[A Part of the Student Series] January 15, 2013

Why the ability to “neither admit nor deny” is important:

Examining the Implications on Corporate Liability of Securities and Exchange Comm’n v. Citigroup Global Markets Inc., No. 11 Civ. 7387, 2011 WL 5903733 (S.D.N.Y. November 28, 2011).

By Ryan Dunigan[1]

Setting the Stage

On November 28, 2011, Judge Jed S. Rakoff of United States District Court of the Southern District of New York refused to approve a consent judgment between the United States Securities and Exchange Commission (“SEC”) and Citigroup Global Markets Inc. (“Citigroup”).[2]^,[3] Under the Citigroup consent judgment, Citigroup would have paid $285 million to the SEC to settle a case that the SEC brought against the corporation.[4] The SEC alleged that Citigroup created a billion-dollar fund (known as “Class V Funding”) that allowed the corporation to sell assets to investors by misrepresenting that the fund’s assets were attractive investments, yet in fact the fund included a substantial percentage of negatively projected assets.[5] Citigroup purportedly had even taken a short position in those very assets.[6]

Consent judgments are the traditional method that the SEC employ to settle cases with defendants.[7] The consent judgment in Citigroup would have allowed Citigroup to settle the case without either admitting or denying the SEC’s allegations.[8]

Unexpectedly, Judge Rakoff did not approve the settlement.[9] Rakoff stated that he was unable to ascertain whether the consent judgment was fair, reasonable, adequate or acted in the public interest, because the consent judgment lacked determinants to answer questions relating to the fairness, reasonableness and adequacy of the consent judgment.[10] A judge must ensure that all of those determinants are present within a settlement agreement before parties within a suit enter into a settlement agreement. Rakoff found that the central questions of any court’s determination as to the approval of any consent judgment is ensuring that a consent judgment is adequate and fair to “parties and to the public.”[11] Rakoff iterated that the consent judgment held no sufficient evidentiary basis to answer the aforementioned questions.[12] Rakoff found that the district court was deprived “of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.”[13] Especially, based on the fact that counsel for Citigroup “expressly reconfirmed that his client was not admitting the allegations,”[14] that the client would “fully contest the facts in any parallel litigation, ”[15] and the SEC took a position, which said, “because Citigroup did not expressly deny the allegations,” this should imply truth of the allegations.[16]

This is not the first time Rakoff treated SEC consent judgments harshly or was weary of approving similar settlement in SEC cases.[17] Due to the fact that Rakoff presides in the Southern District of New York, the home of Wall Street, and his reputation as an expert on corporate criminal liability relating to securities fraud, other district court judges have followed Rakoff in questioning the SEC’s use of consent judgments to settle cases.[18]^,[19] Rakoff’s sentiments as to SEC consent judgments reflect the view of many interested parties: academics, jurists, practitioners and policymakers.[20] Rakoff’s views concerning SEC consent judgments are, therefore, important, because if the sentiments are affirmed or endorsed by the Second Circuit or another circuit, then it may compromise how the SEC will pursue and resolve enforcement actions. Further, it may decrease the level of cooperation that corporations give to the SEC in the investigation of corporate malfeasance. These consequences lead to a world in which fewer corporations are liable for wrongdoing. Therefore, this article will seek to highlight: the SEC’s past and present use of consent judgments, the reasons as to why the agency may use consent judgments, and the practical implications to SEC enforcement actions if the agency stopped using consent judgments.

History of the SEC’s use of Consent Judgments

The SEC’s practice of resolving enforcement action by entering into consent judgments in which a target individual or corporation either admits or denies liability dates back almost 40 years.[21] Defendants desired consent judgments, because agreement with the SEC would not have collateral estoppel consequences for private civil actions, in which the defendants likely faced monetary judgments greater than anything the SEC imposed.[22] The SEC desired consent judgments, because the practice allowed the SEC to settle with a defendant without a long-term discovery process, and settling via consent judgments broaden SEC enforcement powers from merely obtaining injunctive relief to “obtaining admissions to prior misconduct.”[23]

