“If this doesn’t cause a real change, then nothing will.” So spoke Rick Di Mascio, founder and CEO of Inalytics, in a 2012 interview with CIO. The asset management industry had just awoken to State Street’s malpractice within the transition management business—crimes that eventually cost the firm a $30 million fine at the hands of the UK’s Financial Conduct Authority (FCA). At the time, two staffers, and alleged ringleaders of the fraud—Ross McLellan and Edward Pennings—had just been fired.
This, of course, was just the tip of the iceberg.
The following months saw the full scale of the scandal unveiled: At least six institutional clients were victims of undisclosed markups on trades performed by State Street’s transitions staff. Over at Convergex, a New York City-based broker-dealer firm, the regulators unearthed a similar fraud—the company was eventually fined $150 million by the US Securities and Exchange Commission (SEC). A third group, Global Transition Solutions (GTS), also allegedly dabbled in undisclosed markups—many of which were said to be in conjunction with Convergex staff—and is still facing SEC legal action.
Away from the courts and the regulators, at least five firms are known to have scaled back or closed their transition management operations: JP Morgan, Credit Suisse, BNY Mellon, Convergex, and Nomura. Last month Goldman Sachs closed its Australian transitions office, instead running all such business through London.
Years after the initial discovery, the transition scandal came full circle. In April this year, the US Attorney for Massachusetts and the Federal Bureau of Investigation arrested and charged McLellan and Pennings with fraud. The SEC soon joined the action. Khaled Bassily, the former chief of Convergex’s transitions business before leaving the firm in 2013, faced the same fate.
The cleanup, at least from the outside, is progressing. Now that the dust is finally settling, has the transition management industry admitted its faults, repented for its sins, and made amends to its victims?
Five years of scandals, fines, headlines, and lawsuits are enough to make anyone paranoid, making it difficult for clients to push aside that lingering doubt: Was that erroneous cost on my latest transition trade really an innocent mistake?
“Transitions are often very complicated with lots of moving parts, so there will be instances where errors will occur, even with everybody acting in good faith,” says Steve Glass, president and CEO at Zeno Consulting, a specialist transitions advisor. “When errors in transitions occur, pension funds now wonder, is that an honest mistake or is there something more to it?” He is quick to point out that his concern stems from a “natural skepticism” rather than evidence of any recent malpractice. But Glass’ sentiment is echoed by other consultants and asset owners, most of whom declined to comment on the record for this article—a fact that itself is evidence of extreme caution. It is clear, especially since the reemergence of the McLellan-Pennings and Convergex affairs in April 2016, that clients are once again extremely wary of being hoodwinked.
As a result, some practices have changed—but not as much as perhaps would be expected. CIO’s annual survey of transition management clients, conducted every year since 2012, shows investors are more likely now to employ a consultant to help oversee any transitions than they were five years ago. However, more than half of investors are still going it alone, with only 43% admitting to using consultants. Four in five of all respondents this year said they require a transition management agreement for every deal, but this proportion has remained roughly unchanged during the period covered by the survey.
What has changed is access to, and use of, data. Timestamping trades has become more commonplace in the past five years, according to consultants, and clients now have access to far more granular data regarding the trades made during each transition. The providers are more than willing to offer this data, too—for obvious reasons.
A combination of such data and vigilance may have saved at least one client from falling victim to GTS’ transition markups, according to the SEC’s July 2016 legal filing against the firm. GTS and three former staff members—CEO John Place, President John Kirk, and COO Paul Kirk—are accused of conspiring with brokers such as Convergex to take a share of the markups on transition trades while disguising the additional charges as market impact or timing costs through revenue-sharing agreements. On one occasion in April 2011, Place phoned a Convergex trader about a ripe opportunity for fraud, which was recorded and evidenced in the SEC’s lawsuit:
Art by Gérard DuBois
“I have a broker order [which] will be to you within an hour and I haven’t looked at it myself other than to instruct [another Convergex employee] and my people internally to widen some spreads so that we can—we can get aggressive with this particular situation… This particular situation is one that the expectations have been set and it’s an opportunity for you and I to get a little more aggressive but within reason.”
