Banking & Capital Markets

Citi To Take $1.5 Billion Charge

Bank sets aside reserve to cover possible lawsuits stemming from Spitzer probe. Plus: the argument for reverse splits, and why some companies are g...
Alix Stuart and Tim ReasonDecember 23, 2002

On Friday, several Wall Street banks signed a historic settlement with New York Attorney General Eliot Spitzer. In essence, the banks agreed to pay $1.4 billion to close New York state’s investigation into analyst independence and IPO allocation.

This morning, the fallout from that settlement become clearer. Citigroup, one of the companies on Spitzer’s hit list, announced it will take a $1.5 billion charge in the fourth quarter. According to the company, the reserve will go to cover the costs associated with the lawsuit, as well as potential losses from bad loans.

A big set aside, considering Citigroup only has to pony up about $400 million in fines to satisfy the agreement with Spitzer. But Citigroup management said it is reserving $1.3 billion to help cover the costs of potential lawsuits stemming from matters related to Spitzer’s investigation. Said Citigroup CEO Sanford Weill: “We will take a charge in the fourth quarter toward the anticipated cost of resolving regulatory inquiries and associated litigation, as well as increased credit losses.”

In the wake of New York state’s investigation, observers say scores of lawsuits could be filed against Citigroup and other banks. If Spitzer decides to make public all the documents uncovered in his investigation — and that looks like a strong possibility — attorneys could have a field day going after Wall Street banks.

Even Weill conceded that it’s not clear if the $1.3 billion will actually cover the bank’s potential liabilities. “Given the uncertainties of the timing and the outcome of this type of litigation, the large number of cases, the novel issues, the substantial time before the cases will be resolved, the multiple defendants in many of them,” he state, “this reserve is difficult to determine and of necessity subject to future revision.”

The reserve will reduce Citigroup’s fourth quarter results by 29 cents per share (diluted).

The question is: will other banks be forced to set aside reserves to cover potential liabilities stemming from Spitzer’s investigation?

Reverse Psychology Today

For years, reverse stock splits have been seen as window dressing, or a desperate attempt by tiny companies to avoid being delisted. But what about the reverse splits now being completed or considered by such giants as AT&T Corp., Lucent Technologies Inc., and Palm Inc.

Despite analysts’ disdain for reverse splits, there are some practical reasons for doing them. One reason is to appease institutional investors. “A lot of investment funds have covenants that don’t let them buy stocks under certain prices — usually $3 or $5,” says Vincent Sbarra, a senior partner with HBC Capital.

Ulrico Font, senior analyst for Ned Davis Research, says that everybody feels most comfortable with stocks priced between $5 and $50.

The loss of institutional investors was one reason Palm conducted its 1-for-20 reverse split in October, admits CFO Judy Bruner. But both Bruner and Chuck Noski, former CFO of AT&T, say the primary reason for their reverse splits is restructuring efforts that involve spin-offs.

Palm, for example, plans to separate into two companies — one for its handheld devices, the other for its operating system. Yet with its presplit stock trading barely above Nasdaq’s $1 minimum, the resulting shares of both companies wouldn’t otherwise meet listing requirements.

Noski says that if AT&T sold off its cable TV unit, its remaining shares would trade at $4 to $5. Without the planned one-for-five reverse split, that would put AT&T in the red zone for institutional investors. The post-sale price would be way below the median share price of others in the S&P 500.

Which brings up another practical reason for reverse splits: fear of embarrassment.

Gambling with Buybacks

Given the trouble EDS Corp. has incurred from its equity-based hedging program, it’s little wonder such techniques are under fire.

In late September, the Plano, Tex.-based company announced that it had to issue $225 million in commercial paper to buy back 3.7 million of its own shares, thanks to put options it had sold on them through June. The price was $60.61 a share, when EDS stock was selling on the open market for $17.

The announcement, coming on the heels of a surprise profit warning, sent EDS’s share price down 66 percent in the week following.

“The mistake that EDS made was waiting in the hope that the stock price would go back up to the $60 level,” says Banc of America Securities LLC analyst Prakash Parthasarathy. It should have closed out the contracts earlier, he says, although “even if all the stars are aligned right, it shouldn’t be done when there is so much unpredictability in the market.”

But EDS wasn’t alone. When stock prices were soaring, many companies, including Dell, Microsoft, and McDonald’s, sold put options against their own stocks to help pay for the cost of stock option cash-outs. “The whole point was to offset the dilutive effect that stock options have on shares,” says Dell spokesperson Mike Maher.

Dell stopped issuing the puts in 2000, when it saw the economy softening, but said it was liable for up to $1 billion to settle options that will expire this year.

Still, some say this type of equity-based hedging is a valid strategy. “When you know you’re going to need some shares, I think you [can} argue that some policies around puts and calls are a good idea,” says analyst Mark Specker of SoundView Technology Group.

Explains Joe Elmlinger, a managing director in Salomon Smith Barney’s equity derivatives group, “It wasn’t the derivative that caused the loss, it was the decision to buy back shares.”

But even if the market comes back, companies may stay wary. By the end of this year, the Financial Accounting Standards Board is slated to issue new accounting rules on equities and liabilities related to company stock. The new rules include a requirement that will force transactions, including some types of equity forwards, to be considered as liabilities and marked-to-market on income statements.

Meanwhile, the repercussions for EDS are only intensifying. The company received notice of an “informal inquiry” from the Securities and Exchange Commission in early October.