However, it soon became apparent that after courts signed off on these settlements, defendants would start public campaigns denying that they had done what the SEC alleged.[24] Defendants claimed they entered into consent judgments to avoid litigation with a powerful administrative agency.[25] Therefore, in 1972 as a response to defendants’ acts of avoidance, the SEC required a defendant seeking to avoid litigation to sign a consent judgment re-drafted in a way that allowed a defendant to neither admit nor deny the allegations of the complaint and banned a defendant from thereafter to publicly deny the allegations.[26]^,[27]

One comparable agency to the SEC in demanding such cooperation in the form of settlement agreements is the United States Department of Justice (“DOJ”). However, the DOJ rejects allowing defendants, except in the very unusual circumstances, to enter into pleas that accept guilt to a criminal charge without admitting or denying the allegations.[28] This has led to differing resolutions vis-à-vis each agency in even the same case: for example, the SEC and the DOJ announced on the same day that Wachovia Bank would pay $148 million to settle charges that the bank made millions of dollars in profits by rigging bids in the municipal securities market.[29] In the DOJ settlement, Wachovia “admits, acknowledges and accepts responsibility for” manipulating the bidding process.[30] In contrast, in the SEC consent judgment, based on the same facts as the DOJ settlement, Wachovia settled the charges “without admitting or denying the allegations” in the SEC’s complaint.[31]

Prior SEC enforcement actions

In Securities and Exchange Comm’n v. Vitesse Semiconductor Corp., Judge Rakoff questioned the SEC’s use of consent judgments. [32] Rakoff said, “[T]he SEC’s practice of permitting defendants to neither admit nor deny the charges against them remains pervasive, presumably for no better reason than that it makes the settling of cases easier .”[33] Rakoff is right to recognize that ease is a reason for settling cases this way, but in the author’s view that is not the predominant reason the SEC settles cases via consent judgments. Rather, the SEC’s limited resources and the agency’s sensitivity to risk make settling cases via consent judgments the important determinant for the agency.

Resource Constraint

The financial industry grew dramatically over the last decade in both size and scope.[34] During this time, securities markets attracted a great number of participants who deal in new and complex financial products.[35] Under the federal securities laws, the SEC have extensive powers of investigation and enforcement over these markets,[36] which include 12,000 public companies, 4,600 mutual fund families, 11,000 investment advisers, 600 transfer agents, and 5,500 broker dealers.[37] However, currently, the SEC does not have the resources to deal with these responsibilities,[38] and the Dodd-Frank Act place further responsibilities on the SEC such as rule-making and reviewing transactions related to broker-dealers and new financial products.[39] In asking Congress for an increase to the SEC’s 2013 budget,[40] Mary Shapiro the former chairwoman of the SEC said, “We [the SEC] still are not appropriately sized in my view for the job that Congress has laid out for us.”[41]

The Enforcement Division of the SEC is charged with investigating, bringing, and settling cases having to do with violations of the federal securities law. Thus, the Division that will be most affected by an endorsement of Rakoff’s decision. This is also the same Division that received 700,000 complaints, tips and referrals regarding violations of the federal securities laws in 2008,[42] and is charged with investigating each of the 700,000 complaints. However, the SEC’s Enforcement staff nationwide, including lawyers, accountants, information technology staff, and support staff is only 1,400 people.[43] Officials at the SEC have explained that the agency’s staffing levels are not enough with its current responsibilities. Robert Khuzami, the former SEC Director of Enforcement, in testimony before Congress said the SEC is faced with a challenge.[44] Khuzami said that the SEC’s broad mandate, given to it by the federal securities laws, of investigating and enforcing the securities laws to any financial product that fit into the definition of a “security,” have burdened the agency with considerable responsibility.[45]

The SEC is ill-equipped to adequately handle its current responsibilities. The SEC will be further overwhelmed if it is mandated to take to trial or engage in protracted settlement discussions with defendants rather than simply using current consent judgments. Judge Rakoff’s decision will only further restrain the resources of the agency.

