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September 21, 2009 1:12 PM

The Secret Behind Secret Disclosure

Posted by Susan Beck

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Bar Talk Preview from the October 2009 Issue of The American Lawyer

When Manhattan federal district court judge Jed Rakoff scuttled Bank of America Corporation's $33 million settlement with the Securities and Exchange Commission, he didn't mince words. The settlement, Rakoff fumed, did "not comport with the most elementary notions of justice and morality." It was nothing but "a contrivance designed to provide the SEC with the facade of enforcement."

Rakoff also, as he has done throughout the case, raised the possibility that the lawyers could take the fall. He noted that the SEC had said that it could not prosecute individual wrongdoers at Bank of America Corporation because "the lawyers for BofA and Merrill Lynch & Co., Inc., drafted the documents at issue and made the relevant decisions." If that was true, Rakoff asked, "why are the penalties not then sought from the lawyers?" At one point he actually wondered whether the lawyers and the banks had triggered the crime/fraud exception to the attorney-client privilege. Those lawyers, of course, are Wachtell, Lipton, Rosen & Katz, led by Ed Herlihy, for BofA, and Shearman & Sterling, led by John Madden, for Merrill. Both firms declined to comment.

While the facts of the BofA case may be extraordinary, the core legal question is not: What is adequate disclosure to shareholders under U.S. securities law?

What emerged from the proceedings were two distinctly different views about the extent of disclosure that is necessary. Those views collided before Rakoff.

One of the central tenets of securities laws is that shareholders must be given material information in a way that they can understand. Specifics about the way information is delivered and what constitutes "material" have been evolving since Franklin Roosevelt's time.

The information at issue before Rakoff was $5.8 billion that Merrill had set side to pay bonuses to its employees. BofA agreed to the set-aside. But the information was not included in the merger agreement drafted by Wachtell and Shearman in September 2008. Nor was it in the proxy statement that the firms drafted in late October of that year. In fact, the only place that information ever appeared was in an oxymoronically named "disclosure schedule" that was never given to either the SEC or the shareholders.

The SEC's most recent pronouncement about the use of such hidden schedules came out in 2005. The Titan Corporation had filed a merger agreement in anticipation of a merger with Lockheed Martin Corporation. (The merger was eventually called off.) In that agreement, Titan wrote that it had done nothing to violate the Foreign Corrupt Practices Act. At the same time, however, Titan put together a secret disclosure schedule in which it admitted that it was being investigated for FCPA violations. That schedule was not filed with the SEC.

In a subsequent report, the SEC issued a warning to future public filers. The agency wrote that if those filings contained any misleading statement, the filer of the document must provide clarification, and that clarification cannot be made in a nonpublic document.

The SEC's Titan report caused a stir in the M&A and securities bar. Lawyers wondered whether they could continue to use secret disclosure schedules. A 2007 Practicing Law Institute publication authored by Herlihy and 13 others at Wachtell criticized the SEC for "attempting to alter long-standing, established disclosure practices." The publication advised clients to get around the policy by adding an elaborate disclaimer to their proxy statements. The lengthy and highly technical disclaimer would likely baffle anyone but an experienced corporate lawyer. Among other things, it stressed that a merger agreement is "not intended to be a source of factual information about either party."

Turns out, companies commonly use these disclosure schedules to bury sensitive information. Morton Pierce, chairman of the mergers and acquisitions department at Dewey & LeBoeuf, filed an affidavit on BofA's behalf asserting that the use of secret disclosure schedules "was consistent with industry practice." Another partner at a major firm concurs: "They are used in virtually every deal, if not every deal."

BofA followed this approach, and earlier this fall, the bank told Rakoff that the use of a disclaimer, plus the knowledge in the business world that Merrill Lynch employees would be getting bonuses, was adequate notice to the shareholders of the bonus payments.

The SEC's response was simple: Shareholders should not be forced to navigate a maze of confusing language and external sources to be informed about a deal. And Wachtell and Shearman know that, wrote the SEC in September, because of the Titan report, which came out four years earlier.

Rakoff was careful not to reach any conclusions about disclosure issues at this point in the proceeding. His decision, however, is filled with lines like, "If what the SEC says is true . . ." then things might not be so good for BofA or Wachtell or Shearman.

Throughout the case, Rakoff has made statements that would make any lawyer nervous. In an August 25 order asking the parties for more information, Rakoff wrote: "If it was actually the lawyers who made the decisions that resulted in a false proxy statement," it leaves open the question of whether "they should be held legally responsible." In his most recent decision, he again wondered whether the lawyers were liable.

As far as Rakoff is concerned, the case is just beginning. Noting that he expects both sides will continue to litigate, he ordered them to file a case management plan in late September, culminating with a trial on February 1, 2010.

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Hat's off to Judge Rakoff!

It's about time someone of some real authority stood up to the influential crooks who run these over-leveraged and mismanaged financial giants like Bank of America, and to the thugs who run the unfairly-corrupted agencies set up to oversee them.

It seems more than a little silly to hold lawyers responsible for a company's failing to disclose in proxy solicitation materials incident to a merger what is already rife in the financial press. The economic and legal purposes of disclosure might arguably be served by corrections to what is, or has been, generally reported but to assume that anything is to be accomplished by affirming what is already known in any given instance seems a stretch. Failure to include would be one thing if materials contained in a disclosure schedule significantly departed from what has not been already what had been reported and analyzed - but in the instance of Merrill Lynch items contained in the disclosure schedule were not exactly a mystery to begin with. Holding (or threatening to hold) merger lawyers liable in such circumstances is akin to holding fire marshals responsible for instances in which fires break out or occur.

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