Timely Objections Blog

Yesterday, Standard & Poor's relieved the Eurozone's bail-out fund, the European Financial Stability Facility ("EFSF") of its AAA credit rating, possibly hampering the fund's ability to contain the European debt crisis. This comes on the heel's of the S&P stripping both France and Austria of their triple-A rating in favor of a rating of AA+.[1] The effect of the S&P downgrade may be negative. Ratings agencies exist to level asymmetries in information and evaluate risk but one of their inherent oddities is that they seek to compare things whose differences in scale make them incomparable. Ratings agencies also have conflicts of interests, they often evaluate financial products (like collateralized debt obligations) that they do not understand, they seem to lack fixed ways to measure absolute risk, and they are at times, catastrophically wrong.

Elephants and aardvarks

Downgrades should not be considered in a vacuum. When the ratings agencies equate economies based upon ability to repay debt, they artificially equate countries disregarding factors such as size, geo-political risk and political infrastructure that make their comparisons odd.

S&P announced on August 5, 2011 that it would downgrade the credit rating of the United States. Interestingly it announced during the last day of this same month that while the world's only superpower and largest economy would now get only a AA+ rating, securities backed by sub-prime home loans, the same type of investments that led to the worst financial debacle since the Depression (and one from which we have not yet arguably recovered) would receive its once coveted triple AAA rating...unlike the United States.

There is no question that the United States will be able to repay its debts, we will continue to print more money-the larger issue is the continual erosion in the Dollar over time. Although a currency cannot be devalued ad infinitum without catastrophic results, at least for the time being, there is no credible replacement for the Dollar continuing to be the world's reserve currency. No other nation has the assets to back up being the world's reserve currency.

Looking at the S&P's downgrade of the United States in a vacuum, one would think that it is more prudent (according to all three ratings agencies), to prefer Austria, Denmark, Norway, France, Germany, Singapore, Luxemburg, the Swiss or even Finland. There is no consensus by all three agencies on countries like Hong Kong, Australia and the Isle of Mann. Yet other than ratings, the similarity ends there. Comparing the United States, the largest and most analyzed economy in the world with relatively petite nations like Luxemburg and Finland are like comparing the teeth of an otter and an elephant-one is so remarkably larger than the other that a comparison seems problematic. Admittedly both animals have teeth. Or like comparing the speed of an elephant and an aardvark.

To put the utility of comparison between the United States, which has a GDP of $14.657 trillion, in perspective, here are the GDPs of some of the remaining triple AAA rated countries in 2010 according to the IMF [2] :

• Luxemburg has a GDP of $52.43 billion,
• Germany's GDP is $3.314 trillion (largest in the EU)
• France $ 2.582 trillion,
• United Kingdom $2.172 trillion
• Lichtenstein $4.83 billion
• China $10 trillion (largest behind United States)

Comparing the largest most innovate, most scrutinized economy in the world to a nation like China is humorous because in terms of actual accounting standards, any meaningful transparency, the complete absence of a stable democracy or political freedoms-China is a peasant country. When the United States is downgraded, there is no other United States to compare it to, so to some extent, the rating downgrade may not be absolutely everything the media proclaims it to be.

Effect of downgrade on United States so far

When the markets opened on the first Monday after S&P's downgrade of the United States, the benchmark 10-year Treasury bond's yield dropped to 2.5%. Price, which is inverse to yield in bonds, has continued to increase even approaching all-time historic levels. This past August, the 10-year yield dropped almost 60 basis points, piercing below 2% (lower than their historic all-time low in 2008 when Lehman Brothers collapsed). The demand for United States' Treasuries has increased dramatically immediately following the S&P downgrade.

If the United States were deemed less credit worthy (less likely to pay its creditors), then investors and bond holders would demand higher returns for buying any U.S. debt/bonds. The very ability of the United States to borrow money by issuing bonds would be jeopardized. The market has ruled against this logic and to a large extent against S&P-justifiably so.

Remember a government bond is a debt instrument issued by a national government denominated in that government's currency. United States Treasury securities are valued in US dollars-their price is in United States Dollars.

