Federal regulators rejected the idea of requiring an "admission of guilt" in settlements with financial institutions, but the Securities and Exchange Commission asked for the flexibility to clawback higher penalties.

And some lawmakers expressed interest in granting it.

A House subcommittee held a hearing Thursday to consider changes over settlement practices. A recent deal between the SEC and Citigroup (C) received the most attention. Citi could be required to return $285 million to investors of a $1 billion collateralized debt obligation tied to risky mortgages.

U.S. District Court Judge Jed Rakoff rejected the settlement in November because Citi did not have to admit guilt in the case despite evidence its bankers believed the CDO was faulty even as they sold it to their clients. Rakoff also pointed out investors lost $700 million from the instrument, far more than what they would get back. The SEC and Citi appealed, and a ruling on that appeal is still pending in the U.S. Court of Appeals for the 2nd Circuit.

A proposal surfaced during the hearing that would require federal regulators to at least get the financial institution to admit guilt in settlements.

Each representative from the SEC, Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. thought such a proposal would be a bad idea.

"If we were required to get the admission we would have more delay and fewer victims would be able to get their money back," said Robert Khuzami, SEC Director of Enforcement.

"The system would be less safe and sound with the requirement to get the admission because we wouldn't be able to take corrective action as quickly," said Richard Osterman, FDIC general counsel.

Instead, SEC Chairwoman Mary Schapiro wrote to the Senate recently asking for an expansion of the penalty limits in these cases. Khuzami made the point again Thursday.

"When we impose a penalty, we can't base it on all the wrongs that arose out of the financial crisis," Khuzami said. "We have to base it on the evidence of the particular transaction at issue. We can't get investor losses as a penalty. We are limited to disgorgement, which is the amount the company earned on the transaction and a penalty equal to the disgorgement. We can't get the investors losses."

SEC has a tier penalty system. Tier three currently allows for up to a $725,000 penalty per violation, per institution. Schapiro asked to increase that limit to $10 million. She also asked to use investor losses in negotiations or three times the gain of the transaction.

In the Citi case, the bank netted $160 million in profits on the faulty CDO.

"There are instances where investor losses so dwarfs the disgorgement and the gain that we could get, that you would like some more authority," Khuzami admitted.

Rep. Scott Garrett, R-N.J., asked to be included on the letter so that the committee could consider expanded penalty limits.

Frustration with the lack of accountability after the crisis crossed both aisles during the hearing.

"I am one of those who reads the settlements and wonders why didn't someone go to jail?" said Rep. Carolyn McCarthy, D-N.Y.

Rep. Bill Posey, R-Fla., said stiff penalties could have an effect.

"I think when you prosecute people and you penalize them severely, that changes bad behavior," he said. "And when you put somebody in jail, that really changes bad behavior. I don't see anybody going to jail. All the criminal activity on Wall Street — I just see a real lack of accountability in prosecution."

Still, outside of the SEC request for more flexibility for higher penalties, each of the other federal regulators believed they had the tools necessary to police the industry.

Daniel Stipano, chief counsel for the OCC, said it issued roughly 2,200 enforcement actions in last four years. Scott Alvarez, general counsel for the Fed, said it issued three times more formal actions in the years after the crisis than the five years prior.

"My hope is not so much that we raise the amount of enforcement actions, but that the industry gets back to a better more coherent, more safe and sound compliant mode," Alvarez said.

jprior@housingwire.com

@JonAPrior