will hurt the bottom line.  

To the extent that this was the main objection (there was also one on the impact of disclosure relating the "physical effects of climate change"), it seems like a remarkably small issue that could have been readily clarified by the staff.  This suggests that in fact there were other motivations for opposing the guidance.  A hint of what that might have been appears in a later paragraph.  As Commissioner Paredes notes: 

•  Also problematic are the interpretive release's introductory and background discussions on climate change and its regulation. To me, the effect of the discussions is to find the Commission joining the ongoing debate over climate change by lending support to a particular view of climate change. Although the release does not expressly take sides, the release emphasizes the "concerns" and potential harms of climate change and discusses a range of regulatory and legislative developments, along with international efforts, aimed at regulating and otherwise remedying causes of climate change. . . . While the release stresses the risks of climate change and ongoing efforts to regulate greenhouse gas emissions in the U.S. and abroad, the release fails to recognize that the climate change debate remains unsettled and that many have questioned the appropriateness of the regulatory, legislative, and other initiatives aimed at reducing emissions that the release features. In short, I am troubled that the release does not strike a more neutral and balanced tone when it comes to climate change — an area far outside this agency's expertise.

Yet whatever the tone, disclosure apparently is limited to climate change matters that have a material effect on a company's business.  In other words, the SEC is not entering the debate on climate change as much as it is telling companies that material, quantifiable consequences of climate change must be disclosed.

Commissioner Paredes apparently views accurate disclosure as something that should be sidelined when the matter is controversial.  

• Impact of Legislation and Regulation: When assessing potential disclosure obligations, a company should consider whether the impact of certain existing laws and regulations regarding climate change is material. In certain circumstances, a company should also evaluate the potential impact of pending legislation and regulation related to this topic.

• Impact of International Accords: A company should consider, and disclose when material, the risks or effects on its business of international accords and treaties relating to climate change.

• Indirect Consequences of Regulation or Business Trends: Legal, technological, political and scientific developments regarding climate change may create new opportunities or risks for companies. For instance, a company may face decreased demand for goods that produce significant greenhouse gas emissions or increased demand for goods that result in lower emissions than competing products. As such, a company should consider, for disclosure purposes, the actual or potential indirect consequences it may face due to climate change related regulatory or business trends.

• Physical Impacts of Climate Change: Companies should also evaluate for disclosure purposes the actual and potential material impacts of environmental matters on their business.

Mostly the release (as evidenced by the press release) emphasizes the need for companies to disclose the impact of enviornmental/climate change legislation/regulations (and treaties) whenever they can have a material effect on the company.  In short, the release looks like little more than a reiteration of the already existing requirement that material effects on business need to be disclosed.  If no other place, this would be required disclosure as a trend in the MD&A. 

Indeed, the release stressed that the obligations would not "create new legal requirements nor modify existing ones, but are intended to provide clarity and enhance consistency for public companies and their investors." 

The difficulty in reaching consensus can be worsened by the existence of representation of both parties on the body.  The five person commission is prohibited by law from having more than three persons of the same party.  See 15 USC 78d ("Not more than three of such commissioners shall be members of the same political party, and in making appointments members of different political parties shall be appointed alternately as nearly as may be practicable.").  Ordinarily, therefore, the party in the White House gets three seats (and a majority) and the party out of power receives the other two (although there have been cases where the non-majority slots went to independents). 

Of course, its possible to have appointees who represent both parties but have the same philosophical approach to regulation.  In other words, party affiliation isn't by itself a guarantee of diverse viewpoints.

The current Commission, however, does have a diversity of viewpoints that break down along party lines.  The Commission currently has a full complement.  Schapiro, Walter and Aguilar sit in the democratic slots; Paredes and Casey occupy the republican ones.  Four of the current appointees were put on the Commission by President Bush.  President Obama has only had a single appointment so far, the chair, Schapiro. 

Particularly in the area of corporate governance and corporate disclosure, it looks as if any pretense at consensus no longer exists at the Commission.  More decisions seem to be made by a 3-2 vote.  Examples?  The Amendments to Rule 452 of the NYSE to prohibit discretionary voting by brokers in uncontested elections for the board of directors; the proposed rules giving shareholders the right to access.  The most recent is the interpretive guidance on climate change disclosure.    

