As a result of the complexity of securities lending transactions and processes involving many different parties, the practice has led to a broad range of types of litigation. This section describes three types of cases relevant to institutional lenders and their agents: unsuitable investments, inappropriate fees, and dividend arbitrage (also referred to as “yield enhancement”). We also describe some analyses that experts might conduct.
Unsuitable Investments in Reinvested Collateral
In unsuitability cases, plaintiffs often allege that the agents made inappropriate investments from the cash collateral generated in an SLP. These cases fall into two general types:
- The plaintiffs allege that the securities purchased violated the investment guidelines.
- The plaintiffs allege that even if the securities did not strictly violate the investment guidelines, they violated the objective of preserving principal, one common objective of the guidelines.
Claims of violation of the Investment Guidelines have tended to be less common. An example of such a case occurs when plaintiffs allege that the purchase of a particular security violated the provision of the guidelines requiring that a domestic U.S. company must issue any securities purchased under the SBL program.
Plaintiffs typically argue that a foreign entity issued the U.S. security. Defendants commonly argue that the security had a U.S. issuer and that reputable sources like Bloomberg treated the securities as having U.S. issuers. Another example occurs when plaintiffs allege that securities with stated maturities of several years violate the guidelines even when the effective maturity—measured by the reset date for the interest rate—is far shorter.
Following the financial crisis of 2008, when collateral investment portfolios suffered losses, the more frequent allegation has claimed that investments were unsuitable for an SLP (even if permitted by the Guidelines) or that the agent should have sold the securities as the financial crisis worsened. Common plaintiff allegations of failure to preserve principal include the following:
- A realized loss or defaulted security in the collateral reinvestment pool was unsuitable and the agent should never have purchased it or the agent should have sold it at some point during 2007 or 2008 before Lehman Brothers collapsed on September 14, 2008.
- The agent’s internal deliberations revealed concerns with securities that ultimately incurred realized losses, but the agent did not sell those securities prior to default (or the Lehman Brothers collapse, after which many securities suffered significant losses).
For their part, defendants commonly respond with the following:
- The investments were suitable under the Guidelines and the lender (plaintiff) set the Guidelines.
- The agent could not reasonably have foreseen the collapse of Lehman Brothers.
- The agent made an appropriate decision not to sell the securities for a realized loss in the expectation that the security would mature at par and pay off fully.
- The investments were highly rated and historical defaults associated with such highly rated securities are very low (a fraction of one percent or less).
- Many other conservative investors, such as money market funds and local government investment pools, purchased the same securities (e.g., Lehman Brothers notes).
- Plaintiffs and their consultants had access to detailed reports, were sophisticated entities themselves, and should have monitored their portfolios.
- One should view the complained-of securities in the overall context of the collateral reinvestment portfolio and the SLP as a whole.
- The detailed descriptions of permitted investments specify what is suitable for the agent to purchase and that the plaintiffs are cherry-picking securities, with the benefit of hindsight, that had losses.
Experts might conduct one or more of the following analyses, depending on the facts and circumstances:
- Analyze the risk/return characteristics of the purchased securities in the context of the goals of the securities lending program. Generally, greater returns can only be achieved with greater risks. The analysis might include analyzing the historical returns of the complained-of securities and analyzing whether the securities complied with the investment guidelines.
- Analyze the quality of the securities lent—general collateral or specials—to determine what level of risk/return the plaintiff would have needed to generate returns above the rebate rate.
- Analyze whether other investors with similar investment goals and risk preferences purchased the same or similar securities. For example, many money market funds might also have purchased similar securities. Similarly, governmental entities—cities, counties, local governmental investment pools— might also have purchased the same or similar securities.
- Analyze the implications of the high credit ratings that these securities typically received. Moody’s and S&P publish probability of default tables. A high credit rating has historically implied a very low probability of default, often significantly less than 1 percent.
- In some instances, it may be appropriate to analyze the prices of credit default swaps for the complained-of securities. Such an analysis may provide additional insight into the beliefs of market participants.
- Analyze the developments in the broader economy and whether those developments should have reasonably led to the sale of the securities in the collateral reinvestment pool. Plaintiffs often argue that the financial crisis, and especially the collapse of Lehman Brothers, was reasonably foreseeable. It is possible through an analysis of investment analyst reports, statements by federal reserve and government officials, and other market participants to analyze this claim.
