In an August 27, 2010 opinion so massive that its table of contents alone is five pages long, Southern District of New York Judge Kevin Castel granted in part and denied in part the motions to dismiss in the consolidated securities and derivative litigation arising from Bank of America’s January 2009 acquisition of Merrill Lynch and related events. Though the opinion dismisses parts of the lawsuit, other substantial pieces, particularly those related to the controversial bonuses paid to Merrill employees at the end of 2008, will be going forward.



In the whirlwind of events in mid-September 2008 that included the collapse of Lehman Brothers and the dramatic government bailout of AIG, BofA agreed to acquire Merrill Lynch. According to the allegations in the subsequent lawsuits, one of the important features of the merger negotiations related to 2008 bonuses scheduled to be paid to Merrill employees in January 2009. The complaint alleges that BofA agreed to a $5.8 billion bonus pool and agreed that the bonus payments could be accelerated so the payout occurred prior to year end 2008 and before the merger transaction closed on January 1, 2009.


The complaint alleges that these bonus arrangements were not disclosed to BofA shareholders in the proxy materials that were sent to shareholders on November 3, 2008. (The arrangements were described in a "Disclosure Schedule" that was not available to shareholders prior to the shareholder vote).


On October 7, 2008, after the merger was announced but prior to the proxy vote, BofA conducted a $9.9 billion secondary offering. In October and November 2008, while shareholder approval of the transaction was pending, Merrill suffered losses of over $15 billion and also took a $2 billion goodwill impairment charge. The Complaint alleges that BofA’s senior officials were aware of these losses as they occurred. The Complaint alleges that the losses were so significant that BofA management discussed terminating the transaction, prior to the December 5, 2008 shareholder vote on the merger, in which BofA shareholders approved the merger.


In discussions after the merger vote about Merrill’s deteriorating condition, BofA senior management considered whether BofA had the right to terminate the merger under the merger agreement’s "material adverse change" (MAC) clause. On December 17, 2008, BofA Chariman and CEO Kenneth Lewis called Treasury Secretary Henry Paulson to advise him that BofA was "strongly considering" invoking the MAC clause. At Paulson’s invitation, Lewis flew to Washington for a face-to-face meeting, at which Paulson and Federal Reserve Board Chair Ben Bernanke urged Lewis not to invoke the MAC clause.


In subsequent conversations, Lewis again advised the government officials that BofA intended to invoke the MAC clause. According to the complaint, BofA’s board voted on December 21, 2008 to invoke the MAC clause, but on the following day, the Board voted to approve the merger, apparently in part based on Lewis’s statement that he had received verbal assurances from Paulson that BofA would received a capital infusion and a guarantee against losses from risky assets if the merger concluded. Lewis allegedly told the Board that the company would not enter into a written agreement concerning the federal funds because he could not risk public disclosure of the government loans prior to the transaction’s scheduled January 1, 2010 closing. Instead, the government bailout package would be disclosed at the time of the company’s earnings release later in January.


On January 16, 2010, BofA disclosed the fourth quarter losses of both BofA and Merrill and also revealed the federal funding package, which included $20 billion in capital and protection against further losses on $118 billion in assets. In following days, news about Merrill’s bonus arrangement broke.


In response to this news, BofA’s share price declined, and shareholder litigation ensued. The plaintiffs alleged that the defendants misstated and concealed matters related to the Merrill bonuses, the losses that accrued in the Fourth Quarter of 2008 after the merger was announced, and the pressure to consummate the deal from government officials. After the securities and derivative lawsuits were consolidated, the defendants moved to dismiss.


The August 27 Order

Judge Castel’s massive August 27 memorandum opinion and order covers a lot of ground, much of which cannot be easily summarized. For simplicity’s sake, I have summarized here only his rulings pertaining to the major categories of factual allegations.


Merrill Lynch Bonus Payments: First, Judge Castel held that the plaintiffs had sufficiently alleged actionable misstatement with respect to the parties’ "undisclosed written agreement authorizing the payment of bonuses to Merrill," because the proxy "portrayed bonus payments to Merrill employees as a contingent event, when, in reality, the parties had reached agreement as to the timing and range of bonuses." Accordingly, the proxy materials "omitted information necessary to render the statements truthful" and the omission "was material."


Judge Castel also held that the plaintiffs had sufficiently alleged scienter in connection with the Merrill Lynch bonus allegations, at least other than with respect to two specific BofA officials (Price and Crotty) who were not sufficiently alleged to have been involved in the negotiations or disclosures.


Judge Castel found that "the Securities Complaint explicitly alleges awareness of the bonus arrangement on the part of Lewis and [Merrill CEO John] Thain, which was memorialized in the secret Disclosure Schedule." Both of these men, Judge Castle said, "were closely involved in the details of the bonus negotiations, the resolution of which was concealed from BofA shareholders." These allegations, Judge Castle said, "raise an inference of recklessness that is ‘at least as compelling as any opposing inference of nonfraudulent intent.’"


