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Cady Bar the Door Insight & Commentary on SEC Enforcement Actions and Related Issues

SEC Appeal of Citigroup Ruling Pays Off

Posted in SEC Litigation, Structured and New Products

Years from now, it may seem clear that a district court would have to have truly extraordinary reasons for rejecting a settlement between a sophisticated and well-represented investment bank and a government agency litigating against that bank.  Judge Rakoff in the Southern District of New York did just that last November, and sent the SEC and Citigroup back to the drawing board to figure out how to settle their case involving misrepresentations about a pool of CDOs marketed by Citigroup.  At the time, Rakoff was hailed as a hero by many for calling out the SEC for allowing Citi to settle the matter while neither admitting nor denying the allegations in its complaint.  He even gave an interview to the Huffington Post discussing his role as a judge and his assessment of the SEC’s enforcement resources.  Following Rakoff’s cue, at least one other judge took a similarly skeptical approach to another proposed SEC settlement, and the SEC probably started to feel a bit fenced in.

But appealing Rakoff’s ruling was not necessarily the most obvious path to fixing the problem.   In two other similar instances with Judge Rakoff, the SEC retreated with its counterparties, tweaked the settlements in ways he would accept, and moved on.  And the SEC does have other options, including filing cases in administrative court and every other federal district court in the nation.  But given that the country’s financial center is in Manhattan, it can’t easily avoid the Southern District of New York, and certainly doesn’t want to look like it’s ducking its worst judicial tormentor.  After all, he could pop up again as the randomly assigned judge in that court at any point.  So maybe the third time was the charm.

Anyway, late last year, the SEC and Citi got together and decided they were going to go over Judge Rakoff’s head, and appealed his ruling to the U.S. Court of Appeals for the Second Circuit.  This was a risky decision.  If they lost, Rakoff’s reasoning could have been enshrined as the law not just for this case, but for all similar cases in arguably the most important federal court of appeals.  From the SEC’s perspective, that would have been a disaster.  So they appealed, and in the interim, moved for a stay of the district court proceedings so the appeal could be effective.  Rakoff’s order of a quick trial otherwise would have made any appeal moot.

The Second Circuit’s Analysis

Yesterday, the Second Circuit granted the motion for the stay, and as part of its order addressed whether the SEC and Citi were likely to succeed on the merits of their appeal.  The motions panel for the court – including Judges Walker, Leval, and Pooler – dismantled Rakoff’s ruling piece by piece.

Judge Rakoff had said primarily that a consent judgment without an admission of liability from Citigroup was bad policy and failed to serve the public interest because defrauded investors could not use the judgment to establish Citi’s liability in separate civil suits.  The panel saw several problems in his reasoning.  First, it assumed that Citi had misled investors, and that the SEC would win at trial if it simply chose to go through the exercise, when in fact establishing liability at trial was uncertain and carried a lot of risk.  More significantly, while Judge Rakoff believed the SEC’s decision to settle with Citigroup was bad policy, the court held that “[i]t is not . . . the proper function of federal courts to dictate policy to executive administrative agencies.  The court went on, quoting Chevron v. Natural Resources Defense Council, 467 U.S. 837, 866 (1984): “Federal judges – who have no constituency – have a duty to respect legitimate policy choices made by those who do.  The responsibilities for assessing the wisdom of such policy choices and resolving the struggle between competing views of the public interest are not judicial ones: ‘Our Constitution vests such responsibilities in the public branches.”

The court noted that while Rakoff verbally acknowledged his obligation to give deference to the SEC’s decision, the record did not suggest that he really did defer to the SEC’s judgment on any questions regarding agency resources or the likelihood that a better or worse result might come from taking a different path.  “Instead, the district court imposed what it considered to be the best policy to enforce the securities laws.”

As to unfairness to Citigroup from a settlement that included no admissions or findings of fact, the court questioned whether it was a “proper part of the court’s legitimate concern to protect a private, sophisticated, counseled litigant from a settlement to which it freely consents.”

The court also addressed Judge Rakoff’s concern that he could not adequately evaluate the fairness of the settlement unless the underlying facts were conclusively established.  The panel said first that it was not true that Rakoff had no basis to assess the underlying facts.  He did have the evidentiary record amassed by the SEC in its investigation, and the SEC did provide information to the court regarding how the evidence supported the proposed consent judgment.  And he was further free to ask the parties for guidance as to how the evidence supported the claims in the SEC’s complaint.

As for the public interest in the proposed settlement, the panel basically left that determination to the SEC.  The Commission had asserted that the settlement was in the public interest and that the stay was crucial to securing that.  Citing Chevron again, the court held flatly that it was “bound in such matters to give deference to an executive agency’s assessment of the public interest.”

What’s Next

The motions panel was careful to note that its ruling was only preliminary and that the court had not had the benefit of adversarial briefing.  As the SEC and Citi had joined forces in seeking the stay, the district court’s decision was not represented in the papers for that motion.  Counsel will be appointed by the court for the full appeal, which will not be conducted on an expedited basis.  (That will be a fun appointment.)  But I will be surprised if the SEC and Citi do not win this effort to overturn Rakoff’s rejection of the settlement.  The panel noted that while a district court need not “rubber stamp all arguments made by such an agency, . . . [i]t does mean at least that a court should not reject the agency’s assessment without substantial reason for doing so.”   Maybe the merits panel will go the other way, but I am not seeing many substantial reasons propping up Rakoff’s decision at this point.