What the BNY Mellon Forex Settlement Really Means for SWFs

April 23, 2015 by Loch Adamson

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Regulators and law enforcement extracted a hefty fine for fraud at one of America’s most respected financial institutions. Have sovereign wealth funds learned their lesson?

The case certainly seems a blockbuster — at least on the surface. Last month, Bank of New York Mellon Corp. settled two high-profile suits, one each by the U.S. Justice Department and the New York State Attorney General’s Office, as well as investigations by the Securities & Exchange Commission and the Department of Labor. The United States’ oldest bank, founded by the first Treasury Secretary, Alexander Hamilton in 1784, admitted to providing clients with virtually the worst possible prices on certain routine currency trades for more than a decade while claiming it was providing “best execution practices”.

BNY Mellon agreed to pay out $714 million, to be split among plaintiffs, victims, and the government. It also admitted to conduct alleged in the suits, agreed to terminate certain employees, including a top executive in its foreign exchange department, and provide greater disclosure about its pricing of forex transactions. Specific details on how that money will be divvied up have not been divulged, although the N.Y. Attorney General said that the New York State Deferred Compensation Plan and the State University of New York were victims and will be reimbursed. The plan declined to comment and the university did not return an email seeking comment.

Attention has focused on the bold face, federally insured financial institutions along with the teacher, police and firemen pension funds who were allegedly bilked by the years’-long fraud. Yet a clutch of sovereign wealth funds were among the roster of possible victims.

A document dubbed Exhibit A filed with the Justice Department’s last amended complaint in June 2012, shows that over four years, state-owned investors were among the biggest clients of the BNY Mellon forex trading operations that facilitated the alleged fraud. These included the $600 billion Abu Dhabi Investment Authority (ADIA) and the Saudi Arabian Monetary Agency (SAMA), the Kingdom’s central bank.

To be sure, despite the size of the settlement, the numbers involved may not seem big by sovereign wealth standards. “One question here, is it material?” asks Patrick Schena, Adjunct Assistant Professor and Co-Head of the Fletcher Network for Sovereign Wealth and Global Capital at the Fletcher School of Tufts University outside Boston, who advises on custodial issues.

“Best Practice”

It is material, and that’s because the suits speak to the issues of compliance and governance. The Exhibit A document, which is described as being furnished by BNY Mellon in the Justice Department complaint, lists the largest clients, by year, of a particular kind of forex service that was at the heart of what the government calls fraudulent actions — though not necessarily those that fell victim to it.

The roster ranks clients by the total spreads generated by their forex trades and also includes the number of trades and dollar volume. The upshot is that even if all the spreads were ill-gotten, the amounts cited were barely rounding errors in terms of funds under management for these giant pools of state-owned money. Yet for BNY Mellon they added up to major pot of money.

Indeed, sovereign wealth funds generated a steady stream of business for BNY Mellon through these transactions. In 2007, the $51.1 billion Alaska Permanent Fund Corp. (APFC) generated spreads of $2.5 million for BNY Mellon, almost the same amount as the $548 billion Kuwait Investment Authority (KIA). ADIA generated $588,000 for the bank’s forex desk and the diminutive $2.9 billion Alabama Trust Fund just $433,000. The total for BNY’s largest clients in these kinds of forex trades: $278.2 million — and that’s just the big ones.

The next year, 2008, as world markets tumbled and gyrated, forex spreads obtained by BNY Mellon from its biggest clients using this trading service nearly doubled overall to $548 million. SAMA generated spreads worth $7.5 million to the bank and the APFC $4.5 million, ADIA $3.1 million and KIA $1.1 million.

In 2009, SAMA produced $6.0 million in spreads for the bank using the forex service, APFC $3.6 million, ADIA $1.1 million, and KIA $597,000. The total that year from the largest clients was $394.6 million.

The last year covered in Exhibit A was 2010, when APFC generated $3.6 million in spread fees, SAMA $1.5 million, and ADIA $731,000. The total spreads generated by BNY Mellon’s largest clients for the year was $317.6 million.

A phone message left with an APFC spokesperson was not returned. Emails to the Alabama Trust, KIA and SAMA were not returned. An ADIA spokesperson declined to comment. and spokespersons for the Justice Department and the N.Y. Attorney General did not respond to emailed questions.

What was BNY Mellon really up to? While claiming publicly in marketing materials and privately to clients that it was obtaining “best practice” pricing for foreign currency transactions, the bank in at least some cases doing the opposite, handing them the worst deals possible.

Good Reputation

There are two main ways for clients to convert currencies: They could contact BNY Mellon and negotiate currency transactions directly, settling upon an agreed upon rate, based on current market prices, to buy or sell. But BNY Mellon also offered something called a Standing Instruction (SI) service that operated very differently and this is what is at the core of the case.

Under the SI service, BNY Mellon claimed to be providing the best possible prices at the time of the trade virtually automatically, say, when a dividend was paid or other cash generated. Instead, the bank’s trading desk would wait until the end of the trading day, aggregate the transactions, and then pick a price that was at — or near — the lowest of the day if a client was selling and at or close to the highest price, if it was buying, the suits alleged. BNY Mellon would lock in the spread between that and the actual sale or purchase price, for itself.

