American Bar Association

Shifting Tides for SEC Settlements: A Sea Change in the Making?

By Eric Rieder, Paul Huey-Burns, and Nikki A. Ott
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You may be interested in the following programs at the Business Law Section 2012 Spring Meeting in Las Vegas, Nevada, March 22-24. Please check the Business Law Section website for updated schedule information and possible changes to program venues.

2012 ABA Business Law Section Spring Meeting

Current Securities Law Issues for Small Business
Friday, March 23, 2012 -- 8:00 AM - 10:00 AM -- Milano IV, Promenade Level
Sponsored by State Regulation of Securities; Cosponsored by Middle Market and Small Business and Federal Regulation of Securities

For years, the Securities and Exchange Commission (SEC) has gone about settling civil enforcement actions in a manner widely accepted by the SEC bar and courts.

Now, in just the past few months, a combination of judicial decisions, internal policy changes, and public commentary has raised uncertainty about whether this practice will continue.

The SEC has traditionally permitted all defendants in civil enforcement proceedings to enter into consent orders without admitting or denying the allegations in the civil complaint. However, beginning with U.S. District Judge Jed Rakoff's November 28, 2011 decision rejecting a proposed settlement in Securities and Exchange Commission v. Citigroup Global Markets, Inc. (the Citigroup action), this longstanding policy has come under criticism in the courts, the press and Congress. In addition, the SEC itself has modified its procedures for settling charges with litigants who are also the subject of parallel criminal proceedings. In early March, a federal judge in Washington rejected another proposed settlement, albeit on different grounds than Judge Rakoff, reflecting the heightened scrutiny of SEC settlements.

Then, just last week, the pendulum swung again. A three-judge panel of the U.S. Court of Appeals for the Second Circuit issued a preliminary stay of Judge Rakoff's ruling. It concluded, based on a preliminary review, that the SEC and Citigroup had shown that it was likely the court would reverse Judge Rakoff's rejection of their settlement and that they would be seriously harmed absent a stay. The panel's decision is not binding on the Second Circuit judges who will hear the appeal, however, and was delivered without the benefit of any counsel arguing on behalf of the district court's position. The court plans to appoint counsel to argue Judge Rakoff's position on the appeal.

While the panel's decision was quite critical of Judge Rakoff's reasoning, it does not definitively resolve the issue. Thus, the result of the controversy remains uncertain, both for the SEC as well as for parties facing SEC investigations. It is still to be seen whether the ultimate effect will be a dramatic change in how the SEC settles cases, more modest adjustments of its procedures, or, as now seems more likely in the wake of the Second Circuit's stay order, little or no change beyond that the SEC has already made on its own.

History of the Citigroup Decision

On October 19, 2011, the SEC Enforcement Division concluded a four-year investigation of Citigroup Global Markets, Inc. (Citigroup) and its conduct in structuring and marketing a collateralized debt option (CDO) called Class V Funding by filing separate civil actions against Citigroup and one of its executives, Brian Stoker. In essence, the SEC alleged that Citigroup benefitted from a decline in the housing market by structuring and selling a CDO that was designed to include poor-quality Citigroup assets from prior CDOs, then taking a short position on those very assets. Despite what the SEC alleged to be an inherent conflict of interest, Citigroup failed to disclose its role in asset selection or its short position to investors.

The SEC's complaint included allegations one would expect to see in suits alleging scienter-based fraud. For example, the SEC referred to the action as one for "securities fraud." The SEC also stated that Citigroup "knew or should have known that [marketing materials], by failing to disclose Citigroup's role in the selection of the investment portfolio, was inaccurate and misleading," and that Citigroup deliberately structured the Class V transaction as a "prop trade" in which Citigroup knew that it would short assets for its own account, but that Citigroup "did nothing to ensure that the marketing documents accurately disclosed Citigroup's actual interest in the collateral." Despite these fraud-like allegations, the SEC charged Citigroup with violations of sections 17(a)(2) and (a)(3) of the Securities Act of 1933, which only require that the SEC show negligence. Securities fraud allegations under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder (as well as section 17(a)(1) of the 1933 act) require proof of scienter.

