The transition management industry is in a state of transition. Serious failings have prompted regulators in the UK and US into action amid concerns that clients’ interests were not being protected.

The UK’s Financial Conduct Authority (FCA) carried out an investigation into State Street’s transition management (TM) services after allegations that it had deliberately charged clients substantial mark-ups on some transitions that were concealed from them. The FCA concluded that State Street had “acted with complete disregard for the interests of its customers”. 

According to the FCA, the overcharging only came to light after a client identified mark-ups on some trades. Those responsible within State Street then incorrectly claimed this was an inadvertent error, and failed to disclose further mark-ups on other trades conducted as part of the same transition. The overcharging, the FCA found, accounted for over a quarter of State Street’s TM revenue. At the beginning of 2014, the FCA fined State Street UK £22.9m.

“In looking at the issues at State Street and other instances where TM providers had failed to manage conflicts of interest, poor governance and insufficient oversight, the FCA found itself looking at wider industry issues relating to the state of the market, the different business models across providers and whether particular risks for clients weren’t being considered or addressed by firms,” according to an FCA spokesperson. “We felt we needed to get a better understanding of what is a pretty dynamic market, which led us to conduct a thematic review of the transition management industry.”

The review covered all 13 of the firms operating in the UK market at the time. Between 2010 and 2013, those firms transitioned over £165bn annually, with around 700 individual transitions each year. The top five firms accounted for nearly 80% of assets transitioned by volume.

“Overall, we found that TM is a valuable and important service for asset owners and millions of underlying pension fund holders in the UK,” says the regulator’s spokesperson. “Without it, changes between asset class, geography or manager would take longer, be more complex and could result in more risks and higher costs. However, poor conduct by transition managers can have a significant impact on underlying clients, damaging returns for pension fund beneficiaries and undermining market integrity.”

Oversight

One of the main findings of the review was that TM is typically a small part of a large firm and can, therefore, be overlooked by compliance, risk and audit functions. While this wasn’t the underlying factor where incidents of wrongdoing occurred, it was an important part of the industry’s problem.

“Wrong-doing usually comes down to specific individuals or corporate culture,” the FCA spokesperson says, “but where there is strong oversight with appropriate control functions, those individuals would not be able to get away with poor practice.”

The FCA concluded that its existing rules and guidance established an appropriate standard and were fit for purpose. In conducting the review, senior management and control functions at many firms were forced to take a close look at their TM businesses and make appropriate changes. “We have already seen significant improvements,” the FCA’s spokesperson says. 

State Street’s head of portfolio solutions for EMEA, John Minderides, says that since the overcharging came to light, the firm has spent considerable effort and resources rebuilding its business and creating the necessary control and operating environment to provide an industry-leading service. 

“The observations made by the FCA in the thematic review were fair, balanced and useful in reinforcing how these businesses should operate,” he adds.

The FCA is keeping the conduct of TM firms under review within its normal supervisory activities and will continue to apply regulatory sanctions if firms fall short of its requirements. But it is also keen to emphasise the role of investors in ensuring high service standards are met. In its review, the FCA stated its expectation that clients “consider what assistance, education or guidance might best prepare them to carry out their obligations to underlying investors”.

Graham Dixon, specialist transitions adviser at Inalytics, believes it is particularly noteworthy that the FCA “went out of its way” to say clients have a duty to scrutinise managers and ensure they are getting everything they need to ensure they are getting a good service. 

“They have an obligation to have good governance in place and conduct good due diligence,” he says.

This is a critical point. Many experts believe the behaviour of service providers improves when they know they are being appropriately scrutinised in advance. In the US in 2013, the Securities and Exchange Commission (SEC) agreed a $107m settlement with transition management provider, ConvergEx Global Markets (CGM), after it used an affiliate broker-dealer to charge extra ‘trading profits’ (TP) on transitions. Last December, a SEC document said CGM often took TP when carrying out night-time trading for customers due to time-zone differences. It did not take TP from those that actively monitored executions during the day through real-time trade information, or where customers, prior to trading, requested a ‘time and sales’ report detailing the times and prices of individual executions. 

