If the SEC Forces Companies to Admit Guilt ...

For decades the Securities and Exchange Commission has given corporate defendants incentive to resolve enforcement charges by settling those charges without having to admit guilt. That policy could soon be coming to an end.

Amid intensified criticism, pressure is mounting for the SEC to revise its policy and force defendants to own up to their misdeeds or face lengthy trials.

Companies are often reluctant to admit guilt in settling with the SEC because of the amount of baggage that the admission of wrongdoing carries with it. In addition to being the target of shareholder lawsuits, for example, the company also faces the potential loss of government contracts. Individual defendants have additional disincentives since admitting guilt could bar them from subsequently serving as an officer or director of another company, or losing their jobs altogether.

Ever since U.S. District Court Judge Jed Rakoff admonished the agency in three separate settlements, starting two years ago, the SEC has been forced to defend its “neither admit nor deny” language. In considering judicial approval of prior SEC settlements with Bank of America and Vitesse, Rakoff made clear that he disliked the SEC's practice of not requiring defendants to admit guilt. He further said that he would approach any future similar settlement agreements with substantial questions.

In November Rakoff rejected a proposed $285 million settlement between the SEC and Citigroup Global Markets over allegations that the bank's unit misled investors in collateralized debt obligations. Rakoff said the settlement did not meet the legal standard for judicial approval of being “fair, reasonable, adequate, or in the public interest,” because Citigroup's choice neither to admit nor deny the agency's charges “does not provide the court with a sufficient evidentiary basis to know whether the requested relief is justified.”

Both the SEC and Citigroup appealed the judgment, and are awaiting a response from the Second Circuit Court of Appeals.

Depending on what the Second Circuit does, “it could be a real game-changer for the way cases are going to be viewed going forward,” says Bill McGrath, a partner with law firm Porter Wright. “They have taken a bit of a gamble by appealing. If the Second Circuit upholds Judge Rakoff's decision, every district court in that jurisdiction will be bound by the decision.”

The stakes are high for the SEC as well, McGrath says, which may be why it has decided to press the matter. “If [the SEC] can't settle on a neither-admit-nor-deny basis, they potentially face the difficult choice of either filing cases only when they can get an admission, or end up litigating even more cases,” he says.

The end result so far is pro-business groups rallying to the SEC's defense. In an amicus brief filed on Jan. 12, the Business Roundtable, an association of chief executive officers of leading U.S. companies with more than $6 trillion in annual revenue, urged the Second Circuit to reject the “novel, and potentially dangerous, approach to reviewing settlement agreements” that Rakoff endorsed.

If Rakoff's decision is upheld, the Roundtable said, the decision would “seriously disrupt the normal course of regulatory enforcement and compliance.”

In its amicus brief, the Business Roundtable argued that the case potentially affects every major U.S. business, as virtually every large company faces enforcement actions by federal regulators. “Such companies have a significant interest in resolving enforcement actions through consent decrees, and in many cases would be unwilling or unable to settle them if required to admit or deny each of the agency's allegations,” the amicus brief stated.

“If the corporation has to settle, they have to weigh a really unpleasant choice: Do I admit this and face follow-on litigation, or do I go to battle with the SEC?” McGrath says. “There are no easy choices if ‘neither-admit-nor-deny' is eliminated.”

“Depending on what the Second Circuit does, it could be a real game changer for the way cases are going to be viewed going forward.”

—Bill McGrath,

Partner,

Porter Wright

More Challenges Ahead?

No matter the outcome of the Second Circuit's decisions, McGrath says he expects that other judges will continue to challenge the SEC. “Sooner or later, you're going to get a judge that's going to say, ‘If you want me to sign this order, I'm going to want some input into this process,'” McGrath says.

At least one other judge already has cited Rakoff's order, although only for a technical issue rather than the “neither admit nor deny” language.

In that case, SEC v. Koss, the SEC brought charges against stereo headphone maker Koss Corp. and CEO Michael Koss for preparing materially inaccurate financial statements and records, and failing to adequately maintain internal controls for fiscal years 2005 through 2009. Under terms of the settlement, both defendants agreed to an injunctive order without admitting or denying the charges. Michael Koss must also return $242,419 of bonuses and 160,000 stock options to the company in accordance with the Sarbanes-Oxley Act's clawback provision.

