State Street Bank and New York Mellon Bank have recently been sued for overcharging several public sector pension funds for foreign currency exchanges.
The scheme alleged in the suits goes like this: the pension fund contracts with the bank as the custodian of its assets; the pension fund also contracts with an investment manager to invest pension fund assets in foreign securities; the investment manager needs to convert dollars to foreign currency, or vice versa, each time it trades in foreign securities for the pension fund; under "standing instructions" between the bank and the investment manager, the bank agrees to execute the foreign currency exchanges to facilitate the investment manager's foreign securities trades; the bank has a twenty-four hour window to execute each foreign currency exchanges, during which time the exchange rates between the dollar and the other relevant currency fluctuate; the bank executes the foreign currency exchanges from the pension fund's account at the exchange rate as of a specific time of day, but the bank charges the pension fund account at the most expensive exchange rate of the entire day, and the bank essentially pockets the difference; the bank misleads the pension fund and/or the investment manager regarding the bank's foreign currency exchange practices on the bank's pension fund account.
The recent lawsuits allege violations of state law to recover losses suffered by public sector pension funds. A federal law, commonly referred to as ERISA, however, governs most investment-related activity for private sector pension funds. If State Street and Mellon have been applying the same scheme as described above to their private sector pension fund accounts, some very complex ERISA issues would be implicated.
As to the bank, the scheme implicates two fundamental prohibitions under ERISA: fiduciary self-dealing, and fiduciary dishonesty. By exercising discretion over the foreign exchange rates to apply and assess against a pension fund account, the bank would be a "functional fiduciary" of the pension fund under ERISA. By utilizing such discretion to feather its own bed, the bank would be engaged in "fiduciary self-dealing" with pension fund assets. By misleading the pension fund or the investment manager about its foreign currency exchange practices, the bank would be engaged in fiduciary dishonesty.
As to the investment manager, the scheme implicates another fundamental prohibition under ERISA: fiduciary imprudence. As the party utilizing the bank to exchange currencies to facilitate its foreign securities trades, the investment manager has a duty to the pension fund to ensure that the pension fund isn't getting fleeced on the foreign currency exchanges.
Department of Labor regulations known as "Prohibited Transaction Exemptions" (PTEs) as well as a bank-lobbied 2006 amendment to ERISA have created a safe harbor for banks regarding foreign currency exchanges on behalf of ERISA-governed pension funds. Absent the safe harbor, the general ERISA prohibitions against the bank's fiduciary self-dealing would apply. Whether the actions of State Street and Mellon fall within the safe harbor depends on several complicated factors, and remains to be seen. The safe harbor, nonetheless, does not appear to insulate a bank from affirmatively misleading either a pension fund or an investment manager regarding the bank's foreign currency exchange practices. Also, it does not appear that the safe harbor insulates the investment manager from imprudently failing to oversee the bank's foreign currency exchange practices to the detriment of a pension Fund.
Stay tuned. It will require ERISA and Employee Benefits attorneys who are very experienced in the complex field of investment-related ERISA fiduciary duties to discern whether the foreign currency exchanges that are ancillary to international securities trades on behalf of a private sector pension fund have been executed and/or monitored in compliance with ERISA.