The SEC’s document states: “In at least one instance, CGM suspended the practice of taking TP when a customer requested time and sales reports to analyse execution prices and then resumed taking TP after they were told that the customer was no longer conducting the analysis.”

A greater degree of accountability of advisers and monitoring of transition managers is believed by some to have protected investors in countries like Germany.

At a glance

 • Serious failings have prompted an investigation into the transition management industry by the UK’s Financial Conduct Authority (FCA).
• The FCA’s review covered 13 providers, and found poor conduct in what it regards as “a valuable and important service”.
• It highlighted the governance problems caused by the fact that transition management is often a small part of a much larger business – leading to lax oversight.
• But it also reminded users of transition management services of their obligation properly to understand and keep tabs on what their providers were doing for them.
• This point is backed up anecdotally by the experience in Germany, where greater accountability and monitoring appears to have protected investors from the sort of problems experienced in the UK and the US.
• Several big names have withdrawn from the industry – it is an open question whether this has been the result of recent scrutiny.

“Under the German model those running Kapitalverwaltungsgesellschaften (KVG) have a higher stake in how providers deal with clients because they are responsible to the authorities if an issue arises within a fund,” explains Jürgen Winter, head of Universal-Investment’s transition management solutions. “We demand more transparency in Germany, so all the trades of the transition are booked into our records and the contracts are very stringent on liability and best execution.”

To date, no other European regulators have conducted TM industry reviews. To a large extent, this is because many of the providers offering TM services to European clients are based in the UK and therefore subject to the FCA’s jurisdiction.

“Transition management providers tend to be global firms,” says Chris Adolph, head of transition management EMEA at Russell Investments. “A Europe-wide review wouldn’t catch many other names. The FCA’s oversight affects services provided to clients across many European countries, and the Middle East in many cases.”

While the SEC has conducted investigations into both CGM and State Street’s TM activities, it has not conducted an industry-wide review. 

Microscope

Importantly, many experts, including Inalytics’s Dixon and Russell’s Adolph, believe regulation and contractual diligence alone cannot protect investors. 

State Street’s Minderides says: “It is always important to negotiate contracts properly and ensure it provides the assurances and protections the client needs, but it is not only the contract that should be the first point of protection. It is the understanding that comes from conducting proper due diligence.”

Russell’s Adolph explains: “The way to prevent the kind of issues we have seen is for clients to understand the technicalities of how the transition manager is physically interacting with the market and demand transparency on pricing. If the provider knows they are being looked at under a microscope, that will, in itself, change their behaviour.”

The FCA’s review and closer scrutiny should, therefore, improve the service clients receive. It has also, arguably, had a significant impact on the shape of the industry. Several of the biggest names in the field have withdrawn services over the past year, including CGM, JPMorgan, Credit Suisse and BNY Mellon.

Although many of those firms stress their decision to withdraw was not linked to regulators’ activities, the market remains sceptical and many clients are left without a trusted adviser.

“I expect it was a significant factor in BNY Mellon’s decision to exit the business – which has led to SAUL needing to find a replacement transitions manager,” says Kevin Wade, CIO of the SAUL pension fund in the UK. “We will continue to request full transparency on fees as we have in the past with our transition manager. We also consider it important to work with organisations and teams with which we have had long-term relationships.”

Although many large schemes have chosen to appoint panels of transition managers in order to have agreements in place across a range of transition expertise, which also provides some protection against further departures from the industry, others prefer, like SAUL, to use firms where there is already an existing relationship. 

A firm providing a number of services means it has more “skin in the game”, as one senior pension fund manager says, “which should better align the interests of provider and client”.

“Investors always need to know how the trading occurs,” says Universal-Investment’s Winter, summing up the lessons learned. “They need to take the time to look at each transaction, what is happening, does the strategy make sense and how is it being managed? Some expertise is always important and if you’re getting an answer that doesn’t leave you 100% satisfied, ask again. Make sure you understand how the transition will work and how the provider is going to make its money.”