Definite Positive Outcome

There is criticism that the SEC is receiving little in the way of settlement payoffs from allegedly securities fraudsters. In three highly publicized cases, Securities and Exchange Comm’n v. Goldman, Sachs & Co.,[46] Securities and Exchange Comm’n v. Bank of America,[47] and Securities and Exchange Comm’n v. Citigroup Global Markets Inc.[48] the SEC agreed to settlements, which defendants paid $985 million to the SEC. Taken alone $985 million is impressive. Yet, if the allegations within the SEC’s complaint against Citigroup alone are true, then the cost of the corporation’s wrongdoing is $700 million. Nevertheless, using the aforementioned cases as proxies of other SEC enforcement actions, corporations will never settle if they need to take a matter to trial in order to resolve. Corporations employ high priced attorneys and budget millions of dollars for litigation expenses. For the fourth quarter of 2011 alone J.P. Morgan set aside $528 for litigation related expenses.[49] Consequently, drawn-out litigation cost cause shareholders uncertainty, rather than a simple payout stipulated by an agreed upon settlement. Shareholders are the supposed beneficiaries of the SEC’s regulation of public companies, the securities markets and that of judges in approving settlements, thus their protection should be paramount. Moreover, though these costs are certain, there are no real assurances that the SEC would win a case against a corporation.

The probability of a lower reward at trial as compared to a settlement may lead the SEC to investigate and bring only those cases in which the SEC know it will win. The SEC may ignore cases, which winning is difficult. Harder cases include defendants such as J.P Morgan with large litigation reserves and cases that include complex facts regarding highly technical securities funds, which make it harder for a jury to understand. An SEC pursuing only those cases it can win may only go after smaller rather than large corporations, even though the fraud may be far worse and far reaching as to the large corporation.

In light of the resource constraints on the SEC, consent judgments provide a credible threat to parties to in fact settle with the agency. “Credibility is evaluated with an eye to the hypothetical temporal moment when the threat fails to induce the threatened party to surrender and, thus, fails to induce the demanded course of action.” [50] Therefore, without consent judgments, the SEC’s only threat to settle will be via trials. Yet, knowing that the SEC is resource constrained in the quantity and quality of trials it may bring, defendants will find that the agency does not pose a credible threat, and defendants will engage in more corporate malfeasance. Scholars argue that if it is in the interest of a threatening party not to carry out a threatened outcome, then that party’s threat is not credible.[51] However, irrespective of the SEC’s interest, the agency’s resource constraint determines the credibility of its threats.

Some of the basis for Rakoff’s denial of the Citigroup consent judgment lay in the potential for abuse to be imposed by penalties via consent judgment on facts that were “neither proven nor acknowledged is patent.”[52] However, Rakoff’s concern is likely to materialize into reality without consent judgments. Consent judgments will be imposed on small corporations that are unable to effectively claim that facts within an SEC complaint were neither proven nor true.

In the author’s opinion based on the cases of Goldman, Sachs & Co., Bank of America, and Citigroup Global Markets Inc., the SEC may be unable to bear the added responsibility of taking cases to trial or engaging in settlements more rigorous than consent judgments. These cases are examples that the SEC is unwilling to pursue other methods of adjudication other than consent judgments due to the risks associated with these alternatives. Rather than an abusive tactic, these cases reflect an SEC that is pragmatic, conservative in using its resources, and risk adverse, thus may be an agency that is unwilling to react to change well.

Corporate cooperation with the SEC

Usually, after an SEC complaint is filed, corporations immediately hire outside counsel to conduct internal investigations. Outside counsel interviews employees, gathers and reviews documents. The information collected from interviews and documents are synthesized into a formal memorandum and/or presentation to the SEC. Usually, then corporations and the SEC agree to terms such as the creation and revision of internal compliance so as to not repeat the alleged wrong activity by the corporation, and settlement amounts. The terms of these agreements are the consent judgment.

This activity is wealth maximizing for both corporations and the SEC. Corporations avoid a trial. While, the SEC roots out fraudulent activity from corporations for the protection of investors and recoups losses endured by investors. However, such actions will be less common in a world which corporations must admit or deny wrongdoing to avoid litigation with the SEC. The fear of reputational harm, economic harm and collateral estoppel motivate corporations to settle with the SEC.[53] Yet, while reputational and economic harm hurt corporate defendants, the suit and victory of a plaintiff class action is devastating for corporations.

Engaging in an enforcement action with the SEC will include the expense of defense, negative media attention, and corporate efforts and resources directed towards the management of defending an SEC action rather than to corporate operations.[54] Settling with the SEC allows a defendant to resume normal business as soon as possible and manage negative publicity at one time, but not resolving negative media attention correctly impact share prices.[55] For example, even with prior knowledge within markets of a company’s accounting error, a company’s stock will still be negatively impacted by an announcement of an SEC investigation.[56] Thus, avoiding a public relations nightmare is a motivation to settle quickly.

