After New York Attorney General Andrew Cuomo announced (here) earlier today that Citigroup had agreed to a blockbuster settlement regarding auction rate securities, it certainly seemed like the deal would put pressure on other investment banks to adopt similar measures. So perhaps it was not unexpected later in the day that Merrill Lynch announced (here) that it too would "buy back at par auction rate securities sold by it to its retail clients."
If Merrill Lynch’s response is any indication, other banks and broker-dealers may also now find themselves pressured to buy back auction rate securities from their retail clients at par. UPDATE: It appears that UBS got the memo, too; the August 8, 2008 headlines include reports that UBS will be entering its own deal today with state and federal regulators (refer here). There were quite a number of other features to Citigroup’s settlement beyond the retail investor buy back. In addition, Citigroup not only settled with the NY AG, but also preliminarily settled with the SEC as well, as discussed in the SEC’s August 7, 2008 press release (here).
Other companies that want the same degree of resolution as Citigroup may have to swallow many if not all of the terms to which Citigroup agreed, so the entire package is worth a closer look.
Without access to all of the settlement documents, it is not possible to obtain a complete understand of everything to which Citigroup agreed. But there is a great deal of information in NYAG’s and SEC press releases linked above, as well as Citigroup’s own press release about the settlement (here).
The major components of the deal are that Citigroup will buy back at par $7.5 billion in auction rate securities that it sold to individual investors, small business and charities. In addition, Citigroup agreed to use its "best efforts" to liquidate another $12 billion in auction rate securities sold to retirement plans and institutional investors by the end of 2009.
Citigroup also agreed to pay the state of New York a civil penalty of $50 million, and to pay a separate civil penalty of $50 million to the North American Securities Administrators, which, according to the NYAG’s press release, has had a task force conducting investigations into the marketing and sale of auction rate securities.
Beyond these basic outlines, there are a number of other terms designed to make investors whole.
First, Citigroup will, according to the NYAG, "fully reimburse all retail investors who sold their auction rate securities at a discount after the market failed."
Second, as described in the SEC press release, "until Citi actually provides for the liquidation of the securities…Citi will provide no-cost loans to customers that will remain outstanding until all the ARS are repurchased, and will reimburse customers for any interest costs incurred under any prior loan program."
Third, according to the SEC, "Citi will not liquidate its own inventory of a particular ARS before it liquidates its own customers’ holding in that security."
Fourth, in one of the deal’s more interesting components, Citigroup agreed that (according to the SEC press release, which has the best description of this component) with respect to any customer who contends that he or she has "incurred consequential damages beyond the loss of liquidity," that it will participate in a "special arbitration process that the customer may elect and that will be overseen by FINRA." In these proceedings, Citigroup "will not contest liability for its misrepresentations and omissions…but may challenge the existence or amount of any consequential damages." Customers who elect not to participate in these special procedures "may pursue all other arbitration or legal of equitable remedies available through any other administrative or judicial process."
Fifth, with respect to its investment bank clients, according to Citigroup’s press release, "Citi will refund refinancing fees to municipal ARS issuers that issued ARS in the primary market between August 1, 2007 and February 11, 2008, and refinanced those securities after February 11, 2008."
The SEC’s press release emphasizes that Citigroup’s settlement with the SEC is "preliminary" and that the company "faces the prospect of a financial penalty to the SEC after it has completed its obligations under the settlement agreement." The amount of the penalty if any will be based on an assessment "whether Citi has satisfactorily completed its obligations under the settlement," as well as the costs Citi incurred in meeting those obligations.
With respect to the issue of costs to Citigroup, the company itself noted that the financial impact it would sustain as a result of acquiring the $7.3 billion of its retail investors’ auction rate securities "is expected to be de minimus." The company estimates that the difference between the purchase price and the market price is ‘in the range of $500 million on a pretax basis," although the actual pre-tax loss will depend on market values at the time of purchase.
Citigroup did not attempt to estimate the costs to the company of its commitment to use its "best efforts" to liquidate its institutional investors $12 billion in auction rate securities. Nor does its press release reflect an estimate of the costs to the company of the various provisions designed to make its retail and investment bank customers whole. The "consequential damages" arbitrations could be particularly interesting in the respect, and I am guessing these proceedings will also involve some pretty elaborate allegations. Given the marketplace’s reaction to the settlement announcement — Citigroup’s stock closed down 6.24% today — the perception seems to be that the overall costs will something more than "de minimum."
