The US Court of Appeals for the Second Circuit recently issued a ruling that could debilitate the ability of the judiciary to serve as an independent arbiter of federal agency action. Ostensibly titled SEC v. Citigroup, the case actually pitted both the enforcement agency and the mega-bank against an outspoken judge from the Southern District of New York, Jed Rakoff. At issue in the case was whether Judge Rakoff had been correct in delaying judicial confirmation of a consent decree entered into by both parties.
The proposed consent decree related to alleged malfeasance by Citigroup, which, according to the SEC, negligently misled investors while earning a tidy profit of $160 million in the process. Citigroup marketed to investors a billion-dollar fund called Class V Funding III, asserting that the fund's portfolio was chosen by an independent investment advisor. In actuality, the Commission alleges, Citigroup itself had picked many of the assets in the fund and, in fact, took bets against the credit-worthiness of those very assets.
This sort of duplicitous conduct was rife in the run-up to the Great Recession of 2008, leading Congress to pass Section 621 of the Dodd-Frank Act of 2010, which authorized the SEC to implement regulations prohibiting such conflicts of interest in the structuring of securitization deals. In the Class V Funding III matter, the SEC's legal theory was that Citigroup had violated Sections 17(a)(2) and (3) of the Securities Act of 1933.
Bipartisan government commissions have recognized that bank malfeasance played a significant role in causing the recent financial crisis, which had catastrophic consequences for the average American: from 2007 to 2010, the median net worth of families dropped by a jaw-dropping 40 percent. Naturally, there has been a strong public appetite for redress, one manifestation of which was nascence of the Occupy Wall Street movement in September 2011.
The Citigroup enforcement action, like so many others arising out of the financial crisis, should have been a slam-dunk for the SEC. Sadly in this and other cases, the Commission repeatedly dropped the ball. For any number of reasons ranging from budgetary restrictions to regulatory capture, the Commission has taken a tepid approach to pursuing enforcement actions against the banks and other financial institutions that contributed to the crisis. Even in the most blatant cases of wrongdoing, the Commission has established a practice of settling with the offending bank for a paltry sum and allowing the offender to "neither admit nor deny" culpability for the misconduct.
The Class V Funding III investigation followed the same pattern. Even though Citigroup had engaged in arguably criminal conduct that netted the bank $160 million in profits, the SEC did not refer the matter to the Department of Justice for criminal enforcement. Instead, the Commission was content with settling the matter with Citigroup in exchange for:
a) a permanent injunction from future violations of Sections 17(a)(2) and (3) of the 1933 Act;
b) promises by Citigroup to implement internal changes to avoid similar actions in the future;
c)disgorgement of the $160 million in ill-gotten gains;
d) interest of $30 million; and
e) a penalty of $95 million.
To many observers of the financial markets, this deal amounted to little more than a proverbial "slap on the wrist." The permanent injunction component of this settlement deal was particularly risible: presumably Citigroup would have been bound by the 1933 Act even without the injunction. Equally laughable was the promise by the bank to implement changes to its business to avoid similar actions. Citigroup has actually made the same promise in several prior enforcement actions, and one suspects, will make similar empty promises in future enforcement proceedings.
The total settlement amount of $285 million paled in comparison to the $700 million lost by investors in the deal, or the quarterly profit of $3.8 billion enjoyed by Citigroup at the time. Citigroup could easily dismiss the $95 million penalty as the mere "cost of doing business," given that it amounted to an infinitesimal 2.5 percent of profits earned in one quarter.
The Commission could have been content with gifting Citigroup this sweetheart deal and policing any noncompliance under its administrative enforcement process. Instead, the agency applied for the SDNY to confirm the settlement in the form of a consent decree. Courts have in the past, routinely confirmed such proposed consent decrees and the Commission likely expected a similar outcome before the SDNY.
Unfortunately for the agency, Judge Jed Rakoff was assigned the case. Rakoff had previously held the Commission's feet to the fire for entering into a similarly lopsided settlement in the case of SEC v. Bank of America Corp. In that action, Bank of America agreed to pay $33 million in settlement, without admitting any culpability, for alleged misconduct relating to the payment of $5.8 billion in banker bonuses after its takeover of Merrill Lynch & Co. In 2003, Rakoff had similarly been critical of a $500 million settlement proposed by the SEC over accounting fraud at WorldCom Inc.
