Alison Frankel

If you haven’t already, read Jesse Eisinger’s piece for ProPublica and the New York Times on the Securities and Exchange Commission’s case against the upstart credit-rating agency Egan-Jones. The SEC sued Egan-Jones – which challenged the traditional business model for rating agencies by charging users, not issuers, to opine on the riskiness of securities – for exaggerating its bona fides in a 2008 filing. Eisinger questioned the wisdom of sending Egan-Jones “to the guillotine” while letting bigger players, with business models that are susceptible to corruption, off the hook for their patently ridiculous ratings of toxic mortgage-backed securities. “This is your S.E.C., folks,” Eisinger wrote. “It courageously assails tiny firms, and at the pace of a three-toed sloth. And when it goes after its prey, it’s because it has found a box unchecked, rather than any kind of deep, systemic rot.”

Inspired by the piece, I went back to take another look at the SEC’s Apr. 12 complaint against Option One, a relative small-timer in the mortgage-backed securities market. Could Eisinger’s criticism of the SEC’s credit-rating enforcement – that the agency is netting minnows while the sharks swim away – apply just as well to MBS issuers?

Well, yes. But I’m getting tired of asking why the SEC has been so slow to enforce accountability for banks that packaged and sold securities backed by subprime mortgages that didn’t meet even the lax underwriting standards they warranted. So instead, I’m choosing to regard the Option One case as a model for the kinds of actions the already much-maligned mortgage fraud task force keeps promising to bring. From my reading, there’s no reason other MBS defendants can’t be held liable for the same disclosure problems that Option One agreed to settle for $28.2 million.

Granted, the case against the H&R Block subsidiary was clear-cut by the standards of financial fraud litigation. Option One was a major originator of subprime mortgages. In 2006 and 2007 it got into the securitization business. In addition to selling packages of loans to other MBS issuers, it acted as the sponsor of seven MBS trusts with a face value of $4.3 billion, all backed by Option One-issued mortgages. The MBS trust contracts included a provision promising that Option One, as the mortgage issuer, would buy back mortgages that materially failed to meet its representations and warranties. But according to the SEC, Option One knew it didn’t have enough money to make good on those repurchase promises. At the time Option One issued those mortgage-backed notes, H&R Block was quietly propping up its subsidiary, a fact Option One omitted from its MBS disclosures. (For more on Option One and put-backs, here’s a piece I did on the attempts of Sand Canyon, its successor, to block the company that bought the loan servicing business from turning over loan files to noteholders. Stay classy, Sand Canyon!)

How could the SEC extend the theory of the Option One case to other mortgage-backed securitizers? It’s a matter of what MBS issuers knew about the originators of the loans underlying the notes they sold. Option One wasn’t the only subprime mortgage originator that was in trouble in 2007 and 2008: IndyMac, New Century, Ameriquest, American Home Mortgages – the list goes on and on. They all sold loans that were packaged and resold via MBS trusts, which typically offered the same sort of put-back promises as the Option One MBS trusts, assuring investors that the loan originator was responsible for buying back materially deficient underlying mortgages.

In the Option One case, there was a clear link between the originator’s precarious financial condition and the MBS sponsor’s knowledge of the originator’s problems, since the sponsor and originator were one and the same. But couldn’t the same be said about Countrywide and Washington Mutual? History certainly shows those two mortgage giants didn’t have the funds to back repurchase promises. Could their successors at Bank of America and Wells Fargo be liable under the Option One theory? It would be tougher for regulators to use the Option One model against issuers that didn’t originate their own underlying mortgages, but the agency could use its subpoena power to find out what exactly the banks snapping up mortgage portfolios from the likes of New Century knew about originators’ true ability to make good on repurchase claims. My guess is that many of the banks were well aware of their mortgage suppliers’ problems.

My Reuters colleague Aruna Viswanatha has been doing a bang-up job covering the mortgage-fraud task force. Last month, for instance, she reported that the Justice Department used the obscure 1989 Financial Institutions Reform, Recovery, and Enforcement Act to issue MBS-related subpoenas to top financial institutions. FIRREA violations, which require a lower burden of proof than criminal charges, carry stiff civil penalties for misconduct like mail and wire fraud. But there’s nothing wrong with an old-fashioned disclosure case, either. The SEC got almost $30 million from Option One without even explaining a damages theory. If it can do the same against some of the bigger names in mortgage-backed securitization, that would shut its critics up.

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

There’s a very good chance that former Securities and Exchange Commission general counsel David Becker owes absolutely nothing to the folks who lost money in Bernard Madoff’s Ponzi scheme. Nevertheless, on Monday, Becker and his two brothers agreed to turn over every penny of the proceeds they received from their mother’s long-ago Madoff investment account, a total of $556,017. Becker, a partner at Cleary Gottlieb Steen & Hamilton, didn’t return my call seeking comment. But he is doubtless hoping that the $556,017 settlement with Madoff bankruptcy trustee Irving Picard of Baker & Hostetler puts an end to the ugliest chapter in his career.

For a brief while last year, you’ll recall, Becker was the favorite whipping boy of Madoff victims and their congressional champions. Becker and his two brothers were what’s known as net winners in the Madoff pyramid. After their mother’s death in 2004 they transferred the approximately $2 million in her Madoff investment account to a Smith Barney probate account. By September 2006, the will was probated and the account was liquidated. But in December 2010, Picard sued Becker and his brothers, demanding the return of $1.5 million in allegedly fraudulent profits from their mother’s estate.

