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

Submitted by Edward Harrison of the site Credit Writedowns

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.

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

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. skippy

    •Paulson, Bernanke and Geithner blow Lehman up and everybody panics.

    Mobster tactics, show everyone a dead body, all weep and fall into line, via la difference.

    Yeah, Elisabeth Warren is really scary compared to these guys, bloody commies-EW, can’t wait till they blow the cover off her past crimes, that over due elementary school book and charge her compounded interest (with the new accounting standards they should pump it up beyond her ability to ever pay off) and charge her with perjury for stating she has no memory of such Hannis crimes.

    Paulson, Bernanke and Geithner, have they been hanging out with the Russains again, guest membership at the Russian club in NYC.

    Skippy…should uncontrollable laughter be worrisome.

  2. Doc Holiday

    Nice thoughts in that post Edward!

    I just found this additional fairly recent example of the government-wide corruption and collusion associated with this tsunami of self-dealing — which is inside Treasury and throughout wall street:
    Another Chink in the Wall: SEC Grants Self-Dealing Exemption to Goldman Funds"Several months ago, I wrote that the securities industry was threatening to take its case to Congress if the SEC did not loosen restrictions on self-dealing. That threat gained credence recently when the House Financial Services Committee put mutual fund self-dealing rules on its legislative agenda.

    The Goldman Sachs exemption signals the SEC may already be cutting deals to fend off legislation.

    A Priceless Exemption

    Goldman Sachs advises a number of money market funds, such as the Tax-Free Money Market fund, Tax-Exempt Diversified Portfolio and Tax-Exempt California Portfolio, that invest in short-term, tax-exempt securities issued by municipalities….."

    > What a great system of Pre-Berlin Wall Socialism we have today! You can call that change! Comrades and fellow Proletarians, get back to work you slobs, you have taxes to pay to the Bourgeoisie, like Lewis, Paulson, Bernanke….

  3. Doc Holiday

    Somehow, this fits just perfectly: Member and Overseer of the Finance Club… An examination of Mr. Geithner’s five years as president of the New York Fed, an era of unbridled and ultimately disastrous risk-taking by the financial industry, shows that he forged unusually close relationships with executives of Wall Street’s giant financial institutions.

    His actions, as a regulator and later a bailout king, often aligned with the industry’s interests and desires, according to interviews with financiers, regulators and analysts and a review of Federal Reserve records.

  4. john bougearel


    It seems other commenters appreciate the sentiment re KL. An excerpt from my book on the financial crisis resonates to that same sentiment:

    A Stroke of the Pen Was Supposed to
    Solve All of Countrywide’s Ills
    Analyst Kathleen Shanley at Gimme Credit wrote that the BAC buyout
    of Countrywide Financial “would solve the company’s funding
    and liquidity problems with the stroke of a pen and make bankruptcy
    concerns moot.”17 Kathleen Shanley was the most optimistic
    analyst responding to this announcement.
    “I hope Bank of America isn’t throwing good money after bad.
    They struck a deal that wasn’t very attractive. Hopefully they can
    get it right the second time around,” said Eric Schopf, at Hardesty
    Capital Management.18
    The most circumspect comment on this BAC announcement
    came from Hayman Capital Partners’ Kyle Bass: “The worsening
    housing market makes BAC’s timing questionable. The collateral for
    their loans is depreciating at over 20% a year, losses are spiking and
    there’s a big potential ‘fat tail’ to Countrywide’s legal liabilities.”19
    In many respects, the so-called “buyout” of CFC presented a
    whole array of headaches for the acquiring BAC. By doubling down
    The Subprime Devil Sinks Countrywide Financial 145
    on their already ill-advised August 23, 2007, investment in CFC,
    Bank of America’s CEO Ken Lewis effectively averaged down his initial
    investment. Averaging down on a losing investment is generally
    considered a Bozo No-No in the world of portfolio management.
    Always has been. This fact was recognized as far back as 1932, when
    Jesse H. Jones approached his old cattleman friend Dick Coon:
    “Dick, I said, “why don’t we buy some of these
    cheap stocks?” “Hell no,” he said. “Never rope a
    steer going down hill: he’ll kill you every time.”20
    Effectively, Ken Lewis was pulling a Stan O’Neal over at Merrill, who
    was an advocate of “concentrated risks.” Remember, O’Neal was
    the CEO who said the smartest thing he ever did for Merrill was
    make just a few big bets—“frees up time.”