- Review the agent’s internal documentation concerning the investments, if available, and the implications for whether it was appropriate to continue holding the securities within the context of contemporaneous market information and in the context of the overall portfolio.
- Analyze the processes the agent had in place to purchase, monitor, and operate the securities lending program.
Improper and Excessive Fees
In another type of lawsuit, plaintiffs allege that lending agents either charged too high a fee and/or had an incentive to take excessive risks in the collateral investment portfolio because they shared in any income (receiving a percentage of the lending fee) but not in any principal losses.
Defendants commonly make several arguments in response:
- Plaintiffs conducted a lengthy due diligence on an SLP before becoming a client and negotiated the securities lending fee.
- This fee depends on several factors:
- The quality of the lender’s portfolio. A lender possessing a portfolio that has a relatively high proportion of in-demand (or special) securities will find lending easier. The lender can reinvest cash collateral generated from that lending in lower-yielding securities and still earn a positive spread.
- The custody fee and other fees (e.g., asset management fee) the lender pays to the agent’s affiliate, typically another division of the bank. The parties frequently negotiate these fees for each customer and sometimes the parties negotiate them jointly with the securities lending fee. Higher fees in one area might explain lower fees in another. One lender may desire to pay lower custody fees but will accept a higher securities lending fee in return, or vice versa.
- Agents operate in a competitive environment. Lenders frequently interview several lending agents, and negotiate with them, before settling on one. In addition, the fee structure described above (with the agent earning a portion of the securities lending income with no indemnification of losses) is common in the industry.
Plaintiffs also sometimes allege improper fees in connection with allegations of unsuitability.
Experts might conduct one or more of the following analyses:
- Analyze whether the due diligence conducted by the plaintiff in deciding upon the agent was appropriate. Frequently, the plaintiff has engaged in an extensive due diligence process and requested information and obtained quotes from several different agents. The documents and information received can shed light on the range of fee proposals the plaintiff received when establishing its SLP.
- Analyze whether the plaintiff’s fees for other services the agent or its affiliate may have been providing were lower than industry averages. This information is considered sensitive and confidential by most agents and is therefore difficult to obtain in many circumstances. However, it is possible to sometimes find articles and third-party consulting firms that collect and publish this data.
Additional Issues Related to Class Certification
Many of the securities lending issues described in this article are even more relevant in a class certification context. When multiple plaintiffs band together to sue a defendant, they must seek permission from the court to do so as a class. For example, pension plans may band together to sue a defendant because they believe they have similar claims. To be certified as a class, plaintiffs must meet all of the requirements of Rule 23(a) and must satisfy one of three subsections of Rule 23(b).24 In federal class actions primarily seeking damages, the plaintiffs must demonstrate that the class satisfies Rule 23(b)(3) predominance criterion, which requires that common questions of law and fact predominate over any individual questions.
One difference between securities lending class actions and other securities class action cases relates to the element of reliance. The Advisory Committee Notes to Rule 23 (b) (3) state: “a fraud case may be unsuited for treatment as a class action if there was material variation in the representations made or in the kinds or degrees of reliance by the persons to whom they were addressed.”25 In a typical securities class action, the court can presume reliance on alleged misrepresentation if a security at issue trades in an efficient market. An efficient market incorporates all public information, including alleged misrepresentations, into security prices in a timely fashion. Such a presumption, however, does not apply in a securities lending class action and plaintiffs must affirmatively demonstrate that all class members received either identical or substantively similar representations on which the class members similarly relied and thereby suffered injury.
In addition, in its Comcast decision, the Supreme Court held that in order to establish predominance under Rule 23(b)(3), plaintiffs must offer a damages method tied to their theory of liability. How much this has changed class certification opinions is open to dispute: some legal observers claim it has had little effect on class certification, but some district courts have applied Comcast to deny class certification.
Plaintiffs and defendants typically dispute whether the reliance and damages requirements raise important questions in cases involving the suitability of investments in securities lending. The plaintiffs’ position is relatively simple: they believe they do not. According to plaintiffs, the unsuitability of an investment for an SLP (due to the nature of securities lending as a relatively conservative investment) is a common question applicable to all putative class members. Defendants argue the opposite and desire to make suitability into an individualized issue. Defendants argue that an appropriate damages theory— one that matches the theory of liability and contains only members who have sustained injury, among other things—cannot be quantified at the class certification stage. In terms of suitability, defendants often argue that suitability for one investor does not necessarily imply suitability for another. Consider these factors:
- Some lenders have a lower-quality portfolio (fewer in-demand special securities) and hence need higher returns to achieve a positive spread.
