Securities Law Blog

Citigroup Global Markets, Inc. was hit with a $650,000 fine by the Financial Industry Regulatory Authority (FINRA) on Tuesday April 6, 2010 for disclosure and supervisory violations related to its Direct Borrow Program (DBP). The program operated from January 1, 2005 until November 30, 2008.

According to FINRA findings, during this time Citigroup’s DBP borrowed fully paid hard-to-borrow securities owned by the firm’s customers and pooled them together to facilitate Citigroup’s clients’ short-selling strategies. Over 770 different securities were borrowed from more than 2,300 customers, with an average annual value of outstanding loans upwards of $301 million.

According to the FINRA report “Citigroup failed to disclose, or to adequately disclose, certain material information to customers participating in the DBP, including that the securities were hard-to-borrow; that the interest rates could be reduced by the firm; that the brokers received commissions for the duration of the loan; that while the securities were on loan, dividends were paid as “cash-in-lieu” of dividends and were therefore subject to higher tax rates; and, that shares on loan could be sold by the customers at any time.”

So what did they tell customers? Apparently little more than what they told branch managers and supervisors. FINRA found that branch managers and supervisors were not notified that customers of brokers they supervised were involved in the DBP and that many were not even aware that the DBP existed. The report alleges significant failure on the part of Citigroup to monitor DBP, including having no procedures in place to supervise staff, brokers, or client accounts involved in the program.

FINRA also found that the tools traditionally used by supervisors to monitor customer accounts were compromised when shares were lent through the program. Once shares were lent, a customer’s account no longer reflected the customer’s position in the security. This left the account open to the risk of becoming overly concentrated in the security or of losing a significant amount of market value due to the lent security’s loss in value, without detection.

The report claims that three versions of misleading marketing materials about the DBP were distributed to the public by Citigroup. The materials allegedly claimed that the program had little risk, that no customers suffered losses and that the firm tried to avoid interest rate changes.

Citigroup consented to FINRA’s findings, while neither admitting nor denying guilt.