Peeling away financial reporting issues one layer at a time

Is the Judiciary about to Give the SEC a Backbone?*

I have long been frustrated by the SEC's practice of settling cases of financial misconduct without making the defendants admit to the allegations. That policy gives a defendant a significant economic incentive to settle with the SEC, because one who admits guilt to the government may not later deny it in a private action – where the money penalties could be much bigger. For its part, the SEC loves settlements; it makes for many positive press releases and hedges against the embarassing possibility that a case could actually be lost in a court of law.

In general, I despise settlements 'without admitting or denying.' Especially where the illegal conduct is extreme and obvious, I can't possibly see how the public interest is being served by settling without an admission of guilt. I first exclaimed my frustration in a blog post back in 2008 in reaction to the SEC's settlements with Worldcom's auditors. If there has ever been a case where the SEC could have sent an unequivocal message to the audit profession by prosecuting the auditors to the fullest extent of the law, Worldcom was it. Moreover, the public has a right to know how WorldCom's auditors violated the basic standards of their profession without allowing any sort of equivocation to be a part of the story.

Today, however, I am happy to report that I may have one less pet peeve to write about. Indeed, the days of SEC settlements without obtaining admissions of guilt could be over. NYT reports that Judge Jed Rakoff, of the Federal Court of the Southern District of New York threw out the SEC's $285 million settlement with Citigroup because it "did not satisfy the law." Moreover, the judge found that the Citigroup settlement paled in comparison to an earlier settlement with Goldman Sachs, which was ultimately approved last year with no small amount of reluctance.

Below are excerpts (highlighting supplied) from today's scathing 15-page ruling by Judge Rakoff.

From page 15:

Finally, in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency's contrivances.

From page 1:

According to the S.E.C.'s Complaint, after Citigroup realized in 2007 that the market for mortgage backed securities was beginning to weaken, Citigroup created a billion-dollar Fund (known as "Class V Funding III") that allowed it to dump some dubious assets on misinformed investors. This was accomplished by Citigroup's misrepresenting that the Fund's assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negative projected assets and had then taken a short position in those very assets it had helped select. Complaint ¶¶ I, 2, 58.

From page 2:

Although this would appear to be tantamount to an allegation of knowing and fraudulent intent ("scienter," in the lingo of securities law), the S.E.C., for reasons of its own, chose to charge Citigroup only with negligence.

From page 4:

Since then the Court has spent long hours trying to determine whether, in view of the substantial deference due the S.E.C. in matters of this kind, the Court can somehow approve this problematic Consent Judgment. In the end, the Court concludes that cannot approve it because the Court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.

From page 5:

In its most recent filing in this case, however, the S.E.C. partly reverses its previous position and asserts that, while the Consent Judgment must still be shown to be fair, adequate, and reasonable, "the public interest … is not part of [the] applicable standard of judicial review." SEC Mem. at 4 n. 1. This is erroneous. A large part of what the S.E.C. requests, in this and most other such consent judgments, is injunctive relief, both broadly, in the request for an injunction forbidding future violations, and more narrowly, in the request that the Court enforce future prophylactic measures (here, for a three-year period). The Supreme Court has repeatedly made clear, however, that a court cannot grant the extraordinary remedy of injunctive relief without considering the public interest.

From page 8:

Applying these standards to the case in hand, the Court concludes, regretfully, that the proposed Consent Judgment is neither fair, nor reasonable, nor adequate, nor in the public interest. Most fundamentally, this is because it does not provide the Court with a sufficient evidentiary basis to know whether the requested relief is justified under any of these standards.

From page 9

Here, the S.E.C.'s long-standing policy – hallowed by history, but not by reason – of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.

From page 9:

The S.E.C., by contrast, took the position that, because Citigroup did not expressly deny the allegations, the Court, and the public, somehow knew the truth of the allegations. Tr. 12-13. This is wrong as a matter of law and unpersuasive as a matter of fact.

From page 10:

[A] consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies. This, indeed, is Citigroup's position in this very case.

From page 11:

It is harder to discern from the limited information before the Court what the S.E.C. is getting from this settlement other than a quick headline. By the S.E.C.'s own account, Citigroup is a recidivist, SEC Mem. at 21, and yet, in terms of deterrence, the $95 million civil penalty that the Consent Judgment proposes is pocket change to any entity as large as Citigroup.