Note that the two dissenting commissioners (always Paredes and Casey) have done so in rules sought by the self regulatory organization (the amendment to Rule 452), rules that were merely proposals  (access), and interpretive guidance.  Commentary suggests that the interpetive guidance on climate control merely repeats what lawyers already tell their clients.   In other words, the two in opposition felt the need to object to a release that largely reiterates rather than changes the law.

This sort of divisiveness is, it seems, increasingly common in the political realm.  Now, apparently, it is becoming increasingly common in the administrative realm.  One of the consequences is, ironically, a reduction in influence for the dissenters.  In shaping access or repealing the limits in Rule 452, a consensus approach would likely give the dissenters influence on the final terms of the regulation.  Yet by objecting, particularly at the onset, the dissenters largely make themselves irrelevant to the shaping of the final product.  As for the length of time on the commission, Casey's term expires in 2011.  Paredes has until 2013.

The SEC charged the Bank with the failure to disclose the losses.  The complaint included a single claim under Rule 14a-9 against the company.  Omitted was any claim against responsible individuals.  The failure involved a step backwards.  The pattern over recent years has been to identify disclosure failings then pinpoint the responsible persons.  Only in this way can the Commission send a message to persons in comparable positions.   Moreover, this case elevates reliance on counsel to an almost absolute defense.

With respect to the $5 billion in losses, outside counsel advised BofA (according to SEC assertions) that the information did not need to be disclosed because it was within the range of losses of prior quarters and because the proxy/registration materials provided "adequate warning."  This is an argument that the information was immaterial.  To the extent that the SEC is correct that the market expected Merrill to have modest losses or even a gain, this conclusion is problematic.  Materiality is any information important to a reasonable shareholder deciding how to vote.  Losses substantially greater than what was anticipated would likely meet this threshold. 

Interestingly, in opposing the motion to amend the complaint, counsel for BofA did not seriously press the immateriality claim.  Instead, it essentially contended that BofA had no duty to update information about Merrill Lynch.

But more importantly, by the time BofA learned that the projected losses were in the vicinity of $7 billion, two days before the meeting, management did not consult outside counsel.   Instead, they apparently communicated with inside counsel and were again told that the losses did not need to be disclosed because they were in the range of losses incurred in prior quarters.  BofA learned that the projected losses would be somewhere around $7.5 billion the day before the meeting and did not disclose, apparently without consulting anyone.

So why weren't individuals charged?  Here is the explanation provided by the SEC press release:

• According to the SEC's proposed complaint, Bank of America executives at various times discussed the firm's disclosure obligations with internal and external counsel. These executives are not alleged to have deliberately concealed information from counsel or otherwise acted with scienter or intent to mislead. Nor is any counsel alleged to have acted with scienter or intent to mislead. For these reasons, the SEC's proposed complaint does not seek charges against any individual officers, directors or attorneys. SEC staff has advised the Commission that, after a careful assessment of the evidence and all of the relevant circumstances, it has determined that charges against individuals for their roles in connection with proxy disclosure are not appropriate.

Two things make this conclusion problematic.  First, the standard under Rule 14a-9 is not scienter but negligence.  The only question is whether corporate officials were negligent in failing to disclose the information.  Contending that there needs to be deliberate concealment is wrong.

Second, counsel informed management that the losses did not have to be disclosed.  The advise depends upon what counsel knew in providing the advise.  The Commission has alleged that the conclusions provided by counsel were incomplete.  Certainly, the basis for the advise and the role played by counsel in the non-disclosure require further examination. 

In addition to charging individuals, the Commission should have considered causes of action beyond the proxy rules.  The Commission should have considered a claim against the Bank for fraud under Rule 10b-5.  The facts in the proposed complaint indicated that the losses by Merrill were known within the Bank.  In other words, the decision not to disclose was intentional.  The only issue is whether there was a duty to disclose and whether the losses were material. 

