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Unsettling – Judge Rakoff asks the SEC for an explanation in Citigroup matte

Securities case on hold as Judge asks SEC to provide a factual basis for their settlement agreement with Citigroup.

On October 19, 2011, the Securities and Exchange Commission (“SEC” or the “Commission”) filed a lawsuit against Citigroup Global Markets Inc. (“Citigroup”) in the United States District Court, Southern District of New York.

The Allegations

In its complaint, the SEC accuses Citigroup of securities fraud, alleging that in 2007 Citigroup created and marketed a large Synthetic Collateralized Debt Obligation (“CDO”), named “Class V Funding III.”  In helping to create Class V Funding III, Citigroup played a role in determining what assets would be placed in the fund.  Ultimately, Citigroup would sell $343 million in investments to Class V Funding III, to 14 different institutional investors.  At closing, Citigroup also received a $34 million in fees for its work in creating and marketing the fund.

At the same time it was creating and marketing Class V Funding III, however, the SEC alleges that Citigroup was also taking short positions against the collateral that was being used to back the Class V Funding III investments.  This means, of course, that Citigroup was betting on that same collateral to default, which would result in Citigroup’s short position paying out[1].

Thus, if what the SEC was alleging is true, it would mean that Citigroup is truly on both sides of this transaction.   On the one hand they are being paid to create and market the Class V Funding III CDO, as well as to sell the CDO to investors, while on the other hand, Citigroup is buying default insurance against the collateral being used to back the CDO (ie, betting on that collateral to default, thus triggering the insurance policy and paying out to Citigroup).

The Damages

The SEC succinctly alleges that as a result of Citigroup’s actions, Class V Funding III was doomed to fail, causing millions of dollars in loss to investors, while simultaneously benefiting Citigroup financially due to its short position on the assets backing the fund.  The SEC states:

5.  By November 6, 2007, approximately 83% of the CDOs in the Class V III

investment portfolio had been downgraded by rating agencies. Class V III declared an event of default on November 19, 2007. As a result of the poor performance of the investment portfolio, the Subordinate Investors and Super Senior Investors lost several hundred million dollars. Through its fees and its short positions, Citigroup realized net profits of at least $160 million in connection with Class V III.

Thus, the damages to investors in this matter have been calculated at (1) “Several Hundred Million” by the SEC; and (2) the dishonorable profits of $160 million collected by Citigroup in terms of fees and short position payouts.

The Proposed Settlement

On the same day the SEC filed its lawsuit against Citigroup, it announced that the parties in the matter had reached an agreement on the terms of the settlement:

  1. Enjoined Citigroup from violating the agreement between the SEC and Citigroup;
  2. Required Citigroup to pay $160 million in disgorgement, plus $30 million in prejudgment interest, and $95 million in penalties; and
  3. Required, “remedial sction by Citigroup in its review and approval of offerings of certain mortgage-related securities.” (

The press release issued by the SEC announcing the settlement also noted that the settlement was subject to Court approval.

Judge Rakoff’s Rejection

On November 28, 2011, a little bit more than a month after the SEC had filed their action against Citigroup while simultaneously announcing it had settled the matter for $285 million, United State District Court Judge Jed Rakoff rejected the settlement, refusing to sign the settlement agreement and allow the parties out of their obligations to continue with the litigation.

In blocking the settlement, Rakoff took issue with the SEC’s practice of settling cases on “neither an admit nor deny” basis.  What this means is that while the parties to the litigation have agreed to settlement terms, what is missing is any form of factual admission, or denial of the factual allegations, by the settling defendant(s).  Rakoff noted that the agreement between the SEC and Citigroup did not allow the court to determine whether or not the proposed settlement is “fair, reasonable, adequate and in the public interest.” (See Rakoff’s rejection of the Citigroup settlement).

In this case, for instance, the SEC has alleged that Citigroup’s actions caused damages of “several hundred million dollars.”  That figure is actually believed to be about $700 million, and does not count the money that Citigroup made as profit through their actions.  Thus, a very simple math formula can be used to determine that the $285 million Citigroup would pay in settlement, is insufficient to equal what the alleged damages are.

What Judge Rakoff is asking for is an explanation.  He wants to know why a case with damages alleged to be in the neighborhood just south of $1 billion is being settled for $285 million.  Does the SEC believe that certain aspects of its complaint will be difficult to prove?  Does it believe that the $285 million is as much as can be paid by Citigroup without endangering its ability to conduct further business?  What is it about the $285 million that makes this settlement fair and equitable?  He is looking for some context.


