Federal District Judge Jed S. Rakoff was supposed to a approve a $33 million settlement between the SEC and Bank of America (BAC) over the issue of the financial firm making inaccurate statements regarding Merrill Lynch employee compensation. These statements were made in the B of A proxy that was sent to shareholders to approve the Merrill buyout.

It turns out that the judge believes that the SEC let the bank off too easily, and that the seriousness of B of A’s actions warrants more than a $33 million slap on the wrist.

Rakoff made an unusually lucid comment about something that the SEC neglected to consider. “It does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the bank’s alleged misconduct now pay the penalty for that misconduct,”Rakoff wrote. Why should B of A shareholders be forced to be suffer twice when they should not suffer at all?

The SEC and Bank of America will have to return to court for a trial on February 1. The most important issue at hand will be that the judge says that Bank of America “materially lied” in its disclosures about the Merrill bonuses. Ragoff, who reviewed the bank’s willingness to pay $33 million in exchange for what appeared to be an affirmation of its innocence, wrote that if the bank is innocent of lying, it would make very little sense to pay to prove it.

This unexpected action by the judge threatens to destroy a time-honored gentlemen’s agreement between the SEC and major American public companies. The SEC catches corporations doing something that violates the securities laws. Rather than take up the commission’s time which could be better used chasing people like Bernard Madoff, the companies are allowed to settle charges by paying large fines. This usually means that the firms do not admit to anything, although their guilt is generally assumed.

The Ragoff question should be asked about every SEC settlement. Why would a firm that is entirely innocent make a payment to settle charges?

Rakoff’s decision is particularly hard on the SEC which has to explain its behavior to an already cynical public.  The SEC has arranged monetary settlements with thousands of companies as a way for these companies to avoid prosecution. This follows the humiliation of the commission due to its failure to respond to multiple complaints that should have been seen as alarms in the matter of the Madoff fraud. The SEC is now seen, in almost every aspect of its work, as a bumbling agency that takes the easy way out whenever possible.  In Madoff’s case, the SEC was in a room full of doors and could not find a single exit

Ragoff’s single opinion may end up defining both the direction and the ethos of the SEC. If so, he has done the nation’s public company shareholders an incomparable service.

This decision by the judge will have broad implications. The SEC will have to spend more of its time in court actually prosecuting companies for misdeeds. It is unlikely to have the money to do that.  Congress will have to decide whether it wants to live with a culture at the commission of shoddy investigations, easy settlements, and little tough litigation or give the SEC a much larger budget. Corporate America is going to find it is more expensive to cross the solid white line of regulation. The trend will still cost shareholders plenty. All those new legal fees spent in defense of bad behavior will come out of their pockets. That is unless the fines and penalties that are a part of future SEC’s prosecutions are so severe that America’s public companies begin to learn a new lesson. That is, it is less expensive to cheat than to conduct business honorably, in spite of the many executives who became improbably wealthy while shareholders became impossibly poor.

The shareholders who have the least to say about how their companies are run may finally reach the point where they will not have to bear the brunt of the dishonesty at the companies they own and the incompetence at the SEC, the agency that is supposed to oversee these very companies.

Douglas A. McIntyre

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