Judge Criticizes SEC in Citigroup Mortgage Settlement Over CDOs

(November 10, 2011) — Citigroup and the US Securities and Exchange Commission (SEC) have defended their $285 million settlement of claims that the New York bank misled investors over collateralized debt obligations. 

US District Judge Jed Rakoff has asserted that he does not approve of the SEC’s approach to settling securities fraud cases.

At a hearing yesterday, Rakoff questioned each side about why he should approve an accord that doesn’t require Citigroup to admit any wrongdoing. Last month, Rakoff asked Citigroup and the SEC to answer an array of questions about the proposed settlement, including whether it is in the public interest to determine the validity of Citigroup’s alleged fraud. The judge questioned the SEC on why the regulator should accept a payment much smaller than the estimated $700 million that investors lost on the transaction, which Citigroup had bet against.

The SEC filed a response to the questions posed by the court regarding the Citigroup settlement, obtained by aiCIO, which stated: 

“After a thorough investigation of a complex collateralized debt obligation (“CDO”) transaction structured and marketed by Citigroup Global Markets, Inc., (“Citigroup”), the SEC concluded that the company violated Sections 17(a)(2) and (3) of the Securities Act of 1933 (“Securities Act”). Following extensive discussions and negotiations, the Commission and Citigroup agreed to a proposed settlement requiring that Citigroup make a monetary payment of $285 million, consisting of $160 million of disgorged profits it earned on the transaction, $30 million in prejudgment interest, and a $95 million civil penalty. All of the $285 million would be returned to harmed investors under the terms of the settlement. In addition, Citigroup would be enjoined from further violations of the securities law as well as required to implement a series of business reforms in connection with the structuring and marketing of mortgage-related securities.”

In response to the judge’s question about whether — given the SEC’s statutory mandate to ensure transparency in the financial marketplace — there is an overriding public interest in determining whether the SEC’s charges are true, the US regulator replied:

“The interest in providing transparency regarding misconduct by companies in the securities industry is accomplished by the public filing of the allegations in the Commission’s Complaint, which Citigroup has not denied…the detailed allegations of the Complaint, the substantial payment by Citigroup, the company’s lack of a denial of the allegations, and Citigroup’s public statement regarding the matter have put the public on notice as to Citigroup’s conduct.”

The case is U.S. Securities and Exchange Commission v. Citigroup Global Markets Inc., 11-cv-7387, U.S. District Court, Southern District of New York (Manhattan).

Following the financial crisis and housing collapse, countless other cases of alleged fraud and acts of misleading investors among the nation’s largest banks have been brought to light. In June, the SEC announced that JP Morgan would pay $153 million to settle charges of allegedly selling $1.1 billion in mortgage-backed securities that were designed to fail.

Similar to suits against Goldman Sachs, Citigroup, and other US financial institutions, the case against JP Morgan encompasses an accusation that a hedge fund was seminally involved in the selection of the underlying collateral in the portfolio while simultaneously betting against it with a short position. The US regulator asserted that as the housing market crumbled in March and April 2007, JP Morgan executives urged the marketing of Squared CDO 2007-1, a synthetic collateralized debt obligation (CDO) linked to a collection of residential mortgages, without informing investors that a hedge fund — Magnetar Capital — helped select the assets in the CDO portfolio and had a short position in more than half of those assets. Consequently, the hedge fund was positioned to benefit if the CDO assets it was selecting for the portfolio defaulted.