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It’s whispered through phone lines in Manhattan, in London, in Hong Kong. It’s spoken in hushed tones over lunch at the Capital Grille and Four Seasons. It’s passed, in the form of illicit emails, between a whistleblower in Pittsburgh and an aggressive Attorney General in Florida. In whatever form of communication, the message is often the same: FX and transition management, taken together, is a dirty, dirty business.
It’s not nearly that simple. Like in love, all transgressions within the cloistered world of custodial banking look the same from outside. A lover can be unfaithful in various ways, but to a bystander the variation is meaningless. Similarly, a stream of supposedly sordid scandals have wracked the likes of State Street, Northern Trust, and BNY Mellon since the onslaught of the financial crisis, and one could be forgiven for believing that every scandal bore the same method of infidelity. One would be wrong. Be it securities lending (circa 2008), FX transaction costs (circa 2009), or transition management (circa 2011), the method of transgressions within the custodial world was and is unique.
The business of securities lending, of course, has been battered and rebounded. Clients were made whole and reputations have been slowly repaired following material losses in cash-collateral reinvestment pools. Disintermediation—in this case, the separation of securities lending from the custody-banking model—has been spoken about more than acted upon, and whatever the outcome, the problems within this industry have been exposed and dealt with. This is not the case with transition management or FX execution—and vendors fear a similar client backlash, reputational beating, and bottom-line gouging. They are right to be worried.
Within the confines of One Lincoln Street—State Street’s global headquarters in the heart of Boston’s financial district—Nicholas Bonn is the financial equivalent of a fireman. Wherever there is fire, Bonn can be found inside, hose in hand, attempting to douse the flames. In June 2010, as issues surrounding securities lending swirled around the industry and the large custodian, Bonn was brought in from the transition management business to calm client nerves. Having successfully poured water on this potentially explosive situation, Bonn was brought back to transition management in the fall of 2011 after Edward Pennings, a London-based employee in the unit, went rogue. State Street cannot comment on United Kingdom-based employment, but numerous sources told aiCIO that Pennings had misled at least one client and internal compliance about fees on a significant fixed-income transition. That client—the £25 billion Royal Mail pension plan, which until now has not been revealed as the fund at the center of the Pennings Affair—was fully reimbursed, but it takes only a minute for reputations to be ruined, and Bonn has spent the better part of the last six months airport-jumping in an effort to calm customer concerns regarding the pricing—and transparency of that pricing—for transitions. As part of that effort, the firm released a letter to clients stating: “Our normal practice is to reflect our compensation as a commission on market trades and/or a management fee. While we may agree to a compensation arrangement that entails both a commission and a management fee…a commission and a management fee were applied without that being expressly communicated to the client.”
Multiple sources also confirmed that upwards of five separate pension funds were looking into past transitions that involved Pennings, and “multiple” funds, including the Sainsbury’s pension fund, have been compensated in the same manner as Royal Mail.
State Street currently serves as the public face of transition management indiscretion, but another firm—the ConvergEx Group—may soon replace them. An affiliate of the massive BNY Mellon complex (the bank is strenuous in its assertion that it only has a minority stake in ConvergEx, with 33.2% reported ownership), it was “formed in October 2006 through the combination of Eze Castle Software, a leading provider of investment technologies and BNY Mellon’s institutional execution business,” according to the company website. ConvergEx has a complex legal structure, with numerous “legally-distinct entit(ies)” in different geographies, including Bermuda, according to a spokesperson for the firm. It is this Bermuda-based operation that has people talking.
It has been reported that the Securities and Exchange Commission and the Department of Justice are investigating ConvergEx. However, multiple sources confirm that the Federal Bureau of Investigation (FBI) and the Postal Service are also investigating the firm.
The accusation spawning at least part of these investigations, according to sources, is this: ConvergEx, in marketing pitches and literature, claimed to be an agent with regards to transitions. (The firm’s own marketing verbiage makes this clear, with publically available company biographies often beginning with “BNY ConvergEx Group, LLC provides global institutional agency brokerage and investment technology solutions to institutional clients worldwide.”) However, through a complicated structure that seemingly fractured its business units into different legal entities, ConvergEx as a whole—utilizing the benefits of this legally distinct Bermuda-based group—was charging both a commission and a spread on transitions, among other transactions, when dealing with both Employee Retirement Income Security Act (ERISA) and non-ERISA pension plans.
The law on this issue is clear. Transition managers—or in this specific case executing affiliates—can act as an agent and charge a commission or act as a principal and take a markup. They cannot act as agent and principal at the same time without conflicting interests. According to industry insiders, one method for avoiding potential conflicts when an affiliate is acting as a principal for a transition agency broker is to offer the client full disclosure of the specific stocks that are principally traded and the incremental revenue that is generated above the standard commission charge. Indeed, these sources said, using a principal affiliate would only seem necessary when the securities in question were highly illiquid, thus making it a rare occurrence.