At the time, Becker was the SEC’s general counsel. And though he informed the agency’s ethics office of his inheritance (and SEC Chairman Mary Schapiro was aware of Becker’s Madoff proceeds), the GC was not asked to step out of SEC deliberations — and did not recuse himself from the debate — on the appropriate method for compensating investors. When word got out of Becker’s Madoff money, Schapiro took a beating in Congress.

Becker faced even more potentially serious consequences. An exhaustive September 2011 report by then-SEC Inspector General David Kotz concluded with the finding that Becker’s actions merited a referral to the Justice Department’s Office of Public Integrity for a criminal investigation. Becker, who had resigned from the SEC in February 2011 to return to his partnership at Cleary, defended himself before a congressional committee buzzing about Kotz’s allegations; in November, the Justice Department told Becker’s counsel, William Baker of Latham & Watkins, that it was not opening a criminal investigation of the former SEC GC.

Meanwhile, U.S. Senior District Judge Jed Rakoff issued a ruling in Picard’s case against the owners of the New York Mets that could have wiped out any Picard claims against Becker and his brothers. Rakoff determined that Picard could not attempt to claw back allegedly fictitious profits dating back more than two years before Madoff’s firm collapsed. By any measurement, the Beckers’ ties to Madoff ended more than two years before December 2008, when the Madoff fraud was exposed. If Rakoff’s reasoning is upheld on appeal, Becker and his brothers would be off the hook entirely.

Instead, they chose to give back every penny they received from their mother’s Madoff investment. (The difference between Picard’s clawback claim and the $556,017 settlement is the fees and taxes the Beckers paid on their inheritance.)

A Picard spokesperson said the settlement “represents the recovery of an amount equal to 100 percent of the subsequent transfers received by the sons,” noting that to recover more than that, Picard would have had to reopen the probate proceeding, “a time-consuming, expensive and difficult undertaking under Massachusetts law.”

Becker’s lawyers at Latham & Watkins issued a statement pointing out that the Becker brothers are “returning 100 percent of the fictitious profits distributed to them,” which is entirely consistent with David Becker’s previous statements on his Madoff inheritance. “He always expected that he would return any fictitious profits that he unknowingly received,” the statement said. “Mr. Becker has done everything possible, both at the SEC and in his private affairs, to assist the victims of the Madoff fraud.”

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

If the Securities and Exchange Commission were an ordinary investor, it would already be too late in trying to sue the banks that issued (allegedly) deficient mortgage-backed securities.

The SEC is not, of course, an ordinary investor. On Wednesday night, the Wall Street Journal broke the news that the SEC plans to send Wells notices, otherwise known as target letters, to several banks that issued mortgage-backed notes and certificates. The Journal said the agency is looking at whether the banks misled investors about the quality of mortgage loan pools underlying securities issued in 2007 and 2008.

But here’s the thing: The first federal-court MBS class action, against Countrywide, was filed in 2007. By 2008, bond insurers and private investors were busily suing MBS issuers in state and federal courts in New York, starting the clock on the three-year statute of limitations for suits under the federal Securities Act of 1933 and the two-year time limit for fraud cases under the Exchange Act of 1934. Private investors who entertained thoughts of bringing federal claims for mortgage-backed notes issued in 2007 and 2008 would be tossed out of court quicker than you can say “time-barred.”

The SEC, in other words, is running at least three years behind the private securities bar when it comes to MBS litigation. I’ve heard, in fact, that the agency has recently been working with private lawyers to hone its MBS investigation. That makes sense: The list of plaintiffs’ firms that have sunk thousands of hours and millions of dollars into their MBS cases includes Quinn Emanuel Urquhart & Sullivan; Bernstein Litowitz Berger & Grossmann; Kasowitz Benson Torres & Friedman; Patterson Belknap Webb & Tyler; Cohen Milstein Sellers & Toll; Robbins Geller Rudman & Dowd and others.

The mystery is why the SEC has taken so long to see what’s been in front of its face. Remember, the agency spent years investigating Countrywide and its leadership. Weren’t mortgage-backed securities part of the investigation? Same thing with Fannie Mae and Freddie Mac, the two biggest players in mortgage securitization. The SEC began looking at Fannie and Freddie in 2008, and ultimately sued three top execs from each housing agency for allegedly misleading investors about subprime mortgage exposure. Surely someone at the SEC looked at the MBS portfolios Fannie and Freddie amassed — particularly because both agencies reached MBS settlements with Bank of America and GMAC’s Residential Capital in 2010.

Moreover, Fannie and Freddie’s conservator, the Federal Housing Finance Authority, gave the SEC a pretty good road map for MBS litigation with its 17-suit blitzkrieg last summer. (Interestingly, the FHFA may have its own time-limit problems with those cases.) Another arm of the federal government, the National Credit Union Agency, was one of the first MBS plaintiffs to wrest settlements from some of the banks that issued deficient securities. The Justice Department filed an MBS civil suit against Deutsche Bank last May. And the SEC itself warned MBS issuers about their obligation to disclose put-back claims back in October 2010. (The Financial Times reported last September that the SEC was investigating MBS disclosure failures — a pet peeve of the bond insurers’ trade association — but the Journal‘s story Wednesday suggests a broader SEC probe of securitizations.)