Small potatoes? Not for BNY Mellon. In 2009 the SI service generated about 12 percent of its total forex trading volume and about 69 percent of its profits, according to the Justice Department complaint. Negotiated forex trades accounted for 88 percent of trading volume and just about 31 percent of profits. The Justice Department suit claims BNY Mellon made more than $1.5 billion between 2007 and 2010 alone from just its top 200 SI clients. The N.Y. Attorney General’s suit claimed it earned $2 billion over 10 years..

That’s real money for anyone. Accordingly, the BNY Mellon settlement speaks directly to key matters facing state-owned investors. Sovereign Wealth Center has written about the seemingly mundane but critical issues surrounding sovereign wealth fund collateral and the custodial banks that oversee it. BNY Mellon is the largest such bank with assets of $28.5 trillion under custody or administration, with what has traditionally been a good reputation.

Learning Lessons

Nevertheless, for years senior management appears to have actively deceived its clients, refusing to provide time stamps and repeatedly claiming that it was providing best practice execution. Nor was it necessarily alone — rival State Street Corp. was sued by the California Attorney General at the time, now California governor Edmund Brown Jr., for mismarking forex trades by the California Public Employees’ Retirement System (CalPERS) and the California Teachers’ Retirement System in 2009. One former BNY Mellon employee, after learning of the suit against State Street, asked his ex-colleagues whether it was “[t]ime to retire after raping the custodial accounts,” according to the Department of Justice complaint. The State Street suit is still pending.

One lesson: due diligence is imperative to safeguarding stakeholders’ wealth. It’s heartening to report that the APFC, according to the Justice Department suit, grilled BNY Mellon about its SI service and asked specifically whether it was engaging in the same practices described at State Street. The bank sent a link to its website, according to the Justice Department complaint, which falsely claimed it was providing best execution prices, which it did not.

The State of New Jersey Department of the Treasury – Division of Investment, demanded to know why its forex prices were so poor and received a $100,000 payment from the bank. The San Diego County Employees Retirement Association demanded time stamps, but was told they were unavailable and went on to compare its own prices to publicly available data. BNY Mellon claimed the independent data was not definitive. So some institutions were keeping an eye on custodians, as they should.

“I think compliance officers are going to be more focused on these issues,” says Schena. The impact of the BNY Mellon and State Street cases is already being felt. “They’ve become much more transparent in their services related to their standing instruction orders,” he adds.

The second lesson is this: While the $714 million settlement might seem impressive, the Justice Department and N.Y. Attorney General’s suits alleged that the fraud had generated BNY Mellon more than double that amount. How much of the settlement will be tax deductible is not known, but this was no clearly no prosecutorial grand slam.

Bernard Madoff

“This is not a lot they are settling for,” says professor Michael Greenberger of the University of Maryland School of Law. “This is a cost of doing business settlement. This is a slap on the wrist.”

BNY Mellon issued a statement on the day of the settlement. “We are pleased to put these legacy FX matters behind us, which is in the best interest of our company and our constituents,” the company said. “The total settlement is covered by pre-existing legal reserves.” BNY Mellon spokesperson Kevin Heine declined to elaborate on the record.

The cases followed on the heels of the California suit, but also incorporated a False Claims Act filed by among others, Harry Markopolos, who helped uncover the Bernard Madoff Ponzi scheme. Neither the Justice Department, nor the N.Y. Attorney General, or the SEC had too many stones to turnover to find this one.

One clear message for sovereign wealth funds, indeed any institutional investor, is that they can’t rely on regulators for protection if they hope to avoid resembling the proverbial chicken ripe for the plucking. Regulators are often slow off the mark, even in ostensibly transparent and well-run markets, such as those in the U.S.

The Travesty

Will there be reputational damage to BNY Mellon? That depends on one’s perspective. “There was certainly damage when the case came out,” says Bernard Black, a law professor at Northwestern University School of Law and Kellogg School of Management. “The question is, ‘Is this new information? Was it anticipated?’”

Some argue it doesn’t matter at all. “My view is that people just shrug it off,” says professor Michael Greenberger of the University of Maryland School of Law. “Even the people who are a foil for these kinds of transactions.”

Indeed, two years after California filed its suit against State Street, CalPERS renewed its contract with the bank. “How can there be reputational damage when every bank in the country is doing this?,” asks University of Maryland’s Greenberger.

Will such settlements do anything to forestall future wrong doing? There are optimists and pessimists. Professor Geoffrey Miller of the New York University School of Law sees an evolutionary shift. “I believe that this and other huge settlements are slowly inducing a changing attitude at big banks with respect to compliance,” he says.

Others take the position that a lack of regulatory aggressiveness renders such suits useless. “The travesty of these seemingly large settlements is that they do nothing to deter the actions,” says Dennis Kelleher, president of Better Markets, a Washington, D.C.–based advocacy group. “They use today’s shareholders’ money to buy a get out of jail free card. Prosecutors seem allergic to holding executives responsible.”


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