With respect to the BofA directors, Judge Castel concluded that the allegations of scienter were insufficient, but the allegations were sufficient to allege negligence, and therefore, while not stating a claim under Section 10(b), were sufficient to state a claim under Section 14(a). Judge Castel observed with respect to the BofA directors that if they "were aware that the Joint Proxy was materially deficient (as is alleged) or if they should have been aware of deficiencies but took not steps to remedy or inquire about them (as is also alleged), the negligence standard of Section 14(a) would be satisfied." The allegations against Price and Crotty were insufficient event to establish negligence.


Fourth Quarter Losses: Judge Castel also concluded that the plaintiffs had sufficiently alleged actionable misstatements with respect to the alleged failure to disclose the fourth quarter losses. However, while concluding that the complaints adequately allege that the magnitude of the losses was material, the Complaint does not "sufficiently allege how the failure the failure to disclose the losses was ‘highly unreasonable’ and "represented an extreme departure" from the standards of ordinary care."


Judge Castel added that the securities complaint fails "to adequately and plausibly explain why a defendant would be motivated to accurately disclose a ‘turbulent’ and ‘tumultuous’ economic forecast for the quarter yet recklessly or intentionally conceal the dire reality as the quarter unfolded." Accordingly he concluded that the securities complaint "fails to allege scienter as to defendants’ failure to disclose the fourth quarter losses."



However, while Judge Castel concluded that the securities complaint "does not satisfy the threshold for alleging fraud" it does "adequately set forth a theory grounded in negligence." Accordingly he denied the defendants’ motion to dismiss securities plaintiffs’ Section 14(a) claims, as well the derivative plaintiffs’ claims, based on the failure to disclosure the fourth quarter losses.


Undisclosed Federal Bailout Arrangements: Judge Castel found that the plaintiffs had sufficiently alleged an actionable misstatement or omission with respect to the bailout understanding that Lewis reached with Paulson. He found that "detailed, non-conclusory allegations plausibly allege that BofA received concrete assurances from officials …that BofA would receive a massive capital infusion in exchange for proceeding with the Merrill acquisition" but that this agreement was "intentionally not memorialized to avoid public disclosure." Judge Castel concluded that these allegations "adequately alleged the particulars of fraud."


However, Judge Castel found that the allegations about the nondisclosure of the federal agreement fail to satisfy the requirements for pleading scienter. He noted that "the scienter allegations are thin" and that the complaint only explicitly asserts scienter as to Lewis.


Judge Castel noted that the complaint alleges a consciousness on Lewis’s part of avoiding liability because he sought a letter from Bernanke providing immunity from civil claims. Judge Castle observed that the securities complaint does not allege that Lewis or any other defendant "stood to gain from non-disclosure" and to not allege "a quid pro quo type arrangement" or that failing to disclose the federal funding brought a benefit to any defendant.


Judge Castel noted further that "the decision not to disclose federal support originated in an instruction by Paulson." There is, Judge Castel noted, "no allegation that Lewis or any other defendant hatched a scheme to avoid public disclosure of the federal capital support." Rather than "self-interested motivations," Lewis "acted as ‘instructed’ by Paulson." Judge Castel added that "while Paulson’s instruction would not necessarily preclude a finding of scienter if other allegations established motive or recklessness, it anchors the defendants’ concealment to Paulson’s directions."


The defendants, Judge Castel noted, "were acting at the instruction of the Treasury Secretary during a moment of acute economic and political uncertainty. There are no allegations of personal gain derived from the federal funds, or a violation of a statute or regulation in a ‘highly unreasonable’ manner."


The October 2008 Offering: Judge Castel denied the defendants’ motion to dismiss the securities plaintiffs’ ’33 Act claims, except to the extent the allegations related to non-actionable puffery.


Other Holdings: Judge Castel dismissed both the securities plaintiffs’ and the derivative plaintiffs’ allegations relating to the defendants’ disclosures regarding the defendants’ failure to invoke the MAC and the alleged failure to disclose the defendants’ consideration of possible invoking the MAC. Judge Castel also dismissed the plaintiffs’ claims relating to statements about the adequacy of BofA’s due diligence. Judge Castel also rejected the plaintiffs’ claims relating to a number of post-merger statements.


Demand Excused: Judge Castel concluded that the demand was excused on the derivative plaintiffs’ Section 14(a) claims because the directors "faced a ‘substantial likelihood’ of personal liability on the Section 14(a) claim at the time the suit was commenced," which would have "prevented them from exercising their disinterested and impartial judgment to a demand request." However, Judge Castel concluded that demand was not excused as to the derivative plaintiffs’ breach of fiduciary duty claims against the BofA board for approving the merger.



