Since November 28,2011 Judge S. Rakoff of the Federal District Court in Manhattan has been the man of the hour. His refusal to approve a $285 million settlement of the Securities and Exchange Commission (SEC) with Citigroup Global Markets has attracted the attention of all parties involved in alike cases pursued by the SEC. It is not the disapproval itself but rather the reasoning that causes the SEC and future defendants to fear the effectiveness of settlements.
The SEC filed its complaint against Citigroup on October 19, 2011 in a New York federal court. The SEC’s allegations revolve around the misleading and therefore fraudulent sale of collateralized debt obligation (CDO) tied to the U.S. housing market. When mortgage-backed securities were already showing signs of distress, Citibank is accused of “betting against investors.” The default of the CDO resulted in losses for investors amounting to $ 700 million; whereas, Citigroup garnered close to $160 million in profit. The complaint states that “[t]he marketing materials Citigroup prepared and distributed to investors did not disclose Citigroup’s role in selecting assets for [the CDO] and did not accurately disclose to investors Citigroup’s short position on those assets.” Further, the Commission alleges that the materials were misleading in respect to the role Citigroup played in arranging the portfolio. The company was charged with violations of Sections 17(a)(2) and (3) of the Securities Act. The alleged violation therefore consisted in obtaining profits through a material misstatement or omission (Section 17(a)(2)) or by means of engaging in any practice of business operating as a fraud upon the purchaser of securities (Section 17(3)).
The SEC and Citigroup settled the case for $285 million, using a common policy applied in securities fraud cases that allows the defendant to remain neutral regarding the admission of liability. On November 28, 2011 Judge Rakoff of the Federal District Court in Manhattan surprisingly refused to “rubber-stamp” the accord. An approval of the settlement, however, would have put the case in the rear-view mirror.
Judge Rakoff’s Reasoning
Judge Rakoff’s refusal to “rubber-stamp” the agreement stems from a basic concern over the SEC’s policy that allows settlements without admission or denial of liability. This policy was established since 1972 and proved to be convenient for both the SEC as well as defendants. On the defendant’s side, the attractiveness of settling based on this policy is grounded in the fear of private litigation steaming out of the admission of liability. Looking at estimated investor losses in the Citigroup case ($ 700 million) it becomes evident that a settlement of $285 million was an economically convenient solution for Citibank. As Rakoff framed it: “If the allegations of the complaint are true, this is a very good deal for Citigroup. Even if they are untrue, it is a mild and modest cost of doing business.” On the SEC’s side, the “neither admit nor deny settlements” are enabling the Commission to recapture money for investors without being burdened with the costs and efforts of a trial. These arguments are the starting point for Rakoff’s critique. By stating that he was not able to determine whether the settlement was “fair, reasonable and in the public interest,” Rakoff highlighted that he could not draw any facts out of the settlement that would allow him to employ his judicial power and approve the judgment. Rakoff’s hesitation suggests that he will not bless a settlement solely on the basis of the facts from the complaint without any clear statement in the settlement itself. Rakoff further stated that the deference given to the findings of an administrative body should not be understood as absolute: the judicial decision still has to be independent and conditioned upon the question whether the settlement serves the public interest. Otherwise, the constitutional separation of powers would be jeopardized. Explaining the nature of the public interest in the case at hand, Rakoff stressed 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.”
The settlement policy applied in this case allows the SEC to announce victory, despite the defendant not acknowledging defeat. Such a settlement policy restricts private investors from using the defendant’s admission of liability in private civil suits. This is certainly the view Judge Rakoff would take on the issue. Whereas the moral allegations and the desire to redress the public interest seem grounded and appropriate, one has to take a look at the possible consequences such approach could entail. The fundamental question is whether the implementation of Rakoff’s view would result in settlements being fairer and better serving the public interest or in cases moving to trial. If the first scenario were true, settlements including admission of liability would open doors for private plaintiffs to recover losses. It seems though, that the second option is more probable given that the SEC has limited resources to pursue cases. Each case that moves to trial entails huge costs that burden the Commission. Big Wall Street Firms are far better equipped to battle in court and likely to pursue action in trial court rather than settle and admit liability. The more cases move to trial, the less resources the SEC will have to pursue other frauds. If the SEC pursues only a handful of cases, the public interest will be served to an even lesser extent; therefore it is doubtful whether Rakoff’s respectable ideals of truth and morality can be practically implemented.
The Current State of Affairs
On December 16, 2011 the SEC appealed the matter to the Second Circuit. In an official statement, the Director of the Division of Enforcement, Robert Khuzami, accused Rakoff of committing “legal error by announcing a new and unprecedented standard.” Khuzami further added that Rakoff’s view “inadvertently harms investors by depriving them of substantial, certain and immediate benefits.” The following day, the SEC, supported by Citigroup’s memorandum, filed a motion with Rakoff, asking him to stay the proceedings while the appeal is pending in front of the Second Circuit Court. Before Rakoff denied the motion on December 27, the SEC also filed an emergency motion to stay the proceedings before the Second Circuit Court. The appellate court granted temporary halt until January 17, 2012 and until a panel convenes to consider the matter further. The actions the SEC took in front of the Second Circuit Court caused Rakoff to issue a supplemental order on December 29, 2011 that accused the SEC of misleading both the Circuit and the District Court in stressing the urgency to halt proceeding because of the January 3rd deadline for Citigroup to file an answer. Rakoff clarified, that the SEC was aware that Citigroup was planning to move to dismiss the case instead of filing an answer. The very same day the SEC filed a petition for a writ for mandamus. The success of the petition would force Rakoff to approve the settlement.
At the moment, there are no clear predictions as to when the conflict will end — a conflict described as “open warfare.” What remains unsure is whether Rakoff is going to step back eventually and accept the settlement. In 2009 Rakoff refused to approve a settlement of the SEC with Bank of America, but he eventually agreed on a higher settlement in 2010. Whereas a change in the sum of money proved to be sufficient in the Bank of America case, it is doubtful that the same tactic will work in the Citigroup case.