It can only help the monolines and private investors deep in MBS cases to be able to cite parallel SEC suits, but that’s small comfort to Joel Laitman of Cohen Milstein, an MBS litigation pioneer. A year ago, when Laitman was arguing at the U.S. Court of Appeals for the Second Circuit that credit rating agencies should be liable for blessing deficient mortgage-backed notes, Circuit Judge Jose Cabranes asked why the government hadn’t brought a case if the securitization industry was as corrupt as Laitman asserted. “I didn’t have an answer,” Laitman told me Thursday. “No one had an answer.”

Laitman, who lost the Second Circuit appeal, said it’s frustrating that only now has the SEC awakened to MBS abuses. “It’s so late to the game,” he told me. “There’s been a total absence for four years of any meaningful government response.” (An SEC spokesman declined comment, but pointed me to the agency’s “aggressive [record] on the credit crisis front.”)

I’ve been dubious about the new joint MBS task force, but Wells notices to banks means the SEC is serious about its investigation. That’s a good thing. I can’t help joining Laitman, though, in wondering how all of the private MBS cases of the last three years would have been different if the agency had acted sooner.

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

Late Friday the Securities and Exchange Commission confirmed in a statement what the New York Times first reported Friday morning: it has changed its policy on the boilerplate “neither admit nor deny” language in most SEC settlement agreements. But don’t get too excited. The change will affect only cases in which the defendant has admitted guilt or been convicted in a related criminal action. In settlements with those criminal defendants, the SEC will delete “inconsistent” concessions and instead “recite the fact and nature of the criminal conviction or criminal [admission] in the settlement documents.”

In other words, defendants whose guilt has already been established under the higher standard of criminal law can no longer evade responsibility for civil charges. Which leads, of course, to the question of why it took the SEC 40 years to change such a ridiculous policy.

In the weeks since U.S. Senior District Judge Jed Rakoff of Manhattan federal court rejected the agency’s proposed $285 million settlement with Citigroup for misleading investors about a synthetic CDO, the SEC has argued long and loud that the boilerplate Rakoff scorned is intrinsic to its ability to reach settlements with defendants worried about liability in follow-on civil suits by private plaintiffs lawyers. I get that. And as I’ve reported, just about every other federal agency with enforcement power has a similar practice of permitting defendants to settle without conceding they’ve done anything wrong. I have my doubts that deleting pro forma “neither admit nor deny” language from settlement agreements would result in a dramatic change in the value of follow-on private settlements, but perhaps I, like most federal judges, have become inured to boilerplate.

Still, let’s think for a minute about just how absurd it is to include “neither admit nor deny” language in settlements with admitted or convicted criminals. My Reuters colleague Grant McCool points out, for instance, that when BernieMadoff settled with the SEC in June 2009, he wasn’t required to admit wrongdoing, even though he’d already pled guilty to running the biggest Ponzi scheme in history. Crazy, right? And I haven’t noticed anyone citing Madoff’s SEC settlement to suggest that maybe he isn’t civilly liable for defrauding investors.

Seriously: Does any corporate defendant facing civil exposure from a criminal admission or conviction really believe the SEC boilerplate confers any protection from private suits? That’s like saying you’re not naked if you’re wearing Saran Wrap for underwear.

The irony is that the SEC gains as little as defendants lose in the policy change. The agency went out of its way to assert that the revision wasn’t prompted by Rakoff’s crusade. Its statement said the policy change came after “a review by senior enforcement staff that began this spring and separate discussions with the Commissioners over the last several months,” and that it is “separate and unrelated to recent rulings in the Citigroup case.” (And, in fact, the revised policy wouldn’t have changed the boilerplate in the Citi agreement, since that case doesn’t involve a parallel criminal admission or conviction.) I suppose the SEC could argue that at least it can no longer be ridiculed for settlements like the one it reached with Madoff.

But any scrutiny of its “neither admit nor deny” boilerplate can’t be good for the SEC as it challenges Rakoff’s ruling in the Citi case. If no one takes the language seriously, why include it?

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

For the last three years, since the housing bubble burst, the Securities and Exchange Commission has been investigating the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac). Fannie and Freddie, after all, were the biggest players in the mortgage lending and securitization business, and there’s a lot of sentiment that they deserve a hefty share of blame for encouraging the financial industry’s voracious appetite for mortgage loans, no matter how deficiently underwritten. The problem for regulators hoping to hold Fannie and Freddie accountable, though, is that the previously quasi-private agencies went into public receivership conservatorship in 2008. Any SEC suit against Fannie and Freddie would essentially be one wing of the U.S. government seeking damages against another.

But the people who ran Fannie and Freddie in the run-up to the mortgage meltdown were another story. About nine months ago the SEC issued Wells notices to top Fannie and Freddie executives. I’ve heard there was virtually no give-and-take between regulators and defense lawyers for the executives after initial defense responses. So it was a disappointment but not a big surprise to the defendants when, on Friday, the SEC sued three former top officials from both Fannie and Freddie. (Here’s the SEC’s complaint against Richard Syron, Patricia Cook, and Donald Bisenius of Freddie Mac; and here’s the complaint against former Fannie Mae execs Daniel Mudd, Enrico Dallavecchia, and Thomas Lund.) The SEC complaints charge two defendants in each case with full-on securities fraud (the third official in each complaint faces aiding and abetting claims) for allegedly misleading investors about their agencies’ exposure to subprime mortgages. In the Freddie complaint, the SEC asserts that the agency claimed only $2 to $6 billion of its single-family guaranteed mortgages were considered subprime loans, when, in fact, $140 billion to $244 billion in loans fit that classification. Fannie allegedly reported $4.8 billion in exposure when its subprime lending exceeded $40 billion.

