(Updated on Feb. 2, 2010 at 5 p.m. EST)
The Chicago Public School Teachers' Pension and Retirement Fund and the City of Atlanta Firefighters' Pension Plan filed a joint federal lawsuit against Northern Trust, claiming it breached fiduciary duty in managing their assets in securities-lending programs.
Total assets of the Chicago fund are $9.2 billion and the Atlanta fund, $363 million.
The suit was filed Jan. 29 in U.S. District Court in Chicago. Judge Rebecca Pallmeyer is presiding over the case, which seeks class-action status.
The suit accuses Northern Trust Investments NA and its parent, Northern Trust Co., of “breaches of contract and fiduciary duty” in managing assets for the funds related to securities lending.
Rather than invest securities-lending collateral pools for the Chicago and Atlanta funds “in conservative, highly liquid, ultra-short-term investment funds” Northern Trust, “in flagrant violation of its duties, instead locked those funds into risky, long-term investments — including hundreds of millions of dollars of unregistered, illiquid securities that plummeted in value,” the 43-page complaint said.
“For example, as of July 31, 2007, almost 70% of the securities held in (the Short-Term Extendable Portfolio) were not due to mature for over a year-and-half, and over 20% of the securities in STEP were not due for at least 10 years,” the suit alleges.
“The STEP portfolio included hundreds of millions of dollars in exotic, unregistered securities issued by ‘structured investment vehicles' or “SIVs”— entities that were recently identified in hearings before the congressional Financial Crisis Inquiry Commission as one of the ‘causes of the financial crisis' that ‘served no good or productive purpose in the financial system'—and millions more in securities backed by risky residential mortgages and other consumer loans.”
As of July 31, 2007, “over 15% of the securities in STEP were invested in unregistered securities — securities which, by definition, can only be sold under certain narrow circumstances and for which there is no ready market,” the suit said. Those unregistered securities include two structured investment vehicles, “Sigma Finance and (its corporate sibling) Theta Finance Corp. — which were created and managed by the United Kingdom-based investment management company, Gordian Knot …. The notes issued by SIVs are exotic, high-risk investments that were outside the enumerated classes of securities that were permitted to be held in STEP,” the suit said. “Moreover, because SIVs in general, and Sigma and Theta in particular, lacked an established track record, they were inappropriate investments for a conservative fund such as STEP.”
The suit cites warnings of Northern Trust's chief economist, Paul Kasriel, including one in 2006 “that the U.S. housing market was in a ‘recession' and that the housing market would ‘pull the economy down' in 2007.”
“Despite that knowledge, Northern Trust ignored the warnings of its own chief economist and kept the collateral pools … invested in securities with significant exposure to mortgage-backed securities, SIVs and financial institutions that (Mr.) Kasriel warned were overly exposed to mortgage-backed investments,” the lawsuit said. “Because many of those securities would not mature for years, the risk that the collateral pools would incur a material loss from the collapse of the housing bubble that (Mr.) Kasriel identified was highly likely.”
The Chicago and Atlanta funds participate directly in the securities-lending program and cash collateral pools. The Chicago fund also participates indirectly through its investment in a Standard & Poor's 400 midcap index fund, managed by Northern. The amounts the Chicago and Atlanta funds lent in the program, invested in the pool and invested in the S&P 400 fund were unavailable.
Avi Josefson, Chicago-based senior counsel for, Bernstein Litowitz Berger & Grossmann LLP, which is representing the funds in the suit, said Northern imposed withdrawal limitations in September 2008. The pool has had further losses since then, he alleged. The funds remain clients of Northern because the limitations effectively keep the funds from withdrawing, he said.
The suit seeks unspecified award of damages and lifting of withdrawal limitations. In addition, it seeks an order that plaintiffs in the class are not liable for realized and unrealized losses incurred in the collateral pools “as a result the defendants' breaches of their fiduciary and/or contractual duties.”
“While the loss sustained by Northern Trust is small compared to the $9.2 billion value of our portfolio, CTPF trustees, with the assistance of legal counsel, determined that litigation was in the best interest of our pensioners and members,” according to a statement by the Chicago fund.
Kevin R. Huber, executive director of the Chicago fund, referred a call to Mr. Josefson.
Atlanta fund representatives couldn't be reached.
Northern Trust executives, in a statement responding to the lawsuit, said: “We believe the litigation is seeking to assign blame for extraordinary, global economic events of 2007 to early 2009.”
The teachers fund “made the decision to enter a securities-lending program, and has participated in securities lending for nearly two decades,” according to the Northern Trust statement. “In 1995, the fund selected a custom investment option which gave it complete discretion over investment guidelines and level of potential risk and reward. Northern Trust complied with the fund's investment guidelines in reinvesting cash collateral for its securities-lending program.
“For many years, the reinvestment option was a multimillion-dollar revenue generator for the fund. In fact, in 2009 the fund earned $59 million on its collateral reinvestments related to securities lending. … Northern Trust has a long-term relationship with Chicago Teachers and we feel this lawsuit is misguided. Northern Trust will vigorously defend itself against this litigation.”