September 20, 2017 / 7:30 PM / 10 months ago

State Street settles fraud and disclosure failure charges -- lessons follow

NEW YORK (Thomson Reuters Regulatory Intelligence) - The Securities and Exchange Commission has announced that broker-dealer State Street Global Markets and investment adviser State Street Global Advisor Funds Unlimited have agreed to pay more than $35 million(here) to settle charges that they fraudulently charged secret markups for transition management services. The settlement also resolves charges(here) for separately omitted material information about the operation of a platform for trading U.S. Treasury securities.

A U.S. Dollar note is seen in this June 22, 2017 illustration photo. REUTERS/Thomas White/Illustration

Secretive fees and processes that mislead subscribers about a firm’s order-handling operations expose flaws in disclosure processes and its monitoring for accuracy and completeness, as well as the firm’s commitment to transparency and honesty. The commission’s order and penalties offer several lessons for other firms to consider when reviewing compliance processes and the integrity of public-facing statements.


In the Securities and Exchange Commission’s (SEC’s) order, the agency finds that State Street’s scheme to overcharge transition management customers generated approximately $20 million in improper revenue for the firm.

State Street used false trading statements, pre-trade estimates, and post-trade reports to misrepresent its compensation on various transactions, especially purchases and sales of bonds and other securities that trade outside large transparent markets. State Street essentially would agree to a fee arrangement and then secretly tuck in hidden, unauthorized markup.

When one customer detected some hidden markups and confronted State Street employees, the firm sought to conceal the charges by falsely called them a “fat finger error” and “inadvertent commissions,” the SEC said.

In a separate order, the agency found that State Street failed to inform subscribers to its government securities trading platform called GovEx that — despite marketing the system as “fair and transparent” — it provided one subscriber with a “last look” trading functionality that allowed a short period of time for the subscriber to reject a match to a submitted quote.

That subscriber used the last look feature to reject 57 matches that each had a $1 million face value. State Street did not inform the counterparties that their orders had been rejected via the last look feature.

While developing the last look feature, State Street even told another subscriber that the platform did not have such functionality at all.

“Firms that run trading platforms cannot mislead subscribers about their order handling operations,” said Kathryn A. Pyszka, Associate Director of the SEC’s Chicago Regional Office that investigated the GovEx-related disclosure failures.

State Street agreed to pay a $32.3 million penalty to settle the fraud charges for the hidden transition services markups, which violated Sections 17(a)(1) and (3)(here of the Securities Act of 1933 as well as Section 15(c)(1)(here and Section 10(b) of the Securities Exchange Act of 1934(here and Rules 10b-5(a) and (c)(here

A senior executive, Ross McLellan, was discharged by the bank in 2011, and Edward Pennings, another bank executive, are scheduled to go on trial next month for securities and wire fraud.

State Street also agreed to pay a $3 million penalty without admitting or denying the findings that its GovEx-related disclosure failures violated Section 17(a)(2) of the Securities Act of 1933.

In January 2014 State Street settled civil charges with the U.K. Financial Conduct Authority for a 22.9-million-pound ($32.4 million) fine for the same transactions at issue here.


The overcharging scheme at the asset manager firm began in 2010 and involved “transition management” services for institutional investors that were changing fund managers or investment strategies.

The competitive business was not conducive to large profit margins, so McLellan, an executive vice president of State Street, oversaw a plan to target certain deals for unauthorized charges — large ones — where they would be less likely to draw attention, the SEC said.

The overcharging scheme’s first victim was a sovereign wealth fund in the Middle East to which the bank had offered zero commissions for reworking its $6 billion portfolio, saying it would be compensated by the fund’s counterparties, the SEC said.

Instead, Mr McLellan suggested to two UK-based subordinates that the bank “should take one or two basis points of undisclosed mark-ups,” the commission said.

“[N]o one is going to [expletive] notice that . . . It’s a rounding error,” one State Street trader told a colleague on a recorded line, according to the SEC’s order.

The bank hid $2.7 million, or 9 basis points worth of secret mark-ups, as “bid-offer spread” in customer documents.

Mr McLellan’s team also cheated an Irish government agency of $4.5 million and defrauded a UK postal company of $3 million on transition deal charges, the SEC said.


State Street described its GovEx platform as “fair and transparent” in its marketing materials, and on at least two occasions, explicitly denied conferring special treatment by giving an institutional subscriber a chance to reject any match to a quote that it had submitted.

