Appeal Sets Stage for Showdown on SEC's "Neither Admit Nor Deny" Settlement Policy

19 December 2011 Publication
Authors: Bryan B. House

Legal News: Securities Enforcement & Litigation

After U.S. District Judge Jed Rakoff’s November 28, 2011 decision rejecting the proposed $285 million settlement between the SEC and Citigroup, observers wondered whether the SEC would present the judge a revised settlement that might cure what the judge saw as the proposed consent decree’s deficiencies. An appeal was viewed widely as a dangerous proposition that could lead to even worse precedent for the SEC. On December 15, 2011, the SEC ended the speculation and appealed Judge Rakoff’s decision. Thus, the United States Court of Appeals for the Second Circuit may soon decide whether the SEC’s long-standing practice of entering into settlements with defendants that “neither admit nor deny” the SEC’s allegations is appropriate.

The District Court Opinion

In early 2007, Citigroup created a $1 billion fund known as Class V Funding III (Fund) that allegedly sought to “dump” some toxic mortgage-backed securities on “misinformed investors.” SEC v. Citigroup Global Markets, Inc., --- F. Supp. 2d ----, 2011 WL 5903733, *1 (S.D.N.Y., November 28, 2011). While promoting the Fund’s assets as “attractive investments rigorously selected by an independent investment adviser,” Citigroup allegedly selected a substantial amount of negatively performing assets for inclusion in the Fund and then took a short position in those assets. Investors in the Fund lost more than $700 million, while Citigroup reaped net profits of approximately $160 million. Id. at *2.

After a lengthy investigation, the SEC brought a civil enforcement action on October 19, 2011, seeking an injunction and alleging that Citigroup had violated Sections 17(a)(2) and (3) of the Securities Act of 1933 — violations that require a showing of negligence, not knowing or reckless misconduct. That same day (before knowing that the matter would be assigned to Judge Rakoff), the SEC submitted for court approval a proposed consent judgment that required Citigroup, while neither admitting nor denying the SEC’s allegations, to (1) disgorge $160 million of ill-gotten gains along with $30 million in pre-judgment interest, (2) pay a civil penalty of $95 million, and (3) comply with certain remedial undertakings for a period of three years that would prevent control weaknesses. Asserting that the proposed settlement was “fair, adequate, reasonable, and in the public interest,” the SEC and Citigroup asked the court to approve the proposed settlement.

To assess whether the settlement was “fair, reasonable, adequate, and in the public interest,” Judge Rakoff posed several questions regarding the details of the allegations and the proposed consent judgment, and both parties submitted lengthy memoranda supporting the proposed consent judgment. Judge Rakoff, however, was not persuaded, concluding that he could not approve the proposed settlement “because the Court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.” Id. at *4. Specifically, Judge Rakoff noted the lack of evidentiary basis to conclude whether the requested relief was warranted, and while noting that private parties may agree to settle a case without ever agreeing on the facts, he refused to allow the court’s “formidable judicial power of contempt” to be used as “a mere 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.” Id. at *8-*9.

One substantial sticking point was Judge Rakoff’s concern regarding the SEC’s long-standing policy of allowing defendants to enter into settlements without admitting or denying the allegations — a policy that Judge Rakoff said was “hallowed by history, but not by reason.” Id at *9. Judge Rakoff said the policy deprived him of any assurance that the injunctive relief sought was grounded in fact. In response to what he called the SEC’s position that the public “somehow knew the truth of the allegations,” Judge Rakoff noted that Citigroup was free to (and in fact had already indicated its intent to) contest the facts in any parallel civil litigation. Indeed, he noted that, in other related litigation, these “mere allegations” would have “no evidentiary value and no collateral estoppel effect.” Id. at *10.

Judge Rakoff contrasted the SEC’s proposed Citigroup settlement with the 2010 Goldman Sachs settlement (approved by Judge Barbara Jones) involving a similar collateralized-debt obligation transaction, observing that the Goldman Sachs settlement (while noting that Goldman Sachs was not admitting or denying the allegations) contained an “express admission” of wrongdoing that was absent from the proposed Citigroup settlement. Id. at *13, n.7. In the end, Judge Rakoff reasoned that the approval of a proposed settlement without any admission or agreed-upon facts creates the potential for abuse because “it asks the court to employ its power and assert its authority when it does not know the facts.” Id. at *14-*15. Finally, Judge Rakoff noted that “[i]n 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.” Id. at *15.

This was not the SEC’s only well-publicized tangle with Judge Rakoff. He had put the SEC through similar paces in 2009 in connection with the proposed settlement of charges that Bank of America materially misled shareholders in a proxy statement soliciting approval of its $50 billion acquisition of Merrill Lynch. See SEC v. Bank of America Corp., 653 F. Supp. 2d 507, 508 (S.D.N.Y. 2009) (Bank of America I). There, too, Judge Rakoff rejected the parties’ proposed consent judgment, lamenting the absence of particularized facts regarding Bank of America’s alleged conduct and questioning the SEC’s decision not to pursue responsible individuals. He set a trial date and expressed his hope that “the truth may still emerge.” Ultimately, Bank of America and the SEC filed a second proposed consent judgment with different terms, including a larger monetary penalty. SEC v. Bank of America Corp., 2010 WL 624581 (S.D.N.Y. Feb. 22, 2010) (Bank of America II). Judge Rakoff “reluctantly” approved the revised consent judgment, describing it as “half-baked justice at best.”

