Rakoff Order in BofA Case: Game-Changer?
On Monday, Judge Jed Rakoff issued his order rejecting the proposed $33 million settlement of the SEC case against Bank of America. The order raises numerous issues for the SEC such as whether it must now amend its case to include individual defendants, and whether it will now take the case to trial, but to me the more interesting aspect of the order goes well beyond the case itself.
Judge Rakoff focused heavily on the fact that the proposed $33 million settlement was with BofA itself, not the allegedly culpable executives. That means it will be paid by the company, i.e., the existing shareholders. As he put it,
the management of Bank of America - having allegedly hidden from the Bank’s shareholders that as much as $5.8 billion of their money would be given as bonuses to the executives of Merrill who had run that company nearly into bankruptcy - would now settle the legal consequences of their lying by paying the S.E.C. $33 million more of their shareholders’ money.
This, Judge Rakoff declared, was effectively a “proposal to have the victims of the violation pay an additional penalty for their own victimization.” He went on to state that forcing the shareholders who were the victims of the Bank’s alleged misconduct to now pay the penalty for that misconduct was “not fair, first and foremost, because it does not comport with the most elementary notions of justice and morality.”
There is an undeniable logic to the Court’s view of corporate penalties, but the fact is that this is the way the securities litigation settlement process typically works right now, both in SEC cases and in private securities class actions. In SEC cases, the SEC imposes a fine upon the company for its alleged misdeeds, which is then paid by the company’s current shareholders. Under the Fair Funds provision of Sarbanes-Oxley, the penalty is then paid out to the victims — the company’s shareholders during the period that the fraud allegedly occurred. In securities class actions, the company itself similarly settles the private case against it, and the company’s current shareholders pay (usually via the company’s D&O insurance policy) the defrauded shareholders from the class period.
For years, there has been a debate as to whether this practice of having current shareholders pay former shareholders in these settlements makes sense. Although Judge Rakoff did not address this point, there is often a significant overlap in these two groups, so shareholders will actually be paying themselves.
In its filings with Judge Rakoff, the SEC acknowledged that corporate penalties such as the one proposed against BofA will be “indirectly borne by [the] shareholders,” but it argued that this is justified because “[a] corporate penalty … sends a strong signal to shareholders that unsatisfactory corporate conduct has occurred and allows shareholders to better assess the quality and performance of management.” Judge Rakoff, however, ruled that
the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion-dollar purchase of a huge, nearly-bankrupt company, need to lose another $33 million of their money in order to “better assess the quality and performance of management” is absurd.
The SDNY is the home of more securities litigation than any other court, and Judge Rakoff is known to be among the most influential judges on that court in the securities area. If Judge Rakoff finds the current settlement structure for SEC and securities class actions to be “absurd” and “not fair,” then big changes could be on the horizon.
Judge Rakoff’s rejection on August 3, 2009 of the proposed USD $33 Million settlement by the SEC and Bank of America to settle the SEC’s claim that Bank of America violated the proxy statement rules is a lesson in plain common sense which could potentially help shake the typical settlement process and trigger interesting corporate governance discussions in Board rooms.
Judge Rakoff’s decision follows a few recent cases where the SEC was able to hold corporate executives responsible for their actions. On July 31, 2009, the SEC was filing before the same U.S. District Court for the Southern District of New York a civil action for stock option backdating against the former General Counsel and former Chief Accounting Officer of Take-Two Interactive Software, Inc., a video-game company. The SEC claimed that both defendants, Kenneth Selterman and Patti Tay, were directly and indirectly engaged in practices violating Section 10(b) of the Securities Exchange Act, Rule 10b-5 and that they “knowingly, recklessly or negligently solicited proxies by means of a proxy statement … containing statements which, at the time and in light of the circumstances under which they were made, were false and misleading with respect to material facts or which omitted to state material facts which were necessary in order to make the statements made not false or misleading.” Around the same time, came the filing of a settlement for FCPA violation by Nature’s Sunshine Products, Inc. (NSP) and its CEO and former CEO, both of whom had been charged under Section 20(a) of the Exchange Act as control persons. Was Judge Rakoff puzzled over the fact that the SEC could build a case for violation of Section 14(a) of the Securities Exchange Act and Rule 14a-9 against the executives of Take-Two, the company known for the Grand Theft Auto and Mafia II video games, but not against those of Bank of America? In any event, Judge Rakoff clearly questioned the SEC’s investigation process in the case against Bank of America, the SEC’s departure from its own policy to go after company executives and pointed to the many contradictory arguments made in favor of a settlement.
One of the arguments of the SEC for not pursuing Bank management was that “lawyers of Bank of America and Merrill drafted the documents at issue and made the relevant decisions concerning disclosure of the bonuses.” Personally, as a former in-house counsel, I find difficult to believe the argument that “the lawyers (whether outside or in-house counsels) made all the decisions” in such a significant matter without involvement from the senior management and/or the Board itself. If outside counsels were engaged in the drafting of the proxy materials, most likely, in my opinion, the final draft would have been reviewed and approved by an in-house corporate counsel or someone from senior management. In the Matter of W.R. Grace & Co., SEC Release No 39,157 (September 30, 1997), senior executives (who, without being lawyers, had reviewed proxy statements prepared by counsel) had not been exonerated from the lack of disclosure of management retirement perks. Would it be possible that no one, no one at Bank of America reviewed the proxy materials, so that the argument could be made that executive could not be found personally liable?
Assuming, for the sake of argument, that outside counsels did take the decision not to disclose the bonuses and to draft the proxy materials they way they did, couldn’t we entertain the thought that the management could be held liable for its failure to instruct and supervise those outside counsels?
If the in-house counsels were those lawyers making all the decisions, how could the SEC exonerate Bank of America’s management (in particular its General Counsel) from its responsibility to provide shareholders with proxy materials that do not omit material information likely to be considered important by a reasonable investor about to vote? These in-house lawyers making all the decisions, weren’t they coming dangerously close to become control persons?
Judge Rakoff’s order touches upon another issue: whether Bank of America’s decision to try to settle for US $33 Million could be protected under the Business Judgment Rule. First he questions whether the decision to settle rather than litigate was really an informed decision (as required under the duty of care), taking into account the costs associated with both alternatives. Second, he questions whether management is truly disinterested, i.e. whether the Board meets its duty of loyalty and is making a decision to settle for a true rational business purpose rather than its own personal benefit. One could add that the duty of care and oversight would have required a more thorough internal investigation and analysis of how the misleading proxy statement had been allowed to be released, combined with some “house cleaning” measures that would have given the settlement a greater chance to proceed. This should bring Boards across the country to ask themselves the question: settle, yes but on what grounds?
Comment by Cecile Neuvens — September 16, 2009 @ 10:25 pm