In a potentially precedent setting ruling on Monday, a federal judge in New York tossed out a settlement between the Securities and Exchange Commission and Citigroup, effectively telling the SEC -- which is responsible for protecting investors and maintaining fair, orderly markets -- that it isn't going far enough in holding financial institutions accountable for their wrongdoings.
The SEC accused Citigroup of selling investors mortgage-backed bonds that the bank knew would lose value. Citi netted roughly $160 million in profits from the sale of these bonds while investors lost more than $700 million. Under the proposed settlement with the SEC, the bank would have had to pay $285 million in penalties and fees, but would not have had to admit to any wrongdoing, according to the court decision.
The lack of admission was the main reason Jed S. Rakoff, a Clinton-appointed U.S. district judge, said he decided to throw out the settlement. An admission of guilt or innocence is a matter of significant public interest, he said. "The court, and the public, need some knowledge of what the underlying facts are," wrote Rakoff. "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 wording that sounds like it was written for those Occupy Wall Street protesters decrying the nation's big banks and their outsized influenced, Rakoff wrote: "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. ... The SEC, 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."
The ruling "is precedent setting," said a prominent securities lawyer who has represented investors in class-actions suits against financial institutions and is familiar with the decision.
The SEC often settles with large financial institutions without requiring an admission of guilt. And it's extremely rare for a judge to throw out a settlement -- though Judge Rakoff did once previously, in 2009, when he ruled that Bank of America and Merrill Lynch had "effectively lied to their shareholders" when the two firms paid out $3.6 billion in executive bonuses shortly before the bank acquired Merrill and after the bank had accepted billions of dollars in federal bailout funds.
"The way the SEC has always proceeded is a slap on the wrist and a cost of doing business, and all these big banks know it," the securities lawyer said. "If they get in trouble with the SEC, they know they can buy their way out of it without admitting anything. Ninety-nine out of 100 judges go along with it because it is the machine that greases the wheels."
The stakes are high for Citi. If they admit wrongdoing, that would likely be used against them in many more suits. The bank's potential exposure is enormous.
Both the SEC and Citigroup said Monday that they disagree with the ruling. Robert Khuzami, the director of the SEC's Division of Enforcement, said in a statement that the settlement "reasonably reflects the scope of relief that would be obtained after a successful trial," according to the Wall Street Journal.
Rakoff has in the past upheld SEC settlements that avoided an admission of guilt, including the well-publicized 2010 settlement between the SEC and Goldman Sachs in which the investment bank was accused of failing to disclose another hedge fund's involvement in its operations, a "similar but arguably less egregious" situation, in Rakoff's words, than the one Citigroup is accused of by the SEC.
Rakoff has ordered both parties to prepare to go to court in July 2012. Though an appeal is possible, it appears unlikely, the securities lawyer said.