7 Day Search http://interactive.wsj.com/dividends/retrieve.cgi?id=/text/wsjie/data...

New Search: Search Results Help?

December 22, 2004

Leader (U.S.) Mission Control For , Scandal in Japan Shows Dangers of Global Sprawl

Obsession With Bottom Line And Bickering Executives Created a 'Perfect Storm'

A Scathing Internal Report

By MITCHELL PACELLE, MARTIN FACKLER and ANDREW MORSE Staff Reporters of THE WALL STREET JOURNAL

Nearly four years ago, warning lights began flashing at Citigroup Inc.'s Japanese private bank, tucked in a quiet office overlooking Tokyo's Imperial Palace.

Koichiro Kitade, a marketing whiz who headed the office, was roping in hundreds of wealthy new clients. But he had a tin ear for regulation. In August 2001, Japan's Financial Services Agency flagged his group for infractions, including selling securities without prior authorization.

Following a settlement, Citigroup dispatched Charles Whitehead, an American lawyer with Japanese experience, to serve as "country officer" in Japan. Regulators were told that Mr. Whitehead would share responsibility for compliance and control in all Citigroup's business units in Japan, from retail banking to corporate finance.

Under the But Messrs. Whitehead and Kitade, who reported to different Microscope bosses in , clashed badly. And once again, the private bank spun out of control. By late last year, Japanese regulators A Big Loan to had found problems throughout the unit, and Citigroup's efforts Design School to mollify them spiraled into disarray. Internal bickering about Intensified who should talk to regulators, and what they should say, reached

1 of 7 12/23/2004 10:48 AM 7 Day Search http://interactive.wsj.com/dividends/retrieve.cgi?id=/text/wsjie/data...

Regulator's top executives in Citigroup's Park Avenue headquarters. In Scrutiny September, fed-up regulators yanked Citigroup's private-banking Citigroup's Jones license altogether -- a stinging humiliation for Chief Executive Denies Blame Charles Prince, who flew to Tokyo and bowed low in apology. 11/19/04 "It was a train wreck in slow motion," says Mr. Prince. Heard on the Street: The scandal was a humbling lesson for the world's largest Citigroup's CEO financial-services firm. Engineered through a series of massive Faces 'Private deals by Wall Street titan Sanford Weill, Citigroup has achieved Bank' Task enormous profits through its size and global reach. But his 10/21/04 successor, Mr. Prince, is discovering how hard it can be to See more control risk in an organization of more than 275,000 employees coverage of Asia's in 100 nations, where a small deal done badly can cause huge financial sector, reputational damage. from IPOs to banking to bond Now, Mr. Prince is acknowledging that he offerings. and his colleagues were too focused on the bottom line. In a series of sweeping moves, he has beefed up compliance and sent a message that top managers could be held accountable for regulatory lapses anywhere in their domain. The fallout from Japan even reached the executive suite in October, when Mr. Prince fired Mr. Whitehead's boss, Vice Chairman Deryck Maughan; Mr. Kitade's boss, private bank chief Peter Scaturro; and Mr. Scaturro's boss, global investment management head Thomas W. Jones.

A preliminary report on the Japan debacle, commissioned by Citigroup and prepared by former U.S. Comptroller of the Currency Eugene Ludwig, suggests the problem was systemic. "Quite simply, this is a situation characterized by a multitude of failure points within the organization," said the confidential report, portions of which The Wall Street Journal reviewed.

Citigroup's private bank, which brings together a range of banking and investment services under one roof for wealthy clients, has long been integral to its international operations. In recent years, it has also brought problems. In the mid-1990s, Citigroup promised to beef up compliance after its private bank got caught in a headline-grabbing corruption scandal in Mexico.

Mr. Kitade, a 33-year veteran of Citigroup's Japan unit, delivered in recent years the most robust profit growth of all of Citigroup's private bank locations. Between 1997 and 2003, he increased the number of private banking customers from 600 to 6,000. As his superiors set successively higher net-income goals for his unit, Mr. Kitade and his managers pressed to bring in more revenue, the Ludwig report said.

