On January 1, 2009, Bank of America closed its deal to acquire Merrill Lynch in what can fairly be called one of the “distressed” deals of the financial crisis. Prior to closing the deal, the bank had gotten required shareholder approval for the transaction—but without fully disclosing, as Fortune notes, “that Bank of America had already agreed in writing to let Merrill Lynch pay its execs up to $5.8 billion in bonus compensation — a sum amounting to 12% of Merrill's $50 billion price-tag.” (Fifteen billion dollars in pending Merrill losses were also not disclosed.)
This past August, the SEC settled its dispute with Bank of America over the propriety of the bank’s compensation disclosures for $33 million. (As Professor Davidoff puts it, the SEC didn’t want to touch the failure to disclose the pending losses because that “would encroach upon the question of whether the government actually ordered Bank of America not to disclose these losses later in December.”)
However, Judge Rakoff of the Southern District of New York (and former Akron Law Jurist-in-Residence) shocked many when he questioned the settlement and refused to approve it. Wrote Judge Rakoff:
Overall, indeed, the parties’ submissions, when carefully read, leave the distinct impression that the proposed Consent Judgment was a contrivance designed to provide the S.E.C. with the facade of enforcement and the management of the Bank with a quick resolution of an embarrassing inquiry – all at the expense of the sole alleged victims, the shareholders. Even under the most deferential review, this proposed Consent Judgment cannot remotely be called fair.
Professor Davidoff has argued that the failure to disclose the precise terms of the agreed-to bonus payments should be considered immaterial because: (1) the total mix of information available to investors should have made them aware of the pendency of significant bonus payments; and, (2) the form of disclosure should have sufficiently alerted investors because “[a]ny investor knowledgeable about merger agreements and disclosure schedules would read it and know what it meant, how it worked and that there was undisclosed information on that schedule.”
The “total mix” defense is not without its limits, however. The Supreme Court has noted that “not every mixture with the true will neutralize the deceptive. If it would take a financial analyst to spot the tension between the one and the other, whatever is misleading will remain materially so, and liability should follow.” Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1097 (1991). And in this case I think there is at least some merit to the SEC’s position (as set forth by Davidoff) that “an investor should not be forced to ‘puzzle’ through other data,” where the most prominent disclosure on the issue by BoA seems to have been that Merrill would not “pay any amounts to Employees not required by any current plan or agreement (other than base salary in the ordinary course of business).”
Furthermore, materiality is judged by the “reasonable investor” standard, not the reasonable-investor-knowledgeable-about-merger-agreements-and-disclosure-schedules (though there are some good arguments to be made that something like this should be the standard). One of the commentators to Davidoff’s post, “Marco,” put the investor’s dilemma like this:
So, let’s say that I read the proxy statement, which basically informs me not to rely entirely on the info set forth therein and [directs] me to review the full text of the merger agreement. As suggested, I diligently take a look at the merger document, but the material qualifications to key provisions, which are those that truly define the actual content of the agreement, are withheld from me because of confidentiality.
But Davidoff clearly is aware of these points and continues:
[Y]ou can quibble about who is a reasonable investor and whether it is one who would know all of this, whether the information was actually disclosed elsewhere, and whether this bare negative statement is sufficient to establish a disclosure violation. But it all boils down to the fact that Bank of America is right that it has viable defenses here to the S.E.C.’s claims.
And the reason BoA has a viable defense is because the SEC must prove “scienter”—an intent to mislead (or recklessness in connection with making statements likely to mislead). Here, Davidoff makes a great case for concluding that the disclosures were consistent with market practice. This may raise issues about current market practice, but it also makes the SEC’s task of proving scienter very difficult.
I am currently working on a project that argues courts should stop relying so much on materiality to dismiss what they deem to be frivolous suits. This would, among other things, be consistent with the Supreme Court’s admonition, as set forth in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 450 (1976), that:
Only if the established omissions are “so obviously important to an investor, that reasonable minds cannot differ on the question of materiality” is the ultimate issue of materiality appropriately resolved “as a matter of law” by summary judgment.
If this case really can be decided on the issue scienter, then perhaps we are better served by leaving the discussion of materiality to other forums like academia, the SEC (in its rule-making capacity), and Congress–because courts, under tremendous pressure to dismiss "frivolous" suits, have arguably done a bad job of capturing the perspective of actual investors when it comes to their pretrial materiality determinations. This is a point I make in my article "Is Puffery Material to Investors? Maybe We Should Ask Them."
