The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In a strongly worded November 28, 2011 opinion (here), Southern District of New York Judge Jed Rakoff rejected the proposed $285 million settlement of the enforcement action that the SEC brought against Citigroup Capital Markets. But while he emphatically rejected the proposed settlement, his opinion may also suggest how the SEC might salvage this situation without a trial and even how it might structure settlements in the future in order to avoid the kind of blistering criticism that Rakoff administered in his November 28 opinion.

In October 2011, the SEC filed a civil enforcement action against Citigroup in the Southern District of New York and simultaneously filed a proposed Consent Judgment in which Citigroup offered to pay a total of $285 million (consisting of a disgorgement of profits of $160 million, plus $30 million in interest, and a civil penalty of $95 million). The complaint related to a billion-dollar fund that Citigroup created that allowed the company “to dump some dubious assets on misinformed investors.” The fund was marketed as consisting of attractive assets, whereas the fund was arranged to include a “substantial percentage of negatively projected assets.” Citigroup had then taken a substantial short position in the assets. Citigroup realized profits of $160 million, while investors lost more than $700 million.

Because Citigroup had agreed to the proposed settlement and Consent Judgment “without admitting or denying the allegations in the complaint,” Judge Rakoff had in an October 27, 2011 opinion raised a number of pointed questions about the proposed settlement (about which refer here).

In his November 28, 2011 opinion, Judge Rakoff stated that he was “forced to conclude that proposed Consent Judgment that asks the Court to impose substantial injunctive relief, enforced by the Court’s own contempt power, on the basis of allegations unsupported by and proven or acknowledged facts whatsoever, is neither reasonable, nor fair, nor adequate, nor in the public interest.” Judge Rakoff emphatically rejected the SEC’s argument that the public interest was not an appropriate consideration in his assessment of the proposed settlement.

He concluded that the settlement was not in the public interest because it “asks the Court to employ its power and assert its authority when it does not know the facts.” He added that “an application of judicial power that does not rest on the facts is worse than mindless, it is inherently dangerous.”

Judge Rakoff added that in a case like this that “touches on the transparency of financial markets have so depressed our economy and debilitated our lives,” there is “an overriding public interest in knowing the truth.” But instead of establishing what had gone wrong here, the SEC entered a settlement in which the defendant company neither admitted nor denied the allegations. He added that the SEC “of all agencies” has “a duty inherent in its statutory mission to see that truth prevails.” The Court, he said, “must not in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”

Several different times, Judge Rakoff emphasized the paramount importance of judicial independence, particularly when it is called upon to exercise its injunctive power, which, he added, “is not a free-roaming remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated.” Without facts, established either by admission or denials, the use of the court’s injunctive powers “serves no lawful purpose and is simply an engine of oppression.”  

Judge Rakoff also noted that the proposed settlement left the defrauded investors “substantially short-changed” as it “deals a double blow to any assistance the defrauded investors might seek to derive from the SEC litigation in attempting to recoup their losses through private litigation” since they “cannot derive any collateral estoppel assistance from Citigroup’s non-admission/non-denial of the SEC’s allegations.”

Judge Rakoff concluded his opinion by consolidating the case with a parallel action against the Citigroup official responsible for the toxic fund and scheduling the case for trial on July 16, 2012.

At lease according to the November 28, 2011 statement of SEC Enforcement Division Director Robert Khuzami about the opinion, here, the SEC Enforcement Division is deeply aggrieved by Judge Rakoff’s rejection of the settlement. Judge Rakoff’s blistering opinion certainly leaves the parties with some unattractive choices.  It also raises a larger concern that the SEC might not only have to take this case to trial, but in general might have to be prepared to take more cases to trial. This could threaten to overwhelm the SEC’s resources and ultimately even lead to less vigorous enforcement as the increased trial load forces the SEC to conserve resources by bringing fewer cases.

But on further reflection and on closer review, Judge Rakoff’s opinion may offer a way out, both for these parties and for the SEC in general. In footnote 7 on page 13 of the opinion, Judge Rakoff draws a sharp contrast between this settlement involving Citigroup and the SEC’s earlier settlement with Goldman Sachs, which Judge Rakoff noted “involved a similar but arguably less egregious scenario.” (For a detailed background on Goldman’s settlement of the SEC action, refer here.)

