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FINRA Fines Citigroup $600,000 for Failing to Supervise Trading Strategies

Firm also fined for failing to report trades to an exchange and inadequately monitoring Bloomberg messages.

The Financial Industry Regulatory Authority today announced that it has fined Citigroup Global Markets $600,000 and censured the firm for failing to supervise complex trading strategies designed in part to minimize potential tax liabilities. According to FINRA, the firm also failed to report to an exchange trades executed under these strategies and to adequately monitor Bloomberg messages.

Specifically, FINRA says, Citigroup failed to supervise and control trading activities by lacking procedures designed to detect and prevent improper trades between the firm and certain counterparties, and among entities within the firm.

"Increasingly complex trading strategies must be governed by supervision that is equally sophisticated and detailed," said Susan Merrill, FINRA executive vice president and chief of enforcement. "In this case, Citigroup's inadequate supervision resulted in improper trading related to the execution of strategies involving transactions with a principal purpose of limiting tax liability."

The first trading strategy involved the purchase of stock by Citigroup's equity finance desk in New York from a customer — particularly foreign, broker-dealer clients. Then after a period of time, during which the taxable dividends were paid, the stock was sold back to the customer.

When dividends on stock in U.S. companies are paid to foreign investors, these dividends may be subject to withholding taxes, depending on the applicable treaty between the United States and the foreign investor's home country. However, Citigroup and certain clients understood that a "dividend equivalent" paid as part of a swap agreement would not be subject to such withholding taxes.

To take advantage of this strategy, a foreign client would sell U.S. equities to Citigroup's equity finance desk in New York. The New York desk then acted as custodian of this dividend-bearing stock for Citigroup's London affiliate.

The London affiliate then used the stock as the underlying equity hedge in a "total return swap" entered into with the customer. Under the swap, the London affiliate paid the customer a "total return," which was any income the stock generated, including any appreciation in value, as well as an amount equivalent to the dividend. In exchange for the "total return payments," the customer paid the London affiliate interest and covered any decline in the share price.

In the final step, the swap was terminated and the New York desk sold the stock on behalf of the London affiliate. The end result was the firm's foreign clients received the full value of dividends from American securities, the "dividend equivalent," free of applicable U.S. withholding tax. These transactions occurred from 2002 through 2005.

Citigroup paid about $24 million to the Internal Revenue Service in 2006, and earlier, in connection with this strategy. The payments were made after the firm determined there was a risk it could not substantiate the independence of some of the trades to the extent they could be distinguished from stock loans or stock repurchase agreements, and that the "dividend equivalents" would be subject to U.S. withholding tax.

For approximately two years after this strategy began, it was conducted without Citigroup having in place written procedures to govern it. After Citigroup implemented written procedures, trading staff conducted improper transactions that deviated from the procedures that Citigroup had put in place.

This activity included selling the stock to an interdealer broker with the understanding that the counterparty would go to the same broker to purchase the stock, and exchanging Bloomberg messages with counterparties as the swap was being unwound to facilitate the counterparties' repurchase of the underlying securities.

The second strategy was constructed to enhance — for the financial benefit of the firm itself — the after-tax yield on Italian stocks. In addition to the New York and London trading desks, this scheme also involved the firm's Swiss affiliate.

In the Italian equity trades, the London desk directed the New York equity finance desk to borrow stock in Italian companies expected to declare dividends. The New York desk, in turn, loaned the stock to the Swiss affiliate, which then sold the shares back to the New York desk.

In the next step, the New York desk sold these shares to an inter-dealer broker, who then sold them to the London desk. Lastly, the London and Swiss affiliates entered a swap agreement to cover the risk each took on as a result of taking a long (London) and short (Swiss) position. After the dividend was paid, the trades were unwound in reverse order.

The London affiliate held the Italian stocks and collected the dividend, in anticipation of receiving favorable tax treatment from the Italian authorities under a treaty, and in anticipation of generating additional tax benefits for the firm as a whole. This strategy was used from about 2000 to 2004.

Citigroup failed to establish written supervisory procedures specific to these trades. The firm also failed to prevent improper coordination between its related entities. Additionally, some of the stock trades by the New York desk in carrying out both trading strategies were not reported to an exchange, as required by securities regulations.

FINRA also found that the New York desk and counterparties used Bloomberg-terminal messages to communicate about the U.S. equity trades with foreign clients for approximately one year before the firm incorporated the review of the desk's Bloomberg messages into its email review system.

In settling this matter, Citigroup neither admitted nor denied the charges, but consented to the entry of FINRA's findings. In determining the appropriate sanction, FINRA noted that Citigroup discovered and self-reported the violations giving rise to this matter; that the firm hired a law firm to conduct a review of these trades and to assist in remedial efforts; and that the firm and its outside counsel provided substantial assistance to FINRA staff during the investigation.

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