ANALYSIS

Institutions review securities lending programs

Virgilio “Bo” AbesamisAlmost half of US institutional investors are turning their back on securities lending programs, with cash collateral reinvestment losses the leading concern among three quarters of those who participated in a recent survey by Callan Associates, and for a lot of funds the next decision is what course to take in the recovery and mitigation of losses.

Callan’s 2009 Securities Lending Survey found approximately 48 per cent of respondents with securities lending programs were undergoing a controlled withdrawal to reduce the risk profile of the program and minimise current and future losses.

The survey participants represent $1 trillion in assets, and comprise 72 fund and plan sponsor organisations, mainly public and corporate pension funds.

According to Callan, fund and plan sponsors are also reviewing their investment policies and guidelines with a clear resolve to manage risk, understand the attribution of earnings, tighten compliance, seek better transparency and disclosure and strengthen accountability. Less than half were concerned about litigation.

“Collectively, the majority of plan sponsors have placed a high priority on revamping their current securities lending programs,” says Virgilio “Bo” Abesamis, senior vice president of the master trust, global custody and securities lending group at Callan.

“Pursuing litigation at this point would stop that process dead in its tracks until any legal issues were resolved.”

However lawyers argue many funds have been left with no choice but to resort to litigation in a bid to recover the billions of dollars worth of losses they’ve suffered from their securities lending programs.

Darren Check, director of institutional investor services at Barroway Topaz Kessler Meltzer & Check (BTKMC), says funds “did not come out with guns blazing”. They made reasonable efforts to resolve the situation with their custodian, but were “met with a lot of resistance”

“A lot of the funds that we’ve talked to in the US and Europe have tried to resolve this without litigation and would much prefer to have resolved this without litigation, especially because in the majority of instances this is their custodian, so they’re doing a lot of business with these people,” Check says.

“But in the super majority of the funds that we’ve spoken to, they were met with a surprising amount of resistance and negative reaction when they went to the lending agent and said “How can we work this out?”

BTKMC is representing the plaintiff, the New York-based Board of Trustees of the AFTRA Retirement Fund in a class action suit against JP Morgan Chase Bank.

The suit seeks to recover losses resulting from the custodian’s alleged breach of its fiduciary duty to investors in its securities lending program.

Joe Meltzer, the attorney leading the securities lending litigation, says the fund’s losses are “well in excess of $1 million”.

“In terms of relief, the AFTRA case is a class action case, so we’re not looking to recover solely what the plaintiff fund lost, but what they lost and everybody else lost,” he says.

“We’re looking for recompense or reimbursement of what was lost by virtue of inappropriate investments that were made in the context of the securities lending agreement.”

Sharan Nirmul, attorney at law at BTKMC, says following the Lehman Brothers bankruptcy on September 15, 2008, most institutional investors that participate in sec lending were informed that the funds in which the cash collateral from their sec lending activities was invested had “broken the buck”.

As a result, fiduciaries and boards were told they were liable for the deficiencies in the cash collateral in these funds under the terms of their sec lending agreements.

The AFTRA suit centres on investments made by JP Morgan in Sigma Finance, a structured investment vehicle (SIV) which went bankrupt late last year.

“A lot of the outrage was spurred by the fact that in October 2008 when the fixed income instruments like Sigma failed, the funds were on the hook under these agreements for the deficiency of cash collateral, so all of a sudden they’re facing $1 billion from their custodian for the deficiency in the cash collateral account, and this was supposed to be a conservative investment to preserve principal,” he says.

Nirmul says BTKMC has identified structural problems within sec lending programs, in that the risk of the investment of the cash collateral is entirely on the pension fund participating in the program, but yet the benefits are shared equally between the fund and custodian.

“In some cases the custodian or manager gets a larger portion of the profits generated,” he says.

“So you have this built in conflict of interest which makes it all the more important that the manager is attending to their fiduciary duties and watching what’s going on with this cash collateral. Rather than fulfill these duties, in the face of red flags about the quality of these investments in a marketplace that was collapsing, they stood idly by.”

He suggests institutions consider inserting risk-sharing clauses in their sec lending agreements, where the custodian shares the same percentage of loss as the percentage of income received.

Check believes the shake-out will change the way some of the trustees handle their responsibilities around sec lending.

“Not to say anything negative about what they’ve done in the past, but this has put some pressure on funds to say, “we need to do a little bit more due diligence”, he says.

“The fear among a lot of funds these days and trustees is that they’re going to be held responsible.”

For one fund this fear has already been realised. A lawsuit was filed in late May in the US District Court in Indianapolis by a teacher enrolled in the Indiana State Teachers Association long-term disability trust fund.

The teacher is asking the court to require the trustees and fiduciaries of the fund to restore all the money lost as a result of bad investments. The fund faces a $67 million shortfall and is reportedly being investigated by both the Federal Bureau of Investigation and the securities division of Indiana’s secretary of state.

“I think there’s going to be a push in sec lending agreements and other investment agreements for trustees to make sure they’re protected, that their rights are protected, and they’re going to be taking a much harder look at these things,” Check says.

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