The SEC took three important steps with respect to its portfolio of market crisis cases last week. First, it appealed the ruling of Judge Rakoff in the Citigroup case. Second, the agency filed suits against six former high raking executives of Fannie Mae and Freddie Mac. Third it entered into deferred prosecution agreements with the two mortgage giants. Each of these cases provides key insights into the causes of the market crisis. In the end however, the stage is set for a critical, and perhaps devastating test, for SEC enforcement.

First, the Commission took the high risk approach of appealing the decision by Judge Rakoff in its market crisis case against Citigroup (here). In that case the Commission brought suit against the firm, alleging what the Court called an intentional fraud in connection with the sale of interests in a largely synthetic CDO. The fraud centered around allegations that the financial institution failed to disclose, and misrepresented the fact, that it selected most of the collateral left over from its prior initiatives for the entity and then shorted that portion of the portfolio while telling investors that the collateral portfolio had been selected by an independent party.

The court refused to approve a proposed settlement which would be required the firm to consent to a negligence based injunction and pay disgorgement, prejudgment interest and a fine (here). While many commentators have focused on Judge Rakoff’s criticism of the SEC’s “neither admits nor denys” predicate for its settlement, this is not the critical point. Clearly the Court was concerned with that issue. The crux of problem however is the mismatch between the allegations of intentional fraudulent conduct and the negligence charges as well as a fine which appeared inadequate when compared to other similar SEC settlements. Absent any explanation for this by the Commission, the Court was left to repeatedly state in its opinion that there were inadequate facts available to approved the settlement.

The SEC’s appeal is a high profile and very risky move for the agency. It appears focused on arguments made by the Commission in papers filed with Judge Rakoff claiming that the Court has a very limited role in approving settlements and should, in essence, defer to the judgment of the agency. In its papers the Commission offered Judge Rakoff little in the way of insight into the reasons for the apparent mismatch between the factual allegations in the complaint and the charges and terms of the settlement. If the Second Circuit sustains the SEC’s position, the agency will in the future be able to secure approval of its settlements with virtually no court oversight. On the other hand, if the Court of Appeals rejects the Commission’s position, or remands for further proceedings and directs the agency to provide more insight into the process, the precedent could invite additional scrutiny from other district courts. That could significantly impede the SEC’s settlement process. This is particularly true given the leading role the Second Circuit traditionally plays in securities litigation.

Second, the Commission filed two new market crisis cases. Once names three former high ranking executives of Freddie Mac as defendants. SEC v. Syron, Case No. 11 CIV 9201 (S.D.N.Y. Filed Dec. 18, 2011). The defendants are former Chairman of the Board Richard Syron, former Executive Vice President and Chief Business Officer Patricial Cook and former Executive Vice President for the Single Family Guarantee business Donald Bisenius. The second names three former high ranking executives of Fannie Mae as defendants. SEC v. Mudd, Case No. 11 CIV 9202 (S.D.N.Y. Filed Dec. 18, 2011). The defendants are former Chief Executive Officer Daniel Mudd, former Chief Risk Officer Enrico Dallavecchia and former Executive Vice President of Fannie Mae’s Single Family Mortgage business, Thomas A. Lund.

Each case centers on claims that the company and the named defendants failed to disclose and made misrepresentations regarding, the exposure of the firm to the subprime real estate market as the market crisis was unfolding. The actions are thus predicated on claims which are similar to those brought against former Countrywide wide executives and others (here).

The claims involving Freddie Mac focus on the time period from March 2007 through May of 2008. In statements, speeches and filings with the SEC during this period, the complaint alleges that the named defendants misled investors. Investors were lead to believe that the company used a broad definition of subprime loans and that it was disclosing all of its Single-Family subprime loan exposure. Mr. Syron and Ms. Cook reinforce this view by publicly stating that the company has “basically no subprime exposure.” Thus at December 31, 2006 Freddie Mac represented in Commission filings that its the exposure to the Single Family Guarantee business for subprime loans was between $2 billion and $6 billion or about 0.1% and 0.2% of its Single Family guarantee portfolio. In fact, as of December 31, 2006, its exposure in that market was about $141 billion or 10% of its portfolio. These numbers are based on loans the Company internally referred to as “subprime,” “otherwise subprime” or “subprime-like.” By June 30, 2008 that exposure grew to about $244 billion or 14% of the portfolio.

Despite the internal classifications and numbers Ms. Cook is alleged to have provided substantial assistance to Mr. Syron and Freddie Mac in making subprime disclosures in the Information Statements and Supplements and a Form 10-Q by certifying the accuracy of the disclosures which related to her area of responsibility. Mr. Bisenius also certified the accuracy of the subprime disclosures in certain Information Statements and Supplements published during the period and in the Form 10-Q, thus substantially assisting Mr. Syron and Freddie Mac in making the misleading disclosures.

