With Southern District Judge Jed Rakoff's blistering decision on Monday, rejecting the proposed settlement between the SEC and Bank of America Corporation,1 two key questions come to the fore: (1) Will this decision change SEC enforcement practices, which today invite corporate executives to purchase immunity for themselves with their shareholders' money?; and (2) Who is minding the store at the SEC so as to enable its litigators to shoot themselves in both feet? The positions taken by the SEC's staff in defending this settlement could haunt the SEC for years.
For the future, the SEC's staff may hope that other judges will continue to rubber stamp their settlements in the time honored way. But it is difficult to put the genie back in the bottle. Judge Rakoff's incisive opinion exposes a cozy, but "cynical relationship between the parties" under which "the S.E.C. gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger . . . [while] the Bank's management gets to claim that they have been coerced into an onerous settlement by overzealous regulators."2 Such a settlement, he wrote, came not only at the expense of shareholders, "but also of the truth."3
This column views the dysfunction in SEC enforcement practices as the outgrowth of the SEC's long-standing settlement culture, which tends to view litigation less as an opportunity to resolve disputed issues than as an occasion to negotiate a settlement that affirms the power and majesty of the SEC.
Arguably, such settlements were a low-cost means for an underfunded agency to buy general deterrence on the cheap. But once the public has been shown the little man behind the curtain, the great and powerful Wizard looks far less foreboding or impressive. For the SEC, this defeat will embarrass, but it is uncertain that it will provoke reform.
For that reason, this column suggests that the SEC's inspector general should follow up on Judge Rakoff's opinion and investigate the questions that neither side would clarify for the court: How did the SEC make the litigation decisions that it did? Who was responsible for the inadequate investigative record? Who approved this de facto sale of indulgences without any responsible individual defendant being identified?
Factual Background
At the core of the Bank of America case was the SEC's assertion that Bank of America's proxy statement "was materially false and misleading because it indicated to shareholders that Merrill would only make 'required' payments to its employees, such as salary and benefits, but would not pay discretionary year-end bonuses."4 The SEC alleged that "[i]n fact, Bank of America expressly had agreed to allow Merrill to pay up to $5.8 billion in discretionary year-end bonuses."5 That is a perfectly cogent and understandable theory. Because the SEC need not allege scienter in a proxy fraud case,6 the SEC seemingly held considerable leverage to negotiate a favorable settlement against both Bank of America and its officers.
What kind of settlement should the SEC's staff have negotiated with Bank of America? Here, the commission, itself, had recently announced a clear standard. In 2006, the commission issued a policy statement, which after conceding that it had previously vacillated, proclaimed that it was "important to provide the maximum possible degree of clarity, consistency, and predictability in explaining the way that its corporate penalty authority will be exercised."7 With that unusual preface, which certainly suggested that this was not an off-handed casual statement, the commission next announced that the "key question for the Commission is whether the issuer's violation has provided an improper benefit to the shareholders, or conversely whether the violation has resulted in harm to the shareholders."8 In the latter case, it said:
Where the shareholders have been victimized by the violative conduct, or by the resulting negative effect on the entity following its discovery, the Commission is expected to seek penalties from culpable individual offenders acting for a corporation.9
This policy makes obvious sense because otherwise penalties imposed on the corporation just exacerbate the original injury to the shareholders from the nondisclosure.
Applying this logic to the Bank of America case, it seems obvious that it was the BofA's shareholders who were victimized (and no one else) and that no "improper benefit" was received by BofA. Thus, the commission's 2006 policy statement mandated that penalties be imposed on individuals, not the corporate entity, because to penalize Bank of America would simply further "victimize the victims" (as Judge Rakoff found).
Nonetheless, the SEC's staff negotiated a settlement under which Bank of America paid a $33 million civil penalty, and no officer or employee paid anything or was otherwise disciplined.
