By Rachael Williams

In July 2013, the Securities and Exchange Commission (SEC) adopted the “Bad Actor” rule. This rule prevents companies and individuals with a “criminal conviction, regulatory or court order or other disqualifying event” from participating in private offerings and selling investments in hedge-funds or private-equity funds to clients. The rule is part of the 2010 Dodd-Frank regulation but ultimately went into effect in September 2013.

Citigroup’s disqualifying event stems from a 2007 mortgage-backed securities fraud complaint with the SEC that resulted in more than $700 million of losses to investors. Citigroup reached a $285 million settlement with the SEC on August 5, 2014, making it subject to the change in the law. Had Judge Jed Rakoff approved the original settlement offer back in November 2011, Citigroup would not have been subject to the rule. Judge Rakoff originally rejected the offer because he felt the fine was not large enough and disagreed with the SEC not requiring Citigroup to admit wrongdoing as part of the settlement. An appellate court ultimately found he had overstepped his reach, and the settlement was entered nearly three years later in August 2014.

Citigroup remains able to sell private investments to large institutions. However, selling private hedge-funds to wealthy individual clients has become a huge growth area for private banks and financial firms, as increasingly more investors are drawn to alternative investments. Citigroup was forced to send letters to hedge-fund firms informing them that the bank would no longer be able to steer clients to the firms’ hedge-funds. Previously, Citigroup offered approximately 40 hedge-funds to its wealthy clients, who were required to have a net worth of at least $25 million to invest. Citigroup subsequently stands to lose revenue generated from the fees the bank earned for every client placed in a private fund.

Despite the settlement, the bank will attempt to secure a waiver from the SEC to allow it to continue to conduct normal business. The SEC has the option to grant a waiver to certain “bad-actors” if it is in the public interest to do so. Citigroup will likely argue that its sale of private hedge-funds to its clients bears little to no relation to the acts for which it was found in violation of the law. While Citigroup’s sale of mortgage-linked security debt was the basis for settlement, the SEC’s choice to target Citigroup’s sale of hedge-funds demonstrates the trend of increased governmental oversight in this area.

The Volcker Rule provides additional oversight by restricting the profitability of banks through the sale of hedge-funds. Banks may now only invest 3% of Tier 1 capital in hedge or private-equity funds and cannot own more than 3% of any hedge-fund. Subsequently, banks such as Citigroup have begun spinning off internal hedge-fund units and private-equity funds in order to comply with the rule. The “Bad Actor” rule and Volcker rule will continue to have a major impact on the profitability of banks, as banks are increasingly restricted from reaping the benefits of growth in their clients’ hedge-fund and private-equity investments.