On the face of it, last weeks employment tribunal in East London was about a banker claiming he was unfairly dismissed after a trade blunder. On a wider spectrum, the case brought about by State Street Global Markets former head of Global Client Solutions is about putting on trial the issue of undisclosed mark-ups. The case is about transition management mark-ups, but it is being defended by a bank engaged in an industry which has faced litigation as well as criticism of mark-ups levied on FX transactions, cash and stock loan.
An undisclosed markup on a transition management deal in which State Street acts as a so-called riskless principal, alleged former employee Edward Pennings, is no different to the practice of the bank in the FX market, where its traders apply mark-ups but bear no risk. FX in particular has come under the spotlight recently, with several high-profile lawsuits being launched against custodian banks. According to Pennings, a desire to preserve the business model prevented him from disclosing mark-ups on multiple transition management deals, the employment tribunal heard last week.
Pennings was dismissed from his duties as senior managing director in September last year when it came to light that clients such as the Royal Mail pension fund and the Kuwait Investment Authority (KIA) were overcharged on transition management deals. He is now suing the custodian bank for unfair dismissal in a trial that also questions the ethos around the visibility of mark-ups on these deals.
During Pennings cross-examination on Friday, State Streets counsel asserted that, far from seeking to preserve a business model endorsed by the bank, he had lied to clients as well as misled the banks compliance department. On a Royal Mail global corporate bond portfolio transition management transaction, according to the banks counsel, Pennings lied to the client about overcharging and undisclosed mark-ups on both the European and U.S. leg of the transition. The client was made aware of mark-ups charged on the U.S. leg and the amount overcharged on that leg only was subsequently refunded.
Pennings said that it was his bosss decision to rebate Royal Mail for the extra earned on the U.S. transaction only: We didnt pay the European part. They wouldnt know. Pennings further claimed that the global head of the business overruled a decision to pay back the European mark-ups on the transaction.
Pennings told the tribunal he did not accept that he had misled the State Street compliance department or the client. In response to allegations from State Streets counsel that he told the Royal Mail untruths, Pennings said: I dont think they were dishonest. They were not accurate or truthful, but not dishonest. He added that I was in client management mode, expecting the problem to be solved internally. Pressed by State Streets counsel on whether this meant telling an untruth, he said: It depends on the situation, but it was the right thing to do at the time.
Pennings further argued that undisclosed mark-ups were commonplace in the industry, and not something he was obliged to include in the client agreement. He added that, following advice from his superior Ross McLellan, a letter was sent to the compliance department informing them of the overcharging. I wrote a letter about a miscommunication of a futures trade, he said. McLennan was also dismissed last year.
Pennings said he informed State Streets compliance team that a Royal Mail audit of the transition discovered that his team had levied an undisclosed mark-up on the deal. We paid it back, he explained. We didnt want it to be looked as changing the business model. It was only the third time. It was a miscommunication of a futures trade at one basis point.
State Streets compliance team was informed soon after the miscommunication was uncovered. I didnt think it was a great handling of the situation, but it was not misconduct, said Pennings. Asked why he did not approach the compliance team before the client found out, he claimed that the compliance department was under-staffed and not always helpful.
Commenting further on the business model, and how this warranted undisclosed mark-ups, Pennings explained that State Street acted as Royal Mails agent to the multi-asset class transition. As agent, it was obliged to seek best execution of the trades necessary to complete on the transaction. We used the word agency liberally, said Pennings. Technically, State Street acted as ‘riskless principal between client and client counterparty in a transition, explained Pennings. State Street needs to be clearer on the use of the word ‘agent, he said.
State Streets counsel challenged him, saying that the client would have expected to recoup the same value of the assets being sold after the trades were completed.
It emerged at the tribunal that the Royal Mail audited the transition of the bond portfolio of March 2011 and discovered that mark-ups worth about $1 million were charged on the U.S. leg. That amount was paid back to the client. Royal Mail then commissioned an independent study into the transition with the help of performance measurement firm Inalytics, and found it was overcharged for the entire transition. The amount outstanding for overcharging on the non-U.S. trades was then also refunded.
