April 27 (Reuters) - Shareholders opposing a proposed $20 million settlement by Bank of America Corp directors over the purchase of Merrill Lynch & Co said the payout represents a mere 4 percent of directors' insurance coverage, and is grossly unfair.

The shareholders, who are pursuing their case in Delaware Chancery Court, are trying to preserve their claims as U.S. District Judge Kevin Castel in Manhattan weighs whether to approve the settlement in a separate lawsuit.

They fear approval of that accord could wipe out their claims against directors at the second-largest U.S. bank.

In a filing late Thursday, shareholders in the Delaware case said the $20 million represents just 4 percent of available insurance coverage -- suggesting that the coverage totals $500 million -- and 0.4 percent of the $5 billion of damages incurred by the Charlotte, North Carolina-based bank. They also said the proposed settlement violates Delaware law.

Both cases are derivative lawsuits brought on behalf of Bank of America, where payouts would go to the company rather than to shareholders.

"The grossly inadequate proposed settlement is the result of a 'race to the bottom' that was carefully engineered by the individual defendants, willingly pursued by the New York derivative plaintiffs and their counsel -- and inexplicably fostered by the bank and its counsel," the Delaware filing said.

Lawrence Grayson, a bank spokesman, declined to comment.

Castel has directed that parties in the New York case justify in writing the $20 million accord by May 4.

The judge also oversees nationwide shareholder class-action litigation against Bank of America, its former chief executive Kenneth Lewis, former Merrill chief executive John Thain, and others over the Jan. 1, 2009 purchase of Merrill.

Investors faulted Bank of America for not revealing prior to December 2008 shareholder votes on the merger that Merrill was well on its way to an eventual $15.84 billion fourth-quarter loss, and was paying $3.6 billion of bonuses.

The takeover forced Bank of America in January 2009 to get a second federal bailout and contributed to a 93 percent drop in its share price over six months.

Shares closed Friday down 2 cents at $8.25, which is 76 percent below where they traded before the merger was announced.

A $20 million payout is barely one-eighth of the $150 million that Bank of America agreed to pay to settle a U.S. Securities and Exchange Commission lawsuit.

Castel's colleague, Judge Jed Rakoff, grudgingly approved that penalty in 2010 after rejecting a $33 million accord.

The cases are In re: Bank of America Corp Stockholder Derivative Litigation, Delaware Chancery Court, No. CA4307; and In re: Bank of America Corp Securities, Derivative, and Employee Retirement Income Security Act (ERISA) Litigation, U.S. District Court, Southern District of New York, No. 09-md-02058.

(Reporting By Jonathan Stempel)

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