SEC Litigates with Judge, Lets Wall Street off the Hook

Dec 16 2011 - 6:28am

Last month, New York Federal District Judge Jed Rakoff rejected a sweetheart settlement that the SEC proposed with Citigroup, finding it deficient in many ways and calling the fine nothing more than "pocket change." In fact, the settlement was so weak it actually rewarded securities fraud and showed crime pays. But, the rejection was still huge news because judges just don't say "no" to the SEC. Almost always, the SEC files papers in a court to settle a case and the judge always just signs them. It is rare for a judge to even ask a question before signing.

Judge Rakoff is different. He takes his job as a judge seriously. He carefully reads the court filings and he asks questions to determine, as judges are supposed to, whether or not a proposed settlement is fair, adequate, reasonable and in the public interest. The SEC doesn't like this. It expects judges to pull out their rubber stamp of approval and apply it quickly, without having the nerve to question them.

That just isn't Judge Rakoff. In September 2009, he rejected the SEC's proposed $33 million settlement with Bank of America for failing to disclose that it was going to ladle out $5.8 billion in bonuses to Merrill Lynch executives. After that rejection, the SEC actually litigated with Bank of America and then went back to the court with a settlement for $150 million, which Judge Rakoff reluctantly approved in February 2011 because the law left him no choice.

The SEC faced the same choice this time: litigate with Citigroup, the big, powerful, well-connected Wall Street bank, or litigate with a single Federal District Judge who can't actually defend himself.

No one should be surprised that the risk-adverse, Wall Street friendly SEC chose not to litigate against Citigroup for pocketing more than $600 million from its $1 billion fraudulent subprime mortgage scheme that cost its customers more than $700 million. Instead, the SEC decided to litigate against the one federal judge who had the audacity to scrutinize their proposed settlements. As the Wall Street Journal headline correctly captured it, "SEC Cops Want to Fight U.S. Judge."

Ironically, in the eyes of the SEC, Judge Rakoff is a repeat offender (first, Bank of American and now Citigroup!), but Citigroup is literally a repeat offender, having been toothlessly sanctioned by the SEC 5 times in the last 8 years for violations of the securities laws. Judge Rakoff had the nerve to ask the SEC what was the point of slapping their wrist one more time given that the prior five slaps appeared not to make much of an impression. (Such repeated toothless "sanctions" is common for the SEC.)

Notably, the judge also rejected an argument of the SEC that was as novel as it was dangerous. The SEC argued that it could settle cases regardless of whether they were in the public interest or not. Incredulous, Judge Rakoff asked the SEC at oral argument if it was their position that he had to approve the settlement even if it was against the public interest. After several attempts to avoid answering, the SEC finally said that, yes, it could settle cases even if they were against the public interest and the judge had to approve those cases. The court rejected that argument and properly found that, when the SEC settled cases, the settlement had to be in the public interest, which this one was not.

While the appeal will raise some serious issues with the basis for the Court's opinion, it's really arguing that this judge violated the law because he rigorously questioned the proposed settlement. There is a lot at stake in this appeal that has nothing to do with this judge or this case. The role of Federal Courts as an independent check on the parties, even when one party is a federal agency, is at stake. The rule of law being applied equally to everyone, even big, powerful, Wall Street banks, is at stake. And, maybe most important of all, whether the SEC has to determine that a settlement is in the public interest or not is at stake.

Unfortunately, this case also highlights a serious flaw in the legal system. The entire structure of the trial system in the U.S. is based on the adversary system. The belief is that the best way for the truth to come out is for two opposing parties to battle it out, which is supposed to reveal all the important facts. That is what is supposed to provide a judge with enough confidence to conclude that he has all the information to fairly decide a case.

That fundamental structure breaks down when there is a settlement. There are no adversaries at that point. All parties before the judge want the settlement they negotiated approved. They have no interest in bringing anything to the court's attention that would cause him to reject their settlement.

When it is private litigation, that may not matter so much. But, when one of the parties is a regulator like the SEC, that breakdown is of fundamental concern. In the Citigroup case, the result was that key information was not provided to Judge Rakoff and, if the SEC and Citigroup (again both on the same side, arguing for the same thing) succeed in getting the appeal court to overrule him, then no one will ever know all the facts. That too is what is at stake in the case and that is why Better Markets will seek to participate in the appeal to promote and protect the public interest.