The Second Circuit handed down its long awaited opinion in SEC v. Citigroup Global Markets, Inc., Nos. 11-5227-cv, 11-5375-cv and 11-5242-cv (2nd Cir. June 4, 2014). The decision arises out of the refusal of the District Court to enter a proposed consent decree agreed to by the parties to resolve a market crisis case.
The enforcement action
The enforcement action is based on Citigroup’s role in the creation and marketing of a largely synthetic collateralized debt obligation or CDO called Class V Funding III. The firm concluded that the residential real estate market would drop significantly. In late 2006 it decided to construct a CDO-squared – a CDO collateralized by tranches of other CDOs rather than instruments such as bonds – tied to the residential real estate market. The collateral would be largely CDO tranches left from earlier deals.
Credit Suisse Alternative Capital, Inc. or CSAC was retained as collateral manager. An experienced collateral manager was essential to selling the notes. Citigroup selected most of the collateral for Class V, although CSAC did select some, according to the complaint. The marketing material featured CSAC and its experience without disclosing Citigroup’s role in selecting the collateral or that it had a $500 million short position against the Class V collateral it selected. Class V collapsed only months after the notes were sold, leaving investors with millions of dollars in losses. Citigroup made $34 million in fees for structuring the entity and $160 million in net profits on its positions.
The firm settled the action, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3). Citigroup also agreed to disgorge $160 million and pay $30 million in prejudgment interest and $95 million as a penalty for a total of $285 million which would be placed in a fair fund. The settlement required Citigroup to take certain remedial action related to its review and approval of offerings of certain mortgage related securities.
U.S. District Court Judge Jed Rakoff refused to enter the proposed consent decree. After requiring the parties to answer certain questions, and holding hearings, the Court concluded that “. . . the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, the Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.” The case was set for trial along with a companion case against Citigroup employee Brian Stoker. Later a jury found in favor of Mr. Stoker. SEC. SEC v. Stoker, Case No. 11 Civ. 7388 (S.D.N.Y. Filed Oct. 19, 2011); See also In the Matter of Credit Suisse Alternative Capital, Adm. Proc. File No. 3-14594 (Filed Oct. 19, 2011)(settled administrative proceeding against collateral manager and one of its employees).
Court of Appeals
In the Circuit Court the central question was “what deference the district court owes an agency seeking a consent decree,” not the SEC’s neither admit nor deny policy since the Court was told the District Judge was not seeking admissions. There is a strong federal policy favoring the approval and enforcement of consent decrees, the Court stated. In view of that policy, and after reviewing district court decisions articulating various standards, the Court clarified the proper standard. That standard requires that the district court “determine whether the proposed consent decree is fair and reasonable . . . [and that] the ‘public interest would not be disserved’ . . . in the event that the consent decree includes injunctive relief. Absent a substantial basis in the record for concluding that the proposed consent decree does not meet these requirements, the district court is required to enter the order.”
To assess if a proposed consent decree meets the fairness and reasonableness test the court should, at a minimum, consider several factors. Those include: 1) the basic legality of the decree; 2) if the terms are clear; 3) if it reflects a resolution of the actual claims in the complaint; and 4) whether “the consent decree is tainted by improper collusion or corruption of some kind.” While consent decrees vary, the focus here is on ensuring that the decree is procedurally proper.
In considering a proposed consent decree, the question for the district court is not to establish the truth of the allegations in the case. The efforts of the District Court here in this regard constituted an abuse of discretion. This is because “Trials are primarily about the truth. Consent decrees are primarily about pragmatism.” Settlements reflected in consent decrees are about managing risk which is a question reserved for the agency.
At the same time the district court will necessarily establish that there is a factual basis for the decree. In many cases that may be done by examining the claims and factual statements in the complaint. In others more may be required if, for example, there is a question that the proposed decree is the result of improper collusion.
If the proposed decree includes injunctive relief, the district court should consider the test for entering an injunction. In this regard the court must be assured that the public interest would not be disserved by the entry of the injunction. In making that determination, however, the question of whether the proposed decree best serves the public interest is reserved for the SEC. In this case the District Court correctly recognized that it was required to consider the public interest when entering an injunction, but it failed to make any finding that such relief would be a disservice to the public interest. This was legal error the Court held.
To the extent the District Court withheld approval on the theory that the Commission failed to bring the proper charges, its determination was an abuse of discretion, the Court found. The decision of an agency to prosecute, and the manner in which the action is brought, is committed to its discretion. What is before the district court is not that decision but only the proposed consent decree.
The Court concluded by stating that if the SEC does not wish to have the district court scrutinize its consent decrees it has alternatives: “[W]e note that to the extent that the S.E.C. does not wish to engage with the courts, it is free to eschew the involvement of the courts and employ its own arsenal of remedies instead,” citing provisions regarding the authority of the agency to institute administrative proceedings. The order of the District Court declining to enter the consent decree was vacate and the action remanded for further proceedings.
The Second Circuit’s ruling is a clear win for the SEC. Once the question of its neither admit nor deny policy was off the table, the focus of the appeal was the proper role of the agency and the district court when a proposed consent decree is proffered for execution. The Circuit Court answered that question, carving out a specific role for the agency and the court. In holding that issues such as what charges should be brought and how that the terms of the settlement are reserved for the agency, the Court clearly sustained the position of the Commission. Likewise, is holding that the question of the public interest is committed to the SEC the Court adopted an important Commission position.
At the same time, and despite the fact that the Court found that the District Court abused its discretion and erred, it also validated Judge Rakoff’s determination that the court is not simply a “rubber stamp.” To the contrary, the Circuit Court made it clear that district courts have an important, albeit limited, role to play when a proposed consent decree is presented for consideration. The Second Circuit emphasized this point by telling the SEC that if it did now want the district court to scrutinize its consent decrees, the agency should consider instituting administrative proceedings rather than district court actions. The Court cautioned the agency, however, noting that “these [administrative] remedies may not be on par with the relief afforded by a so-ordered consent decree and federal court injunctions.”
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