Second Circuit Says Pragmatism Trumps “Cold, Hard” Facts, Limits District Courts’ Powers in Reviewing SEC Settlements


Summer is coming, but this is probably not the vacation Southern District of New York Judge Jed Rakoff had in mind.  On June 4, 2014, the Second Circuit vacated Judge Rakoff’s order refusing to approve the SEC’s $285 million settlement with Citigroup regarding a 2007 collateralized debt obligation (“CDO”) offering.  The highly anticipated opinion – the decision did not come down until more than a year after oral argument – sharply limits the instances in which a court may reject or even modify a Commission settlement, even when the SEC does not extract an admission of facts or liability.  The decision, which comes at a time when the SEC has been seeking and obtaining more admissions from public companies in connection with settlements, is sure to have a significant impact on the agency’s future approach toward settlements and admissions.

Though the facts of the underlying case are almost a footnote at this point, the SEC had alleged that in 2007, Citigroup negligently represented its role and economic interest in structuring a fund made up of tranches of CDOs.  As with similar allegations against Goldman Sachs and its ABACUS CDO, the SEC alleged that Citigroup hand-picked many of the mortgage-related assets in the fund while telling investors that the assets were selected by an independent advisor.  The SEC further alleged that Citigroup chose mortgage-backed assets that it projected would decline in value and in which it had taken short positions.  Thus, according to the SEC, Citigroup sold investors assets on the hope the CDOs would increase in value, while Citigroup had selected and bet against these same assets on the belief they would actually decrease in value.  The SEC alleged that Citigroup was able to reap a substantial profit from shorting the assets it selected for the fund, while fund investors lost millions.

The SEC brought a settled action in federal court in 2011, alleging violations of Sections 17(a)(2) and (3) of the Securities Act of 1933, which make it unlawful to obtain money or property by means of any material misstatement or omission or to engage in an act or practice that operates or would operate as a fraud upon the purchaser.  Both carry the negligence mental state standard rather than the scienter (intent to defraud) standard.  The settlement terms required Citigroup to disgorge some $160 million plus $30 million in prejudgment interest, and pay a civil penalty of $95 million.  In addition, Citigroup consented to internal changes designed to prevent similar acts in the future.

Consistent with his hands-on approach in other SEC settlements, Judge Rakoff had a number of questions for the SEC (and, to a lesser extent, Citigroup) concerning the proposed settlement.  For example, why should the court approve the settlement where “the defendant neither admits nor denies wrongdoing?”  And, is there an “overriding public interest in determining whether the S.E.C.’s charges are true?”  These were just some of the questions Judge Rakoff posed before ultimately declining to approve the settlement.  In refusing to approve the settlement, the Judge found that the agreement did not provide the court “with a sufficient evidentiary basis” to know whether he could approve the settlement.  In particular, Judge Rakoff worried that approving the settlement would deprive the public of “the truth,” and further that the court would not approve injunctive relief absent “facts—cold, hard, solid facts, established either by admission or by trials.”

In vacating Judge Rakoff’s order, the Court of Appeals held that the Judge had applied the wrong standard and departed from the policy reasons supporting settlement.  Regarding the proper standard, Judge Rakoff required that the settlement agreement not be “unfair, unreasonable, inadequate, or in contravention of the public interest.”  The Court of Appeals agreed, with one significant exception:  adequacy.  The appellate court held that the proper standard is that the consent decree be fair and reasonable and, if injunctive relief is involved (as is uniformly the case with SEC settlements), not contrary to the public interest; absent a “substantial basis” to conclude otherwise, the district court is “required” to approve the settlement.  As to “adequacy,” the court held that this standard was more applicable in class actions where adequacy of the settlement pool for the class would be important; the court held that an adequacy standard was “particularly inapt in the context of a proposed S.E.C. consent decree.”

As to fairness and reasonableness, the Second Circuit held that “[t]he primary focus of the inquiry … should be on ensuring the consent decree is procedurally proper,” the criteria for which are (1) “the basic legality of the decree”; (2) whether the terms of the decree, including its enforcement mechanism, are clear; (3) whether the decree resolves the actual claims in the complaint; and (4) whether the decree is tainted by improper collusion or corruption of some kind.  In undertaking this analysis, the district court must take “care not to infringe on the S.E.C.’s discretionary authority to settle on a particular set of terms.”

Regarding the public interest, the Court of Appeals held that though this was a proper subject of consideration for the district court, Judge Rakoff abused his discretion by declining to approve the settlement because he may have believed that the SEC failed to bring the proper charges against Citigroup.  According to the Second Circuit, district courts do not have the power to tell the SEC what charges to bring, ruling that the “exclusive right to choose which charges to levy against a defendant rests with the S.E.C.”  More generally, the appellate court held, in evaluating whether the public interest would be disserved, the district court is required to give the SEC “significant deference.”

As to Judge Rakoff’s search for “truth,” the court of appeals held that “[i]t is an abuse of discretion to require … that the S.E.C. establish the ‘truth’ of the allegations against a settling party as a condition for approving the consent decrees.”  As the court observed:  “Trials are primarily about the truth.  Consent decrees are primarily about pragmatism.”  Consequently, it was not within the district court’s province “to demand ‘cold, hard, solid facts, established either by admissions or by trials,’” when the whole idea of a settlement was to manage risk, conserve resources, and reach a compromise.

The Second Circuit did not approve the settlement; rather, it remanded the case to Judge Rakoff for further consideration.  It strongly suggested that Judge Rakoff already has a sufficient record before him to approve the settlement, but it allowed for the possibility that he could ask the parties to provide additional information to allay any concerns he might have about improper collusion between them.

The Second Circuit’s opinion will likely have far-reaching consequences for SEC settlements.  As previously reported in Orrick’s Securities Litigation and Regulatory Enforcement Blog, the regulator had already announced in June 2013 that it would begin seeking more actual admissions rather than relying on no-admit/no-deny settlements.  In declining to approve the settlement agreement with Citigroup, Judge Rakoff did not require that Citigroup admit liability; rather, he wanted more facts establishing the truth of the allegations, but crossed the line by questioning the SEC’s policy decisions.  Yet, even when the SEC announced last year that it would seek more admissions, Chair Mary Jo White cautioned that “the ‘no admit, no deny’ protocol . . . will remain for the majority of cases.”  In light of the Second Circuit’s opinion, that is certain to be the case.

The Court of Appeals’ opinion also portends a possible change in how the SEC brings settlements.  In the concluding paragraph of its opinion, the Second Circuit stated that “to the extent that the S.E.C. does not wish to engage with the courts, it is free to eschew the involvement of the courts and employ its own arsenal of remedies instead.”  The court then noted the SEC’s ability to impose disgorgement in administrative proceedings; and, under Dodd-Frank, the agency may now also obtain civil penalties in such proceedings.  The primary difference now between federal court actions and administrative proceedings is the difference between federal court injunctions, which may be enforced through contempt proceedings, and cease and desist orders.  SEC Enforcement officials have recently stated that the agency is likely to bring more settlements in the administrative forum, and the Second Circuit’s concluding words are likely to encourage that approach.