Two days after the release of one of the most scathing judicial opinions in recent memory, the importance of federal Judge Jed Rakoff’s rejection of the SEC’s $285 million settlement with Citigroup is just beginning to sink in. In just 15 pages of moving prose that harken back to Rakoff’s undergraduate degree in English literature, the opinion rips the SEC for its lack of transparency and respect for separation of powers, failure to establish facts or allegations against Citigroup or deter future misconduct, and failure to uphold its obligation to uncover the truth and protect the public at large from financial fraud.
As Matt Taibbi of Rolling Stone magazine most aptly describes the opinion in his article, Federal Judge Pimp-Slaps the SEC Over Citigroup Settlement, it was “one of the more severe judicial ass-whippings you’ll ever see.” The ruling prompted Tyler Durden at ZeroHedge to call for the resignation of SEC Chairman Mary Shapiro. Below is an entertaining clip of Taibbi discussing the impact of Rakoff’s ruling on Countdown with Keith Olbermann.
So, what is the gist of Hizzoner’s objections? First off, Judge Rakoff points out that in a parallel complaint filed by the SEC against a Citigroup employee for his role in putting together the CDO at issue, the SEC alleged that 1) Citi created Class V Funding III (the “Fund”) to dump dubious assets on misinformed investors as the market was tanking, 2) Citi helped select and then took a short position in the assets placed in the Fund, and 3) Citi knowingly misrepresented to investors that the assets had been selected by an independent third-party investment adviser in order to place the Fund’s liabilities. Rakoff notes that while these allegations would be tantamount to a showing of knowing and fraudulent intent (the scienter necessary for a fraud claim), the SEC left many of them out of the complaint against Citigroup itself and chose to charge Citi only with negligence (i.e., a failure to exercise due care rather than an intentional lie). That was the first sign of a problem.
Next, Rakoff points out that through its complaint, the SEC seeks to invoke the court’s injunctive powers – an extraordinary remedy – without having proven any facts or coerced an admission of wrongdoing out of Citi. By contrast, the SEC’s settlement with Goldman Sachs over the Abacus CDO required the bank to admit to “a mistake” and to “regrets” that the marketing materials for the CDO were inadequate. This opened the door for civil lawsuits to further deter the bank from misleading investors in the future. With respect to the Fund, the Judge noted that Citi made clear in open court that it was not admitting to the allegations in the complaint and reserved the right to contest the facts in parallel litigation.
Based on this, Rakoff found that the court was unable to determine whether the settlement was “fair, reasonable, adequate, and in the public interest.” (Opinion at 4) In particular, Rakoff held that,
a court, while giving substantial deference to the views of an administrative body vested with authority over a particular area, must still exercise a modicum of independent judgment in determining whether the requested deployment of its injunctive powers will serve, or disserve, the public interest. Anything less would not only violate the constitutional doctrine of separation of powers but would undermine the independence that is the indispensable attribute of the federal judiciary. (Id. at 4-5)
Next, Rakoff takes issue with the size of the penalty imposed on Citigroup and its impact in deterring future misconduct. In one of the more remarkable passages from the Opinion, Rakoff notes that,
a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, especially in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies. (Id. at 10)
Rakoff is pointing out in no uncertain terms what Taibbi, filmmaker Charles Feguson, and many in the Occupy movement and elsewhere have been saying for some time – Wall Street continues to look at law enforcement as simply the cost of doing business and will not be deterred from illegal conduct unless the size of the penalties increases dramatically or people start going to jail. Essentially, Rakoff is saying that Wall Street has become accustomed to paying off the SEC when it gets caught.
Rakoff further underscores the inadequacy of the penalties imposed on Citi in this proposed settlement by comparing it to Goldman’s Abacus settlement – which itself has been criticized as inadequate, since it punished Goldman for only one of several CDOs that were marketed in the same manner. Rakoff points out that in the Abacus deal, Goldman only made $15 million in profits (compared to the $160 million in profits for Citi from the Fund deal) and that Goldman’s alleged conduct was arguably less blameworthy as Goldman didn’t directly short the assets in the CDO, but just failed to disclose that Paulson & Co., which had helped select the assets, was also shorting the deal. Yet compared to Citi, Goldman was required to pay a bigger penalty ($535 million as opposed to a $95 million penalty for Citi), admit to certain mistakes, implement broader remedial measures, and cooperate with authorities. (Opinion at 13 n.7). It’s thus not surprising that Rakoff was unable to conclude that the Citi settlement was fair, reasonable, or adequate.
Finally, Rakoff reserves his most biting criticism for the SEC itself in failing to uphold its mandate. After noting that this case “touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives,” Rakoff writes that,
the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances. (Id. at 15)
With that, Judge Rakoff rejects the settlement and orders the parties to prepare for trial on the SEC’s complaint on July 16, 2012.
I was left with chills after reading through the end of this Opinion. It was if I had been waiting for years to hear a member of our judiciary stick out his or her neck to confront the inadequacy of the SEC’s long established “enforcement” patterns – slaps on the wrist, no admissions of guilt and certainly no jail time. Indeed, while the cozy relationship between the SEC and Wall Street (with most at the SEC either having worked on Wall Street or harboring aspirations to work on Wall Street in the future) has been called out repeatedly by journalists, writers and commentators, I had never heard a member of the judiciary stick out his or her neck in such a bold manner and confront the SEC.
But Rakoff’s frequent reference to the core principles of the Constitution and the independent judiciary, as well as his reference to “much of the world, [where] propaganda reigns, and truth is confined to secretive, fearful whispers,” (Opinion at 15) reveal just how important this issue was to the fundamental values that set the United States apart. Still, it took tremendous courage for Rakoff to speak out in the face of pressure from such a powerful government agency and refuse to simply wield his rubber stamp like so many of his peers had done before him. Rakoff is correct – passive judicial acceptance of these sorts of bargains (even between two willing parties) does not protect the public interest one iota. In fact, it does worse, by essentially ending the inquiry and withholding from the public the facts it needs to enforce its rights or recover its losses. As Rakoff points out, there is no guarantee that the money recovered by the S.E.C. by way of such settlements (including the $154 million recovered from J.P. Morgan in connection with the Magnetar deal) will actually go to reimbursing defrauded investors.
If we hope to restore confidence in the U.S. financial system and attract private investment, we need to begin by showing those investors that the rule of law will be enforced with more than a wink, a nod and a slap on the wrist. I hope that Rakoff’s opinion gives more members of the bench the courage to stand up and declare that their rubber stamps for agency actions are out of commission.