Judge Rakoff has been an outlier, however, even in the federal courthouse in Manhattan where many of the SEC’s financial fraud cases are filed. In addition to the above-noted Goldman Sachs settlement, JPMorgan Chase & Co. recently resolved nearly identical SEC charges under Sections 17(a)(2) and (3) concerning the structure of a collateralized-debt obligation without admitting or denying the allegations. In that matter, J.P. Morgan consented to a final judgment providing for a permanent injunction, a $133 million penalty, and a total payment of $153.6 million. Judge Richard Berman not only approved the settlement, he called it “another important step in the direction of the financial industry, along with the SEC itself, righting the wrongs and excesses of the recent financial crisis.”  

The SEC Response

In an unusual move, the day of Judge Rakoff’s decision, the SEC’s Director of the Division of Enforcement, Robert Khuzami, issued a statement defending the proposed Citigroup settlement. The statement argued that the similar settlements, reached without the risks and resources of a trial, may “significantly outweigh” the absence of an admission. Robert Khuzami, Public Statement by SEC Staff: Court’s Refusal to Approve Settlement in Citigroup Case (Nov. 28, 2011), available at http://tinyurl.com/cyahw9v. Mr. Khuzami noted that the result of the rejection of such settlements “would divert resources away from the investigation of other frauds and the recovery of losses suffered by investors not before the court.” The statement asserted that Judge Rakoff’s decision ignored “decades of established practice throughout federal agencies and decisions of the federal courts.” Mr. Khuzami added that the settlement provisions challenged by Judge Rakoff “have been included in settlements repeatedly approved for good reason by federal courts across the country — including district courts in New York in cases involving similar misconduct.”

The Appeal and Its Ramifications

The SEC’s appeal reflects the recognition that Judge Rakoff’s view is a fundamental assault on the SEC’s primary mechanism for resolving cases in federal court. In a statement released in conjunction with the notice of appeal, Mr. Khuzami expressed the SEC’s view that “the district court committed legal error by announcing a new and unprecedented standard.” Specifically, the SEC challenges the district court’s conclusion that an admission of facts was a necessary condition for approval of such a proposed consent judgment. The statement noted that “courts have routinely approved settlements in which a defendant does not admit or even expressly denies liability, exactly because of the benefits that settlements provide.” Noting that Judge Rakoff’s decision would result in many more trials and the accompanying risk, the statement contends that the decision “inadvertently harms investors by depriving them of substantial, certain and immediate benefits.”

The SEC’s appeal likely will focus on the decades of approved settlements and the language in court opinions approving the “neither admit nor deny” language. The SEC’s policy has been discussed with approval by the Circuit Courts in the District of Columbia, SEC v. Clifton, 700 F.2d 744 (D.C. Cir. 1983), and the Ninth Circuit, SEC v. Randolph, 736 F.2d 525 (9th Cir. 1984). In its attempt to support the settlement, the SEC also relied heavily on United States v. Microsoft Corp., 56 F.3d 1448 (1995). In Microsoft, the district judge relied on a host of issues outside of the government’s allegations in rejecting the consent decree proposed by the government and Microsoft regarding alleged antitrust violations. On appeal, the D.C. Circuit asked, “With respect to the specific allegations in the government’s complaint, may the court interpose its own views of the appropriate remedy over those the government seeks as a part of its overall settlement?” 56 F.3d 1458. The D.C. Circuit concluded that the answer to this question was “no.” To the point at issue in the Citigroup matter, the D.C. Circuit said, “We think the district judge’s criticism of Microsoft for declining to admit that the practices charged in the complaint actually violated the antitrust laws was … unjustified. … The important question is whether Microsoft will abide by the terms of the consent decree regardless of whether it is willing to admit to wrongdoing.” Id. at 1461.

Judge Rakoff did not address these authorities in his opinion, focusing instead on the facts he had and concluding that he did not have a “sufficient evidentiary basis” to know whether the proposed consent was fair, reasonable, adequate or in the public interest. Judge Rakoff, no doubt, raised interesting questions that may be addressed on appeal, including, whether the public should be “deprived of ever knowing the truth in a matter of obvious public importance”; whether investors injured by the misconduct were “substantially short-changed” by the proposed consent decree, particularly since they would be unable to use the non-admission/non-denial to further private litigation based on fraud; and whether the size of the penalty compared to the resources of the defendant (“pocket change,” as Judge Rakoff called it) should be considered in assessing the proposed settlement. While Judge Rakoff no doubt saw the settlement as serving “various narrow interests of the parties,” he said that such a resolution “cannot automatically be equated with the public interest.” Thus, the appeal may boil down to the same inquiry articulated in the Microsoft case: “At the heart of this case … is the proper scope of the district court’s inquiry into the ‘public interest.’” Microsoft, 56 F.3d 1458.

The importance of the case to the SEC’s enforcement program cannot be overstated. While the Second Circuit could decide the matter on the specific facts of the case and seek to avoid any far-reaching precedent, an opinion from the influential Second Circuit could fundamentally affect the process by which the SEC settles the vast majority of its cases. The ramifications also extend far beyond the SEC, as other agencies, not only the Department of Justice, but also the FTC, the CFTC, and the EPA, among others, routinely enter into settlements that permit defendants to resolve allegations without admission of wrongdoing. What remains to be seen in the interim is whether Judge Rakoff’s decision will impact the SEC settlements currently in the pipeline and those soon to come.


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