* $285 mln settlement tied to housing-related CDO
* Judge Jed Rakoff vigorously questions SEC, Citigroup
* Rakoff had struck down Bank of America settlement
* No timetable for decision
By Jonathan Stempel and Grant McCool
Nov 9 A federal judge made clear he has big problems with a U.S. regulator's approach to settling major securities fraud cases, perhaps imperiling a proposed $285 million settlement with Citigroup Inc over the sale of toxic mortgage debt.
U.S. District Judge Jed Rakoff, whose approval is required for the accord, grilled a senior U.S. Securities and Exchange Commission lawyer over why the regulator should accept a payout far smaller than the estimated $700 million that investors lost on the transaction, which Citigroup had successfully bet against.
At an hour-long hearing on Wednesday in Manhattan federal court, Rakoff also asked why the SEC would agree to bar Citigroup from similar wrongful conduct when it had no recent history of bringing contempt charges for violations of similar prior injunctions, including by that bank.
"It's just for show," Rakoff suggested, while questioning SEC Chief Litigation Counsel Matthew Martens.
Rakoff did not tip his hand on how or when he will rule. "This is an important matter, one that in the court's view raises many interesting issues, and I want to resolve them and give a written opinion," he said.
The SEC accused Citigroup of selling a $1 billion mortgage-linked collateralized debt obligation, Class V Funding III, in 2007 as the housing market was beginning to collapse, and then betting against the transaction.
One Citigroup employee, director Brian Stoker, was also charged by the SEC. He is contesting those charges.
Rakoff's approach reflects his impatience with an SEC settlement process that may appear to not punish wrongdoers sufficiently, or do enough to prevent them from backsliding.
In March, the judge had warned he might strike down future SEC settlements that did not force companies to admit or deny wrongdoing for their alleged improper activity.
The Citigroup settlement requires the third-largest U.S. bank to give up $160 million of alleged ill-gotten profit, plus $30 million of interest.
It also imposes a $95 million fine for the bank's alleged negligence, less than one-fifth what Goldman Sachs Group Inc paid last year in a $550 million SEC settlement over a different CDO.
"So the net effect of this is that you're only returning a very small fraction of what the investors lost, yes?" Rakoff asked Martens.
The SEC lawyer responded that the remedy reflects "what we believe is consistent with our statutory authorization."
Citigroup's fine is barely larger than the record $92.8 million penalty that Rakoff on Tuesday imposed against Raj Rajaratnam in the SEC's insider trading case against the now-convicted Galleon Group hedge fund founder. Rajaratnam was separately sentenced to 11 years in prison and ordered to pay or forfeit $63.8 million in his criminal case.
Rakoff in 2009 struck down an $33 million SEC settlement with Bank of America Corp over the takeover of Merrill Lynch & Co, saying it punished shareholders who were victims of the alleged fraud. He later approved a $150 million accord.
But the judge's gesticulations from the bench and pointed questioning reflected his deep discomfort with whether SEC enforcement in securities fraud cases, even now, is effective.
In questioning Martens, Rakoff asked whether the SEC was asking him not to consider whether the settlement served the public interest because it was not the court's role.
"Am I correctly summarizing your position?" Rakoff asked.
"Yes, your honor," Martens said.
"An interesting position," Rakoff then responded. "I'm supposed to exercise my power but not my judgment."
Martens also rejected the suggestion that by not requiring Citigroup to admit wrongdoing, the SEC is depriving the public of learning the truth of what actually occurred.
Rakoff was also tough on Citigroup's lawyer Brad Karp, a partner at Paul, Weiss, Rifkind, Wharton & Garrison.
After getting Martens to agree that the mortgage securities that Citigroup sold were "real dogs," Rakoff told Karp, "You're not selling much of this junk these days, I understand it?"
Karp tried to assure Rakoff that the settlement requires the bank to impose sufficient compliance measures. "There is no wiggle room," he said. "You can't miss it."
At one point, Rakoff seemed to enjoy putting the lawyers on the spot. After ending his questioning of Martens and turning to Karp, Rakoff told the SEC lawyer: "Let me take you off the hook for a while -- but don't get too comfortable."
The case is SEC v Citigroup Global Markets Inc, U.S. District Court, Southern District of New York, No. 11-07387.