SEC Problems Can’t Be Fixed By Judges

By Chris Gair

From the Chicago Daily Law Bulletin, June 12, 2014

In the wake of our most profound financial crisis since the Great Depression, citizens, elected officials and commentators of various political stripes have condemned what they see as a tepid response to the crisis by law enforcers. The Securities and Exchange Commission and the Department of Justice, which have primary jurisdiction to enforce the securities laws, have (perhaps justly) been criticized for not sufficiently pursuing charges and punishment against banks, brokerage firms and their individual employees for fast-shuffle, self-interested conduct that contributed to the loss of tens or hundreds of billions of dollars by investors.

One of the flash points in these critiques has been over the SEC’s practice of typically allowing corporate defendants in civil enforcement lawsuits brought by the agency to escape without admitting liability and by paying restitution and a modest fine. Often, those payments do not serve as a real deterrent to future misconduct because the cost is passed on to shareholders and nobody responsible for the wrongdoing or failing to prevent it actually feels the pain.

Into this fray two years ago leapt U.S. District Judge Jed S. Rakoff of the Southern District of New York, one of the brightest and most outspoken judges on the federal court. Rakoff was presented with a settlement in which Citigroup agreed to pay the SEC $285 million to resolve charges relating to Citigroup’s alleged chicanery in promoting investments to clients that it knew were going bad and which Citigroup was secretly betting against for its own account. The judge took the highly unusual action of refusing to approve the settlement because the SEC had not extracted an admission of guilt from Citigroup and had not presented any proof from which the court could determine that the settlement was adequate. Questions he posed to the parties in advance of his ruling made clear that he viewed transparency — that is, the public’s interest in knowing the facts — as overriding any interest of the parties in resolving the matter without a trial.

Rakoff’s intervention was clearly well-intentioned — and his criticism of the SEC’s failure to obtain a confession by Citigroup as a prerequisite to allowing it to escape with a slap on its shareholders’ collective wrist may well have been correct. But his ruling represented a sweeping and unprecedented effort to add to the judicial arsenal the role of super-prosecutor, vested with the ability to overrule prosecutors’ discretionary decisions. That would have represented a fundamental change in the balance of power between the executive and judicial branches of government. On June 4, the 2nd U.S. Circuit Court of Appeals swatted away that attempt, vacating Rakoff’s opinion and holding that a federal judge has no business second-guessing the SEC when it decides what settlement is adequate or imposing a requirement that the accused company confess or be proved guilty before being allowed to resolve civil charges.

No matter where one stands on the question of whether the SEC has been aggressive enough in bringing wrongdoers in the financial crisis to justice, the 2nd Circuit clearly got this right. In regular civil cases between private parties, the court has no role in ensuring the fairness or adequacy of a resolution of the case, and almost all such disputes are settled without the judge even knowing the terms of the settlement, much less assessing its fairness. Courts do take a more expansive role in the resolution of class actions, where they are charged by law with assessing the fairness, reasonableness and adequacy of a settlement. The judge must play that role in the class-action context because only a handful of the plaintiffs in the class are actually before the court, supposedly representing the interests of hundreds or thousands of others who may not even know that their interests are at stake. The risk to absent class members is exacerbated by the fact that the plaintiffs’ side of a class action is really controlled by the class’ lawyers, not the representative plaintiffs, and there is a high risk of collusion between the class lawyers and the defendant to achieve a settlement that benefits the lawyers and the defendant at the expense of class members. That risk was highlighted, ironically, the day before the 2ndCircuit’s Citigroup decision in a ruling by Judge Richard A. Posner of the 7th U.S. Circuit Court of Appeals. There, in a class action over leaky Pella windows, the appellate court criticized and reversed the district judge who approved a settlement for not asking enough questions or doing enough to ensure that the settlement was fair to the class of plaintiffs, calling it “scandalous.” And so it appears to have been. Pella apparently bought peace from all class members by the expedient of paying the plaintiffs’ lawyers $11 million and agreeing to pay what would likely turn out to be far less (or maybe close to nothing) to the injured plaintiffs themselves.

In Citigroup, the 2nd Circuit said that Rakoff confused his duty to protect absent class members in a class action from their own lawyers with a perceived duty to protect the public from decisions made by the SEC, which is charged by the Constitution with that task. That is not the proper role of a judge or the courts. The prosecutors, including the SEC, are there to make the tough decisions in the public interest. The SEC knows the strength and weaknesses of its own cases best and whether it can or should extract an admission of guilt as a condition of settlement. The SEC also has the duty to balance the costs and benefits of any particular enforcement action with all of the other potential actions it may need to bring. In short, even if the SEC is doing a poor job, both the constitutional separation of powers and the practical necessities of how to allocate scare prosecutorial resources properly lie in the hands of the SEC, not the courts.