The long-standing policy of the Securities and Exchange Commission ("SEC") to settle cases by allowing a party to neither admit nor deny the agency's allegations has been challenged by United States District Court Judge Jed S. Rakoff, sitting in the Southern District of New York. Judge Rakoff, in criticizing this policy, rejected a proposed $285 million settlement between the SEC and Citigroup Global Markets, Inc. ("Citigroup").1 The court indicated that, because the proposed Consent Judgment, where the SEC was requesting injunctive relief, lacked any proven or acknowledged facts, the court was unable to determine that it was fair, reasonable, adequate and in the public interest.2 Judge Rakoff was particularly harsh in his assessment of the SEC's decision to settle noting that, at worst, the settlement was "a mild and modest cost of doing business" for Citigroup, and that "[i]t is harder to discern from the limited information before the Court what the SEC is getting from the settlement other than a quick headline."

The majority of enforcement cases that the SEC brings are settled out of court, usually without an admission or denial by the defen-dant of the agency's allegations. This policy encourages settlements because admissions of fact by a defendant sufficient to support SEC allegations of wrongdoing could have disastr-ous consequences in any pending or threat-ened private litigation. As Judge Rakoff noted, where there is no admission of wrongdoing, investors are not able to rely in any respect on the SEC's consent judgment in seeking a return of their losses. But, according to Judge Rakoff, "when a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance." On its face, Judge Rakoff's opinion suggests that an SEC consent judg-ment cannot stand in the absence of proven or admitted facts sufficient to substantiate that the requested relief is justified. In this regard, Judge Rakoff's ruling presents a new obstacle to settling cases brought by the SEC which require federal court approval.3

This update summarizes and considers the potential impact of the Citigroup opinion.

Background of the Lawsuit

On October 19, 2011, the SEC filed a complaint (the "Complaint") against Citigroup for violations of Sections 17(a)(2) and (3) of the Securities Act of 1933 (the "Securities Act"). The SEC alleged that, in early 2007, Citigroup, realizing that the market for mortgage-backed securities was beginning to weaken, created a billion-dollar fund (the "Fund") that enabled it to sell dubious assets to misinformed investors. According to the Complaint, Citigroup misrepresented that the Fund's assets were attractive investments rigorously selected by an independent investment adviser. Rather, the SEC alleged that Citigroup included in the portfolio a substantial percentage of negatively projected assets and then took a short position in those assets, which resulted in a net profit of approximately $160 million, while investors suffered a loss of more than $700 million.

Simultaneously with the filing of the Complaint, the SEC presented a Final Judgment (the "Consent Judgment") for the Court's approval together with the consent of Citigroup to the entry of the Consent Judgment, which consent made clear that Citigroup was agreeing to the entry of the Consent Judgment without admitting or denying the allegations of the Complaint. The Consent Judgment: (1) permanently restrained and enjoined Citigroup from future violations of Section 17(a)(2) and (3) of the Securities Act; (2) required Citigroup to disgorge to the SEC the $160 million it realized in profits, plus $30 million in interest, and to pay a civil penalty of $95 million; and (3) required Citigroup to undertake certain internal measures designed to prevent recurrences of securities fraud, subject to court enforcement.

The parties received some prior warning that they were likely to have a difficult time persuading Judge Rakoff to approve the settlement when, in advance of the November 9, 2011 hearing on the proposed Consent Judgment, Judge Rakoff issued an order4 in which he outlined the questions he expected the parties to address, including:

  • Why should the Court impose a judgment in a case in which the SEC alleges a serious securities fraud but the defendant neither admits nor denies any wrongdoing?
  • Given the SEC's statutory mandate to ensure transparency in the financial marketplace, is there an overriding public interest in determining whether the SEC's charges are true? Is the interest even stronger when there is no parallel criminal case?
  • The SEC's submission states that the loss to victims was "at least" $160 million. How was this amount determined? If this is a minimum, what is the maximum?
  • How was the amount of the proposed judgment determined? Why is the penalty in this case less than one-fifth of the $535 million penalty assessed in SEC v. Goldman Sachs & Co.? 5 What reason is there to believe this proposed penalty will have a meaningful deterrent effect?
  • The SEC's submission states that the SEC has "identified ... nine factors relevant to the assess-ment of whether to impose penalties against a corporation and, if so, in what amount." How were the factors were applied in this case?
  • The proposed judgment imposes injunctive relief against future violations. What does the SEC do to maintain compliance? How many contempt proceedings against large financial entities has the SEC brought as a result of violations of prior consent judgments?
  • Why is the penalty in this case to be paid in large part by Citigroup and its shareholders rather
  • han by the "culpable individual offenders acting for the corporation?"
  • What specific "control weaknesses" led to the acts alleged in the Complaint? How will the proposed "remedial undertakings" ensure that those acts do not occur again?
  • How can an alleged securities fraud of this nature and magnitude be the result of simple negligence?

