March 8, 2021

DealBook: For Bank of America, Countrywide Bankruptcy Is Still an Option

The real issue around Bank of America is not whether it survives, but whether it sacrifices Countrywide to save itself. More specifically, will Bank of America put Countrywide into bankruptcy? And will this stem the bleeding?

The Countrywide acquisition will go down in history as a deal from hell. It has already cost Bank of America tens of billions of dollars in litigation settlements, let alone losses resulting in a $20.6 billion charge to earnings in the second quarter. Bank of America has already announced that it expects another $5 billion charge for earnings, and American International Group said this week that it would sue Bank of America for $10 billion, mostly for loans issued by Countrywide. It appears that $5 billion is the floor.

These mounting losses have raised the question whether Bank of America might be overwhelmed by Countrywide’s liabilities. Bank of America could be the first candidate for the new insolvency regime put in place by the Dodd-Frank Act.

But the issue is much more complicated than this. The reason is that the losses of Countrywide are not those of Bank of America. Only if Bank of America took steps after the Countrywide acquisition to assume these liabilities is there a problem.

Let me explain.

Bank of America acquired Countrywide, but it did not assume its liabilities. Instead, the assets and liabilities of Countrywide were held separately in the formerly public company Countrywide Financial Corporation.

The only change was that instead of Countrywide Financial stock being held by the public, it was now held by Bank of America. Because of limited liability laws for corporations, public shareholders of Countrywide Financial are not liable for Countrywide’s debts, and neither is Bank of America.

This is standard procedure in a merger. Limited liability means that a company’s owners are not ordinarily liable for the debts the company incurs. When a company is acquired, its new owner usually just obtains ownership of the company’s stock. But this does not make the new owner liable for the target company’s liabilities.

Companies use limited liability laws to plan and structure their operations, often using hundreds of different subsidiaries. For instance, there was talk last year of bankruptcy for BP, the British energy giant. But this was overstated, because BP’s North American operations were run by a wholly separate subsidiary corporation, which held the company’s Mexican Gulf operations. The real risk of bankruptcy was to this subsidiary.

When Bank of America acquired Countrywide, it did not become responsible for its past misdeeds and any litigation liability. This is true even though it is now clear that Countrywide was insolvent at that time. Even so, Bank of America could have had Countrywide Financial put into bankruptcy and cordoned off these liabilities. It could still have done this today had it continued to operate Countrywide as a separate company.

Unfortunately for Bank of America, it didn’t keep things so neat when it acquired Countrywide. Instead, Bank of America engaged in a number of complex transactions to consolidate Countrywide into its operations.

The complaint filed by A.I.G. against Bank of America describes these transactions: On June 2, 2008, Countrywide Home Loans, a subsidiary of Countrywide Financial, sold Countywide Home Loans Servicing, another subsidiary, to NB Holdings, another subsidiary that was wholly owned by Bank of America. Bank of America paid Countrywide Home Loans for this sale by issuing it a note for $19.7 billion. Countrywide Home Loans Servicing was the actual subsidiary of Countrywide that serviced almost all of Countrywide’s mortgage loans. Countrywide Home Loans also sold a pool of residential mortgages to NB Holdings for $9.4 billion. On Nov. 7, 2008, Countrywide Home Loans sold the rest of its assets to Bank of America for $1.76 billion.

Separately, Bank of America also acquired notes worth $3.6 billion from Countrywide Financial’s bank and the equity in a number of other Countrywide subsidiaries. Bank of America also assumed $16.6 billion of Countrywide’s debt and guarantees.

If the A.I.G. complaint accurately describes these transactions, it means that the net effect was to leave Countrywide Financial and Countrywide Home Loans without assets, except the $11.16 billion payment and the $19.7 billion and $3.6 billion notes ($34.46 billion total). Countrywide’s liabilities stayed with the Countrywide.

Bank of America turned Countrywide into a shell with assets of $34.46 billion, part of it in the form of loans from Bank of America. Once the settlements exceed this amount, Countrywide is out of money. Again, the exact amount is uncertain and this is an approximation, but it appears that Countrywide’s remaining assets are rapidly being subsumed by litigation claims and other liabilities related to the financial crisis.

The best strategy for Bank of America would appear to be to throw the old Countrywide into bankruptcy.

Normally this would be the end of the matter and Bank of America would not be liable for any of Countrywide’s debts.

However, in any bankruptcy proceeding, anyone with claims against Countrywide will argue that Bank of America fraudulently transferred out Countrywide’s assets. And there are other legal arguments, including that Bank of America should be liable for Countrywide’s debts because of these transfers. The A.I.G. complaint against Bank of America, for example, makes a similar claim, arguing that Bank of America is a successor in interest to Countrywide by virtue of these transfers.

The validity of these claims is hard to assess and will depend on how careful Bank of America was in transferring the Countrywide assets. If a court finds that Bank of America underpaid for these assets, Bank of America may be liable for some of Countrywide’s debts.

Bank of America thus still has residual exposure to Countrywide in a bankruptcy and a hefty litigation bill to fight off such claims.

Bank of America’s lawyers are likely poring over these transfers and assessing any liability in anticipation of just such a bankruptcy filing. The bottom line is that, unless Bank of America’s lawyers really messed up the transfers, Bank of America is far from insolvency itself, having the option of cordoning off this liability to a large extent through a bankruptcy filing. If nothing else, a Countrywide bankruptcy would tie this up in litigation for years if not a decades.

Boy, did Ken Lewis really blow this one.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

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