Not only did this approach clearly puzzle Judge Rakoff, to whom the settlement was presented for approval, but the SEC staff's explanation for its failure to charge any officers or agents startled him even more. The SEC's memorandum submitted in support of the proposed settlement explained that all of BofA's witnesses had "stated that they relied entirely on counsel to decide what was or was not disclosed in the proxy statement."10 But were these statements credible? And what did counsel do? Here, the SEC's staff admitted that they did not know, because "Bank of America has not waived the attorney-client privilege [and] [a]s a result, the investigative record does not include any specific rationale as to why" more information about the bonuses was "not disclosed in the proxy statement."11
With these statements, the SEC's staff effectively shot itself in the foot. In a context where corporate officers can be held liable for a negligent failure and where a seemingly material omission had been made, the SEC's staff was effectively saying that "we cannot charge officers because maybe they relied on counsel (but we don't really know)." The Keystone Kops dug deeper than this, and in his prison cell, Bernie Madoff can chuckle and think that nothing has changed.
Such a position could haunt the SEC's enforcement efforts for years to come. If corporate officers need only claim that they relied on counsel to end the inquiry, one can imagine that transaction planners in the future will expressly delegate the preparation of the disclosure documents to the lawyers, possibly with the request that counsel advise the board and management that full disclosure has been made.
Why would the SEC's staff paint itself into so hopeless a corner? The answer involves an old and familiar tendency. Litigators will often make aggressive, even extreme, legal assertions in one case to realize their immediate goals, without recognizing the implications for future cases. For defense counsel, such behavior is less troublesome, because they cannot as easily be bound by their past statements. But for a regulatory agency, the statements made in one case will predictably be used against them in the next.
The SEC has a long history in this regard. Back in the 1970s, when the SEC was still seeking to construe narrowly the private placement exemption, its staff took the position in briefs in the Continental Tobacco case that the fact that investors in a private placement hired their own counsel showed that there was not the preexisting relationship of trust and confidence between the issuer and the investors that the SEC then claimed was a precondition to a valid private placement.12
Of course, this position was both silly and unfortunate (as it discouraged the use of counsel), and the Fifth Circuit did not rely on it in its decision. But such an example shows the need to monitor the positions taken by litigators in an individual case, as they could later embarrass the agency in other litigation.
Normally, the commission does monitor the positions taken by the enforcement division, with the commission's office of general counsel exercising oversight. But what happened in the Bank of America case? Both of the commission's two memoranda submitted to Judge Rakoff were signed only by the SEC's associate regional director. In an important case, higher ranking counsel often sign the briefs, but none appeared willing to step forward in this case. Was the case orphaned because no senior official wanted to accept responsibility?
In the SEC's latest filing on Sept. 9, 2009, the staff again justified the failure to charge individual officers, stating:
The uncontroverted evidence in the investigative record is that lawyers for Bank of America and Merrill drafted the documents at issue and made the relevant decisions concerning disclosure of the bonuses. During the course of the investigation, key executives all stated that they delegated these decisions to counsel, who were aware of the relevant business terms of the transaction.13
That statement just dug the hole deeper. Conceivably, counsel who drafted these disclosures could be sued by the SEC as "aiders and abetters" under Section 20(e) of the Securities Exchange Act, but this would require the commission to prove that counsel "knowingly provided substantial assistance to another person in violation of a . . . rule or regulation under this title." In substance, this probably requires proof of scienter. In contrast, the corporate officer who solicits proxies or signs the proxy statement has made a public statement that is actionable under Rule 14a-9 under a negligence standard. Such persons are more inviting targets, and a wholesale delegation of responsibility to counsel without reviewing the proxy statement may amount to negligence.
What best explains the weak settlement in Bank of America? To some extent, the SEC's litigators were likely constrained by a weak investigative record (for which others in the enforcement division may bear responsibility). But the inference is unavoidable that the commission wanted to announce a seemingly tough settlement in a high-profile case, as part of its understandable campaign to re-establish itself as the tough cop of Wall Street.
This effort has clearly backfired. Although the SEC's staff probably expected that a $33 million settlement would appear severe, that it would generate favorable media headlines, and that the federal court would rubberstamp its settlement, they had the misfortune of encountering a judge who understood that Article III judges can be independent and think for themselves.
At this point, the SEC was in trouble. In its submissions to the court, the SEC admonished the court that "consent judgments should be assessed based on the allegations in the complaint independently of charges or allegations that could have been, but were not, made"14 and that the district court may not "seek . . . information concerning the government's investigation and settlement negotiations."15 This was pushing the judge and even implying that the SEC might appeal an adverse ruling. But the court's opinion rests on the fundamentally strong position that the proposed settlement defied the SEC's own standards.