A risk-free interest rate is the nominal rate of return for an investment with no risk (no credit risk) [3] of financial loss. The risk-free rate of return for almost all this century was the yield of United States Treasuries.

graph.pdf

Why would the market seemingly disregard the opinion of S&P? Perhaps because many people remembered that during the housing bubble, sketchy loans (once again I proffer this as a new legal term of art) were repackaged by investment banks into investment pools and other mortgage backed securities and received the gold standard of financial ratings, the coveted and in theory elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody's. S&P's granting of triple AAA ratings to companies and investment vehicles that turned into junk ratings caused $2 trillion in losses to everyone that relied on them-basically, everyone. No one else seemed to find it ironic that this same agency told the United States by how much it thought its debt should be lowered.

Conflicts of interest and fraud

But back to the credit ratings agencies... Not that long ago, in August 2010 and again in July of 2010, the SEC threatened to charge all three ratings agencies with fraud. Some would say better late than never. During the housing bubble, sketchy loans (I use this as a new legal term of art) were repackaged by investment banks into investment pools and other mortgage backed securities and received the gold standard of financial ratings, the coveted and in theory elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody's. The agencies' granting of triple AAA ratings to companies and investment vehicles that turned into junk ratings caused billions if not trillions of dollars in losses to everyone that relied on them-basically, everyone. The credit ratings agencies are paid by the issuers (their clients) of the securities they were supposed to evaluate, creating an inherent conflict of interest. They were the game's referee and one of its players at the same time.

The SEC report on Credit Ratings Agencies from June 2007 identified another problem other than having the referee in a match being paid by one of the sides, (not the investors or the public's side mind you), that prevented the agencies from giving accurate ratings. The agencies could not give accurate ratings of many of the instruments involved in the housing bubble and credit crisis because of the complexity of the transactions involved and the inability of agencies to understand what they were analyzing.

One could argue that the agencies were not engaging in a deliberate (alright not a horribly deliberate) fraud, that is having a public position of trust, being paid and knowing they cannot do what they are assigned to do but pretending to do it anyway. Mind you, if anyone else had engaged in this behavior, they would have likely been indicted for fraud and possibly RICO.

What may let the agencies off the hook is that they relied on the issuers' (the clients again, usually investment banks) audit committees. Audit committees cannot seem to be comprised of Chia Pets in human dimension. The fact that these committees represented having signed off on the financial instruments in question should mean something-if not, why have these corporate committees?!

Furthermore, one could argue that the credit ratings agencies must not be held responsible for their ratings because they did not and could not have understood the trading transactions taking place at the investment banks because they had to rely on the information they were given which was not itself transparent.

A possible longer term solution to the conflict of interest driven nature of the credit ratings agencies is to take away the compensation structure of the credit ratings agencies and deregulate them completely in-order to discourage inherent conflict of interest or use the Credit Spread Market-problem solved! Take away what is essentially a government-sponsored monopoly of credit ratings agencies and allow investor paid credit ratings agencies, which could open up the market and privatize the ratings industry. Without credit ratings agencies, the market will determine value more efficiently than the analysts at the agencies. A problem with this approach is that there might be variance between the ratings of twenty agencies as opposed to just three, causing the rating on any one agency to mean less and to make more work for risk managers.

No liability

S&P has somehow avoided to this very day, all criminal and civil liability for its part in the most recent financial crisis. If the agencies had some liability for their ratings, they may have a better incentive for assuring that they got them right. Neither the Justice Department nor the SEC (which has itself managed to miss all the major financial debacles of the past five years) has ever charged S&P with criminal conflict of interest (as they in practice do and would do to any number of much smaller economic participants with a much smaller fields of damage). Neither the Justice Department nor the SEC has gone after S&P for admitting before Congress in 2008 and 2009, that their being paid by the issuers (their clients) of the securities they were supposed to evaluate, created an inherent conflict of interest and did in fact wrongly influence their ratings.

Nobody has charged the S&P with criminal fraud or fraud on the marketplace for taking money from issuers in simple bad faith (playing the part of the referee and judge in a boxing match after being paid by one of the boxers) for rating securities, they admitted in sworn testimony they did not understand!

