United States: SEC And Regulatory Settlements: A New Era?

In late 2011, the Securities and Exchange Commission (SEC) sued Citigroup Global Markets (Citigroup) in connection with its 2007 structuring and marketing of a $1 billion CDO. That same day it announced a proposed agreement to settle the matter for $285 million and other relief. Neither event was particularly remarkable. Ninety percent of SEC cases are resolved by settlement, and nine-figure SEC settlements are no longer out of the ordinary. Nor was it unusual for the SEC to announce the lawsuit and settlement simultaneously. Corporations frequently cooperate with the SEC during the agency's pre-filing investigations, and part of that process often involves a negotiated resolution prior to the formal filing of a claim.

What was noteworthy is what did — or didn't — happen next. Calling it unfair, unreasonable, inadequate, and not in the public's interest, United States District Court Judge Jed Rakoff rejected the settlement in an opinion that has generated widespread attention and concern in the legal and business communities. See Opinion and Order, SEC v. Citigroup Global Mkts. Inc., 2011 U.S. Dist. LEXIS 135914 (S.D.N.Y., Nov. 28, 2011) (Citigroup). Does this provocative decision signal a new, more stringent, and more disconcerting standard in settling regulatory enforcement actions?

The Role of the Court

In most civil actions, a court is not required to approve a settlement. In general, the federal rules require the court to enter judgment when parties agree on settlement terms before trial. Fed.R.Civ.P. 68. However, settlements in certain cases — frequently those involving shareholders and regulators — do require court approval. For example, settlements in representative class and derivative actions are conditioned on court approval "only after a hearing and on finding that [they are] fair, reasonable, and adequate." Fed.R.Civ.P. 23(e), 23.1(c). Because of inherent conflicts of interest and the possibility of collusive settlements, the law has long required court approval in similar cases involving trustees and guardians in order to protect incompetent or absent parties. See Hon. Jed S. Rakoff, Are Settlements Sacrosanct? 37 ABA Litigation J. no. 4 at 16 (Summer 2011) (Are Settlements Sacrosanct?).

The requirement of court approval for settlements in cases involving regulators such as the SEC, however, rests on a different footing. There is little need for a court to be concerned that sophisticated and well-represented parties such the SEC or large corporations are unable to determine whether a settlement is in their best interests. Instead, court approval in these cases is required because the settlement terms invoke the court's continuing jurisdiction. These terms typically include injunctive relief, which subjects the parties to the court's power to enforce the settlement's non-monetary provisions, such as a defendant's promise to implement certain corporate governance measures or not to violate the securities laws in the future. Thus the court itself essentially becomes a party to the settlement. See Citigroup, 2011 U.S. Dist. LEXIS 135914 at *10 ("a public agency asks a court to become its partner in enforcement" when it seeks injunctive remedies). The court order approving the settlement is generally embodied in a consent judgment or decree, which allows the agreement to be enforced by judicial oversight and sanctions. Injunctive relief, and thus consent judgments, have long been favored by administrative agencies like the SEC. See 15 U.S.C. §78u(d); SEC v. Vitesse Semicondutor Corp., 771 F. Supp. 2d 304, 308 (S.D.N.Y. 2011) (prior to 1972, SEC's enforcement powers largely limited to injunctive relief).

In evaluating a proposed SEC settlement, the court examines the agreement not only for its fairness, reasonableness, and adequacy but also for whether its terms are in the public's interest. See, e.g., S.E.C. v. Bank of America, 653 F. Supp. 2d 507, 508 (S.D.N.Y. 2009). To a large extent, these factors all merger together. See Citigroup, 2011 U.S. Dist. LEXIS 135914 at * 9 (consideration of the public interest is not "meaningfully severable from the requirements ... that the consent judgment be fair, reasonable, and adequate; for all these requirements inform each other"). This "public interest" aspect traces its roots at least to the 1970s and has been used in courts' analyses of proposed settlements in a variety of cases, including antitrust, environmental, civil rights, and trade regulation suits. See, e.g., United States v. Miami, 614 F.2d 1322, 1333 (5th Cir. 1980) (Title VII); FTC v. Onkyo U.S.A. Corp., 1995 U.S. Dist. LEXIS 21222 (D.D.C. 1998);United States v. Hooker Chemicals & Plastics Corp., 540 F. Supp. 1067, 1072 (W.D.N.Y. 1982) (environmental); 15 U.S.C. § 16(b)-(d) (antitrust); see also Citigroup, 2011 U.S. Dist. LEXIS 135914 at *7 ("The Supreme Court has repeatedly made clear . . . that a court cannot grant the extraordinary remedy of injunctive relief without considering the public interest.") (citation omitted).

