UNITED STATES OF AMERICA
In the Matter of
| ORDER INSTITUTING
PURSUANT TO SECTION
21C OF THE
ACT OF 1934, MAKING
FINDINGS AND IMPOSING
The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative proceedings be instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against respondent BankAmerica Corporation (now known as Bank of America Corporation). In anticipation of this proceeding, the respondent has submitted an Offer of Settlement which the Commission has determined to accept. Solely for the purposes of this proceeding, and for any other proceeding brought by or on behalf of the Commission or to which the Commission is a party, and prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. § 201.100 et seq., the respondent, by its Offer of Settlement, without admitting or denying the Commission's findings except those contained in Section III. A. below, which are admitted, consents to the entry of this Order Instituting Public Administrative Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing Cease-and-Desist Order (the "Order").
Accordingly, IT IS HEREBY ORDERED that proceedings pursuant to Section 21C of the Exchange Act be, and they hereby are, instituted.
On the basis of this Order and the Offer of Settlement submitted by the respondent, the Commission finds that:
On September 30, 1998, BankAmerica Corp. ("BAC"), a former Delaware corporation with its principal place of business in San Francisco, California, merged with NationsBank Corp. ("NationsBank"), a former North Carolina corporation headquartered in Charlotte, North Carolina, to form Bank of America Corp. Both NationsBank and BAC had common stock registered with the Commission pursuant to Section 12(b) of the Exchange Act and were listed, among other places, on the New York Stock Exchange ("NYSE"). Bank of America Corporation ("Bank of America") is a Delaware corporation with its principal place of business in Charlotte, North Carolina, and is a bank holding company and a financial holding company. Bank of America's common stock is registered with the Commission pursuant to Section 12(b) of the Exchange Act and is listed, among other places, on the NYSE.
B. OTHER RELEVANT ENTITIES
D.E. Shaw & Co., L.P. ("Shaw & Co.") is a Delaware limited partnership which, at all relevant times, acted as the general partner and management company for D.E. Shaw Securities Group, L.P. ("Shaw Securities"), a Delaware limited partnership. Among other activities, Shaw & Co. also acted as the general partner or principal shareholder of, or effectively controlled (through Shaw Securities): D.E. Shaw Securities
Trading, L.P. (a Delaware limited partnership); D.E. Shaw Securities, L.P. (a Delaware limited partnership and U.S. broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act); Farsight Financial Services, L.P. (a Delaware limited partnership and U.S. broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act); D.E. Shaw Securities International (a United Kingdom broker-dealer); D.E. Shaw Securities International, Inc. (a Delaware corporation); and D.E. Shaw Securities Trading International, Inc. (a British Virgin Islands business company) (together, "Shaw Securities' subsidiaries"). David E. Shaw is Shaw & Co.'s founder and was, at all relevant times, its principal limited partner and the sole owner of its general partner, D.E. Shaw & Co., Inc. Shaw & Co., Shaw Securities and their subsidiaries are hereinafter referred to as the "Shaw Entities."
In March 1997, BAC entered into a business alliance with the Shaw Entities (the "Alliance"). The Alliance was established to allow BAC to receive certain of the profits from securities and derivatives trading in which the Alliance engaged, and to allow BAC to offer equity derivatives products to its customers. The activities of the Alliance were financed by BAC, and subjected BAC to market risks carrying the potential for substantial losses. The market risks and consequent potential for losses arising from the Alliance's activities were magnified by the significant amount of leverage it employed. By no later than mid-September 1998, that potential came true, in that the Alliance was suffering substantial losses in various of its securities and derivatives positions as a result of worldwide turmoil in a number of fixed income, equity and other financial markets caused by bond defaults and a currency devaluation by the Russian Federation in mid-August 1998. The Alliance's losses in turn created significant potential that BAC would have to recognize substantial losses itself as a result of its relationship with the Alliance.
For the purposes of financial reporting and accounting treatment in filings made with the Commission, BAC treated its financing of the Alliance as a loan. However, the profit participation aspects of the Alliance gave it substantially the risk characteristics of an equity investment rather than of a loan. BAC's accounting treatment of this relationship as a loan did not conform to Generally Accepted Accounting Principles ("GAAP"). It should have accounted for its relationship with the Alliance using the equity method of accounting.
