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In an opinion released today, District Court Judge Rakoff rejects a proposed Consent Judgment agreed to by the S.E.C. and Citigroup Global Markets, Inc. because it does not include sufficient facts for him to determine whether the settlement is in the public interest.

Judge Rakoff’s criticism of the proposed settlement is broad. He takes issue with the S.E.C.’s handling of the matter from its initial complaint (“the S.E.C., for reasons of its own, chose to charge Citigroup only with negligence”) to its adherence to its “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.” Judge Rakoff is unhappy with the size of the settlement, the fact that the S.E.C. is not committed to returning the settlement proceeds to the investors who have been wronged by Citigroup, and the fact that the settlement does not have any obvious benefit for the victim investors. Thus, he concludes that he cannot approve the Consent Judgment.

His decision to reject the agreement and his cogent argument against it may have substantial consequences for future S.E.C. enforcement.

Standard of Review

Judge Rakoff affirms that the standard of review for a proposed settlement that includes injunctive relief is whether the agreement is “fair, reasonable, adequate, and in the public interest.” (opinion at p. 4-5). And the S.E.C. is not the sole arbiter of whether the agreement is in the public interest. It is the court’s duty to “exercise a modicum of independent judgment in determining whether the requested deployment of its injunctive powers will serve or disserve, the public interest. Anything less would not only violate the constitutional doctrine of separation of powers but would undermine the independence that is the indispensable attribute of the federal judiciary.” (opinion at p. 6-7).

Evidentiary Basis for Relief

The Court cannot determine whether the proposed settlement is in the public interest if the parties do not provide a sufficient evidentiary basis for the settlement. Judge Rakoff argues that the S.E.C.’s practice of allowing defendants to neither admit nor deny the allegations means that there is no evidentiary basis for the requested injunctive relief. He states, “the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts while the public is deprived of ever knowing the truth in a matter of obvious public importance.”

Marginal Enforcement

Judge Rakoff explains that the proposed settlement is either a “very good deal for Citigroup [if the allegations are true]” or, at the least, a “mild and modest cost of doing business [if the allegations are not true],” while “[i]t 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.” The proposed penalty ($95 million) is “pocket change” to Citigroup and the proposed settlement leaves the investors “short-changed” because private investors cannot bring securities claims based on negligence and they can derive no benefit from Citigroup’s “non-admission/non-denial of the S.E.C.’s allegations.”

Rejection of the Paradigm?

Judge Rakoff’s reasoning is broad enough to encompass not merely the settlement proposal at issue but also the S.E.C.’s general method of settling enforcement actions without requiring defendants to admit or deny the charges against them. He decrees that “the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that 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.”

Will the S.E.C. change its approach to settling enforcement actions as a result of Judge Rakoff’s opinion? Will other courts latch on to Judge Rakoff’s reasoning and apply it to reject other S.E.C. settlements?

If the S.E.C. changes its practices and begins to require that defendants admit to wrongdoing to settle an enforcement action will investors benefit? Well, as with most legal issues, it depends. If the defendant does agree to make the admissions and settle the enforcement action, then the wronged investors will benefit because they will be able to use those admissions in any subsequent lawsuit.

But that is an important “if.” More likely, if the S.E.C. requires defendants to admit to wrongdoing as a condition of settling an enforcement action, there will be fewer settlements. Defendants will have more to lose from settling and may decide to take their chances at trial. This will increase the costs for the S.E.C. of bringing enforcement actions, because more of the cases will need to be litigated through trial. At least some of those trials are likely to go against the S.E.C. Thus, requiring that the defendants admit to wrongdoing as a condition of settling may lead to less S.E.C. enforcement than we currently see.

But it also may lead to stronger, more developed enforcement cases going to trial. And maybe if the S.E.C. wins significant judgments at trial there will be a real deterrent effect instead of agreed-to penalties that may be considered a “mild and modest cost of doing business.” Thus, a change in approach may lead to fewer settlements but greater enforcement.

Of course, other courts may disagree with Judge Rakoff and the S.E.C. might continue to allow defendants to settle matters without admitting to any liability.