Citigroup Settles SEC Charges for Misleading Investors About CDO Tied to Housing Market

Jack Humphrey, Regulatory journalist
October 21, 2011 /

The Securities and Exchange Commission has sued Citigroup’s principal U.S. broker-dealer subsidiary for misleading investors in a $1 billion collateralized debt obligation (CDO) connected to the U.S. housing market in which Citigroup bet against investors as the housing market began to collapse.

Accordingly, Citigroup Global Markets structured and marketed a CDO called Class V Funding III and exercised significant influence over the selection of $500 million of the assets included in the CDO portfolio.

Citigroup then took a proprietary short position against those mortgage-related assets from which it would profit if the assets declined in value. Citigroup did not disclose to investors its role in the asset selection process nor did it reveal that it took a short position against the assets it helped select.

The CDO defaulted within months, leaving investors with losses while Citigroup made $160 million in fees and trading profits.

The SEC also charged Brian Stoker, the Citigroup employee primarily responsible for structuring the CDO transaction. The agency brought separate settled charges against Credit Suisse’s asset management unit, which served as the collateral manager for the CDO transaction, as well as the Credit Suisse portfolio manager primarily responsible for the transaction, Samir Bhatt.

According to the SEC’s complaints filed in U.S. District Court for the Southern District of New York, personnel from Citigroup’s CDO trading and structuring desks had discussions around October 2006 about the possibility of establishing a short position in a specific group of assets by using credit default swaps (CDS) to buy protection on those assets from a CDO that Citigroup would structure and market.

After discussions began with Credit Suisse Alternative Capital (CSAC) about acting as the collateral manager for a proposed CDO transaction, Stoker sent an e-mail to his supervisor.

He wrote that he hoped the transaction would go forward and described it as the Citigroup trading desk head’s “prop trade (don’t tell CSAC). CSAC agreed to terms even though they don’t get to pick the assets.”

The SEC claimed that during the time when the transaction was being structured, CSAC allowed Citigroup to exercise significant influence over the selection of assets included in the Class V III portfolio. The transaction was marketed primarily through a pitch book and an offering circular for which Stoker was chiefly responsible.

The pitch book and the offering circular were materially misleading because they failed to disclose that Citigroup had played a substantial role in selecting the assets and had taken a $500 million short position that was comprised of names it had been allowed to select.

Citigroup did not short names that it had no role in selecting. Nothing in the disclosures put investors on notice that Citigroup had interests that were adverse to the interests of CDO investors.

The Class V III transaction closed on Feb. 28, 2007. One experienced CDO trader characterized the Class V III portfolio in an e-mail as “dogsh!t” and “possibly the best short EVER!” An experienced collateral manager commented that “the portfolio is horrible.”

On Nov. 7, 2007, a credit rating agency downgraded every tranche of Class V III, and on Nov. 19, 2007, Class V III was declared to be in an Event of Default. The approximately 15 investors in the Class V III transaction lost virtually their entire investments while Citigroup received fees of approximately $34 million for structuring and marketing the transaction and additionally realized net profits of at least $126 million from its short position.

While the SEC’s litigation continues against Stoker, Citigroup has consented to settle the SEC’s charges without admitting or denying the SEC’s allegations. The settlement is subject to court approval.

Citigroup consented to the entry of a final judgment that enjoins it from violating these provisions. The settlement requires Citigroup to pay $160 million in disgorgement plus $30 million in prejudgment interest and a $95 million penalty for a total of $285 million that will be returned to investors through a Fair Fund distribution.

The settlement also requires remedial action by Citigroup in its review and approval of offerings of certain mortgage-related securities.

The SEC instituted related administrative proceedings against CSAC, its successor in interest Credit Suisse Asset Management (CSAM), and Bhatt.

The SEC’s investigation was conducted by Andrew H. Feller and Thomas D. Silverstein of the Enforcement Division’s Structured and New Products Unit with assistance from Steven Rawlings, Brenda Chang and Elisabeth Goot of the New York Regional Office. The SEC trial attorney who will lead the litigation against Stoker is Jeffrey Infelise.


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