Pennings explained that, by trading Royal Mails bonds on a riskless principal basis, the bank aimed to profit from selling the whole portfolio and buying its replacements in the market and to pass on at least some of the economies achieved to the client. In transactions of that kind, the client does not see which counterparties State Street trades with and expects only that the bank will achieve best execution.
This means mark-ups can be invisible. Rather than buying and selling a bond for $100, for example, State Street might buy it for $100 and sell to the client for $101, with State Street pocketing the difference. If it were genuinely acting as principal, State Street would guarantee Royal Mail best execution but assume the market risk that it failed to acquire the bonds in the market at the price promised to the client. We dont say about mark-ups on trading because these are undisclosed. We wouldnt tell the client our cost basis to execute.
Pennings compared the situation to banks collecting spreads in FX and said the selling of bonds is no different. Its clear we were taking an undisclosed spread in our affiliate contract, he said. This would square with what occurs in FX and FX riskless principal. Why is there a difference with bonds? He said that at a simple level they would say they are transparent, that its standard industry practice, that it happens in a handful of occasions in bonds and that the contract allowed for mark-ups.
In fact, Pennings said a similar undisclosed mark-up had already been approved in relation to KIA where a similar markup on bonds was charged. He admitted the team never told the client it would be taking a mark-up. The bid remained constant and the mark-up was built into the price, he added.
On that occasion, Pennings said the rates desk principal and fixed-income desk became involved in the deal. At 11 p.m. they wanted to rejig the language to allow the rates desk to trade on the deal, which would have meant changes, he told the tribunal. The client was not told, said Pennings, as it would have meant renegotiating the deal to allow this involvement, and that something he felt KIA would not readily be able to approve. State Streets compliance team played no part in this change to the KIA deal, said Pennings, because they didnt have to. He added that I believe the contract allowed an undisclosed spread, said Pennings. He believed he did not have to disclose these mark-ups when sourcing bonds from the market.
The tribunal brought to light the issue of transition management fees. State Street clients thought they were getting flat fees when they were actually getting hit by spreads as part of the transition, argued State Streets counsel. So the flat fee is untrue? he asked. Ive not denied that, replied Pennings. I believe it is incorrect, it is untrue, but not a lie. I thought it was an honest mistake because not to disclose undisclosed revenues in the contract. I didnt tell the full amount because I didnt have to. The business model approved of the taking of undisclosed mark-ups.
What if the client had asked?, asked State Streets counsel.
Well, we didnt think about that, replied Pennings.
After a phone call with his boss, Pennings called Royal Mail to tell them there was a miscommunication relating to a futures trade and mark-ups were taken. The U.S. amount of the trade -$950,000 – was subsequently rebated to the client. Pennings said a meeting was held to pay back the European leg, but this was overruled. We didnt give them the right amounts back, he said. Following a conversation with the compliance team, State Street also drafted a letter to Inalytics following the internal audit admitting the error. This did not address the mark-ups allegedly levied on the European trades.
Pennings was suspended in September 2011. His suspension was extended while the bank investigated overcharging on bond transactions more broadly. At a meeting in October, he was told to resign or face a disciplinary hearing. Pennings elected to face a disciplinary hearing in early November and was subsequently dismissed.
Meanwhile, aiCIO, Global Custodians sister title, ran the story of Pennings dismissal. He subsequently informed State Street that he was portrayed in an unfavorable light in the press prior to his side of the story being aired. State Street denied any involvement in this portrayal, arguing it does not comment on the status of its employees.
Pennings said he was treated unfairly by State Street when other parts of the bank behaved in a riskier manner. FX trading is not different because you are still taking risk, he argued. In riskless principal, the FX desk never said how much money they made. But I was fired for overcharging, and theyre not.
Commenting on the proceedings, a State Street spokesperson said: “Mr. Pennings actions fell seriously short of the standards and conduct expected of any employee at State Street, and we have zero tolerance for this. We have addressed the issues directly with the clients that were impacted. His allegations regarding broader involvement of State Street management in approving his actions are completely without merit. We are disappointed that he has been unable to take responsibility for his behavior and that he has chosen this current course of action.”
The tribunal concluded with lawyers from both sides giving statements on behalf of their clients. The parties are expected to find out whether Pennings was unfairly dismissed before the end of the year.
-Janet Du Chenne