By: Thomas Michael
What does it mean to neither admit nor deny allegations? In one of the financial industry’s most recent magic tricks, banks have figured out how to buy “innocence” from the Securities Exchange Commission through settlement.
On Wednesday, November 9th, 2011, Southern District of New York Judge Jed S. Rakoff held an hour long hearing to address concerns with a recent settlement agreement in the case U.S. Securities Exchange Commission v. Citigroup Markets Inc. The proposed settlement amounts to 285 million dollars and requires judicial approval. Matthew Martens and Brad Karp are the attorneys for the SEC and Citigroup, respectively.
The SEC alleges that in 2007 Citigroup (“Citi”) actively misled investors in a 1 billion dollar mortgage backed securities deal called Class V Funding III. Citi marketed the collateralized debt obligations as having been packaged by a third party, when in fact Citi had significant influence over the selection of the assets being bundled. Citi also retained a 500 million dollar proprietary short position, meaning that the bank took an economic interest adverse to investors, betting that the deal would fall in value. This resulted in a $160-190 million profit for Citi and consequently cost investors over $700 million in loses.
The proposed settlement is being challenged for three main reasons. First, that it is inadequate. Second, that it provides no deterrence value for future violations. And third, that by allowing Citi to escape accountability, the deal is contrary to public interest.
Judge Rakoff questioned Martens about the rationale behind the $285 million agreement. According to the SEC, this number represents 160 million in disgorged profits, a 95 million dollar penalty, and 30 million in interest. In other words, Citi is essentially breaking even by relinquishing profits and only being held liable for a small fraction of investor losses. Judge Rakoff pointed out that this case appears to be one of intentional, rather then negligent, fraud, as Citi directly deceived investors. So shouldn’t they be held liable for all of those losses? Judge Rakoff subtly mocked the relatively miniscule penalty, saying, “I won’t be cute and ask what percentage of Citigroup’s net worth is $95 million because I do not have a microscope with me.”
The hearing also focused on recent criticism of the SEC for being too easy on Wall Street by failing to enforce regulations and take proper measures to deter recidivism. As part of the proposed settlement, the SEC is requesting the court grant an injunction preventing Citi from violating securities laws in the future. Judge Rakoff responded to this request by pointing out that the SEC had not once enforced such an injunction in the last decade. In fact, Citigroup has reached a settlement with the SEC for civil fraud accusations at least five times in the past and two of those carried similar injunctions. So what deterrence value does this settlement offer if banks are allowed to pledge not to violate laws and then proceed to repeatedly do so with no fear of additional punishment from the SEC?
Judge Rakoff’s primary contention with the settlement is that it allows Citigroup to effectively resolve the case without admitting or denying any wrongdoing. This creates a situation where truth is sacrificed in favor of convenience, which Judge Rakoff says directly conflicts with the public interest concern for justice. Permitting a settlement without assigning any guilt allows Citigroup to claim they are innocent and are only settling to avoid litigation costs or to appease aggressive regulators. The SEC, on the other hand, can also claim success by pointing to the cash settlement as an indicator of punishment for wrongdoing. With both parties claiming victory, the real casualties of this action are the shareholders, the investors, and the truth.
The arguments supporting settlement are well known and engrained in our judicial system. Avoiding costly litigation, potentially greater penalties, and unwanted publicity are all familiar justifications. The problem here is not with settlements in general, but rather with promoting a cycle of deception and leniency.
The recent protests across the United States and around the world, while controversial and often ill-advised, should at least be recognized as a manifestation of the public’s frustration with the economy and a unified cry for accountability. Allowing the banking institutions that were largely responsible for the economic meltdown to continue to maintain innocence, even when their guilt can be proved, is wrong. The Securities Exchange Commission should not be afraid of strictly enforcing liability and should not have a limited budget that prevents litigation or restricts the pursuit of justice. Citigroup’s policies and practices concerning collateralized debt obligations resulted in the bank losing more than $30 billion and requiring two federal bailouts. If these funds had instead gone to reforming the enforcement practices of the SEC and to giving new financial regulations some much needed teeth, how many of these violations might have been deterred?
It is unfortunate that investors and taxpayers have had to bear the burden of these catastrophic failures and it is wrong not to hold those responsible accountable for their actions. It is wrong to fail to take steps to prevent such violations from happening again. And it is wrong to permit a proclamation of innocence where there is none.
Judge Rakoff asked Mr. Karp whether the bank admits that its actions surrounding the 2007 CDO were wrong. “We do not admit the allegations,” Karp responded, to laughter throughout the courtroom. “But if it’s any consolation, we don’t deny them.” No Mr. Karp, it is not a consolation. Citigroup should not be shielded through estoppel from facing the legitimate claims of those harmed by its wrongdoing.
Judge Rakoff deferred a decision and will issue a written opinion soon.