Opinion and Investing Column

SKARBECK: Judge says no-fault SEC deal is weak, ineffective

December 3, 2011

Ken Skarbeck InvestingA federal judge in Manhattan took a stand against lax oversight of the financial industry, rejecting a $285 million settlement between the Securities and Exchange Commission and Citigroup—and setting a July trial date.

U.S. District Judge Jed Rakoff on Nov. 28 said he could not approve the deal because it did not require Citigroup to admit wrongdoing.

Last month, Citigroup agreed to settle an SEC lawsuit alleging that it misled investors in a $1 billion mortgage fund containing subprime loans it believed would fail. Citigroup took a short position—a bet that the value of the fund would decline—and made over $160 million; investors lost $700 million.

A federal judge must approve such settlements and historically most have rubber-stamped them. But in reviewing this case, Rakoff asked both the SEC and Citigroup to answer nine questions.

The first: “Why should the court impose a judgment in a case in which the SEC alleges a serious securities fraud but the defendant neither admits nor denies wrongdoing?”

The boilerplate no-fault language accompanies most such settlements—along with an agreement not to violate the securities laws in the future. But the SEC rarely goes after companies that break that promise.

“How many contempt proceedings against large financial entities has the SEC brought in the past decade as a result of violations of prior consent judgments?” Rakoff asked.

In fact, an analysis by The New York Times of SEC enforcement actions over the past 15 years found at least 51 cases involving 19 firms where the institutions broke anti-fraud laws they had agreed to never again breach.

Rakoff called Citigroup a “recidivist” since the SEC already had issued cease-and-desist orders in 2005 and 2006 prohibiting violations of the same securities laws the company is accused of breaking with the mortgage fund. He questioned whether the SEC was serious about seeking an injunction against repeat offenders.

The SEC says it has been the agency’s policy since 1972 to avoid having defendants publicly admit fault after agreeing to a settlement. To admit liability would open the firms up to numerous and potent investor lawsuits. The SEC’s position is that swift penalties, obtained without the costs and uncertainty of trial, outweigh the absence of admission.

Rakoff asked hard questions: “How can a securities fraud of this nature and magnitude be the result simply of negligence?” And, why are Citigroup shareholders paying the penalty in this case rather than the “culpable individual offenders” within the firm?

The SEC is expected to file charges against other Wall Street firms related to their dealings in subprime mortgage securitizations. Perhaps Rakoff’s actions will challenge the agency to hold firms to a higher level of accountability, instead of enforcement actions that thus far have been viewed as toothless and amounting to slaps on the wrist.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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