Federal Judge Has Problems with SEC and Big Bank Sweetheart Deal

Rakoff Grills SEC on Why He Should Accept Citigroup Deal
The New York Law Journal by Mark Hamblett  -  November 10, 2011


Southern District Judge Jed S. Rakoff continued to hound the Securities and Exchange Commission yesterday on why he should accept a $285 million settlement in which Citigroup admits no wrongdoing in connection with the marketing of collateralized debt obligations it was also selling short.  For the bulk of an hour-long hearing, Judge Rakoff pressed Matthew T. Martens, the SEC's chief litigation counsel, on the agency's policy of entering into consent judgments with no admission by the defendant, and whether or not the judge had the power to reject the settlement as against the public interest.  "So what you are saying is, that, if I found that a settlement, giving due deference to the SEC, fair, reasonable and adequate, was not in the public interest or was [against the public's interest,] that I would be compelled to approve it?" Judge Rakoff asked.  Mr. Martens' answer was that, as he read the case law, the court's job is to determine whether the judgment is "fair, reasonable and adequate" and "of course, in every case we [the SEC] are looking out for the public interest."  When Judge Rakoff asked Mr. Martens if the court accurately summed up the SEC's position, the attorney acknowledged it had.

"So I'm supposed to exercise my power but not my judgment," Judge Rakoff said.  The lawsuit, U.S. Securities and Exchange Commission v. Citigroup Global Markets, 11 Civ. 7387, charged that Citigroup structured and marketed securities "with collateral consisting largely of subprime residential mortgage-backed securities" in early 2007 when the U.S. housing market and securities linked to that market were already showing signs of distress.  The SEC claimed Citigroup distributed misleading marketing materials, representing it was "acting in the traditional role of an arranging bank, when in fact Citigroup had exercised significant influence over the selection of the assets and had retained a $500 million proprietary short position," or what the commission said was "an undisclosed economic interest adverse" to investors.  The suit was filed simultaneously with the consent judgment on Oct. 19, a practice Judge Rakoff has criticized in the past and yesterday characterized as, "Judge we got a deal, don't muck it up."

In questioning Mr. Martens and Citigroup lawyer Brad S. Karp of Paul, Weiss, Rifkind, Wharton & Garrison, the judge expressed his disapproval that some $700 million in losses were suffered by investors, but the SEC was getting only $285 million: disgorgement of $160 million, $30 million in prejudgment interest and a civil penalty of $95 million.  The judge has said his problem with approving a judgment without an admission of wrongdoing—something Citigroup and similar defendants insist on so they do not face collateral estoppel in private securities actions based on the same conduct—is that it does not get to the truth of the matter.  Mr. Martens said the SEC now accepts settlements with the proviso that the defendants state they neither admit nor deny the allegations because defendants in the past were settling cases and then crowing about their innocence, insisting that the settlement price was merely the cost of litigation.  But the judge wanted Mr. Martens to explain how the public was supposed to know what happened without a trial or at least some kind of admission.  "Doesn't the SEC have an interest in establishing what the truth is?" he asked.  Mr. Martens said the detailed allegations in the complaint ensure that the public "is not left ignorant of the facts," and Citigroup has "agreed to pay a substantial amount of money."  "Let's ask Mr. Karp," Judge Rakoff said.  "We are not admitting the allegations," Mr. Karp answered. He then paused a beat and said, "If it's any comfort, we don't deny them."  The judge appeared convinced that, whatever disagreement he and Mr. Martens may have on the appropriate standard for a judge to apply on monetary terms, case law holds that the "public interest" is an important factor where a party is seeking the "extraordinary" remedy of injunctive relief.  The SEC typically seeks to have an injunction be part of consent judgments to maintain some leverage and control over the defendant concerning ongoing misconduct.  But Judge Rakoff demanded that Mr. Martens site an instance when the SEC has actually gone back to court to enforce an injunction earned in a settlement with a large financial institution. He said he suspected the answer was "zero."  "What you're telling me now is 'We had to have the court exercise its power, the contempt power…but it's just for show, because we don't ever intend to use it.'"  Mr. Martens said that did not mean the injunction did not have value or that the SEC would not move before the judge in a summary proceeding on a violation of the injunction in the future. At least over the last 10 years, he said, the SEC for a variety of reasons has determined that the best course was to bring a new action.  He said an injunction has the benefit of putting the public and investors on notice.  "Perhaps, more importantly, it puts management on notice," he said, and tells management "they need to devote compliance resources."  Mr. Karp did not have to answer too many questions during the hearing, but he told the court that Citgroup had lost more than $30 billion on collateralized debt obligations and it was "net long at all times on CDO exposure."  Mr. Karp also had to reassure the court that Citigroup has already revamped its compliance procedures in the wake of the market meltdown and financial crisis, and it promises to continue to do so in the consent judgment.  He said the new policies and procedures "centralize the flow of information and impose strict accountability" on anyone "who touches a disclosure" on a mortgage-related investment.  "I'm glad to see Citi has had such a remarkable change," Judge Rakoff said. "And I'm sure the economy might have benefited from having that come sooner."  The judge reserved decision on the matter.  Mark Hamblett can be contacted at mhamblett@alm.com.