In evaluating a proposed settlement, it is not the court's role to resolve the merits of the dispute or to drive the parties to what it thinks is the best bargain. See United States v. Cannons Engineering Corp., 899 F.2d 79, 84 (1st Cir. 1990) ("The relevant standard . . . is not whether the settlement is one which the court itself might have fashioned, or considers as ideal...."); SEC v. Randolph, 736 F.2d 525, 529 (9th Cir. 1984) (approval should not be conditioned on what the court considers "to be the public's best interest") (emphasis in original); Citizens for a Better Env't v. Gorsuch, 718 F.2d 1117, 1126 (D.C. Cir. 1983) (the court "need not inquire into the precise legal rights of the parties nor reach and resolve the merits of the claims"). Given the SEC's position as an expert public agency and its lack of a direct financial stake in the outcome (as compared, for example, to cases where counsel are awarded fees contingent on approval of the settlement), courts ordinarily give considerable deference to the SEC's decision to settle on the proposed terms. See, e.g., See Cannons Engineering Corp., 899 F.2d at 84 ("Respect for the agency's role is heightened in a situation where the cards have been dealt face up and a crew of sophisticated players, with sharply conflicting interests, sit at the table. That so many affected parties, themselves knowledgeable and represented by experienced lawyers, have hammered out an agreement at arm's length and advocate its embodiment in a judicial decree, itself deserves weight in the ensuing balance."); S.E.C. v. Randolph, 736 F. 2d 525, 529 (9th Cir. 1984).

A New Standard?

Against this backdrop, Judge Rakoff's rejection of the proposed Citigroup settlement, coupled with increased scrutiny of settlements in other recent cases, stands in stark contrast, both for the relatively minimal deference accorded the SEC's own analysis and for the factors considered in rejecting that proposed settlement.

In Citigroup, the SEC claimed that investors lost $700 million while Citigroup realized a profit of $160 million. The gist of the SEC's complaint, which charged Citigroup with negligent rather than intentional wrongdoing, was that Citigroup had created a billiondollar fund supported by "dubious" mortgage-backed assets. Citigroup purportedly misrepresented the fund's assets as attractive investments selected by an independent advisor when in fact Citigroup had arranged to include weak assets in which it had taken a short position. Citigroup, 2011 U.S. Dist. LEXIS 135914 at *1-2. The proposed consent judgment required the company to pay $285 million in disgorgement and fines, "permanently restrained and enjoined" Citigroup from future securities law violations, and obligated it to undertake various internal measures to prevent a recurrence of the alleged conduct. As has long been the practice in settlement agreements in both private and regulatory suits, the proposed judgment expressly provided that Citigroup neither admitted nor denied the SEC's allegations.

In rejecting the proposed settlement, the court repeatedly acknowledged the substantial deference to be accorded the SEC's recommendation. Nevertheless, the court determined that it lacked sufficient information to conduct its own evaluation of the agreement. Specifically, the court found that it had no "proven or admitted facts upon which to exercise even a modest degree of independent judgment." Citigroup, 2011 U.S. Dist. LEXIS 135914 at * 5. The allegations of the complaint, themselves "not evidence of anything," were insufficient. Id. at *13; see also id. at *19 ("how can it ever be reasonable to impose substantial relief on the basis of mere allegations?"). The court recognized the potential for abuse in imposing penalties without proven or acknowledged facts. Id. at *20. Ostensibly, a powerful government agency could coerce a defendant faced with protracted, expensive litigation to settle on unfavorable terms even where there is no real basis for liability. See id. at *11 (lack of information "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"). Judge Rakoff found that this factual deficiency was "dangerous," explaining that the exercise of judicial power on mere allegations can act as "an engine of oppression." Id. at *20; see also id. at *10 (the court must "be satisfied that it is not being used as a tool to enforce an [unfair, etc.] agreement"). The court held that its approval must be based upon "facts[] established either by admissions or by trials." Id. at 20.

