Losses and lawsuits

Loss Database

Citibank Japan

In an extreme reputational incident, Japan’s Financial Services Agency (FSA) ordered Citibank on September 17 to shutter its private banking operations in Japan. Under the terms of the sanctions, Citibank must "suspend all new transactions with its customers beginning September 29 and discontinue all banking operations by September 30, 2005." This is the second time in less than a week that Citibank Japan was forced to apologise for its business practices. Japan’s Securities and Exchange Surveillance Commission censured Citibank Japan on September 14 for improper business practices related to the sale of privately issued debt and ordered the bank to clean up its internal controls.

Citibank’s private banking unit generates about $90 million of net income in Japan. This is a small portion of its total revenue but, according to the Financial Times, private banking relationships can lead to lucrative corporate banking relationships, and "being locked out of private banking in the world’s second-biggest economy is more significant to Citigroup" than the loss of the $90 million in income would indicate. Because high-net-worth individuals often play an influential role in a country’s corporations, the bank is also losing a valuable source for building relationships that could grow into a variety of business transactions.

The FSA claims that it had little choice but to "conclude that continued future operations are inappropriate". The regulator targeted numerous areas of control weakness within the private bank. These included problems with the compliance structure at the Japan branch, problems with the sales compensation, disclosure and suitability, unclear reporting lines between headquarters and branch operations, unfair and improper transactions, and inappropriate and weak internal control system relating to foreign currency deposit operations.

Citibank apologised for its management failings and promised to enhance its internal control environment. The regulators are requiring a number of control and management initiatives that Citibank Japan is will adopt "in order to ensure thorough compliance with laws and regulations, preserve public confidence, and protect depositors/investors as well as ensure sound and proper management of operations at Citibank NA Japan".

The bank issued a press release outlining specific remedies that it is undertaking in response to the sanctions. These include the creation of a new management committee for Citibank Japan that has authority to oversee controls and compliance across all business divisions, enhanced responsibilities and enforcement powers of the Japanese branch’s compliance officer, a formal review of all compliance and internal control systems, and later strengthening them according to findings, and instituting new sales, disclosure, suitability and education and training programmes for the bank.

Long-Term Capital Management

A federal judge ruled on August 27 that Long-Term Capital Management (LTCM) acted in bad faith for the two years before its collapse in 1998, when it took $106 million in tax deductions to avoid paying $40 million in taxes. The judge ruled LTCM could never reasonably have expected to profit from a series of transactions it made in 1996 and 1997, and therefore cannot claim for tax purposes the losses those transactions produced.

The Federal District Court of New Haven upheld the $40 million in taxes the USInternal Revenue Service ordered LTCM to pay on the transactions and added two penalties for misstating valuations and for understating income tax. LTCM is estimated to owe the government more than $55 million. The 196-page decision criticised the fund’s 1997 tax filing and its decision to record the losses from the investments under the heading ‘net unrealised gains’. The judge in this case characterised the move to conceal tax losses from the sale of some stock involved in one of the transactions as an attempt to "potentially win the audit lottery and evade IRS detection".

The case involved a series of nine complex cross-border lease-stripping transactions into which LTCM entered in 1996. The first set of five transactions involved a firm called Onslow Trading and Commercial (OTC), incorporated under the laws of the Turks and Caicos Islands. OTC leased computer equipment and then subleased its rights to US-based partnerships. The second set of transactions involved trucks OTC leased from two banks that Wal-Mart Stores had sold to the banks. Wal-Mart then subleased the trucks back from OTC.

In both cases, the sublessees prepaid a substantial portion of their rent, which was then used by OTC to buy preferred stock in US companies. In its agreement with LTCM, OTC contributed tranches of this preferred stock to LTCM in exchange for partnership interest in LTCM funds. OTC subsequently sold its partnership interest in those funds back to LTCM, and LTCM cashed in the preferred stock tranches, subsequently incurring losses that were then allocated to LTCM under US partnership tax law.

LTCM also provided loans at 7% interest to OTC. Proceeds from the loans were used to fund cash contributions from OTC to LTCM as well as paying off OTC debt and buying put options. Liquidity puts provided OTC the option of selling its partnership interests in Long-Term Capital Partners back to LTCM at various times at a strike price equal to the net asset value of the partnership interest as determined in the partnership agreement. Downside puts gave OTC the option of selling its partnership interest in the fund back to the parent firm at a strike price equal to the value of OTC’s initial account with LTCM. In a lawsuit filed against the IRS following the audit, LTCM claimed that it acted in good faith in making the OTC investments, that it had followed the advice of its attorneys and auditors in entering into the transactions, that it had followed the rules and that the losses were justifiable.

However, the judge pronounced that evidence and testimony in the case clearly showed that LTCM never could have expected to profit from the dealings - in large part because of the put options and fees it paid to firms that helped broker the deal - and that LTCM Partners probably only entered into the transactions because of expected tax relief. Evidence was cited that LTCM officials initially considered the transactions as tax products, rather than investments.

