Legal scholar argues SEC settlements after Dodd-Frank create potential costs for defendants and the public.
A year ago, Citigroup Global Markets, Inc., among other Citigroup subsidiaries, agreed to pay the U.S. Government $180 million. The U.S. Securities and Exchange Commission (SEC) alleged that Citigroup misrepresented the risks associated with hedge funds’ investments and profited by approximately $2.9 billion. The funds collapsed. The clients lost billions of dollars. Yet the settlement included no factual admissions. No individual was sanctioned. In 2011, a federal judge had even rejected a similar settlement between the SEC and that same Citigroup subsidiary.
The SEC makes and enforces rules associated with trading stock on public exchanges. When the SEC suspects a company or individual has violated those rules, it launches an investigation and can bring charges, either in a court or in an administrative proceeding overseen by the Commission itself. Firms that opt not to fight the allegations agree to settle with the Commission. Over the past decade, settlements between firms and the SEC have largely changed venue from the federal courts to administrative hearings. Between 2007 and 2012, 60 percent of the SEC’s settlements were filed in court. In 2015, that number dropped to 17 percent. In fact, every settlement with a large Wall Street bank pursued by the SEC in recent years has been filed in an administrative proceeding. What changed?
In her recent article, Urska Velikonja, a professor at Emory University School of Law, argues that the transition from the courtroom to in-house settlements is a consequence of The Dodd-Frank Wall Street Reform and Consumer Protection Act. The most significant financial legislation since laws passed in the wake of the Great Depression, Dodd-Frank permits the SEC greater control in choosing whether to bring action against companies for alleged securities violations in a court or in an SEC-run administrative action. Velikonja argues that the additional authority granted by Dodd-Frank has cut down on external review of securities settlements. Without independent checks, Velikonja writes, settlements are less likely to adequately protect the public interest and investors.
In administrative hearings, the SEC Enforcement Division presents the proposed settlement to the five SEC Commissioners for approval. These same Commissioners ordered the investigation originally. In contrast, if the SEC files the settlement in court, the judge often requests additional information to ensure that the settlement is in the public interest.
Velikonja argues that judges may have a broader understanding of public interest than SEC staffers. “When courts review securities settlements, they are not particularly concerned about the SEC’s limited budget or the incessant pressure to report record enforcement statistics,” Velikonja writes. If a settlement does not include individual sanctions, such as fines or loss of broker and investment advisor registrations, shareholders could be the victims of misconduct and pay the price of settlement.
Jed S. Rakoff, a New York federal district judge, observed this problem when he rejected a SEC settlement with Bank of America in 2009. Bank of America had allegedly failed to disclose bonuses that were paid by Merrill Lynch before the firms merged. Had the settlement gone through, Bank of America would have paid the fine with corporate funds, meaning the same shareholders that were allegedly blindsided by the bonuses would have indirectly footed the settlement bill. Rakoff found it unconscionable that the “very management” involved in the alleged wrongdoing could have decided to use more of the shareholders’ money “to make the case against the management go away.”
On the other hand, Velikonja acknowledges certain public benefits to the SEC pursuing settlements in administrative proceedings. Legal scholars and federal judges consider administrative law judges to be experts in their fields. Further, the Commission typically decides cases within 300 days of filing, an expedited process compared to a typical federal court case, which can take years.
SEC investigations remain confidential until an enforcement action is filed. Yet negotiations between the Commission and the alleged company begin long before such filing. Indeed, Velikonja reports that between one-third and one-half of defendants in SEC enforcement actions agree to pay some sort of fine before the Commission even makes a formal allegation. Yet after agreeing to a financial penalty—sometimes even hundreds of millions of dollars—the company can walk away without admitting wrongdoing.
Federal judges have defined the public interest differently. In reviewing the SEC’s settlement with Citigroup Global Markets, for example, Judge Rakoff found that admissions of fact were in the public interest. Without such admissions, Judge Rakoff wrote, “the public is deprived of ever knowing the truth in a matter of obvious public importance.”
Velikonja proposes several policy changes that may shine more light on SEC administrative proceedings and thus help protect the public’s interest in achieving fair settlements with companies that violate securities rules. In settlements that are of particular significance, the SEC could hold public hearings. Alternatively, if the SEC does not wish to gather public opinion on individual settlements, it could instead allow public review of its settlement standards.
Velikonja also offers two alternatives that would increase transparency without legal change: First, because the SEC already reports to numerous House and Senate committees, these committees could request more information on SEC settlements in reports. Second, the SEC could track certain variables and publish results, such as whether the settlements included individual sanctions and admissions of fact.
Last month, the U.S. Court of Appeals for the Tenth Circuit found that the SEC’s use of administrative law judges violated the U.S. Constitution. The future of the practice is yet to be seen.