This sordid tale has no end. According to Bloomberg, S&P is giving its self-coveted triple AAA rating to junk,

"Standard & Poor's is giving a higher rating to securities backed by subprime home loans, the same type of investments that led to the worst financial crisis since the Great Depression, than it assigns the U.S. government.
S&P is poised to provide AAA grades to 59 percent of Springleaf Mortgage Loan Trust 2011-1, a set of bonds tied to $497 million lent to homeowners with below-average credit scores and almost no equity in their properties." [4]

A spokesperson for S&P when asked about why it would give its higher rating of triple AAA yet again to subprime securities repackaged by many of the scions of AIG and Goldman that participated in causing the Credit Crisis and profited from its bailout simply stated, "We believe our ultimate success will be driven by the value investors derive from our ratings and analysis."
However, it is not honest, however much one is paid, to issue a triple AAA rating to what Bloomberg calls,

"More than 14,000 securitized bonds in the U.S. are rated AAA by S&P, backed by everything from houses and malls to auto- dealer loans and farm-equipment leases, according to data compiled by Bloomberg,"

and not the United States of America.

Relatively speaking

Size matters. Pension funds and many of the largest institutional investors have rules about what investments they may invest in and these rules are based on the ratings given to investments by the credit ratings agencies. Consider that Australia, Andorra, Bermuda, Canada, Cook Islands, Denmark, Estonia, Finland, Germany, Hong Kong, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland, and the United Kingdom retain their triple-A ratings.[5] These countries represent less than 21% of the world's collective GDP...my math may be slightly off. If investment funds were limited to investing in triple-A products, it would be preposterous to think that less than 21% of the economy of the world would fund the remaining 79%.

Another weakness of the credit ratings agencies is that there is no set standard employed for measuring absolute risk. What I mean by absolute risk is the measure in gambling parlance, of the risk of ruin. Wall Street and regulators have, in the example of a bank lets say, no better way other than asking for capital ratios to ascertain a bank's risk or ruin. Other factors, like the value of assets and counterparty transactions lack still, even in 2012, transparency.

Because the credit ratings agencies share this problem of being unable to objectively ascertain absolute risk, they lag the markets' own detections of absolute and relative risk. For example, the agencies did not foresee the Latin American debt crises, the European debt crisis, AIG, the Credit Crisis, Enron, Worldcom, or even MF Global. In this sense, credit ratings agencies look backwards better than they can look ahead. Arguably, there are extremely few economists or market participants that can look ahead-this may be a wholly unfair criticism...except this is part of the reason for having the ratings agencies.

The most obvious problems with the existing regulatorily instituted regime of three credit ratings agencies is that they have no competition, no real accountability because they have to be utilized even when wrong, and no liability. This oligopoly ought to be dismantled and the private sector should be allowed to get into the ratings game in the same way that analysts exists in the financial markets for every other type of investment. Doing so would eliminate the existing conflicts of interests within the credit ratings agencies and allow investors to pay the private ratings agencies for their research. Competition will have to drive the caliber of research and ratings upward.

Sadly, nothing in the gargantuan 2,300 page Dodd-Frank Act or that has been discussed in the Senate Committee on Banking, Housing and Urban Affairs addresses the problems with the credit ratings agencies...the same ones that contributed to our recent financial crisis.@

R. Tamara de Silva

Chicago, Illinois
January 17, 2012

R. Tamara de Silva is an independent trader and securities lawyer

Footnotes:
1. The EFSF's ratings are derived from its backers and France and Austria were two of the largest guarantors behind Germany. S&P's downgrade of the EFSF will mean the fund has 440 billion less in Euros than before the downgrade.
2. These numbers are adjusted by PPP (purchasing power parity), basis-this takes into account, relative cost of living and inflation rates, rather than just exchange rates.
3. There are other risks like inflation risk (the principal returned on a debt instrument upon maturity would have less purchasing power) and currency risk (the Dollar could as it has, decline in value relative to other currencies).
4. http://www.bloomberg.com/news/2011-08-31/subprime-mortgage-bonds-getting-aaa-rating-s-p-denies-to-u-s-treasuries.html
5. http://www.standardandpoors.com/ratings/sovereigns/ratings-list/en/us?sectorName=null&subSectorCode=39&filter=E

Last Thursday December 15, 2011 was MF Global Holdings Ltd.'s and MF Global Inc.'s Chief Executive Jon Corzine's third time to testify before Congress. He may not have faired all that well in light of Chicago Mercantile Exchange Group Chairman Terrance Duffy's testimony on December 13, 2011, which seemed to contradict Corzine's previous testimony. Corzine adjusted his testimony on December 15, 2011 to account for the seeming contradiction. However, how well Corzine may have done to avoid perjury or any role in a possible fraud remains to be seen. A closer examination of Corzine's testimony and the events leading up to MF Global's bankruptcy on October 31, 2011 suggests problems. If there is any purpose to be achieved in having Corzine testify again, lawmakers should focus their questions towards the failed purchase of MF Global by Interactive Brokers and all customer agreements, including emails between MF Global and account holders leading up to the purported transfers of $175 million and $700 million in as yet missing customer segregated funds and the firm's use of a type of repurchase agreement.

