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Citigroup Fined by FINRA for Tax Evasion Strategies

The Financial Industry Regulatory Authority (FINRA) has fined Citigroup Global Markets Inc. $600,000 and censured the brokerage firm for tax evasion trading strategies found to be operating among its affiliates. The first scheme involved international clients of Citigroup circumventing US tax laws, allowing them to increase their respective returns. The second scheme was a complex trading strategy that allowed Citigroup to increase its own after tax profits. Citigroup, for its part, failed to supervise its brokers who were involved in these illicit trading strategies.

Further, Citigroup failed to adequately monitor Bloomberg messages and report to an exchange, trades executed under these complex trading strategies. If the firm had in place procedures designed to detect and prevent improper trades between itself and others, this situation may never have developed.

The first trading strategy operated in the following manner:

1. Citigroup’s equity finance desk in New York purchased U.S. equities (stock) from foreign Citigroup clients, acting as custodian of this dividend-earning stock for Citigroup’s London affiliate.
2. The London affiliate would then use the US equity as the underlying equity hedge in a total return swap agreement with the client.
3. The client would be paid a total return under the swap agreement, including any appreciation of the stock as well as the amount equivalent to the dividend.
4. The client would then pay Citigroup’s London affiliate interest as well as any decline in the share price, if applicable.
5. Once these actions had been completed, the swap was terminated and Citigroup’s equity finance desk in New York sold the stock on behalf of the London affiliate.

The legal issue this trading strategy brings about is that when dividends on U.S. equities are paid to foreign investors, these dividends may be subject to withholding taxes. This is subject to the applicable treaty between the U.S. and the foreign investor’s home country. The, “dividend equivalent,” (# 3) however, allowed Citigroup bypass any U.S. withholding taxes, regardless of applicable treaties.

Approximately two years after this trading strategy was implemented, Citigroup finally produced written procedures to govern it. However, trading staff committed actions in violation of these procedures. In addition to the aforementioned strategy, Citigroup was doubly fined for conducting a second strategy aimed at enhancing Citigroup’s own after-tax yield on Italian stocks.

The Italian trading strategy operated as follows:

1. Citigroup’s London affiliate corresponded with the New York equity finance desk as to which Italian companies were likely to pay out dividends in the near future.
2. The New York desk then loaned stock in those Italian companies, and then turned around and loaned that stock to their Swiss affiliate.
3. The Swiss affiliate would then sell that stock back to New York.
4. The New York desk would then sell this stock to a third-party inter-dealer broker, who would then sell the stock to the London affiliate.
5. The London affiliate would then enter into a swap agreement with the Swiss affiliate, with one taking a long position and the other taking the short position, in essence covering the risk on the stock.
6. The dividend would then be paid out, and the trades would be reversed.

By having the London affiliate hold the Italian stocks and therefore collect the dividend (in conjunction with the Swiss swap agreement), Citigroup was able to take advantage of favorable tax treaties between the United Kingdom and the Republic of Italy.

The legal issue raised is that Citigroup failed to prevent improper relationships from developing between its affiliated units. In addition to this, Citigroup failed to establish policies and procedures in order to regulate this type of trading strategy.

Both of these trading strategies involving the New York office, in addition to their respective legal pitfalls, at times involved trades that were not reported to an exchange, a requirement under securities regulations.

In its imposition of fines, FINRA took into consideration the fact that Citigroup discovered and then reported the abovementioned violations. Also, the firm sought outside counsel to review the devious trading strategies, as well as to assist in reconciliatory efforts. Citigroup neither admitted nor denied the validity of the charges brought against them in this matter.