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When Due Diligence is a One-Way Street

by CHRISTOPHER BRAUCHLI

This is a column about due diligence. Presidents of large banks, such as Bank of America’s (BOA) Kenneth D. Lewis may read this column but it is not applicable to BOA since the Present Financial Crisis (PFC) demonstrates that due diligence has no place in BOA’s dealings except when dealing with customers.

Due diligence is the process whereby people who contemplate entering into a business transaction take steps to insure that the transaction is as they believe it to be. For the seller of a product due diligence may be as simple as insuring that the purchaser has the funds with which to complete the transaction. For the purchaser it consists of making sure that the object of the transaction is as it is represented. Thus, someone buying a car employs due diligence to make sure that the car is in the promised condition.

Any one who has borrowed money from Mr. Lewis’s institution knows that even if all the borrower wants to borrow is $.25, Mr. Lewis will not lend that amount until, through due diligence, his employees determine that the borrower has $.50 in assets and an income stream sufficient to assure Mr. Lewis that the bank will get back its $.25 plus a reasonable amount of interest. (Mr. Lewis made an exception to this rule in the case of billions of dollars of mortgages that the bank issued that have now departed the bank’s books for warmer climes) One of the surprises to emerge from the PFC is that as familiar as Mr. Lewis is with the concept of due diligence when dealing with customers, he forgot to use it when entering into a VERY big transaction for the bank.

On September 15, 2008 BOA announced that it was acquiring Merrill Lynch and Co., (ML) the country’s biggest brokerage firm. The due diligence took 48 hours, much less than many people will spend deciding whether to buy a car or even a dishwasher. When asked about this exceptionally short 48 hour due diligence study, Joe Price, the CEO of Bank of America explained:

“We have had a tremendous amount of historical knowledge, both as a competitor with Merrill Lynch, but also have reviewed and analyzed the company over the years. . . . In addition. . . we deployed the team that we would ordinarily deploy in these types of situation, which had well over 45 people from our team on site as well as others off site, outside counsel and the like. So collectively with that group. . . . and the progress that Merrill Lynch had made in reducing the risk exposures . . . . made it possible for us.”

Mr. Lewis added that the bank was not asking for any help from the government in completing the transaction.

The foregoing notwithstanding, in mid-December Mr. Lewis let regulators know the deal was in trouble. It turned out that one of the things the due diligence doers happened to overlook was that ML would have to take a fourth-quarter write-down of $15 to $20 billion. Mr. Lewis explained to analysts that he was surprised to learn that losses of ML were much larger than expected. That was a little like discovering that the car you planned to buy needed a complete set of new tires and you’d not noticed that before you agreed to buy it.

ML’s losses were so large, said Mr. Lewis, that he considered walking away from the deal but decided that would not be “patriotic.” It was more patriotic, he apparently thought, to let the taxpayers help save the deal. (Government regulators did not want the deal to collapse fearing panic in the markets.) Unlike the car buyer who could not get out of the deal because of overlooking bad tires, no one thought BOA should suffer for its lack of due diligence as shown by not noticing that ML needed a new set of tires. Instead, the federal government told Mr. Lewis it would be willing to help him out in completing the transaction.

Under the new deal, BOA has to pay for front tires costing $10 billion, and the feds will pay for the rear tires plus the spare, costing $10 billion plus 90 percent of any additional repairs that are needed. Thanks to that agreement, the deal closed in early January. That is not quite the end of the story. Although the deal has closed, there is still on going discussion about the role the taxpayer will play even though by now the car has left the lot and is hundreds of miles away.

Mr. Lewis has indicated that he and the feds are still negotiating the terms of the feds’ involvement in the transaction. Mr. Lewis would be the first to tell you that when you borrow money from him, there is no room for negotiation after you’ve driven the car off the lot. Mr. Lewis should be grateful that the Feds are not as strict with him as he is with his borrowers.

CHRISTOPHER BRAUCHLI is a lawyer living in Boulder, Colorado. He can be reached at: brauchli1@comcast.net

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