Judge embraces 'Paulson made me' defense

James A. Cohen in Fortune, September 01, 2010

Media Source

There were chortles last year when Ken Lewis rolled out the "Henry Paulson made me do it" defense.

But a ruling in a lawsuit against Lewis and Bank of America (BAC) shows the notion has at least one admirer -- on the federal bench, no less.

U.S. District Judge Kevin Castel ruled Friday that an investor suit can proceed against BofA and top executives including Lewis (right), the bank's longtime former CEO. The suit, which centers on the controversial 2009 deal with Merrill Lynch, says BofA defrauded investors by making false and misleading statements.

But what's raising eyebrows is a part of the suit Castel dismissed. That claim alleged BofA committed securities fraud when it failed to disclose that then Treasury Secretary Paulson dangled a 12-figure bailout package before BofA to prod it to close its purchase of the hemorrhaging brokerage firm.

Plaintiffs say Lewis knew he had a duty to promptly inform shareholders of material events such as Paulson's bailout offer, and many observers assumed a case based on his failure to do so would advance.

"Lewis knew there was this obligation," said Lyle Roberts, a partner at Dewey & LeBoeuf in Washington who isn't involved in the case. "Usually that's all you need."

But Castel ruled that the plaintiffs, led by public worker pension funds in Ohio and Texas, failed to show Lewis and BofA acted recklessly or with intent to deceive when they kept mum on Paulson's promise of bailout funds.

He said Lewis, the bank and the other defendants "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 ruling left some observers scratching their heads.

"I would have assumed the failure to disclose was done for some nefarious purpose," said Fordham Law Professor James Cohen. "That clearly wasn't the assumption here."

The dismissal won't have much effect on this case, which Ohio and other litigants hope to use to extract billions from BofA, according to a statement this week from Ohio Attorney General Richard Cordray. The judge allowed most claims to proceed, whether under the rubric of securities fraud or negligence. Lewis and BofA last month signaled they will vigorously defend fraud claims in a separate case filed by New York's attorney general.

But the ruling could have broader implications. It surprised lawyers, because it seems uncritically to accept a judgment many of them have spent the past 18 months questioning: that a federal official's demands, however ill considered, can ride roughshod over an executive's most basic duties to shareholders.

"Why does it matter that Paulson instructed Lewis not to disclose the information?" asks Kevin LaCroix, a lawyer who writes the D&O Diary blog and tracks securities law for OakBridge Insurance Services of Beachwood, Ohio. "The judge never says why that's relevant."

Indeed, the judge's ruling adds to the haze surrounding the propriety of various actions in the financial crisis – including those of top policymakers such as Paulson. Can officials in a national emergency override a duty to inform shareholders? And if so, in what circumstances?

In this case, at least, Judge Castel seems to have concluded that the answer to the first question is yes. But he leaves the second question unanswered, leaving a void until the next crisis.

A more expansive discussion of the issues at play between the government and corporate leaders in an emergency could have at least set some expectations. But in this as in so many areas, we seem content to head into the next perfect storm, be it economic or military or environmental, totally unprepared.

"I wish the judge had examined the question more fully," said LaCroix. "Why isn't this a violation of securities laws?"