No contest a no go?

No-contest deals have long been a feature of the U.S. market, but they have garnered heavy criticism in a recent decision from U.S. federal court judge Jed Rakoff of the U.S. Southern District of New York. In late November, Rakoff  rejected a proposed settlement between the U.S. Securities and Exchange Commission and Citigroup Global Markets Inc. that would have seen Citigroup pay a $285-million penalty to settle allegations that it misled investors when it sold a collateralized debt obligation (which failed soon thereafter) and shorted the CDO’s underlying assets without disclosing its position.

However, Rakoff refused to endorse the settlement, on the grounds that it’s impossible to tell whether a proposed settlement is fair in cases in which there are no admissions about the facts of the case. Rakoff’s decision stated that although it’s fine for private disputes to be settled without agreeing on the facts, when a public agency is involved, “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.”

Rakoff’s ruling throws into question the SEC’s long-standing use of no-contest settlements to expedite enforcement; and it comes at the ideal time to stoke debate about whether the idea makes sense for Canada. The essential issue is whether the trade-off of factual admissions in exchange for faster resolution is a good one.

As the situation stands, efforts to settle enforcement cases in Canada can be dragged out by defendants who are reluctant to admit to things that could later come back to bite them in other cases, such as a civil suit by aggrieved investors. No-contest settlements would allow both sides in the regulatory proceeding to wrap up their case more quickly, but that would come at a cost to investors looking to leverage a regulatory admission in a subsequent civil case.

To investor advocates, that price is simply too high. Markham, Ont.-based Small Investor Protection Association Inc.’s submission on the OSC’s proposals argues against the introduction of no-contest settlements, due to worries they will hamper investors’ access to restitution, which is already severely limited: “It may well be that this practice will lead to faster settlements, but the question we ask is: So what? If the settlement accomplishes little to nothing for retail investors, we fail to see how it improves investor protection.”

Another strident opponent of no-contest settlements is London, Ont.-based Siskinds LLP, a law firm that does a lot of class-action work. The firm also argues strenuously against the introduction of no-contest settlements in its submission to the OSC, saying: “No-contest settlements are bad public policy and reflect a troubling inclination to favour the interests of issuers and their directors and officers over those of investors.”

Siskinds’ submission argues that no-contest settlements allow violators of securities laws to avoid accountability for their actions, allow regulators to avoid helping wronged investors secure compensation for their losses and undermine the process of regulators to ensure settlements between defendants and enforcement staff are in the public interest.

This last point echoes much of the reasoning in Rakoff’s recent decision — and Siskinds’ submission quotes liberally from that opinion, noting that if OSC commissioners are asked to approve no-contest settlements: “No one would know whether the sanction is too harsh or too lenient — whether it is a sweetheart deal for a wrongdoer who may have some unknown influence over the process or whether the sanction is disproportionately harsh to a wrongdoer who may be unrepresented or whose counsel is not adequately representing his interests.”

The commissioners couldn’t make these judgments “in a vacuum without any admissions by the wrongdoer of the misconduct,” Siskinds’ submission continues. “In short, with no-contest settlements, the wrongdoers are not held to account and the process is entirely lacking in transparency. Such a process is contrary to the public policy underlying the [Securities Act] — namely, investor protection and capital markets integrity.”

On the other hand, a collection of top lawyers who often act for defendants in regulatory proceedings are speaking in favour of the proposal. A joint submission from 13 lawyers from a variety of Bay Street firms — including Joe Groia, Jim Douglas, Wendy Berman, Nigel Campbell, Jeff Leon and Joel Wiesenfeld — maintains that not only should the OSC introduce no-contest settlements, the self-regulatory organizations should as well. They argue that no-contest deals may be a good way for SROs to deal with violations such as supervisory failures by dealers in cases of misconduct by advi-sors and inadvertent operational failures at dealers.

The defence lawyers also claim that fears that no-contest settlements would become the primary way cases are resolved are unfounded. This hasn’t happened with other enforcement innovations, such as executive director settlements, they point out, contending there’s no risk that all cases would end up this way: “No-contest settlements would be appropriate for some cases and not others.”

In particular, the lawyers’ joint submission suggests no-contest deals would not be used in cases of serious securities fraud, as the OSC’s priority is to take those sorts of cases to quasi-criminal proceedings rather than OSC hearings. This means that the types of cases that have raised Rakoff’s ire in the U.S. would be unlikely to be resolved in no-contest settlements in Canada.

Yet, at the same time, the joint submission also argues that the availability of no-contest deals should not be restricted. The OSC is proposing that these deals be available only as part of its “credit for co-operation” program. (The OSC is also looking to bolster other parts of its co-operation program as part of its proposed enforcement initiatives.) However, the lawyers’ joint submission argues the no-contest option should not be limited to these kinds of cases, as there are other situations in which it may make sense.

Moreover, the submission continues, the criticism of no-contest settlements on the grounds that it’s impossible to judge their fairness without admissions of fact would not be as problematic in Canada — OSC rules include a provision that would allow commissioners considering the approval of a settlement to gain access to information about the settlement negotiations. This would give them a factual basis on which to decide whether to approve the deal, beyond what’s made public in the settlement itself.

Yet, according to the plaintiffs’ counsel’s submission, this is exactly the sort of secrecy the OSC should be avoiding: “The OSC’s process must be transparent. The investing public has a right to know what the settling wrongdoer has done. There can be no accountability without transparency.”

Indeed, this submission argues, the fact that defence lawyers support the use of no-contest settlements is itself a compelling sign that allowing these deals is not likely to improve investor protection: “We do not believe that it can be reasonably argued that the proposed introduction of no-contest settlements will strengthen regulatory enforcement. Perhaps the strongest evidence of this is the fact that the [defendants’] bar has been urging the OSC to adopt no-contest settlements for more than 10 years.”

In addition, the plaintiff counsel’s submission says, the defence lawyers’  submission “[reinforces] our position that this initiative is not good for investors and only good for those who have breached Ontario securities laws.”

Rakoff’s decision suggests that no-contest settlements can work both for and against those accused of violating securities laws. In the Citigroup case, for example, his decision notes that if the SEC’s original allegations are true, “this is a very good deal for Citigroup.”

But his ruling also suggests that the lack of facts in these deals leave them open to abuse by regulators extracting penalties in cases they may not have been able to prove.

That said, it seems that Rakoff’s bigger worry is firms getting off too lightly and investors being left to fend for themselves. Rakoff has rejected no-contest deals in the past, only to approve them when larger penalties are agreed upon. For example, in 2009, he refused to approve a settlement between the SEC and Bank of America Merrill Lynch, but later endorsed it when the regulator and the firm renegotiated a higher penalty.

In that case, it was the size of the penalty that  bothered Rakoff; but in his latest ruling, it’s the practice of allowing no-contest settlements at all that appears to be at issue. So, given how frequently these sorts of deals are used in the U.S., the SEC may decide to appeal this decision, which seems to rule out no-contest settlements altogether.

For now, the SEC’s head of enforcement, Robert Khuzami, has said only that the SEC is reviewing Rakoff’s decision. IE