Citigroup Global Markets Inc. experienced a bit of self-inflicted pain last week.
The firm's failure to supervise tax-related stock transactions is carrying a censure and a $600,000 fine, according to the Financial Industry Regulatory Authority (FINRA).
In a recent statement, FINRA's Executive Vice President and Chief of Enforcement, Susan Merrill instructed that "[i]ncreasingly, complex trading strategies must be governed by supervision that is equally sophisticated and detailed ... 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."
Point well-taken perhaps as the issue for Citigroup was their alleged failure to establish procedures that would detect improper trades and to supervise or control these activities.
The trading involved several strategies and complex trading moves described generally as follows.
Citigroup's equity finance desk would purchase stock from generally foreign, broker-dealer clients. Once the taxable dividends had been paid, the stock would be sold back to the customer.
The problem for Citigroup is that when U.S. stock dividends are paid out to foreign investors, there may in fact be a taxable event that would require withholding. In the transactions at issue, Citigroup and its clients apparently believed these transactions were not subject to tax withholding, viewing them as "dividend equivalents" and part of a swap agreement.
To participate in this strategy, foreign Citigroup clients would sell U.S. equities to the firm's equity finance desk in New York, which served as custodian for these dividend-bearing stocks for the firm's London affiliate.
As FINRA elaborates on the scheme: The affiliate would in turn use 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."
Between 2002 and 2005, these transactions resulted in foreign clients receiving the full value of U.S. company dividends, without paying the withholding tax.
Citigroup already paid (around 2006) a substantial $24 million to the Internal Revenue Service due to this strategy. They did so after coming to the conclusion that they could not verify whether some trades were independent.
However, in a somewhat inexplicable failure to supervise, even after the firm put written procedures in place, traders did not follow them.
Related Web Resources
For more detailed information on the Citigroup transactions subject to the supervisorial failure and related matters, visit www.FINRA.org where you will also find extensive resources for industry professionals and investors.
The securities lawyers at Gusrae, Kaplan, Bruno and Nusbaum, have a great deal of experience in advising firms about implementation of supervision policies and related matters. Please contact our lawyers at any time.