Were the Transfers Legal?

In my first article on MF Global, I suggested that the $1.2 billion missing from customer segregated funds may have been incurred due to over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (as they did in fact as yield curves doubled rapidly in some issues) during the last weeks of October, and that funds were transferred to cover margin in customer funds held in European debt. In this scenario, as I suggested, nothing illegal would have occurred because CFTC Rule 1.25 had been amended to permit the investment of customer segregated funds in foreign sovereign debt.

Moreover, if the money was transferred legally and without any fraud, but simply lost in the market, there may not be any right to recover the money by MF Global's customers in bankruptcy proceedings. The use of customer segregated funds for margin payments on repo-to-maturity ("RTM") transactions are not illegal and hence unlikely, without anything else, to be recoverable in bankruptcy.

An alternate illegal scenario is that MF Global may have engaged in some late stage embezzlement of customer funds that were supposed to be segregated from MF Global's accounts and never commingled with any other funds. [1] One way this may have occurred is if the funds were transferred out of customer segregated funds for a legal purpose but without the customers' meaningful consent or, more likely, with an intent to deceive the customer.

MF Global was permitted to invest customer funds, and borrow customer funds so long as the dollar value of the funds taken from the customer segregated accounts remained the same-the accounts were kept intact. For example, if MF Global used customer funds by transferring a specific amount of money out of customer segregated accounts; it was required to simultaneously deposit something of equal value in these accounts to equal the dollar value of what had been taken out.

If MF Global transferred customer funds out of segregated accounts as a loan to MF Global to cover margin calls in existing positions in sovereign debt, (perfectly legal) [2], it may however, be fraud and intent to deceive on its part if MF Global knew it could not repay the money. This fraud may have occurred if MF Global knew (and it would be interesting to argue how it did not) that it sought to legally borrow from customer funds, knowing that it was de facto insolvent and could not replace the money.

In other words, an acceptable use of customer segregated funds for margin payments may not exist if at the time MF Global made the transfers, it was insolvent or in the midst of a crisis where insolvency was around the corner to be seen. Even if MF Global asked for and obtained the consent of its of customers, or consent was not required according to customer agreements, and it legally borrowed the money from customers by replacing it with other collateral (collateral such as commercial paper, as permitted by CFTC Rule 1.25), the transfers would still be illegal because MF Global would be deceiving its customers-knowing it was already insolvent. Even though the rules likely permitted the replacement of funds with other collateral (and the collateral was used) MF Global's actions are arguably illegal because they were deceiving their customers knowing they would not be able to make the customers whole. Meaningful deception like this would be fraud and embezzlement in which case, the funds could be clawed back in bankruptcy proceedings-Please note that I am speculating a bit in specific statements about bankruptcy proceedings and do not specialize in this area of law.

Changing testimony or selective recall?

On December 8, 2011, Corzine testified before the House Agriculture Committee that he had "no idea where the money is" and that "I know I had no intention to ever authorize the transfer of segregated moneys. I know what my intentions were."

On December 13, 2011, Corzine testified that, "I never directed anyone at MF Global to misuse customer funds. I never intended to. And, as far as I am concerned, I never gave instructions that anybody could misconstrue."

On December 13, 2011 Terrance Duffy testified before the Senate Agriculture Committee. In Mr. Duffy's testimony he said that the CME has been conducting their own ongoing investigation of MF Global and discovered on December 10, 2011, after questioning a former MF Global employee who knew about the transfer of $175 of customer funds towards MF Global's broker dealer operations, that Corzine knew all about the transfers and likely authorized them.

On Thursday November 15, 2011 Corzine repeated that he did not authorize any illegal transfers, pointing to his General Counsel and Treasurer as the people who would know about the transfers. However, he was able to recall the $175 million transfer enough to tell the Committee that Duffy likely meant a loan advance from customer segregated funds to MF Global's European operations. Remember that all his previous testimony was to the effect that he, "was totally stunned to learn customer money was missing...did not learn about it until October 30, 2011...etc"- in this context it seems a tad odd for him to suddenly develop a very specific recall about one event of October 28, 2011. Sadly, this was wholly lost on the Committee, which asked not one follow-up question.

