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There are two competing theories of how companies should be governed; one says that management should have a lot of leeway to do what it thinks is best and shareholders should keep quiet and, if they’re unhappy, maybe sell their shares; the other says that shareholders own the company and anything that stands in the way of their replacing inept or corrupt management is bad. The pro-shareholder side has I guess been having a good run lately, what with Chesapeake bowing to Carl Icahn’s demands to be less evil, and with the performance of the Facebook IPO giving evil governance a bad name, but the let’s-say-anti-shareholder position is pretty well entrenched. And the leading exponents, or at least my favorite exponents,* of that view are the law firm of Wachtell Lipton, which invented the poison pill so that managers wouldn’t have to lose their jobs just because someone else wanted to buy their company and their shareholders wanted to sell it.
So let’s say you’re a CEO, and you want to buy a company, and you negotiate to buy that company for stock so your shareholders have to approve the merger. And let’s say juuuuuust hypothetically that, after you agree on the deal and mail the proxies and set up the vote and are about to complete your grand plan, you find out that the company you’re buying is sort of a piece of shit, and that you didn’t know that when you agreed to buy it. Embarrassing for you. What do you do?
Well presumably you ask your lawyers and when those lawyers happen to be Wachtell Lipton they tell you their favorite thing to tell you, which is, “you have lots of options but FOR GOD’S SAKE LEAVE THE SHAREHOLDERS OUT OF IT.” And if you were Ken Lewis in late November / early December 2008, that’s what you did. You can read here his [new lawyers’] defense of his decision not to tell Bank of America shareholders that Merrill had some massive upcoming losses before they voted to approve the acquisition of Merrill; it basically goes like this:
Mr. Lewis was informed by BAC’s CFO that he had consulted with legal counsel, including BAC’s General Counsel and the outside firm of Wachtell, Lipton, Rosen & Katz (“Wachtell”), and had been told that no disclosure of these interim results or forecasts was warranted – a conclusion with which the CFO concurred.
Mr. Lewis was further told that several factors led to this conclusion: BAC’s proxy statement seeking approval of the issuance of additional shares in support of the merger (the “Merger Proxy”) did not contain any predictions about Merrill’s fourth-quarter performance that had to be updated; existing disclosures warned that Merrill’s performance could be negatively impacted by the economic downturn; the losses, though large, were not out of line with losses Merrill had experienced in prior quarters; and investors were well aware that banks were sustaining significant losses as the economy deteriorated.
On the other hand, a few weeks later, according to the shareholders who are now suing Ken Lewis and BofA and everyone else who was nearby:
In mid-December 2008, attorneys from Wachtell, including senior Wachtell partners Eric Roth and Peter Hein, met with BoA’s senior officers – including Defendants Lewis, Price, Cotty and BoA Treasurer Brown – to discuss BoA’s grounds for terminating the Merger by invoking the “material adverse effect” clause in the merger agreement (the “MAC”). As a memorandum prepared by Wachtell summarizing these discussions made clear, Merrill’s
balance sheet reduction was not anticipated at the time BoA agreed to and announced the Merger, but was necessitated by the unexpectedly large fourth quarter losses Merrill had suffered by Thanksgiving …
So! Quick timeline:
- September 15 – BAC agrees to buy MER. MER’s business is going great! I mean, terrible, but reasonably terrible.
- October 31 – BAC and MER file their merger proxy describing the deal, and mail it to shareholders. The proxy makes claims about the deal being ~3% dilutive to EPS in year 1, ~0% in year 2, and accretive in year 3.
- November – Ken Lewis discovers “the prospect of large interim and forecasted losses at Merrill,” leading to the deal being massively dilutive in years 1 through infinity, and keeps it under his hat.
- December 5 – BAC and MER shareholders vote to approve the merger.
- mid-December – BAC executives and lawyers consider calling a MAC and terminating the merger; they bring this threat to the federal government and get some bailout leverage by threatening to walk away from MER.
There is an intuitive appeal to the plaintiffs’ argument that, if Merrill’s losses were a potential material adverse effect that could allow BofA to terminate the merger, surely they were material to shareholders? No?