As is typical where the Enforcement Division staff negotiates a settlement prior to filing an enforcement action, Citigroup and the SEC announced they had settled the charges simultaneously with filing the complaint in the Southern District of New York. Under the terms of the proposed settlement, which required approval from the U.S. district court, Citigroup would (1) neither admit nor deny the SEC's allegations; (2) be permanently enjoined from future violations of sections 17(a)(2) and (a)(3) of the Securities Act; and (3) overhaul its procedures for reviewing and approving CDO transactions for three years. In addition, Citigroup agreed to a $285 million payment, comprised of $160 million in disgorged profits, $30 million in prejudgment interest, and a $95 million civil penalty.

Judge Rakoff's Decision

Judge Rakoff challenged the proposed settlement. He ordered both parties to explain why the proposed settlement was "fair, reasonable, adequate, and in the public interest." His order questioned, among other things, why he should approve a settlement in a case alleging serious securities fraud when the defendant neither admitted nor denied wrongdoing, how the SEC monitors compliance with and enforces injunctions against future violations of the securities laws, and how a securities fraud of such magnitude could be the result of negligence rather than intentional misconduct.

Both the SEC and Citigroup responded to Judge Rakoff's queries in briefs and at a hearing. The SEC's responses focused heavily on the permissible scope of Judge Rakoff's review, the practicalities underlying the SEC's policy permitting no admit/deny settlements, and the possible harm to the SEC's ability to efficiently prosecute enforcement actions and resulting harm to the public that would result if the SEC were no longer able to enter into no admit/deny settlements.

Judge Rakoff issued his decision on November 28, 2011. He rejected the proposed settlement in its entirety, holding that it was "neither fair, nor reasonable, nor adequate, nor in the public interest." Judge Rakoff sharply criticized the mismatch between the SEC's allegations of fraud and its decision to only charge Citigroup with negligent misconduct. He emphasized that the SEC's complaint in the Stoker action accused Citigroup of knowing misconduct in structuring and selling the Class V transaction--an allegation that was not included in the Citigroup complaint. Judge Rakoff further rejected the SEC's arguments that he should not consider the public interest in deciding whether to approve the settlement, noting that evaluation of the public interest in a necessary element of any reward of injunctive relief.

The proposed penalties imposed on Citigroup also came under fire. Judge Rakoff characterized the proposed $285 million payment as "very modest," "pocket change," and "just a cost of doing business" for a company the size of Citigroup. Finally, Judge Rakoff gave little weight to the value of obtaining the proposed injunctive relief, noting that the SEC rarely, if ever, seeks to hold recidivist defendants in contempt for violating prior injunctions.

In the most controversial part of the decision, Judge Rakoff challenged the validity of no admit/deny settlements. Specifically, he refused to issue an injunction, enforced by the court's contempt power, in the absence of any admitted or proven facts. Judge Rakoff criticized the SEC policy permitting such settlements as "hallowed by history, but not by reason," and stated that, absent facts on which to base a decision, "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." Judge Rakoff further decried the fact that private litigants cannot use the allegations in a no admit/deny complaint and settlement for collateral estoppel purposes in private actions, a problem compounded in this case because investors cannot pursue private securities fraud claims based on negligence.

The Aftermath

The Citigroup decision provoked a strong reaction. The SEC's director of enforcement, Robert Khuzami, promptly issued a public statement criticizing the decision. Mr. Khuzami referenced statutory provisions that appear to limit penalties on a "per violation" basis (although defense lawyers have in some cases argued that the SEC has sometimes calculated instances of violations in a way that results in penalties that exceed "ill-gotten gains"). Mr. Khuzami also stated that the Citigroup decision "disregards the fact that obtaining disgorgement, monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission when that relief is obtained without the risks, delay, and resources required at trial."

The SEC and Citigroup both appealed the decision to the Second Circuit. The SEC also filed a petition for mandamus, an alternative route to obtain appellate review. Mr. Khuzami expressed the SEC's belief that Judge Rakoff "committed legal error by announcing a new and unprecedented standard that inadvertently harms investors." The SEC and Citigroup also sought a stay of Judge Rakoff's order pending the resolution of the appeals and mandamus petition.

Initially, the Second Circuit granted a temporary stay. Then, on March 15, the Second Circuit issued a per curiam decision turning that temporary relief into a full stay pending its decision on the appeal and mandamus petition.

