Wall Street History

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Wall Street History

12/09/2011

A Vital Ruling

The other day U.S. District Judge Jed S. Rakoff took issue with the Securities and Exchange Commission’s deal to settle civil fraud charges with Citigroup for $285 million; a deal related to Citi’s selling investors slices of a $1 billion mortgage-bond deal called Class V Funding III, without disclosing that the bank was taking the other side of the trade in betting against some $500 million of the same assets.

Judge Rakoff’s problem was with the boilerplate language used for decades to settle such Wall Street cases where the firm neither admits nor denies wrongdoing; Rakoff saying such language was “hallowed by history, but not by reason.”

Wall Street has always used the ‘out’ of the language to avoid being subject to private class actions. The SEC has in turn argued it was the easiest way to extract settlements in a more timely fashion.

But Rakoff says investors deserve the truth and certainly to neither admit nor deny wrongdoing doesn’t get to it.

So I thought we’d look at the actual ruling in the case, U.S. Securities and Exchange Commission (Plaintiff) v. Citigroup Global Markets Inc., (Defendant).

On October 19, 2011, the U.S. Securities and Exchange Commission (“the S.E.C.”) filed this lawsuit, accusing defendant Citigroup Global Markets Inc. (“Citigroup”) of a substantial securities fraud. According to the S.E.C.’s Complaint, after Citigroup realized in early 2007 that the market for mortgage-backed securities was beginning to weaken, Citigroup created a billion-dollar Fund (known as “Class V Funding III”) that allowed it to dump some dubious assets on misinformed investors. This was accomplished by Citigroup’s misrepresenting that the Fund’s assets were attractive investments rigorously selected by an independent adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negatively projected assets and had then taken a short position in those very assets it had helped select.

Complaint 1. 2, 58. Having structured the Fund as a vehicle for unloading these dubious assets on unwitting investors, Citigroup realized net profits of around $160 million, whereas the investors, as the S.E.C. later revealed, lost more than $700 million….

In a parallel Complaint filed the same day against Citigroup employee Brian Stoker…the S.E.C. alleged that Citigroup knew in advance that it would be difficult to sell the Fund if Citigroup disclosed its intention to use it as a vehicle to unload its hand-picked set of negatively projected assets. Specifically, paragraph 25 of the Stoker Complaint alleges that:

“Citigroup knew it would be difficult to place the liabilities of (the Fund) if it disclosed to investors its intention to use the vehicle to short a hand-picked set of (poorly rated assets)… By contrast, Citigroup knew that representing to investors that an experienced third-party investment adviser had selected the portfolio would facilitate the placement of the (Fund’s) liabilities.”

Although this would appear to be tantamount to an allegation of knowing and fraudulent intent (“scienter,” in the lingo of securities law), the S.E.C., for reasons of its own, chose to charge Citigroup only with negligence, in violation of Sections 17 (a) (2) and (3) of the Securities Act….

Here, the S.E.C.’s long-standing policy – hallowed by history, but not by reason – of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact. There is little real doubt that Citigroup contests the factual allegations of the Complaint. In colloquy with the Court, counsel for Citigroup expressly reconfirmed that his client was not admitting the allegations of the Complaint. He also noted, correctly, that he was free – notwithstanding the S.E.C.’s gag order precluding Citigroup from contesting the S.E.C.’s allegations in the media – to fully contest the facts in any parallel litigation; and he strongly hinted that Citigroup would do just that.

The S.E.C., by contrast, took the position that, because Citigroup did not expressly deny the allegations, the Court, and the public, somehow knew the truth of the allegations. This is wrong as a matter of law and unpersuasive as a matter of fact. As a matter of law, an allegation that is neither admitted nor denied is simply that, an allegation. It has no evidentiary value and no collateral estoppel effect….

As for common experience, a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies. This, indeed, is Citigroup’s position in this very case.

Of course, the policy of accepting settlements without any admissions serves various narrow interests of the parties. In this case, for example, Citigroup was able, without admitting anything, to negotiate a settlement that (a) charges it only with negligence, (b) results in a very modest penalty, (c) imposes the kind of injunctive relief that Citigroup (a recidivist) knew that the S.E.C. had not sought to enforce against any financial institution for at least the last 10 years and (d) imposes relatively inexpensive prophylactic measures for the next three years. In exchange, Citigroup not only settles what it states was a broad-ranging four-year investigation by the S.E.C. of Citigroup’s mortgage-backed securities offerings, but also avoids any investors’ relying in any respect on the S.E.C. Consent Judgment in seeking return of their losses. If the allegations of the Complaint are true, this is a very good deal for Citigroup; and, even if they are untrue, it is a mild and modest cost of doing business.

