UK: Financial Conduct Authority’s Final Notice To State Street UK

FCA final notice – Reference no. 187358 & 194525

Transition Management business in the FCA spotlight over undisclosed mark-ups

The recent FCA fines imposed on State Street could have implications across the industry. Pension funds and other institutional investors may want to take advice as to whether their own transition manager failed to disclose mark-ups.

During the period 1 January 2010 to 30 September 2011, State Street Bank Europe Limited and State Street Global Markets International Limited (collectively "State Street UK") adopted a deliberate and targeted strategy to charge substantial, undisclosed mark-ups on certain transitions, over and above the agreed management fee or commission previously agreed with its clients. A total of USD 20,169,603 was overcharged across six of State Street UK's transition management ("TM") clients during this period, which accounted for 25 per cent of the total revenue for its UK transition management business over the same period.

On 30 January 2014, the FCA issued its Final Notice and found that State Street UK's TM business had systemic weaknesses in its business practices and control environment which facilitated multiple breaches of FCA's Principles of Business. A discounted fine of GBP 22,885,000 was imposed pursuant to State Street UK's agreement to settle at an early stage of the investigation.

Factual background

State Street is a global financial services organisation which provides investment servicing, investment management, and research and trading services to institutional investors. As part of its business, State Street UK offers TM services which involve providing support to clients for structural changes to asset portfolios with the intention of managing risk and increasing portfolio returns. During the period between January 2010 to September 2011, State Street UK's TM clients were predominately large investment management firms or pension funds.

In State Street UK's proposals to its TM clients, it represented that it would manage and minimise the 'implementation shortfall' of a transition, which consist of explicit costs (e.g. commissions, mark-ups, fixed or percentage based project management fees charged by the transition manager and taxes) and implicit costs (e.g. trading costs such as the bid-ask spread, market impact and opportunity costs) associated with moving from one portfolio allocation to another. Furthermore, State Street UK's TM business explicitly held itself out to clients as adhering to the principles of the T-Charter, an industry bestpractice code for transition managers that included principles on disclosure and remuneration, of which State Street UK was a founding signatory.

As part of State Street UK's typical charging model, it formed agreements with clients to charge a commission when trading in equities and take a disclosed spread or mark-up on any fixed income transitions, or impose a fixed management fee instead of a commission or spread. These revenues and charges would be reflected in the key contractual documents such as the TM Agreement and the Periodic/Transition Notice, as well as the pre- and posttrade analysis reports provided to clients.

In 2010, there was a notable shortage of major TM deals and as a result, senior line managers in State Street UK's TM business considered a departure from the typical charging model by imposing mark-ups to trade prices that were not agreed with or disclosed to the clients concerned. This served to increase revenues for the TM business earned from trades conducted on behalf of the clients. Despite some internal concerns with this approach at the working level, the senior line managers of the TM business effectively legitimised the approach by claiming that it was: also used by its competitors; permitted under the terms of the standard agreements with TM clients; and approved by Legal. Based on the assurances of these senior line managers, no independent concerns were raised with the Legal and Compliance teams or disclosed externally. The approach was adopted for six transitions in 2010 and 2011 involving clients such as Ireland's National Treasury Management Agency, the Kuwait Investment Authority and the Royal Mail and Sainsbury pension funds.

In 2011, the Royal Mail Pension Fund ("RMPF") discovered undisclosed mark ups after engaging a financial consultant to compare the trade prices from State Street (found in transaction reports) with publicly available trade prices.

On 21 June 2011, RMPF challenged State Street UK about the existence of the undisclosed mark-ups on certain US fixed income trades conducted on the basis of calculations using publicly available bond pricing information in the US. At the time, the senior line managers of the TM business represented to RMPF that these were "inadvertent commissions" erroneously applied by the trading desks and reflected a one-off error, without disclosing that similar mark-ups had been applied to other trades for RMPF's transition. A USD 1 million rebate for the mark-ups was also arranged for RMPF outside of the proper channels to bypass oversight from Compliance. The matter was later escalated when RMPF appointed a third-party analyst to perform a full post-transition review of State Street UK's cost, the enquiries of which triggered an internal investigation and subsequent notification to the FCA. The investigations revealed that State Street UK's TM business had levied a total of USD 20,169,603 from six clients through undisclosed commissions and hidden mark-ups and had deliberately provided false information to those clients despite holding itself out as complying with the T-Charter.

State Street UK subsequently implemented a comprehensive remediation programme, at its own initiative, to resolve the overcharging issues, as well as established a central function to review and make improvements to the controls and culture across all of its UK businesses. It further contacted the affected clients and offered or provided rebates of the full amount they were overcharged.

Determination

The FCA found severe problems with State Street UK's systems and controls, particularly in respect of failings to adhere to established internal policies and contractual obligations of disclosure to the clients; maintain good record keeping and ensure segregation of duties. The functions of Compliance, Legal, Audit and Risk Management were also found to be not properly resourced which compounded the operational control weaknesses at the time of incidents.

On this basis, the FCA ruled that State Street UK had breached Principle 6 (A firm must pay due regard to the interests of its customers and treat them fairly), Principle 7 (A firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading), and Principle 3 (A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems), and found for a financial penalty of GBP 32,692,888, discounted to GBP 22,885,000 in view of State Street UK's actions to remedy the situation.

Comment

The FCA regarded the breaches in this case to be particularly flagrant and serious as it reflected a culture of prioritising revenue generation over the interests of customers in circumstances where State Street UK was acting as an agent or fiduciary, and in breach of its position of trust. The total sum overcharged from clients was in excess of USD 20 million, which accounted for over 25% of the total revenue earned by State Street UK's TM business during the relevant period, despite the overcharging having only occurred on 3.5% of the transitions over that same period. It also served to highlight the systemic weaknesses in State Street UK's internal systems and controls around its TM business as it ultimately required the independent research of a client in order to expose the overcharging practice.

This FCA decision will likely propel TM clients to impose greater scrutiny over the charging practices of transition managers in future and to increase the expectations for a greater level of transparency in the way fees and costs are calculated, agreed and applied. Financial institutions are advised to review their internal policies and functions to ensure that they align with industry best practice, and there is strict compliance with and enforcement of established protocols across the organisation, in order to minimise the chance of incurring a regulatory breach.

Whilst this decision has been made against State Street UK, it is entirely possible that this practice was widespread throughout the industry. Clients should therefore review their TM relationships and consider whether mark-ups may have taken place on their accounts. Whilst the FCA can impose fines, a successful private legal action will most likely result in damages being awarded to the injured party.

The full text of the FCA Final Notice can be found here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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