In addition to Mr. Duffy's testimony that a MF Global back office employee said Corzine was aware of the transfers, the Committee alluded to evidence that the Chief Financial Officer of MF Global's North American operations (presumably Christine Serwinski) said that Corzine knew about the transfers. If so, there are at least two or more MF Global employees and officers who contradict Corzine's sworn Sgt. Shultz testimony.

Not being perfectly honest with FINRA

On December 8, 2011, Steve Luparello, the Vice Chairman of the Financial Industry Regulatory Authority ("FINRA") also testified before the House Committee on Agriculture about MF Global's collapse. According to Mr. Luparello, MF Global was not completely candid with the Chicago Board of Options Exchange ("CBOE") and FINRA. In late September 2010, MF Global assured both regulatory bodies that it did not have any positions in European sovereign debt.[3] MF Global did in fact have positions in European sovereign debt during this time but because according to GAAP accounting rules, positions held in RTMs are treated as sales and not liabilities, MF Global did not violate the law in hiding its credit and risk exposure to RTM, which are liabilities in the real, non-accounting world. Technically, MF Global was able to get away with it, at least for a time.

A little background may be helpful and a story of another failed firm, Lehman Brothers that generously indulged in a cousin of RTMs, the Repo 105. The Repo 105 was utilized by Lehman Brothers, among other firms that did not survive the last financial crisis including Washington Mutual, Northern Rock and some that did like Citigroup.

This is how it worked and how a liability (a loan) can be transformed into a revenue-generating event (a sale)...if you are an investment bank that is. Lehman entered into repo transactions with offshore banks. Lehman would sell (though actually a loan) a bundle of toxic assets such as sub-prime mortgages and dubiously collateralized debt obligations to the bank. This transaction is characterized on the books of Lehman as a sale. Lehman agrees to buy back or repurchase (hence the term 'repo') the toxic assets at a later date (maturity). In this way, Lehman moves loans and bad assets off its balance sheets towards the end of each financial quarter-removing liabilities dramatically improves a balance sheet- as if they do not exist. Then Lehman reports the sale as a revenue-generating event, in effect moving by way of example, $39 billion off its balance sheet in what is a liability, and reporting it as a sale of $39 billion. It is fraudulent twice over in that Lehman does not disclose on its financials that it has an obligation (a debt to buy back) to pay back the amount loan and it reports the loan as revenue.

In effect, this is what MF Global did with FINRA and CBOE. However, the regulators caught MF Global's exposure to European sovereign debt and told MF Global to keep substantially more money in reserves because of what FINRA identified in May 2011 as a $7.6 billion risk exposure. MF Global appealed to the SEC and because of the appeal process, it was only in August that FINRA and the CBOE were successful in getting MF Global to put up more money for its European debt exposure and utilization of RTMs.

An accounting error

Also on December 15, 2011, the oversight panel of the House Financial Services Committee released a CME Group document the CME had given to the government containing a detailed log of its dealings with MF Global between October 24, 2011 and October 31, 2011. According to this document, Christine Serwinski, the Chief Financial Officer for North America at MF Global, and its Assistant Treasurer, Edith O'Brien, told a Mike Procajlo, an exchange auditor at 1:00 a.m. on Oct. 31, 2011 that the customer money was transferred on Oct. 27 and Oct. 28 and possibly Oct. 26, 2011. "About $700 million was moved to the broker-dealer side of the business to meet liquidity issues in a series of transactions on Thursday, Friday and possibly Wednesday," Serwinski told Procajlo about eight hours before the firm filed for the eighth-largest bankruptcy in United States history.

Barely three days prior, on October 28, 2011, MF Global had submitted a statement to the CME showing that it had $200,178,912 in excess cash in its customer segregated funds as of the close of October 27, 2011.

On October 30, 2011, an official from the CFTC informed Procajlo that a draft statement of the value of MF Global's customer segregated funds, showed a deficit in customer segregated funds for the day ending October 28, 2011. MF Global's Assistant Controller, Mike Bolan and its General Counsel, Laurie Ferber said they believe the customer-funds deficit is "an accounting error." Ms. Ferber had told the CME on October 25, 2011 that rumors about problems stemming from MG Global's European debt trading were not accurate.

