Citigroup and federal fiduciary law

The SEC has reached another peculiar settlement, this time $75 million from Citigroup, plus fines against executives. As with the Goldman settlement, Citigroup didn’t admit fraud, or even, as in that case, a mistake. Citigroup was accused of misleading investors about its exposure to subprime. The bank knew it was exposed to the housing market, but thought its senior tranches were safe.

The misrepresentation concerned $37 billion and basically the life or death of the company. The fine was $75 million, which either ludicrously fails to match the misrepresentation, or suggests Citigroup didn’t really do anything wrong. If it didn’t do anything wrong, then why a fine?

As the WaPo’s new financial crime blog asks:

What if the reality is that, in the SEC’s view, Citigroup’s alleged crimes weren’t such a big a deal, in the big scheme of things? What if any more severe a punishment against the bank or its executives would be disproportional to the alleged wrongdoing? If that’s the SEC’s view, then why bring the case in the first place? Because Citigroup was a big actor in the financial crisis, and regulators needed to show that it would be punished — however lightly — for wrongdoing that helped feed the crisis. That’s called symbolism. And symbolism might have value, so long as we call it what it is.

Or maybe we could call it something else – another politically driven settlement, in what is becoming a disturbing trend.

And then there’s the problem that whatever was going on, Citigroup, or more accurately its shareholders, were getting hit for mere negligence of its executives, as discussed in today’s WSJ. The only way you get fraud out of this is that the securities law section Citigroup was charged under (Section 17(a) of the 1933 Act) includes fraud. The WSJ quotes the SEC’s assistant enforcement chief as noting “[t]here’s not a doubt in the world that this is an antifraud provision.” Well, yeah, but that doesn’t mean that the SEC found fraud, or even recklessness, and it didn’t. The article also noted:

John Coffee * * * said the statute has some “symbolic” value as a fraud charge. “If the SEC wants to call it that, they can.”

Guess so.

Note that the Delaware chancery court dismissed the shareholder suit against Citigroup directors last year because the allegations didn’t show conduct outside the protection of the business judgment rule, and specifically not in breach of the “Caremark” bad faith standard. More precisely, as I discussed at the time,

Chancellor Chandler held that merely claiming that directors made a bad business decision by failure to monitor business risk was not enough to excuse demand in a derivative suit. * * *

Plaintiff alleged that the board (a majority of whom had also been on the Enron board) ignored problems “brewing in the real estate and credit markets” starting in 2005. And, indeed, plaintiff likely could support that claim. The Citigroup management basically bet the company’s future on the vast Ponzi scheme of the real estate market amid growing signs that the scheme was unraveling.

Chancellor Chandler, however, rightly held that this is not the sort of deliberate failure that will establish a duty of loyalty claim for breach of Caremark duties. As the Chancellor reasoned, courts should not second-guess business decisions, particularly when this second-guessing leads to personal liability.

The court’s unwillingness to second guess a business decision rests on two sound bases: courts are poor managers of corporations; and excessive liability for negligent management will deter the sort of risk-taking that diversified shareholders would want corporate managers to engage in. True, the judgment looks like a bad one in retrospect. But we must be concerned about the signals liability sends to corporate executives who do not have the benefit of hindsight.

The important point for present purposes is that this is the sort of judgment about internal corporate governance that is traditionally left to state court. Yet the SEC has decided, in effect, to impose its own rule.

Of course this was supposedly about disclosure, not substantive management. But you have to know about a risk to disclose it. In fining Citigroup for breach of a duty to know, the SEC is getting quite close to the same issue as in the state court case – what did the executives have a duty to know?

The other difference between the cases is that the big SEC fine was against the company rather than liability of executives as in the Delaware case. But should we worry less about the liability because the firm’s innocent shareholders pay it? Not that it makes much of a difference given indemnification and insurance.

By little steps such as this case is the law of corporate governance being shifted from the states to the feds. It is far from clear on general principles that the SEC is the appropriate decision-maker. This case does not give cause for comfort on that issue.