SEC v. BofA: The Other Shoe Drops (The Merrill Lynch Losses) (Part 3)

In its newly filed complaint, the SEC alleged that BofA knew by mid-November that Merrill had estimated fourth quarter losses of over $5 billion.  By December 3, two days before the meeting, the estimated losses were in the vicinity of $7 billion.  On December 4, the day before, the Bank knew that the "known October net losses and estimated November net losses exceeded $7.5 billion."

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.