Rakoff Rejection of Citi / SEC Settlement Pierces Wall Street’s Alice-in-Wonderland Thinking

Below is a recent article published by Securities Lawyer Jake Zamansky on Forbes.com:

It’s not every day that a federal judge issues a landmark decision, particularly one that could help investors wanting to sue giant financial institutions. But that’s what happened Monday, when U.S. District Judge Jed Rakoff rejected a proposed $285 million settlement between Citigroup and the Securities and Exchange Commission that would have allowed Citi to put the SEC’s mortgage-backed-securities case in the rear-view mirror.

The SEC claims that Citigroup misled investors in a $1-billion fund holding assets the bank had projected would lose money. And just as Citigroup was selling the fund to investors, it shorted many of the fund’s underlying assets for its own account.

Under the proposed settlement, Citigroup would have avoided admitting any wrongdoing. Instead, Judge Rakoff struck a blow for investors by employing a little common sense-he essentially ruled that if a court is going to sign off on a settlement, it has to understand the merits of the allegations.

Since 1972, the SEC has allowed defendants like Citigroup to settle cases and pay substantial fines without admitting liability. Why should a bank pay a huge fine without admitting wrongdoing? According to Bloomberg news, the SEC adopted that policy so defendants could later claim publicly-and in private litigation-that they really hadn’t done anything wrong.

Such is the Alice-in-Wonderland logic of Wall Street. In the case of Citigroup, the bank was apparently happy to write a check for $285 million, as long as it didn’t have to admit it had done anything wrong. That admission would make for bad publicity for banks like Citigroup and also hand a hammer to investors looking to sue the bank.

Judge Rakoff is telling us that these “no-fault” settlements make no sense. How can a judge sign off on such a settlement when he or she doesn’t have enough facts to fairly evaluate it?

His decision also means that the SEC should only start fights it can finish, and shouldn’t plan on “wrist-slap” settlements. “If the allegations of the complaint are true, this is a very good deal for Citigroup,” he wrote. “Even if they are untrue, it is a mild and modest cost of doing business.”

Rather than allow Citi-or really its shareholders-to just cut a check and move on, Rakoff scheduled a public trial regarding Citi’s misconduct for this coming July.

The four-years-and-counting Great Recession, caused in large part by Wall Street’s deceptive packaging subprime-mortgage junk products, has apparently had an impact on Judge Rakoff’s thinking. “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,” Judge Rakoff wrote. The proposed settlement is “neither fair, nor reasonable, nor adequate, nor in the public interest.”

Thank you, Judge Rakoff, for forcing Wall Street to finally face the music instead of allowing them to go on living in Wonderland.

Disclosure: Zamansky & Associates are securities attorneys representing investors in arbitrations and state and federal litigations against financial institutions, including Citigroup.

Read article by Securities Attorney Jake Zamansky on Forbes.com

Attending the NASAA Conference

This afternoon I was in Baltimore, Maryland attending the National American Securities Administrators Association (NASAA) conference, where I took  part in a panel discussion entitled “Guiding Investors Through the New Market.” My comments focused on a number of key investor issues including the need for a fiduciary standard, the lack of uniform federal regulation and the general failure of the Dodd-Frank bill.

I also highlighted the imbalance between state and federal regulation. While state regulators are taking a stand on behalf of investors against large financial institutions such as Bank of America and Citigroup, federal regulators have consistently remained asleep at the wheel.

I’ve submitted a more detailed position paper detailing these issues into the conference record.  You can view the document here.

The SEC Needs a Win Against Mozilo

As a New York Times story suggested earlier this week, Federal Judges are no longer rubber stamping the SEC’s settlements with Wall Street. This has put the SEC in an almost impossible situation: drive harder bargains and risk facing off in court against Wall Street’s limitless legal resources or bow to their wishes and risk more rejected settlements.