It is unclear exactly who was at fault for failing to disclose the large losses.  But it is an issue that demands resolution.  The failure to bring claims against individuals sends a message that, with respect to corporate disclosure obligations, it is acceptable to avoid legal responsibilities by simply pointing to counsel.  Moreover, it sends a message that the Commission has little interest in exploring the role of counsel in providing the exonerating advice.  The failure to bring actions against individuals sends the wrong message with respect to corporate disclosure. 

The letters, the new complaint, and other primary materials are posted at the DU Corporate Governance web site.

The allegation was not that BofA knew of the losses on Nov. 3 (the date that the proxy statement was filed with the Commission) but learned of them afterwards and failed to "update" the proxy and registration statement.  Shareholders had learned about Merrill's third quarter losses (in a Form 10-Q filed on Nov. 5 and incorporated by reference into the proxy statement.  The quarter reflected a loss of $5.2 billion.  According to the complaint, the market largely viewed Merrill's problems as over. 

• After Merrill released its third quarter results, the price of its publicly-traded stock rose ~ reflecting the market's assessment that Merrill's financial prospects had improved. In addition, analysts who covered Merrill forecasted that Merrill's net income in the fourth quarter of 2008 would range from a gain of $1 billion to a loss of $1.8 billion -echoing the market's view that Merrill's fourth quarter performance would be a substantial improvement over its $5.2 billion loss in the third quarter.

In fact, according to the complaint, losses ballooned.  By the second week in November, "Bank of America was advised that Merrill had closed its books for the month of October with a net loss of $4.5 billion." 

On November 12, BofA received a report projecting that Merrill would have a fourth quarter loss of approximately $5.4 billion.  The news only got worse.  As the complaint contends, "[o]n December 3, two days before the shareholder vote, Bank of America received an updated report reflecting an estimated net loss of $6.4 billion at Merrill for October and November, and forecasting a quarterly net loss of over $7 billion."  Ultimately (but not before the meeting), the total amount of the net losses for the fourth quarter reached $15.3 billion. 

Yet these losses were never disclosed to shareholders (BofA shareholders were voting on whether to approve the issuance of the shares needed to complete the merger).  Why not?  The complaint asserts that officials at BofA relied on outside counsel.  As the complaint described:

• Between November 12 and November 20, Bank of America's in-house and outside counsel conferred on whether a disclosure had to be made in light of the forecasted $5 billion quarterly loss at Merrill. On November 20, the lawyers erroneously and negligently concluded that no disclosure was necessary because the projected quarterly loss was within the range of losses that Merrill had sustained in the preceding five quarters. In addition, the lawyers concluded that the proxy statement and incorporated filings, which described the challenging market environment and the adverse impact that Merrill could experience as a result, provided adequate warning to shareholders. Although Bank of America and its attorneys determined that disclosing Merrill's forecasted quarterly performance would be risky and speculative, they did not consider disclosing solely the enormous $4.5 billion monthly loss that Merrill had sustained in October, which was known. Nor did Bank of America or its attorneys seek any additional financial data from Merrill to better ascertain the extent of known, as opposed to merely projected, losses as of mid-November, or to learn of any updates as of November 20 (the day they determined that no disclosure was necessary) to the forecasted net loss of $5 billion.

As for the projected losses known to the Bank a few days before the meetings (that the next loss would be $7 billion, more than the prior quarter), management apparently did not consult outside counsel.  Instead, "management again consulted the company's in-house counsel and was erroneously advised that no disclosure was necessary because the forecasted quarterly loss, though larger than before, was still within the range of losses that Merrill had sustained in prior quarters."

Yet things got even worse.  With this update [on Dec. 4, the day before the meeting], the known October net losses and estimated November net losses exceeded $7.5 billion.  This time officials apparently did not consult counsel of any kind. As the complaint alleged:  "Yet Bank of America did not consider whether the update warranted disclosure or otherwise affected Bank of America's prior conclusion that no disclosure was necessary."

In short, there are periods when lawyers apparently advised management that they did not need to disclose the losses.  There was at least one period when management apparently chose not to disclose without consulting counsel. 

The letters and other primary materials are posted at the DU Corporate Governance web site.

