Countrywide Financial's stock rose 23,000% from 1982 through 2003 -- before the housing boom even hit is climax. Then the music stopped, and the biggest mortgage lender in U.S. collapsed. Facing the specter of nearing bankruptcy over the next few years as the housing market reset, Bank of America eagerly scooped up the ailing mortgage company in early 2008 for just $4 billion, one-third of its book value. The deal isn't as amazing at it sounds: the assets BoA purchased would soon incur billions of dollars in losses, wiping much of the firm's value.
Still, Bank of America believed Countrywide's vast distribution system and origination infrastructure would prove very valuable, so it felt enduring the pain of mortgage losses would be worthwhile. But there was another potential problem looming. Countrywide sold billions of dollars in mortgage-backed securities to investors during the housing bubble, which became toxic after it popped. They argued Countrywide misled them about the quality of the bonds. With no Countrywide left to sue, they brought BoA to court instead. Should Countrywide's new parent be responsible for any potential damages?
Intuitively, you might think so. If BoA decides to buy Countrywide's assets, shouldn't the bank also be responsible for any liabilities that could arise from the mortgage lender's liabilities? That's how it works when it comes to direct losses. For example, if the mortgages held by Countrywide decline in value, Bank of America gets hit with the loss. But when it comes to legal claims against the former company, the law gets a little more complicated.
A judge recently ruled that Bank of America should not be responsible for investors' allegations against Countrywide. In complex legal-speak, U.S. District Court Judge Mariana R. Pfaelzer dismissed the investors' claims, saying that BoA's acquisition of Countrywide did not constitute a De Facto merger. For some explanation of the legal theory, I spoke to Charles K. Whitehead, a professor at Cornell University Law School who has also practiced as counsel of several multinational financial institutions during his career.
What's This 'De Facto Merger' Business?
Investors wanted the court to treat BoA's acquisition of Countrywide's assets as a merger of the two firms. If the transaction was a merger, then the new company that resulted would still incur successor liability. Since it was not structured as a technical merger, the investors wanted a judge to rule that, due to the nature of the transaction, it was essentially a merger and should be treated like one in the eyes of the court.
Not In Delaware
You might have noticed that lots of financial firms are registered as Delaware corporations. That might seem odd. After all, Delaware isn't exactly the center of the universe -- and New York City is the financial hub of the U.S. What gives?
Delaware's laws are actually very conducive to business. The Bank of America case provides a pretty clear example of this. Delaware has a long-standing rule of the doctrine of independent legal significance. That means if a transaction complies fully with all the provisions of one part of the Delaware code, then the state will not re-characterize the transaction to fit into a different part of the code. In this case, the judge ruled that BoA properly satisfied the requirements to characterize the Countrywide transaction as an acquisition, so it would not be treated as a merger by Delaware.
The Economic Value of Certainty
This begins to explain one reason why financial institutions love Delaware: its laws provide certainty. As long as a firm checks all the right boxes to comply with a statute, it does not have to worry about the whims of judges.
From an economic standpoint that's a huge benefit. The Bank of America case proves this point well. The bank will not have unforeseen costs related to its acquisition of Countrywide being re-characterized as a merger. If the law provided more flexibility, then the bank could face significant damages if Countrywide's securities misled investors.
But What About Fairness?
Of course, investors might not be as pleased as BoA in this situation. That flexibility could have given them access to the huge institution's deep pockets. Instead, they can only attempt to go after Countrywide's former employees and officers, which would be a very difficult case to win against defendants with much shallower pockets. Don't the investors deserve justice?
Perhaps, but ultimately, the law could have worked more in their favor if they had been a little bit savvier. Under the terms of the mortgage-backed securities, they could have insisted, as a stipulation of purchase, that Countrywide needed their approval to transfer its assets to another firm. Then, investors could have demanded that any such transfer would have included legal liability that could result from misleading information provided in the sale of their mortgages the securities.
That must not be what happened here, however. And even if it were what had happened, it might not have mattered. If investors forbid Countrywide from transferring the assets, then it would likely have defaulted. Bank of America would not have wanted that much uncertainty and potential liability. Then, investors still wouldn't have much money to go after in the bankrupt company. That leaves them in the position of so many others who do business with a company that collapses: left with little leverage to obtain what the failed firm might owe them, forced to join the chorus of creditors in bankruptcy court.