The appeal of Judge Rakoff’s rejection of the settlement between the SEC and Citigroup is spectacular theater.  Behind the scenes, however, is a highly serious issue: does a federal district judge have the power, as a condition to approving a consent judgment, to require an admission of liability or to otherwise impose collateral estoppel effects.

The briefing is complete.  I commend it to you (if you have a couple of hours to spare); it is excellent and entertaining.  Oral argument has been requested but not scheduled.

Here’s some background.  The SEC investigated Citigroup’s marketing of collateralized debt obligations.  The SEC then filed a complaint alleging non-scienter violations of the Securities Act.  The same day, the SEC also filed a proposed consent judgment, enjoining violations of the law, ordering business reforms, and requiring the company to pay $285 million.  As part of the consent judgment, Citigroup did not admit or deny the complaint’s allegations.  Judge Rakoff held a hearing to determine “whether the proposed judgment is fair, reasonable, adequate, and in the public interest.”  In advance, the court posed nine questions, which the parties answered in detail.  Judge Rakoff rejected the consent judgment.

The rejection order rested, in part, on the court’s determination that any consent judgment that is not supported by “proven or acknowledged facts” would not serve the public interest because:

  • the public would not know the “truth in a matter of obvious public importance”, and
  • private litigants would not be able to use the consent judgment to pursue claims because it would have “no evidentiary value and no collateral estoppel effect”.

The SEC and Citigroup appealed, and sought an order staying the rejection order pending appeal.  A panel of the Second Circuit granted the motion, finding that the SEC and Citigroup have a strong likelihood of success on appeal, and rejecting the district court’s holding that a consent judgment may be approved only if “liability has been conceded or proved and is embodied in the judgment.”

The parties then filed appeal briefs.  One of the briefs is from pro bono counsel appointed to represent Judge Rakoff.

The most fascinating feature of the briefing, and the one that makes me nervous about the outcome (why in a moment) is this: Judge Rakoff has retreated from the language in the rejection order, arguing that he did not rule that a defendant must make admissions with collateral estoppel effect.  “Rather,” Judge Rakoff argues, “the district court . . . was simply unable to fulfill its obligation in this particular case to independently determine whether the proposed consent judgment was fair, adequate, reasonable, and in the public interest, when it had not been provided with any ‘evidentiary basis,’ any ‘factual base,’ ‘any proven or acknowledge facts,’ or any other factual showing whatsoever on which to make the requisite determination.”  Judge Rakoff’s brief suggests that, having heard the trial of a Citigroup employee in a related case, he now has enough of a factual record to make the required determination about the consent judgment.

The reply briefs of the SEC and Citigroup, of course, criticize Judge Rakoff for his shift away from the actual language of the rejection order.  Citigroup’s reply brief summarizes it this way: “The district court made clear – three separate times in its 15-page opinion – that it rejected the proposed Consent Judgment expressly because [Citigroup] refused to acknowledge or admit the SEC’s allegations sufficiently to provide collateral estoppel benefits in private civil litigation”.  The SEC provided my favorite line in all of the briefs:  “That the decision as written has no defenders is strong justification for reversal.”

Some might say, “now that Judge Rakoff doesn’t take the extreme position he seemed to, the world is safe; not even Judge Rakoff will require an admission of liability, in the Citigroup case or any other case.  The SEC and issuers can keep settling cases on a no-admit-or-deny basis without risk of rejection.”  I fear that, absent an explicit ruling by the Second Circuit rejecting the power of a federal district judge to require an admission of liability or other collateral estoppel effects as a condition of approving a consent judgment, no-admit-or-deny settlements will become more difficult to reach.  The SEC may well become conservative and, at least in some cases, insist on admissions of liability or admissions of facts that are tantamount to admissions of liability.  It is also possible that other district judges have been persuaded by the position Judge Rakoff took in his rejection order (as opposed to the appeal brief) and themselves insist on admissions.  Of course, Judge Rakoff himself might revert to such a position.  Is an Article III judge subject to judicial estoppel?

The consequences of diminished use of no-admit-or-deny settlements would be severe and cascading.  The primary consequence would be fewer settlements because of the potentially prejudicial impact on related private litigation and criminal proceedings, as well as on D&O insurance coverage.  Most commentary to date has been on the strain increased litigation would put on the SEC.  But the impact of increased SEC litigation on companies and their directors and officers and liability insurers would be significant too.

More SEC litigation, of course, would result in higher litigation costs – a fact that would be magnified by the typical practice of splitting up joint representation at least from the Wells process through the enforcement action.  The defendants in the SEC enforcement action presumably would want their lawyers to defend them in the private litigation as well.  Defense costs would thus be significantly greater than they would be without SEC litigation. Higher defense costs, of course, would mean greater erosion of insurance policies.  Greater erosion of insurance policies would mean less insurance available to resolve the private litigation.  For companies that can’t or won’t write a check to settle the private litigation, less insurance would mean that private litigation would be more difficult to settle.  That would mean that more private cases would go to trial.

To be sure, good securities litigators would find ways to keep defense costs down as much as possible.  But the already expensive and complex process of defending multi-front securities litigation inevitably would become even more expensive and complex to litigate and resolve.