Rejection of the Settlement

According to the court, a significant reason that it was unable to approve the settlement was that the court was unable to determine that the settlement was in the public interest as a result of, among other things, the posture of the defendant in not admitting or denying wrongdoing. This was an important consideration for the court in light of the SEC's request for injunctive relief. Judge Rakoff rejected the SEC's assertion that the "SEC is the sole determiner of what is in the public interest in regard to Consent Judgments settling SEC cases," making clear that this position is "not the law." Instead, Judge Rakoff stated that "a court, while giving substantial deference to the views of an administrative body vested with authority over a particular area, must still exercise a modicum of independent judgment in determining whether the requested deployment of its injunctive powers will serve, or disserve, the public interest." Judge Rakoff further commented that "in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth ... [and] the SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency's contrivances."

The opinion also focused on the SEC's apparent lack of concern for harmed investors who allegedly lost more than $700 million in the Fund. Judge Rakoff took issue with the fact that despite the SEC claims that it is devoted to helping investors recover their losses, there was no firm requirement in the Consent Judgment that the $285 million obtained from Citigroup be repaid to the defrauded investors. There was only a suggestion that the SEC "'may' do so." Judge Rakoff also found "the combination of charging Citigroup only with negligence and then permitting Citigroup to settle without admitting or denying the allegations deals a double blow to any assistance the defrauded investors might seek to derive from the SEC litigation in attempt-ing to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence, but also cannot derive any collateral estoppel assistance from Citigroup's non-admission/non-denial of the SEC's allegations." In an additional admonition to the SEC as to the quality of the settlement, Judge Rakoff noted that the proposed settlement "imposes the kind of injunctive relief that ... the SEC had not sought to enforce against any financial institution for at least the last 10 years."

Based upon its analysis, the Court "regretfully" con-cluded that the Consent Judgment was "neither fair, nor reasonable, nor adequate, nor in the public interest[,] [m]ost fundamentally, because it does not provide the Court with a sufficient evidentiary basis to know whether the requested relief is justified under any of these standards." After rejecting the Consent Judgment, the Court ordered "the parties to be ready to try this case on July 16, 2012."

Potential Impact of Decision

Judge Rakoff's holding poses a significant barrier to SEC settlements that include injunctive relief and, therefore, require federal court approval. The SEC, however, can obtain other forms of relief — including disgorgement, penalties, cease and desist orders, and other equitable relief — through settlement in an administrative proceeding, which does not require court approval. As a result, Judge Rakoff's ruling could prompt the SEC to pursue more cases administratively, limiting the agency's ability to seek injunctive relief.

Robert Khuzami, Director of Enforcement at the SEC, was quick to comment on Judge Rakoff's opinion, stating that the ruling "ignores decades of established practice throughout federal agencies and decisions of the federal courts."6 In the SEC's view, forcing cases to go to trial solely because a company does not admit wrongdoing would divert SEC resources away from investigating other securities violations.

As for next steps, Khuzami has not said whether the SEC intends to appeal Judge Rakoff's ruling. Another possibility is for the SEC to renegotiate a settlement that responds to enough of Judge Rakoff's objections to pass muster – as was done in the Bank of America7 case. Whether or not a similar situation will play out here remains to be seen.

Footnotes

1 SEC v. Citigroup Global Markets, Inc., 2011 WL 5903733 (S.D.N.Y. Nov. 28, 2011).

2 This is not the first time that Judge Rakoff has rejected a proposed SEC settlement. Most nota-bly, in 2009, Judge Rakoff refused to approve a proposed $33 million settlement between the SEC and Bank of America Corporation ("Bank of America") where, inter alia, Bank of America neither admitted nor denied the allegations in the Consent Judgment and took the position in its submission to the court that" the proxy statement in issue was totally in accordance with the law...."SEC v. Bank of America Corp., 653 F. Supp. 2d 507 (S.D.N.Y. 2009). Judge Rakoff later approved a revised settlement that provided for a $150 million fine, and where Bank of America did not contest the accuracy of the"SEC's presentation to this Court of a 35-page Statement of Facts and a 13-page Supplemental Statement of Facts." SEC v. Bank of America Corp., 2010 WL 624581 (S.D.N.Y. 2010).

3 The SEC must proceed in federal district court when it seeks an injunction against violations of the securities laws. See section 21(d) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78u(d) (2006); section 20(b) of the Securities Act of 1933, 15 U.S.C. § 77t(b) (2006); section 42(d) of the Investment Company Act of 1940, 15 U.S.C. § 80a-41(d) (2006); section 209(d) of the Investment Advisers Act of 1940, 15 U.S.C. § 80b-9(d) (2006).

4 SEC v. Citigroup Global Markets, Inc., No. 11-7387 (S.D.N.Y. Oct. 27, 2011).

5 No. 10-3229, at *1 (S.D.N.Y. July 20, 2010).

6 Public Statement by Robert Khuzami, Enforcement Div. Dir., SEC, Court's Refusal to Approve Settlement in Citigroup Case (Nov. 28, 2011).

7 See supra note 2.

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