The allegations in Mudd center on the time period December 6, 2006 to August 8, 2008. Throughout that period Fannie Mae and the named defendants are alleged to have misrepresented the exposure of the firm to subprime and Alt-A loans. In a filing for the period ended December 31, 2006, for example, the firm described its subprime loans as those “made to borrowers with weaker credit histories.” As of that date Fannie Mae claimed to have subprime mortgage loans, or structured Fannie May Mortgage Backed securities backed by subprime mortgage loans, represented about 0.2% or about 4.8 billion of its Single Family credit book of business. What the firm did not tell investor is that it excluded loan products specifically targeted by the company toward borrowers with weaker credit histories, including Expanded Approval or EA loans. The value of these excluded loans and securitizations as of December 31 was about $43.3 billion.

In a November 2007 filing Fannie May told investors that subprime loans were those made to a borrower with a “weaker credit profile than that of a prime borrower.” The company also classified mortgages as subprime if they were originated by a specialty subprime lender or a subprime division of a larger lender. The filing stated that the firm’s exposure to these loans was about 0.2% or about $4.8 billion of its Single Family credit book of business. Again investors were not told that the company excluded at least $43 billion of EA loans, including those from 195 lenders listed on the HUD Subprime Lender list, and that it did not have the capacity to track whether loans were originated by a subprime division of a large lender. The company made similar misrepresentations regarding its Alt-A exposure.

Each complaint alleges violations of Exchange Act Sections 10(b), 13(a), Securities Act Section 17(a)(2) and the pertinent Rules.

Third, the Commission entered into non-prosecution agreements with Freddie Mac and Fannie Mae. These agreements, which are part of a new initiative of the Commission, are modeled on those used by the Department of Justice. Each guarantees the continued cooperation of the firm with the Commission. In each the firm accepted responsibility for the underlying conduct. Each agreement contains a detailed recitation of the facts regarding the failures of each company. Each firm agreed specifically not to contest or contradict the factual representations of the agreements.

The Commission elected not to name either firm as a defendant in an enforcement action based on several factors detailed in each agreement as well as the accompanying press release. Those include: 1) the current status of each company including the financial support provided to the companies by the U.S. Treasury; 2) the role of the Federal Housing Finance Agency as conservator of each company; and 3) the costs that may be imposed on the U.S. taxpayers.

The statements regarding the reasons the Commission chose not to prosecute Freddie Mac and Fannie Mae provide a rare insight into the exercise of the prosecutorial discretion by the agency. Equally rare is the detailed recitation of facts which accompanies each agreement. Those recitations are, in essence, the predicates for the enforcement actions against the former executives. While each company accepted responsibility for its conduct and agreed not to dispute the statements of fact, the agreements are consistent with the tradition of Commission settlements. Stated differently, neither company admitted each of the facts in the detailed recitations but they did agree not to deny them.

The Citigroup case was not resolved with a non-prosecution agreement. At the same time, that case, along with those involving Fannie Mae, Freddie Mac and others, represent an important part of unwinding the underlying causes of the financial crisis which has gripped this nation for years. As Judge Rakoff wrote in his opinion, the public has a right to know what happened and why the nation has suffered so long. If the Commission had been more flexible in Citigroup and adopted the approach used in the settlements with Freddie Mac and Fannie May, a crisis with potentially devastating consequences for SEC Enforcement might have been averted. For example, the Commission could have furnished Judge Rakoff with a detailed recitation of the facts underlying its complaint thus giving the Court and the public additional insights into what happened in that important case. Likewise, the SEC could have explained in its filings with the Court, or perhaps earlier in its press release, the reasons that it chose to charge negligence in the face of its own allegations of intentional fraud. Again this would have given the Court and the public a better understanding of events which contributed to the market crisis as well as an explanation for the proposed resolution of the case.

While the Court may still have disagreed with the Commission about the terms of the settlement, the public would have benefitted and it would have placed any appeal on a firmer ground. At the same time it may have averted a confrontation in the Second Circuit. Indeed, a similar process, with some modification of the settlement terms, convinced Judge Rakoff to approve the settlement with Bank of America despite the fact that the deal was still based on not admitting or denying the underlying facts. That approach may also have carried the day for the SEC in Citigroup and avoid the high stakes game of chicken now being played in the Circuit Court – a game which is not good for the Court, the public or the Commission regardless of who wins.

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