"Controls and compliance were secondary," the report said. "This tone was set from the top by Mr. Kitade."

2 of 7 12/23/2004 10:48 AM 7 Day Search http://interactive.wsj.com/dividends/retrieve.cgi?id=/text/wsjie/data...

In an interview, Mr. Kitade denied that he ignored controls, which he said barely existed at the private bank when he took over. "I did everything I could within my power and budget to increase our capabilities and maintain balance between the functions," he said.

But the FSA's examination of Citibank Japan in 2001 revealed shortcomings. Regulators cited the private bank for 30 instances of inappropriate transactions, including deals that could have helped customers hide losses.

To take charge of the mess, Mr. Weill, then chief executive, turned to Mr. Maughan, a trusted British-born executive who was running when Mr. Weill's Travelers Group bought the brokerage firm in 1997. Travelers later merged with Citicorp. In addition to having extensive experience in Japan, Mr. Maughan was a seasoned fix-it man, whom Warren Buffett tapped to turn around Salomon after a Treasury-bond scandal in 1991.

Mr. Maughan appointed Mr. Whitehead, who had worked with him as an in-house lawyer at Salomon in Japan, to be Citigroup's senior officer on the ground. Regulators were handed a complex organizational chart describing a system under which Mr. Whitehead, as "country officer," would share responsibility for controls and compliance, but Mr. Kitade and other business-unit chiefs would report to division heads outside of the country.

A year later, after Citigroup was rocked by losses in Argentina, Mr. Weill instituted a version of this dual-reporting system globally, dubbed the "matrix." He put Mr. Maughan in charge of country officers globally, as chief executive of international operations.

In Japan, Mr. Whitehead reported to Mr. Maughan. Under the matrix structure, Mr. Kitade reported to Mr. Scaturro, the New York-based head of the global private bank, who in turn reported to Mr. Jones.

Messrs. Whitehead and Kitade clashed from the start. Mr. Whitehead developed a reputation for being heavy-handed, and was known for banging his fists on tables and swearing effusively, according to people who worked there. Behind his back, employees began calling him "Super Chuck." Mr. Whitehead's lawyer said his client wouldn't discuss his work for Citigroup due to confidentiality obligations.

Trouble erupted again in June 2003, when a prestigious Tokyo fashion school complained to government officials it had been "gouged" on a financial transaction. Six Citigroup private-banking customers had extended the school, Sugino Gakuen, what amounted to a one-year loan of about $7 million at an effective interest rate of 26%. (See related article.)

The 20-year Citigroup veteran who structured the deal, Hiroaki Imaizumi, was hauled in for questioning. "This was an unethical deal!" he recalls one regulator barking. "It was a school. Bankers

3 of 7 12/23/2004 10:48 AM 7 Day Search http://interactive.wsj.com/dividends/retrieve.cgi?id=/text/wsjie/data...

have a social responsibility. Why did you violate it?"

Mr. Imaizumi repeatedly denied he had done anything wrong, arguing the terms of the deal reflected its risk to investors. His denials only served to infuriate regulators.

Problems Nearly Everywhere

In November 2003, regulators began a broad inspection of Citigroup. They found problems nearly everywhere, according to Takafumi Sato, director general of the FSA's supervisory bureau, and other FSA officials. These included making loans used by customers for stock manipulation, helping customers misrepresent their profits, misleading customers about the risk of certain products, and failing to perform background checks on new clients to ensure they weren't criminals, regulators say.

"We were surprised at how bad the situation was," says Mr. Sato. "They were committing all sorts of unscrupulous violations."

Other red flags were surfacing in Japan outside the private bank. Regulators accused Nikko Salomon Smith Barney Ltd., a Citigroup joint venture, of manipulating stock prices. The FSA ordered Nikko to suspend trading on its own account briefly and strengthen internal controls. Later, data on 120,000 customers of Citigroup's Japanese retail bank fell off a truck in Singapore, prompting another slap.