There are a few points to keep in mind about the Fannie and Freddie suits. First, the allegations all center on disclosures. There’s no accusation of accounting manipulation or more obvious fraudulent acts. Yet four of the defendants are accused of intentionally defrauding investors — partly because Fannie and Freddie were not registered entities during the entire period of alleged wrongdoing, which means the execs couldn’t be accused of negligence. That’s a high bar, in which the agency has to show the defense acted with fraudulent intent. Second, the former Fannie and Freddie executives — unlike the Citigroup executives who agreed to an administrative settlement in the bank’s 2010 subprime exposure agreement with the SEC — had no leverage because the SEC wasn’t also negotiating with their employer. There was little reason for financial regulators to reign in aggressive allegations, especially because there’s a strong public-relations incentive for the SEC to charge senior executives of agencies that ended up in such severe straits that they had to be placed in receivership, with taxpayers bearing the burden of management’s overly risky strategy.

But if you parse the SEC’s complaints, you’ll see the weaknesses in the agency’s cases. Let’s start with which sector of Fannie and Freddie’s business the allegations involve. The government-sponsored entities, as they’re known, bought lots of subprime loans for the portfolios they securitized and resold as mortgage-backed notes. But that’s not where the SEC accusations lie. The SEC asserts that the Fannie and Freddie officials misrepresented subprime exposure in the mortgage-guarantee business, in which the agencies offered government backing for individual mortgage loans.

Both Fannie and Freddie had, at least in theory, strict guidelines on these guaranteed loans, in which they required mortgage lenders to assure, for instance, that borrowers met income requirements. Fannie and Freddie also bought guaranteed loans from prime lenders, not traditional subprime lenders.

It’s unquestionably true that as Wall Street’s hunger for mortgages to securitize encouraged prime lenders to abandon their own underwriting standards, Fannie and Freddie backed ever-shakier loans, as their internal controls noted. But were loans by prime lenders who purported to meet underwriting guidelines “subprime” loans for disclosure purposes?

The SEC says they were. The Freddie Mac complaint cites a glossary of terms the agency presented to its own board: “There is no longer a clear-cut distinction between prime and subprime mortgages as the mortgage market has evolved,” the glossary said, but Freddie officials relied on the old definitions — that subprime exposure came from loans originated by subprime lenders — in investor disclosures. Similarly, the complaint against Fannie cites a 2008 10Q in which Fannie Mae admitted that more of its traditional guaranteed mortgages resembled subprime loans, but it was not classifying them as such because they didn’t meet Fannie’s definition of subprime loans. (Nor, for that matter, the definition the Treasury Department promulgated in 2007.)

Both Fannie Mae and Freddie Mac — even as they declined to reclassify loans as “subprime” and failed to disclose that increased exposure to investors — did disclose reams of information about the loans they guaranteed. Expect their lawyers to argue that investors were fully apprised of the increasingly risky nature of the mortgages the GSEs were backing.

In other words, the case will turn on how Fannie Mae and Freddie Mac defined subprime loans, and whether executives committed fraud when they did not revise internal definitions to reflect the changing mortgage market. (The complaints are filled with phrases like “subprime-like” and “otherwise subprime.”) From what I hear, the defendants are vowing to fight the SEC all the way to trial (where, OTC has reported, the agency has a decidedly mixed track record). The agency will also have to face formidable defense teams. Here’s the lineup: Thomas Green of Sidley Austin for former Freddie CEO Richard Syron; Steven Salky of Zuckerman Spaeder for former Freddie Chief Business Officer Patricia Cook; Walter Ricciardi of Paul, Weiss, Rifkind, Wharton & Garrison for former Freddie Executive Vice-President Donald Bisenius; James Wareham of DLA Piper for Fannie Mae CEO Daniel Mudd; Laurie Miller of Nixon Peabody for Chief Risk Officer Enrico Dallavecchia; and Michael Levy of Bingham McCutchen for Executive Vice-President Thomas Lund.

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

In 2006, Bear Stearns entered a $250 million settlement of Securities and Exchange Commission allegations that its traders engaged in illicit market timing for certain preferred customers. Like scores of SEC defendants concerned with liability in related civil litigation, Bear insisted on the language that’s become boilerplate in SEC settlements. So “without admitting or denying” the SEC’s findings, the bank agreed to disgorge $160 million and pay a $90 million penalty.

Bear and its successor, JPMorgan Chase, turned to Bear’s insurers to cover the disgorgement. (Penalties aren’t indemnified in Bear’s policy.) The insurance agreements said the bank was covered for damages awards and charges incurred by regulatory investigations, with one catch: The policies excluded claims “based upon or arising out of any deliberate, dishonest, fraudulent, or criminal act or omission,” if there were a final adjudication reflecting that wrongdoing.

