The SEC has responded to questions from the federal judge (SD NY) overseeing the SEC-Citigroup settlement, including why the court should impose a judgment in a case in which the SEC alleges a serious securities fraud but the defendant neither admits nor denies wrongdoing. The SEC responded seriatim in a memorandum in support of the proposed judgment to that question and a series of other questions posed by the court.
In the enforcement action, the SEC alleged that the principal U.S. broker-dealer subsidiary of the financial institution mislead investors about a $1 billion collateralized debt obligation (CDO) tied to the U.S. housing market in which the entity bet against investors as the housing market showed signs of distress. The CDO defaulted within months, leaving investors with losses while Citigroup made $160 million in fees and trading profits. Without admitting or denying the allegations, the financial institution agreed to settle the SEC’s charges by paying a total of $285 million, which will be returned to investors. (SEC v. Citigroup Global Markets, Inc, SD NY, 11-CIV 7387, Rakoff, J).
Noting that the US Supreme Court has expressly endorsed the entry of consent decrees notwithstanding a defendant’s explicit denial of material allegations of the complaint, the SEC said that there is nothing unusual or untoward about a consent decree entered into without an admission of wrongdoing by the defendant, and that criticism of consent decrees for not including such an admission is unjustified. Consistent with this standard practice, the SEC has long used consent decrees in which defendants admit no wrongdoing.
The instant financial institution and the SEC entered into a no admit/deny settlement. In the SEC’s view, it appears that this approach has succeeded in clearly conveying that the conduct alleged did in fact occur. The complaint lays out in detail the alleged facts, the financial institution has paid nearly $300 million as a result, the financial institution has not denied the allegations, and its public statements on the settlement focused on the fact that the firm has overhauled the risk management function, significantly reduced risks on the balance sheet, and returned to the basics of banking.
Courts have repeatedly recognized the balance of advantages and disadvantages in settlements entered in no admit/deny enforcement actions and have been reluctant to upset that balance, said the SEC. While the defendant is not subject to collateral estoppel with regard to the claims asserted, acknowledged the SEC, investors are able to pursue any available private remedies, in addition to the relief obtained by the SEC. Moreover, the SEC was able to bring the matter to a speedy conclusion, obtain compensation for victims in a timely manner, and allocate limited resources to bring additional enforcement actions for the protection of more investors.
The judge also asked, given the SEC’s statutory mandate to ensure transparency in the financial marketplace, if there is an overriding public interest in determining whether the SEC’s charges are true, especially when there is no parallel criminal case. The SEC responded that the interest in transparency regarding corporate misconduct in the securities industry is accomplished by the public filing of the allegations, which the financial institution has not denied. The SEC also noted that there is ongoing action against a former employee of the bank, which provides a vehicle for resolution of the allegations. The SEC fully anticipates that this action will continue through resolution on the merits.
The court also wants to know the total loss to the victims as a result of the financial institution’s actions and how this was determined. The SEC said that the law provides two financial remedies to the SEC in enforcement actions: disgorgement of ill-gotten gains and imposition of monetary penalties in specific dollar amounts or an amount measured by the actor’s gain. As a general rule, the SEC does not recover damages suffered by victims of a securities fraud scheme. As a result, the precise calculation of investor losses is not required in connection with the resolution of an SEC enforcement action.
Determination of the precise amount of investor losses as a result of the bank’s actions is a difficult and imprecise exercise not contemplated by the statutory scheme. Further, the SEC explained that total losses to an investor in a transaction are not necessarily the same as total losses to investors as a result of a defendant’s improper actions, which determination would require proof that the financial institution’s material misstatements or omissions were the proximate cause of the losses suffered by the investors as opposed to other causes. Because loss causation is neither an element of SEC enforcement actions nor the proper measure of its potential statutory recovery, the SEC did not devote resources to calculating proximate causation, which often entails a complex evaluation of a variety of external events and their impact on alleged losses.
