When federal judge Jed Rakoff tossed out a proposed settlement between the Securities and Exchange Commission and banking giant Citigroup on Monday, he signaled to both the SEC and the nation's largest financial institutions that the two parties can no longer snuggle up together in cozy settlements that enable misbehaving banks to pay a fine for their bad deeds without ever requiring the institutions to admit wrongdoing.
According to some legal professionals, Judge Rakoff's decision could be a game-changer, requiring the SEC to really step up to the plate in terms of enforcement.
"If the SEC expects to be suing investment banks in the future -- and I know they do -- this creates a real problem for them if they have to justify their settlements in some detail," said Adam C. Pritchard, a law professor at the University of Michigan Law School.
Judge Rakoff, a Clinton appointee who serves the southern district of New York, wrote in his decision that the SEC's "long-standing policy, hallowed by history but not by reason," of allowing financial institutions to avoid admitting guilt betrays the public interest -- both individual investors and society at large -- by leaving the question of what really happened unaddressed. As long as the bank does not have to acknowledge the facts, the truth remains unknown.
Robert Khuzami, director of enforcement at the SEC, said in a public statement that Judge Rakoff's ruling "ignores decades of established practice throughout federal agencies and decisions of the federal courts."
But Pritchard asserts that it is exactly this history that Judge Rakoff is challenging. "These settlements have traditionally been an easy way out for the SEC. It's been the agency's way of putting the financial institutions on notice, of saying, 'This is how we think the industry should behave, and if you don't want to get in trouble with us, you will do it the way we think you should do it, as represented by the settlement.' Judge Rakoff is saying that he thinks it's time to figure out what the law is, what the obligations are for these banks."
Though Judge Rakoff is only one man in one federal court, he is an especially important judge in the world of finance because his district includes Manhattan. "Cases against large financial institutions tend to be brought in Manhattan because that's where a huge number of the large financial institutions are headquartered," Pritchard explained.
The ruling will likely affect others, as well. "Generally, Judge Rakoff is considered a very thoughtful, well-respected judge, so certainly judges all over the country are going to look at this and think about what he has said," said Daniel Berger, a securities lawyer who has worked on similar cases.
Others are less certain of the decision's long-term significance. "This is not a binding legal precedent," said John C. Coffee Jr., a Columbia University law professor and friend of Rakoff's. "Judge Rakoff is not ruling that in all cases the defendant has to admit or deny the allegations. What's he's saying [to the SEC] is that they haven't done enough. This is a rejection of a first offered agreement. There may well be a sweetened agreement."
This is not the first time Judge Rakoff has thrown out an SEC settlement. In 2009, he dismissed a proposed settlement between the SEC and Bank of America that would have required the bank to pay a $33 million fine for the $3.6 billion the bank paid out in executive bonuses after acquiring Merrill Lynch and shortly before receiving federal bailout funds. In that case, Rakoff argued that the financial penalties were too small in relation to the crime, and eventually agreed to a $150 million fine instead.
"This is just the Bank of America ruling all over again," said Coffee, "with the judge being a little stiffer and a little more determined."
In the immediate term, it's unclear what will happen next, as the SEC declined to comment beyond its public statement. Regarding the specific Citigroup case, Judge Rakoff has ordered both the SEC and the bank to prepare to go to trial in July 2012. It's possible that the SEC would try to appeal Judge Rakoff's decision, but that could prove challenging as the appeals court would have to agree to hear the case, said Berger.
Alternatively, the SEC could proceed with a trial, but that could also prove problematic for the agency. "These cases against financial institutions are wickedly hard to win at the end of the day because in most cases you have to actually show fraudulent intent," said Michael Perino, a law professor at St. John's University. "When you have teams of advisors, lawyers and everybody else saying that the firm complies with the various rules and regulations they’re subject to, defense attorneys are often able to show that the firm acted in good faith. So, the SEC’s perspective is 'well, we could bring far fewer cases and have more trials and run the risk that we're going to lose a fair number of those trials, or we can bring more cases and get settlements and have at least some deterrent effect.’"
While it's too early to accurately predict the implication of the decision on future SEC settlements, it's clear that Judge Rakoff has gone beyond just firing a warning shot to the federal agency whose job is to be the cop on the beat on Wall Street.
As Coffee explained, "What Judge Rakoff is saying is that if the SEC continues to bring these cases, the agency becomes not a watchdog but a yapping small dog incapable of biting."