It is harder to discern from the limited information before the Court what the S.E.C. is getting from this settlement other than a quick headline. By the S.E.C.’s own account, Citigroup is a recidivist, and yet, in terms of deterrence, the $95 million civil penalty that the Consent Judgment proposes is pocket change to any entity as large as Citigroup. While the S.E.C. claims that it is devoted, not just to the protection of investors but also to helping them recover their losses, the proposed Consent Judgment, in the form submitted to the Court, does not commit the S.E.C. to returning any of the total of $285 million obtained from Citigroup to the defrauded investors but only suggests that the S.E.C. “may” do so. In any event, this still leaves the defrauded investors substantially short-changed….In actuality, the combination of charging Citigroup only with negligence and then permitting Citigroup to settle without either admitting or denying the allegations deals a double blow to any assistance the defrauded investors might seek to derive from the S.E.C. litigation in attempting to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence, but also cannot derive any collateral estoppel assistance from Citigroup’s non-admission/non-denial of the S.E.C.’s allegations. Nor, as noted, does the public, especially the business public, have any reason to credit those allegations, which remain entirely unproven.

The point, however, is not that certain narrow interests of the parties might not be served by the Consent Judgment, but rather that the parties’ successful resolution of their competing interests cannot be automatically equated with the public interest, especially in the absence of a factual base on which to assess whether the resolution was fair, adequate, and reasonable. Even after giving fullest deference to the S.E.C.’s views – which have more than once persuaded this Court to approve an S.E.C. Consent Judgment it found dubious on the merits, the Court is forced to conclude that a proposed Consent Judgment that asks the Court to impose substantial injunctive relief, enforced by the Court’s own contempt power, on the basis of allegations unsupported by any proven or acknowledged facts whatsoever, is neither reasonable, nor fair, nor adequate, nor in the public interest.

It is not reasonable, because how can it ever be reasonable to impose substantial relief on the basis of mere allegations? It is not fair, because, despite Citigroup’s nominal consent, the potential for abuse in imposing penalties on the basis of facts that are neither proven nor acknowledged is patent. It is not adequate, because, in the absence of any facts, the Court lacks a framework for determining adequacy. And, most obviously, the proposed Consent Judgment does not serve the public interest, because it asks the Court to employ its power and assert its authority when it does not know the facts.

An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous. The injunctive power of the judiciary is not a free-roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated. If its deployment does not rest on facts – cold, hard, solid facts, established either by admissions or by trials – it serves no lawful or moral purpose and is simply an engine of oppression.

Finally, 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.

Accordingly, the Court refuses to approve the proposed Consent Judgment. 

“Federal Judge Jed Rakoff’s rejection Monday of a $285 million settlement between Citigroup and the Securities and Exchange Commission is playing in some circles as a great populist victory against Wall Street. But it looks to us more like a rebuke of the cozy relationship between regulators and the regulated that too often leaves justice as an orphan….

“Rather than fight in court, the two sides settled on the fine and a promise that Citi would reform its practices, without admitting or denying guilt.   The SEC pockets the cash and a political trophy to appease those who want more bankers punished. Citigroup avoids what it called in its filing to Judge Rakoff the ‘devastating consequences’ of ‘litigating with a regulator’ in today’s marketplace. Citigroup notes, for instance, that Goldman Sachs’ stock price dropped 24% before it settled a similar SEC case in 2010…

“Citigroup says it will contest this suit if Judge Rakoff’s judgment holds on appeal, and we hope it does. A trial might explain how in the world Citigroup could have misled sophisticated outlets like Bear Stearns, insurer Ambac and others who were on the other side of its trades.

“More broadly, we might learn whether these cases have legal merit or are merely easy attempts to extort a deep-pocketed target. The SEC knows companies want to avoid reputational and legal costs, not to mention the risk of a trial lawyer pile-on. But how many cases would the SEC bring if it knew it had to prevail in court?

“A defeat might even cause the SEC to bring fewer of these grandstanding cases against the corporate villain of the moment – for now, it’s Wall Street – and focus more on real financial criminals like Bernie Madoff.”

Well, I don’t necessarily agree with this very last judgment of the Wall Street Journal editorial board, but my bottom line is Judge Jed Rakoff is a true American hero for this vitally important ruling. In my 12/3/11 “Week in Review,” I note that Transparency International ranks the United States No. 24 in the world in terms of clean government. The Journal correctly notes Rakoff rebukes “the cozy relationship between regulators and the regulated that too often leaves justice as an orphan.”

Does the United States want to be No. 1? It should start by making Judge Rakoff’s ruling required reading in our universities as we breed the business and government leaders of tomorrow.

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