Securities lending is an investment strategy in which usually pension funds and mutual funds make short-term loans of their stocks, often to short sellers, in return for the right to control cash collateral provided for the loan. The fund seeks to earn a profit by investing the cash collateral in a short-term bond fund. A profit is earned if the rate of return on the short-term bond fund exceeds the “rebate” rate paid to the stock borrower in return for the right to control the cash collateral.
According to the BP Plan Committee’s complaint (the “Complaint”), the Investment Guidelines reflected in the Plans’ Investment Agreements with Northern Trust permitted Northern Trust to lend securities from the Plans’ accounts for the purpose of “earn[ing] a return through investment of the cash collateral received from borrowers of securities, which would allow: (a) [Northern Trust] to offset its expenses under the Investment Agreements; and (b) the [Plans’ accounts] to better match the performance of their respective benchmark indices.” Northern Trust proceeded to conduct the contemplated securities lending program.
Subsequently, certain of the short-term bond investments made with the cash collateral allegedly defaulted and were marked down in value. As a result, Northern Trust allegedly booked losses to certain Plan accounts, allocated the defaulted securities to a liquidating trust, assigned interest in the trust to the relevant Plan accounts and issued an account payable from the Plan accounts to the cash collateral investment accounts reflecting the marked down value of the assets in the cash collateral investment accounts.
According to the Complaint, these losses were caused because Northern Trust operated the securities lending program in an “imprudent manner without notice to the Plan Committees” by lending a high percentage of the Plan account assets in return for cash collateral that was then invested in instruments with higher aggregate risks than the loaned Plan assets. That is, Northern Rock allegedly conducted the securities lending program in a negligent manner because its program purportedly increased the overall risk being taken in the Plans’ accounts.
The Plan Committees have allegedly requested withdrawal in cash of all of their investments at Northern Trust. Northern Trust has allegedly refused to do so, noting that any such distribution would include interests in the impaired securities contained in the cash collateral investment accounts.
In the Complaint, the Plan Committees assert causes of action against Northern Trust for breach of fiduciary duty under ERISA and breach of the Investment Agreements. As remedies, the Plan Committees seek a declaration that Northern trust breached the Investment Agreements and its fiduciary duties under ERISA, injunctive relief, unspecified disgorgement/restitution, reasonable attorneys’ fees and costs, pre-judgment and post-judgment interest and damages equal to the Plans’ losses “resulting from imprudent investments,” all profits made by Northern Trust through the use of the Plans’ assets and “all profits which the Plan participants would have made if Defendants had performed their obligations under the Investment Agreements.”
For a full copy of the Complaint, please click here.
For many years, securities lending programs were a steady source of additional income for mutual funds and pension funds. This income was split with the fund’s investment adviser, who was responsible for not only arranging the stock loans to short sellers, but also for investing the cash collateral for the loan. Everyone was happy. Unfortunately, as a result of the fixed income liquidity crisis, the advisers frequently are unable to refund the cash collateral to the short seller in full when the stock loan ends. The funds are then unhappily required to make up the difference in principal.
We will continue to monitor developments related to the market downturn and the credit crisis and provide updates at InsureReinsure.com.
