A Securities and Exchange Commission investigation of soured Citigroup Inc. debt funds has subpoenaed former in-house brokers, some of whom contend the bank misled investors about how risky the funds were, according to people familiar with the matter.
The funds invested in municipal bonds and mortgage debt, using borrowed money to enhance the bets. After the mortgage market crumbled starting in mid-2007, the funds' value fell about 77%, to a low in March 2008. A storm of protest from brokers and clients ensued, and Citigroup, following an internal debate, offered share buybacks that reduced investor losses to about 61%.
Three brokers who worked in California for Smith Barney, then a Citigroup unit, concluded the bank hadn't adequately disclosed the funds' risks and also mismanaged them, according to people familiar with the regulatory probe. The brokers received SEC subpoenas and spoke to the SEC in 2009 and again this past summer, these people said. Another former Smith Barney broker from Texas met with the SEC in September, the broker's lawyer said.
The California brokers resigned in 2008 in a dispute over Citigroup's handling of the funds. The brokers filed a claim in an industry arbitration panel that Citigroup had "constructively" dismissed them. They lost in arbitration. If the SEC finds that Citigroup misled investors about the funds' risks and levies a penalty, the California brokers may stand to claim 10% to 30% of certain penalties under provisions of the Dodd-Frank financial regulatory overhaul.
Michael Blumenfeld, a lawyer for the California brokers, said any SEC testimony must remain confidential under agency rules.
The SEC declined to comment. A federal prosecutor monitored some of the SEC meetings with brokers, according to people familiar with them.
Citigroup officials declined to comment in detail, citing the regulatory probe. But Citi denies misleading investors, saying its disclosure was adequate because investors had been put on notice the funds were more volatile than the stock market and that they could lose their entire investment.
The investigation comes as Citigroup is trying to rebuild its reputation after having been rescued by the U.S. government in 2009. Still 12% government-owned, Citigroup has tumbled from its perch as Wall Street's top underwriter in 2007 to No. 6 this year, according to Thomson Reuters.
One series of funds, called MAT Finance LLC, short for municipal arbitrage trust, borrowed at low short-term rates and invested in longer-term bonds that paid higher rates. Some marketing materials called it "an attractive alternative" to a bond index, while other disclosures said it was riskier than the stock market and three times as risky as a bond index.
Although bonds are generally less volatile than stocks, the MAT funds eventually borrowed more than $8 for every $1 invested, magnifying the risk from even small changes in the bonds' value.
The other fund series, called Falcon, contained municipal bonds, mortgage-backed securities and bank loans. Standard & Poor's Corp. gave the Falcon funds a rating of "low to moderate sensitivity to changing market conditions," equivalent to safe, medium-term government bonds, a rating that sales materials highlighted. S&P declined to comment.
The funds raised $2.8 billion from investors between 2002 and 2007. Investors had to have at least $5 million in investible assets, meeting a definition of sophistication and exempting Citigroup from registration requirements.
In Newport Beach, Calif., a team of Smith Barney brokers led by Michael Johnston put $91 million, or 4%, of their clients' assets into the funds, say people familiar with the matter. The particular funds they put their clients in fell 80% to 97% from May 2007 to March 2008, by the brokers' calculation, these people say. Over that same period, a bond index rose slightly.
"Some of my most valued clients will never trust my judgment again," Mr. Johnston said in an email to Citigroup executives.
Sallie Krawcheck, then head of Citigroup's wealth-management division, spoke to several brokers and soon advocated that the bank cover part of the losses on the ground that the funds were less stable than billed, according to people familiar with the matter. Other Citigroup executives balked. The No. 2 executive, John Havens, said a bailout might cost "hundreds of millions more" than other executives believed, according to notes kept by one Citigroup executive. Mr. Havens wasn't available to comment, Citigroup said.
Citigroup, which had poured in cash to stabilize the funds when they received collateral demands from lenders, eventually decided to spend $250 million to cover about one-eighth of clients' losses. Clients who accepted had to give up the right to pursue further claims.
In Miami, Gerald Kazma, a retired cable-TV system developer, invested $4 million in MAT funds in early 2006. According to an arbitration claim he later filed, a Citigroup private banker had told him the return and risk were "slightly greater" than a typical municipal-bond portfolio. Citigroup told the securities-industry arbitration panel the funds' risks were disclosed to Mr. Kazma.
The panel this year awarded Mr. Kazma $1.8 million, two-thirds of his loss, citing "negligent management and negligent supervision" by Citigroup. Three other investors have won a total of $2.1 million from Citigroup in arbitrations this year, while three claims have been denied.
Citigroup has since sold a majority stake in Smith Barney to Morgan Stanley. Ms. Krawcheck left Citigroup in 2008 and now leads Bank of America Corp.'s Merrill Lynch brokerage force. The three brokers in Mr. Johnston's team left Smith Barney in 2008 and have since lost an arbitration claim against Citigroup alleging they were "constructively terminated."
The team appeared at the SEC's New York office for three days in the summer of 2009 and two more days this past summer, according to people familiar with the probe.
The brokers' contention is that in addition to misleading investors about the funds' risk, the bank mismanaged the funds by ignoring its own benchmarks for when to buy and by failing to use hedging tactics to reduce losses, the same people said.
The same team of SEC investigators spoke in September by video conference with another former Smith Barney broker, in Texas. Rogge Dunn, a lawyer representing the brokers, said, "The SEC raised questions regarding whether Citi had disclosed to its financial advisors that Citi's own private bank had rated the Falcon Fund at a risk level of 4 on a 1 to 5 scale, with 5 being the highest risk." Citigroup declined to comment.