Although the fear of reputational and economic harm may induce a corporation to settle with the SEC, the most important inducement for a corporation to settle with the SEC is collateral estoppel.[57]^,[58] Collateral estoppel is the tool that private litigants would use after a successful SEC enforcement action.[59] If a defendant by collateral estoppel were prevented from litigating certain issues decided against that defendant in an SEC enforcement action, then plaintiff classes would be shoe-ins for large class action awards.[60] Therefore, the motivation of a corporation to cooperate is to avoid litigation with perhaps numerous private litigants.

Some conclude that defendants are large beneficiaries of SEC settlements.[61] There are few negatives for a defendant within the terms of a consent judgment. Terms include a number of sanctions most no different than if imposed in a litigated action, and defendants have the protection to re-litigate issues not decided within an enforcement action. So, it is true that settlements give corporations protection by not admitting facts. Most fail, however, to realize the non-admission of guilt is not in favor of corporations or incumbent managers, but for the benefit of investors. Most of whom would be significantly hurt by plaintiff class actions. For these reasons, if the SEC were not able to afford corporations adequate protections via consent judgments, then corporations would decrease their level of participation with the SEC. Less cooperation with the SEC will lead invariably to far fewer corporations that are held liable for corporate wrongdoing.

Both the SEC and corporations are motivated to arrive at an agreement that will avoid time, cost, emotional toll, and risk of trial, and thus both favor a settlement versus a trial.[62] Settlements make cases just, speedy, and an inexpensive determination of justice.[63] Moreover, resource constraints and definite positive outcomes make settlement in SEC enforcement actions highly favored.

Conclusion

Two months after Rakoff’s decision, the SEC decided to no longer allow defendants to neither admit nor deny civil charges when, at the same time, they admit to or have been convicted of criminal violations.[64] Former SEC Director of Enforcement Robert Khuzami said the agency would continue to use the “neither admit nor deny” settlement process when the agency alone reached a deal with a company in a case of civil securities law violations; these types of cases make up the bulk of SEC settlements.[65] The Citigroup case will not be affected by the policy change, because there is no accompanying criminal charge. Rakoff’s decision in SEC v. Citigroup [66] highlights public interest concerns relating to the SEC’s use of consent judgments, such concerns that settlement awards the SEC receive are small in comparison to the losses that corporate fraud cause. Nevertheless, the risk is too high in dismantling a tool that is providing the SEC with a pragmatic method that protect and recoup losses for investors. Rakoff is prodding the SEC to expend more resources seeking out enforcement methods, such as trials, that may have the potential for large gain, yet these methods include more risk than settlements and does not necessarily have the potential for gain expected by Rakoff. An SEC that is resource constrained and risk-adverse should not be obligated to shoulder this risk, because it will only create scenarios that the SEC is acting against public policy. An SEC in Judge Rakoff’s imagination will hold fewer corporations responsible for wrongdoing, thus Rakoff’s SEC should be avoided. However, the judiciary, irrespective of Rakoff, is becoming increasingly weary of these type of settlements, and Congress is seeking to be portrayed as a protector of Main Street rather than Wall Street, therefore it would not be a surprise that in the near future the SEC began to decrease its heavy reliance on consent judgments as its preferred tool to settle corporate fraud cases.

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Notes:

[1] Ryan is an associate at Winston & Strawn, LLP. He is a 2012 graduate of the University of Chicago Law School and University of Chicago Harris School of Public Policy. Ryan is also a former extern with the Securities and Exchange Commission’s Division of Enforcement. This article represents solely the author’s views. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or former employee. This document expresses the author’s views and does not necessarily reflect those of the Commission or other members of the staff.

[2] Securities and Exchange Comm’n v. Citigroup Global Markets Inc., No. 11 Civ. 7387, 2011 WL 5903733 (S.D.N.Y. November 28, 2011).