Rakoff rejected the Citigroup settlement in eloquent fashion [PDF], setting a trial date for an exposition of the facts underlying the deal:
[W]hen a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, 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.
Rakoff expressed the common-sense concern that enforcement actions have no deterrent effect when the penalty for misconduct, like the $95 million "contrivance" proposed by the SEC and Citigroup, is negligible. Particularly irksome to Rakoff was the fact that the settlement deal did not require Citigroup to admit to any material facts, in the absence of which Rakoff could not "exercise even a modest degree of independent judgment."
The decision sent shockwaves throughout the legal and financial community. In what once commenter has called the "Rakoff effect," the SDNY Citigroup decision emboldened others in the judiciary to decline to rubber-stamp proposed agency consent decrees and instead, demand the presentation of underlying facts.
The Commission fought back against the decision quite vigorously (exhibiting a rare solicitude that might have been better utilized in actual enforcement efforts). The agency immediately filed an interlocutory appeal with the Second Circuit seeking a stay of Rakoff's order. Citigroup joined ranks with the SEC on the appeal. The appeal attracted significant media attention and no fewer than ten interest groups filed amicus briefs in the case. In an unusual step, the court appointed an attorney to represent Judge Rakoff's position, given that both the SEC and Citigroup were on the same side on the interlocutory appeal.
After deliberating over the case for more than a year, the Second Circuit finally overturned and sharply rebuked Judge Rakoff's decision. While conceding that a district court need not "rubber stamp" proposed agency settlements, the Second Circuit held that Rakoff failed to afford due deference to the SEC's discretionary authority to settle on terms of its choosing.
While declining to delineate the precise contours of what could generally constitute a factual record sufficient to justify confirmation of a proposed settlement, the court nevertheless held that in this particular case Judge Rakoff likely had enough information to rule on the Citigroup consent degree. He should not have set a trial date to gather further information regarding the proposed settlement.
Tellingly, the court held that in such cases the "primary focus of the inquiry ... should be on ensuring that the consent decree is procedurally proper," and further concluded that "[i]t is not within the district court's purview to demand 'cold, hard, solid facts, established either by admissions or by trials'" before deciding on a proposed agency settlement. The court remanded the case to Judge Rakoff for review under this revised standard.
Under the precedent established by the Second Circuit in this case, district courts are to be relegated to rubber—stamping proposed settlement so long as the correct forms have been filed and the right boxes have been ticked. It is a sad day in American jurisprudence when a court of appeals restricts a district court's capacity to engage in fact-finding, given that that has historically been the lower court's very purview. The decision also raises Separation of Power concerns; by undermine the capacity of the judiciary to demand that administrative agencies explain their actions.
True, agencies have historically enjoyed a broad swathe of judicial latitude over substantive decisions, under the Chevron line of cases. However, Judge Rakoff's order plainly was not a substantive rejection of the Citigroup settlement. Rather, it was merely a request (albeit a sharply-worded one) for the parties to present further evidence surrounding the settlement during a trial. The Citigroup decision renders the SEC free to continue its practice of entering into middling enforcement settlements, all the while leaving the public in the dark about what exactly goes on behind that agency's closed doors.
Akshat Tewary is an attorney practicing in New Jersey, a FINRA arbitrator and President of Occupy the SEC, a nonprofit organization that advocates for financial reform. Tewary filed an amicus brief in Citigroup v. SEC on behalf of an Occupy Wall Street working group.
Suggested citation: Akshat Tewary, Second Circuit Undermines Judicial Independence and Agency Accountability in SEC v. Citigroup, JURIST-Hotline, July 2, 2014, http://jurist.org/hotline/2014/july/akshat-tewary-agency-accountability.php.
This article was prepared for publication by Jason Kellam, a Section Editor with JURIST's Commentary services. Please direct any questions or comments to him at firstname.lastname@example.org