Citigroup faces a day of reckoning in court after a New York judge struck down a $285m settlement the bank reached with its financial regulator, arguing that the deal obscured an "overriding public interest in knowing the truth."
Last month Citigroup agreed to settle claims that it misled clients in a $1bn collateralised debt obligation (CDO), an investment linked to sub-prime residential mortgages. Investors lost about $700m from the CDO, according to the Securities and Exchange Commission (SEC), while the bank made $160m in fees and trading profits.
Judge Jed Rakoff said the deal would have imposed penalties on Citigroup even as it allowed the bank to deny allegations that it misled investors. "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," Rakoff wrote in his opinion.
"In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers," the judge said. "Even in our nation, apologists for suppressing or obscuring the truth may always be found.
"But the SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if fails to do so, this court must not, in the name of deference or convenience, grant judicial enforcement to the agency's contrivances."
Rakoff consolidated the case with a suit brought against Citigroup employee Brian Stoker, who was responsible for structuring the CDO, according to the SEC. He set a trial date for 16 July 2012. Citigroup may try for a revised settlement, which would also have to be approved by Rakoff.
Chicago-based securities attorney Andrew Stoltmann called Rakoff's decision "historic".
"This is horribly embarrassing for the SEC. A federal judge is basically telling them to do their job," he said.
Stoltmann said federal judges have often been little more than a rubber stamp of approval for the SEC. "Imposing fines without admitting liability is a legal charade that has been going on for decades," he said. "The SEC refuses to hold people's feet to the fire and force them to admit liability. It just wants the headline and them to move on," he said.
It is common for the SEC to reach settlements with banks that do not contain an admission of liability. Formally admitting liability would give a powerful boost to investors suing the bank as well as handing the bank with a public relations issue. For the SEC it reduces the chances of a costly court case and to avoid the uncertainty of a trial.
"The SEC's longstanding policy - allowed by history, but not by
reason - of allowing defendants to enter into consent judgments without admitting or denying the underlying allegations deprives the court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact," the judge said.
Rakoff has been a consistent critic of the SEC's tactics. In September 2009 he rejected the regulator's settlement with Bank of America over claims it misled investors about bonuses paid to Merrill Lynch, which the company had taken over that year.
The deal suggested "a rather cynical relationship between the parties," he said. "The SEC gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger," Rakoff wrote. "The bank's management gets to claim that they have been coerced into an onerous settlement by over-zealous regulators. And all this is done at the expense not only of the shareholders but also of the truth."
Rakoff approved a revised settlement in February 2010 in which Bank of America agreed to pay $150m to resolve broader allegations about misstatements to investors.