By Lauren Tara LaCapra
NEW YORK (Reuters) - Top Bank of America Corp lawyers knew as early as January that American International Group Inc was prepared to sue the bank for more than $10 billion, seven months before the lawsuit was filed, according to sources familiar with the matter.
Bank of America shares fell more than 20 percent on August 8, the day the lawsuit was filed, adding to worries about the stability of the largest U.S. bank. It wasn't until Warren Buffett stepped up with a $5 billion investment that those fears were eased, though hardly eliminated.
The bank made no mention of the lawsuit threat in a quarterly regulatory filing with the U.S. Securities and Exchange Commission just four days earlier. Nor did management discuss it on conference calls about quarterly results and other pending legal claims.
The SEC's rules for litigation disclosure are murky, and some lawyers said Bank of America may have been justified in not revealing AIG's lawsuit before it was filed. The bank's litigation disclosures are in line with those of many rivals.
But other lawyers said banks have an obligation to disclose legal threats that could have major consequences.
"Publicly owned companies are supposed to disclose material threatened litigation under generally accepted accounting principles," said Richard Rowe, a former director of the SEC's Division of Corporation Finance, who was commenting generally and not specifically about Bank of America.
Rowe, now a partner in the Washington, D.C., office of law firm Proskauer Rose, said bank executives must make a "judgment call" as to what is material, but "the general rule is, if it's threatened litigation and it's material, and you can put a number on it, you should disclose it."
AIG's lawsuit shows why investors are so fearful: they have no idea how much litigation lurks behind closed doors.
"Management surely has a credibility problem with investors," said Jonathan Finger, whose Finger Interests Number One Ltd in Houston owns Bank of America shares. "They continue to under-address or under-disclose on the mortgage issue."
Finger in 2009 sued the bank over its disclosures related to the takeover of Merrill Lynch & Co.
Bank of America and AIG declined to comment for this article.
SEC staff have this year advised banks including Bank of America, JPMorgan Chase & Co, Citigroup Inc, Wells Fargo & Co, Goldman Sachs Group Inc, and Morgan Stanley to disclose more information about lawsuits that have been filed, as well as legal proceedings that they know the government is considering.
Banks have responded by providing additional information, including legal loss estimates in some cases.
But the agency has given banks more leeway in disclosing the expected cost of early-stage litigation, or threats of litigation whose outcome is more difficult to predict, according to securities lawyers and current and former regulatory officials.
There are two standards for disclosing legal liabilities. One under banks' legal proceedings relies on whether losses are "reasonably probable" and "reasonably estimable." Another, under management's discussion and analysis, is based on whether losses are "reasonably possible." Disclosure relies heavily on management's assessment of the merits of a case.
Companies might need to disclose large potential lawsuits, even if they believe a loss is improbable, as well as less consequential cases if a loss appears certain, said Meredith Cross, director of the agency's Division of Corporation Finance, in an interview with Reuters about the SEC's disclosure requirements.
"The goal has been to have better disclosures, which should result in fewer surprises," said Cross, who was speaking generally and not commenting on any specific institution.
Legal experts say it is difficult for top bank executives to decide exactly what they have to disclose in relation to pending and potential legal matters. That is particularly true in the current environment, they said, in which confidence in large banks is so easily shaken by legal threats that may or may not have merit.
"This is a classic problem in the disclosure regime with litigation," said Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. "You're required to disclose anything material. The question is, 'is it material?' You have to gauge the size and the probability of success, which is very hard to evaluate."
Before suing Bank of America, AIG spent months analyzing publicly available data on a sample of 262,322 loans behind mortgage-backed securities it bought from Bank of America and its Merrill Lynch and Countrywide units between 2005 and 2007.
In its court filing, AIG said marketing materials touted the loans as being much safer than they were.
For instance, AIG said that in almost every bond offering, it was told that none of the mortgages were worth more than the value of the underlying property, when in fact one in six loans were underwater from the day they were born.
AIG raised such issues with Bank of America in January and said it planned to sue unless a settlement could be reached, sources familiar with the matter told Reuters. The sources either had direct knowledge of the legal proceedings or were briefed on them, but were not authorized to discuss the case publicly.