[3] Currently, the Second Circuit is considering the appeal to Judge Rakoff’s rejection of the SEC’s and Citigroup’s settlement. Although, oral arguments on the appeal are not scheduled to early 2013, the Circuit has indicated in a preliminary decision that the SEC is likely to succeed in its appeal.

[4] Citigroup Global Markets Inc., 2011 WL 5903733, at *1.

[5] Id.

[6] Id.

[7] See generally Securities Exchange and Comm’n v. Clifton, 700 F.2d 744, 748 (D.C. Cir. 1983) (making reference to SEC oral argument in which the agency said that consent judgments resolve 90% of SEC’s cases).

[8] Citigroup Global Markets Inc., 2011 WL 5903733, at *1.

[9] Id. at *6.

[10] Id. at *4-5.

[11] Id. at *3

[12] Id. at *5.

[13] Id. at *4.

[14] Id.

[15] Id.

[16] Id.

[17] Judge Rakoff previously criticized SEC settlement policy in the following cases: Securities and Exchange Comm’n v. Bank of America Corp., 653 F.Supp.2d 507 (S.D.N.Y. 2009); Securities and Exchange Comm’n v. Bank of America Corp., Nos. 09 Civ. 8829, 10 Civ. 0215, 2010 WL 624581 (S.D.N.Y. Feb. 22, 2010), Securities and Exchange Comm’n v. Vitesse Semiconductor Corp., 771 F.Supp.2d 304 (S.D.N.Y. 2011).

[18] Howard Fineman, Jed S. Rakoff: Federal District Judge Of New York's Southern District (The Inspirationals), The Huffington Post, December 27, 2011, http://www.huffingtonpost.com/2011/12/27/jed-s-rakoff-federal-dist_n_1171227.html.

[19] Edward Wyatt, An S.E.C. Fraud Settlement, Questioned, Gets Approval, N.Y. Times, February 2, 2012, http://www.nytimes.com/2012/02/03/business/an-sec-settlement-challenged-is-approved.html.

[20] Danné L. Johnson, SEC Settlement: Agency Self-Interest or Public-Interest, 12 Fordham J. Corp. & Fin. L. 627, 664 (2007); Edward Wyatt, S.E.C. Changes Policy on Firms’ Admission of Guilt, N.Y. Times, January 6, 2012, http://www.nytimes.com/2012/01/07/business/sec-to-change-policy-on-companies-admission-of-guilt.html.

[21] Securities and Exchange Comm’n v. Vitesse Semiconductor Corp., 771 F.Supp.2d 304, 308-09 (S.D.N.Y. 2011).

[22] Id.

[23] Id. at 308-09, 308 n.5 (Rakoff explaining the benefits for the SEC entering into consent judgments after 1972. “First, the practice made it much easier for the S.E.C. to obtain settlements. And second, at a time (prior to 1972) when the S.E.C.’s enforcement powers were largely limited to obtaining injunctive relief, the S.E.C.’s focus was somewhat more centered on helping to curb future misconduct by obtaining access to the Court's contempt powers than on obtaining admissions to prior misconduct.” Explaining the SEC benefits further, Rakoff said that, “Once the Court has enjoined a defendant from future violations of the securities laws, the S.E.C., if it has evidence of a subsequent violation, can move summarily to have the Court hold the defendant in contempt, following an expedited hearing, rather than having to go through the laborious process of filing a civil complaint, undergoing full discovery and motion practice, and trying the case to a jury. “ Consequently, it is Rakoff’s belief that, “More than anything else, it is this invocation of the Court's contempt power that mandates that courts carefully assess proposed S.E.C. consent judgments before giving such judgments judicial approval”).

[24] Id. at 308-09.

[25] Id.

[26] Id.

[27] The time, in which consent judgments were becoming a popular tool by the SEC in settling cases, also is the same time the agency created its enforcement division. The enforcement decision was created in 1972.

[28] Id. (citing U.S. Dep’t of Justice, U.S. Attorneys’ Manual § 9–16.010 (2008) and U.S. Dep’t of Justice, U.S. Attorneys’ Manual § 9–27.500 (2006)).

[29] Wyatt, supra note 17.

[30] Id.

[31] Id.

[32] Securities and Exchange Comm’n v. Vitesse Semiconductor Corp., 771 F.Supp.2d 304 (S.D.N.Y. 2011).

[33] Id. at 310.