On December 15, 2011 Mr. Duffy told the House Committee that this so called accounting error was "a telling sign that regulators were being kept in the dark" about MF Global's customer accounts. What was Corzine doing during all of this?

Acquisition by Interactive Brokers

While the exchange was trying to get to the bottom of the accounting error, whose magnitude would not be revealed until the evening of October 30, 2011 as being $900 million, Corzine and other MF Global officials were trying to close a deal to sell MF Global to Interactive Brokers Group, Inc. On that same day, October 30, 2011, MF Global issued a press release at 6:00 p.m. announcing that it had reached a deal with Interactive Brokers.

Corzine as CEO of MF Global negotiated the potential sale of his firm to Interactive Brokers. The first question involved in any sale of a going concern involves the determination of an acquisition price. Corzine would have had to know what the assets and liabilities of MF Global were (the balance sheets) to even begin to negotiate a price. The deal was happening at the exact same time of the transfers.

It is beyond the bounds of credibility to argue that MF Global did not have regular if not daily accounting of cash balance sheets and that Corzine did not see them. If Corzine knew what the company was worth, during the very days in which at least $900 million in customer segregated funds was lost, he must have at a minimum known about the company's impending insolvency. How then could he not have known of the transfers?

In addition, as a matter of course in the futures industry, MF Global likely had to report the total daily amounts carried in segregated funds to the CME-it certainly had to do so from October 24, 2011 onwards. This computation is performed as a matter of course every single day at every futures broker.

Corzine's testimony before Congress would have us believe that hundreds of millions of dollars were moved around without the knowledge or approval of the MF Global's CEO and CFO all while the balance sheets were being scrutinized for an acquisition by Interactive Brokers, which Corzine spear-headed.

Corzine has sworn under oath that he did not know anything about the missing money until October 30, 2011. This is simply not possible.

Suggestions for House and Senate Committees

Further education about the industry is in order. Both the House and Senate soft-peddled the issues, and perhaps unintentionally avoided important questions and asked almost no meaningful follow-up questions, allowing Corzine to stretch the bounds of credibility in evasiveness. Further questioning should focus, among other things, on the representations made by MF Global to Interactive Brokers on October 24, 2011-October 30, 2011.@
R. Tamara de Silva
Chicago, Illinois
December 19, 2011

R. Tamara de Silva is a securities lawyer and independent trader

Footnotes:
1. http://www.timelyobjections.com/john-corzine/
2. Remember CFTC Rule 1.25 which had been amended to allow the investment of customer segregated funds in foreign sovereign debt, was amended back after the fall of MF Global to disallow the investment of customer segregated funds in foreign sovereign debt.
3. http://www.finra.org/Newsroom/Speeches/Luparello/P125233

November 29, 2011

This is the legal version of an NFL upset alert. On November 28, 2011, United States District Judge Jed S. Rakoff rejected what would have been the sixth civil settlement agreement between Citigroup Global Markets Inc. ("Citigroup") and the Securities and Exchange Commission ("SEC") since 2003. The SEC filed a complaint against Citigroup in October because Citigroup had peddled $1 billion in mortgage-bonds through a vehicle called Class V Funding III, without disclosing it was betting against $500 million of those assets-in essence offering something to its customers and not disclosing that it would be betting against them.

Contrary to press reports of the decision, Judge Rakoff is not being an activist judge or legislating from the bench when by refusing to uphold the $285 million settlement agreement. This Judge was upholding (and not without an insignificant amount of courage), the law. Perhaps even more importantly, his decision is a victory for the separation of powers doctrine.

Standard of Review

Civil settlements between the SEC and other parties, or what are alternatively called, consent decrees, are essentially permanent injunctions in that they forbid the party that is accused of violating some part of the securities laws from ever doing so again-often even attaching various conditions and stipulations meant to be honored for all time. The SEC in its filings prior to its last filing (a memorandum in support of a consent order), addressed the legal standard of review required for a court to grant a consent order, except this time when they asked the Court to finally grant the order, they did not fully address the standard of review.

