By Dimitri Lascaris. In 2004, then Bank of Canada Governor David Dodge declared that international investors perceived Canada as the “wild west”‘ of lax securities regulation. This well-deserved reputation stemmed not only from a paucity of convictions for white collar crimes, but also from a civil litigation system that offered few meaningful remedies to aggrieved investors. In particular, it was extremely difficult for investors to pursue violators of the securities laws through class actions.
On December 31, 2005, however, Canada took a modest step toward more rigorous securities law enforcement when its most populous province, Ontario, called into force the country’s first statutory civil liability regime for misrepresentations in the secondary securities market. The regime greatly facilitated the pursuit of securities class actions, but its utility was circumscribed by an array of defendant-friendly rules, such as remarkably low liability caps: unless the plaintiff could prove fraudulent intent, which is quite a challenge in Canada, the liability of directors and officers was capped at the greater of one half of the individual’s annual compensation and $25,000, or roughly the cost of a Toyota Corolla.
Nonetheless, directors and officers of Canadian public companies were now confronted by a new reality. Since Canadian securities regulators would not settle enforcement actions unless the defendants admitted to at least some misbehaviour, regulatory settlements now had the potential to expose the settling party to significant civil liability. This is because aggrieved investors could use admissions of misconduct to establish the liability of the defendants in private litigation. In the face of this new reality, pressure began to build for Canadian securities regulators to abandon their long-standing practice of requiring admissions in settlement agreements.
Lobbyists for directors and officers of Canadian public companies pointed to the different approach of the United States Securities and Exchange Commission (SEC). The SEC’s long- standing practice had been to permit ‘no-contest’ settlements in a broad array of circumstances. In such settlements, the alleged violators of the securities laws admitted to nothing, but were also required not to deny the misconduct either.
Then came the financial crisis of 2008. As a result of that crisis, investors throughout the world learned with painful clarity the degree to which capital markets regulation had failed them. Nowhere was that failure more spectacular than in the United States, where the almost heroic efforts of Harry Markopoulos to expose the vast fraud of former NASDAQ Chairman Bernie Madoff were ignored by SEC enforcement staff who were either too compromised to be concerned, or too inept to understand that there was something to be concerned about. Enter United States District Judge Jed S. Rakoff, a former prosecutor with the U.S. attorney’s office in New York. In one of the most notorious enforcement actions to emerge from the
financial crisis of 2008, Judge Rakoff left no doubt as to his distaste for no-contest settlements. The case was against Bank of America, and arose from the Bank’s acquisition of Merrill Lynch at the height of the crisis. The SEC alleged that, in seeking to sell the deal to its shareholders, Bank of America management had lied to its shareholders about Merrill’s plan to pay $5.8 billion in bonuses despite losing $28 billion in 2008. The settlement rejected by Judge Rakoff imposed a mere $33 million penalty on the Bank (as opposed to the executives who had lied to the Bank’s shareholders), and contained no admissions of wrongdoing. Judge Rakoff’s decision in Bank of America stimulated a vigorous although short-lived debate as to the wisdom of no- contest settlements.
In October 2011, by which time that debate had largely subsided, the Ontario Securities Commission announced that it was pursuing a package of new enforcement initiatives “…aimed at resolving enforcement matters more quickly and effectively.” Arguably the most important of these new initiatives was the abandonment of the OSC’s long-standing policy to require admissions in settlement agreements. Before rendering a final decision on whether to adopt the new initiatives, the OSC afforded members of the public until December 20, 2011 to comment.
Fortunately for the investing public, the OSC’s timing could not have been worse. Shortly following the OSC’s announcement, the SEC sought Court approval of another major enforcement action that emerged from the financial crisis. This time the target was Citigroup, and the judge assigned to evaluate the settlement was none other than Judge Rakoff.
According to the SEC’s complaint, after Citigroup realized in 2007 that the market for mortgage backed securities was beginning to weaken, it created a billion-dollar fund that allowed it to dump dodgy assets on misinformed investors. This was accomplished by Citigroup’s misrepresenting that the fund’s assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negative projected assets, and had then taken a short position in those very assets it had helped select. In this “shitty deal” (to borrow the words of a now infamous executive of Goldman Sachs), Citigroup reaped profits of $160 million, while investors in the fund lost $700 million.
The SEC’s settlement required Citigroup – not the executives who lied – to pay penalties amounting to $285 million, well under half of the investors’ losses. In addition, the settlement did not oblige the SEC to return any of that money to the victims of the fraud, and extracted no admissions from Citigroup in relation to its egregious misconduct.
In rejecting the settlement, Judge Rakoff stated:
“…in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”
Following the release of Judge Rakoff’s decision, the SEC’s Director of Enforcement, Robert
Khuzami, leapt to the SEC’s defence. This, of course, is the same Robert Khuzami who was recently the general counsel of Deutsche Bank, one of the banking industry’s most enthusiastic participants in the activities that led to the financial crisis of 2008. Mr. Khuzami stated:
“The court’s criticism that the settlement does not require an ‘admission’ to wrongful conduct disregards the fact that obtaining disgorgement, monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission when that relief is obtained promptly and without the risks, delay, and resources required at trial.”
This rationalization, which now largely forms the basis of the OSC’s untimely move toward no- contest settlements, begs the central question: what are the goals of enforcement?
Broadly speaking, securities regulators exist for the protection of the investing public, and the two overarching goals of enforcement should be to facilitate compensation to injured investors, and to deter future violations of the securities laws.
In the Canadian regulatory regime, deterrence is, as suggested by David Dodge in 2004, notoriously weak. White collar criminals rarely go to jail in Canada, and the penalties they are made to pay are rarely large enough to constitute a significant disincentive to commit fraud. There is no reason to believe that the adoption of no-contest settlements will enhance deterrence. If anything, by allowing violators to resolve enforcement actions without any admission of wrongdoing, deterrence is likely to be weakened even further.
That leaves us with compensation. Regulators can facilitate compensation essentially by two means. First, regulators can return the penalties paid by offenders to the injured investors. This, however, has never been the practice of Canadian securities regulators, and there is no reason to believe that their practice will change any time soon. The second means by which regulators can facilitate compensation is by compelling violators of the securities laws to admit to misconduct. These admissions can then be employed by private litigants to extract compensation from the violators in civil litigation. The move toward no-contest settlements, however, threatens to deprive investors of this valuable tool for obtaining compensation from securities law violators.
What then will remain if the Ontario Securities Commission institutes a policy of entering into no-contest settlements. One can hardly argue with the claim that settlements will be achieved more expeditiously, but so what? Expeditious settlements matter only if they advance the goals of enforcement, but letting violators off the hook with no admissions will do nothing of the sort. Regulators can always get a faster deal by settling for peanuts, but what then is the point of the deal?
At the end of the day, no-contest settlements are merely a shorter route to nowhere. They are certainly no solution to the massive regulatory failures that contributed to the financial crisis, and they will make a repeat of that crisis – or rather its prolongation – significantly more likely.
Dimitri Lascaris is a a lawyer called to practice in the State of New York and the Province of Ontario, Canada. He currently represents investors in numerous securities class actions against public companies in Canada and the United States, and specializes in cases of financial fraud. Before becoming a plaintiffs’ class actions lawyer, Dimitri was a securities lawyer in the New York and Paris, France offices of a major Wall Street law firm.
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