The Second Circuit's decision did not decide the appeal, which will be done after further briefing by a separate "merits panel"; it simply assessed the "likelihood of success on the merits" in deciding whether the criteria for a stay were met. In its analysis of likelihood of success, however, the stay panel rejected the key points in Judge Rakoff's analysis. Signficantly, the panel held that the district court had not given appropriate deference to the SEC's policy judgment that the settlement was in the public interest, including in regard to the allocation of government resources. The court also questioned whether it was proper for the district court to question Citigroup's judgment that the settlement was in its interest; it expressed its doubts about an approach that would allow for second-guessing the decisions of such a "private, sophisticated, counseled litigant."

The court seemed particularly skeptical of Judge Rakoff's focus on the lack of a binding admission of liability by Citigroup under the settlement, and suggested that requiring such an admission would often make settlement practically impossible. It stated: "Finally, we question the district court's apparent view that the public interest is disserved by an agency settlement that does not require the defendant's admission of liability. Requiring such an admission would in most cases undermine any chance for compromise."

Recognizing that both the SEC and Citigroup sought to overturn Judge Rakoff's decision, the panel noted that its "ruling is made without benefit of briefing in support of the district court's position. . . ." It directed that counsel be appointed to argue in support of the district court's position.

Before the Second Circuit issued its stay, at least two other federal judges echoed Judge Rakoff's concerns regarding no-admit/deny settlements between the SEC and private parties. On December 20, 2011, Judge Rudolph T. Randa of the United States District Court for the Eastern District of Wisconsin initially refused to approve a settlement between the SEC and Koss Corporation and its CEO, Michael Koss. Citing the Citigroup decision, he directed the SEC to submit "a written factual predicate for why it believes the Court should find that the proposed final judgments are fair, reasonable, and in the public interest." The SEC defended the settlement in a brief filed on January 24, 2012. In a footnote, the SEC further argued that Judge Rakoff erred in holding that a reviewing court must find that a settlement is in the public interest, and that it only need find that a settlement is fair, reasonable, and adequate.

Unlike Judge Rakoff, however, Judge Randa ultimately approved the SEC's settlement with Koss Corporation. He stated that the SEC's response "largely satisfie[d] the Court's concerns," provided that the SEC agreed to revise the proposed judgments to provide greater specificity. The court entered final judgments on February 23, 2012.

In addition, Judge Renée Marie Bumb of the United States District Court for the District of New Jersey, issued an order on February 22, 2012, in Federal Trade Commission v. Circa Direct, et al., Case No. 11-civ-2172 (D.N.J.), challenging a no admit/deny settlement of charges of violations of the Federal Trade Commission Act. Judge Bumb has ordered the parties to submit briefs responding to four questions which center on whether the standard that Judge Rakoff applied in Citigroup applies in the case before her and whether, given the lack of any admission of wrongdoing, the settlement is fair, adequate, and in the public interest. The parties' responses were due March 14, 2012.

The issue has also been posed to Judge William H. Pauley III in the antitrust context. On March 6, 2012, the Department of Justice filed in United States v. Morgan Stanley, Inc., Case No. 11-civ-6875 (S.D.N.Y.), copies of public comments and its responses concerning a proposed settlement of charges of civil antitrust violations against Morgan Stanley. The AARP and the Public Service Commission of the state of New York both urged Judge Pauley to reject the settlement, in part based on the fact that Morgan Stanley neither admits nor denies any wrongdoing. Both commenters cited the Citigroup decision in their comments.

Further, Judge Richard A. Jones of the United States District Court for the Western District of Washington earlier this month rejected a proposed settlement between the SEC and three defendants in a case involving an alleged $300 million Ponzi scheme. Judge Jones took issue with the fact that the SEC requested that the court enter judgments on injunctive relief now as part of approving the settlement, but reserve decisions on monetary relief for the future. While Judge Jones' decision did not discuss the same concerns raised by Judges Rakoff and Randa, this latest rejection reflects the heightened scrutiny of SEC settlements.

Congress, too, has taken an interest in the SEC's use of no admit/deny settlements. On December 16, 2011, the House Financial Services Committee announced that it would hold a hearing to examine the SEC's settlement policy, citing to the concerns Judge Rakoff expressed in the Citigroup decision. The committee has not yet scheduled the hearing.

