WASHINGTON - In the largest federal and state settlement of its kind, Citigroup Global Markets Inc. yesterday agreed to buy back, or help investors liquidate, a total of $19.5 billion of auction-rate securities during the next 17 months and pay $100 million of fines to the states, including $50 million to New York.
The "settlement in principle" stems from investigations by the Securities and Exchange Commission, the Financial Industry Regulatory Authority, the North American Securities Administrators Association, and the New York attorney general, as well as states including Texas, Massachusetts, and New Jersey, revolves around the largest firm in the $330 billion ARS market and could serve as a model for future ARS settlements.
Linda Chatman Thomsen, director of the SEC's enforcement division, called the settlement "an outstanding example of federal and state regulatory cooperation for the benefit of investors and markets."
Federal and state regulators said yesterday that their investigations of the ARS market are continuing and could span well beyond the roughly 10 other broker-dealer and banking firms that underwrote and sold ARS to include other market participants such as auction agents and mutual funds.
The "settlement sends a resounding message to the entire auction rate securities industry: This type of deceptive behavior will not be tolerated and we will actively seek justice on behalf of investors in auction rate securities," Andrew Cuomo, New York's attorney general, said during a press conference. "Our goal is simple: to get investors back their money, and that's exactly what this does."
Cuomo said that his office was continuing investigations into other banks but did not elaborate.
"We are proceeding," he said. "Obviously this is an industry-wide situation, Citigroup was one of the largest firms in this business but certainly not the only firm and as you know we've been working on several levels with several of the many different players and that is ongoing."
William Galvin, secretary of the commonwealth of Massachusetts, has filed lawsuits against UBS and Merrill Lynch & Co. over allegedly fraudulent sales practices in connection with ARS.
The ARS market, which had steadily grown in recent years, showed signs of trouble as early as August 2007 when the rating agencies downgraded insurers with exposure to subprime mortgages who had insured the securities. The market then froze in February 2008 when dealers stopped supporting the auctions, resulting in widespread auction failures that left hundreds of thousands of investors stuck holding their ARS.
The regulators have charged that Citi and other firms marketed ARS to investors as highly liquid, cash-like instruments that could be purchased by money market funds, without disclosing the risks that auctions could fail and that they could be stuck with the securities. Some firms mounted campaigns to push ARS on retail investors at a time when their executives were selling their own holdings of these securities.
Under the settlement, Citi, within 90 days, will buy back at par $7.5 billion of ARS that it had sold to 38,000 retail investors, including individuals, small businesses, and charities. The firm also will use its best efforts to help 2,600 institutional investors liquidate $12 billion of ARS by the end of 2009.
Neither Citi nor federal regulators could estimate how much of these are municipal ARS, but an SEC official said that most of the $12 billion held by institutional investors are student loan-related ARS.
Until Citi provides for the liquidation of the ARS under the settlement, it will offer no-cost loans to customers that remain outstanding until the ARS are repurchased. It will also reimburse customers for any interest costs incurred under prior loan programs the firm made available to them.
Citi, which federal regulators said represents about one-fifth of the ARS market and currently holds roughly $8 billion of the securities in inventory, has agreed that it will not liquidate its own inventory of a particular ARS before it liquidates its customer holdings in that security.
In addition, Citi will reimburse for losses all retail customers who purchased ARS before Feb. 12 and then sold them at a loss after that date. The firm also has agreed to participate in a special, public arbitration process, established and monitored by FINRA to resolve the claims of damages suffered by retail investors who were unable to access their funds. Citi will concede liability, but will be able to contest the existence and extent of damages in these proceedings.
Under the new procedures, investors will have the option of having their claims heard by a three-person panel of arbitrators, none of whom would be affiliated with a firm that recently sold ARS. The panels would consist of two public arbitrators and one non-public arbitrator.
"FINRA will work expeditiously with parties to put this process in place as soon as possible so these cases won't be unduly delayed," said Linda Fienberg, president of FINRA's dispute resolution group.
To date, more than 170 cases involving ARS have been filed in its dispute resolution forum, according to FINRA.
The settlement also requires Citi to refund financing fees to muni ARS issuers that issued ARS in the primary market between Aug. 1, 2007 and Feb. 11, and refinanced those securities after Feb. 11.
Finally, Citi will notify all customers of the settlement terms and will establish a telephone assistance line, with appropriate staffing, to respond to questions from customers about the terms of the settlement.
SEC officials said that they may impose an additional financial penalty on Citi after it has completed its obligations under the settlement. They said they will take the firm's cooperation into account in setting the amount, if a fine is imposed.
Citi neither admitted nor denied the allegations of wrongdoing, and issued a statement yesterday saying that since February it has already redeemed or auctioned at par more than 50% of its retail clients ARS holdings.
Cuomo said yesterday that the $50 million Citi will pay the state covers both the firm's substantive conduct and its failure to "properly comply" with its obligations under the attorney general's Martin Act subpoena, which gives the attorney general broad powers to investigate financial fraud.
The NASAA said the $50 million penalty paid to the states reflect Citi's allegedly fraudulent sales practices as well as the firm's destruction of records that were required to be maintained under state law.
The association said that its' members part in the settlement stems from an investigation that was led by the Texas State Securities Board into ARS complaints relating to Citi from investors. The board is expected to meet on Sept. 22 to consider suspending the state license of UBS and fining the bank for alleged fraudulent activity involving auction rate securities.
Texas securities commissioner Denise Voigt Crawford said yesterday that she is "extremely pleased" with the outcome of the record securities settlement, but that she can not discuss any pending investigations of other securities firms because state law forbids such disclosures.
The settlement with Citi is related to a larger coordinated state investigation of ARS problems that is being conducted by a multi-state task force, comprised of securities regulators in 12 states. That task force is being led by Bryan Lantagne, director of the Massachusetts securities division.
Market participants applauded the settlement yesterday, saying it can only help the ARS market.
"This is a market that needs TLC - transparency, liquidity, and a restoration of investor confidence," said Peter Chatzky, chief executive officer of the Napa Group, LLC, which provides short-term adjustable rate securities software. "Certainly the move that many of these banks may make where they're buying back positions at par from investors is going to do a lot for the restoration of confidence. I think it will help provide liquidity in the short run and put them in a better position to provide liquidity in the long run."
Trading of auction-rate securities on the secondary market increased as institutional investors looked to sell the securities, suggesting they were hoping for a more near-term solution, according to Barry Silbert, chief executive of Restricted Stock Partners, which runs the largest secondary market for ARS.
"From a retail perspective, it's a positive, but for the institutional holders, I think the Citi settlement doesn't provide a lot of clarity for what happens next," Silbert said.
Citi's stock closed at $18.62 a share, down $1.08 or 5.48%, after ranging between $18.33 and $19.68 during the day.