The settlement was not immediately approved. Citing Rakoff's decision, U.S. District Judge Rudolph Randa directed the SEC to explain why the proposed settlement with Koss was “fair, adequate and in the public interest,” calling some of the provisions “vague.” In a letter dated Feb. 1, however, Randa changed his mind, since the SEC's response “largely satisfied the court's concerns,” adding that the court would not withhold approval of the settlement.

CITIGROUP QUERIES

In the following excerpt from Judge Jed Rakoff's order in the Citigroup case, the court put forth several questions regarding the case:

(1) Why should the Court impose a judgment in a case in which the

SEC. alleges a serious securities fraud but the defendant neither admits nor denies wrongdoing?

(2) Given the SEC's statutory mandate to ensure transparency in the financial marketplace, is there an overriding public interest in determining whether the SEC's charges are true? Is the interest even stronger when there is no parallel criminal case?

(3) What was the total loss to the victims as a result of Citigroup's actions? How was this determined? If, as the SEC's submission states, the loss was “at least” $160 million, what was it at most?

(4) How was the amount of the proposed judgment determined? In particular, what calculations went into the determination of the $95 million penalty? Why, for example, is the penalty in this case less than one-fifth of the $535 million penalty assessed in SEC v. Goldman Sachs & Co.? What reason is there to believe this proposed penalty will have a meaningful deterrent effect?

(5) The SEC's submission states that the SEC has “identified … nine factors relevant to the assessment of whether to impose penalties against a corporation and, if so, in what amount.” But the submission fails to particularize how the factors were applied in this case. Did the SEC employ these factors in this case? If so, how should this case be analyzed under each of those nine factors?

(6) The proposed judgment imposes injunctive relief against future violations. What does the SEC do to maintain compliance? How many contempt proceedings against large financial entities has the

SEC brought in the past decade as a result of violations of prior consent judgments?

(7) Why is the penalty in this case to be paid in large part by Citigroup and its shareholders rather than by the “culpable individual offenders acting for the corporation?” If the SEC was for the most part unable to identify such alleged offenders, why was this?

(8) What specific “control weaknesses” led to the acts alleged in the Complaint? How will the proposed “remedial undertakings” ensure that those acts do not occur again?

(9) How can a securities fraud of this nature and magnitude be the result of simple negligence?

Source: Judge Jed Rakoff's Order in Citigroup.

In its response to Randa's questions in the Koss case, the SEC continued to take a “this is how we've always done it” position. In that case, McGrath says, the question then becomes: Should the SEC continue to use the same language just because that's the way it's always been done, or should the judge in each case that approves the final judgment have some input into its terms?

At some point, other judges are going to agree with Rakoff's reasoning that the SEC's position is ‘hallowed by history, but not by reason,'” McGrath says.

On the Hill

Rakoff has raised enough controversy that now Congress is getting involved. In December the leaders of the House Financial Services Committee, Chairman Spencer Bachus (R-Ala.) and Ranking Member Barney Frank (D-Mass.), announced that the committee plans to hold a hearing to examine the SEC's “neither admit nor deny” practice. A date for the hearing has not yet been announced.

“The policy of signing agreements without forcing firms to admit or deny wrongdoing raises serious issues,” Frank said in a statement announcing the hearing.  Bachus added: “The SEC's practice of using ‘no-contest settlements' has raised concerns about accountability and transparency.”

McGrath says he does not expect these hearings to result in any major changes. “However, it will be interesting to see if there is any flexibility on the part of the SEC on this issue,” he says.

Even while the SEC has vigorously defended its settlement policy, it has revised the policy for some situations. On Jan. 6, the SEC decided that it will no longer allow the “neither admit nor deny” option for companies that have already admitted to criminal wrongdoing in related securities fraud cases. That change applies only in those cases where there has been an admission of guilt, not in cases where there has been no plea or if there is only civil proceedings.

“If SEC v. Citigroup Global Markets is any indication, the SEC will not change this policy until they have exhausted all appeals,” McGrath says.  One option, however, may be for the SEC to bring more administrative proceedings in front of an administrative law judge.

Stu Pierson, a partner with law firm Troutman Sanders, says, “At the very least, what Judge Rakoff has done is create an issue where something has to give.”