Due Diligence

SEC Approach to Enforcement Under Siege with New York Ruling

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Khuzami-230The Securities Exchange Commission’s entire approach to enforcement on Wall Street was challenged Monday, when a New York federal judge tossed a $285 million settlement between the SEC and Citigroup, announced last month, saying it skirts the law by allowing the bank to neither admit nor deny the allegations. This is standard practice at the SEC—allowing those charged to avoid admitting guilt as long as they will not deny it.

The judge on the case, Jed S. Rakoff of the United States District Court in Manhattan, said the settlement is “neither fair, nor reasonable, nor adequate, nor in the public interest” because it denies the court the evidence to assess the settlement. The practice of allowing defendants to escape admitting guilt means that the facts of the case are not established; as a result, such settlements cannot be used in future civil litigation, such as shareholder lawsuits.

In a statement, Robert Khuzami, Director of the SEC’s Division of Enforcement, said that if the SEC had to choose, obtaining monetary penalties and mandatory business reforms is more significant than admission of guilt. (Does it have to choose?) The regulator also noted that such provisions (that allow for neither admission nor denial of guilt) have been included in settlements repeatedly approved by federal courts around the U.S. “including district courts in New York in cases involving similar misconduct.”

Khuzami continued that the SEC complaint “fully and accurately” sets forth the facts that support its case. He also wrote that while the court called into question the settlement amount, securities law limits disgorgement the regulator can recover to the firm’s ill-gotten gains, plus a penalty that does not exceed that gain. “It was for this reason that we sought to recover close to $300 million, all of which we intended to deliver to harmed investors.” He continued, “The SEC does not currently have statutory authority to recover investor losses.”

In its original complaint, the SEC charged Citigroup with negligence in it sales to clients of a billion-dollar mortgage securities fund known as Class V Funding III. Citigroup allegedly picked some of the securities in the fund but told investors they were being chosen by an independent group. Citigroup then bet against the investments in the belief that they would lose value, netting $160 million in profits for itself, the SEC complaint says. Investors lost $700 million in the fund, according to the regulator.

Because the settlement establishes none of the allegations in the case as fact, Rakoff said it is impossible for the court to judge whether the settlement is appropriate.

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