Money managers cut their securities lending profits

Northern Trust Asset Management, BlackRock Inc. and State Street Global Advisors are giving clients a bigger chunk of the profits from securities that are being lent by their investment vehicles such as collective trusts, mutual funds and ETFs.

The Securities and Exchange Commission began an industrywide sweep in the fall of 2013, examining affiliate relationships in securities lending, said Christopher Kemp, senior principal consultant at ACA Compliance Group Holdings LLC in Boston. The SEC has been looking at the issue since at least 2004, sources said.

All three firms hire another unit of their company to conduct securities lending. Using affiliated entities also had been the subject of lawsuits by institutional investors, who maintained the amount of securities lending profits kept by the affiliates was too high.

The latest manager to implement changes is Northern Trust. It changed the share of profits retained by its agent, Northern Trust Bank, to 30% from 40% for securities lending in most of the funds in the Northern Trust Global Investments Collective Fund Trust, according to information provided by Northern Trust, Chicago.

“The fee changes were the result of an annual review of securities lending practices, market dynamics, risk management and other factors,“ spokesman John O'Connell said in a statement.

BlackRock spokeswoman Tara McDonnell said in a statement the firm implemented its changes to more closely reflect each fund's objectives and lending capacity. BlackRock, New York, twice cut its share of the lending revenue it splits with investors in its iShares exchange-traded funds and in mutual funds. In the first quarter of 2014, company officials dropped a “one-size-fits-all” policy — under which it kept a uniform 35% of the profits — and began keeping between 15% and 30%, depending on the fund.

In January of this year, BlackRock lowered its take to 28.5% on some of its investment vehicles, said Ms. McDonnell.

The Laborers Local 265 Pension Fund, Cincinnati, and the Plumbers and Pipefitters Local No. 572 Pension Fund, Nashville, sued BlackRock in U.S. District Court in Nashville in January 2013, alleging it charged excessive fees by taking 35% of the profits from securities lending in its iShares ETFs and an additional 5% of the revenue to cover administrative fees.

The case was dismissed that August on procedural grounds; last week, the U.S. Supreme Court declined to hear an appeal.

SSgA, another major player in what is called third-party securities lending, began some fee reductions in 2010, cutting State Street's share to 30% from 50%. SSgA fund documents for 2014 show SSGA fund investors now get 85% of the profit from securities lending.

State Street spokeswoman Anne McNally did not reply to multiple requests for information on when the reductions took place and what prompted them.

State Street was the defendant in a class-action suit filed in April 2010 by one small Massachusetts 401(k) plan on behalf of hundreds of other retirement plans covered by the Employee Retirement Income Security Act. The suit alleged State Street took an “unreasonably large” — 50% — share of the net income generated from lending securities owned by a collective trust that the firm ran for the institutional investors. State Street's action amounted to “fiduciary self-dealing and enrichment in violation of the defendants' fiduciary obligations,” the suit said.

State Street settled the lawsuit last year, paying plaintiffs $10 million and agreeing to inform fund investors about details of the revenue split and other securities lending information.

Last month, Northern Trust agreed to pay $36 million to settle a securities lending suit filed by 1,500 corporate pension plans. The suit said, among other things, that keeping 40% of the profits was unreasonable and the company violated ERISA's prohibitions against self-dealing and from engaging in transactions with parties in interest.

Northern Trust still faces another suit by the approximately $14 billion Los Angeles City Employees' Retirement System over the revenue split and losses incurred during the financial crisis.

Northern Trust had disclosed to shareholders in April 2014 that it had received a subpoena from the SEC over its securities lending practices.

Other publicly held third-party securities lenders — including BNY Mellon Corp. unit The Drefyus Family of Funds, which hired its parents as its securities lending agent, and BMO Asset Management, which hired an affiliate for securities lending — do not break out their revenue split for investors.

Mike Dunn, a spokesman for BNY Mellon, in a statement cited other information Dreyfus provides for investors, including the extent to which funds can lend portfolio securities, information on cash collateral and the risks of securities lending. The statement did not explain why the revenue split was not included in the publicly disclosed information. Northern Trust, BlackRock and SSgA also are disclosing some of the same information.

BMO financial group spokesman Nini Krishnappa said for “competitive reasons we're not able to disclose our fee split.”

It's no secret that U.S. asset managers provide barely a sliver of transparency into their securities lending program, said Josh Galper, managing partner of Finadium LLC, Boston, a securities lending consultant.

Mr. Galper said the terms of the profit split and the securities that have been loaned often are not disclosed.

Mr. Kemp said the SEC's exam caused in-house boards that oversee mutual funds and ETFs to question portfolio managers and management as to whether investors are getting as good of a fee split as an outside securities lending provider would offer.

“They don't want to be caught with their pants down,” he said of the boards.

A paper written in 2013 by John Adams, a finance professor at the University of Texas, Arlington, concluded the level of “self-dealing is potentially greater” when money managers use affiliates to conduct securities lending because the split of profits can be set up to put the interests of the corporate parent over those of investors.

Mr. Adams found the returns to investors from securities lending are 40% lower when a specific fund uses an affiliated agent that is part of the same company.

One money manager with a third-party securities lending program, Vanguard Group Inc., Malvern, Pa., doesn't make a profit on securities lending. The company does charge investors for securities lending costs, such as agent fees, broker rebates, and program costs, said Jim Rowley, a senior analyst in Vanguard's investment strategy group. He said those expenses average around 5%.

“We believe since clients bear the risk from lending securities, they should receive the reward, “ Mr. Rowley said.