Both sides entered a "tolling agreement" to stop any legal statutes of limitation from running out while settlement talks were underway, but by March it became clear that AIG was prepared to sue for more than $10 billion, the people said.
Bank of America disputed AIG's claims, saying losses stemmed from the insurer's flawed decision making, as well as broader declines in home values and capital markets, the people said. The parties agreed to enter mediation proceedings during the second quarter, and also floated other proposals to no avail, the people said.
"There were lots of efforts made to avoid the filing over a period of months, but ultimately the discussions were not fruitful," said one of the people.
A key stumbling block was Bank of America's refusal to provide data for all of the loans, to show whether AIG's sample -- the heart of its case -- was representative.
Bank of America "ignored" AIG's requests for such information, while trustees and mortgage-servicers that also had access to the information "flat-out refused to cooperate," according to AIG's complaint.
The Charlotte, North Carolina-based bank has yet to respond in court to AIG's lawsuit, but has said the insurer should have been smart enough to understand what it was buying.
"AIG recklessly chased high yields and profits throughout the mortgage and structured finance markets," spokesman Larry DiRita said. "It is the very definition of an informed, seasoned investor, with losses solely attributable to its own excesses and errors."
Bank of America devotes plenty of space in its regulatory filings to mortgage litigation.
The bank suffered after buying Countrywide Financial Corp, the largest U.S. subprime lender, in 2008 for $2.5 billion. Litigation and loan losses linked to that deal have cost the bank more than $30 billion.
In its August 4 quarterly filing, Bank of America spent nearly 4,000 words on a footnote describing litigation and regulatory matters. The bank said it spent $2.3 billion on legal costs, not including external fees, during the period, and could be short on reserves for future legal liabilities by as much as $2.3 billion.
On June 29, Bank of America said it agreed to pay $8.5 billion to resolve what it said would be much of the litigation it faced over mortgage-backed securities, and set aside another $5.5 billion for future possible claims.
The agreement with 22 investors including the Federal Reserve Bank of New York, Blackrock Inc, Allianz SE's Pimco and others, covered mortgages with $174 billion in unpaid principal balance. Still, many investors have challenged the planned payout and disclosures as inadequate.
On a conference call to discuss the agreement, Credit Suisse analyst Moshe Orenbuch asked for further explanation of securities litigation not covered by the deal.
"That will be an ongoing process," Bank of America Chief Financial Officer Bruce Thompson replied. "And I think if you look at the disclosure and what we have out there, it is pretty fulsome."
Many large U.S. banks offer limited disclosure about their potential future legal bills.
None of the six biggest U.S. banks have volunteered definitive estimates of future legal costs, exact numbers of lawsuits or the potential damages that plaintiffs seek.
In its most recent quarterly filing, for example, JPMorgan said it is facing more than 10,000 legal proceedings, and that it may have to pay about $5.1 billion more to resolve these claims than the sum it has set aside. What that sum is, it does not say. Citigroup and Wells Fargo have made similar disclosures.
Morgan Stanley has offered legal-loss estimates for a handful of cases, totaling $1.7 billion, while Goldman Sachs lowered its legal-loss estimate by $700 million last quarter to $2 billion, even though it also detailed a slew of new legal and regulatory matters.
Barclays analyst Roger Freeman describes such legal-loss estimates as little more than holding a finger to the wind.
"We do not believe that this represents the realistic expected value of legal liabilities," he said of Goldman Sachs' estimate.
Bank of America's shares dropped 20.3 percent on August 8 when the AIG lawsuit was filed, though many other factors influenced bank stocks that day, including Standard & Poor's downgrade of the United States.
Since that time, its stock recovered only after Buffett -- whose Berkshire Hathaway has made several investments in financial firms since 2008 -- expressed support with a $5 billion preferred stock investment.
On Monday, the bank said it sold about half its stake in China Construction Bank for $8.3 billion, which also boosted Bank of America's shares.
But even with the extra capital, Bank of America is sure to face huge legal hurdles over the long term.
"I'm concerned about the litigation, obviously," said University of Delaware's Elson, who is also a Bank of America shareholder. "Until it happens, you just don't know." (Additional reporting by Jonathan Stempel, Joe Rauch and Ben Berkowitz. Editing by Robert MacMillan)