By way of some background, usually, it is the function of the Legislature to make laws that proscribe conduct-not the Judiciary. It is an extraordinary thing to ask a court of law to permanently rule that someone is forever barred from doing something-injunctive relief is an extraordinary remedy because it throws the full weight of the court into what is the de facto making of a law-a judicial order. Breach of a Federal injunction can have criminal consequences-a Federal injunction is no common thing.[1]

The United States Supreme Court established in numerous decisions that there is a four part test courts must use in granting injunctions. Before granting an injunction, a court must determine that the granting of the injunction is at once: 1) fair; 2) reasonable; 3) adequate, and 4) in the public interest (emphasis added). Ebay Inc. v. MercExchange, 547 U.S. 388, 391

The SEC remarkably pled that they need not address the "public's interest," part of the standard of review and that even if they did, they alone could decide that something is in the "public interest." The SEC's argument if followed would abrogate a power given to the court and yet ask the court to stamp its imprimatur and issue an order-thereby making the SEC the judge, jury and executioner.

The Justice Department is part of the Executive Branch and were the Judiciary merely to rubber stamp all settlements entered into between the departments of the Executive Branch and private parties, turning them into judicial orders on the say so of the Executive Branch or other government agencies and departments, the separation of powers would very meaningfully cease to exist. The courts would become in every sense the handmaidens of the Executive and other government agencies, or as in this case, the SEC.

Purely private parties can settle a case without ever agreeing on the facts, for all that is required is that a Plaintiff dismiss his complaint. But when a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importanc

e. pp. 8-9

What Judge Rakoff did in denying the SEC's request for a consent order was have the courage to point out to the SEC that it cannot alone, ignoring case law, determine the standard of review for the judicial approval of the civil settlement between itself and anyone else.

Settlement agreements between the Justice Department and SEC and private citizens are not like settlement agreements between two private parties in a civil matter or easement dispute. More often than not, the SEC presents an individual or concern with a choice between settling a complaint (not a conviction-we are at the stage of a mere accusation) for a fine or facing criminal prosecution against the full force of the United States Department of Justice and every means at its disposable (unlimited). This is Hobson's choice itself. Somewhat analogous to my accosting a stranger and offering the following choice, "I will beat you to a pulp and it will cost every penny you have to recover medically and years of care or, you may pay me $100,000 and we will pretend this never happened." Of course if it were proven that I did this, I would be unceremoniously tossed in a room not of my choosing for some duration and accused of extortion...but I am not the government. Neither are private civil settlements comparable to civil settlements with the SEC or Justice Department.

Judge Rakoff's Ruling

Judge Rakoff also went on to say in his memorandum and opinion that he would no longer approve of SEC settlement agreements that involved the defendants not providing any admissions of wrong-doing, "because the court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment".

In other words, the courts cannot determine what is fair or adequate about a consent agreement between a government agency and private party without some evidentiary basis or knowledge of the facts.

An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous. The injunctive power of the judiciary is not a free- roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated. If its deployment does not rest on facts-cold, hard solid facts, established either by admission or by trials-it serves no lawful or moral purpose and is simply an engine of oppression.

Finally, 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 much of the world, propaganda reigns, and the truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency's contrivances

.pp 14-15.

Citigroup is as the Court points out, a bit of a recidivist. Citigroup has signed many settlement agreements with the SEC without admitting any wrongdoing. It is almost a get out of jail for free card for a fee. Surely there is a purpose to these agreements than merely generating revenue for the SEC by making Citigroup part with pin money? Are these settlement agreements, as the Court and Bloomberg's Jonathan Weil have asked, merely considered the "cost of doing business" or some part of a transaction tax on offending financial titans?[2]

If it were in the public's interest to prevent fraud upon the market, then fines should be significant enough to actually deter illegal conduct. If not, prosecutions should be endured and convictions gotten. The historic role of punishment in the criminal justice system has not been just punishment, but deterrence. In the case of the settlement agreement at hand, the actual fine was $95 million with the suggestion that Citigroup pay up to $285 million-this is pin money to a bank with revenue in the billions of dollars-the "cost of doing business" will not deter anyone, nor is its pursuit an enormously wise use of taxpayer funds-certainly not according to a cost benefit analysis. @

R. Tamara de Silva
Chicago, Illinois
November 29, 2011

R. Tamara de Silva is a securities lawyer and independent trader

Any questions about this article should be directed to tamara@desilvalawoffices.com
Footnotes:
1. The power of the Federal court to protect and enforce its judgments is unquestioned. United States v. New York Telephone Co., 434 U.S. 159, 172-73(1977).
2. http://www.bloomberg.com/news/2011-11-02/citigroup-finds-obeying-the-law-is-too-darn-hard-jonathan-weil.html