Abu Dhabi, Dutch Pensions, SWFs 'Defrauded' Out of Millions on BNY Mellon FX Trades, Lawsuit Alleges

The US Department of Justice has brought a case against BNY Mellon alleging it cheated customers on foreign exchange services, leading to revenues of more than $1.5 billion from some of the largest institutional investors worldwide.

(July 2, 2012) — The Abu Dhabi Investment Authority, the Kuwait Investment Authority, and the Alaska Permanent Fund are among the hundreds of sovereign wealth funds, pensions, asset managers, and other financial institutions worldwide that have been cited as possibly losing millions of dollars in foreign exchange services provided by BNY Mellon, an amended complaint by the US Justice Department has claimed.

The Justice Department had sued BNY Mellon in October in federal court in New York, when claiming that the bank defrauded federally insured banks in handling foreign exchange. The amended lawsuit, filed June 6, alleges that the custodial bank generated more than $1.5 billion from its top 200 standing-instruction clients from 2007 to 2010 by charging their customers at the worst — or nearly worst — price point of the day.

The revenues had been allegedly earned for the price BNY Mellon assigned to clients and the more favorable rates the bank obtained trading for itself, a spokesperson at the US Department of Justice told aiCIO.

Some of the largest revenues earned by BNY Mellon between 2007 and 2010 through its FX services include more than $32 million on the Florida Retirement System; more than $14 million on the Alaska Permanent Fund; roughly $13 million on the Virginia Retirement System and the State of Wisconsin; nearly $8 million on the State of New Jersey; about $5 million on the Abu Dhabi Investment Authority and the Ontario Pension Board Institution; and about $4 million on the Kuwait Investment Authority.

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The complaint also alleges millions of dollars in revenue were collected from endowments — Cornell, Stanford, Washington, and Princeton universities — along with major banks and asset managers, such as Blackrock, Citigroup, Prudential Financial, Goldman Sachs, Royal Bank of Scotland, Putnam Management, Oaktree Capital, and Merrill Lynch. According to the amended Justice Department complaint, BNY Mellon settled with Prudential Financial by agreeing to repay more than half the revenue it generated from the Prudential currency trades in question, after the insurer complained about the pricing of its foreign exchange transactions, Reuters initially reported. The Justice Department said BNY Mellon generated more than $28 million from the trades with Prudential.

When asked about the FX figures, the clients contacted refused to comment on pending litigation.

Questions circulate on whether, following Prudential, other BNY Mellon customers will demand repayment.

Similar to recent legal issues with FX services provided by both BNY Mellon and State Street, the suit revolves around the issue of standing instruction orders. BNY Mellon “automatically provides currency exchange on an as needed basis, when, for example, the client buys or sells foreign securities or receives dividends on foreign exchange services that are repatriated to the United States,” the lawsuit says. “Unlike directly negotiated currency trades, BNY Mellon unilaterally determines the price its clients receive for standing instruction transactions.”

The lawsuit continues: “The standing instruction service was so much more profitable to BNY Mellon than any other foreign exchange service because it relied upon a fraudulent business model. The model involved deliberately concealed the way BNY Mellon was actually pricing stranding instruction transactions while affirmatively misleading customers into believing they were receiving the best prices available, when that was not the case. BNY Mellon accomplished this fraud by knowingly hiding critical facts from clients and/or their investment managers, intentionally providing them confusing and misleading information about the service, and telling them outright lies.”

The amended lawsuit by the Justice Department additionally alleges that BNY Mellon executive David Nichols fraudulently misled customers about the foreign exchange service that the bank was providing them between at least 2004 and 2011. This marks the first time that a BNY Mellon banking executive has been charged personally with regards to FX pricing. According to the lawsuit, Nichols, a defendant in the case, was “instrumental in perpetuating” this “fraud.” The claim adds: “Among other things, Nichols drafted and developed the false and misleading definition of ‘best execution’…In addition, Nichols disseminated this false and misleading definition to BNY Mellon custodial clients who used the bank’s standing instruction service, and encouraged other BNY Mellon employees to do likewise in response to client inquiries.”

Industry sources note that the Justice Department’s latest lawsuit over FX represents, similar to the Bernie Madoff scandal and the subprime mortgage crisis, what happens when an industry becomes too trusting — when a lack of transparency fosters a system with inadequate checks and balances.

In response to the allegations, BNY Mellon spokesman Kevin Heine told aiCIO: “We cannot comment on allegations concerning a settlement. As we have said before, we believe we have strong legal defenses, which is evident by the recent rulings dismissing lawsuits against us in California and Virginia,” referring to a state court in Virginia that recently dismissed a foreign exchange case brought against the company by the Virginia Attorney General, as did a California federal court considering a similar case.

“These recycled allegations reflect a fundamental misunderstanding of the FX market and we will continue to defend this case vigorously. Any suggestion that we engaged in conduct intended to mislead or defraud our clients is simply untrue,” Heine said.

While the US Department of Justice alleged that the $1.5 billion figure was based on BNY Mellon’s internal calculation of the sales margin or sales revenue it earned from standing instruction transactions from foreign exchange trading for the 200 listed custodial clients, Heine had no comment on the figure or how it was calculated. “The belated decision to single out one employee is deeply troubling,” he added.

Amid this pending litigation, what is the solution then to an FX market that critics say have been unregulated and lacking transparency for far too long?

“Pension funds, which pay millions and millions of dollars in custodial fees, have been lazy. They decide to outsource to custodial banks, and they don’t understand FX issues. Pension funds’ Chief Financial Officer or Treasurer should look at the time and price of trades, but they don’t,” Chris Havener, founder & managing director of Royal Oak Capital Management, told aiCIO last year following allegations that BNY Mellon cheated the Massachusetts Pension Reserves Investment Management (MassPRIM) more than $20 million on FX trading. He added that pensions are slowly waking up to the problem of FX manipulation. “This isn’t a perfect world, and despite greater scrutiny, this problem will persist.” Havener said. “This is the problem when you have people running other people’s money. Even though banks have a fiduciary responsibility to their clients, pension funds have dropped the ball on this…Perhaps, but not likely, this will serve as a wakeup call to act upon their naivety.”

The solution to avoid misrepresentations in regards to FX trading is for banks and pensions to form contractually-bound agreements, setting more specific details on the pricing of currency trades, according to Havener. However, smaller companies will not have the clout of larger funds in negotiating contracts, he added.

In response to a flurry of lawsuits, BNY Mellon has proposed adding to its traditional FX trading product with new standing instruction product. While its traditional standing instruction product has relied on a range of rates, its new offering relies on guaranteed fixed-rates that provide protection against extreme currency fluctuations, according to the custodial bank’s website.

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