By Britt K. Latham and Joseph B. Crace 

In a well-publicized opinion dated November 28, 2011, Judge Rakoff of the Southern District of New York refused to approve a proposed Consent Judgment in SEC v. Citigroup Global Markets Inc., — F. Supp. 2d —, 2011 WL 5903733 (S.D.N.Y. Nov. 28, 2011).  The Consent Judgment, which charged Citigroup only with negligence in connection with issuance of a Fund that included “dubious assets,” “(I) ‘permanently restrained and enjoined’ Citigroup and its agents, employees, etc., from future violations of Section 17(a)(2) and (3) of the Securities Act, (II) required Citigroup to disgorge to the SEC Citigroup’s $160 million in profits, plus $30 million in interest thereon, and to pay to the SEC a civil penalty in the amount of $95 million, and (III) required Citigroup to undertake for a period of three years, subject to enforcement by the Court, certain internal measures designed to prevent recurrences of the securities fraud here perpetrated.”  Id. at *1.

Judge Rakoff primarily took issue with “the SEC’s long-standing policy — hallowed by history, but not by reason — of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations,” holding that without findings of fact, the Court could not approve the settlement.  Id. at *4.  Judge Rakoff concluded that “the parties’ successful resolution of their competing interests cannot be automatically equated with the public interest, especially in the absence of a factual base on which to assess whether the resolution was fair, adequate, and reasonable. . . .  [T]he Court is forced to conclude that a proposed Consent Judgment that asks the Court to impose substantial injunctive relief … on the basis of allegations unsupported by any proven or acknowledged facts whatsoever, is neither reasonable, nor fair, nor adequate, nor in the public interest.”  Id. at *6.

In short, Judge Rakoff appears to imply, if not expressly state, that the “public interest” demands some sort of public accounting of the facts whenever the SEC settles an enforcement action, or else “the public is deprived of ever knowing the truth” regarding the underlying dispute.  Id. at *4.  While such sentiment is admirable, and the opinion makes numerous valid points regarding the intellectual honesty — not to mention the underlying fairness — of the SEC’s current enforcement practices, depriving defendants (and the SEC) of the ability to settle regulatory actions without entering into what is effectively a judgment on the merits seeks the perfect at the expense of the “good enough.”

Conditioning court approval of settlements with the SEC on the inclusion of admitted factual findings would have serious consequences for both the SEC and defendants.  First, Judge Rakoff’s decision implies that the public interest in knowing the “truth” outweighs the public interest in having a more active enforcement regime.  The SEC, like any government agency, has limited resources.  Limiting the SEC’s ability to settle cases to only those matters in which it could win a trial on the merits, or at least wring a public admission of liability from a defendant, would ultimately increase the SEC’s cost of obtaining any recovery in a given action.  As further discussed below, admissions by defendants made in the context of regulatory proceedings greatly increases the risk associated with private litigation based on the same alleged violation of the securities laws.  Therefore, many defendants would prefer trial to conceding liability in what necessarily becomes “bet the company” litigation.  In addition to increasing both the cost of enforcement (ultimately born by the taxpayer) and the cost of defense by forcing adjudication on the merits, the downside risk for each party increases as well:  the SEC risks recovering nothing at all, and defendants risk bankruptcy should both the SEC and private litigants seek to collect on judgments.

Indeed, the effects of such an enforcement regime would almost certainly have consequences beyond regulatory actions.  Private plaintiffs (and their attorneys) would be understandably reluctant to settle or resolve parallel private civil lawsuits if the eventual SEC settlement or verdict would provide them with an automatic judgment.  Judge Rakoff’s opinion appears to contemplate such an arrangement.  See id. at *5 (holding that the proposed settlement 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 / non-denial of the SEC’s allegations”).  If the successful resolution of an SEC enforcement proceeding were automatically equated with the success or failure of parallel private litigation, the stakes for defendants would be raised considerably.  This is especially true if the SEC action involves allegations of fraud, thereby creating possible liability outside the scope of a company’s insurance policies.

(Britt K. Latham is a Member of Bass, Berry & Sims PLC, focusing his practice on complex business, securities and class action litigation and the representation of clients in connection with internal and governmental investigations.  Joe Crace is an attorney at Bass, Berry & Sims PLC, concentrating his practice on corporate and securities litigation, shareholder litigation and general commercial disputes.)