Yesterday, in testimony before Congress, former MF Global CEO Jon Corzine attempted to insulate himself from the firm’s massive bankruptcy and the potential fraud associated with $1.2 billion of customer funds that remain missing. “As the chief executive officer of MF Global, I ultimately had overall responsibility for the firm. I did not, however, generally involve myself in the mechanics of the clearing and settlement of trades, or in the movement of cash and collateral,” Corzine testified. Thus begins the long process of determining Mr. Corzine’s guilt or innocence. Yet if a recent court case is any indication, a paradigm shift away from an odious status quo may have occurred–and Mr. Corzine may be the first major financial figure prosecuted in this new legal environment.
On November 28th, a funny thing happened on the way to a deal between the Securities and Exchange Commission (SEC) and Citigroup. U.S District Court Judge Jed S. Rakoff rejected a settlement allowing the bank to pay a $285 million fine without admitting they did anything wrong. He further took the SEC to task for allowing repeat offenders like Citi to avoid fraud charges and other statutory consequences that should accrue to serial violators of the law. “Applying these standards to the case in hand, the Court concludes, regretfully, that the proposed Consent Judgment is neither fair, nor reasonable, nor adequate, nor in the public interest,” Rakoff wrote in his summation.
The case itself is an appalling example of fraud. According to the SEC, Citigroup put together a $1 billion collateralized debt obligation (CDO) tied to the American housing market and sold it to investors. Citi then turned around and bet against those investors when the housing market began to “show signs of distress.” The CDO defaulted within months of its inception, and investors were stuck with the loss. At the same time, Citigroup made $160 million in fees and trading profits.
“The SEC alleges that Citigroup Global Markets structured and marketed a CDO called Class V Funding III and exercised significant influence over the selection of $500 million of the assets included in the CDO portfolio,” noted the Commission on its website. “Citigroup then took a proprietary short position against those mortgage-related assets from which it would profit if the assets declined in value. Citigroup did not disclose to investors its role in the asset selection process or that it took a short position against the assets it helped select.”
If a brokerage firm secretly betting against its own creation, shafting its own investors, and making a profit in the process has a familiar ring to it, that’s because Goldman Sachs wiped out investors in a similar kind of deal. In 2007, hedge fund manager John Paulson, convinced the housing market was about to tank, put together a portfolio of mortgage-backed securities designed to do exactly that–tank. ACA Management handled the portfolio and Goldman Sachs banker Fabrice Tourre, aka “Fabulous Fab,” marketed the deal, even as emails reveal he knew the fund was failing. When it did indeed fail, Paulson made a cool $1 billion.
The SEC investigated and the resulting $550 million fine was the largest penalty ever paid by a brokerage firm. Goldman admitted it “failed to provide vital information” to investors. Yet the SEC allowed the firm to avoid fraud allegations, and while the fine seems large, it amounts to about two weeks’ worth of profit for a firm that made $3.3 billion in the first quarter of 2010.
In other words, the SEC did nothing that would discourage the kind of dubious deals that have generated a level of contempt for Wall Street–and by unfortunate extension, capitalism–that has resonated among a substantial portion of the electorate. Yet the SEC was quite proud of its accomplishment. “This settlement is a stark lesson to Wall Street firms that no product is too complex, and no investor too sophisticated, to avoid a heavy price if a firm violates the fundamental principles of honest treatment and fair dealing,” wrote Robert Khuzami, director of the SEC’s Division of Enforcement.
Judge Rakoff wasn’t about to let history repeat itself. “As a matter of law, an allegation that is neither admitted nor denied is simply that, an allegation,” Rakoff said of the settlement between the SEC and Citigroup. He then told both parties that unless they can come to an agreement regarding Citibank’s culpability, the case will go to trial in front of a jury. Rakoff scheduled the trial for July 16, 2012. The trial will also include a related case against Brian Stoker, who both structured and marketed the jerry-rigged CDO.
This ruling stands in stark contrast to what the SEC was willing to settle for. A guilty verdict against Citi at a trial permits the filing of additional lawsuits by aggrieved investors. On the other hand, the settlement would have shielded the bank from litigation arising from the SEC’s findings. In his ruling, Rakoff took both Citigroup and the SEC to task. With respect to Citigroup, the judge noted that “a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies. This, indeed, is Citigroup’s positon in this very case.”
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