A proxy battle is brewing to stop the transfer of hedge funds with substantial holdings in Citigroup's mutual fund from being transferred to Legg Mason. It could create a stumbling block for the anticipated business swap between the two companies.

The New York-based hedge fund, Elliott Associates with $5 billion under management, is the largest shareholder in Citigroup's Salomon Brothers closed-end fund. Elliott holds 6% of the fund, which trades at a heavy discount. Elliott - together with Western Asset Management and Karpus Investment Management - is anxious for Citigroup to finalize the transaction.

"Their own materials say this deal is good for Citi, good for Legg, but what's in it for SBF shareholders?" said Elliott Portfolio Manager Mark Levine.

Elliott hopes to stop transfer of the $1.4 billion fund before shareholders vote on Oct. 21, right before the deal is inked on Oct. 28. Terms call for Citigroup to give Legg Mason $430 billion in asset management business while Legg would turn over its brokerage network.

"The historical average 14% discount to [net asset value] measured from the beginning of 2002 and ending Aug. 31, 2005 implies approximately $200 million in aggregate value trapped in the [Salomon] fund," according to Elliott.

The majority of Citgroup's 20 closed-end funds trade at a discount to their asset backing. Anonymous investors in several funds indicated they planned to veto the transfer unless Citigroup closed the discount. This can be achieved through a share buy-back or merging with an open-ended fund.

In another setback, a recent ruling by the New York Stock Exchange stated that only Citigroup fund shareholders could vote on the transfer. Brokerage houses have the authority to vote for their client's shares if the client does not. Since brokerages usually favor management, Citigroup has its work cut out to get investors' approval.

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