One was that no individuals had been charged.  The other was that the false disclosure was not related to the burgeoning losses incurred by Merrill Lynch sometime around the date shareholders voted but involved the failure to make adequate disclosure with respect to the bonuses paid by Merrill.  Even then, the alleged misstatement was not about the amount of the bonuses.  The Commission essentially charged BofA with having falsely stated that the Merrill bonuses had not been approved when in fact they had.  Not a loser to say the least, but not the strongest fraud action.  After all, while the proxy statement may have misrepresented the state of bonus approval, the inevitability of approval may have rendered them immaterial.

There was a sense that the original case was a compromise.  BofA agreed to settle for a large penalty while the SEC brought about the most innocuous action that could be maintained.  Only Judge Rakoff rejected the compromise.

This compromise became clear in the Commission's efforts over the last few weeks to amend the complaint.  Now having to litigate, the Commission has apparently realized that by giving away the issue of the losses, it has a weaker case.  As a result, the Commission filed a motion asking for permission to amend the complaint and add a claim related to the nondisclosure by BofA the "extraordinary losses" sustained by Merrill Lynch.  In objecting to the motion, BofA noted that, in addition to the prejudice that it would suffer, that the SEC actually knew about the non-disclosure of the losses in the first half of 2009.  (A detailed affidavit by Victor Hou from Cleary sets out what the Commission knew and when).  In other words, the SEC was aware of the possible claim, did not bring it in the aborted settlement, but has now sought to add it back into the case.

Unfortunately for the SEC, Judge Rakoff denied the motion.  He rightfully noted that with a March 1 trial date, BofA did not have time to adequately prepare.  Judge Rakoff indicated that the Commission could file a separate action, which it promptly did.  We will discuss this new complaint in the next post.   

The letters and other primary materials are posted at the DU Corporate Governance web site.

One of the more inexplicable steps taken by the SEC during the financial meltdown in the Fall of 2008 was the sudden ban on short sales.  It seemed like a doubtful step, devoid of empirical evidence and possibly done in violation of mandatory procedures.

An article in the New Yorker (Eight Days) cast an interesting light on the motivations for the step.  The article looks at eight days during September, just  before and just after the failure of Lehman.  The article mostly profiles Geithner, Paulson and Bernanke but with an occasional guest appearance from Chris Cox, then the Chair of the SEC.  On Sept. 18, with the markets teetering from the failure of Lehman and all of the collateral consequences, near panic had arisen over the potential failure of the two remaining large investment banking firms, Goldman and Morgan (Merrill had already agreed to merge with BofA).  Paulson apparently put pressure on the Commission to ban short selling to save these two firms.

As the article notes:

• Cox was probably the most free-market-oriented of the group [Paulson, Bernanke & Geithner], and a ban on short selling went deeply against the grain.  .  .  .  In fact, before that day, none of the five commissioner members supported such a ban.  During calls that day and the previous day, however, government officials came out in favor of a  ban.  And in one such call, when Cox said he was worried about unintended consequences, Paulson grew impatient.  "You can sort it out later!" he said.  "You have to save them now or they'll be gone while you're till thinking about it." 

What did the Commission do in response?

• At the meeting that night, the S.E.C. commissioners were informed that the Treasury and the Fed supported urgent action.  In light of this, and the fact that the U.K. had taken a similar step earlier that day, the commission voted unanimously to temporarily ban short selling in seven hundred- and ninety-nine financial stocks.

In short, the SEC was apparently pressured into it by the Fed and Treasury.

It would be easy in hindsight to suggest something untoward about all of this.  The SEC, after all, is an independent agency and ostensibly less susceptible to political pressure.  Nonetheless, the circumstances were largely unprecedented.  The markets, as the article reveals, were in meltdown mode.  Regulators needed to respond quickly, vigorously and without a script (like when Treasury decided to issue a "temporary" guarantee of money market funds).  Whatever the lack of empirical evidence for the impact of short selling, the immediate concern with two other mammoth financial institutions suffering the same fate as Lehman likely warranted the action.

The Complaint alleged Chais committed securities fraud beginning in 1970, when he formed and managed the Funds.  Chais represented to investors that he was an “investing wizard” executing a complex trading strategy.  The Complaint asserted, however, that Chais was a close friend of Madoff and was an “unsophisticated investor” who turned over substantially all of the Funds’ assets to Madoff.  Nonetheless, Chais received approximately $270 million in fees for his “services” between the years of 1995 and 2008.  

