Citigroup’s CSO Fund Bets the Farm and Investors Lose

A long festering feud between Citigroup and some of its most valued clients has now approached the boiling point.  The feud is likely to lead to securities arbitration claims and Zamansky & Associates is launching an investigation on behalf of investors.  The clients and fund in question is Citigroup’s Corporate Special Opportunities Fund, also known as CSO Partners, which is a small hedge fund based in London’s Berkeley Square.

Unlike other fund collapses, investors aren’t only likely to file claims based on suitability; future claims with regard to Citigroup’s CSO Fund could include gross negligence, and a breach of basic investment protocol and fiduciary responsibilities.  This is also another likely example of the phenomenon known as “style drift,” which I have blogged about regularly before.

Investors in the CSO Fund are legitimately angry.  Not only have they been inappropriately prevented from redeeming their funds, but fund manager John Pickett allegedly placed a “bet the farm” investment that was entirely too risky.  In June of 2007, the Wall Street Journal reported that Mr. Pickett purchased a bundle of loans in a private auction on behalf of a German Media company; which represented more than half of CSO Funds’ assets of roughly $700 million.  Led by Morgan Stanely, seven banks ran the auction.  Needless to say, investors didn’t sign up for this type if risk and its unclear if the transaction even met Citigroup’s internal controls.

Arguing that the terms of the deal had changed, John Pickett tried to back out, but after a significant amount of legal wrangling with Morgan Stanley, Citigroup/CSO Partners settled.  Under the deal, according to the Journal, CSO Partners would purchase about $746 million of the loans at face value which had already deteriorated significantly as well as the other side’s legal expenses.  Obviously the term “settled” is used loosely here.

CSO Partners fund manager John Pickett resigned and reportedly accused his bosses who negotiated the settlement of conflicts of interest - both of which were previously employed by Morgan Stanley.  Had Citigroup not settled and paid the legal costs, according to the story CSO Partners allegedly would have reported a modest positive return for 2007 - not a 10.9 percent loss.  Investor redemptions came flooding in and the fund froze out investors immediately.  Ever since, they’ve watched their holdings in Citigroup’s CSO Fund dwindle down to ten cents on the dollar.

At its peak, the CSO Fund managed almost $4.2 billion and had a net asset value of about $58 million and debt of about $880 million according to the Financial Times.  That’s a huge amount of leverage.  Way too much for executives reminiscent of the Keystone Cops.  They bungled their way to huge losses and in all likelihood were paid handsomely to do so.  As Douglas McIntyre of 24/7 Wall Street put it, “taking the value of assets down that much in such a short period requires as much skill as showing an increase of a similar size.  In other words, it’s extraordinary.”

The apparent disregard Citigroup has for its client’s is shocking.  After such poor management, they still refuse to make their CSO Fund customers whole leaving them little option but to seek legal recourse.

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Cioffi and Tannin’s Indictment: Good News for Investors

Ralph Cioffi and Mathew Tannin, the former managers of the Bear Stearns’ hedge funds that collapsed last year, were indicted today. The SEC also filed civil charges today as well. I appeared on CNBC this afternoon to discuss whether the evidence will be enough to show “intent” and whether criminal charges were warranted. The answer is a resounding yes to both questions, especially given Tannin’s “smoking gun” email from his personal account to Cioffi’s wife’s email account where he frets over the funds future performance just days before making upbeat comments to investors. Cioffi’s withdrawal of $2 million from the funds before the collapse appears to provide evidence of his “intent”.

The criminal and SEC developments could bode well for investors seeking recovery of losses through the arbitration process. Tannin and Cioffi will be called to testify in arbitration hearings before their criminal trials take place and likely will exercise their Fifth Amendment rights against self incrimination. Attorneys can ask the arbitration panel to take what’s called an “adverse inference”, which means panelists can assume that if the defendants answered the questions, rather than pleading the Fifth, the answers would have adversely affected their interest.

It should be noted that JP Morgan has put aside billions of dollars for litigation costs when it acquired Bear Stearns.

Wall Street Witch Hunt

Auction Rate Securities: A Scandal Made Possible by the SEC

The SEC’s Division of Enforcement has never been considered a tough minded regulator. But the collapse of the auction rate securities market underscores just how frighteningly ineffective the division really is.

