Overturning SEC v. Citigroup: Why the Original Decision Still Matters

By Steven  Jacobson

Steven Jacobson is a rising freshman at University of Pennsylvania.

"[It] was the shot heard ’round the world,” said Cornelius Hurley, director of Boston University’s Center for Finance, Law & Policy [1]. And, on June 4th, 2014, that shot was struck down as the US Court of Appeals for the Second Circuit overturned the November 2011 decision handed down by Southern District of New York Judge Jed S. Rakoff in the case US Securities and Exchange Commission v. Citigroup Global Markets, Inc. It was the rare case in which both sides were satisfied with the outcome; Citigroup escaped with only a minimal fine, and the SEC received more freedom to settle cases on its own terms. Yet, despite its reversal, Rakoff's decision has significantly impacted the manner in which the SEC settles cases with large corporations.

The case came about when the SEC filed a lawsuit against Citigroup in October 2011. The suit alleged that in 2007, just before the height of the financial crisis, the bank had bundled negatively-projected assets into a $1 billion financial product called a collateralized debt obligation (CDO) and sold it to investors, representing it as a highly attractive investment predicted to perform well by a third-party adviser. However, the bank secretly short sold the mortgage-backed securities in the CDO. In other words, Citigroup sold something that it had actively betted against to investors. As the bank predicted, the CDO's value plummeted, its investors lost $600 million, and Citigroup's short sale made it $160 million.

Usually, when a settlement such as this goes to court, the judge will approve it, and if not, it’s usually over a fixable procedural matter. However, Judge Rakoff delivered a surprising verdict when he rejected the settlement because it lacked an official admission of wrongdoing on Citigroup’s part. In Rakoff’s written opinion, he emphasized four standards by which to measure such settlements (also called, in legal terms, consent judgments or consent decrees): fairness, reasonability, adequacy, and benefit to the public interest. Of those four tenets pertaining to the SEC v. Citigroup settlement, Rakoff wrote:

“It is not reasonable, because how can it ever be reasonable to impose substantial relief on the basis of mere allegations? It is not fair, because, despite Citigroup's nominal consent, the potential for abuse in imposing penalties on the basis of facts that are neither proven nor acknowledged patent. It is not adequate, because, in the absence of any facts, the Court lacks a framework for determining adequacy. And, most obviously, the proposed Consent Judgment does not serve the public interest, because it asks the Court to employ its power and assert its authority when it does not know the facts" [2].

Rakoff went on to emphasize the value of the truth to the public interest, writing that the SEC “of all agencies” is obligated to reveal the truth to the public, and since it failed to do so, the court could not approve the settlement [1]. The judge also griped that Citigroup and the SEC did not provide enough information that the settlement was reasonable, pointing out that despite the bank’s willful deception of its customers, it was only charged with negligence. The apparent lack of information provided in the agreement combined with the absence of an official disclosure of malpractice, Rakoff commented, “An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous" [2].

The biggest surprise of Rakoff's surprising decision was his mandate of an admission of culpability in the settlement. For years, the SEC had been settling cases without requiring such a confession—a practice that Rakoff noted was prevalent in the SEC's history but questionable in a practical sense. However, the policy certainly has its apologists, such as Michael Klausner, a professor at Stanford Law School. He's one of many experts that see Rakoff's decision as leading to more defendants contesting their charges in court instead of quickly agreeing to settle cases with the agency. "Rakoff has made a point," he said. "But I don't think it is feasible in very many cases in the enforcement regime" [3]. The SEC's resources are already stretched tightly, as it has recently lost more cases than it has won; an increase in trials would not improve that ratio. 

Therefore, many delighted in the reversal of Rakoff’s decision in early June by a three-judge panel of the Second Circuit. The court affirmed the SEC’s power to tailor settlements as it sees fit, asserting that Rakoff abused his discretion by requiring the agency to establish the truth of the allegations. The Second Circuit added that Rakoff had not indicated a condition of his approval of the civil accord on a requirement for a declaration of liability when the initial proceedings began. The Appeals Court saw that this was with good reason, as they found no basis in the law to require such an admission in a settlement. The Court wrote "[the] primary focus of the inquiry . . . should be on ensuring the consent decree is procedurally proper, using objective measures." And, in response to Rakoff's assertion that he lacked such "objective measures," the court said, “the district court here, with the benefit of copious submissions by the parties, likely had a sufficient record before it to determine if the proposed decree was fair and reasonable" [4]. 

It seems likely, as Klausner suggests, that Rakoff was trying to make a point, but he exceeded that goal through causing a substantive change in policy. In 2012, the SEC began to require confessions from defendants in more some egregious cases. Under White, the SEC has already put this to use, receiving admissions from JPMorgan Chase & Co. over its $6.2 billion trading loss in the London Whale scandal and from Philip Falcone over dealings at his hedge fund. Other district judges have followed Rakoff's lead and have refused to approve a number of other settlements between that lack confessions. 

The Second Circuit’s ruling is probably for the best, as it returns the freedom to further negotiate with defendants and speeds up the judicial process. However, by letting the Southern District of New York's final opinion sit for as long as it did, the Second Circuit allowed Rakoff's decision to have an effect, allowing the brilliant, iconoclastic judge to have a lasting, even if minor, impact.


[1] Hurtado, Patricia. "Citigroup SEC Accord Revived as Agency Power Strengthened."" Online Article. Bloomberg News. Bloomberg L.P., 4 June 2014. Web. 26 June 2014. <http://www.bloomberg.com/news/2014-06-04/citigroup-wins-order-reviving-285-million-sec-accord.html>
[2] US Securities and Exchange Commission v. Citigroup Global Markets, Inc. 15. Southern District of New York. 28 Nov. 2011. 4Closure Fraud. 4ClosureFraud.org, 28 Nov. 2011. Web. 26 June 2014. <http://4closurefraud.org/2011/11/28/u-s-securities-commission-v-citigroup-global-markets-inc-285-million-citi-settlement-with-sec-rejected-by-judge-jed-rakoff/>
[3] Stempel, Jonathan, and Sarah N. Lynch. "U.S. Appeals Court Voids Judge's Rejection of SEC-Citigroup Accord." Reuters. Thomson Reuters, 04 June 2014. Web. 29 June 2014. <http://www.reuters.com/article/2014/06/04/us-citigroup-sec-idUSKBN0EF1E220140604>
[4] Sharp, Richard T., Wayne M. Aaron, and Ian E. Browning. "Second Circuit Vacates Judge Rakoff’s Decision Refusing to Approve Citigroup’s “Neither Admit nor Deny” Settlement with the SEC and Clarifies Standard for Evaluating Consent Decrees in Favor of Pragmatism."Milbank.com. Milbank, Tweed, Hadley, and McCloy, 6 June 2014. Web. 26 June 2014. <http://www.milbank.com/images/content/1/6/16665/US-LIT-SEC-v-Citigroup-6-Jun-2014.pdf>

Photo Credit: Flickr user Securities and Exchange Commission