In May 2010 I wrote about the settlement on the Goldmans case questioning the SEC approach to settlements. Similar issues have now arisen surrounding the SEC settlement on the investigation into Citigroup and its activities in the sub prime market – the difference being that this time it is the judge who was asked to ratify the settlement who is questioning the process.
The Opinion and Order of the District Judge Jed Rakoff dated 28 November 2011 makes interesting reading [ U.S. Securities and Exchange Commission v Citigroup Global Markets Inc 11 Civ.7387 (JSR) United States District Court S.D. New York ] and although his comments are directed in relation to the injunctions that the SEC were seeking against Citigroup as part of the settlement, they are nonetheless important to the overall approach that is increasingly being adopted by other regulators.
The SEC allegation was that when “Citigroup realized in early 2007 that the market for mortgage-backed securities was beginning to weaken, Citigroup created a billion-dollar Fund (known as “Class V Funding III”) that allowed it to dump some dubious assets on misinformed investors. This was accomplished by Citigroup’s misrepresenting that the Fund’s assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negatively projected assets and had then taken a short position in those very assets it had helped select.”
Citigroup realised net profits of around $160m by adopting this approach it was alleged.
The judge quoted a parallel complaint against a Citigroup employee where the SEC had alleged in that complaint that “Citigroup knew it would be difficult to place the liabilities of [the Fund] if it disclosed to investors its intention to use the vehicle to short a hand-picked set of [poorly rated assets] …. By contrast, Citigroup knew that representing to investors that an experienced third-party investment adviser had selected the portfolio would facilitate the placement of the [Fund’s] liabilities.” The judge thought this appeared to be tantamount to an allegation of knowing and fraudulent intent but the SEC for reasons of its own chose to charge Citigroup only with negligence, in violation of Sections 17 (a)(2) and (3) of the Securities Act and submitted to the Court the Consent Judgement for approval which included the recitation that Citigroup consented to the entry of the consent judgement without admitting or denying the allegations of the complaint. This consent judgement included permanent restraints enjoining Citigroup and its agents and employees from future violations of sections 17 (a)(2) and (3) of the Securities Act and required Citigroup to disgorge $160m in profits, pay $30m in interest and pay a civil penalty of $95m and to undertake certain internal measures to prevent recurrences of the securities fraud allegedly perpetrated.
The Court decided it was unable to approve the consent judgement “because the Court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.”
The consent judgement needed to fulfil 4 criteria that were set out in SEC v Bank of America Corp of being fair, reasonable, adequate and in the public interest. The SEC in this case tried to argue that the public interest was not part of the applicable standard of judicial review. The judge disagreed because the SEC were seeking an injunction forbidding future violations and asking the Court to enforce prophylactic measures for three years and in his view the Supreme Court had repeatedly made clear that a court cannot grant the extraordinary remedy of injunctive relief without considering the public interest.
The judge came to the conclusion that the consent judgement sought was neither fair, nor reasonable, nor adequate nor in the public interest. Most fundamentally because the SEC did not provided the Court with sufficient evidentiary basis to know whether the requested relief was justified under any of the standards and if the Court were to become a mere handmaiden to a privately negotiated settlement on the basis of unknown facts then the public are deprived of ever knowing the truth in a matter of obvious public importance.
“Here, the S.E.C.’s long-standing policy – hallowed by history, but not by reason – of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.” The judge noted it was clear that Citigroup intended to contest the SEC’s allegations whereas in contrast the SEC took the position that because Citigroup did not expressly deny the allegations the Court and the public somehow knew the truth of the allegations.
“As for common experience, a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, 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 real truth lies. This, indeed, is Citigroup’s position in this very case.”
The judge went on to say: “Of course, the policy of accepting settlements without any admissions serves various narrow interests of the parties. In this case, for example, Citigroup was able, without admitting anything, to negotiate a settlement that (a) charges it only with negligence, (b) results in a very modest penalty, (c) imposes the kind of injunctive relief that Citigroup (a recidivist) knew that the S.E.C. had not sought to enforce against any financial institution for at least the last 10 years, see SEC Mem. at 23, and (d) imposes relatively inexpensive prophylactic measures for the next three years. In exchange, Citigroup not only settles what it states was a broad- ranging four-year investigation by the S.E.C. of Citigroup’s mortgage-backed securities offerings, Tr. 27, but also avoids any investors’ relying in any respect on the S.E.C. Consent Judgment in seeking return of their losses. If the allegations of the Complaint are true, this is a very good deal for Citigroup; and, even if they are untrue, it is a mild and modest cost of doing business.
It is harder to discern from the limited information before the Court what the S.E.C. is getting from this settlement other than a quick headline. By the S.E.C.’s own account, Citigroup is a recidivist, SEC Mem. at 21, and yet, in terms of deterrence, the $95 million civil penalty that the Consent Judgment proposes is pocket change to any entity as large as Citigroup. While the S.E.C. claims that it is devoted, not just to the protection of investors but also to helping them recover their losses, the proposed Consent Judgment, in the form submitted to the Court, does not commit the S.E.C. to returning any of the total of $285 million obtained from Citigroup to the defrauded investors but only suggests that the S.E.C. “may” do so. Consent Judgment at 3. In any event, this still leaves the defrauded investors substantially short-changed. To be sure, at oral argument, the S.E.C. reaffirmed its long-standing purported support for private civil actions designed to recoup investors’ losses. Tr. 10. But in actuality, the combination of charging Citigroup only with negligence and then permitting Citigroup to settle without either admitting or denying the allegations deals a double blow to any assistance the defrauded investors might seek to derive from the S.E.C. litigation in attempting to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence, see, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), but also cannot derive any collateral estoppel assistance from Citigroup’s non-admission/non- denial of the S.E.C.’s allegations.”
The judge went on to say that it could not be reasonable to impose substantial relief on the basis of mere allegations, it was not fair because the potential for abuse in imposing penalties on facts that were unproven nor acknowledged were patent. It was not adequate because there was no framework to determine adequacy and it was not in the public interest because the Court was being asked to employ its power and assert its authority when it did not know the facts.
The judge went on to say 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. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”
The SEC intend to appeal this judgement but the principles have wider application to any regulatory agency that adopts an enforcement approach of imposing penalties on the basis that the targets are permitted to avoid admitting or denying the allegations made against them.
Change will only ever come about if large financial institutions are not able to get away with flaunting rules by paying their way through a series of penalties which do not require them to admit or deny the allegations against them.
©Jaitly LLP