It all started with Judge Jed S. Rakoff’s denouncement of the SEC’s settlement with Bank of America for allegedly misleading shareholders about losses pending at Merrill Lynch, which at the time was in the process of being acquired. Judge Ellen Segal Huvelle then refused to accept a settlement with Citigroup, which also was accused of misleading shareholders about tens of billions of dollars in potential losses.

Judges are frustrated that the SEC’s settlement patterns harm shareholders who actually bear the brunt of the fines. They also want the SEC to negotiate stiffer penalties holding executives personally liable for fraudulent acts.

There are many reasons why large Wall Street firms are able to negotiate such generous terms with the SEC. One reason is the so-called “revolving door,” where former SEC officials representing Wall Street sit across from their past colleagues who themselves might be eying lucrative Wall Street jobs. But another is that Wall Street knows that the SEC is at a disadvantage if push comes to shove and a trial is scheduled.

The SEC rarely argues cases in a courtroom and even more rarely prevails against large Wall Street banks. With a track record like that, Wall Street’s legal representatives have the leverage they need to protect senior management and continue practices that exploit investors.

But that could all change in October when the trial against former Countrywide Financial CEO Angelo Mozilo is scheduled to begin.

A settlement agreement has yet to be struck between the SEC and senior executives of mortgage giant Countrywide Financial, including Mr. Mozilo. The SEC has accused them of misleading investors about their lending standards. It’s conceivable that an agreement may prevent a trial or that a judge could dismiss the charges, but considering the judicial scrutiny of late, the terms of a settlement would not be favorable to Mr. Mozilo and his former colleagues. Thus, it certainly looks like a civil fraud trial will get started this October.

The symbolic importance of the trial has been noted by several experts including former SEC chairman Harvey Pitt, who said that the case is “significant because it is a reflection of the SEC’s commitment to go after people who have been involved in the financial meltdown.”

I agree with Chairman Pitt, and I’d take it a step further: a win for the SEC would provide its enforcement team with the leverage they need to negotiate stiffer terms for settlements. Future settlements could and should include admissions of liability, as well as personal financial liability of the wrongdoer and his or her manager if applicable.

For the SEC, this is a “bet the farm” lawsuit and one that could lay the groundwork for the future of enforcement on Wall Street.

More Half-Baked Justice from the SEC

Last year, Judge Jed Rakoff of the United States Southern District of New York struck a blow on behalf of all investors when he ordered the SEC and Bank of America back to the negotiating table. He deemed the settlement agreement the SEC submitted for Bank of America’s alleged failure to disclose billions of dollars of losses at Merrill Lynch as inadequate and poorly constructed. When the SEC and Bank of America went back to the drawing board and agreed to somewhat stricter terms, still without admission of guilt, Judge Rakoff reluctantly approved. But not without a last salvo.

Judge Rakoff proclaimed that the revised settlement represented “very modest punitive, compensatory, and remedial measures that are neither directed at the specific individuals responsible for the nondisclosures nor appear likely to have more than a very modest impact on corporate practices or victim compensation…While better than nothing, this is half-baked justice at best.”

The same “half-baked justice” Judge Rakoff described last year was evident in the SEC’s recent settlement with Citigroup. The SEC alleged Citigroup executives hid $40 billion in toxic mortgage industry assets from its shareholders. Citigroup paid a $75 million fine for what might be one of the biggest accounting scandals on record and managed to avoid using the word “fraud” to describe its actions. Carefully crafted by Citigroup’s attorneys, the terms of the settlement were clearly designed to protect executives from liability and undermine shareholder’s seeking to recover their losses.

Goldman Sachs executives similarly managed to escape blame stemming from the SEC’s accusation that the firm inappropriately constructed the ABACUS CDO transaction. To recall, Goldman created ABACUS so that its clients would unknowingly invest in securities design to fail. To avoid admitting fraud and spare the reputations of senior-level executives, Goldman paid a fine of over $500 million. The settlement was so favorable to Goldman Sachs that its stock price rose 5% percent.