ConvergEx, however, claims no laws were violated because of disclosures made to clients. A firm spokesperson denied all wrongdoing. “We appropriately disclose our methods of compensation and the capacities in which we act in transitions to our transition management clients,” the firm told aiCIO in a written statement. “For example, in our transition management agreements we disclose that affiliates of our transition management business act on a principal basis in connection with transitions and may, in appropriate circumstances, earn a mark-up or spread. Those agreements also disclose that transition management will earn a commission. There is nothing improper about such disclosed compensation arrangements.” When asked about the level of disclosure regarding the money made on principal bids, and the frequency with which such principal affiliates were used, ConvergEx would not comment.
The firm’s ConvergEx Global Markets (CGM) entity terminated multiple employees in recent months “after learning that certain employees violated our code of conduct,” according to the spokesperson. Also “no longer with the firm” is Anthony Blumberg, who was considered central to the Bermuda operation and lead G-Trade, its “global electronic business, (which) is also distinct from CGM and separately-managed.”
“ConvergEx is cooperating fully with the authorities in connection with these inquiries,” the spokesperson concluded. “As in all such inquiries, we cannot speculate when the matter may be resolved nor can we freely share with you information about the nature of the inquiries other than to inform you that they primarily involve certain non-electronic trade execution practices conducted through CGM, which was managed separately from transition management before being wound down in the fourth quarter of 2011.” They did not deny that the FBI was investigating the firm.
(aiCIO was unable to confirm whether the FBI investigation was being executed jointly or separately from the Department of Justice investigation.)
Regardless of the veracity of the claims against ConvergEx’s transition business, the concerns raised against the firm have already wreaked havoc. In late December, London-based private equity group CVC Partners backed out of a deal that would have seen a majority share in ConvergEx purchased for $1.9 billion, citing concerns over “non-electronic trade execution practices” in the Bermuda-based CGM group. As of the publication date of this article, no charges had been filed against ConvergEx.
The problems with the transitions business go beyond a rogue employee or one firm’s allegedly nefarious structures, according to Rick Di Mascio, the leader of London-based analytics firm Inalytics. Di Mascio—whose staff includes Graham Dixon who, along with State Street’s Bonn, is largely credited with creating the transition management business—is the resident bomb-thrower in this world, among others; a call by Di Mascio to a transition manager, as of late, is never a good sign. (Di Mascio and his firm were the group brought in to investigate State Street’s transition for Royal Mail after the fund raised questions about cost; they reportedly charge upwards of £100,000 for such services.) Indeed, it is not the Pennings Affair—which he cannot comment on—that gets Di Mascio truly going: it is the very nature of the transition business as it currently stands.
One of the ebullient Brit’s favorite targets is the pre- and post-trade estimates provided by transition managers, ostensibly intended to allow clients to benchmark performance. “The data is offered up, but what does it say?,” Di Mascio asks. “Transition managers, as an industry, now provide Inalytics with their track-record data as a part of selection exercises. The data is extremely valuable and instructive: There is at least one transition manager that has never had its total costs exceed its pre-trade estimate—in 100% of instances they’ve come in below the pre-trade estimate. The whole basis of a pre-trade is an estimate, acknowledging that the short-term market swings can cause the outcome to vary.” Although he declined to name names, some pre- and post-trade estimate records are “statistically impossible,” he says.
To providers, the issues relating to foreign exchange transaction costs are in a way both less and more serious than those seen with their transition management businesses. On one hand, they feel that the actual allegations are less damaging to their reputations; on the other, profits from the FX business are so large, and contribute so much to the custody banks’ bottom line, that even the slightest risk to the business worries those at the top of the organization chart.
Unlike transitions—where State Street’s problems are vastly different from that of ConvergEx—recent legal issues with FX services provided by State Street and BNY Mellon have largely revolved around the issue of standing instruction orders. Most FX transactions are negotiated directly between an FX dealer bank and an investment manager. For about 5% of the trades, custodians claim, the investment manager will ask the end-user client’s custodian to deal with the transaction—often because it’s an odd lot of shares, or the security in question creates some other hardship. For this service and because they are taking on additional risk, the custodians claim, a slightly higher price is charged to the client. The most commonly used analogy here—and it is used so regularly as to become humorous when reporting on this subject—is that of a convenience store. Regular FX transactions are like buying food wholesale; standing instruction orders are like buying food at a convenience store. To get a smaller unit, let’s say, of milk, one is willing to pay a slightly higher price. To the custodians, this justifies charging slightly more for standing instruction FX transactions.