Even so, it is clear that the court's concern with the proposed agreement was not that the defendant was being oppressed but that it was getting off too easily. The court questioned why Citigroup had been charged only with negligence when a related SEC complaint claimed that it had acted with "knowing and fraudulent intent." Citigroup, 2011 U.S. Dist. LEXIS 135914 at *3. It viewed the proposed penalty as "pocket change," the prophylactic internal measures as "inexpensive," and the injunctive relief as essentially meaningless since the SEC had not sought to enforce similar provisions for at least 10 years. Id. at *15. In the court's mind, "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." Id.

More unusually, the court focused special attention on the interests of a particular subset of the general public: injured shareholders. SEC settlements are sometimes criticized as unfair to shareholders, but that usually has been with regard to current shareholders, who technically are not parties but who arguably suffer unjustly when the company is made to foot the settlement bill for the misconduct of individual executives. See Statement of the Securities and Exchange Commission Concerning Financial Penalties (Jan. 4, 2006) ("the imposition of a penalty on the corporation itself carries with it the risk that shareholders who are innocent of the violation will nonetheless bear the burden of the penalty"). Here, however, the court focused on those directly injured by the alleged conduct, who may in fact no longer be shareholders and who usually seek redress through their own class action suits. SEC settlements sometimes provide for a "fair fund" distribution to provide injured shareholders with proceeds recovered in enforcement actions. See, e.g., SEC Rule of Practice 1100; Statement of the Securities and Exchange Commission Concerning Financial Penalties, SEC (Jan. 4, 2006) ("the penalty itself may be used as a source of funds to recompense the injury suffered by victims of the securities law violations"). The proposed Citigroup settlement, though, did not "commit" the SEC to return anything to allegedly defrauded investors. Citigroup, 2011 U.S. Dist. LEXIS 135914 at *15. The court repeatedly criticized the SEC because, by failing to require Citigroup to admit the complaint's allegations, the proposed settlement "avoids any investors' relying in any respect on the S.E.C. Consent Judgment in seeking return of their losses." Citigroup, 2011 U.S. Dist. LEXIS 135914 at *15; see also id. at *13 (without an admission of liability, there is "no collateral estoppel effect"), at *16 (settlement "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"). In other words, the settlement did not allow plaintiffs separately suing the company and its employees to ride the SEC's coattails. (In fact, a leading plaintiffs' class action firm filed an amicus brief opposing the Citigroup settlement to make this very argument.)

To the extent that the court examined the broader interests of the public at large, it seemed to go beyond the traditional interest in corporations complying with the law and with deterring and punishing their noncompliance. See, e.g., Cannons Engineering Corp., 899 F.2d at 84 (considering whether terms are "fair, reasonable, and faithful to the objectives of the governing statute"). Here the court paid particular attention to the public's interest in, simply, "the truth:"

Citigroup, 2011 U.S. Dist. LEXIS 135914 at 21; see also id. at *14 ("a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed as a cost of doing business" rather than "as any indication of where the real truth lies"); at *16 ("the public ... [has] no reason to credit those allegations, which remain entirely unproven"). The court's consideration in this context of a vague public "right to know" similarly appears to be without precedent.

A New Era?

Given all of the attention devoted to Citigroup, it is tempting to overstate its significance. It remains one opinion by one judge in one case. To be sure, that judge has expressed similar concerns in other cases, and those concerns have been echoed by a few other jurists. See, e.g., Letter from Hon. Rudolph T. Randa to counsel, SEC v. Koss Corp., Case No. 11-C-991 (E.D. Wis. Dec. 20, 2011); Vitesse Semicondutor Corp., 771 F. Supp. 2d 304 (Rakoff, J.); Order, SEC v. Citigroup, Inc., Civil Action No. 10-1277 (ESH) (Aug. 17, 2010 D.D.C.); SEC v. Bank of America, 653 F. Supp 2d 507 (S.D.N.Y. 2009) (Rakoff, J.). But those decisions have been the exception, and even in those cases the courts — including Judge Rakoff — ultimately approved the settlements, sometimes with modifications. See SEC v. Bank of America Corp., 2010 WL 624581 at *1 (S.D.N.Y. Feb. 22, 2010) (approving modified settlement on enhanced record). Moreover, the SEC's pending appeal of Citigroup may result in an appellate opinion scaling back even those exceptions. Regardless, courts retain considerable discretion to accept or reject proposed consent decrees, and there is not yet any indication of a widespread judicial movement away from the historical norm that accords substantial deference to agency recommendations even in the absence of admitted or proven facts.

