Rakoff's rejection of S.E.C.-Citibank settlement

You might have heard that U.S. District Judge Jed Rakoff rejected the Securities and Exchange Commission's proposed settlement of its complaint against Citibank. The S.E.C. alleged that Citibank had offered a collection of mortgage-backed securities (collateralized debt obligations, or CDOs, to be precise) to investors without revealing that Citibank itself was shorting those securities -- in other words, that Citibank was betting against them and assumed they would be lousy investments. As is customary in such cases, Citibank opted to settle with the S.E.C., giving up the profits it made on the deal plus a penalty. As is also customary in such cases, Citibank admitted no wrongdoing, even as it promised not to engage in such behavior in the future.

Translating that last bit: "I'm not saying I did it, and I promise not to do it again."

If that sounds fishy to you, join the club. Unfortunately, the club doesn't include a lot of federal judges: they routinely approve S.E.C. settlements with such terms. I don't know why the judges approve, but I assume it has to do with deferring to the S.E.C.'s presumed expertise in performing cost-benefit analyses of potential litigation. The judges, in other words, assume the S.E.C. has concluded that going to trial is not likely to result in a better net outcome.

Judge Rakoff disagreed. It's worth reading his opinion to see the numerous ways in which the S.E.C. did not well serve the general public.

The S.E.C. initially agreed that any settlement had to be "fair, reasonable, adequate, and in the public interest", but in a more recent filing the Commission asserted that "the public interest ... is not part of [the] applicable standard of judicial review" (that's Rakoff's quotation of the S.E.C.'s original wording, from page 5 of his opinion). Even if "the public interest" had to be taken into account, the S.E.C. wanted Rakoff to agree that the Commission was the one to decide what was in the public's best interest. Rakoff, though, would have none of that: not only is the public interest a vital consideration, but the court (Rakoff) must be the arbiter of what is in the public interest.

Rakoff then considers the other requirements, or "standard for judicial review", of any settlement: fairness, reasonableness, and adequacy. It's here that Rakoff makes a point that commentators I've read all miss. The problem he sees isn't that the S.E.C. is whitewashing wrongdoing for a song (which is what the Commission's critics have long accused it of doing). Rather, the problem is that the S.E.C. is asking courts to force defendants to modify their behavior without ever showing that the defendants misbehaved in the first place.

This is a smart way to challenge the S.E.C.'s timid and arguably lazy (if not sleazy) practice of prosecution-by-threat. Rakoff can't out-and-out say that the S.E.C. has been complicit (or at least too cozy) with the companies it is supposed to regulate, though reading between the lines, I detect a whiff of that accusation. Rakoff can, however, challenge the S.E.C. on the patently illogical "I'm not saying I did it, and I promise not to do it again" language in its settlements. The judge even noted that Citibank's attorney was ready to deny the allegations in court; that the company chose instead to settle with the S.E.C. strongly suggests that it views the settlement

... as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies.

(Rakoff's words, from his opinion.)

Rakoff makes a convincing argument that the S.E.C. and Citibank were playing a game rather than engaging in a genuine dispute. The settlement would have allowed both to claim victory without the cost and risk of a trial. Citibank, obviously, would have gotten off with a slap on the wrist. Rakoff thinks the S.E.C. was after high-profile headlines that would putatively prove to everyone that it was doing its job. Neither was genuinely interested in fighting over what Citibank did.

The S.E.C.'s willingness to play along with Citibank is hard to explain except as either collusion or sheer laziness. That's what Rakoff found so unpalatable. It's not that Rakoff wants to stick it to Citibank, or Wall Street generally. (Or even if it is, Rakoff can't say that out loud.) Rather, he wants the public to see what, if anything, Citibank did wrong. One way would be through a trial. The other would be through a settlement that included both meaningful penalties and meaningful admissions of wrongdoing.

Of course, the S.E.C. could drop its case. If it did, though, we, the general public, should demand that it be dissolved, and replaced by an organization with genuine teeth (and a spine). Really, that's the choice the S.E.C. should face: go after Citibank, or go out of business.