The Citigroup case is not the first time that Judge Rakoff has butted heads with the SEC.  In previous litigation between the SEC and Bank of America, Rakoff held up a proposed settlement until he was satisfied that the settlement was equitable.

The concept at the core of this situation between Judge Rakoff and the SEC seems to be that of accountability.  In this matter, the SEC has come down with some strong allegations against Citigroup.  It has alleged that Citigroup assembled a CDO that was predestined to fail, was paid handsomely for doing so, and then bet against its own creation to default, profiting when it did so.

If these allegations are true – then Judge Rakoff is right to question the $285 million settlement when it comes accompanied with no factual stipulations.  Without accompanying facts, how is anyone to know how many investor funds were truly lost, or what actions Citigroup took to facilitate sales in the doomed CDO.  Most importantly, how is anyone to gain any comfort in the belief that this won’t happen again?  A “neither admit nor deny” settlement, reached behind closed doors, provides no form of assurance or stability to the general public.

The Argument for Settlement

Critics of Judge Rakoff in this matter have a compelling argument.  To encourage settlement between parties to any civil litigation, it is important that the judiciary not overstep its bounds in interjecting into the settlement process.  If the courts were to become viewed as impediments to settlement, the number of cases that were resolved before trial would be drastically reduced and the burden on the court system would be untenable.  Accordingly, it is important to maintain a balance such that parties to any litigation believe that if they settle a matter in good faith, the Court will sign off on that settlement.


In attempting to enforce the securities laws of the United States, the SEC is faced with a daunting prospect and is not happy with Judge Rakoff’s rejection of their settlement in matter that will result in a substantial sum being returned to investors ($285 million is not peanuts).  Accordingly, the SEC is appealing his rejection of the settlement to the second circuit court of appeals based on “plain legal error.”  The Commission appears incensed with belief that Rakoff is meddling in their enforcement actions and questioning the legitimacy of their settlements.

The banks and other financial institutions against the SEC is pitted in some of these enforcement actions, many of whom are the only businesses whom will ever truly understand some of the complex financial instruments that were created, are full of ivy league educated financial gurus.  The best and the brightest in the financial industry, many of whom have compensation models that are based on the amount of money that they generate for their employer.  These same institutions employ as legal counsel some of the biggest and most influential law firms in the world.  Some of these legal minds bill out at over $1000 an hour to lend their expertise to representing these institutions.

It is against this conglomerate of financial institutions, law firms, and of course the big accounting firms, that the SEC must compete.  While working at the SEC is certainly prestigious in its own right, the Commission cannot match the compensation of many of the Securities lawyers in the private sector, and does not have the financial resources to take on the big banks of Wall Street and their army of legal counsel and financial experts.

So, when considering all those factors, it is little wonder that the SEC does not respond kindly to Judge Rakoff’s scoffing at their $285 million settlement.

On Balance

All things considered, I believe that Judge Rakoff got it right in the Citigroup case.  The SEC filed a scathing complaint against Citigroup, alleging that Citigroup knowingly created and sold a doomed investment vehicle, and profited from their short bets against that same vehicle.    If those allegations have any merit – then Citigroup must answer for this and make those investors who lost money whole.  Based on the settlement amount of $285 million, it is entirely unclear how those investors who lost their money on Class V Funding III will be recompensed.  It is further unclear what, if any, responsibility Citigroup is taking for its actions.  It must be known whether or not Citigroup is settling this matter and accepting that it did wrong, or whether they are maintaining innocence and settling to avoid the costs and negative press of prolonged litigation.

Ultimately, I believe that the SEC and Judge Rakoff will find some common ground on this matter, and the Citigroup settlement will go through.  Moving forward, however, it will be interesting to see if Rakoff, and his judicial peers effect Commission enforcement actions, as they seek more disclosure and fact finding in the SEC’s enforcement efforts.

The article provided above is for general information purposes only and should not be relied on as specific legal advice. This article does not form an attorney-client relationship. If you have any questions about this article, please feel free to contact Eric J. Camm at

[1] In this case, taking a short position against collateral or a fund such as Class V Funding III means that one is basically buying an insurance policy on a default of the collateral.  You pay premiums to the company issuing you the insurance to maintain your coverage, but, in the event that collateral or fund that you have insured defaults, your policy triggers and you are paid the value of your policy.

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