Opinion

Alison Frankel

Judge in SEC’s Bear Stearns case catches Rakoff fever

By Alison Frankel
February 15, 2012

U.S. District Judge Frederic Block of Brooklyn federal court will probably, in the end, approve a $1 million settlement between the Securities and Exchange Commission and former Bear Stearns fund managers Ralph Cioffi and Matthew Tannin. He said as much in open court Monday, presiding over a settlement hearing rather than the civil trial scheduled to begin that day. But for everyone except Cioffi, Tannin, and their lawyers, the real story at Monday’s hearing was Block’s stream-of-consciousness musings on the appropriate role of a judge overseeing an SEC case. If there was any doubt that U.S. Senior District Judge Jed Rakoff has inspired soul-searching in the nation’s federal judiciary, the utterly compelling transcript of the hearing before Block should put it to rest. (My Reuters colleague Jessica Dye attended the hearing and sent me the transcript.)

Rakoff, as you’ll doubtless recall, last November rejected the SEC’s $285 million proposed settlement with Citigroup over an allegedly misleading mortgage-backed CDO. The Manhattan federal judge said he had to consider not only the interests of Citi and the SEC, but also the public interest in the settlement. “Anything less would not only violate the constitutional doctrine of separation of powers but would undermine the independence that is the indispensible attribute of the federal judiciary,” Rakoff wrote.

Those are powerful words, and Rakoff’s Brooklyn colleague apparently heard them. “You allege [in the complaint] that [Cioffi and Tannin's] activity caused $1.8 billion of investors’ losses, and yet, when all is said and done, this case is being settled for — relatively speaking — chump change,” Block said to the SEC’s John Worland. “I think there’s a public interest in all of these things.”

Block first called on both SEC and defense lawyers — Hughes Hubbard & Reed for Cioffi; Brune & Richard for Tannin — to explain why the settlement was finalized only on the verge of trial. (He was irritated that he’d cleared three weeks on his calendar.) More fundamentally, though, he asked how the two sides expected him to evaluate the fairness of the deal.

“We all know about my colleague, Judge Rakoff, and everything that happened in a case that apparently is more profound than this one, right?” he said. “But I just wonder at what the role of the court is when the court is being asked to sign off and give its consent to your arrangement. I mean, I guess no judge likes to feel that he or she is a rubber stamp. So what do you envision the role of the court is?”

In particular, Block questioned a proposed injunction barring the former Bear Stearns fund managers from the securities industry for a limited time. After Worland tried to justify the terms of the settlement, Block said, once again, “Am I just a rubber stamp here or is there some inquiry I ought to be making about these provisions? About the fairness of it? Or the reasonableness of it? I’m not so sure I necessarily agree with everything Judge Rakoff wrote, but what should be the judge’s role when the judge is being asked to consent to one of these types of things?”

Then, again citing the relatively small money penalty compared to the investor losses the SEC alleged, Block asked, “Should I write Judge Rakoff, you know, to reflect on whether these hundreds of thousands of dollars and these relatively small penalties adequate or not?” Despite assurances from the SEC and defense counsel (who reminded the judge that their clients had been acquitted in a criminal trial) that the settlement was fair and appropriate, Block asked both sides to submit letter briefs “in light of Judge Rakoff’s standards, which I may not totally agree with.”

I called defense lawyers at Brune & Richard and Hughes Hubbard but none were available to comment. An SEC spokesman declined to comment on Block’s Rakoff-related remarks. The agency, remember, has asked the 2nd U.S. Circuit Court of Appeals for leave to appeal Rakoff’s rejection of the Citi settlement; it has previously argued (to its own detriment before Rakoff) that it’s not the role of a judge overseeing an SEC settlement to consider the public interest.

Carlyn Kolker wrote a terrific piece for On the Case posing the question of who will argue Rakoff’s side of that question if and when the 2nd Circuit takes the SEC’s appeal. If the appeals court is looking for volunteers, Brooklyn is just a subway ride away.

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Very interesting development. Based on everything I have read about these hedge funds and the criminal trial it was probably wise for the SEC to “cut their losses” and admit defeat sooner rather than later. The SEC probably raised the white flag of surrender after high-level brass saw a delivery truck with the Defendants’ file-cabinet-sized summary judgment pleadings.

IMO it is very telling that the SEC’s civil complaint OMITS several crucial details of the alleged misconduct, namely:
(1) the identity of ANY of the investors (alleged victims);
(2) the manner in which the investors (alleged victims) came into contact with the hedge fund and subsequently agreed to invest in the hedge fund(s).

The SEC’s complaint makes it sound like Cioffi was “targeting” unsuspecting investors who unwittingly decided to invest in a hedge fund by “accident”, in the same way that Charles Keating sold debt securities to 90 year old grandmothers in the lobby of Lincoln Savings adorned with government-insured seals of approval.

The SEC’s complaint seems to be predicated upon the existence of both (1) an identifiable “hedge fund industry” and (2) judicially ascertainable “industry standards” by which that “industry” operates. While it is undeniably true that a “hedge fund industry” does exist in the legal and accounting sense, it may be very difficult to present admissible evidence of any readily-ascertainable “industry standards” upon which Hedge Fund investors could reasonably expect to rely, other than the plain language of the Trust Indentures and other applicable transactional documents which those investors knowingly signed.

The SEC’s complaint contains repeated references to Cioffi’s alleged withholding of negative information about the deteriorating subprime market; but it is likely that the investors signed written agreements which not only allowed Cioffi to withhold various types of information from investors, but which also expressly prohibited investors from ever claiming any reliance upon any such withheld information (based the investors assurances that they were fully capable of performing their own independent due diligence).

Also the SEC’s complaint apparently assumes ipso facto that it was actually possible for Cioffi (or anyone else) to generate or obtain “accurate” accounting reports which could meaningfully describe the hedge funds’ “true financial condition” at a particular point in time. However virtually every RMBS/CDO offering document contains explicit disclaimers and warnings essentially stating (in not so many words) that it is IMPOSSIBLE for ANYONE to generate scientific, independently-verifiable formulas or models which accurately predict the instrument’s expected cash flows with any reasonable degree of certainty. Given that there was (and is) no “readily ascertainable” method of objectively valuing/monitoring the individual RMBS/CDO securities associated with these hedge funds, it may be very difficult for the SEC to establish that Cioffi actually provided investors with “false” valuations in the first instance, let alone that Cioffi actually believed they were “false”.

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