Also, when you're not in the business of convincing people to fund you, you're in the business of convincing people to buy what you're selling and sell what you're buying, which further constrains you from saying "what we're selling is dogshit."¹

Anyway I found a certain poignancy in Citi's correspondence with the SEC over Morgan Stanley Smith Barney, which was released on Friday. Citi and Morgan Stanley had a joint venture in MSSB, and MS valued it at around $9bn, and Citi valued it at around $22bn, and at most one of them was right and, while the answer turned out to be "neither," it was much closer to MS than C. Citi was quite wrong, and since this was eventually resolved by a willing seller (Citi) selling to a willing buyer (MS) at a valuation of $13.5bn, Citi had to admit its wrongness in the form of a $4.7 billion write-down, and the stock did this:

Which is the market's way of saying: no biggie Vikram, we already knew you'd be taking the writedown, honestly we thought it'd be worse than that, we just didn't say anything because we didn't want you to feel bad, but we're glad that's cleared up now.

But the SEC doesn't get to do that, because – and this is sort of endearing – the SEC has to pretend that a company's financial statements convey meaningful information about the actual world, and so last year they sent Citi a bunch of letters to the effect of "um, really, with that MSSB valuation?" To be fair even Citi was admitting, back in its 10-K a year ago, that MSSB wasn't worth what its balance sheet said it was worth – but it said that this was a temporary impairment and so didn't need to be reflected on Citi's financials since MSSB would recover soon and anyway it's not as if Citi was looking to sell at a depressed price. Here is how the SEC responded in April:

We note your disclosure related to the temporary impairment of your equity method investment in the Morgan Stanley Smith Barney (MSSB) joint venture. Please address the following:

• You assert that, as of December 31, 2011, you do not plan to sell your investment in this joint venture prior to recovery of the value. Please tell us how you were able to reach this conclusion given the fact that you are currently in negotiations with Morgan Stanley to sell at least part of your equity interest in this joint venture pursuant to options held by Morgan Stanley.
• We note that you have based the fair value of this equity investment on “the midpoint of the current range of estimated values.” However, you do not disclose this range, nor do you disclose how the range was estimated.

Citi's response is absolutely gorgeous; it says:

• We are not in fact negotiating with Morgan Stanley about selling the rest of MSSB, and
• We can't disclose our internal estimate of MSSB's value, because that would hurt us in our negotiations with Morgan Stanley about selling the rest of MSSB.

See what they did there?² The SEC did, a few months later anyway, when the negotiations got so advanced that the SEC pushed Citi for more information about its internal valuation of the MSSB joint venture. Citi obligingly provided that valuation to the SEC, confidentially, ten days after it disclosed the write-down.

Also during these negotiations Citi's investment banking division provided a valuation of MSSB "that slightly exceeded Citi's carrying value of approximately $11 billion for that 49% interest as of June 30, 2012." So:

• Citi provided a valuation of an asset to its counterparty as a negotiation tool,³
• which was higher than the valuation it reflected in its publicly filed financial statements,
• which was higher than its internal estimate of the correct valuation,
• which was closest to the market's estimate of the correct valuation, and the ultimate valuation at which Citi sold the asset.

So Citi "knew" that its financials, and the valuation it gave in negotiations with MS, were "wrong." Making this all a little sketchy, but also a lot no-harm-no-foul. Citi was locked into putting a brave face on its MSSB valuation, because admitting that there was a problem would have actually cost shareholders money, in the form of a worse negotiating position with MS. And so Citi provided two separate estimates of MSSB's value, to MS and to Citi's own shareholders, that did not accurately reflect what it thought it would ultimately get for MSSB. And then it didn't. And since everyone pretty much knew that that was going on, no one has much cause to complain. The typical fraud lawsuit starts with "you lied about X, and when you came clean, the stock dropped by $Y, so give us $Y"; here the lawyers' damages would be negative. Citi came clean, as it were, about MSSB, and the market breathed a sigh of relief.

So, I imagine, did Vikram Pandit, though in his case the relief didn't last long. Citi did what probably really was the right thing for shareholders: it maintained with a straight face that MSSB would be cheap at $22 billion. That was wrong, of course, but since no one believed it, it all worked out okay.

Citi: SEC letters and responses [EDGAR]
SEC Pressed Citi for More Details on Brokerage Joint Venture [WSJ]

1. Unless you're Lloyd Blankfein? This is a fine line.

2. No really, it really says this. To be fair the second part is phrased as "such disclosure could place Citi at a competitive disadvantage in the event that negotiations with Morgan Stanley regarding fair value were to take place in connection with the exercise of the above-referenced options."