    Hopefully, Lewis’s newly discovered lies about when he knew what he knew about MER’s balance sheet will further undermine his position at BAC and make his removal by the financially captured Obama admin a bit easier to stomach.

  5. Fiat_Money_Tyrant

    Lewis sent BofA’s top accountant – Neil Cotty – over to Merrill in the fourth quarter before the deal closed. Cotty was then “directly involved” in instructing Merrill to mark down assets.

    From the FT story Mar 20:


    With Mr Cotty’s involvement in December, the people familiar with the matter said, Merrill took a fourth-quarter writedown of $1.9bn in leveraged loans and a $2.9bn reserve against an exposure to derivatives linked to asset-backed securities.

    Mr Cotty also gave his blessing to a $1bn writedown of credit default swaps involving investment grade companies. The markdown of a position on the “high vol 4” index transformed a gain of $100m into a loss of $900m, said a source.

    In a statement issued by BofA, Mr Cotty said: “While BofA had access to Merrill’s financial information in the fourth quarter and had input into many accounting policy and valuation issues, Merrill management was responsible for these decisions regarding the marks and other valuations.”

    Ultimately, Nelson Chai, Merrill’s chief financial officer, did not sign Merrill’s annual report – called a 10-K – issued in February. Mr Cotty signed the report. BofA said: “Nelson Chai, until the middle of January, was planning on signing the 10-K, but upon his resignation, Mr Cotty was asked to sign the document.”


    Perhaps a deal was made. Merrill agreed to take these massive writedowns, in return B of A uses those losses to extort TARP money from Treasury (I know I know this is contrary to the idea that poor Lewis was forced to close against his will; maybe Lewis figured out that cooking Merrill’s books would force Treasury’s hand; who knows, maybe cooking Merrill’s books was Treasury’s idea). So what was in it for Merrill? Merrill wanted to get its bonuses.

    Considering that B of A took no action after closing to get the $4billion Merrill paid itself in bonuses (notwithstanding a massive $15 billion fourth quarter loss), that indicates that B of A agreed in advance Merrill can take its bonuses which explains B of A’s balk at pursuing the bonus issue.

    So Merrill’s writedowns enabled B of A to get $20b in TARP funds and a boatload of loan guarantees locking Treasury into Lewis’ bad deal; with B of A’s blessing Merrill people got their astronomical bonuses courtesy of the US taxpayer; and shareholders at both companies sucked up some more losses.


  6. Doc Holiday

    When I read about Lewis and all this crap, it really makes me think of my favorite on-topic swine info, which I would like to share with my fellow comrades:

    FYI: Planting orchards next to pig farms allows for efficient access to swine manure for fertilizer, but may also result in porcine exposure to flying fox saliva from partially eaten fruit or urine, from both of which the novel paramyxovirus was isolated (Chua et al. 2002b). Though remaining harmless to fruit bats, the Nipah virus acquired the capacity to cause a severe neurological and respiratory syndrome in young pigs characterized by a loud, nonproductive,“barking” cough (Mohd et al. 2000). Displaying an unusual host promiscuity, the virus caused respiratory distress in other animals proximate to the pig farm—goats, sheep, dogs, cats, and horses (Uppal 2000).

    The subsequent trucking of infected pigs to five states in Malaysia and into Singapore resulted in 229 human cases, nearly half of which (48%) ended in fatality (CDC 1999). A cull of more than 1 million pigs in affected areas effectively ended the outbreak (Lam 2003).

    Long-distance live animal transport has also been blamed for the spread of swine influenza viruses in the United States,where livestock may travel an average of 1,000 miles (Wilsonet al. 2000). Throughout much of the 20th century, influenza viruses had established a stable H1N1 lineage within U.S. pigs, becoming one of the most common causes of respiratory disease on North American pig farms (Zhou et al. 1999). That seemed to have changed in August 1998 when thousands of breeding sows fell ill on a North Carolina pig farm. An aggressive H3N2 virus was recovered, bearing the H3 and N2 antigens of the human influenza strain circulating since 1968. Not only was this highly unusual, but, upon sequencing of the viral genome, researchers found that it was not just a double reassortment (a hybrid of human and pig viruses, for example), but a never-before-described triple reassortment of human, avian, and porcine influenza virus gene segments (Zhou et al. 1999), which raised concerns about further mammalian adaptation of influenza virus (Wuethrich2003b).

