U.S. District Judge Jed S. Rakoff delivered a rare strike against one Wall Street culprit that thought itself above the law: Citigroup Global Markets Inc. The law community already worries that “if Judge Rakoff’s view prevails, it may affect the willingness of defendants to settle,” according to a recent article on the Consumer Law & Policy blog.
The crux of the matter was that Citigroup established a billion dollar fund, called “Class V Funding III,” a collateralized debt obligation comprised of suspect assets, which it unloaded on gullible investors, earning a $34 million fee and about $160 million in net profits. The Securities and Exchange Commission (SEC), in its Complaint Summary paragraph to the U.S. District Court, noted that it classified the Citigroup action as a securities fraud action.
However, Rakoff noted in his scathing Opinion and Order brief that “although this [the SEC charges] 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.”
Rejecting Sugar-Coated Deal
“The S.E.C., 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,” Rakoff said.
The Court rejected a sugar-coated deal between the SEC and Citigroup in a scathing Opinion and Order brief by Rakoff, filed at the U.S. District Court for the Southern District of New York on Nov. 28.
Rakoff noted that the SEC complaint was careful in its wording, using boilerplate language such as “without admitting or denying guilt,” language that has been around at the SEC for ages.
In a response to Rakoff’s opinion, which can be found on the SEC website, Robert Khuzami, director of the division of enforcement at the SEC, states: “Monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission [of guilt]. … The settlement provisions cited by the court have been included in settlements repeatedly approved for good reason by federal courts across the country.”
Publicity Driving Allegation
“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,” Rakoff said.
Rakoff rebuked the SEC further, accusing that the complaint was filled with innuendos and lacked any facts with which the court could decide on the merits or demerits of the complaint.
“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,” Rakoff said.
Remedy Charged Is Pittance
“The Court concludes, regretfully, that the proposed Consent Judgment is neither fair, nor reasonable, nor adequate, nor in the public interest,” Rakoff stated.
The agreement between the SEC attorneys and Citigroup called for Citigroup to pay $285 million and allows Citigroup to plead guilty without admitting guilt. The total amount is divided into $160 million, which covers profits obtained by illegal or unethical acts, $30 million in prejudgment interest, and $95 million in civil penalty.
Within a few years of receiving a federal government bailout of $476.2 billion in cash and guarantees under a number of bailout funds, Citigroup reported for the third quarter of 2011 $3.8 billion in profits on $21 billion in gross revenues in mid-October, a 73 percent increase over earnings during the same period in 2010.
The judge called the remedy “a mild and modest cost of doing business,” as the total fine amounts to a mere 7.5 percent of Citigroup’s third quarter profits.
The public has been incensed since the government bailed out institutions considered too big to fail, including Citigroup, despite these institutions being the culprits that caused that economic upheaval in the first place.
Experts point out that the judge is again driving home a lesson that needs to be learned when letting institutions off the hook with a pittance remedy and government bailouts.
The March Oversight Report by the Congressional Oversight Panel suggests that government bailouts, which could also be applied to pittance remedies, “created a moral hazard: very large financial institutions may now rationally decide to take inflated risks because they expect that, if their gamble fails, taxpayers will bear the loss. Ironically, these inflated risks may create even greater systemic risk and increase the likelihood of future crises and bailouts.”
Investors Shortchanged
“We sought to recover close to $300 million—all of which we intended to deliver to harmed investors,” Khuzami said in his rebuttal to the Court’s opinion.
The alleged fraud was perpetrated on about 15 investors who bought Class V III tranches with a face value, printed on the security, of $843 million, according to the SEC complaint before the U.S. District Court, filed in October.
Rakoff accuses that the Consent Judgment lacks any remedy for the defrauded investors and is a mere fraction of what is owed to the investors, when compared to Citigroup earnings.
In his response, Khuzami stated that the SEC’s statutory authority doesn’t allow it to recover losses for investors.
The SEC litigation absolves Citigroup because “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,” Rakoff stated.
SEC Enforcement Actions Due to the Financial Collapse
The SEC published on its website enforcement actions for hiding risks from investors, overpricing, and other fraudulent activities in the securities market that caused the financial meltdown.
As of Oct. 19, the SEC had issued penalties amounting to $1.97 billion and charged 81 firms and individuals with charges ranging from fraud to negligence.
All accused settled for a small amount without admitting guilt or reimbursing defrauded investors. Furthermore, the SEC charged the accused mostly with negligence, eliminating the possibility for private litigation.
J.P. Morgan Securities settled for $153.6 million in June. J.P. Morgan reported second quarter revenue of $7.3 billion and $2 billion in net income.
Charles Schwab was charged with making misleading statements concerning different types of securities and paid $118 million in January. The 2010 annual reports show net revenue of $4 billion and net income of $454 million.
Goldman Sachs, charged with defrauding investors, settled with the SEC in July 2010 for $550 million and an agreement to restructure its business. Goldman’s 2010 second quarter revenues amounted to $8.84 billion.
Bank of America paid $150 million to the SEC for “misleading investors about billions of dollars in bonuses being paid to Merrill Lynch executives at the time of its acquisition of the firm, and failing to disclose extraordinary losses that Merrill sustained,” according to the SEC publication.
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