Corp. currency traders used a foreign-exchange system called "Charlie" to create fake trades and overcharge Virginia pension funds by at least $20 million, according to allegations in recently unsealed documents in a Virginia court.
The allegations, made by a whistleblower group, are part of a widening probe by state prosecutors into whether custody banks such as Bank of New York Mellon and Corp. shortchanged public pension funds in executing currency trades used to complete financial transactions abroad.Bank of New York Mellon and State Street deny wrongdoing and said they will vigorously fight legal actions against them. In a statement Thursday, Bank of New York Mellon said: "Money managers transact with us at competitive FX prices and we provide reliable, low-risk service and execution."
Separately, Florida Attorney General Pam Bondi on Thursday intervened in a 2009 whistleblower lawsuit in a claim that alleges Bank of New York Mellon overcharged Florida pension funds for foreign-exchange transactions.
California has intervened in a whistleblower claim against State Street; Virginia has intervened in the whistleblower claim against Bank of New York Mellon.
Shares of Bank of New York Mellon and State Street fell 1.2% and 1.5%, respectively, Thursday in 4 p.m. composite trading on the New York Stock Exchange, following a Wall Street Journal report about the probe.
"Custodian banks make a fair amount of money off of [foreign-exchange] transactions as part of their custody operations," said Giri Cherukuri, head trader at OakBrook Investments in Lisle, Ill. She added that "they may have to change their business practices."
Currency trading is a high profit area for some big banks. According to the Office of the Comptroller of the Currency, U.S. banks generated $5.6 billion in foreign-exchange trading revenue in 2009 and $7.2 billion in the first three quarters of last year, making currency trading one of the largest sources of banks' trading profits.
Bank of New York Mellon generated 2009 revenue of $4.26 billion for its asset-servicing unit, including $757 million from foreign-exchange and other trading activities, the latest full-year figures available. The $4.26 billion figure was more than half of the bank's total 2009 revenue, though the 2009 total included an unusual one-time item. Asset servicing typically accounts for about a third of the bank's revenue.
For some banks, foreign-exchange trading revenue is on the rise. Bank of New York's revenue from foreign-exchange trading for clients jumped about 60% in the fourth quarter of 2010 compared with the third quarter of last year, and they rose 19% from 2009's fourth quarter, according to brokerage firm Guggenheim Securities.
The states are investigating claims that the banks didn't charge the pension funds the currency rates that the banks paid but consistently charged them the highest currency-conversion prices of the day, and pocketed the difference. The suits say the banks similarly overcharged when the pension funds exited the trades.
U.S. investors trading in global stock markets must convert dollars into the currencies of the foreign countries in which they invest. Custody banks facilitate the foreign exchange.
Ms. Bondi's motion to intervene was filed in a Leon County circuit court in a move that enables her to control the case. Ms. Bondi, a trustee of Florida's State Board of Administration, a $154.8 billion pension and fund program for Floridian teachers and employees, will file a formal complaint "in the near future," Thursday's filing said.
The 2009 Florida lawsuit was filed by a Delaware shell company called FX Analytics, which also filed the Virginia case against Bank of New York Mellon. Two lawyers, Michael Lesser at Boston firm Thornton & Naumes LLP and Philip Michael in New York, are handling the claims in California, which is suing State Street, and Virginia, which is suing Bank of New York Mellon. Bank of New York Mellon is one of the nation's largest custody banks. The Virginia suit said the bank touts its "24-hour trading capability" and refers to itself as "foreign-exchange specialists."
The court documents filed by FX Analytics allege that currency traders at Bank of New York Mellon at times waited for hours before cherry-picking prices beneficial to them that they would charge the Virginia state pension fund.
Custody clients typically deal in currencies through two ways, known as "direct" or "indirect" trading. In direct trading, clients trade for themselves by negotiating pricing and ensuring a good foreign exchange.
Public pension funds, often ones that don't want to hire people to negotiate, can opt for indirect execution, also known as "standing instruction" or "non-negotiated," according to the Virginia complaint.
