The SEC has again been ordered to justify the terms of a high profile and important settlement. The query comes in its latest high profile market crisis case, SEC v. Citigroup Global Markets Inc., Case No. 11 Civ. 7387 (S.D.N.Y. Filed Oct. 19, 2011). The court directed that the parties appear on November 9, 2011 to answer questions about the proposed settlement including:

  • Why the Court should impose a judgment in a case which “alleges a serious securities fraud” but the defendant neither admits nor denies the wrong doing?
  • What was the total loss here?
  • How was the penalty calculated and why is it about one fifth of that assessed in the Goldman Sachs case?
  • How were the factors identified in the SEC’s statement on financial penalties applied here?
  • Since an injunction is part of the settlement, how does the SEC monitor compliance and how many contempt proceedings against large financial entities have been brought arising from consent decrees in the past decade?
  • Why is the penalty to be paid in large part by Citigroup and its shareholders rather than culpable offenders and if those offenders could not be identified why not?
  • What “control weaknesses” lead to the acts alleged in the complaint and how do the proposed remedial undertakings which are part of the settlement ensure they will not happen again?
  • How can a securities fraud of this nature and magnitude be the result of simple negligence?

This is not the first time of course that a Court and particularly Judge Rakoff, who is presiding over this case, has posed these or similar questions. Judge Rakoff raised similar concerns regarding the SEC’s action against Bank of America that arose from its acquisition of Merrill Lynch. After difficult hearings, an opinion which charged that the Commission’s investigation was essentially a sham and significant amendments to the terms of the proposed settlement, the Court ultimately, albeit reluctantly, deferred to the Commission and signed the settlement. Whether the Court will again require changes to the settlement or if it will ultimately defer to the Commission and execute a consent decree remains to be seen.

Once way to consider the issues raised by Judge Rakoff is to compare Citigroup to the Commission’s actions against Goldman Sachs and J.P. Morgan and Goldman Sachs. SEC v. Goldman Sachs, Case No. 322 (S.D.N.Y.); SEC v. J.P. Morgan Securities LLC, Civil Action No. 11-04206 (S.D.N.Y.). While there are differences between the three cases the key elements in each are similar:

  • Each is based on undisclosed conflicts;
  • Each centers on transactions involving a specially constructed entity built at least partially of collateralized debt obligations or CDOs tied to the housing market;
  • In each the investors who were sold notes tied to the constructed entity – ABACUS for Goldman, Squared CD) 2007-1 for J. P. Morgan and Class V Funding III for Citigroup – were lead to believe that the collateral was selected by the manager who had a good reputation in the industry;
  • None of the investors in ABACUS, Squared or Class V were told that in fact the defendant participated, and in Goldman and J.P. Morgan hedge fund clients of the bank, in that process;
  • None of the investors knew that those involved in the collateral selection other than the manager had adverse interests to theirs: Paulson hired Goldman to create an entity it could short; J.P. Morgan shifted millions in paper loses from its books into the entity and hedge fund Magnetar Capital was short; and Citigroup loaded the entity with collateral left over from other deals and then shorted that specific collateral.

The settlements are also based common elements. In each case there is an injunction prohibiting future violations. In each there is a monetary component. In Goldaman and Citigroup an employee of the firm involved in the matter was charged. In J. P. Morgan no firm employee was named as a defendant although an employee of the manager was named as a Respondent in a related administrative proceeding. No senior executive of any of the three firms was named as a defendant.

There are however significant differences in the settlements. Goldman was charged with fraud and consented to the entry of an injunction based on antifraud Section 17(a) of the Securities Act. Both Goldman and the Commission took rare steps: Goldman made an admission in the settlement papers of an error and not properly disclosing the facts. The Commission dropped its Exchange Act Section 10(b) claim as part of the deal before any discovery, motion or court ruling. Goldman did agreed to pay the largest civil penalty ever paid by an investment bank, $550 million. The firm did not pay disgorgement and retained the fees paid by Paulson for the construction of the entity. Remedial steps are also being implemented.

J.P. Morgan in contrast was only charged with negligence. The firm paid $18.6 million in disgorgement and a $133 million penalty, far less than Goldman. The firm also agreed to implement certain remedial steps.

Citigroup, like J.P. Morgan, was only charged with negligence. The firm did agree to disgorge its trading profits of $160 million but, like Goldman, not its fees. The firm will pay the lowest civil penalty in this group of cases at $95 million and agreed to implement certain remedial steps.

The significant difference in the terms of the settlements despite the similar nature of the cases is sure to spark a series of questions by Judge Rakoff at the November 9 hearing. Likewise, the disparity between Goldman’s fraud charge and admission contrasts sharply with the negligence based charges and settlements involving J.P. Morgan and Citigroup. The huge disparity in civil penalties is also sure to be a key subject of discussion.

In the end however the focal point may well be the overall approach of the SEC in these cases and others where the courts have raised questions about the settlements of the agecny. Each complaint paints a picture of a deliberate, intentional fraud which only matches the charges and settlement in Goldman. The mismatch between the Commission’s allegations in J.P. Morgan and Citigroup raises significant questions about the quality of evidence underlying the claims, the exercise of charging discretion and the settlement process. It is perhaps for this reason order provides that “Given the S.E.C.’s statutory mandate to ensure transparency in the financial marketplace, is there an overriding public interest in determining whether the S.E.C.’s charges are true?”

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