A wise decision from Judge Rakoff

Thank you, Judge Jed Rakoff, for insisting that the SEC and big financial services firms come clean with the facts surrounding their legal battles before asking courts to sign off on a settlement.

“An application of judicial power that does not rest on facts is worse than mindless; it is inherently very dangerous,” the federal judge wrote last week in a landmark order rejecting a $285 million settlement between Citigroup Inc. and the Securities and Exchange Commission.

“The injunctive power of the fiduciary 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,” Mr. Rakoff wrote.

The SEC in October accused Citigroup of fraud, and the banking giant quickly agreed to settle the charges for $285 million and a promise to behave better. As is pretty much standard fare in settlements between the SEC and financial services firms, Citigroup would have been allowed to put the matter to rest without an admission or denial of guilt, or without even having to disclose publicly all the facts surrounding the case.

Not so fast, said the judge.

In a scathing 15-page opinion rejecting the settlement, Mr. Rakoff, who is known as something of a nonconformist in legal circles, concluded that in the absence of any proven or admitted facts, it is impossible to determine whether the proposed settlement was fair, reasonable or adequate.

Purely private parties can settle a case without agreeing on facts, for all that is required is that a plaintiff dismiss his or her complaint, the judge wrote. But when a public agency asks a court to become its partner in enforcement by imposing wide- ranging injunctive remedies on a defendant, “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.”

And with that, he told the two sides to be prepared to do battle in court in July.

To this, we say, amen.

Certainly, Mr. Rakoff deserves kudos for holding the SEC to a higher standard than it apparently holds itself.

SHINING A LIGHT

He deserves even more for shining a light on the all-too-cozy relationship between regulators and the regulated. Indeed, by allowing Wall Street firms to settle allegations of corporate malfeasance — including outright fraud — without so much as an admission of guilt, the SEC often stands in the way of defrauded investors’ ability to recoup their losses through private litigation.

But the judge most deserves praise for his insistence that the SEC and Citigroup fess up to what really happened in 2007 when Citigroup allegedly created, sold — and even had the audacity to bet against — a batch of mortgage-backed investments that it knew were destined to fail. When the housing bubble burst and those investments did, in fact, fail, investors were left holding the bag for $700 million, while the bank pocketed $160 million, according to the SEC.

By not allowing the SEC and Citigroup to sweep the facts surrounding the case — however egregious those facts may or may not be — under the rug, the judge is sending a strong message to regulators, the regulated and investors that the status quo no longer will be tolerated.

If other judges follow his lead, the threat of public disclosure likely will discourage some Wall Street firms from taking advantage of the ignorance, greed and downright naiveté of ordinary investors. Eliminating easy settlements may even help prevent another financial meltdown.

What’s more, the threat of having to engage in long and costly court battles could discourage the SEC from pursuing frivolous cases as a way to extort fines or garner positive headlines for itself, and, instead, encourage the commission to focus on meaningful cases involving serious crimes against investors.

Given that the ruling involves Citigroup, the SEC and mortgage-backed securities, it would be easy to characterize the decision as a populist victory against big, bad banks and rich people.

But that would be too simplistic. It also would miss the real point of the judge’s ruling.

Regardless of whether Citigroup and the SEC eventually reach a settlement in the case, Mr. Rakoff’s harsh rebuke of both parties may herald a new era of regulation. It is our hope that if a new regulatory climate emerges, it will be marked by more thoughtful and more rigorous enforcement on the part of regulators, and less collaboration among regulators and the regulated.