Second Circuit Says Wall Street Can Play “Truth or Settle”

On June 4, 2014, a three-judge Second Circuit panel reversed and remanded Judge Rakoff’s 2011 order that rejected an S.E.C. settlement with Citigroup. The proposed settlement resolved the S.E.C.’s securities fraud case against Citigroup for misrepresenting its role and financial interest in a billion dollar investment fund. United States Securities and Exchange Commission v. Citigroup Global Markets, Inc., Docket Nos. 11-5227-cv(L); 11-5375-cv(con), 11-5242-cv(xap), 2d. Cir. (June 4, 2012).

According to the S.E.C. complaint, Citigroup “exercised significant influence” in selecting the fund’s assets, which were largely collateralized by subprime mortgage-backed securities. At the same time, the S.E.C. alleged, Citigroup took a short position in the mortgage-backed assets and earned $160 million when the assets performed poorly. The fund investors, on the other hand, lost millions of dollars.

Soon after filing the complaint, the S.E.C. entered a consent decree with Citigroup. Citigroup agreed to disgorge the $160 million net profits from the alleged conduct and pay $30 million in prejudgment interest and $95 million in civil penalties. The decree also imposed injunctive relief and remedial action. Citigroup made no admission of guilt or liability.

Judge Rakoff submitted a series of question to the S.E.C. and Citigroup to determine how fair and effective the consent decree would be. After a hearing on November 9, 2011, the court concluded that the proposed consent decree was “neither fair, nor reasonable, nor adequate, nor in the public interest” because sufficient basis did not exist to determine whether it was justified under those standards. S.E.C. v. Citigroup Global Markets Inc., 827 F.Supp.2d 328, 332 (S.D.N.Y. 2011). The judge largely criticized the lack of underlying facts on which to base an approval decision, as “the public is deprived of ever knowing the truth in a matter of obvious public importance.” Id. The judge refused to approve the consent judgment and set the case for trial. The Second Circuit granted a stay of the proceedings and determined that it could exercise jurisdiction over the interlocutory appeal.

The Second Circuit found that Judge Rakoff abused his discretion in applying an incorrect legal standard. In giving deference to the S.E.C. or any other enforcement agency in reaching a consent decree, the proper standard for review is “whether the proposed consent decree is fair and reasonable, with the additional requirement that the ‘public interest would not be disserved’ when it includes injunctive relief.” Omitting the term “adequacy” from the standard of review, the Court concluded “the district court is required to enter the order” unless a “substantial basis in the record” exists to conclude that the proposed consent decree does not meet the requirements.

According to the Court, Judge Rakoff abused his discretion when requiring the S.E.C. to establish the “truth” of the allegations against Citigroup as a condition for approving the consent decree. Trials are for “truth.” Consent decrees concern “pragmatism.”

The Second Circuit’s decision is a victory for Wall Street, which has been plagued in recent years by numerous enforcement and regulatory actions. Still, some argue that Judge Rakoff’s decision spurred needed public debate on appropriate penalties for wrongdoing in the financial industry and influenced government enforcement.

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