In a long-awaited decision, the United States Court of Appeals for the Second Circuit today overturned Judge Rakoff's highly controversial decision which refused to approve a $285-million settlement between the United States Securities and Exchange Commission (SEC) and Citigroup Global Markets Inc. The settlement contained no admission of liability by Citigroup to wrongdoing.

A three-member panel held that the lower court had "abused its discretion by applying an incorrect legal standard in assessing" the settlement and returned the case for reconsideration. The decision has significant implications both in Canada and the United States, which have seen considerable recent developments relating to the acceptance of no-contest settlements by securities regulators.

Summary of the U.S. District Court Proceedings

In October 2011, the SEC filed a complaint against Citigroup alleging that the company had negligently misrepresented its role and economic interest in structuring and marketing a billion-dollar fund. The fund contained almost $500 million worth of dubious subprime securities tied to the already faltering U.S. housing market. Citigroup had represented to investors that the portfolio had been chosen by an independent investment advisor, however, as the SEC alleged, Citigroup had "exercised significant influence" over the selection of the assets. In addition, Citigroup marketed the fund to investors while, at the same time, having taken a significant short position in the very assets it had helped to select. In the end, Citigroup realized profits of approximately $160 million from its short position, while investors suffered more than $700 million of losses.

Shortly after filing the complaint, the SEC and Citigroup agreed to settle. In the proposed settlement, Citigroup agreed to an injunction barring future violations, disgorgement of $160 million, a penalty of $95 million and prejudgment interest of $30 million. Citigroup also agreed to make internal changes to prevent similar acts from occurring in the future. As was typical of SEC settlements, Citigroup was also not required to make any admission of guilt or liability. This was consistent with the SEC's long-standing "no-admit, no-deny" policy.

In November 2011, the settlement was brought before Judge Rakoff of the U.S. Southern District Court of New York for approval. The settlement was rejected. The District Court refused to approve the settlement on the basis that in order to employ the court's significant injunctive and contempt powers it had to be satisfied that it was not being "used as a tool to enforce an agreement that is unfair, unreasonable, inadequate, or in contravention of the public interest." Despite the substantial deference due to the SEC, Judge Rakoff found all of these standards to have been violated and that an insufficient evidentiary record (which included a lack of proven or admitted facts), had been put before the Court to justify the relief being sought. In rendering his decision, Judge Rakoff strongly criticized the settlement, questioning whether the SEC was simply getting a "quick headline," and also harshly criticized the SEC's no-admission policy, which he described as "hallowed by history but not by reason." Judge Rakoff ordered the matter to be set down for trial.

Aftermath to the District Court Decision

In the United States, investor advocates hailed Judge Rakoff's decision as a step forward in the broader effort to crack down on Wall Street. Several U.S. judges followed Judge Rakoff's lead and rejected or questioned SEC settlements that failed to include sufficient evidence or admissions. In December 2011, the U.S. Congress also announced that it would review the SEC's no admission policy in light of accountability and transparency concerns. Following significant criticism, SEC Chairman Mary Jo White recently announced that the SEC has shifted its policy and will now seek admissions in certain cases.

In the meantime, in Canada, the Ontario Securities Commission (OSC) had only a month before Judge Rakoff's decision proposed new enforcement initiatives that included, most significantly, a no admission settlement policy substantially similar to the SEC's (commonly referred to as a "no-contest" settlement). After much consultation and monitoring of the developments in the U.S., the policy was adopted by the OSC in March of this year. Like the SEC's recent position, and likely in part due to investor support for Judge Rakoff's decision, the OSC also revised its position to clearly stipulate that it will nonetheless continue to require admissions in certain cases.

Immediately after Judge Rakoff's decision was rendered, both the SEC and Citigroup appealed. In March 2012, the SEC obtained a stay of the decision from the Court of Appeals after having demonstrated, among other things, a strong likelihood of success on the merits of the appeal.

The U.S. Court of Appeals Decision

After much anticipation, the U.S. Court of Appeals has today rendered its decision on the merits and overturned Judge Rakoff's decision to reject the Citigroup settlement.

In rendering its decision, the Court began by affirming the view that there is "no basis in the law for the district court to require an admission of liability as a condition for approving a settlement" between the parties. This decision, it held, "rests squarely with the SEC".

The Court of Appeals clarified the proper standard for reviewing a proposed settlement by a district court in these cases. Specifically, a court is required to determine whether the proposed settlement is fair and reasonable and, in cases where injunctive relief is sought, the court must consider whether "the public interest would not be disserved". As the Court noted, the primary focus of the inquiry should be on ensuring that the settlement is procedurally proper. In engaging in the analysis, the Court of Appeals cautioned that a district court must take care not to infringe on the SEC's discretionary authority to settle on particular terms, including without having required admissions of liability.

The Court emphasized: "[a]bsent 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." In many cases, the Court of Appeals noted, setting out the allegations together with factual statements by the SEC, which are neither admitted nor denied by the wrongdoer, ought to suffice to allow the district court to conduct its review.

The Court held that Judge Rakoff had abused his discretion by requiring the SEC to establish the "truth" of the allegations against a settling party as a condition for approving the settlement. As the Court of Appeals noted: "Trials are primarily about truth. Consent decrees are primarily about pragmatism."1

Implications of the Decision

The decision of the United States Court of Appeals will have significant implications not only for no-contest settlements entered into by the SEC but also those entered into by Staff of the OSC, as the latter ventures into previously unchartered territory.

The decision serves to not only discourage judicial second-guessing but also confirms that the substantial deference typically afforded to securities regulators when in engaging in settlements will extend to even those settlements that do not contain admissions of guilt or liability. The decision also confirms that, at least in the U.S., no contest settlements can be approved on the basis of factual statements made within settlement materials, which are neither admitted nor denied, as opposed to proven and admitted facts (as had been required by Judge Rakoff), which would have rendered such settlements difficult, if not impossible, to conclude.