Officials at the Illinois State Board of Investments never asked Northern Trust Co. to hit home runs; they just didn't want the firm to create problems.
But errors by Northern Trust, Chicago, in reporting its use of minority brokerage to the board wound up jeopardizing the longtime custodial relationship and the $2.4 billion in S&P 500 and fixed-income indexing assignments with Northern Trust Global Investments.
The problem has already cost Northern Trust at least $750,000 to $800,000 a year in custodial fees. In addition, Northern Trust reimbursed the board $126,000 for staff and legal work in investigating the errors and related compliance issues.
Northern Trust enjoyed a secure relationship with the board, dating to 1984. But the relationship began to unravel in December, when the board noticed a discrepancy in Northern Trust's reporting on its use of minority brokerage.
The errors led the board to issue requests for proposals for custodial, securities lending and index management services, all provided by Northern Trust.
"Northern Trust did not report the numbers accurately," said William Atwood, executive director of the Illinois system, who provided details of the situation. "These are all very troubling issues."
In July, the board rehired Northern for all three services; its fee proposals were compelling. Besides forgoing the $750,000 to $800,000 annual custodial fee, Northern Trust cut its share of the securities lending fee to 15% from 25%, while boosting the board's share to 85%. The annual gross revenue from securities lending is about $3 million.
"Basically, Northern was prepared to give custody in exchange for the securities lending and index management," Mr. Atwood said. The index fee remained at one basis point for the first $1 billion, declining to a half basis point for larger amounts.
"They would be working for their old fee," if the errors had not been discovered, he said.
Northern Trust might still lose the Illinois board's indexing. After the board rehired it in July, trustees learned of the departures of three key executives in index management and reissued RFPs for indexing. The board hopes to make a decision later in September.
A Northern Trust spokesman declined to comment about anything involving the board.
Board policy mandates that managers spend 15% of their trading commission dollars with minority brokerages. "Most managers have no problem complying," Mr. Atwood said. "Unless the policy jeopardizes their investment management, they have to comply."
For fiscal 2003, Northern Trust reported $176,000 in total brokerage commissions, including $41,000 — or a 23% share — with minority firms. In updating a report, the board's staff discovered Northern Trust left out transition management services it handled for the board. With those transitions, Northern Trust's generated $1.6 million in commissions, including $218.000, or 13%, for minority-owned firms.
"Northern Trust's ability to use minority brokerage in transitions and index management was poor," Mr. Atwood said.
"Northern Trust subsequently made changes in how it manages the passive portfolio, enabling them to use more minority brokerage and exceeding our standards, " he said
But it's unlikely Northern Trust will regain the absolute confidence enabling it to enjoy another protracted run without having to rebid for its services.