If the SEC were to appeal, it would likely represent their biggest litigation blunder since they decided to prosecute Ray Dirks.16 There also, the SEC overlooked how weak the factual record was and assumed that appellate courts would automatically defer to them.
On the other hand, if the case does go forward to trial, the outcome can only exacerbate the debacle. Even if the SEC were to win, a more severe penalty on Bank of America would only visit greater injury on the shareholder victims. Only if the SEC were at a higher level (and probably the highest level) to reconsider its position and amend its complaint to charge BofA corporate officers could the outcome benefit BofA shareholders. This would, however, require an often monolithic and smug bureaucracy to admit error. That would signal real and desirable change at the SEC, but don't bet on it.
Whatever the arguable legal merits of the SEC's position, it is clear that they have lost in the court of public opinion, as the press has uniformly supported Judge Rakoff (including even the Wall Street Journal, which seldom has a kind word for the judiciary). Effectively, Judge Rakoff has informed the SEC that its favorite maxim—"Sunlight is the best disinfectant; electricity, the best policeman"—applies to it as well as to others. For the short term, the critical decision for the SEC is whether to amend its complaint to name some BofA officers. If it does not and New York Attorney General Andrew Cuomo does sue them (as now appears likely), the SEC will have sustained another self-inflicted wound.
For the longer term, the issue is how to change the SEC's culture. Bank of America is another failure of the SEC's reliance on illusory settlements. Just as the SEC entered into a weak settlement with Bernard Madoff in 2006 that required him only to register as an investment adviser (and ignored the irregularities and inconsistent statements that the SEC's investigation had revealed), so too is the Bank of America evidence of continuing organizational dysfunction.
Too often, the goal of the SEC has been to achieve a settlement with a defendant that affirms its authority, but makes no sense. This may be the product of logistical constraints and caseload pressure, and a partial answer may be to allocate more resources to the SEC. But the SEC has to be prepared to litigate (and not reflexively settle). Ultimately, this dilemma may require that the SEC bring fewer cases in order to be able to litigate more intensively those that it does bring.
One last prescription also seems necessary. The SEC's inspector general has conducted a number of recent investigations into what failed at the SEC. But he has not yet examined the litigation decision-making process at the agency. Judge Rakoff's inquiry has ended, but key questions remain. The SEC's inspector general should pick up where Judge Rakoff left off.
John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.
Endnotes:
1. See SEC v. Bank of America Corporation, 09 Civ. 6829 (JSR).
2. Id. at p. 12. Memorandum Order, dated Sept. 14, 2009.
3. Id.
4. See Memorandum of Plaintiff Securities and Exchange Commission in Support of Entry of the Proposed Consent Judgment (Aug. 24, 2009) at 20.
5. Id.
6. See Beck v. Debrowski, 559 F.3d 680, 682 (7th Cir. 2009) (liability for a material omission in a proxy statement can be imposed, even if issuer "believed in perfect good faith that there was nothing misleading in the proxy materials); Wilson v. Great Am. Ind. Inc., 855 F.2d 987, 995 (2d Cir. 1988). In the Second Circuit, this rule goes back at least to Gerstle v. Gamble-Skogmo Inc., 478 F.2d 1281, 1300-01 (2nd Cir. 1973).
7. See Statement of the Securities and Exchange Commission Concerning Financial Penalties at 1 (Jan. 4, 2006) (available at www.sec.gov/news/press/2006-4.htm).
8. Id. at 2.
9. Id.
10. See Memorandum of Plaintiff Securities and Exchange Commission, supra note 2, at 25.
11. Id.
12. See SEC v. Continental Tobacco Co., 463 F.2d 137 (5th Cir. 1972).
13. See Reply Memorandum of Plaintiff Securities Exchange Commission in Support of Entry of the Proposed Consent Judgment (Sept. 9, 2009) at 13.
14. Id. at 14 (citing United States v. Microsoft Corp., 56 F.3d 1448, 1459 (D.C. Cir. 1995).
15. Id.
16. See Dirks v. SEC, 463 U.S. 646 (1983).
