In an eloquent opinion that reaffirmed the truth-finding mission of the courts, Judge Jed S. Rakoff rejected the $285 million settlement agreement Citigroup reached with Securities and Exchange Commission, or SEC, to resolve charges that the giant bank had gamed the mortgage bond market.
The judge told the parties to prepare for trial on July 16, 2012.
The SEC alleged that Citigroup led investors to believe that the investments in a $1 billion mortgage-bond deal were independently selected, when in fact they were assets with negative projections chosen by Citigroup.
Citigroup allegedly took a short position in these assets that netted the bank $160 million in profits, while investors lost $700 million, according to the Nov. 28 opinion.
Simultaneous with its filing of the complaint in October, the SEC and Citigroup filed their consent judgment to settle the matter.
In a public statement issued in response to Rakoff’s opinion, the SEC said the consent judgment would have been a good outcome, considering the risks and expense of trial. The SEC also said it was “fair, adequate, reasonable, in the public interest, and reasonably reflects the scope of relief that would be obtained after a successful trial.”
Rakoff, who sits on the U.S. District Court for the Southern District of New York, said in his opinion that the consent judgment was “neither fair, nor reasonable, nor adequate, nor in the public interest.” Most fundamentally, this is because it does not provide the Court with a sufficient evidentiary basis to know whether the requested relief is justified under any of these standards.
The decision was not a surprise, given some comments from Rakoff in October. While several aspects troubled Rakoff, his main issue was that the consent judgment allowed the case to be resolved without Citigroup either admitting or denying the charges.
While this is a fairly common occurrence in regulatory matters, Rakoff said it means there would be no actual factual finding, only allegations, left floating out there.
Private parties often settle cases without agreeing on the facts, because the plaintiff can just dismiss the complaint, the opinion said.
This consent judgment, on the other hand, enjoins Citigroup from violating certain securities laws again, and imposes internal changes in procedure supposed to prevent this kind of thing from happening. The court necessarily has an enforcement role in such an agreement, not the least of which is “the formidable judicial power of contempt,” the opinion said.
Court and the Public it Serves Need the Facts
That being the case, Rakoff said, the court and the public it serves need the facts to be established.
“[O]therwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance,” the opinion said.
Rakoff noted another enforcement issue implicated by this kind of settlement: private actions by wronged investors.
When an allegation is neither admitted nor denied it has no evidentiary value and no collateral estoppel effect as a matter of law, and can’t be used as evidence in subsequent litigation, the opinion said.
According to Rakoff, the deal would have been pretty sweet for Citigroup. The bank was only charged with negligence, despite the fact that another suit against an individual arising from the same set of bond sales charged that person with knowingly engaging in the conduct, which brings it up to the level of fraud.
In addition, the penalty is modest compared to the investor losses, and the settlement sought to impose “injunctive relief that Citigroup (a recidivist) knew that the SEC had not sought to enforce against any financial institution for at least the last 10 years,” the opinion said.
The internal procedural changes would have been relatively inexpensive, and an intense four-year investigation into Citigroup’s mortgage-backed securities offerings would have gone away.
Most to the point, investors would not be able to rely in any way on the SEC action in seeking return of their losses, the opinion said. Private investors can’t bring securities claims based on negligence and Citigroup can deny the wrongdoing.
The judge also said, whether the allegations are true or not, Citigroup probably views the settlement as just a modest cost of doing business. He called the $95 million civil penalty “pocket change” to an entity as large as Citigroup. The rest of the rejected settlement consisted of disgorgement of profits and interest.
The SEC Took Exception
The SEC delivered its written public statement on Rakoff’s ruling though Robert Khuzami, director of the Division of Enforcement.
Khuzami said focusing on the lack of an admission overlooks that fact that the other elements — disgorgement, a civil penalty penalties and mandatory business reforms — may outweigh the importance of an admission if the risks, delay, and expense of trial are taken into account.
In addition, this type of consent judgment has been an established practice in federal agencies and federal courts for decades, Khuzami said, adding that to refuse an “advantageous settlement” solely because of the lack of an admission just diverts resources away from other investigations.
The SEC also took exception to Rakoff’s contention that the settlement meant the whole $700-million mess was left as a set of mere allegations. Khuzami said the consent judgment contained the “reasoned conclusions of the federal agency responsible for the enforcement of the securities laws after a thorough and careful investigation of the facts.”
Khuzami also said Rakoff overlooked the realities of securities law, which he said limits disgorgement to the amount obtained through the illegal behavior, plus a penalty up to that amount. The SEC does not currently have statutory authority to recover investor losses.
The SEC said it will continue to review the court’s ruling and take whatever steps best serve the interests of investors, which could mean an appeal to the 2ndU.S. Circuit Court of Appeals.
A trial in the case would no doubt be high legal drama. Rakoff described what is at stake as he closed his opinion: “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 SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”
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