No problem, right? The SEC settlement explicitly said that Bear didn’t admit deliberate or dishonest behavior when it agreed to the disgorgement. The insurers, represented by DLA Piper, Drinker Biddle & Reath and several other firms, balked at paying, but JPMorgan, with counsel from Proskauer Rose, sued to enforce the policies. In September 2010, New York State Supreme Court Justice Charles Ramos agreed that Bear hadn’t admitted anything. “An insured’s settlement or consent to entry of an order with the SEC, wherein it did not admit guilt, will not preclude if from disputing those findings in subsequent litigation with its insurers,” Ramos wrote in an order refusing to dismiss JPMorgan’s suit. “The [SEC settlement] does not contain an explicit finding that Bear Stearns directly obtained ill-gotten gains or profited by facilitating these trading practices.”

Ramos’s decision was issued before the SEC’s “neither admit nor deny” boilerplate became a source of controversy, thanks to U.S. District Senior Judge Jed Rakoff of Manhattan federal court. I’ve speculated on the consequences if other judges opt to abide by the rules Rakoff seems to want to impose on corporate defendants setting with federal agencies. But a ruling Tuesday by the New York state Appellate Division, First Department, suggests the boilerplate language that Ramos cited — and Rakoff has derided — may no longer offer defendants much benefit even without judges specifically rejecting it.

As my Reuters colleague Joseph Ax reported, the appeals court dismissed the JPMorgan suit against the insurers. But the decision’s implications may be broader than that. In an opinion written by Justice Richard Andrias, the state judges simply didn’t pay much heed to the SEC “neither admit nor deny” boilerplate. “Read as a whole,” the decision said, “the offer of settlement, the SEC Order … and related documents are not reasonably susceptible to any interpretation other than that Bear Stearns knowingly and intentionally facilitated illegal late trading for preferred customers, and that the relief provisions of the SEC Order required disgorgement of funds gained through that illegal activity.” Moreover, in a footnote, the opinion referred explicitly to Rakoff’s criticism of SEC boilerplate in SEC v. Vitesse Semiconductor.

JPMorgan counsel John Gross of Proskauer referred my call to a JPMorgan spokesman, who didn’t get back to me. Insurance counsel Joseph Finnerty III of DLA Piper didn’t return a call for comment.

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

If there’s one federal jurist the Securities and Exchange Commission absolutely, positively did not want to see at the top of the docket in its $285 million settlement with Citigroup, it was Senior Judge Jed Rakoff of Manhattan federal court. Rakoff has been a festering sore for the agency since 2009, when he rejected a proposed $33 million settlement with Bank of America over failing to disclose bonus payments to Merrill Lynch executives in merger-related documents. In a March 2011 opinion in the Vitesse Semiconductor case, Rakoff took the agency to task for agreeing to settlements in which defendants neither admit nor deny wrongdoing. Then in July he claimed jurisdiction over the SEC’s case against former Goldman Sachs director Rajit Gupta, accusing the agency of forum shopping in filing an administrative action against Gupta. You can only imagine the teeth-gnashing at the SEC when Rakoff was assigned the Citi case. After the SEC tried to argue that Rakoff doesn’t have the power to consider the public interest in his evaluation of the proposed settlement, Monday’s rejection of the settlement was practically a foregone conclusion.

So you may be wondering — as I was — how it is that Rakoff ended up with the Citi case. The answer, according to his chambers and Chief Judge Loretta Preska of the Southern District, is that the assignment was purely random. Yes, there are 41 federal district judges in the district, so the odds of any of them overseeing multiple, unrelated cases filed by the same plaintiff are long. But according to Preska and Rakoff’s chambers, that’s what happened here.

The SEC filed the Citigroup case in federal court in Manhattan, rather than Washington, D.C. (where it filed a $75 million settlement with Citi in 2010) because the new Citi case includes SEC charges against Brian Stoker, a Citi Global Markets employee who allegedly structured and marketed the CDO that’s at the bottom of the case. Unlike the two Citi employees in the 2010 case, Stoker refused to settle with the agency. So in anticipation of litigation with him, the agency filed the entire Citi case in New York.

Once it was filed, it went into what’s known in the Southern Distrrict as “the wheel.” Preska said there are actually different wheels for each category of civil suit, but each active judge is equally represented on each wheel. (They’re also not actual wheels, but electronic simulations.) Rakoff is a senior judge, which means he can pick and choose which civil wheels he’s on. But like many of the judges who recently took senior status in the Southern District, he’s still on all of the civil wheels. He’s no more likely than any other judge in the district, in other words, to be assigned any particular case.

“It’s wholly random,” Preska told me. “There is no under-the-table nothing.” Rakoff’s chambers confirmed that both the BofA and Citi cases were assigned to the judge by random.

The Gupta case was a somewhat different matter. Under the Southern District’s rules, criminal cases and SEC enforcement actions “arising from the same alleged fraud” are assigned to the same judge. So once Rakoff was assigned the Galleon insider trading cases, the SEC’s Gupta action was considered related. (Lawyers in civil cases in Manhattan federal court can also indicate that new complaints are related to pending cases, which, as I’ve explained, is how Rakoff came to oversee so much of the district court litigation related to the Bernard Madoff liquidation.)

And before we get caught up in alternative conspiracy theories about how Rakoff got the Citi case, we should remember that the SEC’s litigation with BofA and Citi stand out mainly for the way Rakoff handled those cases. Rakoff wasn’t assigned the agency’s $535 million settlement with Goldman Sachs, which was approved by U.S. District Judge Barbara Jones of Manhattan federal court, nor the SEC’s $154 million deal with JPMorgan Chase, which got a green light from Manhattan federal judge Richard Berman in June 2011.

