The Securities and Exchange Commission is investigating whether Citigroup Inc., J.P. Morgan Chase & Co., Bank of America Corp. and Deutsche Bank were aware that WorldCom Inc. was riskier than they told investors before a $10-billion bond sale, two people familiar with the matter said.
The regulator is looking into the sale after bondholders said in a lawsuit that Citigroup analyst Jack Grubman and other bankers were aware of the risks and didn't inform the public, according to the sources, who declined to be identified.
The bonds, which the banks helped sell in May 2001, 14 months before WorldCom filed for bankruptcy protection, now trade at 35 cents on the dollar.
"Anytime the SEC is investigating, you can be pretty sure they've got smoke at least, if not actual fire," said Larry Soderquist, director of the Corporate and Securities Law Institute at Vanderbilt University. "This absolutely raises the stakes for any banks that sold these bonds."
The bondholders, led by New York Comptroller Alan Hevesi, who represents $118 billion in state pension funds, made their claims in a brief dated March 8 in U.S. District Court in the Southern District of New York. The brief, earlier reported by the New York Times and the Wall Street Journal, sought to avoid a postponement of proceedings in a long-running suit.
The 24-page brief, accompanied by 363 pages of bank documents, says internal memos show the banks "had much more access to what was happening within WorldCom than they presently acknowledge."
Ashburn, Va.-based WorldCom filed for Chapter 11 in July 2002 after discovering $3.85 billion in accounting errors.
The SEC and representatives of the banks declined to comment. In legal papers in response to the suit, the banks said they acted properly and were unaware of fraud.
The bondholders' suit cited reports by Grubman, 50, then a Citigroup telecommunications analyst. He left Citigroup in August 2002 and agreed in April to pay $15 million and be barred from the securities industry as part of a settlement with Wall Street banks that ended a government probe into biased research.
In a Feb. 8, 2001, report that was circulated to Citigroup clients, Grubman wrote that WorldCom would take in more cash from sales than it paid out for expenses by 2002, a measure known as free cash flow. He recommended that clients buy the stock.
A month later, in a memo intended only for internal use at the bank, Grubman forecast the opposite.