There will be plenty of questions left after today’s hearing on a $285 million fraud settlement Citigroup Inc. reached last month with the Securities and Exchange Commission.
But there should be only one answer from Jed S. Rakoff, the federal judge in New York assigned to weigh the merits of the agreement: You’ve got to be kidding.
The case involves the creation and sale of one of the more toxic versions of an investment whose structure almost defies explanation -- a $1 billion synthetic collateralized debt obligation that was based on other collateralized securities that were in turn tied to subprime residential mortgages. The CDO was put together by Citigroup’s broker-dealer unit in early 2007, just as the housing market started to slump. It wasn’t meant to make money for the buyers; it was designed to blow up, the SEC says. Before the year was out, the CDO was in default. Investors eventually lost almost everything.
For Citigroup, the CDO worked out well. The SEC lawsuit says the bank bet against the CDO and made a $160 million profit. The nonprofit organization Better Markets, which has asked Rakoff to oppose the settlement, estimates Citigroup’s profit at $600 million to $700 million. As in most SEC deals with companies in securities-fraud litigation, Citigroup will be allowed to say it neither admits nor denies wrongdoing. The agency takes this conciliatory route on the assumption that it will generally be outlitigated and outlasted by Wall Street firms.
The settlement wouldn’t be so troubling if Citigroup hadn’t done this many times before. As Bloomberg View columnist Jonathan Weil pointed out last week, five times since 2003 the SEC has accused Citigroup’s broker-dealer arm of securities fraud. Each time, Citigroup settled the SEC’s accusation without admitting or denying wrongdoing, paid fines and promised not to break the law again. There were no consequences for subsequent violations. At a minimum, the SEC should lay out a schedule of additional fines for these kinds of repeat offenses.
Rakoff has a record of skepticism toward the SEC’s sweetheart deals. The most memorable was his rejection in 2009 of Bank of America Corp.’s plan to pay $33 million to settle an SEC lawsuit. The agency had accused the bank of misleading investors about its purchase of Merrill Lynch & Co. In the end, Bank of America paid $150 million.
Based on Rakoff’s questions about the Citigroup settlement filed last month with the court, he seems to have doubts about its merits. One point he will consider is whether this deal serves the public interest by promoting fairness and transparency in financial markets. Initially, the SEC said the proposed agreement met the public-interest standard. In a court filing this week, the agency seemed to say that question was for the SEC to decide rather than the court.
Some of the investors in the CDO disagree. Union Central Life Insurance Co. says it opposes the settlement because many of the facts the SEC excavated in its investigation will be “swept under the rug without public scrutiny.”
The size of the SEC’s fine -- $160 million in disgorged profits, $95 million in penalties and $30 million in interest -- verges on anemic. Goldman Sachs Group Inc. paid a $535 million fine for a similarly constructed CDO. The distinction, the SEC says, is that Goldman acted with scienter, which in such cases means knowingly engaging in securities fraud. The SEC says Citigroup was simply negligent. If so, that doesn’t seem to square with the case laid out in the lawsuit.
The SEC is a long way from reclaiming its role as a sensible industry watchdog. Renegotiating the Citigroup settlement would set it on course to redeem its enforcement bona fides. Barring that, Rakoff should tell Citigroup and the SEC to come back to him with an agreement that better reflects the severity of Citigroup’s actions.
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