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Once Again, Judge Rakoff Rejects SEC Settlement Agreement

Thursday, December 1, 2011

Tatiana Rodriguez | Bloomberg LawSEC v. Citigroup Global Markets Inc., No. 11-CV-07387 (S.D.N.Y. Filed Oct. 19, 2011) In rejecting the recent consent judgment between the Securities and Exchange Commission (SEC) and Citigroup Global Markets Inc. (Citigroup), Judge Jed S. Rakoff of the U.S. District Court for the Southern District of New York brought to light the issues that arise in granting a regulator's request for injunctive relief based on allegations the defendant neither admits nor denies. Judge Rakoff rejected the settlement agreement, finding both that it was not in the public interest because allegations are an insufficient basis to grant injunctive relief, and that the settlement was not in the investors’ interest. Judge Rakoff has previously rejected or criticized SEC settlements where the defendant neither admits nor denies the allegations.

Procedural History

On October 19, 2011, the SEC and Citigroup entered into a settlement agreement to resolve the SEC's case arising from Citigroup’s alleged misrepresentations with respect to the marketing and structuring of a synthetic collateral debt obligation (CDO). Citigroup allegedly misrepresented to investors that CDO assets were selected by an independent investment adviser, when in fact, Citigroup significantly influenced the selection of assets with the intent to short them—an interest adverse to its investors. The SEC filed with its complaint a proposed final judgment and consent judgment by Citigroup (Consent Judgment). The Consent Judgment would (1) permanently restrain and enjoin Citigroup, its employees, and agents from future violations of Sections 17(a)(2) and (3) of the Securities Act of 1933; (2) require that Citigroup disgorge its profits and pay a civil penalty totaling $285 million; and (3) require that Citigroup take certain internal measures to prevent the recurrence of the securities fraud it allegedly perpetrated. For further detail, see Bloomberg Law Reports®—Securities Law, Citigroup Settles with SEC for Structuring a CDO-Squared Portfolio with the Intent to Short Selected Underlying Assets(Oct. 27, 2011). Following the filing of the Consent Judgment, Judge Rakoff solicited responses from both parties to nine questions regarding SEC settlements. The questions addressed, among others, the following topics: (1) why a court should impose a judgment where the defendant neither admits nor denies the serious securities fraud alleged; (2) whether there is an overriding public interest in determining whether the allegations are true, particularly where there is no parallel criminal case; (3) how the size of the penalty was determined; (4) how the SEC maintains compliance of the injunctive relief provided; and (5) how Citigroup's actions only rose to the level of negligence, as the SEC alleged. The SEC and Citigroup both filed responses and a hearing was held to further address Judge Rakoff's questions. For further discussion on the parties' responses, see Bloomberg Law Reports®—Securities Law, Apples to Apples? A Comparison of Recent SEC Enforcement Actions Involving CDOs (Nov. 17, 2011).

Review of Consent Judgment

The Court stated the standard of review for a consent judgment is whether it is fair, reasonable, adequate, and in the public interest. The Court rejected the SEC and Citigroup's Consent Judgment, stating it was (1) not reasonable because relief cannot be based on allegations; (2) not fair, given the potential abuse in imposing penalties on the basis of facts that are neither proven nor acknowledged; (3) not adequate, given the absence of facts; and (4) not in the public interest for the Court to exercise its authority when it does not know the facts. — Public Interest The Court primarily focused on whether it was in the public interest to approve the Consent Judgment. As an initial matter, the Court addressed the SEC’s argument that the "public interest" element was not part of the Court's standard of review and that even if it was, the SEC was the sole arbiter with that respect. The Court rejected that argument, explaining that since most SEC judgments include requests for injunctive relief, a court is required to consider the public interest before imposing this "extraordinary remedy." Moreover, as various courts have stated, while giving deference to the SEC’s administrative authority, a court must still "satisfy itself" and exercise "a modicum of independent judgment" in determining what is in the public interest. — Neither Admit nor Deny The Court further stated it could not approve the Consent Judgment because the parties had not submitted sufficient evidence, merely allegations. Specifically, the Court explained, it could not base the Consent Judgment solely on allegations that Citigroup neither admits nor denies, as those allegations provide no evidentiary value or collateral estoppel effect. Approving the settlement without knowledge of some underlying facts would render the Court "a mere handmaiden to a settlement privately negotiated." While recognizing the SEC's policy of permitting settling parties to neither admit nor deny the subject allegations, the Court reiterated that the policy prevents the Court from having any basis in fact to provide injunctive relief. The Court further noted this policy does not prevent Citigroup from contesting the allegations in parallel private litigation or otherwise. It is solely prevents Citigroup from denying it in the media. The Court rejected the SEC’s argument that it is sufficient for Citigroup to not deny the allegations, stating it is wrong as a matter of law and unpersuasive as a matter of fact: "An application of the judicial power that does not rest on facts is worse than mindless, it is inherently dangerous." Judge Rakoff observed that accepting settlements without admissions solely benefited the "narrow interest of the parties." For example, Citigroup benefited by (1) only being charged with negligence, (2) receiving a modest penalty, (3) being subject to injunctive relief that Citigroup, "a recidivist," knows will not be enforced, and (4) being required to implement only inexpensive preventive remedial measures for its internal controls for three years. In contrast, Rakoff had difficulty recognizing how the SEC benefited from the settlement, aside from the "quick headline." — Investors' Interests The Court also stated that although the SEC purports to support investors by potentially returning to investors the amount it was to receive from Citigroup, the monetary fine leaves investors substantially short-changed. Additionally, the Court questioned the SEC’s expressed support for private civil actions, as the combination of charging Citigroup solely with negligence and permitting the firm to neither admit nor deny the allegations fails to assist investors. That is, investors cannot bring a private action based on negligence or derive any collateral estoppel from the non-admission/non-denial of the SEC’s allegations. Further, Rakoff observed that where these types of settlements are coupled by modest penalties, they are treated as "a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the truth lies." He stated that Citigroup essentially expressed this position to the Court; Judge Rakoff referred to the $95 million penalty as pocket change to Citigroup. Judge Rakoff concluded by remarking, "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." — Goldman Sachs and Scienter The Court also stated in a footnote that it was "troubled" when comparing the SEC's settlement with Citigroup to the SEC's previous settlement with Goldman Sachs. According to Judge Rakoff, the Goldman Sachs case involved similar, but less egregious, facts, as it was an outside hedge fund—not Goldman Sach's own trading desk -- shorting the CDOs, and Goldman Sachs made a substantially smaller profit of $15 million. Goldman Sachs nonetheless was required to pay a $535 million penalty, significantly greater than the $95 million penalty imposed on Citigroup, which made a $160 million profit. The Court dismissed the SEC's justification that the claims against Goldman Sachs were scienter-based violations, as the SEC did not explain why Goldman Sachs was more culpable than Citigroup. Judge Rakoff further illustrated his confusion in the characterization of Citigroup's conduct as negligent by pointing to language found in a parallel complaintfiled by the SEC against Citigroup’s employee Brian H. Stoker, who was also charged under Section 17(a)(2) and 3, based on his role in structuring and marketing of the CDO at issue. The Court noted that in the Stoker complaint, the SEC's description of Citigroup's conduct is tantamount to an allegation of Citigroup's knowledge and fraudulent intent. But such language is absent in the complaint against Citigroup and the SEC "for reasons of its own charged them with negligence," Judge Rakoff observed. — Trial Date Set The Court consolidated the Citigroup case with the action against Stoker. The trial date was set for July 16, 2012. 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