I don’t know, man, “material.” But I’d focus on the fact that, for all of Ken Lewis’s I’m-not-a-lawyer-I-just-did-what-they-told-me folksiness in his brief, he’s a natural born lawyer. Here is an exchange from the shareholder meeting quoted by the plaintiffs:
PARTICIPANT: You didn’t respond to the lady’s comment. This will dilute our shares. Will it not? Yes or no; not in the future, someday, but this afternoon?
MR. LEWIS: We have said as I recall in the [September 15] presentation that we will have dilution in the first year, break-even in the second; and then accretion in the third.
True! He did say that! Sure at the shareholder meeting, in responding to that question, he knew the deal would be dilutive for all time, but you’ll notice that he doesn’t say “we will break even in the second year.” He says “we have said that we will break even in the second year.” And they had said that. In the past. What is the problem?
More seriously the proxy itself never says “this deal will be accretive in year X” for lots of reasons, including that the EPS effect of the deal would be more or less pure guesswork. (It’s an investment bank! In fall of 2008! How the hell would you know?) Instead it says things like:
In reaching its conclusion to approve the merger agreement, the Bank of America board considered a number of factors, including the following material factors: … the fact that application of such potential expense savings and other transaction-related assumptions and adjustments to the combined net income forecasts for Bank of America and Merrill Lynch made by various third-party brokerage firms and published as consensus estimates by First Call would result in the combination being 3.0% dilutive in 2009 and breakeven in 2010;
Each of FPK and J.C. Flowers prepared illustrative pro forma analyses of the potential financial impact of the merger under certain assumptions, including: consensus analyst EPS and long-term growth estimates for Bank of America; a negative balance sheet (mark-to-market) adjustment of $8.785 billion pre-tax ($6.275 billion after tax), as estimated by Bank of America management; the impact of certain revenue synergies and the assumed loss of overlapping revenues, as estimated by Bank of America management; and pre-tax cost savings of $7.0 billion, with 25% realized in 2009, 60% realized in 2010, 80% in 2011 and 100% in 2012 and beyond, as estimated by Bank of America management. Based on these assumptions, each of FPK and J.C. Flowers determined that the merger would be 2.5% dilutive to Bank of America’s consensus analyst estimated EPS in 2009, 0.3% accretive to Bank of America’s consensus analyst estimated EPS in 2010, and increasingly accretive to Bank of America’s consensus analyst estimated EPS in subsequent years. … Neither FPK nor J.C. Flowers has assumed any responsibility for updating or revising its opinion based on circumstances or events occurring after the date thereof.
This is the stuff merger proxies are made of: tautological statements that if you take certain assumptions, and add them to analysts’ consensus EPS estimates, and manipulate them in the described ways, you get the described results. The conclusions you draw from that – like, say, “these assumptions are reasonable, the consensus EPS is probably right, and the described results likely predict the future results of the merged company” – are your problem. They’re not Ken Lewis’s problem. He never said those things.
If your theory is that the shareholders should decide who to buy – and, I mean, that’s kind of the theory of the NYSE rules requiring a shareholder vote to approve this deal, isn’t it? – then this looks pretty crummy. The shareholders get to make their decision based on outdated fairness opinions applied to publicly available information, with no insight into current-quarter performance or the current thinking of BofA or Merrill executives or advisors.
On the other hand if your theory is “shh, shareholders, the grown-ups are in charge here,” then … I guess? After all, Ken and his crack team did have their eye on the massive losses at Merrill, and were considering – in the light of everything they knew about BofA’s operations, its regulators, its counterparties, and its negotiations with Merrill – the best way to handle those losses, on a spectrum from “call a MAC and walk away” to “close the deal but use this as leverage to get some free money out of the government.” The binary up/down shareholder vote can’t achieve the same range of results, or respond to the situation with all the nuance it may have required.
Still. You’d think that, after making such a bad deal in the first place, BofA’s management might have appreciated an informed second opinion.
* Ooh full disclosure ooh.