Why a Federal Judge Trashed the SEC’s Settlement With Citigroup

by Marian Wang ProPublica

When the Securities and Exchange Commission struck a deal with Citigroup over a failed security that the bank sold to investors, we asked whether regulators had handed Citigroup too sweet of a deal [1].

Today in Manhattan, U.S. District Judge Jed Rakoff appeared to reach that very conclusion: “If the allegations of the Complaint are true, this is a very good deal for Citigroup,” Rakoff wrote as he refused to sign off [2] on the $285 million proposed settlement agreement.

While the full opinion is worth a read [2], here’s a summary of the judge’s objections:

The allegations brought by the SEC don’t match the charges.

The SEC, in its complaint, alleged that Citigroup knowingly misrepresented or failed to disclose to investors key information about the CDO, known as Class V Funding III. We first reported on Class V last year, in our story on CDO self-dealing [3], noting that the CDO contained risky pieces of other Citigroup CDOs.

Specifically, the SEC charged that Citi put risky assets into the deal, bet against it, and then didn’t disclose that to investors. According to SEC, “Citigroup knew it would be difficult” to sell the CDOs if it disclosed all that to investors.

Judge Rakoff concluded [4], “This would appear to be tantamount to an allegation of knowing and fraudulent intent.”

But in the end, the SEC only charged Citigroup – and one low-level exec – with negligence – a lower standard of proof than intentional fraud. Charges were also not filed against other, more senior Citi execs who, according to the SEC, also knew details of the deal.

The boilerplate language in the settlement that forbids future violations by Citigroup is essentially meaningless.

“By the S.E.C.’s own account, Citigroup is a recidivist,” wrote Rakoff, who noted that the SEC had not sought to enforce that prohibition for at least a decade.

The context here is more than adequately explained [5] by a recent New York Times article that found that Citigroup had agreed on at least four other occasions not to violate that same anti-fraud statute, only to continually break that promise.

The fine is too modest to have a deterrent effect.

According to Rakoff, the fine in this case is so mild that it’s more or less “pocket change to any entity as large as Citigroup” and starts becoming just a cost of doing business.

Rakoff loathes the longstanding tradition of reaching settlements without any admissions of wrongdoing.

Sure, it’s standard in these types of settlements, and judges have routinely signed off on such language, but Rakoff has signaled in the past that he has serious qualms about these non-admission, non-denial settlements.

For one, he says the deal with Citi shortchanges investors, who according to the SEC lost more than $700 million: With no mea culpa from Citi, private investors have a much harder time bringing their own lawsuits against the company – which for Citigroup is precisely the point.

Rakoff also argues that the tradition cheapens judicial power, which must be used in conjunction with “cold, hard, solid facts.” A non-admission of guilt but agreement to pay, while in keeping with established tradition, denies the court of established facts on which to decide whether the settlement is reasonable, he said.

The truth should come out

Finally, Rakoff argues that especially when it comes to the financial sector – and especially now – the public deserves to know the truth: “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.”

One thing Rakoff didn’t touch on? A discrepancy we raised last month [1]: Citigroup seems to believe this deal with the SEC would have settled all of its potential liability over CDOs – something the agency denied.

The SEC’s response

The SEC issued a statement today defending its settlement: “We believe that the proposed $285 million settlement was fair, adequate, reasonable, in the public interest, and reasonably reflects the scope of relief that would be obtained after a successful trial,” said Robert Khuzami, the SEC’s head of enforcement.

Khuzami pointed out that Rakoff’s objection to the lack of admission of guilt “ignores decades of established practice throughout federal agencies and decisions of the federal courts.”

That response is in line with what Khuzami has said in the past – that securing corporate confessions from companies like Citi, while ideal, would slow down the agency’s investigations.

“No one disagrees with the sort of abstract notion that you’d like to have admissions in your cases,” Khuzami said earlier this month [6]. “One has to make choices between competing demands.”

The agency has also argued that taking banks to costly trials would divert scarce resources toward their other securities fraud fighting efforts, and be counterproductive.

What’s next?

The case has been scheduled for trial next year – something Citigroup would presumably like to avoid, given the mountains of evidence in the SEC’s possession that would become public should the case indeed go to trial.

But a trial is still not a sure thing. Rakoff initially rejected a proposed SEC settlement with Bank of America, but he eventually approved the deal [7] last year after the agency came back with a bigger fine. It’s unclear if the SEC will try to do the same this time around.

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