On May 31, 2006, the SEC’s Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. Here’s an excerpt from that release:

The SEC order finds 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 the securities laws. The violative conduct 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 in order to
• prevent failed auctions, to set a “market” rate, or to prevent all-hold auctions;
• submitting or changing orders, or allowing customers to submit or change orders, after auction deadlines;
• not requiring certain customers to purchase partially-filled orders even though the orders were supposed to be irrevocable;
• having an express or tacit understanding to provide certain customers with higher returns than the auction clearing rate; and
• providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.

The release also noted:

Some of these practices had the effect of favoring certain customers over others, and some had the effect of favoring the issuer of the securities over customers, or vice versa. In addition, since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities (emphasis mine). By engaging in these practices, the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities.

In justifying the paltry $13 million fine the SEC imposed, a spokesperson said the agency “considered the amount of investor harm and the firms’ conduct in the investigation to be factors that mitigated the serious and widespread nature of the violations.” In particular, the firms voluntarily disclosed the practices they engaged in to the SEC, upon the staff’s request for information, which allowed the SEC to conserve resources.

With the advantage of hindsight, it’s clear that the SEC never understood the inherent and significant damage that was created by brokerage firms rigging the auction in the first place. It’s also worth noting that if Wall Street firms simply cooperate with the SEC that partially justifies a wrist slap. Finally, if SEC still mistakenly believes that the their “cease and desist” order prompted the big brokerage firms to warn investors of the risks in buying auction rate securities, I have some clients they should definitely meet.

Auction Rate Securities: An Investor Scandal of Significant Proportions

Our office has been flooded in recent days with inquiries from panicked investors who have suffered incredible harm because of the collapse of the auction rate securities market. All these investors vehemently insist they acquired auction rate securities because their brokers advised them they were as good as cash but would pay higher interest rates than government treasury bills or FDIC-insured savings accounts. Firsthand accounts from investors are posted on Dealbreaker, available here. Now that the market for auction rate securities has all but dried up, these investors can no longer make good on routine financial commitments such as monthly mortgage and credit card payments.

Although we are still sifting through mounds of evidence in preparation of filing our first claims, here is what we have already determined:

The investors we represent have provided irrefutable evidence that their brokers assured them that auction rate securities were as good as cash. Although Wall Street firms can cite some boilerplate warnings in their offering materials, they clearly marketed auction rate securities as being risk free, liquid investments. And indeed they were risk free, as long as Wall Street firms were willing to provide liquidity to prop up the market.

And therein lays the magnitude of this scandal.

One of the egregious blind spots of individual investors is they rarely take the time to understand the financial incentives behind the products Wall Street sells them. Underwriting or serving as a broker-dealer for auction rate securities was a hugely profitable business for the big brokerage firms, garnering them millions of dollars in fees. In addition to peddling auction rate securities to individual investors, the brokerage firms also bought these securities for their own proprietary accounts, yet another whopping conflict of interest.

And true to form, the big brokerage firms got caught manipulating the market. In May 2006, the big brokerage firms agreed to pay more than $13 million to settle SEC charges they were sharing confidential information between January 2003 and June 2004. The SEC said the violations were “serious and widespread.”

The Big Four accounting firms clearly understood the inherent risks of auction rate securities. A year after the SEC settlement, the Big Four accounting firms warned their corporate clients to classify auction rate securities in their portfolios as “investments” rather than “cash equivalents.” As of yet, we have found no evidence of any brokerage firm offering similar counsel or warnings to their clients.

The credit crunch that was sparked by the sub-prime mortgage mess – for which investors can also thank the big brokerage firms – has impaired the balance sheets of the big brokerage firms, so they no longer have the flexibility to provide liquidity and support for the $350 billion auction rate securities market. (Note to individual and corporate investors: the interests of a brokerage firm always take precedent over yours.) The repercussions and the extent of the fallout is not yet fully understood; in addition to individual investors that have been impaired, an untold number of corporations will likely be forced to join Bristol-Meyers Squibb ($270 million write-down) in taking massive write-downs relating to the auction rate securities on their books.

Merrill Lynch already has been sued by one of its corporate clients for peddling auction rate securities. Rest assured, when all the facts about the auction rates securities market are known and understood, the legal fallout could quite possibly be more formidable and damaging than Wall Street has ever before experienced.