Larger funds often engage in foreign exchange transactions through their custodial banks. The custodial banks recognize that it is their job to help fund managers meet their fiduciary obligations to the funds clients. As one explained, “Understanding the fiduciary role of the fund manager, it is our goal to provide best execution for all foreign exchange executed in support of our clients’ transactions.” As seen in recent court filings, some custodial banks are now accused of actually providing the worst rate of the day to their clients.

In 2009, the State of California sued State Street for $200 million for allegedly overcharging the California Public Employees’ Retirement System (CALPERS) for foreign exchange (FX) trades and costs. Last year Washington state did the same. In February, Virginia sued Bank of New York Mellon (BoNY) for the Virginia Retirement System.

Just last month, the Manhattan U.S. Attorney and the New York Attorney General filed suits against BoNY. The bank allegedly promised clients the best possible FX rates but used the worst rates available, making heavy profits on the price differential.

The suit by the U.S. Attorney quotes some eye-popping emails generated by BoNY. One executive confided internally to a colleague: “We charge a premium for our services (i.e., we have the audacity to think we are entitled to a spread on every trade. How1990’s is that?)” That same executive also was caught in an email arguing to protect his bonus: “We have to protect this revenue source at the outset because if this flat fee methodology permeates the customer base, then the aggregate revenue over time could be substantial. This is currently our revenue and it should remain so; we all understand how the bonus pool funds.”

We understand that many public fund trustees are aware that their custodian banks might be presenting them with less-than-favorable FX rates, but the problem is not high on their priority list. Relying on investment managers to work with custodian banks on their FX transactions is not enough. Managers have a number of responsibilities, and FX is typically not their specialty.

Trustees need to take precautions in their FX trades, making sure that they trade within the day’s trading range. Then they need to ensure they’re not consistently trading at the day’s worst prices. If timestamp data is available, then they will know if they are trading at a rate that was fair, based on the rate available and the size of the transaction. Otherwise, the banks are left to determine pricing.

Trustees should not let the bank have free reign over what rate they will convert for the fund. Unless discussed, banks are going to choose a rate that is more favorable for them than for the client. At Hagens Berman, we are working with trustees to determine whether they too have claims they should pursue.