From page 11:

While the S.E.C. claims, that it is devoted, not just to the protection of investors but also to helping them recover their losses, the proposed Consent Judgment, in the form submitted to the Court, does not commit the S.E.C. to returning any of the total of $285 million obtained from Citigroup to the defrauded investors but only suggests that the S.E.C. "may" do so. Consent Judgment at 3. In any event, this still leaves the defrauded investors substantially short-changed.

From page 13:

The Court is also troubled when it compares the proposed Consent Judgment with the consent judgment entered last year between the SEC and Goldman Sachs… Goldman involved a similar but arguably less egregious factual scenario … Nonetheless, the consent judgment in Goldman required Goldman to pay a $535 million penalty, even though it made only $15 million in profits. … [T]he SEC does not explain how Goldman's actions were more culpable or scienter-based than Citigroup's actions here. Furthermore, the consent judgment in Goldman contained several terms that are notably missing from the proposed Consent Judgment here. First, the consent judgment included …[an] express admission from Goldman … By contrast, Citigroup has not agreed to cooperate with the SEC in any cognizable respect.

* * * * * *

As one can plainly see, Judge Rakoff has frequently rejected the SEC's interpretation of the law and the facts. It deeply saddens me to see how the agency that I worked with and long admired has become a shell of its former self – brought on by a lack of resources, a lack of will among its leadership to pursue cases, and the ever spinning revolving door.

But, the SEC needs more than a single ruling in a federal district court to get it back on track. The SEC sorely needs new leadership: someone with a sense of history, vision and a backbone.

Actually, it needs someone like Judge Rakoff. But, at least for today, I'll have the satisfaction of knowing that someone is finally insisting on making securities law violators, no matter how well politically connected, fully accountable for their actions.


*Thanks to Roger Collins of Thompson Rivers University in Canada for giving me the title for this post; and thanks to Lynn Turner for supplying the key excerpts to Judge Rakoff's ruling.


  1. Reply Steven November 29, 2011 – The full text of the ruling. It’s deliciously scathing in calling out the SEC on it’s wrist slapping.

  2. Reply Lynn Rees November 29, 2011

    Hello Tom,
    Interesting post, as always. I understand your frustration in the fact that Wall Street firms are typically able to settle SEC allegations with a financial penalty (sometimes paltry when compared to the firm’s size) and without admitting guilt. And, Judge Rakoff’s decision, at first glance, would appear to be a step in the right direction for finally bringing some justice to Wall Street shenanigans.
    However, I think a closer inspection might cause one to pause. If the choice for firms is to admit guilt as part of a settlement, or go to court and fight, I would think that wouldn’t be much of a choice at all. Firms will go to court and take their chances, regardless of what the potential financial consequences might be. The reason is because by admitting guilt, the firm is not only further damaging their reputation (thereby, affecting future revenue), but also opening up the floodgates for future litigation. Faced with such a choice, it would seem that the firm would choose going to court every time.
    So, in the long run, Judge Rakoff’s decion will have the following effects. First, an already understaffed SEC will be less able to pursue violations because they will need more resources to fight in court the ones they find. Second, an already overburdened court system will be further weighed down.

  3. Reply Adrian November 29, 2011

    Very interesting article, thank you.

  4. Reply Independent Accountant December 1, 2011

    Bravo Rakoff. I’ve said for over 30 years that the SEC’s enforcement division is a sham. It should end the practice of letting defendants neither admit nor deny guilt. If the SEC only brings 10% as many cases a year and takes every one to trial, investors will be better off.

  5. Reply Bob Abidor December 25, 2011

    Corporations have been viewing SEC enforcement actions like class action litigation: come up with a sum to make plaintiffs’ counsel happy (here substitute SEC) then propose the minimum amount to pay to the class. Never admit actual responsibility, just pay the sum as a cost of doing business.
    The SEC has a far greater responsibility to the investing public than does class action counsel. When the two roles become confused, we have the mess we have now. Unless and until appealled Judge Rakoff’s decision will have limited legal effect beyond his courtroom, hopefully a well-reasoned decision by a Judge of the most prominent court handling financial matters (Southern Distrcit of NY)will carry some weight with the SEC. Whether the wishy-washy Obama administration will push to support this effort is a serious question.

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