Defending The SEC’s Neither-Admit-Nor-Deny Policy
If you’re reading this blog, you know well by now that on November 28th, Jed Rakoff, a U.S. district judge in the Southern District of New York, rejected an attempt by the SEC and Citigroup to settle a fairly prominent enforcement matter, and that the SEC has decided to appeal Rakoff’s decision to the Second Circuit. To recap, the SEC had accused Citi of misleading investors about a $1 billion collateralized debt obligation tied to the U.S. housing market. Judge Rakoff ripped the SEC in his opinion declining to approve the settlement, and in particular took issue with the Commission’s policy to settle enforcement actions with a statement that the defendants neither admit nor deny the factual allegations made in the complaint. Others have taken great glee in the opinion, and made the Commission appear to be feckless or even corrupt. The House Financial Services Committee has scheduled a hearing in January to examine the neither-admit-nor-deny policy. Other judges are also starting to get in on the act. I think the attacks are unfair because they largely ignore the resources issue that underlies the policy.
A Kernel of Truth
First, though, the criticisms bear some truth. The result of the policy is not especially gratifying for anyone on the government’s side. Certainly, the SEC’s enforcement staff does not derive a lot of satisfaction – after working hard to put a case together – from including language in settlement papers that says a defendant does not admit to doing what the complaint says it did. Also, there are some instances, as when a defendant facing parallel proceedings is convicted of substantially identical criminal securities violations, that failing to force the defendant to admit to facts alleged in a complaint is somewhat silly. But because of the massive resources deficit the SEC faces when compared with the industry it is charged with policing, the alternatives to maintaining the policy in most instances are much worse.
SEC Budget and Responsibilities
Remember, it appears that the Enforcement Division’s budget for fiscal year 2011 was roughly $450 million(link is external). Meanwhile, Bank of America’s marketing budget in 2010 was $2 billion(link is external). JP Morgan Chase held $4 billion in litigation reserves for the third quarter of 2010. A year later, the hedge fund industry held over $2 trillion(link is external) in assets under management.
With its allotted budget and staff, the Enforcement Division brought 735 cases last year. The cases touched on accounting fraud, unregistered broker-dealers, municipal securities, FCPA violations, structured derivative products, naked short sales, insider trading, investment adviser compliance violations, auditor misconduct, broker-dealer compliance violations, Ponzi schemes, public pensions, delinquent filings, microcap fraud, asset-backed securities, auction rate securities, misappropriation of “side-pocketed” assets at hedge funds, unregistered offers and sales of securities, fraud in PIPE transactions, transfer agent recordkeeping, broker-dealer recordkeeping, and Reg. FD violations, among many, many other types of securities law violations. It is a dizzying array of issues and violators.
Effect of Abandoning the Neither-Admit-Nor-Deny Language
Deleting the neither-admit-nor-deny language in standard SEC settlement papers would compel many defendants to litigate their cases. The collateral consequences of admitting to willful violations of the securities laws can be dire. They can include bars or suspensions from association with broker-dealers, once FINRA moves in, as well as liability in private class action suits or shareholder derivative litigation. One can be sure that those private plaintiffs would be waiting in the wings to take advantage of the preclusive effect of black-and-white admissions to press their own claims. The SEC defendants would have no choice but to fight fiercely to limit negative factual findings as much as they could to minimize these adverse effects. The result in many cases would be more trials.
The world, though, bears many more securities violations than the SEC can address. An SEC staff member there has to act like a microeconomist(link is external), focusing efforts as efficiently as possible to get the most deterrent effect from the matters they can address. While the SEC does take cases to trial – and it has taken more over the last five years than it did in the three years before that – an unavoidable side effect is that resources devoted to those trials are not spent investigating and proving up the assortment of violations listed above.
Abandoning the standard settlement language would mean the SEC could no longer pick its trial battles carefully, deciding which factual situations could get the agency the most bang for its litigation buck. Instead, it would have to prepare for almost every matter as if a trial were inevitable, because it almost certainly would be.
It’s hard to know how many cases the SEC could resolve each year in this context, but it wouldn’t be 735. It might be 40 or 50. To the extent this happened, the effect would be to fundamentally change the SEC’s mission as a law enforcement agency. Many more Ponzi schemes would escape scrutiny. Many registration violations, often precursors to larger frauds, would never be caught. The costs to victims of those violations would be enormous.