Judge Stein’s opinion in In re Citigroup Securities Litigation.pdf, 2010 WL 4484650 (S.D.N.Y. November 9, 2010), is key reading for those who want to understand the “gallimaufry of financial instruments” at the heart of Wall Street’s subprime mortgage meltdown.  The financial instruments explained by Judge Stein are: Subprime and Alt-A Mortgages, Residential Mortgage Backed Securities, Collateralized Debt Obligations, Structured Investment Vehicles, Auction Rate Securities and Collateralized Loan Obligations.  The opinion is as good as summary as one can have.

 Plaintiffs in the case are a proposed class of investors in Citigroup who purchased shares between January 1, 2004 and January 15, 2009 – a financial time period that will live in infamy.  Defendants are Citigroup and fourteen of its senior executives.  In a complaint that “weighs six pounds,” plaintiffs allege violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, claiming that Citigroup materially misled investors about the company’s financial health and caused them to suffer damages when the truth about Citigroup’s assets was finally revealed.  Defendants moved to dismiss, arguing primarily that plaintiffs’ complaint fails to satisfy the heightened pleading standards applicable in securities fraud actions.  

Bottom line: although the entire “gallimaufry” of Citibank’s investments tanked, Judge Stein sustained securities fraud claims only as to Citigroup’s conduct between February 2007 and April 2008 concerning its Collateralized Debt Obligations. 

The major distinction between the sustained CDO claims and the other claims at issue in the complaint was a precise allegation that Citigroup misled investors by failing to disclose the extent of its CDO holdings, and failed to properly value its CDO risk consistent with other market “barometers.” Citigroup’s public filings also misleadingly separated its CDO risk from its overall mortgage risk, a point that became all too clear when the subprime dominoes (including the CDOs) began to fall. 

Judge Stein’s finding of “scienter,” i.e., intentional or reckless conduct necessary for a securities fraud claim, is based on the allegation that Citigroup, and those executives responsible for its public statements at the relevant time (seven of the fourteen named as defendants), “saw the risks and … maneuvered to avoid them.”  In other words, “Citigroup was taking significant steps internally to address increasing risk in its CDO portfolio but at the same time was continuing to mislead investors about the significant risk those assets posed.” 

There is much in the opinion worth chewing over beyond what I’ve highlighted in this post, including the determination that Vikram Pandit’s statements in 2008 when he took the helm at Citigroup to the effect that “we are a pillar of strength in the markets” are only expressions of “corporate optimism” don’t give rise to securities violations.