As the probe deepened, it brought into sharp relief the tension between Mr. Whitehead and the business heads. "Mr. Kitade told us that he 'hated' Mr. Whitehead," Mr. Ludwig reported. "They communicated rarely with each other, and their infrequent exchanges were known to be contentious."

The Ludwig report characterized Citigroup's handling of the probe as "poor at every level and at every stage of the process. Local Private Bank management reportedly gave the inspectors inadequate office space and their requests were addressed slowly. The FSA concluded that many private bankers were not candid with inspectors." One panicked employee shredded marketing materials.

Mr. Kitade denied in an interview that he stonewalled investigators. "My very clear message was that we do everything to help the inspection," he said. "No lying. No hiding."

It is unclear when senior executives like Messrs. Maughan, Jones, and Scaturro first became aware of the severity of the problems. "In hindsight, one may fairly question whether global business and international supervision was close enough to recognize the severity of the management discord in Japan," the report noted. Citigroup auditors in New

4 of 7 12/23/2004 10:48 AM 7 Day Search http://interactive.wsj.com/dividends/retrieve.cgi?id=/text/wsjie/data...

York, who operate independently of business units, are supposed to be another line of defense. Four months after the unfavorable 2001 FSA report, however, these auditors had rated the Japanese private bank "satisfactory."

When investment-management chief Mr. Jones visited Tokyo in February 2004, private bankers were eager to defend their sales practices. Messrs. Kitade and Scaturro, the global private-bank chief, "essentially wanted to push back," Mr. Jones recalls in an interview. "Whitehead was arguing up to Maughan that pushing back against the FSA would only infuriate them further." Representatives of Messrs. Maughan and Scaturro declined to comment on all Citigroup matters.

By spring, regulators were complaining that Mr. Whitehead hadn't taken charge of compliance and controls. In his report, Mr. Ludwig cited a "reported admission" by Mr. Whitehead to regulators that he "lacked authority" over business lines. In interviews, FSA regulators said they were angry to learn that very little had truly changed between 2001 and 2004. "The people who were in positions of responsibility, and who should have known all that was going on in the bank, didn't know," says the FSA's Mr. Sato.

Mr. Jones was growing increasingly concerned. Chief executive of Citigroup's global investment-management businesses since 1999, Mr. Jones had previously held senior positions at Travelers Group and TIAA-CREF. In 1969, as a student at Cornell University, Mr. Jones briefly achieved national fame for leading a student revolt to demand a black studies program.

In April, he flew to Japan to apologize in person to Hisashi Ono, director of planning and research in the FSA's inspection bureau. "Please consider that it is not necessary to embarrass Citigroup Private Bank publicly," he wrote in a follow-up letter. "If you will allow six months to October 15, 2004 and then reexamine Citigroup Private Bank, you have my commitment and promise that all problems identified by FSA will be corrected completely." He pledged to give the FSA a "detailed work plan and target dates for corrective action."

But Citigroup's top in-house lawyer in Japan, who reported to Mr. Whitehead, recommended against providing the FSA a detailed plan before the FSA's findings were complete, arguing that regulators could view it as "premature," according to an e-mail to Mr. Jones in late April.

Following a meeting with an FSA supervisor, Mr. Whitehead warned Messrs. Jones, Maughan, and Scaturro in a May 12 e-mail that the private bank might be booted out of Japan if it didn't replace its "senior management" and create a "robust control environment."

Mr. Ludwig's report noted that "the business and international divisions blamed each other as the situation deteriorated, and they continue to do so today."

'A Crescendo'

In May, said Mr. Jones, "the argumentation back and forth about the right course of action

5 of 7 12/23/2004 10:48 AM 7 Day Search http://interactive.wsj.com/dividends/retrieve.cgi?id=/text/wsjie/data...

had reached such a crescendo that [Citigroup President Robert] Willumstad stepped in" and took charge of the matter, initiating weekly meetings with Messrs. Jones, Scaturro, Maughan and others. Douglas Peterson, Citigroup's global audit chief, was installed as chief executive officer of Japan, with authority over all operations and controls. In July, Mr. Whitehead left Citigroup. Mr. Kitade resigned under pressure in August.