According to the Complaint, Chais concealed from investors the fact that he turned the Funds’ assets over to Madoff.  When asked questions regarding his trading strategy, Chais allegedly offered nebulous and false responses.  Moreover, Chais specifically told his accountant not to disclose Madoff’s name to investors.  Consequently, investors were unaware that Chais deposited the Funds’ assets with Madoff until after Madoff’s Ponzi scheme collapsed.  

The Complaint further alleges that Chais and his accountant prepared and distributed investors’ account statements based on information received from Madoff regarding the Funds’ investment performances.  Around 1995, Chais told Madoff, “he did not want there to be any losses in any of the Fund’s trades.”  Between 1999 and 2008, Madoff did not report any trading losses on behalf of the Funds.  As a result, the Funds reported returns of at least 10% per annum since 1995.  Nevertheless, Chais and his accountant continued to prepare and distribute investors’ account statements using information provided by Madoff.

Based on the foregoing allegations, the SEC asserted Chais committed securities fraud for two reasons.  First, Chais made misstatements and omissions to investors regarding his role in managing the Funds.  Second, Chais was at least negligent in distributing investors’ account statements that he should have known contained false information.  As a result, the SEC claimed Chais violated Section 17(a) of the Securities Act; Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; and Section 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.

The SEC sought, among other relief, a judgment (1) enjoining Chais from committing future violations of securities fraud, (2) ordering disgorgement of ill-gotten gains, and (3) ordering payment of civil money penalties.  In his Answer, Chais denied committing securities fraud and argued he was not an investment advisor to the Funds.  Although Chais denied his alleged friendship with Madoff, he admitted turning over substantially all of the Funds’ assets to Madoff.  In addition, Chais claimed insufficient knowledge to form a belief as to the amount of fees he received from the Funds, but he admitted receiving some amount of fees for his services.

Chais admitted he did not want Madoff’s name disclosed to investors.  He denied, however, making representations to investors that he was managing the Funds’ investing and trading strategies.  Chais told investors, “if they were uncomfortable with the lack of information they were receiving, they could withdraw their investment or decline to invest.”  Also, Chais admitted preparing investors’ account statements based on information received from Madoff.  Furthermore, Chais denied requesting that Madoff not show trading losses on behalf of the Funds.  Because Chais did not request that Madoff not show trading losses, the reported returns on the Funds’ investments would not have alerted Chais to the fact Madoff was providing false information. 

In addition to denying violation of federal securities laws, Chais stated three affirmative defenses.  First, the SEC’s “claims . . . [were] barred by virtue of . . . [the SEC’s] own conduct, which provided credibility to Madoff.”  Second, the doctrines of waiver, estoppel, and unclean hands barred the SEC’s claims.  Third, Chais’ receipts from Madoff were irrelevant to the SEC’s claims.  He sought, among other relief, dismissal of the SEC’s claims and attorneys’ fees. 

The first asserted affirmative defense is peculiar: the SEC’s failure to thwart the Madoff Ponzi scheme “provided credibility to Madoff,” and thus, barred the SEC’s claims against Chais.  In other words, Chais claimed the SEC’s failure to discover the Madoff fraud provided assurance to investors, including Chais, that Madoff was running a legitimate investing business.  At first glance, this defense may seem tenuous.  Contingent upon the ultimate factual determinations in the case, however, this defense may inoculate Chais’ actions from liability that, absent the SEC’s bungle, would otherwise violate federal securities laws.  In sum, SEC’s own missteps in the Madoff case may provide Chais with a defense to the SEC’s charges and raise the SEC’s own failures as an issue in the case at bar.  

The primary materials for the post are available on the DU Corporate Governance website. 

Most know Judge Murray as a smart, no nonsense ALJ who has served as chief forever (actually since 1994).  Less well known is her involvement in the Women in Prison Project where she has coordinated efforts to provide educational opportunities for women in prison.  According to the Women of Worth web site:    

How will the ultimate recipient be selected?  By online voting.  So go to the site (http://www.womenofworth.com/honorees/Honorees_2009.aspx) and cast a vote for Judge Murray.