The SEC’s lackluster enforcement record during the financial crisis stands in stark contrast to the country’s state regulators. Attorneys General and securities regulators from many states have done all the heavy lifting, and have extracted meaningful settlements along the way. Most notable is Massachusetts Secretary of State William Galvin. Among Mr. Galvin’s accomplishments is ordering Bear Stearns to pay back 100 percent of any losses suffered by Massachusetts residents who invested in the firm’s infamous, sub-prime laden, hedge funds that spectacularly collapsed in 2007. He also was among the earliest regulators to take action against Wall Street for misleading investors about auction rate securities and he has ordered the Madoff feeder-fund Fairfield Greenwich to pay its investors every penny they lost.

Another active state enforcement official is Mark Connolly, Director of Securities Regulation for New Hampshire, who has accused UBS of fraud for its sales practices related to Principal Protected Notes issued by Lehman Brothers. His case is especially notable because unlike the SEC, he isn’t afraid to use the word “fraud” to describe “misleading investors.”

I could write for hours about all of the significant cases filed by state regulators, but there is a common theme: state securities regulators help investors recover losses from fraudulent schemes and seek to deter it from happening again within their borders.

Unfortunately the same cannot be said of the SEC.

SEC Settlements Lack Personal Accountability

When a corporation commits fraud, should the S.E.C. just go after the corporation, or should corporate executives also be held personally accountable? That is a question the SEC is apparently struggling with.

After the SEC announced its $75 million settlement with Citigroup for failing to disclose $40 billion worth of toxic subprime mortgage investments to shareholders, SEC enforcement director Robert Khuzami touted that his settlement “sends a message within the company,” and “it sends a message to the industry.”

I disagree that company fines alone deter wrongdoing. I believe the SEC needs to hold high-ranking individuals liable.

Just a few days before the Citigroup settlement was announced, the SEC announced it had reached a $100 million settlement with Dell for overstating its earnings. Michael Dell and Kevin Rollins, the current and former CEO, were each fined $4 million, and James Schneider, Dell’s CFO, was fined $3 million. In announcing the settlement, Mr. Khuzami’s stated that, “Accuracy and completeness are the touchstones of public company disclosure under the federal securities laws. Michael Dell and other senior Dell executives fell short of that standard repeatedly over many years, and today they are held accountable.”

Though Mr. Dell and his cronies probably got off easy, at least they were asked to pony up more than a few thousand bucks. The only Citigroup executives that were fined were the CFO and the IR executive, who paid a paltry $180,000 collectively.

A great example of how personal liability can send shockwaves throughout an industry is the WorldCom class action case, which was led by former plaintiff’s attorney and current candidate for New York Attorney General Sean Coffey. He recovered $6 billion for shareholders and forced WorldCom’s directors and officers to contribute $24.75 million, which was 20 percent of their net worths.

Commenting about Mr. Coffey’s settlement, the CEO of Glass Lewis said, “This may be one of the most important steps toward reinforcing the importance of performing the directorship duties with fidelity toward shareholders. It’s going to be very sobering to board members around the country.”

Corporate executives, especially on Wall Street, could use a similarly sobering moment after operating with impunity for years.

Bank Stocks the Next Tech-Bubble?

It comes as no surprise that the subprime/credit crunch crisis has led to an increased level of securities class action filings. Research firm Cornerstone just released a report which shows the financial sector was the target of the most filings with 63 in the first half of 2008 alone. The research is an indication that many believe there are disclosure issues which led to inflated stock prices.

But another area of concern is that brokers made speculative plays in these stocks on behalf of their retail clients. Sensing a bottom, many brokers loaded up their clients with stocks like Citigroup, Merrill Lynch, and even Bear Stearns. Trying to catch a falling knife is not an appropriate recommendation for an investor with amoderate or conservative risk profile and we are seeing such complaints become more common.

