Two US pension funds have sued BlackRock, the manager of the iShares exchange-traded fund range, accusing the firm and nine of its directors of “looting” securities lending returns that should have accrued to iShares investors.
In the lawsuit, filed in January at the Tennessee Middle district court, the Laborers’ Local 265 pension fund and Plumbers and Pipefitters Local 572 pension fund say they seek to recover funds spent by iShares’ management on “grossly excessive compensation” to securities lending agents affiliated with iShares’ parent company, BlackRock.
The pension funds allege that BlackRock has historically kept for itself a disproportionate share of securities lending revenues.
Citing a study authored in 2012 by consultant Finadium, the Tennessee pension funds say in their lawsuit that most large pension plans allow their securities lending agents around ten percent of gross securities lending revenues as a fee for their services.
Last year IndexUniverse.com reported that iShares retains a 35 percent share of lending revenues in its US ETF range, down from a 50-50 split in 2010.
Securities lending revenues are a significant source of income for BlackRock. The firm earned $397 million in securities lending fees in 2011 and $157 million on securities lending fees in the second quarter of 2012 alone, according to the lawsuit.
According to the plaintiffs, BlackRock earns money from loans of its clients’ shares and bonds in other ways too.
“In addition to borrowers’ fees, BlackRock Fund Advisors and affiliated entities generate revenue by reinvesting the cash collateral collected from securities borrowers into short-term, BlackRock-affiliated investment vehicles such as money market accounts,” they assert.
In Europe, Deutsche Bank analyst Christos Costandinides estimated in 2011 that ETF managers can effectively double what they earn from their funds’ stated management fees from “ancillary” activities like securities lending, the provision of derivatives, and trading.
The average manager of a physically replicated ETF range earned 26 basis points (0.26 percent) a year from securities lending, on top of average annual management fees of 46 basis points, Costandinides calculated.
Using an affiliated lending agent, rather than an independent entity to conduct securities loans is also inefficient, allege the Tennessee lawsuit plaintiffs. They cite a 2011 study by John Adams of the University of Texas, in which Adams and his co-authors Sattar Mansi and Takeshi Nishikawa provide evidence that the returns on securities lending programmes are significantly lower when fund managers use affiliated lending agents, rather than negotiating their securities lending programmes on an arms-length basis.
The scope for fund managers to use “shadow banking” activities like securities lending to boost revenue is now under increasing pressure worldwide.
In Europe, securities market regulator ESMA ruled recently that from 2013 the managers of the region’s UCITS funds (funds authorised for distribution to retail investors) may not profit from lending the shares and bonds owned by the investors in their funds. Instead, they will only be able to make a deduction from gross lending revenues to reflect the costs of running the lending programme.
BlackRock has recently argued that the costs of running a securities lending programme are set to rise as a result of a new policy of offering indemnities to a broader range of clients. These indemnities are intended to insure against losses incurred by a potential default of a securities lending counterparty.
The Tennessee pension funds are asking for the return from BlackRock to all iShares investors of the difference between what those investors actually earned from securities lending transactions and what they would have earned if lending had been carried out by a non-affiliated body—a sum that could total several hundred million dollars.
According to the Financial Times, which reported the lawsuit on Sunday, BlackRock has said that “the complaint is without merit, and we will contest it vigorously.”