Still, it is worth considering whether Citigroup does perhaps signal a new era. Rightly or wrongly, the SEC has been subject to increasing criticism since the onset of the financial crisis. See, e.g., David S. Hilzenrath, SEC Staff's 'Revolving Door' Prompts Concerns About Agency's Independence, Washington Post, May 12, 2011; Are Settlements Sacrosanct? at 17 (referring to the "sometimes too-cozy relationship between administrators and those they supervise"); Donald C. Langevoort, The SEC and the Madoff Scandal: Three Narratives in Search of a Story, 2009 Mich. St. L. Rev. 899-914 (2009); Danne L. Johnson, SEC Settlement: Agency Self-Interest or Public Interest, 12 Fordham J. Corp. & Fin. L. 627, 669 (2007) (institutional self-interest, including cost concerns and risk aversion, may unduly motivate the SEC to settle cases). Judge Rakoff previously described another rejected SEC proposal as a "a cynical deal, whereby the SEC got to proclaim publicly that it had taken action in a very high visibility situation, while the bank got to claim that it had bought peace at a cheap price," and he similarly intimated that the SEC in Citigroup was seeking a "quick headline." Are Settlements Sacrosanct? at 17; Citigroup, 2011 U.S. Dist. LEXIS 135914 at *15. To the extent that courts perceive — again, rightly or wrongly — that such concerns are valid, they may be less willing to defer to the SEC and demand more of the evidence required in Citigroup. See Are Settlements Sacrosanct? at 17 ("the days of blind deference to administrative agencies are long past").

Nor are judges deaf to the rumblings of larger social issues. Judge Rakoff's concluding remarks stating that the financial crisis had "depressed our economy and debilitated our lives" and suggesting that the SEC in this case "fail[ed]" in its duty "to see that the truth emerges" echo a heightened hostility to "Wall Street" recently raised in the press, political campaigns, and popular culture. See Citigroup, 2011 U.S. Dist. LEXIS 135914 at *11 ("the public is deprived of ever knowing the truth in a matter of obvious public importance"). Indeed, his decision was widely applauded. See, e.g., James Downie, Judge Rakoff Courageously Rejects SEC-Citigroup Settlement, The Washington Post, Nov. 28, 2011; Neal Lipschutz, Rakoff Decision May be 'Unprecedented,' But He Is Still Right, WSJ Law Blog, Dec. 16, 2011.

Whether courts will scrutinize proposed settlements more closely because of diminished faith in administrative agencies or because they adopt the suggestion that the "right to know the truth" is inherent in the public interest, they may demand more of a factual showing than has been required in the past. The suggestion that a court must have facts "established either by admissions or by trials," Citigroup, 2011 U.S. Dist. LEXIS 135914 at *20, presents a very real and troubling impediment to settlement. Because of the frequent pendency of parallel suits and investigations, defendants are reluctant to admit to facts or conduct that could have a binding effect in other cases — criminal as well as civil — and they may be unwilling to settle with the SEC on terms that heighten their exposure in those cases. And even where a defendant believes a case has no merit, its refusal to admit to allegations would require it to defend against a suit that could be settled more cost-effectively prior to lengthy litigation and trial. In short, fewer settlements mean prolonged litigation if not also more trials, resulting in an increased drain of time, money, and management resources.

It may be possible to craft an "admission" that provides the court enough "truth" to approve a settlement without giving plaintiffs and prosecutors in related cases a basis to assert collateral estoppel. In contrasting the Citigroup settlement, Judge Rakoff favorably referenced another SEC settlement in which the corporate defendant vaguely "acknowledged" that certain marketing materials were "incomplete" and that it was a "mistake" to omit certain information, and further added that it "regrets" the omission. Citigroup, 2011 U.S. Dist. LEXIS 135914 at *18 n.7. While sufficient to satisfy the court for purposes of approving the settlement, those statements arguably fall short of an admission of legal liability, at least of the intentional fraud necessary for criminal prosecutors and class action plaintiffs. Whether defendants in other cases can similarly thread the needle will depend on the facts of the case, the drafting skills of counsel, and their own comfort with the risk of increased exposure in parallel cases.

