The horrible self-dealing of Ken Lewis and the principal-agent problem

I don’t much like Ken Lewis. It should be fairly obvious to everyone that he is a man who has only his own interests at heart. But, his revelation that BofA bought Merrill Lynch for the agreed-upon September price, despite Merrill’s having an additional $7 billion in losses is grounds for legal action.

Let’s review the situation.

In September, Hank Paulson, Ben Bernanke, and Tim Geithner committed the financial blunder of the century in allowing Lehman to fail spectacularly without any contingency plan for the probable market fallout. (Yes, Tim Geithner was a principal actor in this fiasco.)  Now, there was nothing wrong in letting Lehman Brothers fail.  However, there was something very wrong with bailing out Fannie Mac and Bear Stearns and allowing everyone on Wall Street to believe Lehman was too big to fail.  And there was even more wrong in having no contingency plan for the fallout.

So as a direct result of that fallout, Merrill Lynch was poised to be the next to go under.  Enter Ken Lewis, our White Knight.  I have to admit to being idiot enough to have thought the Bank of America – Merrill deal was a good one.  It seemed all was well when Ken Lewis plunked down $44 billion in September (even though Barclays got much of the Lehman assets for a song days later).  But, as markets went into freefall, so too did Merrill Lynch, hemorrhaging losses.  So why did Ken Lewis buy the company without at least trying to negotiate a lower price tag?

Answer: self-dealing.

It was the real thing. The banker, as you may have guessed, is Ken Lewis, CEO of Bank of America. And the bad guys harassing him are Hank Paulson, then Treasury secretary, and Ben Bernanke, head of the Federal Reserve, aided and abetted by shadowy henchmen.

The script for this stranger-than-fiction melodrama was provided by that rabid (and fiercely ambitious) bulldog New York state attorney general, Andrew Cuomo. Mr. Cuomo, back in February, had been grilling Mr. Lewis on what his keen canine eye detected as another indignity — the awarding of $3.6 billion to employees of Merrill Lynch, the giant brokerage firm acquired by BofA on Jan. 1 of this year.

What had Mr. Cuomo frothing at the mouth was that the $3.6 billion was shelled out even though Merrill suffered losses upwards of $15 billion in 2008’s fourth quarter alone.

We must point out how fortuitous it was that losses had not reached, say, $30 billion, since by the peculiar calculus being used to reward red-ink, that would have boosted Merrill’s bonus tab to $7.2 billion. And enraging the chronically enraged Mr. Cuomo all the more was that the bonuses were distributed even while the losses manifested themselves but were not disclosed, least of all to the bank’s shareholders.

According to Mr. Cuomo’s dour narrative, the product of four hours of interrogation of Mr. Lewis, the merger with Merrill was proposed in September after two days of due diligence (sounds more like due negligence to us). It gained approval of shareholders of both companies on Dec. 5. Barely a week later comes the revelation: Merrill’s losses were spiraling ever higher, causing an increasingly frantic Mr. Lewis to weigh calling the marriage off.

He reckoned he could legally do so thanks to MAC (material adverse event), recognizing that $7 billion more in losses than had been projected when the merger was agreed to was a very big MAC, indeed. He diffidently informed the powers-that-were of his plan to nix the nuptials and was summarily summoned to powwow with them in Washington that very evening. And it was there that Messrs. Bernanke and Paulson put the screws to him to not break the deal lest he trigger a systemic calamity.

On Dec. 21, Mr. Lewis, still of a mind to ditch the merger, communicated his determination to Mr. Paulson, who bluntly warned that he would give the boot to Mr. Lewis and his board unless the acquisition went through. To that bald threat, Mr. Lewis’ retort was a resounding purr: “That makes it simple. Let’s de-escalate.”

And de-escalate he did. The merger became a done deal right on schedule. To help salve any hurt feelings, Bank of America got $118 billion in loan guarantees from rich Uncle Sam to absorb any potential losses from Merrill.

