Robert Khuzami, head of the SEC's enforcement division, should have seen it coming. For all his faux outrage in November at a New York federal court's rejection of his $285 million proposed settlement with Citigroup, he had stuck his chin out by letting his chief counsel lecture the bench on the limits of judicial authority.
U.S. District Judge Jed S. Rakoff had submitted a list of pointed questions asking the SEC why he should impose judgment when it had alleged Citigroup committed serious securities fraud but neither admitted nor denied wrongdoing. Citigroup, according to the agency's complaint, had created a billion-dollar fund of dubious assets, sold it to misinformed investors, and then shorted a position on the assets it had helped select. The bank made a $160 million profit; the investors lost more than $700 million. Yet the SEC had charged Citigroup only with negligence; it also was vague about the investors' total loss, how it determined the penalty amount, and what it would do to ensure compliance in the future.
In response Matthew T. Martens, the SEC's chief litigation counsel, baldly told Rakoff in a memo that judicial review of the settlement should be "limited and deferential." In a footnote, Martens wrote, "Although the SEC strongly believes that the proposed consent judgment here is in the public interest, that is not part of [the] applicable standard of judicial review." So long as a settlement is not "unfair, inadequate, or unreasonable, it ought to be approved," he argued.
At a hearing on Rakoff's inquiries, Martens affirmed he was arguing that the district court had no business assessing the public interest. "An interesting position," the judge responded. "I'm supposed to exercise my power but not my judgment."
Rakoff followed up with a fiery opinion rejecting the consent judgment in language that could have been lifted from an Occupy Wall Street blog. He noted that the agency had expressly endorsed "in the public interest" as integral to the standard of review the year before when he grudgingly approved a Bank of America consent judgment. He also wrote that the commission's assertion that it
is the sole determiner of the public interest "is not the law," citing Supreme Court authority that "a court cannot grant the extraordinary remedy of injunctive relief without considering the public interest."
And Rakoff was just warming up. "The injunctive power of the judiciary is not a free-roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated," he wrote. "If its deployment does not rest on facts - cold, hard, solid facts, established either by admissions or by trials - it serves no lawful or moral purposes and is simply an engine of oppression."
Federal judges don't often write such things, nor do they publicly warn that they won't be made "a mere handmaiden to a settlement privately negotiated on the basis of unknown facts." Rakoff spurned the settlement and told the parties to be ready for trial in July (SEC v. Citigroup Global Mkts. Inc.
, 2011 WL 5903733 (S.D.N.Y.)).
The opinion sparked immediate headlines in New York, editorials denouncing judicial intrusion into the SEC's business, and a rare notice of appeal from the agency. "We believe the district court committed legal error by announcing a new and unprecedented standard that inadvertently harms investors by depriving them of substantial, certain and immediate benefits," the notice stated.
Clearly, Rakoff had hit a nerve. In early January the Business Roundtable filed an amicus brief in the appeal identifying the principal issue as "whether and in what circumstances a district court may reject negotiated settlements between companies and regulatory agencies." Its brief argued that a defendant's ability to settle without admitting misconduct is important for a variety of legal and business reasons.
But getting Rakoff's ruling reversed may be a problem. Peter J. Henning, a professor of law at Wayne State University in Detroit and a former senior attorney in the SEC's enforcement division, says it isn't clear the agency can
appeal, since there is no final judgment. The SEC maintains that Rakoff's ruling constituted a denial of injunction and therefore is
final. But just in case, the agency filed a writ of mandamus, which Henning says requires a showing of compelling need and is rarely granted. "This is unexplored territory," he says. "No one has ever seen fit to raise these issues with the SEC before."
The public interest argument, of course, can cut both ways. "To me, the public interest would be served by deference to the SEC," says Michael Klausner, professor of law and business at Stanford University. "It's the only sensible accommodation to our dual enforcement system with the plaintiffs bar. What's really at issue here is the public admission of wrongdoing."
Nearly 20 years ago, former U.S. District Judge Stanley Sporkin invoked the public interest when he refused to approve a Justice Department settlement with Microsoft in an antitrust case. The parties appealed to the D.C. Circuit, which reversed, stating that Sporkin had exceeded his authority (U.S. v. Microsoft Corp.
, 56 F.3d 1448 (D.C. Cir. 1995)). The appeals court remanded the case, removing Sporkin from the proceedings for bias - and the settlement eventually was approved.
Since then, Henning says, consent judgments rejected by judges usually involve agreements between private parties and the specter of collusion. "A judge can't simply reject a settlement with a government agency and order the parties to trial," he contends. "In this case, the consent judgment may have been quick and dirty, but it wasn't collusive."
So why did Rakoff lash out? "In part, it stems from the SEC's approach," says Thomas O. Gorman, partner in the Washington, D.C., office of Dorsey & Whitney who writes the SEC Actions
blog. "When Judge Rakoff asked for more evidence [to justify the negligence charge], the agency took a very hard line."
The SEC's response, Gorman says, "seemed to arrogate the public interest to itself alone." And that, he says, was very risky in such a high-profile case. "It will be difficult for the Second Circuit to find that Judge Rakoff has no role, that he's just a rubber stamp. But if the district court does
have a significant role to play and may look to the public interest, it will invite more judicial scrutiny of settlements."
Indeed, Rakoff's opinion has already gained some loft. In December, U.S. District Judge Rudolph T. Randa in Milwaukee asked the SEC why its proposed settlement with headphone maker Koss Corporation was "fair, reasonable, adequate, and in the public interest," citing Rakoff's opinion in his letter. After the SEC offered to amend language, Randa indicated he would approve the settlement. Rakoff's logic - and his passion - may be catching.
"On the surface, Citigroup
is about the SEC's 'neither admit nor deny' policy," says William P. McGrath Jr., a partner at Porter Wright Morris & Arthur who writes for its federal securities blog. "But the case also raises separation of powers issues. It could get that bloody."