BAC also made statements in filings with the Commission on Forms 10-K and 10-Q which described business advantages of the Alliance. BAC's filings on these forms, however, were materially misleading in that they did not disclose the market risks to which the Alliance exposed BAC and the potential for substantial losses arising out of those risks.
In a press release filed with the Commission on Form 8-K on September 15, 1998, BAC discussed certain of the effects on its operations of the worldwide financial turmoil caused by the fiscal and monetary crisis of the Russian Federation. This release, however, was materially misleading, in that it did not disclose the potential for substantial losses to BAC from the Alliance and that the Alliance had already incurred substantial losses that presented increasing potential for substantial losses to BAC at the close of its third quarter on September 30, 1998. Eventually, on October 14, 1998, Bank of America disclosed that it had taken a $372 million "writedown" (which reduced net income for the three month and nine month periods ended September 30, 1998) as a result of the activities of the Alliance. Net income reported by Bank of America for the quarter ended September 30, 1998 was $374 million.
In sum, BAC's incorrect accounting treatment of and inadequate disclosures concerning the Alliance, and its market risks, created an understated picture of its risk profile in a time of worldwide market turmoil.
1. BAC's Alliance with the Shaw Entities
BAC financed the Alliance through two agreements. On March 13, 1997, BAC, through Bank of America National Trust & Savings Association, one of its subsidiaries, entered into a Credit Facility Agreement ("Credit Facility Agreement"), under which BAC agreed to provide Shaw Securities and its subsidiaries with what were termed "Revolving Loans" for up to $1.6 billion. BAC was to receive base interest at the federal funds rate plus 0.375% on the amounts advanced under the Credit Facility Agreement. BAC was also entitled to a "Facility Fee" equal to 50% of Shaw Securities' consolidated net income before income taxes, accruing quarterly but not payable until it reached a balance of $200 million; and Shaw & Co. was to receive the other 50% of Shaw Securities' pre-tax profits in the form of a Management Fee. The Credit Facility Agreement provided that losses incurred by the Alliance would first be used to reduce the accrued Facility Fee to as little as zero, and that losses not used to offset the accrued facility fee would be carried forward to offset future facility fees. In addition, losses by the Alliance, if large enough, could impair the ability of Shaw Securities to repay the amounts advanced and the base interest thereon.
BAC also agreed to advance $100 million to Shaw & Co. pursuant to a Subordinated Loan Agreement ("Subordinated Loan Agreement"). In exchange, BAC received a warrant for a 4.99% interest in Shaw & Co., exercisable by either party ten years after its issuance at a price of $100 million. The Subordinated Loan Agreement also provided that Shaw & Co. would make an annual "interest" payment to BAC on the subordinated loan equal to 4.99% of Shaw & Co.'s profits, which would be derived, in substantial part, from Shaw & Co.'s 50% share of Shaw Securities' net profits.1
2. BAC's Exposure to Market Risk From the Alliance
By April 1998, BAC had advanced to Shaw Securities a total of $1.3 billion under the Credit Facility Agreement. In addition, BAC had advanced $100 million to Shaw & Co. under the Subordinated Loan Agreement, and Shaw & Co. had transferred approximately $75 million of those funds to Shaw Securities. BAC accounted for these advances as loans.
Shaw Securities used the $1.375 billion it received directly or indirectly from BAC to make capital infusions in its subsidiaries and to replace prior substantial funding that it had received from others. Shaw Securities' subsidiaries then used these funds to finance the Alliance's trading of equity and fixed income securities and derivatives using over a dozen strategies.2 These trading strategies involved taking securities and derivatives positions that were sensitive to fluctuations in the market value of the various portfolios held by the Alliance, changes in rates of exchange between currencies, and interest rate changes. This exposure to market risk, coupledwith the significant leverage used in connection with certain strategies, in particular, a sizeable position in fixed income securities that Shaw called the Fixed Income Portfolio, had the potential to cause substantial losses to BAC.
