CITIGROUP: ANOTHER MARKET CRISIS CASE GROUNDED IN CONFLICTS
First there was Goldman, then J.P Morgan and now Citigroup. The SEC filed another market crisis case centered on conflicts by Wall Street bank who created a CDO tied to the residential real estate market and then sold interests to their clients without disclosing their role in the collateral selection or that it had bet on the collapse of its creation. SEC v. Citigroup Global Markets, Inc., Case No. 11-Civ-7388 (S.D.N.Y. Filed Oct. 19, 2011). Unlike Goldman, but like J.P. Morgan, Citigroup is not based on intentional fraud but negligence. Like its predecessors, Citigroup settled along with the collateral manager. Like Goldman, the Citigroup employee alleged to have been in charge of the project is litigating with the Commission.
The latest case is based on the role of Citigroupin creating and marketing a largely synthetic collateralized debt obligation or CDO called Class V Funding III. The deal began to unfold in late 2006 when personnel from Citigroup discussed the construction of a CDO-squared – a CDO collateralized by tranches of other CDOs rather than instruments such as bonds – tied to the residential real estate market. The group believed that a significant downturn in that market would occur. Part of the discussion focused on having a CDO-squared purchase unsold CDO tranches from CDOs previously structured by Citigroup.
Securing a third-party investment adviser who would select the investment portfolio would facilitate the placement of the notes the CDO-squared would issue according to Citigroup. Citigroup engaged Credit Suisse Alternative Capital, Inc. or CSAC, a registered investment adviser. CSAC was an experienced collateral manager with a good reputation. By early January 2007 CSAC and Citigroup executed an engagement letter in which the investment adviser agreed to serve as “Manager” for Class V Funding III. Citigroup would serve as “Placement Agent.” Under the agreement CSAC was to “identify Collateral” and “direct the purchase of securities” for the investment portfolio.
As the CSAC agreement was being negotiated Citigroup personnel compiled lists of CDO tranches from previous deals. Citigroup selected CDOs for inclusion in the investment portfolio. Once the agreement was completed CSAC did in fact select about $150 million in CDOs for the portfolio. That brought the total notional amount of synthetic CDOs included in the investment portfolio to $870 million. The portfolio also included nine cash CDO tranches with a total notional value of $130. Six of the nine were from CDOs structured and marketed by Citigroup.
The marketing materials for Class V were prepared by Citigroup personnel. Those materials represented that CSAC was the “collateral manager.” They included a description of CSAC’s track record and investment philosophy. Also included was a section detailing the adviser’s rigorous approach to the selection of assets for the investment portfolios of CDOs managed by it.
The materials did not disclose the role of Citigroup in the selection of the collateral. It also did not mention that by the time notes in Class V were marketed, Citigroup had a $500 million short position on the Class V III collateral for its own account taken only against the collateral it had selected.
Citigroup marketed Class V to U.S. and foreign financial institutions. Ultimately 15 investors purchased tranches of the entity with a face value of about $843 million. While at least one investor questioned the quality of the collateral held by the entity, ultimately that investor relied on the reputation of CSAC.
Class V essentially collapsed by November 2007, just months after Citigroup sold the notes. By July many of the assets in the portfolio had been placed on negative watch by one or more of the rating agencies. Moody’s downgraded every tranche of Class V by November 7. Within days the entity was declared to be in an Event of Default.
Investors lost millions of dollars. This was consistent with the views of experience CDO traders about Class V. Once trader characterized the portfolio as “a collection of dogsh!t” and “possibly the best short EVER!” Another called it “horrible.”
Citigroup made millions of dollars. For its role Citigroup was paid $34 million in fees for structuring the entity. It also made $160 million in net profits on its positions.
The Commission’s complaint alleges a single claim for relief. It asserts violations of Securities Act Sections 17(a)(2) and (3).
Citigroup settled the action, consenting to the entry of a permanent injunction prohibiting future violations of the sections cited in the complaint. Citigroup also agreed to disgorge $160 million and pay $30 million in prejudgment interest and $95 million as a penalty for a total of $285 million which will be placed in a fair fund. The settlement requires Citigroup to take certain remedial action related to its review and approval of offerings of certain mortgage related securities. The settlement is subject to approval by Judge Rakoff.
The Commission also filed a related administrative proceeding captioned In the Matter of Credit Suisse Alternative Capital, Adm. Proc. File No. 3-14594 (Filed Oct. 19, 2011). The Respondents are CSAC, Credit Suisse Asset Management LLC, the successor to CSAC and Samir Bhatt who worked at CSAC and in 2006 and 2007 served as the Director of its Leveraged Investment Group. The Respondents settled, consenting to the entry of a cease and desist orders based on Securities Act Sections 17(a)(2) and Advisers Act Section 206(2). The entity Respondents also agreed to pay $1 million in disgorgement which was the fee for the deal plus prejudgment interest and a civil penalty of $1,250,000. Mr. Bhatt agreed to be suspended from association with any investment adviser for a period of 6 months.
A third action was filed naming as a defendant Brian Stoker, the principal Citigroup employee responsible for overseeing the structuring of Class V and the drafting of the offering memorandum and pitch book. SEC v. Stoker, Case No. 11Civ. 7388 (S.D.N.Y. Filed Oct. 19, 2011). This case is in litigation.
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