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SEC Must Tread Carefully With New Admission of Guilt Demands

Bruce Carton | September 10, 2013

The Securities and Exchange Commission announced an extraordinary  settlement in August in which the defendants—billionaire hedge fund manager Philip Falcone and his hedge fund firm Harbinger Capital Partners—actually confessed to the misconduct alleged by the agency as part of the deal.

 The  settlement including such admissions was a first for the agency and was a sharp departure from decades of prior practice in which the SEC routinely allowed defendants to settle cases while “neither admitting nor denying” the allegations against them.

The SEC's “neither-admit-nor-deny” settlement policy dates back over four decades. In November 1972, the SEC issued a statement formalizing a policy that defendants in its enforcement actions could not settle a case while simultaneously denying the allegations in the agency's complaint.  The SEC clarified in the same release “that a refusal to admit the allegations is equivalent to a denial unless the defendant or respondent states that he neither admits nor denies the allegations.”

Over the next four decades, the SEC went on to settle thousands of cases in which defendants neither admitted nor denied the charges filed against them. This arrangement promoted settlements because it eliminated the risk to defendants of having admissions in SEC cases used against them in other proceedings, such as private litigation or criminal prosecutions. Just as importantly, this policy helped the chronically understaffed SEC resolve the overwhelming majority of its cases through quick settlements that did not require a major investment of its litigation resources.

There must have been at least some rumblings over the years that the SEC's “neither-admit-nor-deny” policy was too weak in allowing defendants to settle cases while remaining conspicuously mute as to the veracity of the claims against them. Assuming there were, they were voiced very quietly. That all changed in November 2011, however, when Judge Jed Rakoff, a U.S. District Judge for the Southern District of New York, rejected a settlement in SEC v. Citigroup because, as Rakoff wrote, the court had not been “provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.”

“The SEC's prior longstanding policy incentivized the vast majority of defendants to take the carrot—a neither admit nor deny settlement—and avoid the stick—a long and costly trial.”

—Thomas Sporkin,

In a highly unusual ruling, Rakoff blasted the SEC's longstanding policy as being “hallowed by history, but not by reason.”  He added that it turned the court into a “mere handmaiden” to the parties' private settlement and that it deprived the public of “ever knowing the truth in a matter of obvious public importance.” Rakoff said that “no admission” settlements were frequently viewed in the business community as simply “a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies.”

In the 18 months that followed Rakoff's Citigroup decision at least four other federal judges issued similar rulings. Most recently, in March 2013, a federal judge in New York reserved judgment on the parties' request to approve an SEC settlement because he found that the “ground is shaking” beneath the SEC's policy.

Criticism of the SEC's policy did not come only from the judiciary, however. Members of Congress also commenced a steady stream of attacks on the policy.  In May 2012 the Committee on Financial Services held a hearing on “Examining the Settlement Practices of U.S. Financial Regulators,” and called then-SEC Enforcement Director Robert Khuzami to testify on the wisdom of the existing policy and practice. Khuzami defended the policy, telling Congress that if the SEC eliminated “neither-admit-nor-deny” settlements, “there would be far fewer settlements and much greater delay in resolving matters and bringing relief to harmed investors.”

A New Direction

The arrival of Mary Jo White as the new chairman of the SEC in April 2013, however, provided the agency with an opportunity to rethink its approach to settlements, and White didn't take long to signal a change. On June 10, White told Sen. Elizabeth Warren (D-Mass.) that the SEC's settlement policy was under active review “to determine what, if any, changes may be warranted and whether the SEC is making full appropriate use of its leverage in the settlement process.” Then on June 18, White announced that the agency had completed this review and would begin to require admissions of wrongdoing from defendants to settle enforcement actions in certain instances. Specifically, she clarified to her staff, the SEC would demand admissions in cases in which the defendant engaged in “egregious intentional misconduct” or “misconduct that harmed large numbers of investors.” Chair White emphasized, however, that “neither-admit-nor-deny” settlements would still remain a “major, major tool” used by the SEC.

In August Falcone and Harbinger became the first defendants to expressly admit to SEC allegations. The collateral impact of such admissions will now be tested in related litigation, including a class-action lawsuit against Harbinger filed by its investors. Interestingly, the SEC settlement reportedly provides that Falcone and Harbinger's admissions do not preclude them from taking other positions “in litigation or other legal proceedings in which the Commission is not a party,” and the effect of such language on other cases may now need to be litigated.

Perhaps even more significant is the impact that the SEC's new settlement policy may have on the SEC. It is no secret that the large financial institutions that the SEC regulates have massive budgets and resources that dwarf those of the SEC. Bank of America's marketing expenses in 2010, for example, were nearly double the SEC's entire 2010 budget. Similarly, JPMorgan's litigation reserves for its third quarter that same year quadrupled the SEC's budget. If too many of these institutions find themselves forced to litigate and go to trial in cases that they would have previously settled under the old policy, the SEC will quickly find itself stretched to the breaking point as it works to prosecute them.

Thomas Sporkin, a partner with law firm BuckleySandler who was previously a senior SEC enforcement attorney, points to the SEC's recent trial against Goldman Sachs' Fabrice Tourre as an example of how demanding a single trial can be. Sporkin says that the Tourre trial “likely took a team of litigators out of circulation for the better part of six months.” He believes that it would be an extreme challenge for the SEC to manage a number of such trials simultaneously, especially given the immense legal firepower that each financial institution it opposes will undoubtedly bring to the battle.

The risk to the SEC, then, is that it will feel pressure—either by the terms of its own evolving new policy or from internal or external sources—to demand admissions in more cases than it can reasonably litigate should the defendants refuse such demands and choose to fight.  The SEC's prior longstanding policy, Sporkin says, incentivized the vast majority of defendants to “take the carrot—a neither admit nor deny settlement—and avoid the stick—a long and costly trial that could end with a finding of liability that could have all sorts of devastating collateral consequences.” Because the budget-constrained SEC has so few “sticks” at its disposal, however, the agency will need to tread very carefully with its new policy to avoid being completely overwhelmed with litigation.