Does Ken Lewis and Bank of America have a way out?

Ignoring the swine flu issue, which may or may not turn into anything serious in the end, one of the big scandals brewing in the background is the coercion by the government of Ken Lewis and Bank of America to act against their own shareholders in the buyout of Merrill Lynch. Basically, if Ken Lewis is to be believed, Bank of America was prevented from backing out of the Merill Lynch deal in order to save the country's banking system, at the expense of Bank of America shareholders. This is a serious issue that goes all the way to the highest levels of government. In particular, Henry Paulson, Ben Bernanke, and since he was the president overseeing the Treasury, George Bush, seem to have engaged in some dubious behaviour. It is also possible that Timothy Geithner may be involved in this somehow, since he was the head of the New York Federal Reserve at the time, but that is uncertain right now. Henry Paulson has shifted the blame to the Federal Reserve; and the Federal Reserve has denied that it asked Bank of America to break securities laws.

The only thing that might keep this issue from blowing out of control is the fact that the questionable actions occurred under the prior Bush administration and hence the Republicans may not want to escalate the issue (Democrats likely have no incentive in turning this into a big battle.) Regardless of what either party does, a lot will depend on the shareholder lawsuits and any SEC ruling.

In the mean time, let's look at what New York Times' Deal Professor says. In this case, the opinion is given by Peter Henning, a law professor at Wayne State Law School. Let me excerpt some of his comments:

The antifraud provisions of the Securities Exchange Act of 1934, Sections 10(b) and 14(a), prohibit misstatements or omissions of material facts in connection with the solicitation of proxies from shareholders and in public statements made by a company. A company has a duty to ensure that shareholders have truthful information, and if a prior disclosure is no longer correct or complete, then additional information must be disclosed to ensure the market is not operating on false data.


When the government tells you not to disclose information, however, the analysis may be different. In the criminal law, there is a defense that the federal courts now recognize called “entrapment by estoppel” that might be a means for Mr. Lewis and Bank of America to avoid liability in the securities suits and in connection with the Securities and Exchange Commission’s investigation of its disclosures.


The usual defense of entrapment arises when a defendant claims a government agent enticed him into engaging in criminal conduct that the person was not otherwise disposed to commit. For example, a drug addict cooperating with the police repeatedly cajoles an old friend into furnishing drugs, finally wearing the person down and then having him arrested once he succumbs to the requests. In such a case, the defendant can be acquitted because of entrapment. There is something unsavory about the government creating a crime that otherwise would not have occurred.

Entrapment by estoppel is a more recent development in the criminal law that concerns the increase in government regulation and licensing. There are four basic elements of the defense: (1) that a government official told the person the act was legal; (2) the person relied on that advice; (3) the reliance was reasonable; and (4) given the reasonable reliance, prosecution would be unfair.

The doctrine is most often asserted in gun possession cases in which the defendant claims that a dealer or other authorized seller said it was permissible to buy the weapon and later the person is arrested because of some condition, like a previous conviction, that makes it illegal to possess the weapon. Unlike regular entrapment, this defense is based on reasonable reliance on a statement by someone acting on behalf of the government approving conduct that turns out to be criminal.

The first and third elements of the entrapment by estoppel defense are the key. It is not Mr. Lewis’s interpretation of what the government officials said that counts, but whether he was told that Bank of America should not make any disclosure and that the conduct would be legal. This may be a matter of nuance, and already a Federal Reserve spokeswoman denied that the Fed told Bank of America that it should not make any disclosures otherwise required by law.

Even if Mr. Paulson and Mr. Bernanke told Mr. Lewis not to disclose the information, the obligations of the federal securities laws on disclosing material information are clear, so it is arguable whether reliance on their direction about what to disclose was reasonable. It may be important to learn what Bank of America’s lawyers said about the issue to determine whether any reliance was reasonable.

IANAL (I am not a lawyer) and my impression is that legal cases dependent on various interpretations so who knows how correct this legal scholar's opinion is. In any case, as if we didn't have enough problems with the banking sector, this Bank of America controversy is going to lurk in the background. The real concern will materialize if criminal charges are laid against Ken Lewis. I think it would make a mockery of government and the banking regulators if Ken Lewis is jailed for following government orders.

Well, whatever one thinks of John Thain, he certainly did his shareholders a huge favour. It looks like he managed to sell Merrill Lynch at a big premium when in fact it seems to have been nothing more than an insolvent firm. It borders on the unethical and was a total disaster for Bank of America, but Thain bailed out the Merrill Lynch shareholders. I was critical of his high compensation and I still am, but certainly saved his shareholders tens of billions of dollars.


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