“But 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.” With these words Judge Rakoff rejected the SEC’s proposed settlement in its Citigroup market crisis case and set it for trial. SEC v. Citigroup Global Markets Inc., Case No. 11 Civ. 7387 (S.D.N.Y.).

The action against Citigroup is the Commission’s latest market crisis case centered on conflicts of interest and deception tied to the sale of interests in a synthetic CDO linked to the subprime real estate market. According to Judge Rakoff, who was asked to approve the settlement (here), the underlying conduct is far worse than that in the action against Goldman Sachs. That case yielded a fraud injunction, a record penalty and an admission. The proposed deal with Citigroup, in contrast, is based on negligence and a far smaller penalty.

Judge Rakoff began his opinion by detailing the standards under which the Court is to review a proposed consent judgment from a regulator such as the SEC. The SEC and Judge Rakoff have been down this path before. This section of the opinion should be boiler plate. Not here. Instead, the Court accused the Commission of omitting a key concept, flip flopping and misstating the law in an apparent effort to usurp the role of the judiciary.

The proposed consent judgment must be “fair, reasonable, adequate, and in the public interest . . .” This standard is quoted by the Court from a brief filed by the SEC in support of its proffered consent decree in the Bank of America case. In Citigroup however the Commission “partially reverses its previous position . . .” omitting the public interest prong of the test. This is erroneous Judge Rakoff concluded. The Court also rejected the SEC’s back up position that the agency “is the sole determiner of what is in the public interest . . . [this] is not the law.” While an administrative agency is entitled to substantial deference, the Court must exercise “a modicum of independent judgment” in evaluating whether it is in the public interest to issue an injunction. To do less undermines basic separation of powers principles.

The Court also raises a question about the allegations in the complaint against the financial institution. Here the opinion quotes a paragraph from the parallel complaint against Citigroup employee Brian Stoker which states in part: “Citigroup knew it would be difficult to place the liabilities (of the Fund) if it disclosed to investors its intention . . .. [to short it and] Citigroup knew that representing to investors that an experienced third-party investment adviser had selected the portfolio would facilitate the placement . . . “ of the securities. (emphasis by the Court). This paragraph “would appear to be tantamount to an allegation of knowing and fraudulent intent . . . “ Judge Rakoff concluded. It was, however, dropped by the SEC from the Citigroup complaint.

When the proper standards are applied to the proposed settlement here, the Court concludes that the settlement cannot be approved. Central to this determination is the omission of any factual predicate for the serious allegations of wrongful conduct to support the significant relief sought in the form of an injunction. Judge Rakoff does not specifically demand that the “neither admitting nor denying” predicate for the proposed settlement be dropped, although he comments unfavorably on the standard. He does however require that the Court have “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 fact, while the public is deprived of ever knowing the trust in a matter of obvious public importance.”

In reaching his conclusion Judge Rakoff also questioned the adequacy of the terms of the settlement. For Citigroup it is a good deal, according to the Court. Whether the serious allegations of fraud are true or not for the financial institution the settlement is “a mild and modest cost of doing business.” For the SEC it is “harder to discern . .. what . . .[it] is getting . . other than a quick headline.” The real issue, however, is what the defrauded investors are getting which, according to the Court, is “substantially short-changed.”

In the end, the Court concluded that the settlement is not “reasonable,” it is “not fair,” and it “does not serve the public interest.” Rather, it is “a cost of doing business imposed [on Citigroup] by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies . .. “ the Court found.

Whether the case will actually proceed to trial remains to be seen. In Bank of America Judge Rakoff ultimately did approve a consent decree despite significant misgivings. That approval came only after the parties furnished the Court with a significant quantity of factual material and revamped key settlement terms including the procedures to be adopted and the amount of the penalty. Here neither the Commission nor Citigroup appear anxious to explain how the substantial allegations of fraud asserted in the complaint turn into charges of negligence and a fine that is much more modest than those in similar cases. At the same time the choices appear to be: 1) Explain to the Court; or 2) Tell it to the jury.

Regardless of the outcome here, perhaps in the future the SEC will finally begin to match the allegations in its complaints to the charges and the terms of the settlements. It may also take a page from other regulators and furnish some explanation in court papers or a press release for its determinations. It is after all a disclosure agency.

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