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

In 2010, when the Securities and Exchange Commission brought a case against Citigroup for misleading investors about the bank’s exposure to subprime mortgages, the SEC filed the proposed $75 million settlement in Washington, D.C., federal court. Judge Ellen Huvelle gave the agency some gruff about the deal, in which two individual Citi defendants also settled SEC claims through an administrative action, but she eventually accepted the settlement without demanding any big changes.

The SEC and Citi must be looking back with regret at those halcyon days. For reasons the agency has not explained, when it filed a proposed $285 million settlement with Citi last month, it opted for the federal court not in D.C. but in Manhattan. There, the case — which involves claims that Citi defrauded investors in a mortgage-backed CDO — was randomly assigned to U.S. District Judge Jed Rakoff, who has recently been engaged in a highly-publicized campaign of insisting on corporate accountability in SEC settlements. The SEC proceeded to undermine its credibility in Rakoff’s court by arguing, as my colleague Erin Geiger Smith reported, that it’s not the judge’s role to consider the public interest in SEC settlements.

In a 15-page, eminently quotable exercise in rhetoric issued Monday, Rakoff pushed the agency into the grave it dug for itself, rejecting not only the proposed settlement but also the SEC’s assertion that he must heed its assessment of the public interest. “A court, while giving substantial deference to the views of an administrative body vested with authority over a particular area, must still exercise a modicum of independent judgment in determining whether the requested deployment of its injunctive powers will serve, or disserve, the public interest,” Rakoff wrote. “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 took particular issue with the SEC’s standard operating procedure of permitting a defendant to settle claims without admitting to underlying allegations, describing the agency’s strategy as “hallowed by history but not by reason.” The SEC asserted that because Citi did not expressly deny its allegations the judge and the public could infer their truth. “This is wrong as a matter of law and unpersuasive as a matter of fact,” Rakoff wrote, adding later in the ruling, “An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous. The injunctive power of the judiciary is not a free-roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated. If its deployment does not rest on facts — cold, hard, solid facts, established either by admission or by trials — it serves no lawful or moral purpose and is simply an engine of oppression.”

The proposed settlement, the judge said, offered an obvious benefit only to Citi; Rakoff wrote that it is “harder to discern” what the SEC gets from the agreement “other than a quick headline.” (He contrasted the terms of the SEC’s $535 million settlement with Goldman Sachs with the proposed Citi deal, asserting that the Goldman case “involved a similar but arguably less egregious factual scenario.”) The public, meanwhile, is left with unproven facts and inadequate relief, according to Rakoff. “How can it ever be reasonable to impose substantial relief on the basis of mere allegations?” he wrote. “It is not fair because, despite Citigroup’s nominal consent, the potential for abuse in imposing penalties on the basis of facts that are neither proven nor acknowledged is patent. … And, most obviously, the proposed consent judgment does not serve the public interest because it asks the court to employ its power and assert its authority when it does not know the facts.” (Interestingly, the plaintiffs firm Robbins Geller Rudman & Dowd filed a proposed amicus brief asking Rakoff to reject the deal for that very reason.)

Rakoff’s ruling suggests that he’s not willing to approve a deal without an admission of wrongdoing from Citi. “The court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance,” he wrote. But as Andrew Longstreth has reported for On the Case, there are clear costs to the public if the SEC demands terms defendants simply won’t agree to.

That was substance of the SEC’s response to Rakoff’s ruling Monday. “The court’s criticism that the settlement does not require an ‘admission’ to wrongful conduct disregards the fact that obtaining disgorgement, monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission when that relief is obtained promptly and without the risks, delay, and resources required at trial,” enforcement director Robert Khuzami said in a statement. “It also ignores decades of established practice throughout federal agencies and decisions of the federal courts. Refusing an otherwise advantageous settlement solely because of the absence of an admission also would divert resources away from the investigation of other frauds and the recovery of losses suffered by other investors not before the court.”

The agency didn’t respond to my specific question about why it filed the proposed Citi deal in Manhattan rather than in Washington.

Citi counsel Brad Karp of Paul, Weiss, Rifkind, Wharton & Garrison didn’t return a call for comment.

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

On June 28, 2010, the Enforcement Director of the Securities and Exchange Commission, Robert Khuzami, spoke on the phone with Mark Pomerantz, a partner at Paul, Weiss, Rifkind, Wharton & Garrison. Pomerantz and Khuzami had worked together as assistant U.S. attorneys in Manhattan in the 1990s; according to Pomerantz, he was partly responsible for Khuzami’s promotion to chief of the office’s securities unit. But this wasn’t a social call. Pomerantz represented Citigroup, which had agreed to settle SEC allegations that it drastically underreported its subprime mortgage exposure. The deal was held up, however, by the agency’s insistence that Citi CFO Gary Crittenden face fraud claims for allegedly misleading investors.

Pomerantz told Khuzami, as he had many times before, that Citi would suffer collateral damage if Crittenden were accused of fraud. According to Khuzami, he just told Pomerantz to “talk to Crittenden.” But soon after the June 28 call, another Citi lawyer, Lawrence Pedowitz of Wachtell, Lipton, Rosen & Katz, told SEC Associate Enforcement Director Scott Friestad that Khuzami had agreed to back a non-fraud settlement with Crittenden.

