Harry Markopolos Scores Again: State Street Settles for $382 Million on Foreign Exchange Fraud

Harry Markopolos, famed for having warned the SEC of signs of fraud by Ponzi schemer Bernie Madoff, has now become a serial crimebuster. Markopolos, as part of a “whistleblower legal group,” presented evidence of foreign exchange trading abuses of mutual and pension funds by the custodians Bank of New York Mellon and State Street. The chicanery was that the foreign exchange trading was a secondary, or “indirect” service. The funds would buy or sell foreign stock and the two banks, would have to execute foreign exchange transactions as part of the service. As the Wall Street Journal wrote in 2011, both the SEC and some state prosecutors took up the Markopolos group’s findings:

The Securities and Exchange Commission is investigating State Street Corp.’s foreign-exchange trading on behalf of pension funds in a sign that law-enforcement probes into how custody banks process tens of thousands of foreign-exchange trades are widening…

The SEC joins a growing list of law-enforcement agencies now investigating how State Street and New York rival Bank of New York Mellon Corp. process currency transactions for state and local pension funds. The inquiries are examining whether the two banks properly charged state and local pension funds to exchange currency to complete global securities transactions.

The inquiries were sparked by a whistleblower legal group that has sued the banks in California, Virginia and Florida. The legal group sued State Street in California and BNY Mellon in Virginia and Florida.

The Bloomberg reported on the SEC investigation of State Street pointed out that the State of California, on behalf of CalPERS and CalSTRS, and the Arkansas state pension fund were suing State Street.

A Wall Street Journal story a few months before described the Bank of New York Mellon allegations in detail:

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.

Bank of New York Mellon settled with the SEC, the Department of Justice, and the New York Attorney General for a total of $163 million. State Street settled yesterday with the SEC and the Department of Justice for $382 million. The SEC describes the misconduct:

The Securities and Exchange Commission today announced that State Street Bank and Trust Company has agreed to pay $382.4 million in a global settlement for misleading mutual funds and other custody clients by applying hidden markups to foreign currency exchange trades.

As part of its custody bank line of business, State Street safeguards clients’ financial assets and offers such services as indirect foreign currency exchange trading (Indirect FX) for clients to buy and sell foreign currencies as needed to settle their transactions involving foreign securities. An SEC investigation found that State Street realized substantial revenues by misleading custody clients about Indirect FX, telling some clients that it guaranteed the most competitive rates available on their foreign currency exchange trades, provided “best execution,” or charged “market rates” on the transactions. State Street instead set prices largely driven by predetermined, uniform markups and made no effort to obtain the best possible prices for these clients.

State Street has agreed to pay $167.4 million in disgorgement and penalties to the SEC, a $155 million penalty to the Department of Justice, and at least $60 million to ERISA plan clients in an agreement with the Department of Labor.

The SEC has not published the order because the settlement needs to be approved by a judge. However, State Street has agreed to make some admissions of misconduct.

This is another example of how easy it is for financial intermediaries to fleece customers. I’m told by a source with knowledge of State Street’s position that the bank claimed that customers knew that the bank was charging a markup. It’s remarkable that State Street tried brazening it out that way. Having done studies for the Treasury departments of some major banks, it is true that banks mark up foreign exchange transactions to customers who don’t deal directly with the interbank traders. But in my day it was most, and even now I’d hazard many, didn’t know they were paying what amounted to a sales commission. And I saw some salesmen who had come up with ways to scam customers on the pricing when they executed their trades too. But the foreign exchange market is unregulated, so caveat emptor.

By contrast, Bank of New York Mellon and State Street were clearly violating US regulations asset management customers if they weren’t disclosing the foreign exchange markups and were lying about best execution. Both custodians have a fiduciary duty to these clients. I’ll be interested to see the eventual order as to how the SEC framed the securities law violations and what more it has to say about the conduct and the basis for the fines.

Finally, although I have not seen confirmation in the press, I would assume that the Markopolos group approached the SEC under its Dodd-Frank-created whistleblower program. If so, this would be one of the largest whistleblower settlements to date. And while we’ve criticized Dodd Frank for failing to address the causes of the crisis, results like this demonstrate it is helping to stop some types of misconduct.