Pension funds and custodians are now more likely to meet in the courtroom than the boardroom, as the former aim to recoup some of their recent losses.
Pension funds have lost heavily in the recent economic downturn. Estimates from the International Monetary Fund, and the Paris-based think-tank the Organisation for Economic Co-operation and Development, range between $4 – $5 trillion. Now pension funds want some of that money back.
The tipping point for the pensions funds came in late 2008, after Northern Trust settled an out-of-court case with the University of Washington (UW) regarding the mismanagement of its securities lending program.
The University claimed that Northern Trusts cash collateral reinvestment program resulted in $7.5 million loss, the majority of which occurred after UW officials contacted Northern Trust in order to withdraw from the program after the collapse of Lehman Brothers. According to a statement from UW: Between Sept. 17 and 23, Northern Trust notified UW that losses had grown from $750,000 to $5.3 million and finally to $7.5 million. In each incident, the UW gave notice to Northern Trust to terminate its participation in the securities lending program and return its securities.
Northern Trust and UW have a 20 year relationship, and the case resulted in a swift out-of-court settlement.
Less than a month after the settlement, the pension plan for BPs North American unit sued Northern Trust over similar circumstances. BP went into detail regarding Northern Trusts securities lending program. According to the complaint filed in the United States District Court For The Northern District Of Illinois (21 October 2008): The Plans suffered such capital losses because, among other reasons, NTI engaged in such a high level of securities lending for certain Collective Funds (and indirectly the Index Funds) and negligently loaned NTGI Trust securities to borrowers who also were debtors of the Collateral Funds.
The lawsuit also pointed out that although Northern Trust shared in the income earned through securities lending, it did not share in any of the losses on the collateral investment what economists called a moral hazard. This is at odds with the actions of Northern Trust in 2008. Q3 2008 saw a pre-tax charge of $167.6 million to cover what Northern Trust described as actions taken to provide support for Northern Trusts securities lending clients. This was later put down to a collateral deficiency.
J.P.Morgan has also been issued with a similar lawsuit. In January 2009, the Board of Trustees of the AFTRA Retirement Fund issued a class action against the bank, claiming that it had breached its duties regarding the securities lending program.
J.P.Morgan used cash collateral from the securities lending program to purchase medium-term notes issued by Sigma Finance. Sigma Finance, a structured investment vehicle, collapsed in October 2008, following a cut in funding by J.P.Morgan. Despite the fact that in December 2007 analysts claimed Sigma lacked liquidity, and J.P.Morgan was offering the vehicle a funding line, the bank buried its head in the sand and refused to heed the warning signs, according to the lawsuit. The case is ongoing.
Although there have been a number of cases relating to securities lending losses, another custodial revenue stream has entered the spot-light in recent weeks. In mid-October, the California Public Employees Retirement System (Calpers) filed a lawsuit against State Street for overcharging Calpers and sister fund California State Teachers Retirement System on foreign-exchange trades. The trades have been backdated to 2001, and according to Calpers, the excess trades amounted to $56 million.
According to a State Street spokesperson: We categorically deny any allegations of wrongdoing and will defend ourselves against any litigation.
The case has taken an unexpected turn in recent weeks. Calpers hired UK firm Record Currency Management to look into its forex charges back in 2003. In an interview with the Wall Street Journal, Neil Record, CEO of RCM, said: We submitted that report at the end of 2003…and we found uncompetitive pricing.”
This highlights an important insight into the relationship between custodians and pension funds. According to RCM, Calpers knew full-well that it was being overcharged six years before the pension fund decides to take State Street to court. If this is the case, then the benefits Calpers gained from its custodial relationship outweighed the fact that according to the lawsuit State Street artificially priced foreign exchange deals at rates that were not in the best interest of the funds.
But now profits have dried up, and pension funds find themselves under increasing pressure to maintain the promises made regarding retirement payouts to their members. Trustees are throwing often decade-old relationships in the bin in search of revenue. State Street has served as CalPERS custodian since 1992.
It is not just custodians that have been issued with lawsuits. In mid-November, Ohio Attorney General Richard Corday filed a lawsuit against Standard & Poors, Moodys, and Fitch for “providing unjustified and inflated ratings of mortgage-backed securities in exchange for lucrative fees from securities issuers.”
The lawsuit is on behalf of the Ohio Public Employees Retirement System, the State Teachers Retirement System of Ohio, the Ohio Police & Fire Pension Fund, the School Employees Retirement System of Ohio, and the Ohio Public Employees Deferred Compensation Program.
Corday has accused the rating agencies of “spectacularly misleading evaluations of mortgage-backed securities due in part to the lucrative fees they received from the same issuers they were supposed to be objectively evaluating.”
Originally at the heart of the economic downturn, credit rating agencies faded out the mainstream business pages as the focus moved to regulation and remuneration. Yet pension funds have kept them central to their plans to recoup losses.
In July 2009, Calpers waded back into the courtroom and sued the big three ratings agencies, accusing them of negligence in rating mortgage derivatives resulting in $1billion loss for Calpers.
It is unsurprising to see companies accumulating reserve funds in anticipation of court settlements. State Street has increased its legal fund by an additional $250 million, after spending around two-thirds of the $625 million fund set up in 2007.
One pension fund is taking an extra step in order to mitigate losses. In an odd twist to the capitalist system, trustees of the Missouri State Retirement System, MOSERS, are considering suing sell-side firms for future losses.
The $6.8billion pension fund lost $2billion in 2008. As a result, a MOSERS board resolution stated: In carrying out its responsibilities to prudently invest and manage the assets of the system, MOSERS shall actively monitor the assets for any losses that may have occurred as a result of a violation or potential violation of federal and state securities laws or a breach of any duty owed the system.
MOSERS will employ a legal team to monitor unprofitable investments, and issue litigation if deemed necessary.
Giles TurnerNews Editor