In July 2010 the SEC announced its deal with Citi. As part of the settlement, Crittenden and another individual defendant, former Citi investor relations chief Arthur Tildesley, settled administrative actions that didn’t involve fraud allegations. Six months later, an anonymous (but obviously insider) source tipped U.S. Senator Chuck Grassley that Khuzami had forced the agency to drop fraud claims against the execs as a favor to his friends in the defense bar. The SEC’s inspector general, H. David Kotz, undertook an investigation of the complaint.

The result of the investigation, announced Thursday, is an utterly compelling 43-page report. The inspector general cleared Khuzami of violating any SEC guidelines or offering any preferential treatment to Citi. The settlement, Kotz said, was the product of long negotiations between the bank and enforcement-division lawyers. And though it would have been “advisable” if another SEC lawyer had also been on the phone when Khuzami spoke with Pomerantz on June 28, 2010, Kotz said that Khuzami cured any misunderstanding about what he said to Pomerantz when he offered in an subsequent email to Friestad to insist on fraud claims if the staff felt it was important.

“The OIG found that Khuzami also included at least some staff members on every meeting he had with defense counsel, and in instances where certain staff members could not attend, Khuzami made sure to brief them after the meetings,” the report said. “In addition, the OIG found that Khuzami held several internal meetings with the staff in which he gave the staff members ample opportunity to express their views on the Citigroup case. The enforcement staff consistently testified to the OIG that they felt they had the opportunity to express their views throughout the Citigroup investigation.”

But it’s impossible to read the public version of the IG’s report (which is, unfortunately, heavily redacted) without getting the sense that the white-collar bar is a club of insiders. This is a rare window into how SEC settlements are made — and how defense lawyers’ access to SEC decision-makers may affect the process.

Citi was represented by Brad Karp of Paul Weiss and Pedowitz of Wachtell when it reached the outlines of a deal with the SEC enforcement staff in Sept. 2009. The deal would permit the bank to resolve the SEC’s investigation of its subprime disclosures by agreeing to claims that it misled investors without the intention of defrauding them — a so-called Section 17(a) charge under the Securities Act of 1933. (Section 17(a) is considered a fraud claim, but it’s not intentional fraud.)

When the SEC resolved to charge individuals, things got more complicated. The agency appears to have sent Wells notices to a number of potential Citi defendants, but the enforcement staff eventually decided to focus on Crittenden, the CFO, and Tildesley, the former investor relations head. Crittenden hired John Carroll of Skadden, Arps, Slate, Meagher & Flom. Tildesley was represented by Mark Stein of Simpson, Thacher & Bartlett. According to the IG’s report, Citi supplemented its team with Pomerantz of Paul Weiss, specifically to make the SEC aware of the implications for the bank-which faced securities fraud class actions — if individual Citi defendants were accused of fraud.

Carroll, Stein, and Pomerantz had all intersected with Khuzami in the Manhattan U.S. attorney’s office, according to the report. (Khuzami’s deputy, Lorin Reisner, overlapped with Khuzami, Carroll, and Stein but not Pomerantz.) Khuzami worked closely with Stein and Pomerantz, and he stayed in touch with Pomerantz after he left the prosecutors’ office and joined the legal department at Deutsche Bank. Khuzami actually hired Pomerantz on a long-running matter for Deutsche Bank.

In talks with the SEC enforcement staff, Tildesley and Stein agreed pretty quickly to a Section 17(a) settlement. Not Crittenden and his counsel, Carroll of Skadden. (Khuzami told the IG’s investigators that Crittenden was concerned he’d have to step down from a position in his church if he settled the SEC claims.)

Pomerantz of Paul Weiss, meanwhile, repeatedly contacted Khuzami to argue that Citi would suffer if the SEC charged Crittenden with securities fraud. According to the IG report, he sent an email directly to Khuzami on April 6, 2010; Khuzami immediately forwarded it to the enforcement staff. In June, Pomerantz emailed Khuzami to ask him to meet with Citi’s board chairman, Dick Parsons. Khuzami, Reisner, and Friestad all attended the Parsons meeting, which didn’t seem to change the dynamic of discussions between the SEC and Crittenden.

Then came the crucial June 28 phone call between Pomerantz and Khuzami. Pomerantz, who gave testimony to the SEC inspector general, said he recalled Khuzami suggesting in that call that it might be possible to charge Crittenden with something other than securities fraud. “Pomerantz described Khuzami’s comment as ‘a little crack in the door’ and ‘a light and the light was not an upcoming train’ and noted that it reflected ‘some willingness to consider whether the staff could entertain a non-fraud resolution as to Crittenden,’” the report said. Khuzami, by contrast, told the IG that he never agreed to any such thing. “[He said] there was no such agreement, and [he] didn’t agree to any such thing, and [he] couldn’t agree to such a thing,” the report said.

Pomerantz, however, told his Citi co-counsel Pedowitz and Crittenden counsel Carroll that the SEC had moved away from charging Crittenden with fraud. Pedowitz emailed Friestad, and in a follow-up phone call, said Khuzami was now backing a non-fraud settlement with Crittenden. Friestad told the IG’s office that Pedowitz’s assertion came as news to him, but he pretended to know what the Citi lawyer was talking about. Then he went to Reisner since Khuzami was out of the office. (Reisner’s reaction is redacted.)