BAC was aware on an ongoing basis of both the performance of, and the degree of market risk associated with, the Alliance's trading. During the second quarter of 1998, while the Alliance was profitable, losses in the Fixed Income Portfolio negatively impacted the Alliance's profitability. In mid-August 1998, Russia devalued the ruble and defaulted on certain of its loan obligations, precipitating a crisis in global financial markets. By the last week of August, this crisis had caused growing losses in the Alliance's Fixed Income Portfolio and other of its securities and derivatives positions. In September and October 1998, the Alliance's losses increased nearly every day, and eventually became hundreds of millions of dollars.
On September 23, 1998, BAC and the Shaw Entities agreed to a restructuring of the Alliance, which provided, among other things, that Shaw & Co. would no longer receive any portion of Shaw Securities' consolidated net income before income taxes, but be compensated through asset-based management and performance fees, and that the base interest would be reduced and eventually eliminated. Thereafter, BAC decided that it would treat the Alliance as an equity investment for accounting purposes. Although the terms of the restructuring did not forgive any of the obligations of the Shaw Entities to repay advances under the Credit Facility Agreement, the realistic ability of BAC to obtain full repayment had been significantly impaired by this time as a consequence of the Alliance's losses.
In late September and early October, 1998, continued deterioration of the financial markets led certain financial firms that had extended collateralized credit to the Shaw Entities to demand increased collateral protection. In order to avoid forced liquidation of Alliance holdings, Bank of America agreed to acquire the Fixed Income Portfolio as of October 7, 1998. On or about October 5, 1998, Bank of America's Policy Committee decided to take a writedown as a result of the losses incurred by the Alliance. On October 14, 1998, Bank of America publicly announced that it had written off $372 million as of September 30, 1998 because of the losses incurred by the Alliance.
3. BAC's Accounting For and Disclosures About the Alliance
a. Accounting Treatment of the Alliance
In its reports on Forms 10-Q and Form 10-K for 1997 and its reports on Forms 10-Q for the first two quarters of 1998 filed with the Commission, BAC classified its financing of the Alliance as a loan. In the financial statements contained in each of these reports, BAC accounted for the relationship by including it within the balance sheet entries for "Loans." BAC included income from the Alliance within the income statement entry for "Interest Income" from "Loans."
b. Incomplete Disclosures
BAC made statements about the potential benefits of the Alliance in certain of its reports on Forms 10-Q and 10-K filed with the Commission between March 1997 and September 1998, but did not disclose the extent to which the Alliance exposed it to market risk. In the "Management's Discussion and Analysis" ("MD&A") section of its Form 10-Q for the first quarter of 1997, BAC stated only that it had "[e]stablished a relationship with D.E. Shaw & Co., Inc. [sic], a private investment banking company, which significantly enhances [BAC's] ability to offer equity-related products to its customers[.]"3 In its Form 10-K for 1997, BAC twice referred to the Alliance, but these disclosures did not add materially to BAC's prior disclosure about the Alliance in its Form 10-Q for the first quarter of 1997.4
In its Form 10-K for 1997, BAC also made certain "Qualitative and Quantitative Disclosures About Market Risk" ("Market Risk Disclosures").5 More specifically, BAC discussed the "potential of loss arising from adverse changes in market rates and prices," including, but not limited to, the market risk arising out of BAC's private equity investment activities.6 BAC noted that its private equity investments were "subject to fluctuations in their market prices or values. Since these market prices or values may fall below BAC's investment costs and thereby expose BAC to the possibility of loss if the investments were sold, BAC is subject to equity risk, when conducting these activities."7 BAC did not mention the Alliance in this regard, however, and did not say anything about the market risks arising out of the activities of the Alliance in the 1997 Form 10-K.
c. Report on Form 8-K
On September 15, 1998, BAC filed a press release in Form 8-K entitled "BankAmerica Issues Update on Effects of Market Conditions." In this release, BAC estimated that its after-tax profit for the current quarter would be in excess of $500 million. In the same release, BAC discussed the "negative impacts" of "turbulent conditions in global markets" on its non-interest trading income and its non-interest income from equity investment activities. BAC also disclosed a reversal of $12 million of interest income from purchasing and carrying securities accrued in July and August 1998, compared to $53 million of interest income recognized in the second quarter of 1998. The press release stated that this negative swing in interest income was "primarily attributable to one borrower where BAC's relationship included a yield enhancement entitling BAC to a 50 percent share of net profits." BAC did not disclose that the "borrower" to which it referred was Shaw Securities, that the Alliance already had substantial losses as a result of the global market turmoil, and that there was increasing potential that this market volatility would cause substantial losses to BAC as a consequence of the continued deterioration in the Alliance's financial performance.
