After Citigroup, Will Settling SEC Enforcement Actions become Harder? SEC Press Release

The Securities and Exchange Commission’s Director of Enforcement, Robert Khuzami, today, issued a press release regarding a New York federal district court’s recent rejection of an SEC’s settlement with Citigroup.  Khuzami announced that the SEC is appealing the lower court’s ruling to the U.S. Court of Appeals for the Second Circuit.

In the Citigroup case, U.S. District Judge Jed Rakoff refused to accept a settlement between the SEC and Citigroup in a case involving the bank’s sale of mortgage-backed securities that cost investors almost $700 million in losses while the bank garnered profit of about $160 million.  Rakoff ruled that  the underlying allegations were ‘unsupported by any proven or acknowledged facts,’ and rejected a $285 million settlement between the SEC and Citigroup.  The SEC claimed that the settlement reasonably reflected the relief it would likely have gotten had it won at trial.

Khuzami’s press release argues that Rakoff has created a “new standard” that is “at odds with decades of court decisions that have upheld similar settlements by federal and state agencies across the country. ”  He is correct that courts have routinely approved SEC settlements in which a defendant does not admit or expressly deny liability, thus providing incentives for both the SEC and defendants.  However, Citigroup’s failure to acknowledge wrongdoing is actually what bothered Judge Rakoff.  Rakoff concluded that the settlement “is neither fair, nor reasonable, nor adequate, nor in the public interest.”

In a period when the public has become ever more skeptical about the fairness of financial bailouts and deals between governmental agencies and banks, Judge Rakoff’s decision appears to channel that same skepticism.  Might this be the beginning of the end of the SEC’s practice and policy of settling cases with defendants without requiring the defendant to admit to liability of some kind, even if modest?  For at least one judge, that appears to be the case.  And, if it is the beginning of a trend, this could mean more trials and fewer settlements.  If so, the danger of changing the SEC’s settlement approach to these cases could prove time consuming and expensive not just for the SEC and defendants but also for federal judges like Judge Rakoff.

THE RECURRING DUE DILIGENCE FAILURES WITH PRIVATE OFFERINGS

FINRA Sanctions Eight More Firms.  FINRA’S  recent announcement that it had sanctioned eight more firms and 10 individuals, and ordered restitution totaling more than $3.2 million, for selling interests in private placement offerings without having a reasonable basis for recommending the securities is yet another warning to firms that fail to conduct adequate due diligence on alternative investment products.

NASD Conduct Rule 2310 requires member firms, when making a recommendation to a customer to purchase or sell a security, to have reasonable grounds to believe that the recommendation is suitable for the customer.  What this means, under FINRA rules, is that member firms who sell alternative investments such as Regulation D offerings must be able to demonstrate that they have an understanding of the potential risks and rewards of the security.  That demonstration must go beyond simply reading prospectuses, private placement memoranda, and other scripts passed along from issuers or participants in the offering process.

The eight firms and their reps FINRA snctioned sold interests in several high-risk private placements, including those issued by Provident Royalties, LLC, Medical Capital Holdings, Inc. and DBSI, Inc., which ultimately failed, causing significant investor losses.  The oft-forgotten message FINRA makes with these cases is that firms have at least two continuing responsibilities with alternative securities offerings.  The first is that member firms need first to document for themselves, and convey to their clients, an understanding of the inherent risks of private offerings; and the second is, after doing so, ask themselves whether these products are suitable for their customers.  Failing to conduct adequate due diligence makes this impossible to do since a selling firm may have no reasonable grounds to believe that the Regulation D offfering is suitable for any customer.

As with these cases, FINRA has shown no reservation in imposing supervisory liability , under Rule 3010, on principals of these firms for failing to conduct meaningful due diligence prior to approving such offerings for sale to customers.