This content is from: Corner Office

Custodial Bank Cheated Clients on Foreign Exchange, Lawsuit Alleges

The Arkansas Teacher Retirement System class-action lawsuit against State Street Corp. looks at custodial banks’ foreign-exchange transactions with public plans.

Pension funds’ foreign investments may pose a risk that plan sponsors did not even realize — getting ripped off on the currency exchange.

The Arkansas Teacher Retirement System filed a class-action lawsuit February 10 against State Street Corp., on behalf of itself, as well as similarly affected custodial customers. The lawsuits follows word that several states have started looking at custodial banks’ foreign-exchange transactions with public plans, and the California attorney general’s 2009 filing of a complaint against State Street for its FX practices with the California Public Employees’ Retirement System and the California State Teachers’ Retirement System. State Street has said that it believes it has done nothing wrong.

The Arkansas lawsuit alleges that for more than a decade, State Street has conducted foreign-exchange transactions in “an unfair and deceptive” way to maximize its profits at the expense of its custodial customers. “Defendants have charged many of their custodial customers (a) inflated FX rates when buying foreign currency for those customers, and (b) deflated FX rates when selling foreign currency for those customers, and pocketed the difference between the actual and reported rates,” the suit claims.

“The allegations are that banks are systematically gaming the system,” says Marc Machiz, a partner at law firm Cohen Milstein Sellers & Toll PLLC, of these cases. “My first instinct is to say, let’s look at that contract and see, is there room for abuse? You really need to know the precise language of the contract and the instructions given by the plan, and then look at the records and see if, how, and why the bank departed from what was promised.”

The varying sophistication levels and market power of plan sponsors likely means that these contracts’ terms vary, Machiz says. The language on foreign-exchange pricing in some custodial contracts “could have been obtuse, or it could have been ‘We will use our judgment,” says Denise Valentine, a senior analyst at Aite Group, LLC, a research and advisory firm focused on financial services. “Possibly the pension funds did not examine the contract to that extent, and now they are saying, ‘That is not what I want.’ They are not necessarily experts in foreign exchange.” Of course, she says, wrongdoing by banks also is possible.

The Arkansas suit alleges that prices were supposed to be set in accordance with the interbank rate at the time of the transactions, Machiz says. “But one transaction at a time is not how FX is typically priced when you talk about small transactions executed pursuant to standing instructions,” he says. The U.S. Department of Labor’s Employee Benefits Security Administration issued guidelines in November 1998 that cover foreign-exchange transactions for the private retirement plans governed by ERISA (the Employee Retirement Income Security Act). Because of the huge volume involved, the guidelines allow custodial banks to aggregate many routine FX transactions with a value of less than $300,000 from different customers, then disaggregate them and establish the individual prices each day based on published prices at a fixed time each day, with the time and pricing methodology set by the contract.

That arrangement gives banks some flexibility on the timing of the actual transaction, which could hurt or help the bank versus the contract price, Machiz says. It also allows the bank to aggregate transactions, effectively netting out buys and sells within its own order book, a kind of cross-trade that is cost-free to the bank, he adds. “The idea is that in the long run, it would all come out in the wash: Some days the client would get a better price than what the bank got in the market, some days it would get a worse price,” he says. While ERISA does not cover public plans, he says, the courts may agree with the Labor Department that for smaller transactions executed as part of standing instructions, contracts that do not tie the price paid by the client to the price actually obtained by the bank on the market can nevertheless be fair to the client.

Machiz advises all retirement plan sponsors to have an expert examine the foreign-exchange provisions in their custodial contracts. “They really should ask themselves: Do I have contract provisions that are sufficiently strong that although I do not get the best deal every time, I will get a fair deal over time?” he says.

Related Content