The Goldman settlement, he noted, involved a substantially higher civil penalty (i.e., a $535 million penalty on only $15 million in profits, compared to the proposed Citigroup settlement in which the company agreed to pay a $90 million penalty on $160 million of profits). But even more importantly, as Judge Rakoff noted, the consent judgment in the Goldman case involved an “express admission” from Goldman that the marketing materials for its toxic securities “contained incomplete information.” Judge Rakoff also noted that the Goldman consent judgment involved remedial measures beyond those to which Citigroup agreed, and also involved Goldman’s undertaking to cooperate with the SEC in ways in which Citigroup had not.

The contrast that Judge Rakoff drew between the Goldman settlement and the Citigroup settlement may suggest a way that the SEC and Citigroup may yet be able to settle this case (and for that matter, for future parties to try to avoid the objections that Judge Rakoff raised in connection with this proposed settlement).  

First, just as when the SEC and the Bank of America previously faced Judge Rakoff’s rejection of the proposed settlement of the SEC’s action against BofA, it seems that Citigroup is going to have to make a greater monetary contribution for a proposed settlement to pass Judge Rakoff’s scrutiny. (Judge Rakoff’s summary of the sequence of events surrounding the SEC’s settlement with BofA is described here.)

But if the parties want to avoid the July 2012 trial date, they are also going to have to work out a deal that omits the “neither admits nor denies” formulation. Judge Rakoff disparaged the SEC’s long-standing practice of including formulations of this type in its enforcement action settlements as “hallowed by history but not by reason.” 

In order to reach a settlement that will pass muster with Judge Rakoff, Citigroup apparently also will have to agree to express admissions of the type included in the Goldman consent judgment. Citigroup has an obvious interest in avoiding any admissions, not the least because of the impact the admissions might have on pending investor litigation. But it is worth noting that Goldman’s admissions to which Judge Rakoff referred approvingly may not be prohibitive. Goldman admitted only that its marketing materials contained “incomplete information,” and that it was a “mistake” that the materials did not explain the role of Paulson & Co. in selecting the assets underlying the toxic securities. As distasteful as Citigroup might find it to make this type of admission, it would have to be far preferable to facing trial.

Whether or not the parties are able to work out a formulation that is mutually acceptable and that satisfies Judge Rakoff remains to be seen. The one thing that is for sure is that if the parties are not able to work out a revised deal that passes Judge Rakoff’s muster, there will be a very interesting trial in his courtroom next July.

One final thought. I found it particularly interesting that one of Judge Rakoff’s objections to the absence of any factual admission as part of the settlement was that this absence deprived the investor plaintiffs the benefit they might hope to derive from the SEC litigation. I am sure the private plaintiffs’ securities bar was heartened by this comment. No doubt the litigants in this case will be interested to see if there are any helpful admissions in any forthcoming settlement – as will private litigants with respect to SEC enforcement action settlements going forward.

Wayne State University Law Professor Peter Henning has an interesting November 28, 2011 post about Judge Rakoff’s opinion on the Dealbook blog (here). Among other things, Professor Henning questions whether admissions on the order of Goldman’s would be enough to satisfy Judge Rakoff. David Bario’s November 28, 2011 Am Law Litigation Daily article about Judge Rakoff’s opinion can be found here. Alison Frankel’s November 28, 2011 post about the opinion on Thomson Reuters News & Insight can be found here.

Special thanks to the several readers who sent me links to Judge Rakoff’s opinion.

Here’s One for My Friends at the SEC (Who Could Probably Use a Little Cheering Up): So, a lawyer dies and goes to heaven. (I know, I know, an implausible opening, but bear with me.) The lawyer has just walked through the pearly gates and she’s surveying the scene. She sees an old man walking down the street in judicial robes. So she says to St. Peter, “Who’s the old guy in the robes?” And St. Peter says, “Oh, that’s just God. He thinks he’s a federal judge.”

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In a November 9, 2010 order (here) in the Citigroup subprime-related securities suit, Southern District of New York Judge Sidney Stein dismissed a host of allegations and a number of individual defendants. However, Judge Stein denied the motion to dismiss as to plaintiffs’ claims regarding Citigroup’s exposure to its CDO portfolio, which Judge Stein described as the plaintiffs’ "principal" allegations.

Among the defendants who must answer these allegations are seven individual defendants, including former Citigroup CEO Charles Prince and former Citigroup board member (and former Treasury Secretary) Robert Rubin.

As reflected here, plaintiffs first sued Citigroup and certain of its directors and officers in November 2007. In their February 20, 2009 consolidated amended complaint, which named as defendants the company and 14 of its directors and offices, the plaintiffs alleged that the defendants had mislead investors about the company’s financial health and caused them to suffer damages when the truth about Citigroup’s assets were later revealed.

