Terra Extraneus

The demise of Bear Stearns and the bankruptcy of Lehman Brothers, followed by the purchase of Merrill Lynch by Bank of America, heralds the final end of the Wall Street business model.

B of A’s CEO claims that for seven years he predicted the commercial banks would end up owning the investment banks. Merrill’s CEO claims that this would be great for Merrill’s 16,000 registered representatives because they will have access to B of A’s customer base.

However, the bank owned model of broker dealers and the Wall Street model have been radically different. The banks have never been as tolerant of risk nor as tolerant of salesmanship. As a result, the banks have had a narrower range of products.

Merrill Lynch training and compliance has always been enviable in the industry. But, neither will be as necessary in the new world where banks dampen the sharp edges more than regulators. Banks like to charge fees and so many of the free services with which Merrill Lynch built its book of business will no longer be free. Banks like the wealthy and have very little to offer the non-wealthy (currently defined as someone with less than $500,000 of investable assets). Retail broker dealers liked everyone. It is interesting to see which business model failed.

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Imagine that you had a right to exercise certain stock options that you had earned. Imagine that the contract under which you were going to exercise the stock options gave you a three month window in which to do it, but that no one sent you a copy of the contract or the amendment that contained the three month limitation. Assume that the stock issuing company admitted that you never got the amendment and could not have known about the three month exercise window. Imagine that after you tried to exercise, you were told you were outside the three month window and your options had been cancelled. Breach of contract, right? All the elements are there: contract, breach of contract, and now you just have to prove damages.

Well, imagine the stock issuer puts on an expert that testified that no sensible investor would have exercised those options because at best, at the time, they were a break even proposition. Therefore, you have no damages. The expert was not allowed to give an opinion that you would not have exercised the options.

Surely that testimony was irrelevant, right? Just as your damages in most state would be limited to delivery date pricing, i.e., the price of the stock on the date you should have exercised but could not because of the breach of contract brought about by failing to give you a copy of the contract amendment, the other side should not be allowed to speculate about whether you would have exercised or allowed the options to expire, right?

The United States Court of Appeals for the First Circuit, in First Marblehead Corporation v House, held the expert’s testimony was admissible and would support a verdict that the employee had no damages because the expert testified a reasonable investor would not have been likely to have exercised the stock options because at best it was a break even proposition.

The testimony was not that the employee could not financially afford to exercise. The testimony was not that the employee would have lost so much money exercising that the exercise would have been uneconomic. The testimony was just that it would have not been attractive enough for the reasonable investor. That seems speculative. Worse, it allowed a party to breach a contract with impunity.

Of course, as it turned out, it would have been a good investment because several years later when the company went public the stock value would have been multiples of the cost of exercising.

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