The court’s question suggests that the SEC has identified investor losses of at least $160 million. That is not what the SEC asserted in its complaint. What was said was that the financial institution, as a result of its short position in the assets in the CDO portfolio and its structuring fee, realized net profits of at least $160 million. It is this amount that forms the basis for the disgorgement figure
The court noted that the SEC’s submission states that the Commission has identified nine factors relevant to the assessment of whether to impose penalties against a corporation and, if so, in what amount; but the submission failed to particularize how the factors were applied in this case. The court asked if the Commission employed these factors in this case and, if so, how should this case be analyzed under each of those nine factors.
With regard to the first factor, what was the benefit, if any, to the company as a result of the violation, the SEC noted that the financial institution directly benefitted in the amount of $160 million as a result of the CDO transactions, and the magnitude of the direct benefit to the entity counseled in favor of a significant monetary penalty.
Regarding the second factor of whether the penalty will recompense or further harm the injured shareholders, the SEC noted that, while the shareholders here will indirectly bear the cost of any penalty imposed on the company that is not an unjust result where, as here, the shareholders were the indirect financial beneficiaries of the misconduct. The proposed resolution allows for the creation of a Fair Fund to provide recompense to harmed CDO investors; and it is the SEC’s intent to initiate a Fair Fund. Thus, in the SEC’s view, the imposition of a penalty here serves to provide recompense to the victims.
On the third factor, the need to deter the particular type of offense, the SEC noted that an important deterrent effect was the filing of the action, which revealed the firm’s CDO business and the misleading representations to investors. Also, the imposition of a substantial penalty, in addition to a disgorgement payment, as the result of the transactions can serve to alter the financial calculus of this firm and other companies that would engage in similar transactions in the future. On the fourth factor of the extent of injury to innocent parties, the SEC said that this factor weighs in favor of significant monetary sanctions in this action.
Regarding the fifth factor of whether the complicity was widespread throughout the firm, the SEC did not uncover evidence to support a conclusion that there was widespread illicit conduct by individuals throughout the firm in connection with the CDO transactions.
Intent is the sixth factor. The SEC concluded that the evidence did not clearly establish an intent to defraud.
On the seventh factor, the difficulty of detecting this type of offense, the SEC said that the investigation of securities law violations concerning the structuring and marketing of CDOs is difficult given the complexity of the transactions and the lack of transparency in the CDO market.
On eighth factor of the remedial steps taken by the company, the SEC noted that the proposed consent judgment includes a series of undertakings by the firm designed to prevent a repeat of this conduct in the future. But the firm has been the subject of prior SEC enforcement actions, noted the Commission, and recidivism is taken into account by the SEC in determining the appropriate penalty.
On the ninth factor on the extent of cooperation, the SEC observed that the firm did not provide an extraordinary level of cooperation. Thus, this factor is neutral.
In response to the question of how it will maintain compliance, the SEC noted that the defendant is a registered broker-dealer and thus subject to SEC examination. Also, civil contempt is a remedy available to the SEC if the firm engages in an ongoing violation of an injunction.
The court also queries why the penalty in this case is to be paid in large part by the financial institution and its shareholders rather than by the culpable individual offenders acting for the corporation. The SEC noted that the payment of a penalty by the company does not unfairly harm the shareholders because they were not the victims of the alleged fraud but rather its indirect beneficiaries.
More granularly, the court asks what specific control weaknesses led to the acts alleged in the complaint. In referring to control weakness, the SEC was referring to the failure to ensure that complete and accurate disclosures were made to investors regarding the selection of the CDO portfolio.
The court also asked how a securities fraud of this magnitude could be the result of negligence. Based on a careful review, the SEC decided to charge the firm with violations of Section 17(a)(2) and (3), which claims were firmly supported by the factual allegations. The SEC emphasized that the decision not to pursue additional charges was committed to an agency’s absolute discretion and is not a proper area of inquiry in evaluating a consent decree.