On Monday, Judge Jed Rakoff issued his order rejecting the proposed $33 million settlement of the SEC case against Bank of America. The order raises numerous issues for the SEC such as whether it must now amend its case to include individual defendants, and whether it will now take the case to trial, but to me the more interesting aspect of the order goes well beyond the case itself.

Judge Rakoff focused heavily on the fact that the proposed $33 million settlement was with BofA itself, not the allegedly culpable executives. That means it will be paid by the company, i.e., the existing shareholders. As he put it,

the management of Bank of America - having allegedly hidden from the Bank's shareholders that as much as $5.8 billion of their money would be given as bonuses to the executives of Merrill who had run that company nearly into bankruptcy - would now settle the legal consequences of their lying by paying the S.E.C. $33 million more of their shareholders' money.

This, Judge Rakoff declared, was effectively a "proposal to have the victims of the violation pay an additional penalty for their own victimization." He went on to state that forcing the shareholders who were the victims of the Bank's alleged misconduct to now pay the penalty for that misconduct was "not fair, first and foremost, because it does not comport with the most elementary notions of justice and morality."

There is an undeniable logic to the Court's view of corporate penalties, but the fact is that this is the way the securities litigation settlement process typically works right now, both in SEC cases and in private securities class actions. In SEC cases, the SEC imposes a fine upon the company for its alleged misdeeds, which is then paid by the company's current shareholders. Under the Fair Funds provision of Sarbanes-Oxley, the penalty is then paid out to the victims — the company's shareholders during the period that the fraud allegedly occurred. In securities class actions, the company itself similarly settles the private case against it, and the company's current shareholders pay (usually via the company's D&O insurance policy) the defrauded shareholders from the class period.

For years, there has been a debate as to whether this practice of having current shareholders pay former shareholders in these settlements makes sense. Although Judge Rakoff did not address this point, there is often a significant overlap in these two groups, so shareholders will actually be paying themselves.

In its filings with Judge Rakoff, the SEC acknowledged that corporate penalties such as the one proposed against BofA will be “indirectly borne by [the] shareholders,” but it argued that this is justified because “[a] corporate penalty ... sends a strong signal to shareholders that unsatisfactory corporate conduct has occurred and allows shareholders to better assess the quality and performance of management.” Judge Rakoff, however, ruled that

the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion-dollar purchase of a huge, nearly-bankrupt company, need to lose another $33 million of their money in order to “better assess the quality and performance of management” is absurd.

The SDNY is the home of more securities litigation than any other court, and Judge Rakoff is known to be among the most influential judges on that court in the securities area. If Judge Rakoff finds the current settlement structure for SEC and securities class actions to be "absurd" and "not fair," then big changes could be on the horizon.