Federal Judge Rejects Proposed $285 Million Settlement Between SEC And Citigroup
In a sharply-worded order, a federal judge rejected the proposed $285 million settlement between the Securities and Exchange Commission (“SEC”) and Citigroup over a collapsed $1 billion mortgage-bond fund. Ruling that the boilerplate “neither admit nor deny” settlement language employed by the SEC failed to satisfy the required standard in evaluating such settlements, United States District Judge Jed S. Rakoff declined to approve the proposed settlement and added the case to the July 2012 trial docket. While the parties are likely to submit a revised settlement for approval, the decision casts doubt on a long-used practice often used by regulatory agencies.
During early 2007, Citigroup created a billion-dollar fund known as Class V Funding III (the “Fund”) that sought to shed toxic mortgage-backed securities. Citigroup pitched the Fund’s assets to prospective investors as attractive investments that had been handpicked by an independent investment adviser. However, in reality, Citigroup purposely selected a substantial amount of negatively-performing assets for inclusion in the Fund and then took a short position in those assets, betting that their value would decline over time. Investors ended up losing more than $700 million in the deal, while Citigroup reaped net profits of approximately $160 million.
After conducting an investigation, the SEC brought separate civil enforcement actions on October 19, 2011 against Citigroup and a single employee. That same day, the SEC presented for the Court’s approval a proposed consent judgment as to Citigroup that, while neither admitting nor denying the SEC’s allegations, called for (1) the disgorgement of $160 million of ill-gotten gains along with $30 million in pre-judgment interest, (2) a civil penalty of $95 million, and (3) the imposition of certain internal controls for three years. Asserting that the settlement was “fair, reasonable, and in the public interest,” the SEC asked that the settlement be approved.
However, after Judge Rakoff asked both parties to answer several questions concerning the proposed judgment, the SEC retreated from its previous position and asserted that the “public interest…is not part of [the] applicable standard of judicial review.” Finding this position contrary to established Supreme Court precedent, Judge Rakoff concluded that the proposed settlement was “neither fair, nor reasonable, nor adequate, nor in the public interest.” Noting the lack of any evidentiary basis to conclude whether the requested relief was warranted, Judge Rakoff refused to allow the court 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…”
Judge Rakoff appeared most troubled by the SEC’s request to approve a proposed settlement on the basis of allegations unsupported by any proven or acknowledged facts. Asking how it could ever be reasonable to impose substantial relief on the basis of mere allegations, Judge Rakoff concluded he would not approve the settlement. The SEC, said Judge Rakoff, would not be allowed to use a judicial rubber-stamp to avoid carrying out its inherent statutory mission to see that the truth emerges. To exercise judicial power in a scenario without an underlying factual basis was not only mindless, but “inherently dangerous.”
The proposed settlement also would afford no assistance to private litigants, who could not use any admissions to prevent Citigroup from taking a contrary position in a different legal forum. Indeed, by not admitting any wrongdoing, 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. Rather than serve as a deterrent to future conduct, the proposed settlement was more akin to a “mild and modest” cost of doing business imposed by maintaining a relationship with a regulatory agency, and, if the allegations in the complaint were true, was “a very good deal for Citigroup.”
Judge Rakoff also questioned the SEC’s decision to charge Citigroup with negligence instead of fraud-based violations. The distinction is important, for rather than being accused of actual knowledge of wrongdoing, Citigroup instead faced negligence charges that cannot serve as the basis of any future securities claims brought by private investors. Drawing a contrast to the SEC’s earlier settlement with Goldman Sachs (the “Goldman Settlement”), which paid a $535 million penalty after disgorging $15 million in profits in a “similar but arguably less egregious factual scenario,” Judge Rakoff questioned how Citigroup’s $160 million in profits could justify a fine of only $95 million. Additionally, and perhaps hinting at the direction of future negotiations between the SEC and Citigroup, Judge Rakoff pointed to an “express admission” of wrongdoing in the Goldman Settlement that was conspicuously absent in the proposed Citigroup settlement.
In an unusual move, the SEC released a statement from Robert Khuzami, the Director of the Division of Enforcement, defending the settlement and arguing that the bargained-for settlement reached without the risks and resources of a trial may “significantly outweigh” the absence of an admission. Additionally, Mr. Khuzami clarified that the entire settlement would be returned to harmed investors, likely through the establishment of a Fair Fund.
Judge Rakoff set the matter for trial in the July 2012 docket, although it is more likely that the two sides will submit a revised settlement that addresses Judge Rakoff’s concerns. While the Goldman Settlement will likely serve as a starting point due to Judge Rakoff’s implicit blessing, his decision makes it clear that both the amount and culpability of a potential settlement will need to be adjusted in terms of severity to pass judicial muster.
Firm Chairman Burton W. Wiand observed that Judge Rakoff’s decision raises some interesting, but not necessarily novel, questions relating to the SEC’s enforcement program. As an administrative agency, the settlements reached by the SEC are often compromises that allow the agency to extend its resources and enforcement efforts. Judge Rakoff’s experience as a criminal prosecutor seems to have left him with little appreciation for that role. He appears to want to question the decisions of regulators in their area of expertise, which may not properly be his role. That is not to say that the questions he raises may not be valid, but it may simply be that he is not the proper person to give the answers.
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