Fred R. Conrad/The New York TimesJudge Jed S. Rakoff of Federal District Court in Manhattan.As President Ronald Reagan famously said, “There you go again.” Judge Jed S. Rakoff of Federal District Court in Manhattan followed through on Monday with his threats by rejecting another settlement by the Securities and Exchange Commission. This time, he turned down the S.E.C.’s accord with Citigroup over the bank’s sale of mortgage-backed securities that cost investors almost $700 million in losses while the bank garnered profit of about $160 million.
The S.E.C. settles most cases, and the resolution usually involves neither an admission nor denial of liability by the defendant, even if a civil penalty is assessed and an injunction issued that prohibits future violations of federal securities laws. It is this failure to have any acknowledgment of wrongdoing that has gotten under Judge Rakoff’s skin, leading him to reject the settlement because it “is neither fair, nor reasonable, nor adequate, nor in the public interest.”
Judge Rakoff has previously raised questions about how the S.E.C. has settled a case. In 2009, the judge held up the S.E.C.’s settlement with Bank of America over misleading disclosures by the bank in soliciting proxies for its takeover of Merrill Lynch, rejecting a civil penalty that effectively penalized the very shareholders who were misled.
He also hinted at his dissatisfaction with how the Bank of America settlement did not resolve what really harmed investors, or who was responsible for the violation. When he rejected the first settlement, Judge Rakoff pointed out that it came at the “expense, not only of the shareholders, but also of the truth.” He eventually approved a bigger settlement of $150 million in 2010, albeit “reluctantly,” because the resolution was restructured and there was a stronger factual basis for finding the shareholders were not being made to pay the price for any misconduct.
Judge Rakoff’s concern with finding the “truth” about the Citigroup transaction is now the basis for rejecting the proposed settlement because “the court, and the public need some knowledge of what the underlying facts are.” Without some acknowledgment that the S.E.C.’s allegations have a basis in fact, Citigroup had agreed to pay $285 million to dispose of a case quickly.
Judge Rakoff also noted the disparity in the S.E.C.’s treatment of Citigroup and Goldman Sachs, which paid a $550 million penalty to settle civil charges over its sale of a collateralized debt obligation tied to subprime mortgages. At least Goldman was forced to state that its disclosures “contained incomplete information” and that it made a “mistake” in how it marketed the securities. Citigroup did not make a similar acknowledgment and paid a much smaller penalty even though it directly profited on the transaction, which was not the case with Goldman.
In the end, Judge Rakoff was dissatisfied with a settlement that only cost Citigroup what he called “pocket change” as a penalty without any determination that it acted improperly.
The crucial question is whether Judge Rakoff’s decision could lead to an end to the S.E.C.’s policy of settling its cases without any admission of liability by the defendant. Although Judge Rakoff is only one federal district judge, his approach may be influential with other judges who do not wish to be seen as mere “rubber stamps” for the S.E.C.
The rationale for the settlement policy is rooted in a doctrine called “collateral estoppel,” by which a party can use the outcome in one case against the losing side in a second proceeding. For example, if the S.E.C. were to win a judgment against Citigroup, establishing that it defrauded the purchasers of the securities, then these purchasers could rely on that decision to prove their own individual fraud claims against the bank. Citigroup would be “estopped” from denying that its actions violated the law because that issue was already proved in the S.E.C.’s case.
The S.E.C. policy regarding settlements allows the agency to announce a victory, while the defendant does not acknowledge a defeat, so the settlement cannot be used against it by private plaintiffs. It is, if you will, the best of both worlds – the case is concluded favorably for the S.E.C., which usually issues a news release promoting the penalties, while the defendant does not suffer the consequences of an adverse judgment.
For Judge Rakoff, this approach requires the court to be a “handmaiden” to the S.E.C.’s decision to settle the case, using the judicial authority to order payment of a penalty and issuance of an injunction without the benefit of knowing whether the allegations are true. Although the S.E.C. rules do not permit a defendant to deny there was a violation, it is the lack of any admission of wrongdoing that is troublesome.
The S.E.C. has pursued this approach for years, and it is unlikely to change because of the benefits that come from settlements. Requiring some acknowledgment of wrongdoing by defendants is likely to result in fewer settlements and more trials, which are costly for an agency already laboring under budgetary constraints.
One possibility is for the S.E.C. is to try to draft language that permits a defendant to give a nod toward its misconduct without being sufficiently specific to set off any collateral estoppel effect. The Goldman settlement involved carefully drafted language acknowledging a “mistake” and “incomplete information” that did not appear to be enough to establish that it committed securities fraud. That approach may become a template in future cases when a judge raises issues along the lines of Judge Rakoff’s objections.
Another possibility is for the S.E.C. to appeal Judge Rakoff’s decision, asking an appellate court to order him to accept the settlement or reassign the case to a different judge. That would be difficult, however, because it requires seeking a writ of mandamus, which are granted only in extraordinary circumstances.
By rejecting the settlement, Judge Rakoff set the case for trial, which is scheduled to begin in July 2012. Much like the S.E.C.’s complaint against Bank of America, neither side is particularly interested in going into court, so they are likely to try to negotiate a new settlement that meets enough of the judge’s objections to pass muster.
Whether Judge Rakoff would even accept a small admission of wrongdoing by Citigroup along the lines of what Goldman acknowledged remains to be seen. It appears the judge wants something more, i.e. the “truth,” which he may not get.