Two former executives within the asset management unit of Citigroup will fight Securities and Exchange Commission charges that they siphoned nearly $100 million from mutual fund investors through a finely executed, behind-the-scenes scheme involving a questionable transfer agent setup.
Last week, the SEC filed a long-anticipated enforcement action against former Citigroup Asset Management Chief Executive Officer Thomas W. Jones and the unit's former Senior Vice President, Chief Financial Officer and Fund Treasurer Lewis E. Daidone. The executives, nonetheless, claim that they acted in good faith and are characterizing the regulator's fraud charges as "unfounded and overreaching."
"Mr. Jones did not aid and abet any fraudulent activity during his watch," said Jones' attorneys G. Irvin Terrell, who represented President Bush in the 2000 election debacle, and James Doty, in a joint statement from the law firm Baker Botts in Houston.
"Mr. Jones oversaw a rigorous management process in the Citigroup Transfer Agency matter, supported by both experienced internal staff and external consulting experts," the statement indicated. "The record will demonstrate that [he] achieved substantial benefit for mutual fund shareholders and that he made every effort to fulfill his fiduciary duty to them. Mr. Jones is a victim of this situation, not a perpetrator of wrongdoing."
Daidone's attorney, Richard Morvillo of the Washington law firm Mayer Brown Rowe & Maw, did not return calls seeking comment. Morvillo, however, told the financial press when the news first broke last week that Daidone also "acted in good faith and with the advice of counsel."
Citigroup settled SEC fraud charges against its Citigroup Global Markets and Smith Barney Fund Management units over the alleged transfer agent windfall three months ago by distributing $208 million to investors (see MME 06/06/05). It neither admitted nor denied any wrongdoing. The company's only comment last week regarding Jones and Daidone was that its issues with the SEC "were settled in May of this year."
Other Run-Ins
This isn't Citigroup's only run-in with regulators, nor is it the only occasion where its powerful executives may have gone astray. Last fall, the NASD stuck Citigroup with a $250,000 penalty for distributing misleading information about its hedge funds (see MME 11/01/04), and in those same weeks, former Vice Chairman Deryck Maughan and private banking chief Peter Scaturro left amid a scandal at the firm's Japanese unit, where clients were allegedly misled in some private bond sales. That incident reportedly led to the ouster of Jones from Citibank. He now runs his own private equity fund.
The latest allegations of wrongdoing at Citigroup, however, point to an executive culture where company profit was placed ahead of shareholder interest, SEC officials said.
"We're looking to hold those individuals responsible for this conduct accountable," said James M. McGovern, senior trial counsel for the SEC Northeast Regional Office.
In short, Jones and Daidone led a successful initiative to create an affiliated transfer agent to serve the firm's Smith Barney family of mutual funds at steeply discounted rates. But, the SEC claims, "rather than passing the substantial fee discount on to the mutual funds, Citigroup took most of the benefit of the discount itself, reaping tens of millions of dollars in profit at the expense of mutual fund shareholders."
The SEC's case against Jones, 56, of New Canaan, Conn., and Daidone, 48, of Holmdel, N.J., seems to rest on two points. First, the executives knowingly disregarded advice from an outside consulting firm questioning the legality of their transfer agent idea, and, secondly, they crafted a presentation to the Smith Barney fund boards that disguised the windfall Citigroup would enjoy.
During the 1990s, SEC documents reveal, the Smith Barney funds used a division of Denver-based First Data as its full-service transfer agent. That contract was to expire in June 1999. First Data had been booking big profit margins on a "highly automated" business function, and the executives wanted Citigroup to reap those easy profits. So, in the spring of 1997, Jones ordered Daidone to begin negotiations on a deal that would make that scenario happen, the SEC says.
First, Deloitte & Touche Consulting was retained to comprehensively review the TA function. A Deloitte team worked on location at Citigroup Asset Management, using a conference room on the same floor as Daidone's office, the SEC documents indicate. Jones, meanwhile, received regular briefings on the project. As early as November of that year, Deloitte confirmed that, "First Data earns high margins" and there exists "a unique opportunity for Smith Barney to divert those profits to the firm."
Deloitte and Daidone quickly concluded that Citigroup Asset Management should create an affiliated TA of about 121 people and contract technology only with First Data, or rivals DST or SunGuard. DST was chosen in February of 1998 because, in part, First Data did not submit a bid. The windfall to the Citigroup unit was expected to be $40 million annually, the SEC says. But a month later, when it learned it might lose the contract, First Data offered a $25 million annual fee concession and use of its proprietary sub-accounting system.
Nearly $80M a Year
Citigroup passed on the offer, so First Data sweetened the deal by offering discounts measured as a percentage of the total annual fees First Data would receive from the funds. It would reach 40% by 2003, and Deloitte projected that the discounts could grow to $39 million annually. Deloitte, however, noted in a presentation to Citigroup executives late that month that "a true discount would go to the funds, not [the Citigroup TA]" and that "this relationship will be extremely difficult to sell to the fund boards."
Not completely sold, the Citigroup executives decided to still go forward with DST, but sometime in April 1998`, a higher-ranking executive with the firm instructed Jones to negotiate further with First Data. By June of that year, the First Data discount had grown to upwards of 60% and more than $80 million annually.
Deloitte, however, was skeptical, the SEC says. In a briefing later that month, the consultants questioned whether the proposed TA unit, which had shrunk to just 14 employees, could justify such big profits: "We anticipate a larger organization would be needed to satisfy the fund boards in the First Data scenario." They were also curious about the legality of the discount: "This legal structure is questionable at best. This arrangement would in no way be acceptable to the fund boards."
The executives ignored the warnings, the SEC says, and in late July of 1998, a recommendation was made from Daidone to Jones that they go forward with the First Data arrangement.
In February of 1999, Daidone began preparing a presentation on the TA proposal for the boards of the Smith Barney funds with the assistance of a Deloitte technology specialist. According to the SEC, Daidone told the Deloitte representative at various times that they had to "spin" the proposal to make it attractive to the funds' boards. The final presentation, regulators say, was materially misleading by failing to accurately disclose the fee discounts, the fact that the DST proposal was recommended by Deloitte, and it mischaracterized the Citigroup unit as sacrificing its own interests to benefit the funds.
By September of last year, the TA unit had contracted even further, the SEC says, and came to resemble nothing more than a call center staffed by seven people. But over a five-year period beginning in 1999, it earned net pre-tax revenues of about $104 million. A market downturn that began in 2001 is partly blamed for lower revenue than Citigroup previously projected.
Nonetheless, the SEC says, Jones and Daidone earned credit for generating that revenue. Therefore, the regulator is asking the courts to suspend or bar them from the industry, for each of them to disgorge their ill-gotten gains, and to pay a civil penalty and perhaps additional fines.
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