On October 14, 1998, Bank of America filed with the Commission on Form 8-K a press release that announced, among other things, that Bank of America had written off $372 million as of September 30, 1998, because of losses incurred by the Alliance. In the same Form 8-K, Bank of America announced net income for the third quarter of 1998 of $374 million.
E. DISCUSSION AND ANALYSIS
1. Incorrect Accounting Treatment
BAC's Forms 10-Q and 10-K for 1997 and its Forms 10-Q for the first two quarters of 1998 were deficient in that they incorrectly classified BAC's financial relationship with the Alliance as "Loans" in its balance sheet and included income from the Alliance as "Interest Income" from loans in its income statement. These classifications failed to conform with GAAP because while the relationship was documented in the form of two loans, the profit participation aspects of the Alliance gave it the risk characteristics of an equity investment rather than of a loan.8 First, the Alliance obtained its capital solely from funding it received, directly and indirectly, from BAC. Second, the Alliance's securities and derivatives portfolios exposed BAC to market risk which was magnified by the Alliance's use of leverage. Finally, BAC's Facility Fee of 50% of Shaw Securities' consolidated net income before income taxes, pursuant to the Credit Facility Agreement, when coupled with its entitlement to annual interest of 4.99% of Shaw & Co.'s net profits pursuant to the Subordinated Loan Agreement, entitled the Bank to potentially receive more than fifty percent of the Alliance's net profits. Accordingly, BAC should have applied the equity method of accounting for this investment and reported its investment in the Alliance under the classification of "Other assets" in its balance sheet and reported any earnings or losses from this investment under the "Non-Interest Income" category of its income statement. 9
Although BAC decided after the September 23, 1998 restructuring of the Alliance that it would henceforth account for its relationship with the Alliance as an equity investment, that decision was untimely. BAC should have accounted for its relationship with the Alliance as an equity investment from the outset, and its failure to do so violated Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder.
2. Inadequate Disclosures
BAC made inadequate disclosures concerning the market risks associated with the investment. The Alliance's trading strategies resulted in positions that were sensitive to fluctuations in the market value of the various portfolios held by the Alliance, changes in rates of exchange between currencies and interest rate changes. This exposure to market risk, coupled with the leverage used in connection with certain strategies, in particular, the Fixed Income Portfolio, had the potential to cause substantial losses to BAC. Although BAC made disclosures concerning the potential benefits of the Alliance and concerning BAC's market risks in Forms 10-K, 10-Q and 8-K, these disclosures did not appropriately disclose the market risks presented by the Alliance and accordingly were in violation of Section 13(a) of the Exchange Act and Rules 13a-1, 13a-11, 13a-13 and 12b-20 promulgated thereunder.
a. Deficient Forms 10-K and 10-Q
Rule 12b-20 promulgated under the Exchange Act provides that: "[i]n addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading."
As noted above, the Management's Discussion and Analysis section of BAC's report on Form 10-Q for the first quarter of 1997 discussed the perceived business advantages of the Alliance, describing it as "a relationship with D.E. Shaw & Co., Inc. [sic], a private investment banking company, which significantly enhances [BAC's] ability to offer equity-related products to its customers[.]" BAC's report on Form 10-K for 1997, filed March 31, 1998, also noted that BAC had "established a relationship with D.E. Shaw & Co., Inc.[sic], a private investment banking company, which significantly enhances [BAC's] ability to offer equity-related products to its customers," and depicted the Alliance positively by describing Shaw & Co. as "one of the most technologically sophisticated firms on Wall Street." BAC made no mention of the market risks to which BAC was subjected by virtue of its investment in the Alliance. Thus, BAC's description of the Alliance in its Management's Discussion and Analysis omitted material information and thereby failed to comply with Rule 12b-20.