Clearly, brokers fell asleep at the wheel on two levels: there was no reasonable basis for expecting the financial services industry was finished with its subprime write-downs unless they were duped nor was there any reasonable basis for many investors to buy financial stocks during the past year and a half.

During the tech-bubble, we filed many claims on behalf of investors whose brokers pushed them into bottom fishing for tech stocks that were rightly beaten down. This is another example of Wall Street’s history repeating itself.

Needless to say, any broker who recommended buying bank stocks in the past year and a half should be prepared to explain their rationale in an arbitration hearing.

The Hapless Members of Citi’s ELKS Club

It’s only a hunch, but experience tells me you can soon expect to be reading a lot about “ELKS” and other structured investments in the business press.

The name evokes images of a hardy, austere and stable animal able to withstand the harsh elements of the forest. But not in this story. For some Citigroup customers, ELKS might conjure images of a broker who duped you into buying risky securities that were inappropriate with your investment goals.

Citi’s ELKS (equity linked security) product is a risky derivative instrument where an investor is offered a specified return on a structured security tied to an individual stock. Providing the stock maintains a minimum value, the guaranteed return is paid. If the stock ever falls below the minimum value (sometimes around 80 percent), the ELKS immediately convert into shares of that stock. Then if the price of the underlying stock declines, the investor could receive a stock worth much less than the initial investment.

Here’s the catch: ELKS offer potentially higher returns, but the downside risk is unlimited if the stock goes south. If the underlying stock happens to dramatically increase in value, the investor only gets the guaranteed return.

For Citigroup, it’s a classic case of “heads I win, tales you lose.” The bank charges investors an upfront commission to buy ELKS and likely earns additional profits through hedging. Not surprisingly, brokerage firms were aggressively peddling structured derivative products like ELKS to unsophisticated retail investors a few years back, prompting FINRA to warn member firms of concerns that customers didn’t understand the inherent risks.

There’s evidence that FINRA’s warnings weren’t heeded. I represent a retired couple over 80 whose Citi broker last year bought $300,000 worth of ELKS on their behalf. The ELKS were highly unsuitable for retirees simply looking to preserve capital. The highly volatile stocks my client’s ELKS were derived from included Yahoo!, Cemex and Sandisk. The couple has lost nearly a third of their principal as the underlying stock’s value plummeted.

Admittedly, I have only encountered one ELKS case so far, but many brokerages firms peddled similar products using monikers such as PACERS, STRIDES, SPARQS, and ELEMENTS. Some commentators were critical of me when I sounded the early alarm about auction rate securities, but that warning proved quite prescient. Recall, that the SEC uncovered wrongdoing in the ARS market in 2006, but the activity persisted. Sadly, I can’t help but suspect that the experience of my elderly clients with ELKS is not an isolated incident.

Stay tuned.

The Piety of Henry Blodget

Henry Blodget and I have a history, there’s no denying that. Back in 2001 I sued him and his former employer Merrill Lynch for fraudulently touting tech stocks that Mr. Blodget privately confided were “POS,” “pieces of junk” and “pieces of crap.” My case caught the attention of former New York Attorney General Eliot Spitzer and ultimately led to the $1.4 billion global settlement and Mr. Blodget’s lifetime ban from the securities industry.

Although countless investors lost hundreds of millions of dollars because of his bogus research reports (and he was allowed to keep most of the millions of dollars he was paid to write them), Mr. Blodget has refused to fade from the limelight he once enjoyed. He has successfully transformed himself into a prolific journalist, penning commentaries in august publications such as the New York Times and running various websites including Clusterstock, which specializes in stock research. Given his disgraced past, that takes real cajones.

Last week Clusterstock launched a mild broadside at yours truly, questioning my transparency though essentially conceding the merits of my argument regarding a blog post I wrote on some failed Citigroup hedge funds. The site says Mr. Blodget agrees that “it is possible” that I’m correct in speculating that Citi’s brokers were likely instructed to market the collapsed hedge funds as conservative investments “but he would like see evidence of this.”