Numerous lawsuits have been brought against both banks over the issue of FX overcharging. While the individual accusations vary—the state of California is suing State Street largely over a disagreement regarding the words “based on”—the underlying theme of the claims remains constant: Custodians were charging more than they should. Extending the convenience store example from the plaintiff’s side of the argument, a quart of milk was costing 10 cents above what it should have been, and pension funds were none the wiser. A handful of funds—including the Massachusetts Pension Reserve Investment Management (MassPRIM), New York City’s pension plans, the state of Washington’s pension fund, and others—were or are involved with the lawsuits against BNY Mellon, either directly or through their state’s Attorney General. (BNY Mellon had a whistleblower—Grant Wilson, who was with the bank for 19 years before leaving a year ago—within its organization who passed documents to the Attorney General of Florida and is the basis for many of the lawsuits against the bank.) Washington has settled with BNY Mellon. MassPRIM has switched 5% of its business to Russell Implementation Services. In January, BNY Mellon reached a partial settlement with the Department of Justice, whereas it would have to be transparent about how it comes up with FX rates. State Street has settled one lawsuit, and maintains its innocence. A firm spokesperson told aiCIO that “State Street has always accurately disclosed the amount of currency exchanged in every foreign exchange transaction where State Street Global Markets is the counterparty, including every indirect FX transaction. Among other things, this information has been available to custody clients and their investment managers via our online client portal. Beginning in 2009, we provided additional information about the way we set rates for indirect foreign exchange transactions, including the difference between the rates we set and interbank market rates at the time that State Street Global Markets sets them.”
Transition management and FX are two premier examples of asymmetric knowledge in the investment management space. Pension funds are notoriously understaffed. Their leaders, with the help of consultants, largely focus on three interrelated decisions: asset allocation, risk management, and manager selection. If these three take up 90% of their time, transition management and FX transactions compete with a plethora of other decisions for the last 10%. The result: When a pension engages with a custodian or other provider of these services, there is a material mismatch between what the customer knows and what the vendor knows. As Mercer Sentinel’s Ben Gunnee says: “Clients are undergoing a process of education, but it is not their day job so it is difficult to monitor.”
Take the ConvergEx example. If the firm did in fact describe in its contracts the complex legal structure outlining how third-party affiliates will act as principals during a transition, one can only imagine how long a pension executive’s attention will be held once the nuances of Bermuda-based corporate structures arise. This doesn’t mean that ConvergEx would be at fault—pensions, after all, are expected to be sophisticated purchasers in the investing marketplace—but it does suggest an asymmetric base of knowledge that works in the transition manager’s favor.
Di Mascio, ever the iconoclast, believes that the industry is structured this way on purpose. “In the fund management industry, there are recognized templates – for example, investment management agreements (IMAs) in the UK,” he says. “They are worked on every day of the week, and they are used all the time because you’re appointing managers all the time. It’s a constant process – so all the nuances are constantly being ironed out.” In the world of transition management, he says, “the asymmetry of knowledge isn’t even the biggest problem. The biggest problem is the fact that most transition management agreements (TMAs) are written by the transition manager, and the client—because he may only do one every blue moon—doesn’t necessarily have the legacy knowledge to understand what the small print means. The contract is written to protect the transition manager, not the client.” He also notes the stale nature of contracts in the transition space. “In addition, the actual agreement the event is covering was probably written years ago, covered in dust, and even then was written by the transition manager,” he says. “As a result, the chances of a client picking up on the nuance of this is very remote.”
Mercer Sentinel’s Gunnee pins much of the blame on the industry itself. “The industry hasn’t helped itself—there was the T-Charter that tried to bring transparency for clients—but now clients just want confidence. They want good execution and transparency,” he says. “The State Street incident sparked people’s interest if they had been unfairly treated, in most cases it will depend on the way the contract is written.”
It is perhaps because of an acknowledgment of this asymmetry—and the implied naivety in letting it persist for so long unaddressed—that pension plans and consultants are reluctant voices at best in this recent battle. According to numerous sources, executives with the UK-based pension plans, plus their consultants, are (perhaps ironically) less than happy that State Street is so actively reimbursing clients. It is difficult to go back to a pension board, the logic goes, and tell them that a transition you were very happy with six months ago has been revealed to be deficient. The reimbursement, in effect, is an admission that the pension executive missed something the first time around.
But will anything change? Many firms are quietly hoping that the problems within State Street and BNY Mellon and its affiliates will cause a breakdown of the long-dominant custody model, where basic services were perhaps underpriced in order to retain higher-margin businesses such as FX, securities lending, and transition management. But asset management is not a nimble industry. Both WSIB and the California Public Employees’ Retirement System (CalPERS) renewed custody mandates with State Street despite the lawsuits. It may be a dirty business, as some say, but it also tends to be sticky.
This stickiness and the limited number of firms providing these services are often cited as the reasons that so few pension funds are willing to speak out on this issue. It may be a dirty business, but it’s an essential one, and maintaining good relationships with consultants and custodians could be more valuable to a pension than the relatively small amounts of alleged overcharging for these ancillary services.
Yet fraud is fraud. Whatever the outcome of the transition management revamp at State Street, of the investigations of ConvergEx, and of the FX lawsuits at BNY Mellon and State Street, institutional investors must now be fully aware that providers, although ostensibly partners, are capitalist enterprises which first and foremost look out for their own. Rapid disintermediation of the traditional transition and FX business may be a step too far at this point, but the realization that asset owners and their consultants must keep a closer eye on how these services are executed, priced, and reported is an idea whose time is now. As Inalytics’ Di Mascio says: “Put it this way. If this doesn’t cause a real change, then nothing will.”