Siding with SEC, Second Circuit Vacates Judge Rakoff’s Rejection of ‘No Admit’ Settlement in Citigroup Case

June 6, 2014

Today, the U.S. Court of Appeals for the Second Circuit vacated U.S. District Judge Jed S. Rakoff’s decision rejecting an “admit no fault” consent judgment between the Securities and Exchange Commission (SEC) and Citigroup Global Markets. From the outset, this case has provided fodder for the debate over whether the SEC should crack down harder on securities fraudsters by requiring admissions of guilt and other penalties in negotiated settlements.

The case stems from Citigroup’s structuring, marketing and sale of a billion-dollar fund, known as the Class V Funding III. The SEC brought suit in 2011, alleging that Citigroup had told investors that the fund’s investment portfolio was chosen by an independent investment advisor when in fact Citigroup itself had “selected a substantial amount of negatively projected mortgage-backed assets in which Citigroup had taken a short position.” The SEC alleged that Citigroup reaped a profit of $160 million on its short position, while the fund’s investors suffered millions of dollars in losses.

At the same time it filed suit, the SEC negotiated a proposed consent judgment with Citigroup, and presented it to Judge Rakoff for approval. Under the proposed consent judgment, Citigroup agreed to a permanent injunction barring it from violating federal securities laws; the disgorgement of $160 million; payment of prejudgment interest; and payment of a civil penalty, among other provisions. The consent decree did not call for the admission of guilt or liability by Citigroup or anyone involved.

Very quickly, Judge Rakoff made clear that he was not in the business of rubber-stamping proposed settlements. In advance of his initial hearing, Judge Rakoff issued a number of pointed questions to the parties, 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 wrongdoing?”, and “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?”

After a contentious hearing during which Judge Rakoff grilled the SEC, he issued an order declining to approve the consent judgment, finding it “neither fair, nor reasonable, nor adequate, nor in the public interest … because it does not provide the Court with a sufficient evidentiary basis to know whether the requested relief is justified.” Judge Rakoff went on to state: “[W]hen a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant … the court, and the public, need some knowledge or 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.”

The SEC and Citigroup appealed and, in a strongly worded opinion, the Second Circuit vacated Judge Rakoff’s order. In what can only be viewed as an unqualified victory for the SEC, the Second Circuit held that Judge Rakoff abused his discretion by applying too high a standard in reviewing the consent order and failing to give the SEC proper deference in its decisions to resolve the case on its own terms.

At the outset, the Second Circuit made clear that the “decision to require an admission of liability before entering into a consent decree rests squarely with the SEC.” The appeals court then went on to clarify the proper standard for reviewing a proposed consent judgment involving an enforcement agency. The appeals court held that a district court must determine that the proposed consent decree is “fair and reasonable, with the additional requirement that the ‘public interest would not be disserved’ … in the event that the consent decree includes injunctive relief.”

Significantly, the Second Circuit went on to stress that there is no need for district courts to determine whether a proposed consent decree is adequate. Distinguishing SEC actions from class actions (where court only approve settlements upon a showing that they are “fair, reasonable and adequate” to all class members), the Second Circuit found that SEC actions did not pose the same adequacy concerns as class actions settlements.This is because in class actions all class members release their claims against the defendants, while SEC enforcement actions generally do not bar private investors from pursing their own actions.

Turning to Judge Rakoff’s decision, the Second Circuit found that he abused his discretion by requiring that the SEC to “establish the ‘truth’ of the allegations against a settling party as a condition for approve the consent decrees.” As the Second Circuit put it: “Trials are primarily about the truth. Consent decrees are primarily about pragmatism.” Recognizing that consent decrees “provide parties with a means to manage risk,” the Second Circuit found that the SEC, not the district court, is best positions to assess the litigation risks. “It is not within the district court’s purview to demand ‘cold, hard, solid facts, established either by admission or by trials’, as to the truth of the allegations in the complaint as a condition for approving a consent decree.”

Moving on to the “public interest” analysis, the Second Circuit held: “The job of determining whether the proposed SEC consent decree best serves the public interest … rests squarely with the SEC, and its decision meters significant deference.” Because Judge Rakoff made no finding that the injunctive relief proposed would “disserve the public interest”, the Second Circuit remanded the case back to Judge Rakoff. But, as guidance, the appeals court noted that a consent decree that barred private litigants from pursing their own claims “may” disserve the public interest.

For those hoping that Judge Rakoff’s crackdown on so-called “no admit” settlements would lead to stronger penalties and more guilty admissions from fraudsters, this decision is a setback. The real winner is the SEC. The Second Circuit’s decision strongly affirms the deference accorded to the SEC in resolving its enforcement actions. While the SEC has recently expanded its policy to require defendants to admit fault under certain texts, as discussed here, today’s decision affirms the SEC’s flexibility, as acknowledged in SEC Enforcement Director Andrew Ceresney’s statement on the ruling:

“We are pleased with today’s ruling by the Second Circuit Court of Appeals reaffirming the significant deference accorded to the SEC in determining whether to settle with parties and on what terms. While the SEC has and will continue to seek admissions in appropriate cases, settlements without admissions also enable regulatory agencies to serve the public interest by returning money to harmed investors more quickly, without the uncertainty and delay from litigation and without the need to expend additional agency resources.”

But there is another important takeaway for investors. The Second Circuit’s decision underscores the important role of private litigants in enforcing the securities laws and supplementing SEC enforcement actions. In fact, one reason the Second Circuit accorded so much deference to the SEC was because, in many cases, private investors can pursue independent remedies apart from the SEC action. Furthermore, it is no secret that private investors have had greater success than the SEC in returning money to investors. In an amicus brief submitted to the Supreme Court in the Halliburton case, the Council of Institutional Investors noted that the SEC disbursed $54 million to harmed investors in 2013. “In comparison,” the brief continued, “settlements of private securities class-action suits yielded $2.9 billion in 2012, the majority of which went into investors’ pockets.” Such comparisons underscore the important role private investors play in the policing of our federal securities laws.

In the meantime, the ball is back in your court, Judge Rakoff.

For copy of the Second Circuit’s decision, click here.