3. Ooooh is that bad? Is it Fraud to tell someone that an asset you own is worth $100X when you value it internally at $80X? No, right? I mean not if your counterparty is Morgan Stanley. Ponder CDO cases however.

• The Too Big To Fail Subsidy Is Negative Sixteen Billion Dollars, Or Possibly Some Other Number
• Michael Milken Seems To Have Been Overdue For Another SEC Investigation
• Ratings Agency Would Prefer Not to Be Sued, Won’t Cut U.S. Debt Rating

You don't want to live in a town where the police and the mob work together.

In a completely unrelated note, the Second Circuit recently heard arguments from the SEC — the federal agency statutorily charged to enforce the nation’s securities laws — and Citigroup — a company targeted for securities laws violations that it refuses to admit or deny committing — on the SAME SIDE.

This should be a red flag.

They wanted the Second Circuit to spank Judge Jed Rakoff for having the audacity to ask the SEC to kindly do its job. The nerve of some people.

Well, securities law may not be as sexy as drone strikes, but I watched the SEC try to pull off just as naked an executive power grab.

So it was my first return in my new capacity as a journalist to the federal courthouse that I’ve visited time and time before as a lawyer. It’s a different experience walking in without a suit and without drilling yourself to make sure you remembered everything you needed for the hearing. Almost relaxing in a way.

The courtroom was an absolute zoo, built far too small for a hearing that had the attention of the media and every financial institution worried about the future of their relationship with their regulator. Add in the army of clerks dropping in to watch, and the courthouse had to set up an overflow room with folding chairs and a TV simulcasting the event (and even that room was eventually standing room only).

When I first got there, the TV only showed the floating face and torso of Judge Rosemary Pooler, joining the proceedings from the Northern District of New York, in a courtroom that looked eerily like the backdrop to a hostage video with sparse, utilitarian walls, a light switch and a flag. I felt bad watching her sit like an interviewee in a green room with a hundred lawyers and journos watching her every move. It felt like Legal Big Brother.

The background of the case is simple enough. In 2011, the SEC and Citigroup brought a consent decree to Judge Rakoff. The judge felt obliged to ask for some factual backup before rubberstamping a decree that basically let Citigroup off the hook for activity that, at the time, public opinion thought pretty severe. When the SEC and Citigroup failed to meet this basic standard to Judge Rakoff’s liking, he declined to approve their consent decree. Basically, if the SEC really has gathered enough evidence to reach a reasonable settlement with someone, they should be able to provide the judge with some evidence to back up its reasonableness. In math class you have to show your work.

This isn’t the first time Judge Rakoff has issued a controversial ruling challenging accepted government policies. Remember, this is the guy who made the death penalty unconstitutional for a hot minute. Now he’s questioning the SEC’s chummy totally professional and arms-length relationship with Wall Street.

Interestingly, because the subsequent acquittal in the Stoker case brought to light facts that the SEC and Citigroup originally failed to provide Judge Rakoff, he no longer believes that he must deny the consent decree and would almost assuredly approve the agreement on remand. No harm, no foul, right?

But Michael Conley for the SEC and Brad Karp for Citigroup weren’t thrilled with this possible result, asking the Second Circuit instead to reverse the lower court decision.

Why? Well, the money exchange came when Judge Raymond Lohier (the final judge on the panel was Judge Susan Carney) asked about deference and why an Article III judge would question the judgment of an executive agency that presumably reached its decision based on a sound review of the evidence.

The lawyer for Judge Rakoff, Rusty Wing [disclosure: I used to work with Rusty at LSW, though I had no involvement whatsoever with this matter], pointed out that the SEC is entitled to deference — but that doesn’t mean they aren’t wrong, eliciting laughter from the audience and a snarky “No! Really?” from Judge Lohier himself.

It sounded a lot like the SEC was going to the mat on this one because they didn’t want “deference” as much as they wanted “tyranny” — a ruling affirming that any decision they reach is subject to zero judicial review based on their status as part of the executive branch because we should all just trust the executive branch without any transparency. Sounds a lot like drone strikes to me.

Depending on the outcome of the hearing, when Mary Jo White gets there and starts kicking tail, as Elie suggests, she will have a couple drones at her disposal.

Judge Rakoff Rejects SEC’s “Contrivances” In Citigroup Settlement [Forbes]

More stories from Above The Law:

• California Law School Claims Free Speech Right To Offer Piss-Poor Education And Be Accredited For It
• Mom Hires Lawyer to Force Son to Go To The U. Amateurs!
• A Law School Scarier Than The Job Market?