Risk Management

Citigroup Answers Auction-Rate-Securities Charge

Citi says it is working with regulators to find a solution to the auction-rate-securities fiasco.
Stephen Taub and Marie LeoneAugust 1, 2008

Responding to accusations from New York State Attorney General Andrew Cuomo’s office that it duped clients into buying illiquid auction-rate securities, Citigroup says it “acted in good faith and in the best interests of our clients, and there is simply no basis for claims to the contrary.”

The banking giant reportedly received a letter from David Markowitz, chief of New York state’s investor-protection bureau, alleging that Citi “repeatedly and persistently committed fraud” by falsely representing to customers that ARS were as liquid as cash, according to Reuters. Markowitz also purportedly claimed that Citi destroyed case-related audiotapes of phone conversations that were under subpoena.

Reuters reported that the letter was sent from Cuomo’s office to Citi on Friday. At press time, CFO.com had not yet received a copy of the letter or a return call from the Attorney General’s office. However, a Citi spokesperson confirmed receipt of the letter and the subject matter, noting that it did mention the possibility of a lawsuit against the bank. In a statement, Citi said it was “working with market participants and regulators to find an industry-wide solution to Auction Rate Securities issues.” Citi continued: “We are actively working with regulatory authorities, including the NY Attorney General, to secure the best and fastest route to providing liquidity.”

ARS are municipal bonds, corporate bonds, or preferred stocks with interest rates or dividend yields that are periodically reset through Dutch auctions. While credit markets were strong, there was a thriving market for the debt, and many investors bought the securities as short-term investments that were equivalent to cash. However, when the credit crisis dried up the demand for ARS, the debt lost its cash-like liquidity — although not its underlying value.

In May 2006, the Securities and Exchange Commission fined 15 major broker-dealers a total of $13 million for practices related to the ARS market. The firms, which neither admitted nor denied the findings, consented to the entry of an SEC cease-and-desist order. Those that agreed to pay the largest fine, $1.5 million, included Citigroup, Bear Stearns, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, and RBC Dain Rauscher.

At the time, the commission alleged that between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of securities laws. Those practices included allowing customers to place open or market orders in auctions; intervening in auctions by bidding for a firm’s proprietary account or asking customers to make or change orders; and providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.

Based on Friday’s report from Reuters, Citi learned in mid-June about the destruction of subpoenaed documents, but failed to tell Cuomo’s office until June 30. However, Citi said that it is its “practice to recycle tapes.” The company asserted that “the recycling of the tape in question was inadvertent. As soon as we learned of the oversight, we immediately suspended all recycling of tapes and preserved all existing tapes.” The company also said it reported the “oversight” to regulators and has fully cooperated with them in all aspects of the investigation.

Earlier on Friday, Citigroup said it had received subpoenas and/or requests for information from various self-regulatory agencies, as well as government agencies, in connection with the sale of auction rate securities. The company also said in a regulatory filing that the SEC has launched a formal investigation into the matter.

In addition, the banking giant said it is responding to subpoenas from Texas and Massachusetts, in addition to New York, and that it is the target of several class-action lawsuits related to its marketing, sales, and underwriting of ARS. The lawsuits allege, among other things, violations of the federal securities laws, federal investment adviser laws, and state common law, it added. Several of the class-action lawsuits have been consolidated in the Southern District of New York.

In March, CFO.com reported that two lawsuits were filed in U.S. District Court in New York charging that the company deceptively marketed the securities as liquid equivalents to money-market funds, and did not reveal material information about them. One of the suits reportedly claimed that, rather than “disclosing the true nature of ARS and the substantial liquidity risks associated with them, defendants continued to push as many ARS[s] as possible unto its customers in order to unload inventory off its already troubled balance sheet.”

At the time, Alex Samuelson, a company press representative, told CFO.com: “We believe [the lawsuits] to be without merit and will defend [ourselves] against the actions.”