Judge Orders SEC to Explain Why Citigroup Is Getting Off Easy for Deceiving Clients

Last Updated Oct 31, 2011 9:08 AM EDT

Federal judge Jed Rakoff has two words regarding Citigroup's (C) $285 million settlement with the SEC to resolve charges that the bank defrauded its own clients: This stinks. He is asking securities regulators to justify the deal at a hearing set for Nov. 9 and to answer a number of key questions, including:
  • Why is the SEC, which charged Citi that misled investors in selling them a pool of toxic mortgage securities shortly before the housing market crashed in 2008, allowing the company to settle the allegations without admitting (or even denying) any wrongdoing?
  • Is there any reason to think that the fine slapped on Citi will deter future financial fraud?
  • How much money did Citi clients lose in the $1 billion collateralized debt obligation transaction? The SEC said in the Oct. 19 settlement that the loss was "at least" $160 million, which suggests that the amount could be greater.
  • How did the SEC calculate the financial penalty, which came to only $95 million? (The rest of the settlement amount consisted of profits and fees Citi earned from the deal, plus interest.) That is less than one-fifth the $535 million fine the agency levied against Goldman Sachs (GS) last year in resolving a similar CDO case.
  • Why is the SEC asking Citi and its shareholders to pay most of the fine, rather than also seeking restitution from individual executives at the company?
  • Can securities fraud on such a massive scale be attributable only to negligence?
How Citi is getting off easy
That last one is a doozy because it highlights a major weakness in the settlement -- its narrow scope. The SEC limited its legal case against Citi to a single transaction, a CDO dubbed "Class V Funding III" that the financial giant assembled in 2006-07 as the roof was caving in on the housing sector. The investment defaulted in a matter of months, while the bank made $160 million in profits and fees.

But as ProPublica's Jake Bernstein and Jesse Eisinger have reported, Citi packaged at least 18 CDOs around the same time it was peddling Class V Funding III. It marketed more than $20 billion worth of these deals in 2007 alone. Most of those investments contained mortgage-backed securities whose value had already fallen and that the banking giant had struggled to sell. The CDOs also included toxic assets that select Citi clients had been allowed to pick so they -- and the bank -- could bet against the investments. That caused enormous losses for investors on the other side of the deals.

In other words, Citi appears to have left lots of bodies in the ground, but it's paying the price for only one of those hits. And even there it's getting off lightly. The SEC charged only one Citi banker under the settlement, a lower-level executive named Brian Stoker who was gracious enough to stick his head in the noose with a series of incriminating emails.

Trouble is, Stoker was a tiny cog in a big machine. So why is the SEC pulling its punches with Citi and other investment banks implicated in a CDO scheme that makes the insider-trading high-jinks practiced by oafs like Raj Rajaratnam look like a littering violation? Fear. Eisinger says:
This is a matter of will and leadership. Its chairwoman, Mary L. Schapiro, while deserving credit for pushing investigations of structured investments, is sending the signal that she does not want to lose. Her agency is meekly willing to get token settlements when the situation calls for Old Testament justice.
Someday, the SEC will have to go up against a top executive who has resources to fight, and who was too sophisticated to put anything rash in writing. This seems to be our fate: our bankers took reckless risks, but our regulators take none.
Line in the sand
Here's another problem with the SEC's risk-aversion in prosecuting banks for their CDO-related offenses. Settlements, unlike trials, set no legal precedents. They leave no bright lines that financial firms must respect and that reinforce corporate law against the kind of systematic malfeasance that led to the housing crash.

This isn't the first time Rakoff has taken a stand before against Wall Street banks. In 2009, he rejected the SEC's $33 million settlement with Bank of America (BAC) over charges that the company had failed to disclose that Merrill Lynch planned to award large financial bonuses before B of A bought the troubled investment bank following the financial crisis. The judge later approved the deal after the total penalty was raised to $150 million. But he wasn't happy about it, calling the settlement "half-baked justice at best."

In truth, though, a bold U.S. District judge is no substitute for a strong financial regulator. Rakoff can't force Schapiro to draw a hard line against such misconduct, only raise objections when remedies are weak. That stinks, too. Because clearly the best way to protect the financial system isn't to haggle over how to punish fraud -- it's to prevent fraud in the first place.

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