SEC-Citi Settlement Under Scrutiny

The U.S. Securities and Exchange Commission (SEC) has defended its $75 million settlement with Citigroup Inc. (C) to square off charges for the misleading disclosures of subprime exposures made by Citi in 2007. The SEC has asked for court approval over this arrangement.

In July, Citi had agreed to pay $75 million in an effort to settle charges brought by the SEC over subprime exposures disclosure by the company. Besides allegations against the company, the charges also individually targeted two of the Citi executives for preparing and approving deceptive statements. Both have agreed to settle the charges.

This scrutiny comes as the U.S. District Court Judge Ellen Segal Huvelle was not satisfied with the settlement, asking for further information before the accord’s approval. Judge Huvelle questioned why the current shareholders of Citi should suffer for the alleged misdoings of Citi’s executives, notably Gary Crittenden and Arthur Tildesley, Jr.

SEC argued that the penalty represents less than 0.3% of Citi’s second quarter 2010 revenues and charging this amount would not result in an excessive negative impact on the company’s operations or substantially impact the current shareholders of Citi.

The settlement was described as fair, reasonable and in the public interest by the SEC. The penalty, said the SEC, is justified considering the weightiness of the misconduct; the penalty amount was also arrived at by analyzing Citi’s estimated gain from such puffed-up prices for the securities and other relevant factors. Additionally, according to the SEC, no other individuals were as closely related with the misdoings than were Crittenden and Tildesley.

The Charges and the Settlement

According to the SEC charges, Citi had repeatedly made misleading statements regarding its subprime exposure in its earnings calls and public filings between July and October 2007. The company had claimed to have reduced its subprime exposure during that period to $13 billion from $24 billion reported at the end of 2006.

However, Citi had failed to disclose that it still possessed around $40 billion in “super senior” tranches of collateral debt obligations backed by subprime mortgages and related instruments named “liquidity puts.” This announcement was only made as late as November 2007.

In order to settle charges levied against them, Crittenden, former chief financial officer of Citi, has agreed to pay $100,000. Tildesley, former head of investor relations and currently head of cross marketing at Citi, would pay $80,000. Citi in turn agreed to pay $75 million for settling the charges.

Citi’s settlement of SEC charges came just a couple of weeks after Goldman Sachs Group Inc.’s (GS) $550 million settlement with the SEC over a civil fraud suit linked with mortgage investments. The SEC had alleged that Goldman defrauded investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.

The recent financial crisis precipitated by the meltdown of the subprime market has resulted in an intense scrutiny by the SEC into the subprime exposure of the Wall Street companies and any related misdeeds. Going ahead, we expect the SEC to retain its surveillance.

This is not the first time that a SEC settlement with a company is being questioned by the judge so rigorously before approval. In fact, last year, a U.S. judge in New York nixed a proposed $33 million settlement between the SEC and Bank of America Corp. (BAC). The agreement was for settling a charge over alleged misstatements to shareholders made by the Bank of America during the Merrill Lynch acquisition in early 2009. Later, an amended $150 million settlement was approved.

Our Take

Such charges by the SEC can hardly bring good tidings for Citi. They tend to dampen investors’ confidence in the stock and are a blow to its reputation and financials. Nevertheless, Citi’s restructuring efforts are impressive, though the sluggish rate of economic recovery and high level of unemployment are expected to somewhat restrict the company’s earnings.

We also believe that the shrinking of its business through assets sale and the CARD Act will prove to be challenging to the revenue. Yet Citicorp, the company’s core business, remains attractive. Its global footprint would help earnings and should make up for losses in other areas.

Citi is currently rated as Zacks #3 Rank (Hold), implying no clear directional pressure on the stock over the next one to three months. The stock is also rated Neutral.

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