    The continuous cycle of U.S. mass animal movement, involving inter-auction movements and intra-auction mixing, may provide a built-in dispersal mechanism for potentially zoonotic diease agents (Shields and Matthews 2003). Within months of the appearance of the new swine flu virus in North Carolina, it surfaced in Texas, Minnesota, and Iowa (Zhou et al. 1999). Within one year, it had spread across the United States (Webby et al.2000).

    The rapid dissemination across the nation was blamed on the cross-country transport of live pigs (Wuethrich2003b). In the United States, pigs travel coast to coast, frequently born in North Carolina, fattened in the corn belt of Iowa, and then slaughtered in California. It is often cheaper to transport the animals to the feed rather than transport the feed to the animals (USDA ERS2003). While this regional segmentation of production stages may cut down on short-term costs for the pork industry (Bur-rell 2002), the highly contagious nature of zoonotic diseases like influenza, perhaps made further infectious by the stresses of transport (Wuethrich 2003b), must be considered when calculating the true cost of long-distance live animal transport.
    More here: The Human/Animal Interface: Emergence and Resurgenceof Zoonotic Infectious Diseases

    Pigs Like Lewis InfoThank you for your time! This calls for a song: PiggiesSorry Edward, but this seemed like a place for all this to happen…

  7. emca

    Good insight and time line…

    to Doc’s link to thestreet article on the continuing efforts of GS to stand about the competition I ran across this quote:
    “As if to guarantee the independence of its fund managers, it (GS) promises the managers and dealers will “maintain offices physically separate” from each other.”

    One would assume that proximity equates to culpability.

    Problem of secrecy in self-dealing solved!

    I guess this constitutes regulation, in a sense?


  8. skippy

    @doc h, masticate on this time line for the swine flu, not bats but fly,s living off the pig excrement, same conditions, feed lots and profit loss keeping it clean, to the detriment of the locals.

  9. Brick

    I still don’t think we have got to the root of what went on or why. I think there are some missing pieces from the jigsaw. Rumours that Countrywide magically acquired billions on its balance sheet the day before it was taken over worry me. Was this a bailout on the Countrywide take over or was it a miss timed attempt at a bailout by the FHLB.

    Bank of America was originally targeting Lehman in that fateful weekend, but just as the treasury played hard ball and refused to throw in some cash they announced a deal with Merril Lynch. If Merril really was that bad how come Lehman was not, as Barclays clearly seem to be making money from Lehman.

    Maybe the assets were marked down again so that they could miraculously be marked up again in the first quarter. The question upper most in my mind is what did Paulson know about Ken or Bank of America that could gain such a hold on him to be less than 100 percent honest with his shareholders, if he was at all. My guess is that Merrill was not as bad as they made out and this is all part of an engineered bank recovery in the first quarter.

  10. Fred

    Key problem with your description — revisions to the accounting marks cannot constitute an MAE under the ML BAC merger agreement.

    Lewis could not terminate the agreement given the terms he agreed to. BAC investors did get creamed, and Ken Lewis was directly responsible. He did not disclose the revision because doing so would have exposed his mistake.

  11. Doc Holiday

    Re: “(GS) promises the managers and dealers will “maintain offices physically separate” from each other.”

    ROTFLMFAO …. this is crystalized retardation, I mean give me a fuc-ing break, I guess GS hand delevers the loot from the piracy they engage in (in small bags) i.e, they all have separate pirate ships and they all have to use flags and hand signals to convey how much loot they have on board, or in their pockets — and they all don’t have phone lines or cell phones or ways to tap into mutual accounts or use mutual payroll, or mutual bonus funds, etc, etc — yes, Goldman is cut off from each office and there are no tunnels or bridges and thus the offices shall physically remain seperated by both space and time for ever more …. and all the pirates lived and remain living happily ever after in The Land That Forget Regulation and Reality…… What the hell are these people thinking? This is a dead give away that the SEC is corrupt and no one cares! Shit, they might as well have an ATM in their fucking lobby!

    If that bit of shit from SEC doesn’t expose the massive conflicts of interest then I’m a monkeys illegitimate uncle and I see no reason why these friggn crooks should not be ripped apart for shark meat ASAP (and all the crooked judges and bought off authorities).

    Full Disclosure: The author is about to eat toast and have cereal and perhaps a nice apple and then, I don’t know….

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