It is worth noting that the $12 billion retail investor buy back that Merrill Lynch announced today, while clearly designed to try to ingratiate the company to regulators and to try to buy the company some room to maneuver, acknowledged only one part of the Citigroup’s multi-component settlement. Merrill’s initiative lacked any provision for liquidation of institutional investors’ holdings, and it similarly lacked any of the "make whole" components of the Citigroup settlement. Regulators will undoubtedly press Merrill for similar concessions.
Whatever the aggregate costs to Citigroup of the settlement announced today will ultimately be depends to an enormous extent on whether this settlement, and the others that undoubtedly will be reached in the coming days and weeks, are collectively enough to melt the frozen auction rate securities market. At this point, nobody is buying the securities because they don’t want to get stuck with an asset they can’t turn around and sell if they have to. But if confidence does return, the banks and other companies will be able either to hold these newly acquired assets on their balance sheets at par, rather than at a discount, or to sell the assets in an orderly marketplace at reasonable marketplace prices.
On the other hand, it is possible that all that is happening is that the problems are being shifted around. The banks will have to be taking on to their balance sheets a huge quantity of illiquid assets at a time when their balance sheets are already under pressure. All of them will face the same desire, and perhaps need, to sell these assets, at the same time that they will also be under pressure to use their "best efforts" to help their institutional investor clients unload their holdings. These arrangements address the retail investors problems (which is fair, appropriate and necessary, from both a practical and prudential standpoint), but the other problems are not yet solved, and they will not be finally solved until there are as many interested buyers as they are eager would-be sellers. And these arrangements certainly bake in a host of holders who will want to be sellers.
The key component of the settlement may be the "best efforts" provision pertaining to institutional investors, which Citigroup described in its press release as follows:
Citi will work with issuers and other interested parties to provide liquidity solutions for Citi institutional investor clients. In doing so, Citi will use its best efforts to facilitate issuer redemptions and/or to resolve its institutional investor clients’ liquidity concerns through resecuritizations and other means. The New York Attorney General will monitor Citi’s progress and, beginning on November 4, 2008, retains the right to take legal action against Citi with respect to its institutional investor clients. The other regulators have entered into a similar arrangement but with a December 31, 2009 date.
If these efforts prosper, they may go a long way toward restoring an efficient marketplace for these securities. The problem is that, without a funtioning marketplace, it is not immediately apparent (at least from this brief description), how institutional investors’ "liquidity concerns" will be resolved, short of Citigroup itself buying out the institutional investors too –although to my eyes at least this "best efforts" stops short of a firm buyout commitment.
It may be that a Citigroup buyout of institutional investors is implied in this "best efforts" provision, especially given the looming threat of further state regulatory action, amoint to an implicit buyout commitment. To the extent other banks provide similar commitments, it might well be enough to unfreeze the marketplace for these securities. Which unquestionably would be a good thing for all concerned. The risk of course is that the banks could wind up holding a pile of assets nobody else wants.
There are many unanswered questions. One of the more practical questions is what the Citigroup settlement announced today will do for the private auction rate securities litigation pending against the company (about which refer here). The settlement clearly seems calculated to try to make at least the retail investors whole, and at least for those retail investors who are comfortable with the special "consequential damages" procedure, there would seem to be no point for continuing the class action (although I would be interested to know if readers have a different perspective). Institutional investors may well have another view, particularly until it is known whether Citigroup’s "best efforts" to liquidate the investors’ auction rate securities holding are successful.
Or is the Worst Yet to Come?: Coincidentally, my friends Kimberly Melvin and Cara Tseng Duffield of the Wiley Rein law firm published a memorandum today whose title seems even more provocative in light of today’s development. Their memo, entitled "Auction Rate Securities: Is the Worst Yet to Come?" (here), has a detailed overview of the outstanding claims involving auction rate securities that is informative and useful.
The memo was written prior to and therefore without awareness of the Citigroup settlement, The memo still makes for interesting reading. Among other things, the memo contains a number of interesting observations concerning the insurance implications of the ARS claims. The authors note that because many of the ARS claims arise out of the defendant companies’ investment sales activities, the claims likely do not represent D&O insurance losses; rather the claims "appear to represent primarily E&O exposures."
Finally, and pertinent to the Citigroup settlement, the authors note that "to the extent that the investment banks buy back or rescind their customers’ ARS, thereby receiving the securities in return for par value, issues exist regarding whether the banks have suffered a covered loss."
I Never Really Wanted to Sell CDOs, I Wanted to be a Lumberjack: And now, for something completely different, I recommend Mark Gilbert’s August 7, 2008 Bloomberg column entitled "CDO Market is Dead, Not Just Pining for Fjords" (here).