In a scathing Opinion and Order issued on Monday, November 28, 2011, Judge Jed Rakoff rejected the SEC proposed settlement with Citigroup Global Markets for $285 million, suggesting the SEC was hoping for "a quick headline" and finding "that the proposed Consent Judgment is neither fair, nor reasonable, nor adequate, nor in the public interest." Instead, the Judge consolidated the Citigroup case with a related matter, SEC v. Stoker , No. 11-civ-7388 (S.D.N.Y. Filed Oct. 19, 2011), and set a trial date of July 16, 2012. The decision could have a significant impact on how the SEC will approach and settle cases and what defendants who want to settle will be forced to consider.

As discussed here, the Commission filed its Complaint against Citigroup on October 19, 2011 in federal court in New York, where it alleged that "[t]he marketing materials Citigroup prepared and distributed to investors did not disclose Citigroup’s role in selecting assets for [a $1 billion collateralized debt obligation ("CDO")] and did not accurately disclose to investors Citigroup’s short position on those assets." On the same day, the SEC has also filed its separate complaint against Brian Stoker, the Citigroup employee primarily responsible for structuring the CDO transaction.

Citigroup agreed to pay $285 million (consisting of $160 million in disgorgement, $30 million in prejudgment interest and a $95 million civil penalty) to settle with the SEC. In an October 27, 2011 Order (discussed here), Judge Rakoff scheduling a hearing for November 9, 2011 to "ascertain whether the proposed judgment is fair, reasonable, adequate, and in the public interest" and raised certain questions On November 7, 2011, the SEC filed its Brief in response to Judge Rakoff’s questions (as discussed in greater detail here).

In rejecting the settlement, Judge Rakoff pointed to the Complaint filed against Mr. Stoker and the SEC’s allegation that "Citigroup knew it would be difficult to place the liabilities of [the Fund] if it disclosed to investors its intention to use the vehicle to short a hand-picked set of [poorly rated assets]" and that "Citigroup knew that representing to investors that an experienced third-party investment adviser had selected the portfolio would facilitate the placement of the [Fund’s] liabilities" (emphasis supplied by Judge Rakoff). However, as the Court pointed out:

Although this would appear to be tantamount to an allegation of knowing and fraudulent intent ("scienter," in the lingo of securities law), the SEC, for reasons of its own, chose to charge Citigroup only with negligence, in violation of Sections 17(a) (2) and (3) of the Securities Act, 15 U.S.C. § 77q(a) (2) and (3).

Judge Rakoff noted that the SEC consented to the settlement "without admitting or denying the allegations of the complaint." As a result, Judge Rakoff said he "cannot approve" the settlement "because the Court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment."

Judge Rakoff scolded the SEC for its position that the Court should not consider the public interest when reviewing the proposed settlement. The SEC’s October 19 submission in support of the settlement correctly acknowledged that the public interest was part of the standard of review, but the Commission’s November 7 brief argued it was not part of the applicable standard. Judge Rakoff pointed out that the "Supreme Court has repeatedly made clear" that when a party such as the SEC seeks a permanent injunction, the Court must consider the public interest. Judge Rakoff also rejected the SEC’s argument that it is the sole determiner of what is in the public interest.

In rejecting the settlement, Judge Rakoff said:

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. Purely private parties can settle a case without ever agreeing on the facts, for all that is required is that a plaintiff dismiss his complaint. But when 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.

The Court described the SEC’s long-standing policy of allowing parties to settle without admitting or denying the allegations as "hallowed by history, but not by reason" and depriving the Court "of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact." He noted that at the November 9 hearing, counsel for Citigroup noted that he planned to contest the allegations in any parallel litigation.

The Court noted that "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 … rather than as any indication of where the real truth lies." He further stated that "[i]f the allegations of the Complaint are true, this is a very good deal for Citigroup; and, even if they are untrue, it is a mild and modest cost of doing business."

Judge Rakoff pointed out that it was difficult to see "what the SEC is getting from this settlement other than a quick headline," going as far to note that the SEC only promised that it "may" return the $285 settlement to investors. While the SEC stated at oral argument that it supported the use of civil actions to help investors recoup losses, Judge Rakoff expressed the view that

the combination of charging Citigroup only with negligence and then permitting Citigroup to settle without either admitting or denying the allegations deals a double blow to any assistance the defrauded investors might seek to derive from the SEC litigation in attempting to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence … but also cannot derive any collateral estoppel assistance from Citigroup’s non admission/nondenial of the SEC’s allegations

As a result, "the parties successful resolution of their competing interests cannot be automatically equated with the public interest."

Judge Rakoff concluded that it was not reasonable, fair, adequate or in the public interest to ask the Court "to impose substantial injunctive relief, enforced by the Court’s own contempt power, on the basis of allegations unsupported by any proven or acknowledged facts whatsoever." The most obvious problem, according to the Court was it was being asked "to employ its power and assert its authority when it does not know the facts," a practice Judge Rakoff described as "worse than mindless, it is inherently dangerous."

Judge Rakoff consolidated the case with the Stoker matter, adopted the existing Case Management Order in that case and set a trial date of July 16, 2012.