To me, this sounds like a deal was worked out whereby BofA got a bailout if it went through with the deal. But, it should be plain from the events above that Ken Lewis did NOT have his fiduciary responsibilities for his shareholders top of mind.

So, let’s recap.

• Paulson, Bernanke and Geithner blow Lehman up and everybody panics.
• Merrill looks ready to blow up and take the system down with it.
• Bank of America steps in – or better yet, is coerced in – and pays $44 billion for Merrill.
• But, the market freefall continues, taking WaMu, AIG and Wachovia down with it.  Merrill loses its shirt in this disaster.
• By December, Ken Lewis is ready to pull out of the deal, citing the MAC (material adverse change) clause as grounds.
• Paulson and Bernanke go ballistic (Geithner was prepping to be Treasury Secretary) and get Ken Lewis to do something he thinks is bad for shareholders
• By February, BofA needs to be bailed out again to the tune of tens of billions more government money from Tim Geithner.  BofA’s stock tanks – shareholders are looking at 90%+ losses.
• Now, the SEC is investigating.

This whole episode stinks to high heaven and Ken Lewis doesn’t even look the worst of the lot here. That honor goes to Paulson and Bernanke.

But, what about the shareholders? Oh, those people, right. Don’t they deserve better? Yes, they do. But, they are not going to get better because mega-corporations are run by managers who are in it for their own enrichment and shareholders have zero say. This is a classic principal-agent conflict.

The essence of the principal-agent problem comes when a principal (let’s call them the owners) hires an agent (we’ll call them the managers) to act on her behalf. Often times, one is just too busy – or too inexperienced – to manage a business or negotiate a contract or what have you. So, one hires a professional steeped in experience to do it.

For instance, sports agents, made famous by the film Jerry Maguire, are the classic agents to the sports stars principal. As it happens, the agent has his own agenda – and this may or may not be the same as the principal’s employing him. You will recall the 2007 incident when Alex Rodriguez negotiated his own contract with the New York Yankees baseball team in order to make sure the result was one that was most favorable to his wants and needs (See NY Times article here.)

In business, the same dynamic is at play. While a dry cleaner can be the owner-proprietor of his own store, he cannot run two stores or ten stores at the same time (think George Jefferson). George needs to hire managers to run those stores – and he better hope those managers don’t have their hand in the till.

In today’s age, corporations are absolutely enormous, globe-spanning enterprises whose owners – the shareholders – individually have no influence over decision-making. What’s more is, the larger the organization, the less likely anyone is to have sway over the company’s managers. Supposedly, that’s why there is a board of directors, right?

A board of directors is a body of elected or appointed persons who jointly oversee the activities of a company or organization. The body sometimes has a different name, such as board of trustees, board of governors, board of managers, or executive board. It is often simply referred to as “the board.”

A board’s activities are determined by the powers, duties, and responsibilities delegated to it or conferred on it by an authority outside itself. These matters are typically detailed in the organization’s bylaws. The bylaws commonly also specify the number of members of the board, how they are to be chosen, and when they are to meet.

In an organization with voting members, e.g., a professional society, the board acts on behalf of, and is subordinate to, the organization’s full assembly, which usually chooses the members of the board. In a stock corporation, the board is elected by the stockholders and is the highest authority in the management of the corporation. In a nonstock corporation with no general voting membership, e.g., a university, the board is the supreme governing body of the institution.

So, where was Bank of America’s Board of Directors? Didn’t they see that Merrill had imploded. Why did they allow this travesty to take place? Shareholders had approved the merger on 5 Dec 2008, 16 days BEFORE Ken Lewis had said he was willing to back out. So they obviously had no say here.

Only the board of directors could have stopped Ken Lewis consummating a merger that should never have taken place or that had been re-negotiated. You should notice that this is the exact same run of events that we witnessed in the Countrywide transaction as well.

But, in the end, the deal went ahead as planned and Bank of America shareholders got their clocks cleaned as a result.

Sources
Shareholders Be Damned! – Alan Abelson, Barron’s
Board of directors – Wikipedia