Another recorded phone call from May 2011 revealed Place and John Kirk “understood that the markups were not otherwise disclosed to the client and that GTS could not share in the markups if there was a chance that the client might learn of the practice,” according to the SEC. The client in this instance requested timestamped data, the filing revealed, and so GTS stuck to the agreed pricing model.
(A spokesperson for Convergex said it had “no comment” for this article, “having resolved its SEC case and exiting transition management for unrelated commercial reasons over two-and-a-half years ago.” Place and Paul Kirk had not responded to requests for comment at the time of publication; John Kirk could not be reached for comment.)
The provision of timestamped data and other forms of high-quality, high-detail information are now common practice in transition management. No one interviewed by CIO reported any reluctance on the part of providers to supply this data. Some even open their doors to let clients see firsthand how the transitions happen and who is responsible for them.
“I think both clients and consultants are becoming more diligent with asking secondary questions,” says Steve Kirschner, head of Russell Investment’s Americas transition management arm. “In the past there’s been a bit of a box-checking attitude toward due diligence. Now clients demand, ‘Prove this to me; let me see what you’re doing.’”
The balance of power among providers has undoubtedly shifted post-2011. While some big-name banks remain prominent in transition management—Citi, State Street—the past few years have seen the rise of transition specialists and asset managers as a force to be reckoned with. Names like Loop Capital, Pavilion, and BlackRock have all ranked consistently well in CIO’s transition management surveys over the years.
This change in the transition currents may be due to cost dynamics that are chasing out bank providers, argues Steve Webster, formerly head of portfolio solutions at State Street and now running his own consultancy firm. “A lot of people have suggested this means the sector is shrinking,” says Webster, who has also held senior transition management roles at Credit Suisse, Dutch bank ABN-AMRO, and JP Morgan. “I don’t think it’s shrinking—it’s just changing. Banks have cost-constraint issues and a huge amount of regulatory restrictions that have cornered them.”
Price competition has eroded much of the margin providers used to get from transitions, Webster continues. When pricing transitions, some providers had begun to quote prices lower than a penny per trade—fine when dealing highly liquid equities, but difficult transactions that need more legwork from brokers will cost considerably more than this.
“Both clients and consultants are becoming more diligent with asking secondary questions. In the past there’s been a bit of a box-checking attitude toward due diligence. Now clients demand, ‘Prove this to me; let me see what you’re doing.’”“If a pension fund wants to get the lowest rate, it will find transition managers willing to bid that rate,” Zeno’s Glass says. “And even at the bottom rate, the pension fund has a right to expect the managers to do a good job. But this can create an environment in which transition managers work at cut-rate prices with very little margin.” That’s not to suggest that managers are “doing anything untoward,” adds Webster. “It’s just that if you’re a big investment bank you’re going to focus on the things you do best. You could argue that costs have gone up in the industry, but the pricing hasn't—if anything, the pricing has continued to go down. That has put a squeeze on the sorts of services that these large firms can provide.”
Is it possible that a pressure-cooker scenario of low margins could have contributed to the bad habits in the past? Two anonymous sources say, hypothetically, it could have fed into the desire to squeeze out extra profits—creating incentives for malpractice. More worryingly, they add, this dynamic has not been addressed by regulators.
Little has changed from a client perspective. According to CIO’s 2016 transition management survey, 9% of respondents were “uncertain” about their typical compensation arrangement. More than two-thirds of respondents—68%—said they still used a commission-based model, despite the historic abuse of this method. However, there has been a marked increase in the use of flat fee arrangements since 2012, with 16% saying they used the method this year.