Courts could also adopt other factfinding procedures short of trial or admission. In class and derivative cases, courts regularly consider documents, deposition transcripts, and other evidence submitted by the plaintiffs to evaluate the fairness of proposed settlements. See, e.g., Are Settlements Sacrosanct? at 16 ("substantial written submissions detailing the bases" of the settlement are often provided in class actions, in "stark contrast" to the sparse record provided in regulatory actions). The Tunney Act already sets out a procedure to determine whether the public interest is satisfied in proposed antitrust settlements. While it expressly does not require that the court conduct an evidentiary hearing, it provides that the court may examine documents, take testimony of witnesses (including government and expert witnesses), and appoint a special master. 15 U.S.C. § 16(e), (f). Similarly, in rare instances where a criminal defendant is allowed to tender a guilty plea without admitting the underlying conduct (an Alford plea), the government is required to proffer evidence establishing guilt. See United States Attorney's Manual, §9-16.015. There is nothing to prevent the SEC from convincing the court of the strength of its allegations by providing selections from its investigatory record without requiring the defendant to admit to them. In fact, Judge Rakoff appeared to use such a procedure in approving an SEC settlement that he previously had rejected for lack of a sufficient factual record. See Bank of America, 2010 WL 624581 at *1 (SEC presented 35-page undisputed statement of facts as well as deposition transcripts and "other evidentiary materials"). Such procedures could benefit defendants to the extent that they do not require an admission, although they could make available to the public information and documents that may be inculpating or embarrassing, particularly if not provided in full context. In addition, these types of evidentiary procedures could provide insurers with ammunition to argue that a regulatory settlement is not insured. See generally, J.P. Morgan Securities Inc. v. Vigilant Ins. Co., 2011 WL 6155586 (N.Y.A.D. 1 Dept.) Dec. 13. 2011)

Conditioning settlement approval on admissions or proven facts may also mean fewer cases for the SEC. As the SEC itself has noted, settlements benefit the agency by freeing up its limited resources to pursue additional investigations. See SEC Press Release No. 2011-265, SEC Enforcement Director's Statement on Citigroup Case (Dec. 15, 2011). To the extent that fewer settlements are approved, the agency may be able to take on fewer matters, and those that it does pursue likely will take longer to resolve, particularly if they cannot be resolved short of trial. Obviously, a defendant will incur greater costs to defend a more protracted case. Parties to an SEC enforcement action could settle without the need for court approval, but that would require the SEC to forego injunctive remedies, a doubtful scenario. The SEC could also avoid heightened judicial scrutiny by resorting to administrative proceedings, which allow for similar settlement relief without the need for court approval. However, those proceedings present certain disadvantages — e.g., no jury, circumscribed discovery, limited grounds for appeal — that a defendant may prefer to avoid.

Aside from a longer, more expensive, and more public process, adoption of the Citigroup standard may result in an increase in the price of settlements. If the SEC must spend more resources bringing fewer cases, defendants can expect the price of settlement to rise, particularly since each case must carry a concomitantly greater deterrent impact. Separately, a court may be more willing to accept an admission-free settlement that includes enhanced monetary and other relief as a tacit proxy for a defendant's confession of wrongdoing. See Citigroup, 2011 U.S. Dist. LEXIS 135914 at *14 (a settlement without admissions and with very modest penalties is frequently viewed as a cost of doing business rather than "as any indication of where the real truth lies"). In fact, Judge Rakoff criticized the Citigroup settlement in part because it was settled much more cheaply than the $535 million penalty and heightened remedial and cooperation provisions included in a prior settlement — approved by Judge Rakoff — in another case, one that Judge Rakoff characterized as involving similar but arguably less egregious facts. Citigroup, 2011 U.S. Dist. LEXIS 135914 at *18 n.7.

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At least for the time being, it would be prudent to reserve judgment on the broader impact of the Citigroup decision. Indeed, we likely will hear more from Judge Rakoff and the Second Circuit in this very case before the matter is over. In the meantime, it is safe to say that judges across the country will take notice of the decision, authored by a prominent, experienced, and respected judge, and that many will think hard about Judge Rakoff's reasoning when the next proposed regulatory settlement hits their docket. And that settlement may not be limited to matters involving the financial crisis, investment banks, or even the SEC. If indeed Citigroup reflects a new standard, it is one that arguably will apply to any regulatory enforcement agency in any industry. Whether in turn that decision ushers in a new era of fewer settlements and more trials will be something to watch for in 2012.

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