Mr. Blodget understands full well how the game is played, particularly since Merrill’s brokers dutifully peddled his research to clients, even when they began to openly question the integrity of his analysis. Furthermore, the Wall Street Journal recently quoted a Smith Barney broker as saying, “”That’s why they bought it,” said the broker whose clients, many of them wealthy retirees, invested in the Falcon fund. “These kinds of clients weren’t looking for a home run.”

Interestingly, Mr. Blodget remained mum on my comment that Citi was positioning its own brokers as fall guys, when in all likelihood they were merely following the direction of the company’s wealth management executives. I’d expect this comment to strike a particular nerve given that Mr. Blodget took the fall for Merrill’s conflicted research while his senior managers was given a free pass. As I noted in my earlier post, Wall Street’s senior executives almost never are held accountable for the wrongdoing under their watch.

Finally, there is Mr. Blodget’s issue with my transparency:

Since Zamansky is taking a stand for “transparency,” Blodget thinks it might also have been appropriate for Zamansky to disclose that he is in the business of suing companies based on allegations like the ones above.

Setting aside the irony of Mr. Blodget requesting transparency, my interests in the Citi hedge fund post were patently obvious. But in deference to Mr. Blodget’s new found piety, I must point out that in my blog post I referenced angry calls from investors who are my clients. If that wasn’t clear enough, my biography is clearly posted on Seeking Alpha, a financial blog aggregator which is where Mr. Blodget originally saw my post. And finally, my blog post first appears on my law firm’s website.

Most people in the industry know – Mr. Blodget certainly one of them – that I represent investors who have been harmed and abused by Wall Street.

Suffice to say, I never thought I’d see the day when I’d be holding myself accountable to Henry Blodget. Perhaps that explains the pigs I’ve just seen flying past my office window.

Falcon Falling: Citi’s Hedge Fund Litigation Problem

I’m no expert on public relations, but I’d expect the flacks at Citigroup would go to great lengths to avoid maligning the firm’s Smith Barney brokers. But the financial giant’s public defense for peddling risky proprietary hedge funds to wealthy clients seeking conservative investments implicitly undermines either the integrity or the competency of the firm’s brokers.

“Our disclosures and marketing material sufficiently outlined the inherent risk in the funds and their leveraged strategies,” an unnamed spokesman said in a statement issued to the Wall Street Journal regarding the firm’s Falcon and ASTA/MAT hedge funds, which have lost about 75 percent of their value in the past year.

Oh really? Well if the disclosures were so sufficiently outlined, then how come I’m getting calls from outraged clients who vehemently insist they bought into the hedge funds because they were repeatedly assured by their brokers that the funds were extremely low-risk investments? Smith Barney brokers themselves apparently are even willing to acknowledge that these assurances were given. I quote verbatim here from The Wall Street Journal:

Citigroup brokers and fund managers assured prospective investors that the new hedge funds were low-risk, with Falcon likely to post losses of no more than 5% a year in the worst-case scenario, according to people familiar with the situation.

“That’s why they bought it,” says a Smith Barney broker whose clients, many of them wealthy retirees, invested in the Falcon Funds. “These kinds of clients weren’t looking for a home run.”

Investors rely on the overtures of their brokers, who fashion themselves as financial consultants or advisors, not highly compensated salespeople. “We make money the old-fashioned way. We earn it” – as Smith Barney used to say.

Unfortunately, most brokers don’t have the training or the acumen to understand highly complex and sophisticated financial instruments. So they dutifully rely on the representations given to them by their superiors, who are richly compensated for moving the products out the door.