“No one on our feed should have Last Look. There is no Last Look functionality on GovEx,” the bank said.

In an effort to attract companies that could provide liquidity for the platform, however, the bank allowed one early user a chance to reject any match to a quote that it had submitted.

Between July and October of 2010, Subscriber A rejected 57 of 157 matches with a total value of $157 million, the SEC said.


In February, legendary investor Warren Buffett took direct aim at fees investors pay. According to Buffett, “You don’t get better because you charge a lot. That does not make you a better judge of securities or anything like that.”

In the financial services sector, there are several traditional ways to get paid, including markups (The firm buys an instrument for $75, sells it to a customer for $80, and pocket the $5); and commissions (The firm sells an instrument for $75 and charges the purchaser $5 for the transaction).

Many retail investors cannot fight back if they don’t know about hidden fees or if the fund is charging incorrect fees: but some do, and many institutional investors have the staff and other resources to spot these inconsistencies more readily.

Regulators want to see disclosures on fees and commissions so all customers can spot where claims made in marketing material run contrary to what appears on statements or on the brokerage company’s website.

A financial adviser should carefully explain fees with customers before they sign up for the adviser’s services. Robo-advisers must clearly state management fees on their websites, and all advisers and brokers must regularly tell investors how much they are paying in management fees on their account statements.

A firm must pay due regard to the information needs of its clients and communicate information to them in a way that is clear, fair and not misleading. But that is minimum effort. Explaining what the fees mean and what they are for, and being conspicuous about advertising them showcases a firm’s willingness to go above and beyond what the rules state.

They also enable a business with competitive rates to showcase them and challenge their peers for the business of savvy investors.

The systemic weaknesses in State Street business practices and control environment were revealed by such a savvy investor; a client notified State Street staff that it had identified mark-ups on certain trades that had not been agreed.

The client did not notify a regulator, so State street had the opportunity to claim the mistake was a one-off and to reimburse that one client.

The firm deliberately failed to disclose the existence of further mark-ups on other trades conducted as part of the same transition (i.e., portfolio restructuring).

Firms must take reasonable care to organize and control its fee disclosures with adequate reporting that require employees to document in writing the fees they state and require clients to acquiesce to them, also in writing.

Periodic review of all written lists of fees and expenses must be conducted and documented, and all employees must feel empowered to come forward on an anonymous basis to inform their manager or compliance department that such important details are not being clearly and accurately communicated.

The company should also periodically test its billing software to insure customers are correctly charged.

With regard to its GovEx platform, State Street’s compliance department was on notice that this tool required monitoring — starting with the fact that it marketed the system as “fair and transparent.”

All trading platforms and technological capabilities offered to paying customers must be offered truthfully, with the same privileges regarding trading capability and no preferences for one client over another.

Firms cannot mislead subscribers about the functionality of their technology. Compliance departments cannot be everywhere, though, and this is where risk controls and required reporting come in again.

Conversations with clients should be documented and, when possible and with notice to the client, recorded, with some of these conversations reviewed on a randomly selected, periodic basis.

Compliance departments must also keep up with regulatory investigations and enforcement actions that resemble their own business: “Last look” was a controversial practice in currency markets before.

In 2015, Barclays PLC paid $150 million to resolve an investigation by New York’s banking regulator that it exploited “last look” in a way that sometimes hurt its foreign-exchange clients.

If a business tells customers that there’s no last look functionality, then they will feel safe trading on its platform, as they feel they are not competing with high-frequency traders.

Violating this trust comes with a big price-tag in terms of negative press and relationship building, which, for all the financial technology in the world, is still what business transacting in financial services depends upon.

(Julie DiMauro is a regulatory intelligence expert in the Enterprise Risk Management division of Thomson Reuters Regulatory Intelligence. Follow Julie on Twitter @Julie_DiMauro. Email Julie at

This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Sept. 11. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

0 : 0
  • narrow-browser-and-phone
  • medium-browser-and-portrait-tablet
  • landscape-tablet
  • medium-wide-browser
  • wide-browser-and-larger
  • medium-browser-and-landscape-tablet
  • medium-wide-browser-and-larger
  • above-phone
  • portrait-tablet-and-above
  • above-portrait-tablet
  • landscape-tablet-and-above
  • landscape-tablet-and-medium-wide-browser
  • portrait-tablet-and-below
  • landscape-tablet-and-below