On November 28, 2011, Judge Jed S. Rakoff, of the U.S. District Court in the Southern District of New York, issued an opinion and order in Securities and Exchange Commission v. Citigroup Global Markets, Inc., No. 11 Civ. 7387, rejecting Citigroup's $285 million settlement offer. This case, brought by the SEC in October 2011, stems from a fund created by Citigroup in early 2007 named Class V Funding III. It will now require the SEC to either appeal the decision, or go back to the drawing board in starting a new settlement with Citigroup which may pass muster before Judge Rakoff.
The SEC alleged that Citigroup used the fund to offload $1 billion of mortgage-backed securities from its balance sheet as the U.S. housing market was beginning to deteriorate. The SEC further claimed that when marketing the securities to investors, Citigroup failed to disclose that they had chosen the underlying securities for the fund and instead stated that an experienced third party investment adviser had hand-selected the securities for the fund. Additionally, Citigroup also failed to disclose to prospective investors that they bought short positions in these same assets that they selected for the fund. In the end, Citigroup realized net profits of around $160 million, while investors in the fund lost more than $700 million.
In its complaint, the SEC charged Citigroup with negligence, in violation of Sections 17(a)(2) and (3) of the Securities Act of 1933. The other, traditional anti-fraud provision, Section 10(b) and Rule 10b-5 thereunder of the Securities Exchange Act of 1934, which requires scienter, was not charged. When filing the complaint, the SEC simultaneously presented a Consent Judgment, in which Citigroup neither admitted nor denied the allegations in the complaint, and agreed to pay $285 million. This payment included $160 million in disgorged profits, $30 million in interest thereon, and a $95 million civil penalty. Citigroup further agreed to implement internal measures designed to prevent future misrepresentations when marketing securities to prospective investors. Unlike in private litigation, when a government agency enters into a Consent Judgment with a defendant, it must be approved by a federal judge.
Applying the standard of review set forth in his prior decision, SEC v. Bank of America Corporation, 653 F. Supp. 2d 507, 508 (S.D.N.Y. 2009), Judge Rakoff held in Citigroup that the proposed Consent Judgment was "neither fair, nor reasonable, nor adequate, nor in the public interest." Judge Rakoff took issue with the fact that Citigroup did not admit or deny the allegations laid out by the SEC, and explained that such a refusal inhibits the Court's ability to decide whether such a settlement is fair, reasonable, adequate, and in the public interest. While the practice of government agencies settling with corporations without an admission of liability has been approved by federal courts around the country for generations, Judge Rakoff reasoned that "the court, and the public, need some knowledge of 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."
With the ability to neither admit nor deny the allegations, Judge Rakoff stressed that the Consent Judgment gave Citigroup a "very good deal," since a $95 million penalty "is pocket change" to a firm that size, and the total $285 million could be written off as "a mild and modest cost of doing business." This was similar analysis to his Bank of America decision two years earlier, where he rejected a $33 million proposed settlement (subsequently a $150 million settlement was approved). Judge Rakoff underscored his intent in similarly rejecting the Citigroup settlement, and instructed both parties to be ready for trial on July 16, 2012.
Shortly after Judge Rakoff issued his opinion, the SEC's Enforcement Director expressed his disappointment and disagreement. Robert Khuzami emphasized that Citigroup's $285 million settlement offer reasonably reflected what the SEC likely would have received after a successful trial, and that Judge Rakoff's opinion ignores an established practice used by government agencies that do not have the resources to take every case to trial. To further his point, Khuzami explained that if the SEC were to take every case to trial, it would take longer for harmed investors to see any recovery, and the SEC would have to "divert resources away from the investigation of other frauds." Moreover, Khuzami countered Judge Rakoff's claim that the SEC's complaint consisted of "mere allegations," and stressed that the complaint listed "reasoned conclusions of the federal agency responsible for the enforcement of the securities laws after a thorough and careful investigation of the facts."
While it is too early to tell whether other courts will adopt Judge Rakoff's order, it is clear that if they do, the SEC may have to change its policy on settling cases with defendants that neither admit nor deny liability. The agency simply does not have the resources to take every case it brings to trial. Keeping that in mind, it is also clear that the SEC could proceed differently when bringing such cases in the future. For instance, the SEC knows that financial firms would rather go to trial than settle and admit full liability on a fraud count. This is because of the negative implications for their securities licenses and investment banking activities both domestically and internationally. For example, states could revoke their licenses and the firms could be disqualified from private placements for a period of time. Specifically, proposed amendments to Reg D and Rule 262 of Reg A for small offerings would disqualify underwriters found to have intentionally violated the anti-fraud provisions. Moreover, the Plaintiffs class action bar would certainly use the "admission" against the firms in their parallel civil actions.
Alternatively, the SEC could follow the approach they used in the settlement reached with Goldman Sachs in July 2010. SEC v. Goldman Sachs & Co., 10 Civ. 3229 (SDNY 2010). In that case, which had similar facts to Citigroup, Goldman acknowledged that marketing materials contained "incomplete information," and that a "mistake" was made in marketing the securities in question to prospective investors. Although that language falls short of admitting full liability, with a record $550 million combined disgorgement and penalty, and a promise to reform their business practices, District Court Judge Barbara S. Jones approved that settlement. While that admission was carefully tailored so as to prevent any collateral estoppel effect in individual investors' actions against Goldman -- such as not saying the information was "material" -- it remains to be seen whether Judge Rakoff would approve a settlement with a similar admission.
Additionally, the SEC also has the option of bringing securities law violations as SEC administrative proceedings. In administrative proceedings, the case is tried before an SEC administrative law judge, the SEC's Rules of Practice govern procedure, and the entire case can be tried and completed generally in less time than a case can be completed in federal court. It is important to note, however, that there is a limit on penalties that the SEC can pursue in administrative proceedings. That is, the SEC currently can seek a maximum of $150,000 for individuals and $725,000 for entities, per violation. Mary Schapiro, Chairman of the SEC, made a significant step towards changing that.
The same day that Judge Rakoff issued his decision in Citigroup, Chairman Schapiro sent a letter to Congress asking that it increase the penalties that the agency can pursue for securities law violations in both civil actions and administrative proceedings. Thus, if the proposed changes were made and the SEC had chosen to bring Citigroup as an administrative proceeding, they could seek the same disgorgement and penalties permitted in federal court. Moreover, they could settle administrative proceedings without the consent of a federal judge; only the ALJ has to approve it.
Chairman Schapiro's proposed changes would also allow the SEC to pursue investor losses in addition to the net profits made as a result of the wrongdoing. Still further, the proposed changes would include increasing the maximum penalty to triple the net profits made, and would allow for that number to be as much as tripled again for repeat offenders. Thus, if these proposed changes were applied to the Citigroup case, the maximum penalty would be $1.4 billion, or nine times the original $160 million disgorgement of profits, regardless of whether it was brought as a civil action or as an administrative proceeding.
Time will tell whether other courts decide to embrace Judge Rakoff's decision. To these authors, that seems unlikely. In the meantime, Chairman Schapiro's latest letter to Congress and the Goldman settlement demonstrate the SEC's willingness to adapt to Judge Rakoff's recent propensity to reject settlements.
If you have questions about the material presented in this alert, please contact any member of Baker Hostetler's Securities Litigation and Regulatory Enforcement Team.
Authorship Credit: Marc D. Powers and Jonathan Nowakowski
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