Also, although LTCM’s partners acknowledged that the IRS could challenge the transactions from a tax perspective, the firm went ahead with them before receiving written legal opinions from its tax specialists.

Bank of Ireland

The UK Financial Services Authority fined the Bank of Ireland (BoI) £375,000 ($673,800) on September 2, after one of its UK branches breached anti-money laundering rules by failing to have in place systems to detect a series of high-risk, cash transactions worth approximately £2 million, which were undertaken in breach of their policies and procedures. The transactions in question appear to be suspicious and are currently being investigated by law enforcement.

The fine was imposed due to the failure of the Bank of Ireland to take reasonable steps to detect the misuse of the bank drafts facility provided by a BoI branch. The misuse concerned 40 bank drafts issued between January 1998 and October 2002 worth approximately £2 million. The drafts were issued for cash at the request of one of the branch’s largest customers and all 40 bank drafts were made payable to the ‘Bank of Ireland’. These transactions were in breach of BoI’s policy and procedures, particularly as issuing bank drafts in this manner disguised the identity of the true owner of the cash and, as such, was an effective means of laundering money. These transactions were not identified as suspicious by staff at the branch or by other managers who were aware of the transactions.

The cash used to purchase the bank drafts was deposited in an internal branch account without first passing through the customer’s account. This practice, in breach of BoI’s policies and procedures, allowed the customer to use the drafts’ outstanding account as a deposit account, which could have prevented law enforcement agencies from establishing the true owner and source of the funds. The transactions were outside the normal business activity of the customer, who had asked staff not to use his name on any checks or correspondence relating to the draft transactions; this failed to arouse suspicion.

BoI failed to detect the misuse of the draft facility until it was identified during a branch audit in March 2003, when drafts issued to the customer worth £1.8 million were found to be outstanding. There was a high risk that these transactions could have been used to facilitate money laundering and they are being investigated by the appropriate law enforcement agency. The bank allegedly did not take appropriate steps to ensure that it had in place a system to check that staff had understood the money laundering training that was delivered to them, specifically the recognition and reporting of suspicious transactions. The systems and controls to monitor the issuing of bank drafts and staff training were the same across BoI’s branch network but the misuse of bank drafts only occurred in one branch.

Upon discovering the breaches, BoI notified the FSA and has since devoted significant resources to investigating the matter and ensuring that the misuse is not replicated elsewhere in the branch network. The bank has also taken steps to introduce a revised training programme that involves checking that staff understand their responsibility to recognise and report suspicious transactions, in addition to putting in place a requirement that drafts outstanding for longer than six months and with a value in excess of £10,000 be subject to oversight independent of the issuing branch.

The First database is managed by Penny Cagan, head of research at the OpVantage division of Fitch Risk. Email: [e-mail]

Citibank Japan

2004-September-17: Financial Services Agency, ‘Administrative actions on Citibank NA’, www.fsa.go.jp/news/newse.html

2004-September-14: Securities and Exchange Surveillance Commission (Japan), ‘Recommendation based on the inspection result of Tokyo branch of Citibank, N.A.’, www.fsa.go.jp/sesc/english/news/reco/20040914.htm

2004-September-19: Financial Times, ‘Citigroup forces to shut private banking arm in Japan’

2004-September-19: New York Times, ‘Japan Shuts unit of Citibank, citing violations’, by Todd Zaun

2004-September-17: Citigroup Press Release, ‘Citibank, N.A. Japan Branch Statement Regarding Financial Services Agency Announcement’ www.citigroup.com/citigroup/press/2004/040917a.htm

2004-September-17: eFinancial News, ‘Regulators shut down Citigroup’s Japan arm’, by Vivek Ahuja

2004-September-17: Financial Times, ‘Another blow for Citigroup: a devastating ruling in Japan means more work for Chuck Prince’, by David Wighton

Long-Term Capital Management

2004-September-4: Economist, ‘Taxing the ghost – Long-Term Capital Management’

2004-August-31: Hedge World News, ‘Court Denies Long-Term Capital Tax Claim’, by Chris Clair

2004-August-30: New York Times, ‘Tax Ruling Casts A Long Shadow’, by Lynnley Browning

2004-August-30: Wall Street Journal, ‘Judge’s Ruling In LTCM Case May Resonate’, by Diya Gullapalli and Henny Sender

Bank of Ireland

2004-September-2: FSA Final Notice, ‘The Governor and Company of the Bank of Ireland’, www.fsa.gov.uk/pubs/final/boi_31aug04.pdf

2004-September-2: Reuters News, ‘UK fines Bank of Ireland for monitoring breach’, by Jodie Ginsberg

2004-September-2: Dow Jones International News, ‘UK’s FSA Fines Bank Of Ireland’