Hopped over to courtroom 14-B at 500 Pearl Street yesterday afternoon where I saw Judge Jed Rakoff hammer SEC and Bank of America lawyers over the proposed settlement regarding Merrill Lynch bonuses.

The news is that Rakoff refused to approve the settlement. He ordered the lawyers to get to the bottom of the “who/what/where” of the case, saying the settlement “seems to be lacking in transparency.” He’s asked them to file briefs answering those questions on the 24th, and then responses on September 9th.

The hearing itself was very interesting. Rakoff was clearly very skeptical of the arguments presented by both legal teams, which seemed rather unimpressive.

The judge wondered immediately why, given the “serious questions” raised in its complaint, the SEC wasn’t going after more facts. If BofA and Merrill conspired to lie to shareholders about bonuses that had been agreed to when the merger was signed, then why isn’t the SEC trying to figure out who is responsible? “Was it some sort of ghost? Who made the decision not to disclose [the bonuses]?” said Rakoff.

David Rosenfeld, lead lawyer for the SEC, meekly replied that they haven’t made any allegations against specific individuals. This clearly didn’t satisfy Rakoff who argued that to make the complaint, they “must have determined who physically committed these acts.”

[By the way, Rosenfeld struck a few of us in the gallery as badly prepared. He seemed to stumble a lot, and the judge and court reporter repeatedly told him to speak up. He wasn’t familiar with specifics so frequently had to defer to another SEC lawyer. Even though the hearing revolved around BofA’s proxy filing, Rosenfeld and his team didn’t have a copy of the document with them.]

So who led the merger negotiations when the discussion of bonuses came up? The SEC offered two names: Greg Curl for BofA and Greg Fleming for Merrill. Of which the SEC says it has only spoken to one: Fleming.

Were details of those negotiations circulated to top management? Yes, Merill CEO John Thain and BofA CEO Ken Lewis were aware of them according to the SEC’s lawyers.

But according to BofA’s lawyer, Cleary Gottlieb’s Lewis Liman, they apparently weren’t aware of what was in “the disclosure schedule,” the document where bonus details were laid out. That schedule was supposed to be attached to the SEC filing detailing the merger. Conveniently, it wasn’t. And of course that’s nobody’s fault.

Oddly, given Liman’s insistence that the proxy was very thorough, Rakoff didn’t ask him why the disclosure schedule wasn’t attached.

Rakoff also asked the SEC lawyers why the settlement is so puny. A $33m fine for $3.6 billion worth of misconduct? “Why isn’t this a grossly unfair amount?” he asked. SEC lawyer David Rosenfeld seemed badly prepared for this question. He cited the Wachovia/First Union case, saying that $37 million settlement was the right precedent. Again the judge was skeptical, noting it revolved around $500 million worth of misconduct. Here you have $3.6 billion.

More to the point, perhaps, Rakoff asked why the settlement is being collected from the corporation and “not from individuals responsible for orchestrating the misleading [SEC filing]?” Rosenfeld mumbled something about the degree of misconduct, the need for deterrence and finding the closest precedent to justify the structure of the settlement. As for going after specific individuals, Rosenfeld says he can’t. The executives are all hiding behind attorney-client privilege. The judge was not impressed with this excuse, noting that if BofA execs are asserting they relied on advice of counsel, which they seem to be, then they have to waive privilege.

Liman offered some pretty pathetic arguments of his own…

People shouldn’t have been surprised by the Merrill bonuses because the company had already accrued $12 billion for that purpose through Q3.

What do you do with this? Merrill may have had an accounting entry saying they owed their people bonus money, but Merrill wouldn’t have lasted long enough to PAY the bonuses had it not been for bailouts.

He argued that $3.6 billion wasn’t a lot of money. After all it worked out to an average of $91k per recipient.

“I’m glad you think $91k isn’t a lot of money,” retorted the judge. And in any case, as NY Atty General Cuomo reported two weeks ago, nearly 700 Merrill employees got bonuses north of $1 million. 149 got more than $3 million.

Liman also trotted out the cliché about bonuses being necessary for “retention.” To this Rakoff responded with the obvious: “how many banks were hiring people when the bonuses were paid?”

My least favorite defense argument was about the structure of TARP. Since it came in the form of preferred stock, which has a fixed dividend, Liman argued its value wasn’t impacted by expenses like bonuses.

Liman forgets that besides preferred, TARP investments included warrants, essentially options to buy common stock. Of course the common is impacted by expenses.

And how is the value of preferred stock not impacted when $3.6 billion is subtracted from the balance sheet? That’s a lot less cushion protecting preferred stockholders in bankruptcy. Not exactly a far-fetched scenario only a few months back.

Last Liman argued that no one could have been misled by the bonuses because they weren’t a surprise. He waved his hands in the air suggesting it would be impossible to find anyone, anywhere in the press who didn’t expect Merrill employees to get incentive comp. This is Wall Street(!) he protested.

Indeed it is.