The Second Circuit Court of Appeals heard argument in SEC v. Citigroup Global Markets, Inc., No. 11-5227-cv, one of the most closely watched SEC enforcement actions. The Court’s decision has the potential to shape the future of SEC settlements in district court enforcement actions. Before the Court the SEC was joined by Citigroup in arguing for the reversal of the district court’s order refusing to enter their settlement while court appointed counsel defended the ruling of Judge Rakoff. A host of groups weighed in with amicus briefs.
Central to the resolution of the case is the role of the district court when presented with a proposed settlement in an SEC enforcement action which requests the entry of an order by the court for injunctive and other relief. The enforcement action here stems from Citigroup’s role in the creation and marketing of a largely synthetic collateralized debt obligation or CDO called Class V Funding III. The firm concluded that the residential real estate market would drop significantly. In late 2006 it decided to construct a CDO-squared – a CDO collateralized by tranches of other CDOs rather than instruments such as bonds – tied to the residential real estate market. The collateral would be largely CDO tranches left from earlier deals.
Credit Suisse Alternative Capital, Inc. or CSAC was retained as collateral manager. An experienced collateral manager was essential to selling the notes. Citigroup selected most of the collateral for Class V, although CSAC did select some, according to the complaint. The marketing material featured CSAC and its experience without disclosing Citibank’s role in selecting the collateral or that it had a $500 million short position against the Class V collateral it selected. Class V collapsed only months after the notes were sold, leaving investors with millions of dollars in losses. Citigroup made $34 million in fees for structuring the entity and $160 million in net profits on its positions.
The firm settled the action, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3). Citigroup also agreed to disgorge $160 million and pay $30 million in prejudgment interest and $95 million as a penalty for a total of $285 million which would be placed in a fair fund. The settlement requires Citigroup to take certain remedial action related to its review and approval of offerings of certain mortgage related securities.
U.S. District Court Judge Jed Rakoff refused to enter the proposed consent decree. Initially, the Court held hearings and requested that the parties answer a series of questions. Following the submission of those responses another hearing was held. Ultimately the Court refused to enter the proposed judgment, concluding: “. . . 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, the Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.” SEC v. Citigroup Global Markets Inc., Case No. 11 Civ. 7387 (S.D.N.Y.). The Court ordered the case be set for trial with the companion action against Brian Stoker, the mid-level Citigroup employee who oversaw the deal. The SEC appealed, filed a wit of mandamus and requested a stay of the order that it proceed to trial which was granted. Later the case against Mr. Stoker, based on essentially the same facts as the Citigroup action, was tried and the jury found against the SEC. SEC v. Stoker, Case No. 11 Civ. 7388 (S.D.N.Y. Filed Oct. 19, 2011); See also In the Matter of Credit Suisse Alternative Capital, Adm. Proc. File No. 3-14594 (Filed Oct. 19, 2011)(settled administrative proceeding against collateral manager and one of its employees).
The central issue before the Appeals Court is the role of the judiciary in agency settlements. In its brief the SEC argued that: “The district court did not defer to the Commission’s decision to resolve the matter though a consent judgment, which the Commission reached after years of investigation and lengthy negotiations with Citigroup. This decision reflected the Commission’s judgment that the settlement best served the public interest given the balance of various factors, such as litigation risk, resource allocation, and the relief contained in the judgment . . . “ In making this argument the SEC claims that the ruling of the district court conflicts with well established judicial precedent and that it interferes with executive power vested in the agency.
In this case the settlement was fair, reasonable and in the public interest, the SEC told the Court. This determination is based in part on the fact that the agency obtained 80% of the monetary relief available under the statute, includes a mandatory injunction to alter key business practices, minimizes the risks for the agency and conserves its resources.
Citigroup largely echoed the Commission’s views, arguing in favor of reversing the district court and requesting that and order issue directing that the settlement be entered. Calling the position of the District Court a “new rule,” the firm told the Second Circuit that a district court has “extremely circumscribed” authority when presented with an agency consent decree as in this case. Here the district court abused its authority because the proposed decree was negotiated at arms-length, was reasonable and adequate and served the public interest as determined by the SEC.
Counsel appointed to advocate the position of the district court rejected the contentions of the SEC and Citigroup arguing: “Confronted with puzzling anomalies in the case at hand, the district court properly held that it could not determine whether a problematic consent judgment invoking the court’s injunctive powers satisfied the well established standards of judicial review because the parties had not provided the court with the slightest factual or evidentiary basis upon which to exercise its independent judgment.”
Citing Judge Rakoff’s ruling in SEC v. Bank of America, the brief rejected the notion that the district court required an admission of liability in Citigroup. Rather, a statement of facts as in Bank of America would have been sufficient to provide the district court with a factual basis for the proposed decree. Here the SEC did not provide such a statement. Likewise, the defendant did not even make the kind of acknowledgement that Goldman Sachs did in SEC v. Goldman Sachs where the firm admitted errors.
Citing the same “adequate, reasonable and in the public interest” standard for entering a consent decree relied on by the SEC and Citigroup, the brief states that deference to the agency does not mean failing to inquire as to whether that standard for entering the injunction and other requested relief has been met. This is particularly true on the record in this case where there are substantial unanswered questions to be resolved such as: 1) the inconsistency between the facts in the complaint alleging an intentional fraud and its charging sections which are based only on negligence; 2) the discrepancy between the amount of the penalty here and the Goldman Sachs action which is based on similar conduct; and 3) the demand for broad injunction relief in the face of the SEC’s admission that the conduct terminated years ago and that it has failed to enforce other “obey the law” injunctions entered against Citigroup.
A group of law securities law professors seemed to have summed up the critical issues before the Court: “As scholars who study securities enforcement and the SEC, we have concerns about the SEC’s practices, exemplified in this case, of settling enforcement actions alleging serious fraud without any acknowledgement of facts, on the basis of pro forma “obey the law” injunctions, a commitment to undertake modest remedial measures, and insubstantial judicial penalties.”
A decision is expected later this year.