Strange Loops in BofA Case

Douglas Hofstadter, author of Bach, G�del and Escher and I am a Strange Loop, surely would enjoy the spectacle of a federal judge's rejection of the SEC's recent settlement with  Bank of America (BAC). The BofA case is rife with the recursive loopiness that has been the grist of Hofstadter's writings.

The case arises from BofA's acquisition of Merrill Lynch for $19 billion in January. BofA failed to inform its shareholders that Merrill Lynch might pay up to $5.8 billion in bonuses soon after shareholders voted on the deal. The SEC alleged that this omission violated the securities laws, and BofA agreed to pay a $33 million fine to settle the case.

The parties need Judge Jed Rakoff to sign off on the settlement, but he wants more information. He thinks that the $33 million fine may be too small in light of the large size of the undisclosed bonuses. But he is also concerned about the fine being paid by taxpayers because the government owns shares of BofA, so maybe no fine should be imposed at all. The judge wonders if the fine is inappropriate because the SEC has not alleged any wrongdoing by actual human beings. "Was it some sort of ghost?" asked the judge. Judge Rakoff has given the SEC and BofA until today to do some explaining.

Shareholder Victims Punished Twice
The first infinite loop in all of this is the very idea of fining a corporation for hiding information from its shareholders. The theory of the fraud is that BofA's shareholders might have voted down the merger if they had known the truth about the bonuses (as well as the truth about Merrill's rising losses just before the shareholder vote, but that's another story). The shareholders approved the merger and, in theory, BofA's value declined as a result. So the shareholders paid once when their BofA investment declined in value and will pay again through the $33 million fine.

Fining a corporation for disclosure fraud effectively punishes the shareholder victims a second time. The GAO has reported that this issue was a matter of heated debate at the SEC during the Chairman Cox era. Cox's SEC adopted a policy that it would pursue individual wrongdoers rather than shareholders when it was the shareholders who were harmed. Current SEC chairman Mary Schapiro has reversed a number of bad Cox policies, but in appearing to reverse this one, she may have tossed the baby out with the bath water.

Taxpayers Fining Taxpayers
It's not the circularity of punishing shareholder victims that seems to bother Judge Rakoff, however. He seems more concerned about taxpayers being saddled with part of the fine. The federal government received BofA shares in return for $25 billion in TARP funds in October. Like other BofA shareholders, the federal government--taxpayers--indirectly would be paying the $33 million fine.

But here the government is actually better off due to another bit of circularity. The fine would be paid to the U.S. Treasury, i.e., to taxpayers. Despite Judge Rakoff's concern for the taxpayer qua shareholder, it is other shareholders who would be treated unfairly.

Let's assume that the government owns 10% of BofA and that it therefore indirectly pays 10%--$3.3 million--of the fine. The other shareholders pay the remaining $29.7 million. The government, unlike the other shareholders, is also on the receiving end. It gets back its $3.3 million share of the fine and a $29.7 million windfall contributed by the other shareholders. The taxpayer breaks even on the part of the fine that it pays to itself and ends up $29.7 million ahead.

If Judge Rakoff is concerned about the taxpayers, he should argue for a larger fine. Based on the 10%/90% split assumed above, every $1 million increase in the fine would generate an additional $900,000 windfall for the taxpayer. There may be a solution to the financial crisis in here somewhere.

Shareholders Suing Shareholders
Another irony is that shareholders who sold before the news of the bonuses affected the stock price--presumably at an inflated price--will not be on the hook for any fine, yet they were shareholders when their company committed the fraud. The shareholders who bought the BofA shares at an inflated price were not even shareholders when the fraud was committed, yet they suffer the decline in BofA's value and will be saddled with the fine.

Adding insult to injury, shareholders have sued BofA for misrepresenting Merrill's financial condition. Again, any recovery for harming shareholders will be paid by the harmed shareholders. Although damages are likely to be paid by BofA's directors and officers insurer, this is, in effect, BofA's (shareholders') money. Directors and officers are typically reimbursed by a corporation for any judgments against them, which means that D&O insurance actually insures shareholder assets, not D&O assets. A corporation's shareholders pay to insure themselves against being sued by themselves on account of their own injuries.

Regulatory Collision
The coup de grace for those still living in a linear world is the very idea of suing a bank for providing misleading financial information. Throughout the financial crisis, banks have lobbied hard to make their already suspect asset valuations even less connected to fair market values. Banking disclosure is generally designed to project the appearance of financial stability, not to expose a bank's deteriorating financial condition.

The regulatory purpose of banks' public disclosure is schizophrenic. Under the linear securities model, public disclosure should provide transparency and promote efficient markets. Under the recursive banking model, it is supposed to project safety and soundness and promote depositor confidence. During financial crises, the banking model reigns.

The BofA fraud reflects the collision of securities and banking regulation. The nondisclosure of the Merrill bonus plan and its mounting losses violated the securities laws. But their disclosure could have caused shareholders to reject the deal or BofA CEO Ken Lewis to cancel it under the deal's material adverse change clause. Lewis claims that then-Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke made it clear to him that the deal's failure could destroy Merrill, exacerbate the financial crisis, and make the regulators, let us say, less solicitous of Lewis' and BofA's interests in the future (which, by the way, is not the crude extortion it may seem but banking regulators' express statutory prerogative and responsibility).

Judge Rakoff is shining a harsh, securities-style spotlight on some of the contradictions in the way we regulate publicly traded companies. Perhaps his inquisition will serve a constructive purpose, if not in connection with the BofA settlement, then in prompting regulators in future cases to tackle some of the more intransigent absurdities in the way we regulate corporate misconduct. If nothing else, perhaps we'll see an entertaining Hofstadter critique of the government collecting fines from itself, shareholders suing themselves, and other infinite loops in financial regulation.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. The views expressed in this article do not necessarily reflect the views of Morningstar.com