At Bank of New York Mellon, the bank would place currency trades for pension funds seeking to make global securities transactions through an electronic pipeline called "Cash Management System," or CMS. CMS then would route the currency request through a bank foreign-exchange system called Charlie.
Instead of pricing the currency trade for the pension fund at the time it was made, the complaint alleges, the bank identified higher prices if the pension fund was buying currencies, and pocketed the difference.
When the pension fund received a monthly custody report, the suit alleges, it was given only the fake, or "falsified" rate. The reports don't contain time stamps.
In one trade cited in the Virginia lawsuit, the whistleblower alleges that in October 2009, Bank of New York Mellon profited after carrying out a foreign exchange of Canadian dollars for a client at the worst U.S. dollar-Canadian dollar rate of the day.
According to the complaint, the fund, which the lawsuit didn't identify, needed to convert $12.5 million into Canadian dollars. Bank of New York sold $12.5 million of the client's money and bought Canadian dollars in the interbank market when the U.S. dollar bought 1.0795 Canadian dollars. Bank of New York Mellon took possession of C$13.5 million.
The fund, however, received C$13.35 million, based on the lowest rate of the day when one U.S. dollar was at C$1.0682. That allegedly enabled Bank of New York to pocket about C$141,250.
If the pension fund had opted to trade the currency itself, rather than allow the bank to do it, the bank's profit would have been about C$6,250, according to the suit.
In a separate Reuters article, Martha Graybow and Tom Hals report, U.S. states ramp up foreign currency trade probes:
U.S. states are stepping up probes into whether banks overcharged public pension funds millions of dollars in converting currencies for securities trades, a lucrative area of banking.
Officials in Florida, Virginia and California are examining foreign-exchange fees paid by state retirement systems and they are getting help from would-be whistle-blowers who have filed private lawsuits against Bank of New York Mellon Corp and State Street Corp.
Florida Attorney General Pam Bondi filed on Thursday a state court notice of intervention in a case involving Bank of New York Mellon, according to a court filing.
"The AG's office is investigating this practice," spokeswoman Jennifer Krell Davis said in an email.
Foreign exchange traditionally has been a rich source of revenue for U.S. banks, particularly custodial banks, which not only profit from buying international stocks and bonds for pension funds and other investors, but also on trading dollars into other currencies. Foreign exchange overall is a huge business, with average daily volume of $4 trillion.
States are examining whether banks charged their pension plans false exchange rates for foreign currency trades rather than the actual rates. Washington state announced in October it had recovered $11.7 million from State Street after a dispute over foreign exchange trade costs from 1997 to 2007.
The Florida lawsuit and others are tied to financial investigator Harry Markopolos, best known for trying to warn regulators that Bernard Madoff was running a fraud, said Patrick Burns, spokesman for Taxpayers Against Fraud, a Washington group that has worked with Markopolos.
News of the widening scrutiny helped push down shares of both Bank of New York Mellon and rival State Street. The two large custody banks reject accusations of wrongdoing.
There may be similar cases that have not yet been made public, said a source familiar with the matter who requested anonymity because litigation is pending. There is interest in bringing other cases, although pension funds are cautious about upsetting relations with banks, this person said.
The same whistle-blower that sued State Street in a California lawsuit, FX Insider Trading, also sued the company in a New York state court, according to legal database Westlaw, part of Thomson Reuters. The New York case was filed in April 2008, about a week after FX launched the California case.
While the state of California decided to join the State Street case, the New York attorney general's office does not appear to have done the same. An order to extend time to intervene was entered in the New York case last fall, Westlaw shows, and the matter is still under seal.
A spokesman for the New York Attorney General declined to comment.
Investors have long complained about dealers hoarding pricing information in foreign exchange and other over-the-counter markets. Part of last year's Dodd-Frank financial reform law is geared at improving transparency in over-the-counter derivatives.
