Dogged by shareholder lawsuits and by multiple law-enforcement investigations into his bank’s ill-fated merger with Merrill Lynch, Bank of America CEO Ken Lewis announced on Sept. 30 that he would leave his post by the end of the year. There is no doubt that Lewis, who was removed as chairman by shareholders earlier this spring, is resigning under tremendous pressure, and some Wall Street watchers are speculating that his resignation signals an impending criminal charge. Jim Cramer of CNBC’s Mad Money commented on the resignation, “No bank can afford to have its CEO indicted, and that may have been on the table behind the scenes.”
Certainly Judge Jed S. Rakoff wants heads to roll and doesn’t mind saying so. The U.S. District Court judge recently refused to approve a $33 million settlement in Securities Exchange Commission v. Bank of America Corp, a civil enforcement action challenging Bank of America’s failure to publicly disclose $3.6 billion in planned bonus payments to Merrill Lynch executives when the companies merged. Deriding the settlement as a sweetheart deal for executives, Rakoff demanded that the bank name the individuals most responsible for the mess. Speaking to the New York Times, Rakoff recalled an era when prosecutors pursued bad men rather than bad businesses. “The feeling then,” he said, “was if a crime had been committed, it was important to discover who the persons were who made the wrongful decisions.”
At the root of Lewis’s woes is a merger that more closely resembles a shotgun wedding. Bank of America negotiated a hasty takeover agreement with Merrill Lynch over the course of a single September weekend following the shocking collapse of Lehman Brothers. Treasury secretary Hank Paulson aggressively championed the deal as integral to his effort to stem the rising financial crisis. But in the weeks between the announcement of the deal on Sept. 15, 2008, and its consummation in January, Merrill Lynch booked a breathtaking $15.3 billion in additional losses – a fact not disclosed to the public by executives at either concern.
Merrill’s staggering losses required Bank of America to accept a $20 billion infusion of additional federal cash immediately following the merger, and Bank of America’s shares now trade at a fraction of their former value. Virtually everyone is angry, and they seem, at the moment, to have settled on a common enemy: Ken Lewis. Congress is irate that Treasury found it necessary to commit billions in additional funds from the Troubled Asset Relief Program (TARP) to Bank of America, and Rep. Dennis Kucinich (D., Ohio) has accused Ken Lewis of conspiring to make the payments necessary. Bank of America shareholders are suing. Their numerous civil complaints say that Lewis sold out their interests by saddling them with a disproportionate share of the cost of rescuing the world economy at the behest of bureaucrats in Washington.
Law-enforcement activities suggest a trap slowly closing on the unpopular chief. New York State attorney general Andrew Cuomo already has subpoenaed Lewis in connection with an investigation of the merger, and the federal securities laws under which the SEC has pursued Bank of America also provide for criminal sanctions against individuals. But the events surrounding the merger indicate that Paulson and Bernanke may have placed improper pressure on Lewis to disregard his legal duties to his shareholders. If that is true, then Lewis looks less like a criminal than like the hapless pawn of top government regulators determined to stem the crisis at any cost.
Lewis testified that he became aware of the “staggering deterioration” of Merrill’s assets as a result of a worried phone call from Bank of America CFO Joe Price several days after the December 5 shareholder vote approving the deal. By then, Merrill Lynch had unexpectedly lost roughly $11 billion. Horrified, Lewis called Paulson to tell him that Bank of America would likely invoke an escape-hatch provision in the merger contract called the “material adverse change,” or “MAC,” clause. A court might or might not have agreed that the bank was justified in doing so, but Lewis and Bank of America’s board of directors thought they would best serve their shareholders by walking away from the deal and letting the courts resolve the issue.
Paulson immediately summoned Lewis and Price to a meeting in Washington with himself, Bernanke, and Fed staffers to discuss the possibility that the merger would not take place. During that meeting, Lewis was told that a MAC clause is difficult to legally invoke, according to Lewis’s testimony. Lewis was unmoved, so, when Paulson and Lewis spoke again on December 21, Paulson threatened that the Fed would fire Lewis and the entire Bank of America board of directors if they invoked the MAC clause – an action that the Fed is empowered to take in exceptional circumstances.
Paulson allegedly offered a carrot in addition to this remarkable stick: the promise of at least $20 billion in additional TARP funds following the merger. When Lewis asked Paulson for a written commitment for additional aid, Paulson – after consulting with Bernanke – refused to make one. Lewis testified that Paulson said, “First, it would be so watered-down, it wouldn’t be as strong as what we were going to say to you verbally, and secondly, this would be a disclosable event and we do not want a disclosable event.” Lewis clarified that Paulson did not want the government to be required to disclose that it was committing additional TARP funds to bail out Bank of America until after the merger with Merrill had taken place.
Lewis related both Paulson’s threat and his promise to Bank of America’s board on December 22, and the board decided to proceed with the merger agreement as previously negotiated. Bank of America completed the merger in early January and shortly thereafter disclosed both Merrill’s shocking losses and the Treasury’s commitment of additional TARP funds to a weakened Bank of America.
Bank of America’s shareholders were surely shortchanged in the merger; but was Lewis criminally responsible, or was he punk’d by a duo of super-regulators determined to control the fate of Bank of America by installing a whole new management team, if necessary? The latter seems likely. Paulson himself admitted in testimony before the House Governance and Oversight Committee that he threatened Lewis and the Bank of America board with removal if they didn’t press forward.