Judge Stein emphasized the length and weight of the amended complaint, noting that it is "536 pages long, contains 1,265 paragraphs, and weights six pounds." The amended complaint alleges that defendants misled investors about its exposure to what Judge Stein described as a "gallimaufry of financial instruments." However, as Judge Stein noted, the plaintiffs’ "principal grievance" is that Citigroup "did not disclose that it held tens of billions of dollars of super-senior tranche CDOs until November 4, 2007," and that even after that date, until April 2008, the company did not disclose the full extent of its exposure.

The basic thrust of the plaintiffs’ CDO-related allegations is that though the company disclosed that it was deeply involved in underwriting CDOs, the company did not disclose that billions of dollars of the CDOs had not been purchased at all but instead had been retained by Citigroup. In November 2007, the company disclosed that it was exposed to super-senior CDO tranches in the amount of $43 billion and that it estimated a write down of $8 to $11 billion of those assets. The plaintiff alleged that this disclosure omitted an additional $10.5 billion worth of holdings that the company had hedged in swap transactions.

In his November 9 order, Judge Stein found that the plaintiffs had adequately alleged that Citigroup’s CDO valuations were false between February 2007 and October 2007. In concluding that these statements were made with scienter, Judge Stein noted that the plaintiffs’ claims "concern a series of statements denying or diminishing Citigroup’s CDO exposure and the risks associated with it." These statements, Judge Stein found were "inconsistent with the actions Citigroup was allegedly undertaking between February 2007 and October 2007."

Citigroup was, Judge Stein found, "taking significant steps internally to address increasing risk in its CDO exposure but at the same time it was continuing to mislead investors about the significant risk those assets posed. This incongruity between word and deed establishes a strong inference of scienter."

Judge Stein then went on to hold that the plaintiffs allegations of scienter against seven of the individual defendants was insufficiently particularized, but that the allegations against the remaining defendants were sufficient, in part because these individuals attended meetings concerning the company’s CDO exposure during the period in question and in part because they were responsible for the company’s SEC filings, and therefore bear responsibility for the statements under the "group pleading doctrine."

Judge Stein also found that even the company’s disclosures in November 2007 were materially misleading because they omitted to disclose the additional $10.5 of CDO exposure that the company had hedged. However, Judge Stein concluded that the allegations of individual scienter were only sufficient against the company’s CFO at the time, Gary Crittenden.

Judge Stein the concluded that the plaintiffs’ allegations regarding the other financial instruments in the "gallimaufry" of financial assets were insufficient. Judge Stein granted the motion to dismiss the plaintiffs allegations as to all of the financial assets other than the company’s CDO assets.

Discussion

Though Judge Stein significantly narrowed the plaintiffs allegations and though he dismissed out seven of the 14 individual defendants, substantial portions of plaintiffs’ complaint survived – and more importantly from the plaintiffs’ perspective, what Judge Stein himself described as the plaintiffs’ "principal" allegations substantially survived dismissal, and the plaintiffs managed to keep some of the higher profile defendants in the case as well.

I am sure the plaintiffs in this case would have preferred to keep their other allegations in this case, but with the remaining allegations, the plaintiffs still have a substantial basis on which to proceed. As I have often noted on this blog, the name of the game for the plaintiffs is to survive dismissal and to try to move on to the settlement phase. Of course the defendants may well take a different view, and where this case may ultimate wind up remains to be seen.

In the meantime, I do think it is interesting to note that pretty much all of the mega subprime cases – AIG, Countrywide, Fannie Mae, Washington Mutual, New Century Financial – seem to have survived the initial pleading stage, in whole or in part. Thus while there has been considerable discussion (among other places, on this blog) about whether or not the plaintiffs are fairing poorly in the subprime lawsuit dismissal motions, it definitely seems that in the high profile cases, the plaintiffs claims are managing to survive.

As noted here, Judge Stein has previously denied in part the motions to dismiss in the separate subprime-related Citigroup bondholders’ action.

I have in any event added the Judge Stein’s ruling in the Citigroup case to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

Special thanks to a loyal reader for providing me with a copy of the Citigroup ruling.

The Latest on the BankAtlantic Securities Class Action Trial: While the rest of us have been going about our daily business, the BankAtlantic Securities Class Action trial has been going forward in federal court in Miami. Now, according to a reliable source, after four weeks of trial, 13 fact witnesses and a damages expert, the lawyers are going to begin delivering their summations today. The case could be going to the jury shortly. The verdict form weighs in at a hefty 53 pages. Stay tuned, we could have a rare securities class action jury trial verdict just ahead.

