“Jessep: You want answers?
Kaffee (Tom Cruise): I think I’m entitled to them.
Jessep: You want answers?
Kaffee: I want the truth!
Jessep: You can’t handle the truth!”
A Few Good Men
written by Aaron Sorkin
We returned from Thanksgiving to the blockbuster news that highly respected Federal Judge Jed S. Rakoff of the United States District Court in Manhattan, has rejected a proposed $285 Million litigation settlement between the US Securities Exchange Commission (“SEC”) and financial behemoth, Citigroup.  Why would a Judge do such a thing?

According to the SEC’s allegations, they sued Citigroup (S.E.C. v. Citigroup Global Markets) for structuring 2007 ‘mortgage derivatives’ transactions – for those familiar with the terminology, involving a billion-dollar mortgage securities fund, somewhat less than charmingly named ‘Class V Funding III.’  If you don’t remember, or never really understood, ‘mortgage derivatives,’ they were those incredibly complex financial investment packages that many economists believe brought the US (and perhaps the world’s) economic system to the very brink of collapse in the Fall of 2008.

Specifically, and in greatly simplified terms, these involved taking massive numbers of home loans, tossing them all into a great big pot, then slicing and dicing the contents of the pot to make up what were called tranches (tranche being the French word for slice, section, series, or portion) – then grading the pot according to it’s collective risk by sorting the contents into smaller pots A, B and C, and, finally; selling these packages to investors on the worldwide financial markets.

The problem in a nutshell was that these investments were uniquely poised to fail in a real estate market sliding quickly from its dizzying heights directly into the financial toilet.  Other problems were that, somehow, the tranches could become better quality than their component parts, helped along by friendly ratings agencies that often stood to profit from the sales by the issuer.  Oh yes, and the really big problem was that many of the home loans contained in these tranches were of the NINJA variety – ‘no income, no job, no assets,’ – essentially, subprime junk loans.

In fact, these particular mortgage derivatives over which the SEC sued Citigroup, were so problematically valued that (the SEC alleges), after issuing these financial investment securities to willing buyers, Citigroup went on to make other investments with other clients’ money, and perhaps even some of their own, betting against the performance of these very securities.  Thus, according to the SEC, Citibank was bound to win, either through the issuance of the securities, or by betting against the very securities it had issued and sold to investors – not exactly the usual circumstances which one might expect in dealing with their trusted financial advisor.
Now, a $285 Million Settlement payment by Citigroup is surely not chump change, beer money, or, by anybody’s measure, even a modest sum.  It is nearly a third of a Billion dollars.

But, Judge Rakoff, in throwing out the proposed settlement, wrote that the settlement was “neither fair, nor reasonable, nor adequate, nor in the public interest.”   Why, you ask?  Because, settling the case in this fashion and at this time and for this amount of money, was, according to Judge Rakoff’s reasoning, a way for Citigroup to buy it’s peace while at the same time also keeping the real facts from coming out – real facts which then could be used by others to sue Citigroup civilly for securities fraud-type claims, including class actions, to restore investors’ investments in these tainted financial products.

Judge Rakoff also wrote that the S.E.C.’s usual settlement policy of allowing a company like Citigroup to settle for a monetary payment without admitting any legal liability — “hallowed by history, but not by reason,” wrote Judge Rakoff  — can be seriously abused, the judge continued, because “it asks the court to employ its power and assert its authority when it does not know the facts.”

Investors lost $700 million in the fund according to the S.E.C’s allegations, while, at the same time, Citigroup realized about $160 million in profits by allegedly betting against their own investors.   By settling with the SEC, all the facts would be buried and never come to light. Judge Rakoff’s decision says that it is about time that these facts are made public, wherever the chips may fall, or crash land, to mix the metaphor.  Among other things, Judge Rakoff’s ruling also called Citigroup a “a recidivist,” ( ‘serial offender’), noting that Citigroup had violated the anti-securities-fraud provisions of federal law many times already.

This ruling may well throw the proverbial monkey-wrench into the SEC’s securities laws enforcement efforts in this, nearing the end of the fourth year, of the Great Recession, as some commentators now fear that huge financial companies will not have the motivation to reach settlements of securities claim cases with the SEC in the future if they cannot settle and effectively hide the facts of their alleged wrongdoing.

But, Judge Rakoff, known for his clear writing and bold thinking, firmly addressed these concerns in citing the overriding public interest in knowing the truth, which his ruling seeks to serve:  “An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous . . .. 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.”
In parting, the remaining question is: Can we really handle the truth?