The SEC won a significant victory in its Citigroup market crisis case last week. A panel of the Second Circuit Court of Appeals concluded that the Commission has a probability of success on the merits while chiding the district court for not deferring to the agency in the settlement process. The panel concluded that it has jurisdiction over the Commission’s appeal from the district court’s order refusing to enter the SEC’s settlement and granted a stay of the directive setting the case for trial. SEC v. Citigroup Global Markets, Inc., Docket Nos. 11-5227- cv, 11-5375-cv, 11-5242-cv (Decided March 15, 2012). Yet the Circuit Court failed to address the critical question in the case.

The appeal arises from the refusal of the district court to approve the settlement negotiated by the SEC and Citigroup Global Markets in a Commission law enforcement action. The case alleged fraudulent conduct in connection with the sale of interests in a CDO squared. Specifically, the complaint claimed that Citigroup sold interests in an entity it helped construct without disclosing that it had selected many of the CDO tranches to be used from those left from earlier deals. Investors also were not told that Citigroup would ultimately short the tranches it selected. At the same time investors were led to believe that an independent adviser selected the tranches. The complaint charged negligence based on claimed violations of Securities Act Section 17(a)(2) and (3). The settlement proposed to enjoin Citigroup from future violations of the Sections cited in the complaint, impose certain remedial procedures and require the defendant to pay a civil penalty of $285 million which would be distributed into a fund for investors.

The district court rejected the settlement in a sternly worded opinion following a hearing. The court concluded that the settlement was not fair, adequate or in the public interest. In its opinion, the district court repeatedly chided the SEC for its policy of accepting settlements with no admission of liability. The case was ordered to trial. The Commission sought review by the Second Circuit, filing a direct appeal and, in the alternative, a writ of mandamus, and requested a stay of the district court proceedings pending appeal. SEC v. Citigroup Global Markets Inc., Civil Action No. 11-5227 (S.D.N.Y.).

The significance of the Circuit Court ruling far exceeds its technical limitations. As the panel noted, its ruling is limited to preliminary questions, is not binding on the judges who will hear the merits of the case and was made without the benefit of briefing on the opposite side of the SEC since Citigroup joined with the Commission. Nevertheless, at the core of its ruling is the panel’s conclusion not just that the SEC has a probability of success on the merits – a key test for granting a stay – but also the clear suggestion that the district court far exceeded its role. While the panel did allow that the courts have a role in the settlement process beyond being a “rubber stamp,” it made it clear that role is circumscribed, limited and must be undertaken in the context of giving significant deference to the agency. This is precisely the theory advocated by the Commission and is nothing less than a vindication of its position at this point.

The panel’s opinion however fails to examine or even really discuss one of the critical issues in the case. Central to the panel decision is its rebuke of the district court’s critique of the SEC’s settlement policy which permits defendants settle without admitting or denying the factual allegations in the complaint. This has been perhaps the most widely discussed point of the district court’s ruling. Regardless of its popular appeal however, this issue is, as the panel makes clear, a policy question committed to the discretion of the SEC and other agencies who employ a similar approach. If there is to be a change in this policy it must come either from the agencies or Congress, not the courts. This is the constitutional divide between the executive and administrative and judicial branches of government on which much of this case is perched.

A critical issue not addressed by the Circuit Court is the apparent inconsistency in the Commission’s complaint against Citigroup which flows through into the settlement. As the district court stated, the detailed factual allegations asserted by the SEC against Citigroup are of an intentional fraud. Yet the charges are negligence. The settlement parrots the charges by seeking an injunction based on negligence and a penalty which reflects that charge.

The apparent and unexplained inconsistency within the SEC complaint is the under current of the district court’s ruling which is often overlooked. Yet it presents a fundamental issue not of agency discretion but of prosecutorial conduct. The SEC is a regulatory and enforcement agency. It brought the Citigroup action after a long and presumably exhaustive investigation in which it carefully marshaled the facts, collecting untold numbers of documents and taking testimony under oath from each pertinent witness. The facts in the complaint should tie to the legal theories selected in the charging sections to inform the defendant of the charges and tell the public what happened in the view of the agency. This clarity is absent here. In this case the facts from the SEC’s investigation present a picture of an intentional fraud. The legal theories the agency matched with those facts paint another picture about negligent conduct.

This is not a question of agency settlement policy but rather one grounded in the obligations of a prosecutor. To be sure the SEC can chose to settle the case on whatever basis it deems appropriate. That however is not the issue here. In this case the settlement terms reflect the legal charges. Rather, it is the complaint which is internally inconsistent, telling conflicting stories.

The Commission acts as a prosecutor when it brings a law enforcement action such as the Citigroup complaint. When it files such a complaint it is enforcing the law under a directive from Congress and it is obligated to act in the public interest. Its allegations can and do injure the reputation of those against whom they are asserted. In making those allegations it has a legal and ethical obligation to ensure that its claims are accurate and fully supported by the facts and law. Overstating those facts is more than a misstatement of fact. It can and does harm those against whom the allegations are made as well as the public interest such an action is suppose to serve. It can result in overreaching, inappropriate settlements or years of costly and unnecessary litigation. When, as here, the facts alleged in the complaint are at odds with its charging section, those prospects loom large, presenting fundamental questions which must be resolved.

Despite the critical nature of the question here, to date it has not been addressed by the Circuit Court, the SEC or Citigroup. Perhaps when counsel is appointed to defend the position of the district court and the matter is heard by the Second Circuit on the merits, this key issue will finally be resolved.

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