Changes to the SEC's Settlement Policies

In addition to the possible changes that may stem from the Citigroup decision, the SEC has made its own changes. On January 6, 2012, the SEC announced a new policy under which any defendant who has been found guilty of or who has admitted to engaging in criminal conduct, either by conviction or by entering into a nonprosecution or deferred prosecution agreement (NPA or DPA, respectively) that contains admissions or acknowledgments of criminal conduct, will be prohibited from settling parallel SEC charges without admitting the SEC's allegations.

The new policy also permits the SEC staff to include in settlement documents the fact and nature of the criminal conviction or NPA or DPA, and, importantly, any relevant facts that the defendant may have admitted during a plea allocution or in the NPA or DPA. As in the past, defendants will be prohibited from denying the SEC's allegations or suggesting that they are not based in fact.

The SEC's new policy will not affect the majority of SEC enforcement proceedings. Rather, it applies only to enforcement proceedings in which (1) a defendant is also subject to parallel criminal proceedings and (2) the defendant has admitted or acknowledged criminal conduct. It is unclear, however, whether the policy will evolve and affect other situations, such as civil actions involving multiple defendants or separate cases involving related conduct. For example, it remains to be seen whether the SEC will begin to insist that a settling corporate defendant admit facts admitted by an officer or director in a related criminal proceeding (or in an administrative proceeding in which the SEC has made "findings" of misconduct).

Future Impact

The fate of no admit/deny settlements with the SEC (or other federal agencies, for that matter) is undetermined. Should the Second Circuit uphold the Citigroup decision (which now must be considered unlikely following the panel's stay decision), the SEC will be forced to reexamine and perhaps overhaul its settlement procedures. In this scenario, the SEC will only be able to seek injunctive relief, including mandatory prophylactic measures, if the defendant provides some sort of admission or proof of wrongdoing. Judge Rakoff appears to have telegraphed his preference for this procedure in footnote seven of the Citigroup decision, in which he compared the Citigroup settlement with the SEC's 2010 settlement of similar charges against Goldman Sachs. The Goldman Sachs settlement involved not only a much larger financial penalty and evidence of extensive cooperation with the SEC, but also Goldman Sachs' admission that the marketing materials at issue "contained incomplete information," that Goldman Sachs made a mistake in issuing such incomplete information, and that "Goldman regrets that the marketing materials did not contain that disclosures."

The SEC's recent changes to its policy for settling with civil litigants subject to parallel criminal investigations may, in fact, be the first step along this road, despite the fact that the SEC expressly denied that the Citigroup decision, which did not involve parallel criminal proceedings, spurred the policy change. Although the new policy only affects a limited subset of SEC enforcement actions, settlements that meet the new SEC standard are more likely to satisfy the standard set forth in the district court's Citigroup decision.

Alternatively, the SEC may settle cases in a manner that does not require court approval of injunctive relief. For instance, the SEC may increase its use of administrative proceedings, opting for cease-and-desist orders rather than injunctive relief. This may be an attractive solution, particularly in light of the fact that the SEC invariably seeks permanent injunctions prohibiting future violations of the securities laws, but rarely enforces those injunctions, even against defendants with long histories of settled violations. As the SEC admitted in the Citigroup action, it has not pursued civil contempt proceedings against a large financial institution in at least 10 years, and it has no statutory authority to seek criminal contempt. Instead, when faced with a recidivist defendant, it brings a new enforcement action (although it may take prior actions into account in deciding what penalities to seek).

As suggested by the Second Circuit, Judge Rakoff's reasoning represents a significant departure from current standards for approving settlements with the federal government. Indeed, the SEC's practicality arguments, which SEC Chairwoman Mary Schapiro recently reiterated while staunchly defending its policy of permitting no admit/deny settlements at a news media breakfast on February 22, 2012, clearly resonated with the Second Circuit panel deciding the stay request. So too did the separation of powers concerns presented by a district judge rejecting an agency's judgment about when and how to settle a case. If the Second Circuit merits panel applies the reasoning of the stay panel, the SEC may not need to change its approach to settlement at all. Yet even if it prevails, the SEC may seek to foreclose public or legislative criticism by making some changes, as it chose to with respect to settlements in cases involving parallel criminal actions. The answers to the questions raised by the Citigroup decision may not emerge until after the Second Circuit, Congress, and the SEC itself have contributed to the current debate. Until that time, the future of the SEC's settlement procedures and policies will remain unsettled.

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