"In the end in this business, given the opportunity, those that hold certain information will take advantage as much as they can within the legal limits," said Sang Lee, who specializes in foreign exchange market research at advisory firm Aite Group in Boston.
"Overall, I think the potential is there for this investigation to become really widespread."
Getting government officials to step in to lead lawsuits initiated by would-be whistle-blowers is key to such cases moving forward. Whistle-blowers can share in any potential settlement or other payments that companies may make.
The Florida lawsuit and a similar case in Virginia were brought by an entity called FX Analytics, which has ties to Markopolos, the Boston-based investigator whose warnings to regulators on Madoff went unheeded for years.
The Virginia case, which recently was unsealed, seeks $150 million in damages from Bank of New York Mellon. Virginia Attorney General Kenneth Cuccinelli has intervened in the case, his spokesman said on Thursday.
Bank of New York Mellon said the allegations against it were without merit. It said money managers at pension funds and other institutional clients "transact with us at competitive foreign exchange prices and we provide reliable, low-risk service and execution."
California announced a case against State Street in 2009 that sought $200 million for committing an "unconscionable fraud" against the state's biggest pension funds, including the California Public Employees' Retirement Systems, or Calpers.
State Street spokeswoman Carolyn Cichon said the bank's "FX services are consistent with our contractual obligations with the California state entities and we are defending ourselves against the charges made in the complaint."
One plaintiffs' attorney, Reed Kathrein of law firm Hagens Berman LLP, said he examined State Street contracts with a couple of pension fund clients, but those contracts did not contain the same language as the CalPERS deal with State Street, which specified the trades be priced at the time of the trade.
"We were not able to find anything that led us to the same place," he said.
Bank of New York Mellon shares fell 1.2 percent to $31.46 on Thursday, while State Street declined 1.5 percent at $46.54, both on the New York Stock Exchange.
Finally, this little tidbit from Advisor One:
In a Huffington Post report, Markopolos was quoted as saying FX fraud would be the next big scandal, adding that the way the fraud works is for banks handling foreign currency transactions for public employee pension funds indicate that buys are made at the previous day’s highs and sells at the lows: “So they're giving you a false train ticket and taking 1 to 1 1/2 percent a trade ... that's a direct loss to the states, and it’s also a direct loss to the private party pension funds and not only that but the international pension funds of other nations so this is global.”
Markopolos went on to say, “The banks that are doing it, it's 25-33% of their bottom line net income per year, so it's like being addicted to heroin, they can't afford to pull the needle out because their share prices will collapse. It's also a case of false financial statement reporting—when a quarter to a third of your net income is fraud-based, and you're not telling shareholders that, then you have a Sarbanes-Oxley issue.”
Currency trading is huge business for banks. HUGE! The amount of money they make trading currencies on behalf of clients is incredible. And it's a market that's not regulated so a lot of dubious things can take place, especially with unsuspecting clients who can be easily duped. I'm not going to comment on the allegations in these articles but if State Street or Bank of New York Mellon lose these cases, their reputation will take a hit. It's going to cost them a lot more than damages.
You may be shocked to discover that many pension funds do not pay attention to currencies. And yet on any given year, large currency swings can have a material impact on performance. Here is where I'm going to plug my former boss at PSP Investments, Pierre Malo. Before joining PSP, Pierre was head of currencies at the Caisse de dépôt et placement du Québec. He retired from PSP and is now consulting. You can visit his site, Pierre Malo Consulting Inc., and feel free to contact him with any questions you have on F/X matters and pension funds. He is one of the nicest people I ever met in finance and he knows currencies and how to deal with banks to make sure they're not screwing you (he is also an expert on governance).
I have nothing against banks making money in F/X markets trading fairly, but if they're screwing clients to juice their profits, then they should be prosecuted. Period. The same goes for other activities in bond, equity and derivatives markets (banks are making a killing in CDS market). Pensions have a fiduciary duty to safeguard pension assets and make sure that banks are not shortchanging them in any way.