Both Bernanke and Paulson have denied that they instructed Lewis not to publicly disclose Merrill’s bloodied balance sheets. But their denials hinge on a false distinction between disclosing the additional $20 billion in TARP funds that a combined company would need because of the staggering Merrill losses and disclosing the losses themselves. Lewis testified that Paulson made a firm promise to provide an additional $20 billion in TARP money to Bank of America on the heels of the merger but refused to put the promise in writing because a written commitment would require a public disclosure. According to Lewis’s testimony, Paulson made his opposition to disclosing the $20 billion commitment crystal clear, and Lewis felt that he had no choice but to go along:
Q: Were you instructed not to tell your shareholders what the transaction was going to be?
LEWIS: I was instructed that “We do not want a public disclosure.”
Q: Who said that to you?
LEWIS: Paulson.
Q: Had it been up to you, would you have made the disclosure?
LEWIS: It wasn’t up to me.
Q: Had it been up to you.
LEWIS: It wasn’t.
But why would Paulson think it so important to hide the government’s $20 billion commitment? The most plausible answer is that doing so would have indicated the presence of Merrill’s staggering losses – losses that regulators needed to obscure in order avoid damaging the market value of both banks and risking a shareholder revolt against the merger.
The criminal penalties for deceiving shareholders are no joke. Lewis could face a terrifying array of charges under statutes that authorize draconian prison terms. If Lewis knowingly withheld material information from shareholders, he could be charged with violating SEC Rule 10b-5, an offense punishable by up to 20 years in prison, or with violating Section 807 of the Sarbanes-Oxley Act, which authorizes sentences of up to 25 years. In addition, because Lewis spoke to Paulson by phone about the Merrill losses and about the importance of non-disclosure, he could be charged separately under the federal wire-fraud law for each instance in which he used a form of electronic communication in furtherance of a “scheme to defraud” Bank of America shareholders. Each such phone call or e-mail is a separate offence punishable by up to 20 years in prison.
Paulson and Bernanke are theoretically vulnerable to criminal charges as well. Each played an active role in Lewis’s decision-making process and each advocated a course of conduct that led to the completion of the merger without notice to Bank of America shareholders of Merrill’s accelerating losses. Even in the absence of threats or intimidation, this would have been enough to expose Paulson, and perhaps Bernanke, to charges of conspiring with Lewis to aid and abet the violation of federal laws. A handful of fire-breathing commentators are pushing for wide-ranging indictments of both public and private players. “Ken Lewis, Henry Paulson . . . Ben Bernanke . . . should all be prosecuted for extortion, conspiracy to extort, criminal fraud, and theft of honest services; and they should be imprisoned if convicted,” opined Fox News analyst Andrew P. Napolitano.
In reality, a former Treasury secretary and a current Federal Reserve chairman are unlikely to be indicted for corners they cut in their efforts to stave off the collapse of the financial system. Bernanke was recently rewarded for his conduct last fall by President Obama’s decision to nominate him for a second term in office. But letting Paulson and Bernanke off the hook will only redouble the determination of politicos and shareholders to exact punishment on the only remaining culprit.
Prosecutors should, however, resist demands to scapegoat Lewis. Federal law allows U.S. attorneys to exercise considerable discretion about whom to charge criminally, and the availability of strong legal defenses and an absence of true moral culpability are legitimate reasons to exercise restraint. If charged, Lewis would argue that simply complied with the demands of federal officials who apparently had the authority to tell him what to do.
There are at least two legal theories under which Lewis could argue that government pressure should exonerate him.
The first such defense is an affirmative defense of “public authority” under federal law. To prevail, Lewis would have to argue successfully that, even if he did violate federal securities law and other fraud statutes, he only did so in reasonable reliance upon a grant of authority by Paulson and Bernanke. The difficulty for Lewis in making this defense would be that most federal courts, including the federal appeals court with jurisdiction over New York, have declined to allow such arguments unless the government officials had actual authority to override federal law in order to stabilize the financial markets. The language of the congressional authorization for TARP is extremely broad, but it contains no preemption clause. It seems doubtful that Congress meant to empower Paulson and Bernanke to disregard existing criminal statutes.
The courts ought to reconsider, however, whether this “actual authority” standard is appropriate in the context in which Lewis found himself. If Lewis was essentially forced to proceed with the merger while hiding the Merrill losses from shareholders by regulators with the manifest power to harm his company, then perhaps their apparent authority should be adequate to trigger this defense. The D.C. Circuit Court of Appeals recognized in United States v. Barker, a case involving an illegal request from a former CIA official then employed by the White House, that apparent public authority sometimes is sufficient. Given the extraordinary circumstances that Lewis faced, other courts might follow suit.
Courts have also recognized a second defense that might apply to Lewis: a defendant’s reasonable belief that a government official had exempted his conduct from the law may negate the required mens rea, or criminal intent, needed for conviction. Lewis testified that Paulson had instructed him to avoid disclosing the government’s commitment of additional TARP funds, and, by extension, the dire financial problems at Merrill Lynch. If Lewis’s interpretation of the Treasury secretary’s instructions were reasonable but mistaken, that fact would cast doubt on whether he acted with criminal intent in following those instructions.
Prosecutors should decline to charge Lewis with a crime for acceding to the demands of high federal officials who explicitly threatened to decapitate Bank of America if he resisted. To do otherwise would raise justifiable due-process concerns and could further poison the government’s already-strained relations with other bank chiefs, any one of whom could have found himself in Lewis’s shoes. To prosecute Lewis while giving Paulson and Bernanke a free pass would send an even worse signal: that the government will take care of its own, and that politicians will find their scapegoats among those who attempt to run productive enterprises rather than among those who attempt to regulate them.
– Marie Gryphon is a senior fellow at the Manhattan Institute’s Center for Legal Policy.