Furthermore, separately from its Management's Discussion and Analysis, BAC made disclosures in its Form 10-K for 1997 concerning the market risks from its private equity investments, but only stated that these investments are "subject to fluctuations in their market prices or values. Since these market prices or values may fall below BAC's investment costs and thereby expose BAC to the possibility of loss if the investments were sold, BAC is subject to equity risk, when conducting these activities." BAC made no mention of its investment in the Alliance in connection with these disclosures. It also did not describe the market risks and leverage of the Alliance's activities, or the extent to which BAC was thereby subjected to the potential for substantial losses. As a result, BAC failed to comply with Rule 12b-20.
b. Inadequate Filing on Form 8-K
Furthermore, BAC's press release filed with the Commission on Form 8-K on September 15, 1998 was inadequate. By early September 1998, the financial turmoil in a number of fixed income, equity and other financial markets resulting from the Russian ruble devaluation and bond defaults had greatly increased BAC's exposure to the undisclosed market risks of the Alliance discussed above. By September 15, 1998, the Alliance was suffering substantial losses that were increasing almost every day, and the turmoil in the financial markets continued unabated. The September 15, 1998 Form 8-K disclosed a negative swing in interest income consisting of a reversal of $12 million of interest income primarily from the Alliance's activities which was accrued in July and August 1998, compared to $53 million in interest income the previous quarter. However, the Form 8-K omitted to disclose that the Alliance had incurred substantial losses in its portfolio and that substantial losses to BAC could result from the continued deterioration in the Alliance's financial performance. BAC was sufficiently aware of the losses already incurred by the Alliance, as well as the undisclosed risks and potential for loss to BAC from the Alliance, that it could have made more complete disclosure on September 15, 1998. That it made a decision on or about October 5, 1998 to write down $372 million as a result of the losses from its relationship with the Alliance did not obviate its earlier disclosure obligations. BAC's omissions in the Form 8-K filed on September 15, 1998 violated Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20 thereunder.
BAC's above-described deficiencies in accounting treatment and disclosure should be of particular concern to public companies undertaking transactions that involve significant potential for losses from fluctuations in market values of assets.
Based upon the foregoing, the Commission finds that Bank of America violated Section 13(a) of the Exchange Act, and Rules 13a-1, 13a-11, 13a-13 and Rule 12b-20 promulgated thereunder.
In view of the foregoing, it is appropriate to impose the sanction specified in Bank of America's Offer of Settlement.
ACCORDINGLY, IT IS HEREBY ORDERED THAT Bank of America shall cease and desist from committing or causing any violation, and committing or causing any future violation, of Section 13(a) of the Exchange Act, and Rules 13a-1, 13a-11, 13a-13 and Rule 12b-20 promulgated thereunder.
By the Commission.
Jonathan G. Katz
|1|| Shaw Securities also agreed to assist BAC to develop an equities derivatives business to serve the needs of BAC customers, and customers that Shaw Securities referred to BAC.
Prior to entering into the Alliance, BAC discussed the Alliance and the application of the federal banking laws to the Alliance with the Office of the Comptroller of the Currency ("OCC"). The OCC orally informed BAC that it did not object to BAC undertaking to participate in the Alliance. However, the OCC did not address the federal securities laws issues applicable to the Alliance.
|2||These strategies included trading activities involving currencies, fixed income securities, futures contracts, convertible securities, and equity securities.|
|3||Form 10-Q, Quarterly Report for the Period Ended March 31, 1997, at 15.|
|4||In the "Business and Properties" section, BAC again stated it had "established a relationship with D.E. Shaw & Co., Inc. [sic], a private investment banking company." Form 10-K, Annual Report for the Period Ended December 31, 1997, at 2. In the MD&A section, BAC repeated verbatim what it had disclosed about its relationship with D.E. Shaw in its Form 10-Q for the first quarter of 1997. Id. at 18 (incorporating by reference BAC's 1997 Annual Report to Shareholders, at 22).|
|5||Id. at 19 (incorporating by reference BAC's 1997 Annual Report to Shareholders, at 45-49).|
|8||See AICPA Notice to Practitioners, "ADC Arrangements", dated February 10, 1986 for characteristics of acquisition, development and construction (ADC) arrangements implying investments in real estate or joint ventures.|
|9||See APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock", paragraphs 11, 19 and 20.|
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