[34] Strengthening the SEC’s Vital Enforcement Responsibilities: Hearing Before the United States Senate Committee on Banking, Housing and Urban Affairs, 111th Cong. (2009) (statement of Robert Khuzami, Former Director, Division of Enforcement, U.S. Securities and Exchange Commission)

[35] Id.

[36] Richard M. Phillips Et Al., SEC Investigation: The Heart of SEC Enforcement Practice, in The Securities Enforcement Manuel: Tactics and Strategies (Richard M. Phillips ed., 1997).

[37] Khuzami, supra note 30.

[38] Michael A. Perino, SEC Enforcement of attorney Up-the-Ladder Reporting Rules An Analysis of Institutional Constraints, Norms, and Biases, 49 Vill. L. Rev. 851, 853-57 (2004).

[39] Enhanced Oversight After the Financial Crisis: The Wall Street Reform Act at One Year: Hearing Before the United States Senate Committee on Banking, Housing and Urban Affairs, 112th Cong. (2011) (statement of former Chairman Mary L. Schapiro, former Chairman, U.S. Securities and Exchange Commission)

[40] Fiscal Year 2013 Securities and Exchange Commission Budget: Hearing before the Subcommittee on Financial Services and General Government Committee on Appropriations United States House of Representatives, 112th Cong. (2012) (statement of former Chairman Mary L. Schapiro, former Chairman, U.S. Securities and Exchange Commission)

[41] David Cook, SEC's Schapiro: Budget undersized to fulfill new market-watchdog duties, The Christian Science Monitor, February 28, 2012, http://www.csmonitor.com/USA/Politics/monitor_breakfast/2012/0228/SEC-s-Schapiro-Budget-undersized-to-fulfill-new-market-watchdog-duties.

[42] Khuzami, supra note 30.

[43] United States. United States Securities and Exchange Commission. In Brief: FY 2011 Congressional Justification. Washington, D.C.: February 2010, 3, 8.

[44] Khuzami, supra note 30.

[45] Id.

[46] Securities and Exchange Comm’n v. Goldman, Sachs & Co., No. 10-Cv-3220, 2010 WL 2779309 (S.D.N.Y. July 14, 2010).

[47] Securities and Exchange Comm’n v. Bank of America Corp., Nos. 09 Civ. 8829, 10 Civ. 0215, 2010 WL 624581 (S.D.N.Y. Feb. 22, 2010)

[48] Citigroup Global Markets Inc., 2011 WL 5903733.

[49] Associated Press, J.P. Morgan misses Street; 4Q profit drops 23% (Feb. 20, 2012, 9:44 AM), http://www.crainsnewyork.com/article/20120113/FINANCE/120119941#; see also Halah Touryalai, 10 Wall Street Expenses That Make The SEC’s Budget Look Pathetic, Forbes, February 11, 2011, http://www.forbes.com/sites/halahtouryalai/2011/02/17/10-wall-street-expenses-that-make-the-secs-budget-look-pathetic/ (discussing how the SEC in outmanned in resources in comparison large banks).

[50] Oren Bar-Gill and Omri Ben-Shahar, Credible Coercion, 83 Texas Law Review 717, 722 (2005).

[51] Id.

[52] Citigroup Global Markets Inc., 2011 WL 5903733, at *6

[53] Johnson, supra note 17, at 664.

[54] Id. at 664-66.

[55] Id.

[56] Ehsan H. Feroz, Kyung Joo Park and Victor Pastena, The Financial and Market Effects of the SEC’s Accounting and Auditing Enforcement Releases, 29 Journal of Accounting Research 107 (1991).

[57] Collateral estoppel prevents a party in a suit from trying to litigate the issue in another case when that issue was ruled upon in the former case. Once an issue is decided upon a party that the ruling forever bound the party.

[58] Johnson, supra note 17, at 666.

[59] Id. at 667.

[60] Id at 666.

[61] Id at 669.

[62] Id at 651.

[63] Id.

[64] Wyatt, supra note 17.

[65] Id.

[66] Securities and Exchange Comm’n v. Citigroup Global Markets Inc., No. 11 Civ. 7387, 2011 WL 5903733 (S.D.N.Y. November 28, 2011).

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Ryan Dunigan

Ryan Dunigan