Citigroup Hedge Funds ASTA/MAT and Falcon plummet in value, leading to Commencement of Lawsuits

Citigroup offers to cash investors out of Falcon funds in exchange for waiving legal claims- deadline of June 30, 2008 to accept or reject Citigroup offer.

Investors have until June 30, 2008 to accept a settlement offer of between 45% and 54% of their initial investment in certain hedge funds managed by Citigroup, or reject the settlement offer and retain the right to file a lawsuit. This development is the latest in the rapidly unfolding near-collapse of several hedge funds marketed heavily by Citigroup to its Smith Barney customers as higher-yielding alternatives to money market funds. Investors have reported that, notwithstanding the risky nature of the funds' investments, Citigroup personnel marketed the funds as a higher-yielding investment than a municipal bond, but with little if any additional risk.

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Investors Unaware of Hedge Fund Risks

Smith Barney brokers and fund managers reportedly specifically advised prospective investors in Falcon that the new hedge fund was likely to post losses of no more than 5% a year in the worst-case scenario.

Unbeknownst to investors, the Falcon funds were not safe alternatives to money market funds, but in fact were engaged in a highly risky investment strategy that exposed them to disastrous losses in the event of adverse movements in the credit markets or a lack of liquidity in the bond markets. According to a class action lawsuit filed in federal court in New York City, the Falcon funds employed municipal bond arbitrage, carried commercial debt obligations and held asset-backed mortgage instruments whose value was closely tied to the condition of the credit and bond markets.

Moreover, Falcon heavily invested in other funds under the Citigroup umbrella that employed these risky investment strategies. These funds included the "ASTA/MAT" funds, which themselves were engaged in the highly risky investment strategy known as "municipal arbitrage," in which the funds essentially amassed a leveraged portfolio of high quality, tax-exempt municipal bonds and simultaneously hedged the duration risk in their municipal bond portfolios by shorting the equivalent taxable corporate bonds. The risky strategy backfired when taxable bonds appreciated in value even as tax-free municipals dropped in value. As one commentator, Douglas A. Dachille of First Principles Capital Management, said: "Anytime you have the assets underperforming the hedges and they are leveraged, you basically have two options– to sell the assets or call up your investors and get more equity."

When the problems in the asset backed securities and bond markets accelerated in early 2008, the Falcon and ASTA/MAT funds reportedly nearly imploded. Investors in ASTA/MAT have reported that the funds have lost 80% of their initial value, and the Falcon Plus Strategies fund is now reportedly worth only one-quarter of its initial value after losing over half its value in the fourth quarter of 2007 alone. On March 20, 2008, Citigroup announced that because of the Falcon funds' low cash position and ongoing dislocation in the credit markets, it had indefinitely suspended redemptions from the Falcon funds (and payments of related redemption proceeds).

Investor Outcry

In response to investor outcry over its misleading marketing of its hedge funds and their rapid near-collapse, Citigroup has now taken the unusual – if not unprecedented – step of offering investors in these funds an opportunity to recoup some of their losses. Citigroup's offer has been extended via a complicated tender offer ("Offering Memorandum" or "OM") that involves investors tendering their shares and executing a release of claims in return for 45 cents per share and 75% of the liquidation value of the portfolio over 45 cents per share, less the funds' "cost of capital" (which is not defined in the OM). Citigroup's tender offer is available to investors in Falcon Two, Falcon Two B, Falcon Three, Falcon Four, and Falcon Plus2. The "tender price" may vary from fund to fund. As of April 18, 2008, the offer was reportedly 45 cents for the first three funds and 54 cents for Falcon Four.

Investors who accept the tender offer are required to sign a general release, and will forever waive any and all legal claims that they may have against Citigroup and its affiliates. Investors in the funds who do not wish to settle for approximately 50 cents on the dollar and waive their rights to assert legal claims against Citigroup and its affiliates have an absolute right to pursue individual litigation or arbitration claims. However, investors who decline to accept the tender offer and pursue their own individual legal claims face the risk that they will recover less than Citigroup is offering via the tender offer, or even nothing at all.

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Last updated on Oct-23-09

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