Print | Share | Reprint

Rakoff attacks SEC settlement practices

by William McConnell | Published November 29, 2011 at 12:18 PM

As he signaled he might do earlier this month, Federal District Judge Jed S. Rakoff on Monday rejected another Securities and Exchange Commission settlement with a major financial house over marketing of mortgage-backed securities.

Rakoff denied the SEC's request for approval of a $285 million settlement with Citigroup Inc. over the firm's 2007 marketing of the billion-dollar Class V Funding III, a fund the SEC alleged that Citigroup used to shed some poorly performing mortgage-backed assets and misrepresented to unsuspecting investors as an attractive investment, only to then take out short positions against many of the assets included in the fund. He directed the parties to be ready for trial on July 16.

This is the second SEC suit related to marketing of housing-related assets that Rakoff has rejected since August 2010 and the third rejected overall by federal judges. Rakoff previously tossed out a settlement with Bank of America Corp., and Judge Ellen Huvelle rejected a different settlement with Citigroup in August 2011.

Monday's opinion, however, goes well beyond the issues in the latest Citigroup case and attempts to set a higher bar for all SEC settlements with financial firms. Rakoff questioned whether the long-standing SEC practice of allowing financial firms and executives to settle misconduct claims without admitting or deny the underlying accusations has ever been appropriate but also said the issue is particularly important now as the government attempts to sort through the causes of the housing bubble and the resulting 2008 financial panic.

"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," he wrote. "In much of the world propaganda reigns, and truth is confined to secretive, fearful whispers ... but the SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges."

The bottom line in any SEC settlement is a requirement that the public interest be served, Rakoff said. "The Supreme Court has repeatedly made clear ... that a court cannot grant injunctive relief without considering the public interest."

Rakoff strongly criticized the SEC's contention in its most recent filing in the case, in which he said the SEC appeared to reverse its position that settlements must be in the public interest. "The SEC partly reverses its previous position and asserts that, while the consent judgment must still be shown to be fair, adequate and reasonable, 'the public interest ... is not part of [the] applicable standard of judicial review.' "

Rakoff said the SEC's latest position is "erroneous." He also blasted the SEC's "fall-back" position that the agency should be the sole determiner of what is in the public interest in regard to consent judgments in SEC cases. "That, again, is not the law," he said.

While the SEC or any other expert agency is due "substantial deference" in such decisions, a court "must still exercise a modicum of independent judgment in determining whether the required deployment of its injunctive powers will serve, or disserve, the public interest."

"Anything less would not only violate the constitutional doctrine of separation of powers but would undermine the independence that is the indispensable attribute of the federal judiciary."

Regarding the Citigroup case at hand, Rakoff said the court had not been presented with sufficient evidence to know whether the settlement served the public interest. "The court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes 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."

Despite the SEC's long-standing policy -- "hallowed by history, but not by reason" -- of allowing defendants to enter consent judgments without admitting or denying the underlying allegations, Rakoff said "there is little real doubt that Citigroup contests the factual allegations of the complaint." As a result, such allegations have no evidentiary value, and are why a consent judgment cannot be used as evidence in subsequent litigation, he said.

This judgment and similar ones make perfect sense for accused parties but offer little value to the government or the public, he said. Typically they result "in only very modest penalties" that the business community views as "a cost of doing business." He noted that without admitting anything, Citigroup was able to negotiate a settlement that charges it only with negligence, results in a very modest penalty and imposes inexpensive monitoring measures that are in place for only three years. In exchange, Citigroup settles a broad four-year investigation and avoids any SEC finding that private investors can rely on if they pursue claims on their own.

The SEC on the other hand, gets nothing other than "a quick headline" from the settlement, he said.

Rakoff contrasted the rejected settlement with Citigroup with one approved in a similar case against Goldman, Sachs & Co. In Citigroup's alleged scheme the firm realized net profits of $160 million, whereas the investors in the company's fund lost more than $700 million.

The SEC's proposed settlement, consisting of $160 million in disgorgement, $30 million in prejudgment interest and a $95 million civil penalty, indicate the penalty may be far too low, he said. The proposed civil penalty "is pocket change to any entity as large as Citigroup," Rakoff wrote.

In the Goldman case, the firm paid a $535 million penalty after earnings of $15 million in allegedly ill-gotten profits.

Although businesses may eagerly enter such agreements to avoid years of protracted litigation and potentially greater financial penalties, Rakoff said they too should worry about being abused by an overreach of government power.

"An application of judicial power that does not rest on facts is worse than mindless; it is inherently dangerous," he wrote. "If its deployment does not rest on facts -- cold, hard, solid facts, established either by admissions or by trials -- it serves no lawful or moral purpose and is simply an engine of oppression."

The SEC strongly defended its actions in regards to Citigroup narrowly and the broader issue of its settlement practices generally.

"While we respect the court's ruling, we believe that the proposed $285 million settlement was fair, adequate, reasonable, in the public interest, and reasonably reflects the scope of relief that would be obtained after a successful trial," said Robert Khuzami, director of the SEC's enforcement division.

"The court's criticism that the settlement does not require an 'admission' to wrongful conduct ... ignores decades of established practice throughout federal agencies and decisions of the federal courts," he said. "Refusing an otherwise advantageous settlement solely because of the absence of an admission also would divert resources away from the investigation of other frauds and the recovery of losses suffered by other investors not before the court. The settlement provisions cited by the court 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."

Citigroup declined to comment, pending further review of the decision.

Share:

Tags: Citigroup | Federal District Judge Jed S. Rakoff | law and regulation | Securities and Exchange Commission

Regulatory

Rakoff attacks SEC settlement practices

Free preview

Meet the journalists

William McConnell

Assistant Managing Editor: Regulatory & Arbitrage

Movers & Shakers

Video

Fewer deals despite discount debt

Sectors