- The addition of the allegedly unsuitable securities might add very little additional risk to one lender’s portfolio (due to variation in amounts of stocks actually loaned) or because the lender is diversified.
- Some lenders hold in their own portfolios the same securities that their complaint alleges the agent should have sold.
- Some lenders had options to invest in collateral vehicles with lower risk and specifically rejected them. The reasons why one lender would reject such an option likely vary by lender.
- Lenders have varied levels of sophistication.
- Lenders received varied investment advice from consultants. For example, some clients might have received advice to continue holding investments that the complaint alleges were unsuitable.
In terms of damages, a defendant might argue that plaintiffs must specify their damages theory and that it must match their liability theory. For example, if a plaintiff alleges that the agent improperly purchased broad classes of securities, defendants might argue that the plaintiff must specify what alternative portfolio of investments the agent should have purchased and then require plaintiff to explain how, for each lender, that alternative portfolio would have made sense in terms of the required returns that investor desired.
Securities Lending and Dividend Arbitrage
With dividend arbitrage (yield enhancement) transactions, taxpayers temporarily lend securities to parties in lower tax and/or withholding tax jurisdictions across the record date for dividend payments. These parties then return the securities after dividends are paid. The lender, borrower, and intermediary bank share the tax savings. Dividend arbitrage transactions can take a variety of forms, often involving stock loans and/or equity swaps. Entities use these across international borders.
Numerous variations on the basic structure of a dividend arbitrage transaction exist, some extremely complex. A proper analysis of any particular transaction structure usually requires an in-depth understanding of the transaction.
The Internal Revenue Service, financial regulators, and their counterparts in foreign countries frown on purely tax motivated transactions. Their challenges argue that such transactions entail little to no risk and that the parties would not have entered into these transactions in the absence of tax benefits. In other words, they argue that the transactions had no economic substance.
Taxpayers often argue that they complied with all statutes, that they acted for the benefit of their stakeholder-beneficiaries, that the transactions were profitable even without the tax benefits, and that the transactions entailed significant risks. To show that the transactions were profitable in such securities lending cases, defendants often argue that the parties profitably used the loaned securities in other parts of their equities business because the parties could:
- On-loan the borrowed securities to other counterparties, generating fee income.
- Use the borrowed securities to take a short position in the security.
- Use the borrowed securities in proprietary scrip arbitrage transactions.
- Use the borrowed securities in pairs trading.
- Use the borrowed securities in synthetic hedging transactions.
Defendants often argue that, besides the usual risks that accompany securities lending described in Section 30.2(b) (counterparty risk, liquidity risk or risk of recall, operational risk), they were exposed to numerous other risks inherent in equities finance operations, including:
- Price risk: prices move adversely on proprietary positions.
- Idiosyncratic risk: A particular security does not move in tandem with similar securities and can cause losses on certain types of arbitrage positions.
- Event risk: Adverse news specific to a company.
- Cost of capital risk: Transaction costs, during the life of the transaction, are higher than expected.
- Hedging risk: A hedged position does not fully hedge as expected due to unforeseen circumstances.
- Model risk: Strategies dependent on computer models suffer losses due to errors in the models.
- Funding risk (also known as “rollover risk”): Positions financed with shortterm obligations face more rapid increases in short-term rates compared to the long-term rates of the securities maintained with those short-term
- Currency Risk: exchange rates change and adversely affect the taxpayer.
- Squeeze Risk or Corner Risk: The holder of a short position cannot borrow the security if it becomes highly desirable to borrowers.
- Systemic Risk: Market prices decline in aggregate.
- Legal and Regulatory Risk: The expected legal and regulatory rules turn out not as expected.
Experts may conduct one or more of several different analyses.
- Analyze the transactions at issue. This typically involves understanding the structure of the transaction, as well as the costs and benefits of the transaction.
- Analyze the business of the taxpayer more generally to understand how (and whether) the transaction fits into the larger set of operational activities. For example, borrowed securities might be used by the agent in one of the
numerous ways listed above.
- Analyze whether the economic substance of the transactions at issue is supported by other transactions the taxpayer entered into. For example, the costs and returns associated with the transactions may be comparable to, or consistent with, the costs and returns of other, non-challenged transactions.