Bond-Pricing Case to Be Settled

Citigroup, Goldman, Two Others
To Pay a Total of $20 Million
To End Overcharging Allegations
By Susanne Craig and Aaron Lucchetti
Staff Reporters of The Wall Street Journal
July 28, 2004

Four Wall Street brokerage firms, including Citigroup Inc. and Goldman Sachs Group Inc., will pay a total of $20 million to settle allegations that they overcharged investors buying corporate bonds and paid them too little when they sold them.

The payments represent the largest penalties to date in continuing regulatory investigations into the $23 trillion bond market, one of the murkiest but fastest-growing homes for investors' savings and retirement nest eggs.

The action indicates that regulators are paying closer attention to whether investors are getting a fair deal when they buy and sell bonds. In recent years, regulators have focused on stock-trading issues that tend to touch individual investors directly. However, while bonds traditionally have been bought or sold by sophisticated investors such as insurance companies and pension funds, individual investors are buying more bonds on their own.

The firms' payments were announced today as part of a settlement with the National Association of Securities Dealers. The four firms will pay $5 million apiece. Besides Citigroup and Goldman Sachs, the settling firms are Deutsche Bank AG and Miller Tabak Roberts Securities LLC.

The NASD alleges that the four firms, which are neither admitting nor denying wrongdoing, hurt their big institutional customers with prices that exceeded regulatory guidelines and couldn't be justified to regulators. Each firm's $5 million penalty includes restitution, which in the case of Citigroup is as high as $486,000. The self-regulatory organization also contends that the firms failed to properly supervise their traders and keep thorough records of their activities. The firms also have agreed to revise their supervisory procedures.

Goldman revealed in a regulatory filing in February that the NASD was investigating five specific corporate-bond transactions, but the names of the other firms involved in the inquiry weren't widely known until now. The fines are higher than expected, easily exceeding those levied against eight firms last month for pricing improprieties in the municipal-bond market.

The NASD's corporate-bond investigation focuses on pairs of trades that involved the apparently simultaneous purchase and sale of the same face amount of a particular bond. That means that each pair of trades was essentially risk-free to the Wall Street firm involved. Yet, the NASD found that the markup or markdown of the bonds in each pair varied from about 10% to 33% as they changed hands, the people say. The trades all involved so-called distressed debt, which are bonds that have fallen sharply in price -- usually because of operating, financial or other problems at the issuing company.

The trades, which took place between 2000 and 2002, had higher markups or markdowns than the 5%-or-less standard that long has been considered the rule of thumb in the securities market for sales and purchases of bonds by a Wall Street broker-dealer. Some Wall Street firms have maintained that so-called spreads greater than 5% may be appropriate for distressed debt considering that such bonds' trading volatility increases the risk for losses.

But the NASD has argued that the firms' markups or markdowns weren't justified in the specific cases under the microscope because they were essentially risk-free. Moreover, the settlements are expected to say that the firms' trading desks in general failed to create certain required records and that documents that were created were at times inaccurate, while supervision of trading activity was spotty.

As they have gravitated toward bonds, individual investors have become big buyers of municipal bonds in particular, while professional investors such as hedge-fund managers remain the biggest players in the distressed-debt market. But numerous factors explain why the June municipal-bond cases drew smaller fines from the NASD, an average of $76,250 apiece for each of the eight Wall Street firms.

The June regulatory action dealt with smaller trades and fewer allegations of supervisory and record-keeping wrongdoing. Also, the Wall Street firms in the municipal-bond cases didn't pocket as much profit from the alleged improper trades, and the spoils were spread among more than just the eight named trading firms. In that case, the broker-dealers were accused of not going far enough to figure out the fair-market price for the municipal bonds they were buying and selling on behalf of investors.

The NASD's pricing rules require that markups be fair and reasonable. The NASD adopted the 5% benchmark in the 1940s based on studies showing most market transactions occurred at markups of less than 5%. Permitted markups may vary based on the type of security involved, its availability and the length of time the bond has been in a dealer's inventory, among other factors.

The cases come several months before regulators will make more up-to-the-minute bond-pricing information available to the public. Investors traditionally have found it difficult to get price information on bonds, in part because most are traded among various Wall Street firms over the counter, not on a centralized exchange that disseminates price information. The Bond Market Association, a lobbying group representing bond dealers, argued in a letter to regulators last week that price information for thinly traded corporate bonds should be released publicly only after a delay designed to preserve the ease of trading, or liquidity, in the market.

The four distressed-bond cases are somewhat similar in nature. They include allegations that the firms failed to create records of orders from some customers, among other things. The NASD's inquiry also found that the firms' supervisory systems often didn't provide for a review of trades to determine if they complied with the NASD markup policy, among other shortcomings in oversight.

For instance, in the case against Goldman Sachs, the NASD found a price discrepancy of 30%, one of the largest, the person says. Regulators allege that Goldman's written policy regarding markups and markdowns appeared strict, providing that they should be less than the 5% guideline advocated by the NASD. But in practice, traders on the high-yield and distressed-bond desks believed that, in light of considerations such as the thinness of the market, research costs and sales efforts, there was no practical limitation on markups or markdowns for bonds they traded. Moreover, regulators concluded that, during much of 2000 and 2001, no Goldman supervisor regularly reviewed the firm's high-yield bond trades.

Meanwhile, at Deutsche Bank the NASD found that neither the head of firm's distressed-bond desk nor its high-yield sales supervisor was properly registered with regulators despite a suggestion by the firm's compliance department to do so. Miller Tabak and Deutsche Bank have settled charges that they failed to register one or more supervisors

Treasurys
Treasurys plummeted on stronger-than-forecast consumer-confidence and new-home-sales reports and a weak sale of Treasury Inflation-Protected Securities, or TIPS.

Vigorous selling boosted the 10-year note yield by 0.12 percentage point, back to about where it stood in early July.

Meanwhile, at $11 billion, the Treasury's first-ever auction of 20 ½-year TIPS was too large for the amount of demand, dealers said.

At 4 p.m., the benchmark 10-year note was down 31/32 point, or $9.69 per $1,000 face value, at 101 5/32. Its yield rose to 4.601% from 4.481% Monday, as yields move inversely to prices. The 30-year bond's price was down 1 17/32 points at 100 28/32 to yield 5.312%, up from 5.207% Monday.

Municipal Bonds
California Gov. Arnold Schwarzenegger and leaders of the Democratic-controlled state Legislature late Monday agreed on an estimated $103 billion spending plan that contains few of the health and welfare cuts Mr. Schwarzenegger sought. But the plan also contains no tax increases, which bond investors said was a victory for the governor and his allies.

The budget for the fiscal year that began July 1 relies on more than $5 billion in borrowing and $1.5 billion in accounting maneuvers to close a large structural gap. Spending cuts total about $5 billion.

"It's the first sign of a little vulnerability [of Mr. Schwarzenegger] to the political process," said Eleanor Brennan, who helps manage the Scudder California Tax-Free Fund.

A final vote on the spending plan is expected before week's end.

--Michael S. Derby and Tom Sullivan contributed to this article.

Write to Susanne Craig at susanne.craig@wsj.com and Aaron Lucchetti at aaron.lucchetti@wsj.com