Judge Rakoff Becomes Worst Nightmare for CITI and SEC

In a precedent setting decision, Judge Jed S. Rakoff of New York refused to approve a $285 million agreement between Citigroup (Bank of America) and the U.S. Securities and Exchange commission (SEC) to settle charges that Citigroup misled investors with regard to collateralized debt obligations (CDOs) tied to the housing market. In fact, the SEC accused Citigroup of selling mortgage backed bonds (CDOs) that the firm was betting against. The result made Citigroup $160 million in profits while investors lost over $700 million. In the proposed agreement, Citigroup would not admit or deny any wrongdoings which, is typical in the resolution of these disputes, and pay $285 million in penalties and fees.

Of particular importance to the judge was the failure of Citigroup to admit or deny any wrongdoings. In his opinion Judge Rakoff stated: "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." By failing to give the agreement another rubber stamp approval, the judge is effectively letting the SEC know that it is not going far enough in holding financial institutions accountable for their wrongdoings. Under the extreme circumstances of the case, Judge Rakoff has said that "the court and the public need some knowledge of what the underlying facts are, for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is prevented from ever knowing the truth in a matter of obvious importance." In a lengthy scathing opinion, the judge said that it is impossible to determine whether a settlement is fair, reasonable or adequate in the absence of any proven or omitted facts.

Actually, this is not the first time that Judge Rakoff has refused to approve an SEC settlement. He is known for questioning the fairness of SEC settlements. In 2009, he was assigned to approve a $33 million settlement between the SEC and Bank of America related certain disclosure violations in the $29.1 billion takeover of Merrill Lynch & Company. Rakoff rejected the offer as being unfair and later approved a settlement for five times the original settlement, or $150 million, for the same violations after the parties went back to the table to negotiate a new deal. The ultimate question for Rakoff was whether the settlement was "fair, reasonable, adequate and in the public interest." His questioning an SEC settlement and requiring Bank of America and the SEC to justify its fairness was virtually unheard of in the legal community where such agreements were automatically rubber stamped.

Back in 2010, Judge Rakoff approved a $550 million settlement between the SEC and Goldman Sachs which involved the failure to disclose a hedge fund's involvement in helping to choose the underlying investments and betting on the investment to fail. Judge Rakoff in discussing the similarities of the two cases said that they were "similar but arguably less egregious", when asked to compare the Goldman case to the pending Citigroup case.

Settlements between financial firms and the SEC are often seen as just another cost of doing business. Firms get caught doing something they shouldn't be doing and they know they can sit down with the SEC and work out a monetary settlement, without having to admit anything. It's simply a matter of buying their way out of a jam by paying a fine and 99% of the time the judiciary rubber stamps the agreement because that is the way the system works.

Only time will tell in the SEC and Citigroup case. Judge Rakoff has notified the parties to be ready to go to trial in June 16, 2012. It will be interesting to see if the same magic works in this case as it did in the Bank of America and Merrill Lynch takeover, where he effectively told the parties that the settlement they submitted to the court for approval was unfair. The sides came back later after hammering out a deal which was five times higher than the original, which was approved.

Either way, the precedent setting opinion of Judge Jed Rakoff has shined a light on the cozy relationship that has long existed between the SEC and Wall Street firms. Hopefully, his resounding criticism of both the SEC and Citigroup will lead to the emergence of new regulatory era, where there will be more rigorous enforcement and less collaboration between securities cops and the perpetrators.

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