Price is, of course, central to decision-making—but vigilance is just as important. “The conversation needs to be about the kind of attention the bid will get you,” Glass says. “Is the transition manager going to put all positions into an algorithm and let it do the work?” Asset owners and consultants, he continues, “really need to pay attention to the systematic controls and internal compliance protocols that each of these providers has in place.”
“It would be imprudent for a fiduciary to simply assume malpractice isn’t going to happen,” Glass argues, remembering his days as a general counsel to a public pension fund in the ’80s and ’90s. “What should a reasonable fiduciary do in light of these headlines? Become ever more diligent, ever more watchful—I think that’s the best medicine.”
Isn’t that the regulator’s job?
In its 2014 review of the transition management sector—conducted in direct response to the State Street and Convergex scandals—the UK’s FCA warned of several potential risks and conflicts, which providers still in the market have since sought to address. The regulator highlighted front-running, providers acting as both agent and counterparty, revenue-sharing agreements (as allegedly struck between GTS and Convergex), and the aforementioned low-balling of quotes. The FCA also criticized a lack of clarity in managers’ marketing materials, and warned that small transition teams in larger firms could make it “easy for senior managers… to underplay oversight of transition management in the belief that it is a low-risk, quasi-project management business.”
Despite these criticisms, the regulator decided that its existing rules and guidance “establish a high standard and are fit to govern transition management practices.” Outside of State Street’s $30 million fine, the FCA has not taken enforcement in the sector any further, instead placing the emphasis on clients and providers to effectively police themselves. The SEC has focused on enforcement but has also made no changes to its rules.
The T-Charter, launched in 2007 by Inalytics’ Di Mascio and Graham Dixon (then at Credit Suisse but now Di Mascio’s colleague at the London-based manager analysis firm), sought to aid the self-policing effort. Provider signatories to the voluntary code promised to maintain clear audit trails for all activities related to the transition, abide by the T-Charter’s cost-estimate model, and act in the best interests of clients throughout trading.
“It would be imprudent for a fiduciary to simply assume malpractice isn’t going to happen. What should a reasonable fiduciary do in light of these headlines? Become ever more diligent, ever more watchful—That’s the best medicine.”While the charter’s efforts were necessary and useful, they were not enough, says Andrew Williams, principal at Mercer’s specialist transition consultant arm Sentinel. The T-Charter “did some great things in terms of education” and airing the industry’s issues, he explains, but “ultimately it couldn’t act as judge and jury on specific cases as some people perhaps thought or hoped. It was comprised of transition managers, so they were conflicted in passing judgement on others.”
Perhaps because of those inefficiencies, the T-Charter has been dormant for several years as an industry voice, although its standards are still maintained by providers. There have been discussions of resurrecting the charter, Williams says, but its impact would likely be minimal. “There was talk of going into a bit more detail in certain areas such as performance measurement or remuneration, but it was pretty tricky to get where it got to in the first place,” he adds.
That passes the buck back to the clients and their consultants. “What it really boils down to is that pension funds and consultants need to ask the right questions,” Glass says. “When interviewing transition managers it’s not enough to ask, ‘Are you part of the investment bank or are you part of the asset manager arm?’”
Fortunately, the trend of institutions scaling up in-house resources and professionalizing is also increasing the scrutiny of third-party providers, Williams says. “Funds are no longer just a pension manager and a trustee board that meets every quarter; they’re a CIO and a small internal investment team. General knowledge in-house has become more sophisticated as pension funds’ investments have become more complex.”
Although scrutiny has risen, trust in transition management may be recovering: 8% of respondents to CIO’s 2016 survey said they had little or no trust in the industry, compared to 27% in 2012. This year, 56% said they “mostly trust” transition managers, more than double the 24% that said so in 2012. But there’s still work to be done—just 3% of respondents said they trust providers “completely.”
“There probably is a bit more nervousness around transition management than in the past,” Williams concludes. “These stories stick with people. We’ve seen the scandals but we’ve also seen thousands of transitions that have gone well. These clients are happy, because the managers did a good job.” Just don’t let your guard down.