The BofA/Merrill Lynch merger was one of highest profile events during the peak of the global financial crisis in late 2008 and early 2009. The disclosures in early 2009 about Merrill’s losses and about the bonus payments were highly controversial. As a result, Judge Castle’s opinion in the consolidated shareholder litigation undoubtedly will provoke extensive scrutiny and commentary. There are indeed a number of parts of the opinion that are worthy of discussion, but the part this is the most interesting to me is his conclusion regarding the inadequacy of the scienter allegations in connection with the alleged failure to disclose the federal bailout that Lewis negotiated with Paulson.


As alleged in the complaint, this massive federal package was negotiated after the shareholder vote but before the deal closed. Its existence was apparently critical to the BofA board’s vote to go forward with the deal rather than to invoke the MAC clause. Moreover, it was understood that Paulson’s verbal agreement would have to be disclosed if it were reduced to writing – and accordingly, it was not reduced to writing so it wouldn’t have to be disclosed.


In concluding that these actions, which seem to have been taken precisely so that something everyone recognized as important would not have to be disclosed prior to the merger closing, do not give rise to a strong inference of scienter, Judge Castel relied on two considerations: (1) Paulson "instructed" Lewis not to disclose the federal package; and (2) Lewis had nothing to gain personally from withholding disclosure.


Though these factors undoubtedly are relevant, it strikes me that these points do not necessarily answer the question whether or not Lewis consciously misled BofA shareholders of acted with reckless indifference to the truth.


It could be argued that the allegations strongly suggest that Lewis did not want the BofA shareholders to know that the only way the BofA board was willing to go forward with the deal was the existence of massive federal support. A plausible inference is that he, like Paulson, feared the chaos that would have emerged if these facts were revealed before the deal closed. It is also plausible to infer that Lewis and others didn’t want to anger Paulson and risk losing the proffered federal support.


These might all have seemed like good and sufficient reasons to withhold the information, but whether or not the reasons might have seemed good and sufficient does not answer the question whether Lewis and others acted with awareness of or conscious disregard whether BofA shareholders would be misled.


The fact that Paulson "instructed" Lewis to withhold disclosure does not answer the question whether or not Lewis was aware BofA shareholders would be mislead; to the contrary, it might actually suggest a concern that BofA’s shareholders couldn’t be trusted with the truth. (Indeed, Paulson’s instruction arguably does nothing more than make him complicit in the alleged deception, which in Paulson’s case, encompassed not just BofA shareholders but also U.S. taxpayers.)


Why is Paulson’s "instruction" relevant at all to the question whether or not the securities laws were violated? Is Castel suggesting that there is some sort of immunity from securities liability if the actions were at the request of a government official? It seems to me that the supposed relevance of Paulson’s instruction is surprisingly unexamined in Castel’s opinion, and the entire discussion of the issue is disconnected from the question whether or not Lewis knew that the shareholders would be misled.


Judge Castel’s emphasis on Lewis’s lack of personal benefit, while not irrelevant, is also beside the point. Lewis’s lack of personal benefit certainly doesn’t answer the question whether Lewis and others were deliberately taking steps to avoid disclosing material information because they were afraid of what would happen if they did.


In the final analysis, I think Judge Castel’s ruling can perhaps only be understood by his observation that these events took place "during a moment of acute economic and political uncertainty." While this fact has nothing to do with whether or not Lewis was consciously withholding information from BofA shareholders, it does suggest Castel is simply unwilling to permit liability for actions taken at the direction of senior public officials at a time of national exigency. It is almost as if he is saying, with shrugging shoulders, "What else was BofA going to do?" I certainly understand this way of looking at these circumstances. The problem is that it doesn’t necessarily address the questions required by the securities laws.


Judge Castel does not actually say he is inferring either an official instruction or national emergency exception to the requirements of the securities laws. But by emphasizing those aspects of the situation, he seems to be suggesting that these exceptions exist and apply.


To be sure, Judge Castel did observe that the scienter allegations regarding the nondisclosure of the federal package, which he characterized as "thin," might have been sufficient if they were accompanied by adequate allegations of motive or recklessness. It could be argued that his ruling is simply a reflection of insufficient factual pleading, which may be the case. Nevertheless, his analysis raises many questions that in my view are insufficiently examined, whether or not the scienter allegations themselves were or were not sufficient.


Given the high profile nature of this case, I suspect there will be much discussion of Judge Castle’s opinion in the weeks and months ahead. Legal proceedings arising out of these circumstances do seem to attract controversy – as, with for example, Judge Rakoff’s high profile rejection of the SEC’s settlement of its enforcement action against BofA arising from these circumstances.


I have in any event added Judge Castel’s opinion to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.