When Khuzami got word that Citi believed he’d agreed to a non-fraud settlement for Crittenden, according to the IG’s report, he was none too pleased. In a call on July 1, 2010, he told Pomerantz that the Paul Weiss lawyer had read too much into their previous discussion. Pomerantz told the IG’s office, however, that by the end of the July 1 call, he still believed Khuzami would support a non-fraud settlement with Crittenden, even though Khuzami told him the deal would have to be negotiated with Carroll, not with the Citi lawyers. “Pomerantz said that by the end of the conversation, he was ‘certain the state of play was that hopefully we would be back on track,’” the report said.

Carroll, according to the report, was surprised when Reisner and Friestad informed him that the SEC was still pursuing fraud claims against his client, whatever he had heard from Pomerantz. “Confusing day,” Carroll said in an email to Friestad; in a subsequent phone call, Friestad told the IG, Carroll said, “What the heck is going on? I’ve known you for 16 years. I don’t think I’ve ever had a call like this in my life from you guys.”

On July 3, 2010, Khuzami sent an email to Friestad that weighed heavily in the IG’s evaluation of his conduct. It’s partly redacted but said, “Regardless of whatever miscommunications or strategy is behind what Larry or Mark told John,” Friestad should “confirm the [enforcement team] is OK [with a non-fraud deal for Crittenden].”

Frustratingly, the public version of the report does not disclose how the enforcement staff came to accept a non-fraud deal with Crittenden. (Those terms were eventually offered to Tildesley as well.) But it was the IG’s conclusion that 43-page report Khuzami never intended to cut the enforcement staff out of decision-making or to confer preferential treatment on Citi.

SEC spokesman John Nestor told Reuters reporter Aruna Viswanatha that the agency is “pleased that the report found the anonymous allegations were completely without merit.” I left messages for Pomerantz, Carroll, and Pedowitz but didn’t get a response.

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter

One of the most controversial aspects of the U.S. Supreme Court’s June 2011 ruling in Janus v. First Derivative Traders was that the Justices rejected the Securities and Exchange Commission’s interpretation of federal securities laws. The SEC said Janus Capital wasn’t liable for the allegedly misleading statements in a prospectus issued by a Janus mutual fund, even though the SEC argued that it was — and even though federal courts traditionally pay deference when they ask agencies to offer their expertise in interpreting the law.

The SEC took another blow Monday, when a three-judge panel of the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of an auction-rate securities class action against Merrill Lynch, despite an SEC brief arguing the case should proceed. The SEC agreed with a Merrill ARS investor who asserted that the boilerplate disclosure Merrill posted after a 2006 SEC consent decree shouldn’t shield it from claims it manipulated the market for ARS. The Second Circuit panel felt otherwise.

To be sure, Judge Robert Katzmann, writing for a panel that also included Judges Robert Sack and Amalya Kearse, said that the Merrill opinion should be read narrowly. “We see no need to fix the ‘exact molecular weight’ of the deference that we owe to the SEC’s position,” Katzmann wrote. “We readily acknowledge that at least some deference to the agency’s position is appropriate, given the SEC’s expertise and accountability. Here, however, we are unable to agree with the SEC’s application of the legal principles governing Merrill’s disclosures.”

But it’s notable that the appeals court declined to adopt the SEC’s view after expressly asking the agency to weigh in. U.S. District Judge Loretta Preska of Manhattan federal court had dismissed the class action in March 2010, ruling that Merrill’s posted disclosures, which followed an SEC investigation of the ARS market, were an adequate warning that the firm bid on its own securities to prop up prices. The Second Circuit already had considered the post-2006 disclosures all ARS issuers agreed to in a July 2011 ruling, Ashland v. Oppenheimer, but hadn’t asked the SEC about the reach of the disclosures. So after Girard Gibbs appealed Preska’s dismissal of the Merrill class action, the appeals court sought a letter brief from the agency.

The SEC, like the class, asserted that Merrill’s disclosure didn’t go far enough in disclosing its interference in the ARS market. The Second Circuit said that it did. “We find no error in the district court’s conclusion that Merrill’s disclosures of its support bidding practices sufficed to preclude [the class's] claim that these practices were manipulative,” the opinion said. “These disclosures revealed, at the very least, the possibility that Merrill would place support bids in some auctions that it managed and that in the absence of these bids, some of these auctions might fail.”

I asked an SEC spokesman for the agency’s response but didn’t hear back. Class counsel Jonathan Levine of Girard Gibbs said, “We’re disappointed that the Court of Appeals disagreed with the SEC conclusion that investors should have been allowed to proceed with claims.”

Merrill was represented by Jay Kasner, Scott Musoff, and Paul Lockwood of Skadden, Arps, Slate, Meagher & Flom, which also prevailed in the appeals court’s Ashland ruling in July.

Even though the Second Circuit has now upheld the dismissal of two ARS cases, that’s not the end of all ARS litigation, according to George Carpinello and Adam Shaw of Boies, Schiller & Flexner. They represent individual plaintiffs in two ARS cases brought by individual investors, including a case against Merrill that Preska — the judge who dismissed the Merrill case at issue before the Second Circuit — greenlighted. “The court made it clear that this is a limited ruling,” said Carpinello. “It clearly had problems with the way the facts were pled…Our cases are about what was said to our clients at a particular point in time when the broker had knowledge of what was going on.”

For more of my posts, please go to Thomson Reuters News & Insight

Follow me on Twitter