A landmark insider trading case in Australia has undermined attempts by Citigroup to regain ethical authority, argues Justin O'Brien, in Sydney.
Alleged defects in the ethical governance of Citigroup, the largest integrated investment bank and financial services firm in the world, have been aired in yet another jurisdiction. In what has the potential to be a landmark case, the Australian Securities and Investments Commission has accused Citigroup Global Capital Markets of insider trading and unconscionable behaviour.
The case centres on allegations that Citigroup prevented its proprietary desk trading on its own account in a manner that was detriment to a client, Toll Holdings. Citigroup's mergers and acquisitions team had been advising Toll in a long planned Aus $4.6 billion bid last August for the logistics and transport conglomerate Patrick, a corporation that also controls Virgin Blue, Australia's low-cost airline.
The court proceedings, which opened in Sydney on Friday, were sandwiched between breaches of the tax code and an order liquidating a small graphics company.
Just after 10.30am a phalanx of lawyers and their associates entered the court. To the visible amusement of the registrar, the complex manoeuvring began to test stringent new rules on the management of conflicts of interest introduced after a series of financial scandals in Australia.
Proceedings were promptly adjourned until June 23rd when a trial judge is appointed. The legal teams thanked the registrar and departed, leaving the court to determine once again the detritus of small-time violations of corporation and tax law. The low-key start masks the importance and complexity of the issues in ASIC v Citigroup Global Capital Markets (Australia).
According to the statement of claim issued by ASIC, a trader working for the proprietary arm of the bank, Andrew Manchee, started buying Patrick stock on the morning of August 19th, 2005. Patrick had announced a profit warning the previous day and its stock was initially languishing. By lunchtime Mr Manchee had amassed more than one million shares.
Citigroup Global Capital Markets head of equities, Malcolm Sinclair, noticed the trading and allegedly had a conversation with a senior executive responsible for managing the trading arm. According to the claim, he told the executive, Paul Darwell: "We may have a problem with that."
ASIC alleges that this conversation, although circumspect, represented a material breach of insider trading laws. It imparted material information across the Chinese walls separating advisory services from a bank's own proprietary trading unit. It is alleged that failure to manage this process effectively allowed Citigroup to cheat its client and the market.
"This is a significant case raising two very important issues for the securities industry - having arrangements for managing inside information and dealing with conflicts of interest," said Jeremy Cooper, deputy chairman of ASIC when the case was announced earlier this month.
According to ASIC, Mr Darwell did nothing and allowed Mr Manchee to continue consolidating his position. In the closing hour of trading, with the market awash with rumour of an impending bid, Citigroup abruptly changed tactics.
ASIC attributes this change to an "unusual" invitation by Mr Durwell to Mr Manchee to join him for a smoke on the pavement outside the office at 3.30pm. It is alleged by ASIC that he "told Mr Manchee to stop buying shares in Patrick."
Seven minutes later the trader returned to his desk. He progressively liquidated nearly 20 per cent of his holding in the remaining 20 minutes of trading. The bank's decision not to discipline Mr Manchee suggests a crucial, if controversial, calculation. "Buying" would continue to drive up the price of Patrick, which would have been detrimental to its client. "Selling" could be construed as taking advantage of daily price movements or, at worst, a benign if unauthorised and misguided attempt to minimise exposure.
The change in strategy was picked up, however, by the sophisticated monitoring system set up by the Australian Stock Exchange. The system automatically logs significant changes in trading behaviour and reports suspicious activity to ASIC. Part of the claim against Citigroup requires the New York-based bank to provide recompense to Toll for the total rise in the Patrick share price that day.
The regulator is basing its case on the materiality provisions of the legislation. These suggest any contact represents a breach and therefore a potential threat to the integrity of the marketplace. The claim alleges that Citigroup "did not have in operation arrangements that could be reasonably be expected to ensure that inside information was not communicated to the Citigroup employee who traded in Patrick shares for the benefit of Citigroup".
Citigroup has denied any wrongdoing. The bank maintains that neither the information disclosed to Mr Durwell nor the instructions to Mr Manchee were of sufficient quality to constitute material breaches of the insider trading provisions. The personnel involved have not been placed on administrative leave but remain in place on full salary.
The allegation that Citigroup Global Capital Markets is guilty of "unconscionable conduct" relates primarily to the maladroit attempts to minimise the perception of a conflict. The failure to prevent Mr Manchee from selling enabled Citigroup to extricate itself from a potential problem but at a handsome profit.
In a statement the global bank commented: "Citigroup doesn't believe ASIC has any basis of a claim and that this is an attempt to regulate the proprietary trading desks, which are a feature of all major investment banks."
Prosecutorial success will have an impact far beyond Australia's shores. It has the capacity to fundamentally transform the way in which investment banks are governed.
ASIC is narrowing the gap in national regulatory priorities in policing global markets by replicating the more aggressive model of enforcement seen recently in the US. It is also playing a leading role in attempts to synchronise the enforcement agenda of members of the International Organisation of Securities Commissions (IOSCO) through the development of reciprocal enforcement recognition.
The case has aroused significant international interest among regulators and apprehension within the industry. Responding to questions at an Australasian Compliance Institute conference in Melbourne last Wednesday, a senior ASIC executive confirmed that the regulator had consulted with international colleagues before proceedings against Citigroup were brought.
The drive towards greater international harmonisation and co-operation opens the possibility that the case in Sydney could redefine the duties of investment banks trading on their own account while simultaneously advising clients on complex mergers and acquisitions.
What also emerges from this is a co-ordinate move in Australia from reliance on industry assertion that conflicts are being effectively managed towards a much more sceptical interventionist approach. The Citigroup litigation was announced just weeks before the publication in Sydney of a discussion document on managing conflicts of interest. The document provides detailed guidance that mirrors the measures introduced to combat defects with analyst research on Wall Street in 2003.
"Conflicts of interest impact the quality of the financial services provided and, in our experience, poorly managed conflicts tend to result in poor service to consumers and a market that is not fair and transparent," said the ASIC deputy chairman, Mr Cooper, when releasing the report.
The document covers the use and potential abuse of research and the fiduciary responsibilities a bank owes to its clients. No advice on proprietary trading is provided. This is attributable to the litigation now before the court. Nevertheless, it is inevitable that thetiming of the litigation will impact on the wider public debate about whether it is possible to shore up Chinese walls. For Citigroup the timing of the action could not be worse. It was brought just three days after the Federal Reserve in Washington released the bank from acquisition restrictions in the US. These were imposed after a glut of governance failures.
Recent failures to manage ethical issues in the corporation included the manipulation of the Eurobond market in the UK, which led to one of the largest single fines imposed by the Financial Services Authority. In Japan, Citigroup's private banking arm was forced out the lucrative private banking market after admitting poor governance procedures.
Chief of operations in Tokyo, Douglas Peterson, was forced to issue a contrite apology in December 2004. To make matters worse, just last month Citigroup saw its efforts to acquire a controlling interest in Turkey's fifth largest bank spurned in favour of an offer from the National Bank of Greece.
Chairman and chief executive, Charles Prince declared on his accession to the top job in Citigroup that he should be judged on his capacity to improve the ethical foundations of the corporation. The proceedings now active in Australia suggest he has failed.
Dr Justin O'Brien is director of the corporate governance programme at the school of law, Queen's University Belfast