Despite those moves, the FSA on Sept. 17 rescinded Citigroup's private-banking license altogether, effective Sept. 30, 2005. It accused the private bank of constructing "a law-evading sales system," and cited it for 83 violations.

Mr. Prince turned to Mr. Ludwig's Promontory Financial Group to examine how the problem got so out of hand. On the third weekend in October, he received Mr. Ludwig's preliminary report.

"In our experience, we have found that problems of the magnitude that Citigroup is confronting in Japan often have a 'perfect storm' element to them. That was also true here," the report said. "However, experience also has taught us that a business failure of the kind witnessed in Japan is typically an indication of deeper fault lines in the control structure of the organization as a whole. This is also our conclusion here."

When the audit committee of Citigroup's board of directors gathered in New York on Monday, Oct. 18, Messrs. Scaturro, Peterson, and Prince briefed the committee on the events in Japan. Mr. Jones urged the committee to view the problems in Japan as the product of multiple levels of failure, including a global audit system run at the time by Mr. Peterson, rather than as the work of a few "bad apples."

Late that afternoon, Mr. Jones was given a copy of the Ludwig report. "I wasn't particularly concerned about myself. The only mention of me is in two different footnotes," he says.

Just before a scheduled board meeting the next morning, Messrs. Jones, Maughan and Scaturro sat down with Messrs. Prince, Willumstad and Ludwig in the library adjoining Mr. Prince's office. Messrs. Maughan and Scaturro spoke about the problems, and argued that the report contained errors. Mr. Jones told Mr. Prince about apologizing in person to the regulators, and about being steered away from further contact with regulators. Mr. Prince, he said, "kind of shrugged his shoulders and looked away."

That afternoon, as he was waiting to address a board committee, Mr. Jones got a note summoning him to Mr. Prince's office. When he arrived, Messrs. Prince and Willumstad were seated at a conference table.

"We feel we've got to make some difficult decisions," Mr. Prince said, according to Mr. Jones. "We feel the best thing to do is separate the management responsible for this situation." He asked Mr. Jones to leave the company.

"How is this a fair thing to do?" Mr. Jones recalls asking. Mr. Prince told him that he didn't want to get into degrees of culpability, Mr. Jones recalls. In separate meetings, Messrs. Maughan and Scaturro were also asked to leave.

After hiring New York lawyer Stanley Arkin, Mr. Jones initiated a lawsuit last month in

6 of 7 12/23/2004 10:48 AM 7 Day Search http://interactive.wsj.com/dividends/retrieve.cgi?id=/text/wsjie/data...

New York state court accusing Mr. Ludwig of defamation in his report. A footnote to the report, the lawsuit alleges, incorrectly suggested that Mr. Jones was "derelict in his duties," providing "apparent justification" for his firing. A spokeswoman for Mr. Ludwig declined to comment.

Mr. Prince has declined repeatedly to comment on the dismissals, but he has been vocal about steps he is taking to try to prevent another such disaster. Compliance officers, for example, no longer answer to business heads like Mr. Kitade, but report up an independent chain of command directly to the head risk officer in New York. Mr. Prince says he plans to revamp employee training to focus on ethics, and is considering changing the compensation system to tie individual pay more to the health of the entire Citigroup franchise. He has begun lecturing employees about a new way to think about the franchise, in which its DNA no longer means "deliver numbers always."

"It's our fault, because all we talk about is delivering the numbers. We've done this forever," he explains. But employees must recognize they cannot "chew up the franchise" in pursuit of short-term profits, he says. "The game is a long-term game."

Write to Mitchell Pacelle at [email protected], Martin Fackler at [email protected] and Andrew Morse at [email protected]

7 of 7 12/23/2004 10:48 AM