A letter from NY Attorney General Andrew Cuomo to (h/t Instapundit via Sec Law Prof Blog) reveals that then Secretary of the Treasury Henry Paulson intervened to prevent Bank of America from backing out of its deal to buy Merrill Lynch when BofA learned of enormous previously undisclosed loses.

Paulson threatened to use his TARP powers to remove the BofA executives and board if they invoked contractual provisions allowing BofA to terminate the transaction because the losses constituted a materially adverse event. Paulson also forced BofA to conceal the extent of losses from the public.

Paulson’s threats were made at the request of Chairman of the Federal Reserve, Ben Bernanke, who was concerned with systemic failure if BofA did not acquire Merrill Lynch, and Merrill Lynch failed

Subsequent to the transaction, BofA has suffered tremendous losses due to the Merrill Lynch purchase:

Gaping losses at the brokerage firm forced Bank of America to seek a second financial lifeline from Washington last week, leaving Mr. Lewis’s bank, the nation’s largest, facing an uncertain future.

Mr. Lewis, who had pressed ahead with the acquisition at the urging of federal regulators, is now fighting to right his troubled empire and safeguard his job.

The tension between the two men had been building since mid-December, when the implications of Merrill’s latest losses — $15.3 billion during the fourth quarter alone — began to sink in.

UPDATE: The Commissioner called my attention to this story earlier today, with the question of whether the securities laws were violated. Since Cuomo had not yet released the letter, I held off. This is a very interesting question, because the action was taken at the insistence of the Federal Reserve and Secretary of Treasury under special TARP powers. I wish I had an easy answer to this, but this is a unique twist. BofA executives may have breached their fiduciary duty to the corporation and shareholders, and may have failed to disclose material facts in violation of the securities laws. Normally, this would give rise to liability, but again, these circumstances are so unusual that it will take some time to sort this through.

Certainly, BofA shareholders should be furious. The stock has been hit dramatically as a result of the Merrill Lynch purchase, and shareholders have suffered.

UPDATE No. 2: Some are claiming that Paulson and Bernanke committed “securities fraud.” Let’s not throw around words too loosely. Regulators generally have absolute immunity from civil suit for actions taken within the scope of their regulatory function. There are criminal securities statutes, but again, it is hard to see how a regulator could be in violation of such statutes merely because one may disagree with the actions taken, provided the actions were not for personal monetary or other gain. This is a truly unusual circumstance, and I am not sufficiently familiar with the TARP legislation (and neither are the Congressmen who voted for it!) to delineate what additional protections if might afford not only regulators, but regulated entities acting at the direction of regulators. There may be other criminal laws implicated, for example, if false testimony was given or false documents filed with the federal government.

UPDATE No. 3: The Washington Post now is reporting the story. Looks to me like Paulson is throwing BofA Chairman Ken Lewis under the bus:

Yesterday, spokespeople for Paulson and Bernanke said both men denied telling Lewis what to disclose to shareholders. “It has long been the Fed’s view that questions of this nature are best addressed by individual institutions and their legal counsel,” said Michelle A. Smith, a Fed spokeswoman.

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