SEC puts securities lending on list of things to watch

Add securities lending to the list of things on the Securities and Exchange Commission's radar screen.

"When we looked into market timing and late trading, we saw to an extent that we had never seen before how advisers would breach their fiduciary duty to clients," said Kevin W. Goodman, Los Angeles-based assistant regional director of the SEC. At a securities lending conference in February, Mr. Goodman outlined the commission's focus on securities lending.

In its examination of mutual fund market timing and late trading, the SEC found that advisers "blatantly put their interests above those of mutual fund shareholders," Mr. Goodman said in an interview. "That raises the likelihood that a similar breach could happen in the securities lending area."

Mutual funds are big lenders of securities.

Mr. Goodman emphasized that the focus was on securities lending in the mutual fund world, which the commission regulates, but plan sponsors that lend securities also need to be on guard, particularly regarding their relationships with lending agents, custodians and investment managers.

Robert A. Wittie, a partner in the Washington office of Kirkpatrick & Lockhart Nicholson Graham LLP, heard Mr. Goodman's speech at the conference and was somewhat surprised by the new focus.

"As far as the application to pension funds, it's not an area I think on which the SEC has been highly focused in the past," he said. Mr. Wittie concentrates on financial transactions and the regulation of investment companies and financial institutions.

"But in light of their recent experience, the SEC views any place where there is a significant amount of money changing hands as something worthy of their more considered attention than perhaps had been given in the past," Mr. Wittie added. "They seem to have concluded that (securities lending) is an activity they hadn't thought had much potential for a problem but now think it is one that may have potential for problems."

Michael P. McAuley, senior vice president and chief product officer in Boston-based State Street Corp.'s securities finance division, said securities lending was a logical next step for the SEC.

"They've gone through late trading and market timing and looking at adherence to fiduciary obligations," he said. "Securities lending is the next logical set of transactions to look at. I see it as an extension of what they've already done."

He added that he was "pleasantly surprised" at the openness with which the commission has explained how it will examine securities lending.

For starters, if a beneficial owner is using either an outside lending agent or a custodian for securities lending, the SEC will be interested in understanding what kind of due diligence went into the decision, the commission's Mr. Goodman said.

"The analogy is similar to when we see advisers who choose brokers," he said. "If you're an adviser and you're helping clients choose a broker, you need to do that in a way that's best for clients. You need to do due diligence.

"It's the same thing with helping a client choose a securities lending agent," he said, pointing out that the choice cannot be made "just because it's easy. You need to go through a reasonable due diligence process."

As with many areas of SEC examination, the securities lending focus is on conflicts of interest, real or potential. For plan sponsors, these conflicts would most likely arise from their securities lending partners — the lending agent or custodian acting as lending agent.

One potential area of conflict, Mr. Goodman said, is in collateral management.

"The management of collateral is what generates fees," he explained. "If the risk being taken on the management of collateral is not commensurate with what the client expects, that's a problem. The conflict may be that the lending agent takes risks because they share in the income" earned from those investments.

Mr. Goodman was quick to note that the agency has not uncovered that sort of wrongdoing but was on the lookout for it.

The other areas of focus include how securities lending clients — beneficial owners — are treated by their agents. For example, the SEC would ask whether utilization rates are higher for clients that pay higher fees.

Also, the commission will examine the communications between portfolio managers and securities lending officials to determine whether the securities lending activities are putting undue strain on the portfolio manager.

"Generally, securities lending is thought of as producing some incremental income," Mr. Goodman explained. "The real focus is on the core investment strategy. Our concern is if the securities lending activity is putting limitations on the core strategy or the ability to implement the core strategy."

He said portfolio managers should be able to implement the investment strategy without having to first think about the securities lending function.

Jerry W. May, securities lending officer for the $64.5 billion Ohio Public Employees Retirement System, Columbus, said he welcomes the SEC scrutiny.

"(Mr. Goodman) mentioned risk management and how that's related to securities lending, and that is a positive from our perspective," Mr. May said. "The idea of fundamental fairness is a positive for the industry. More transparency in the lending market and a firmer grasp of the risks I think are necessary goals for everybody in the industry."