The News from San Antonio: I have arrived in San Antonio for the PLUS International Conference, where I have noticed among other things that the winner of the PLUS1 Award at this year's conferfence will be my good friend and former law partner Gary Dixon of the Troutman Sanders firm. The PLUS1 award is given annually to the person "whose efforts have contributed to the advancement and image of the professional liability industry." No one deserves this award more than Gary, who is one of the lions of our industry. My congratulations to Gary. If you are at the conference this week, I hope you will plan on attending the award ceremony at lunch on Thursday to help congratulate Gary for this honor.

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On July 12, 2010, in one of the more high-profile investor actions filed as part of the subprime securities litigation wave, Southern District of New York Judge Sidney Stein substantially denied in part the defendants’ motions to dismiss in the Citigroup Bond Litigation. A copy of the opinion can be found here.

As detailed in greater detail here, Citigroup bondholders first filed their suits in September 2008 in connection with 48 different Citigroup bond offerings in which Citigroup raised over $71 billion between May 2006 and August 2008. (The first of these cases was filed in New York state court but later removed to federal court.) The defendants include the company itself and related corporate entities, as well 28 current or former Citigroup directors and officers and nearly eighty investment banks that served as offering underwriters in the bond offerings.

The plaintiffs, who purchased bonds in some of the offerings, alleged that the defendants had violated sections 11, 12 and 15 of the Securities Act of 1933 by failed to truthfully and fully disclose in the bond offering documents information concerning the company’s exposure to "toxic mortgage-linked documents."

Specifically, the plaintiffs alleged that Citigroup had failed to disclose Citigroup’s exposure to $66 billion worth of CDOs backed by subprime mortgage assets; Citigroup’s exposure to $100 billion in structured investment vehicles backed by subprime mortgage assets; that Citigroup "materially understated reserves" held for residential loan losses; Citigroup’s exposure to $11 billion of auction rate securities; that as result of these exposures, Citigroup was not, contrary to its representations, "well capitalized" and in fact required a massive government bailout.

In his July 12 order, Judge Stein first held that the plaintiffs had standing to assert claims in connection with all of the 48 offerings, even though plaintiffs had not purchased bonds in all offerings. Because the offerings were based common shelf registration document containing at least some common information, he found that the plaintiffs have standing to assert claims common to all purchasers.

But while he found that the plaintiffs has standing to assert Section 11 claims, he granted the defendants’ motions to dismiss the plaintiffs’ Section 12 for lack of standing, based on the insufficiency of plaintiffs’ allegations about whom the plaintiffs bought their investments from.

The centerpiece of the defendants’ dismissal motions was their argument that the plaintiffs had failed to allege any actionable misstatement or omission. Judge Stein found that that the plaintiffs’ had adequately alleged misrepresentation or omission as to Citigroup’s CDO exposure; with respect to plaintiffs’ allegations about Citigroup’s SIV exposure, at least with respect to statements made after those exposures were consolidated on Citigroup’s balance sheet; plaintiffs’ allegations about the adequacy of Citigroup’s residential mortgage loan loss reserves; with respect to Citigroup’s statements about the adequacy of its capitalization; and with respect to Citigroup’s statements that its financials were GAAP compliant.

However, Judge Stein also found that the plaintiffs had not sufficiently alleged misrepresentation or omission in connection with their allegations concerning Citigroup’s SIV exposure, at least those made prior to the consolidation of the SIV assets onto Citigroup’s financial statements; and about Citigroup’s exposure to auction rate securities.

Thus while a portion of plaintiffs’ claims did not survive defendants’ dismissal motions, a substantial portion of plaintiffs’ case will be going forward.

Both because of Citigroup’s prominence and because of the sheer magnitude of dollars involved in this case, this is a high profile decision. Though there is definitely a school of thought that defendants are faring better on the subprime securities cases in general, the plaintiffs are still managing to get some cases past the initial pleading hurdles, particularly in many of the highest profile cases (e.g., Countrywide, New Century, Washington Mutual, etc.).

In addition, Judge Stein’s decision in the Citigroup Bondholders case is the latest of several recent rulings in subprime related securities cases in the Southern District of New York that have favored the plaintiffs, including the recent decisions in the Ambac Financial subprime related case (about which refer here) and in the CIT Group subprime related securities case (about which refer here).

I have in any event added the July 12 decision in the Citigroup Bondholders’ suit to my running tally of subprime related securities class action lawsuit dismissal motion ruling, which can be accessed here.

Andrew Longstreth’s July 12, 2010 Am Law Litigation Daily article about the decision can be found here. A July 12, 2010 Bloomberg article about the decision can be found here.

Special thanks to a loyal reader for providing a copy of the opinion.

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