Herein lies the vicious circle: Citigroup concocts inherently risky funds for its brokers to sell to their wealthy clients that generate handsome fees for the firm and commissions for its brokers. The brokers are told to market the fund as a “conservative” investment, notwithstanding that fact that the funds are so levered that a few ticks the wrong way causes the house-of-cards to collapse. The brokers mimicked the company’s recommended sales pitch to their clients and successfully wrangled hundreds of millions of lucrative assets.

Citigroup, understanding that it has a significant legal liability on its hands, publicly insists that company sufficient disclosed the risks when it marketed the funds. If that was truly the case, the brokers who marketed the funds will deservedly be held legally accountable for failing to educate their clients about the obvious risks.

But more than likely, many of the Smith Barney brokers who marketed the funds themselves were likely led to believe the funds were in fact “low risk.” At a minimum, there was a lack of due diligence. Now that markets are under pressure, Citigroup wants to shift the onus of blame to its brokerage force, rather than hold its wealth management executives accountable. Blaming the folks who followed orders – rather than the ones who gave them – is the way Wall Street works.

Chairman Waxman’s CEO Compensation PR Stunt

Next month, Congress will be schlepping in the former chief executives of several financial services firms damaged by the subprime crisis to question them about their compensation packages. House Oversight and Government Reform Chairman Henry Waxman (D-Calif.) has sent letters to Angelo Mozilo, CEO of Countrywide Financial, Charles Price, former CEO of Citigroup and Stanley O’Neil, former CEO of Merrill Lynch. According to reports Chairman Waxman intends to ask them why they “stand to collect tens of millions of dollars in severance payments and other compensation,” even as their current and former companies are losing billions of dollars in the subprime mortgage meltdown.

It’s certainly understandable to perceive these golden parachutes as obscene. Mr. Mozilo is supposedly getting more than $110 million on top of the $47 million he got last year, while Countrywide Financial erased billions of dollars in shareholders equity. Mr. Prince is allegedly getting more than $29 million in “accumulated benefits” and supposedly even received a bonus for 2007. Mr. O’Neal walked away with more than $161 million in “accumulated benefits.” Citigroup and Merrill together have written down more than the GDP of most third world countries.

By any measure, paying these men hundreds of millions of dollars for their recent performance is not justified – which is exactly why Mr. Waxman is calling in the wrong people. It should instead be the corporate board members overseeing the compensation committees that should explain the payouts. Maybe executive compensation consultants hired by corporate boards should face questioning too, such as Hewitt Associates of Lincolnshire, Illinois, and Mercer Human Resources, which were involved in the decision to give Dick Grasso over $100 million. The ones who accepted authorized pay shouldn’t be flogged.

The individuals Chairman Waxman should have sent letters to include Harley Snyder, CEO of HSC, Inc., John Finnegan, Chief Executive Officer of The Chubb Corporation and Alan J.P. Belda, Chairman and CEO of Alcoa, who chaired the compensation committees of Countrywide, Merrill Lynch, and Citigroup, respectively. Hopefully not lost on Chairman Waxman would be the fact that all these men hold the title of CEO. In this elite fraternity, sometimes one hand washes the other. For example, Mr. O’Neil was just named to the board of Alcoa. It would of course be too obvious of a conflict for Mr. Prince to serve on Alcoa’s board, so Mr. Belda got the next best thing. The point is, those holding the power don’t have the motivation to change the status quo.

Chairman Waxman needs to get to the source of the problem which lies squarely with the board of directors and compensation committee members. Not holding them accountable is like patching a leaky roof with duct tape every time it rains. Unfortunately, without their presence next month’s hearings are the equivalent to nothing much more than a witch hunt wrapped-up in a PR stunt.

If Chairman Waxman was truly interested in relating compensation to performance, why stop at publicly held companies? He should call in sports stars like Alex Rodriguez, Carl Pavano, and Albert Belle, notoriously over-paid underperformers. I know what you’re thinking. Congress holding hearings with professional baseball players sounds ridiculous, doesn’t it?