The transition management industry has been marred in recent years as failings at some large firms sparked regulatory action. In the UK, the regulator handed State Street a hefty fine and began a Thematic Review of the industry. Meanwhile, several large players exited the market.
Trust, so integral to a smooth transition, has been lost. Dark clouds often have silver linings however, and the industry is emerging from the storm in a cleaner, more transparent form. While the value of good transition management has been underscored by the regulator, the industry has some way to go in restoring confidence. But everyone has a part to play and the regulator has made it clear investors must share the responsibility of ensuring the best outcomes from transition projects. While trust is essential in transition management, blind trust is no longer acceptable.
The storm breaks
For several years the transition management industry has been battered by an onslaught of negative headlines as regulators on both sides of the Atlantic announced investigations into allegations of serious failings at a number of leading providers.
The UK’s Financial Conduct Authority (FCA) embarked on a Thematic Review and several large-scale providers, including JP Morgan, Credit Suisse and Convergex exited the market in whole or in part. In December, Convergex, a leading transitions provider, agreed to pay $150m and pleaded guilty to allegations it repeatedly overcharged investors through hidden fees.
“In the UK, the industry has been in a state of paralysis, waiting for the FCA to announce its findings of the Thematic Review and investigation into State Street before making statements about the future,” says Graham Dixon, specialist transitions adviser at independent advisory firm, Inalytics.
Both were announced in quick succession early this year. On 31 January the FCA fined State Street £22.9m after it allowed a culture to develop in the UK transition management business which “prioritised revenue generation over the interests of its customers”.
This allowed deliberate overcharging to take place and continue undetected. State Street UK breached three of the FCA’s principles of business in failing to treat its customers fairly, failing to communicate with clients in a clear fair and not misleading way and failing to take reasonable care to organise and control its affairs responsibly, with adequate risk systems.
On 10 February the FCA published the findings of its review into transition management. The FCA found, while firms broadly met their requirements, the quality and effectiveness of controls, marketing materials, governance and transparency varied. “Our main finding,” according to an FCA spokesperson, “is that transition management often constitutes a small business within a large firm and can therefore be overlooked by the senior management and control functions. While this may not have caused the problems seen at some firms, which have been due to the conduct of specific individuals or poor culture, the problems would not have happened without the failure of oversight.”
The review also drew attention to the asymmetry of knowledge between clients and providers of transition management services. Clients who are unfamiliar with the process may not be aware of potential conflicts of interest or understand how the transaction is being carried out, which could affect the value of their assets. Overall the review concluded the existing rules governing transition management were sufficient.
The silver lining
Although the lack of additional rules imposed may appear underwhelming on the surface of it, the review has served as a stark warning to providers that the regulator will not hesitate to take action where firms fall short of its requirements.
The review process has also resulted in significant improvements in the oversight and management of transition services. “Where firms have had to respond to the FCA, senior management, risk management and operations functions have all been forced to take a close look and review their own practices,” the FCA said. “That has had an impact. Our visits stimulated discussion, which has resulted in improvements being made.”
In conducting the review and providing specific feedback where necessary, the FCA has also set the bar for the high standards required of transition providers.
“Nobody can be under any doubt what the regulator expects,” Dixon says. “The duty of care is right at the top of the FCA’s specifications and those responsible for transition management businesses need to be taking their duties very seriously.” The fine imposed on State Street is evidence the FCA will not pull any punches in punishing those found wanting.
Although small in comparison to the $150m the SEC fined Convergex, the scale of State Street’s fine is significant in proportion to the size of its transition management business, sending a strong message to the industry.
“Any subsequent action the FCA takes could be much more punitive,” Dixon predicts. The FCA’s readiness to take punitive action should prove comforting for investors. Furthermore, the review itself highlighted the value of the transition management process. Done properly, it helps to ensure investors get the best returns on their assets during a period of particular vulnerability.
“Transition management provides a valuable service to asset owners and we found a genuine desire among providers to do the right thing,” the FCA emphasises.
“We want it to work well. If it doesn’t, or clients lose trust, that could lead to long-term harm to underlying consumers. Transitioning assets themselves or taking a target-manager approach may not result in the best outcomes. The transition management industry has lost trust in recent years. The question now is how to rebuild and maintain that trust.”
There is also strong evidence the storm of negative coverage has improved how clients interact with transition managers. According to Chris Adolph, head of transition management EMEA at Russell Investments: “How providers are managing transitions has not changed dramatically, but client awareness has increased. They are asking more questions about where firms are making money. We have been asking clients to ask those questions for a long time.By asking them, clients are less likely to end up in a situation where, for example, overcharging can occur.”
This is critically important, not just in terms of the outcomes for investors, but also because the FCA has made clear that investors must take their fiduciary responsibility seriously when undertaking transitions. In its report the FCA states it expects clients “to consider what assistance, education or guidance might best prepare them to carry out their obligations to underlying investors”.
“Investors must be cognisant of their duties to see that the business is done right,” the FCA’s spokesperson states.
The direct message to clients in the FCA’s review came as a surprise to some experts and underlines the need for investors to conduct proper due diligence and satisfy themselves they have everything necessary to achieve the best possible transition, including putting pressure on providers to achieve the level of understanding and transparency they feel they need.
“This is an important message,” says Andrew Williams, senior consultant at Mercer Investment Consulting specialising in transition manager research. “It is important for investors to demonstrate they have taken the necessary level of responsibility and accountability, and have the required level of internal or external expertise to function on an appropriate level, understand the interaction, process, contractual arrangements and report on performance.”
Building better defences
Furthermore, the underlying business models of transition managers have not changed and are unlikely to change following the review. The conflicts of interest arising from those business models, which the FCA drew particular attention to in its review, will not, therefore, disappear.
According to Ross McLellan, president at Harbor Analytics and former head of transition management at State Street: “Brokers own their own execution venues now and transition management is the perfect business to assist in building revenue and lowering costs on those venues by building large volumes in a short space of time.
“Not a lot has changed in the transition management industry in the last few years, but the level of disclosure has increased markedly,” McLelland continues. “Two years ago the due diligence process was not as robust. Now there is greater disclosure of TM providers’ business models and where they are making money, which wasn’t always clear before.”
Even though disclosure has improved, for many investors, transitions will remain a peripheral issue, making it more difficult for them to gain the appropriate understanding and control when a transition occurs. This combination of factors necessitates considerable due diligence during the transition manager selection process. Investors must not assume the action by the FCA has rooted out all the potential issues arising from the different manager models.
As Martin Mannion, head of trustee services at the John Lewis Partnership pension plan and chairman of the T-Charter committee, warns: “Transition management is the right kind of high-risk, low-frequency activity for something to go wrong. Investors need to be aware of the potential conflicts of interest transition managers may have, make sure those conflicts are managed and that they achieve the appropriate price transparency.”
Managing conflicts should be the number one issue for investors, according to Lachlan French, global head of transition management at Blackrock. “Having the appropriate checks and balances in areas of possible conflicts is key to minimising those conflicts. This should be the most important consideration for clients,” he stresses.
Lowest common denominator
While asset owners are increasingly asking the right questions and being more thorough in their due diligence, the cost pressure resulting from competition among providers and from clients, is effectively forcing many transition managers to generate revenue elsewhere. While this may not necessarily be negative for the outcome of transitions for asset owners, investors need to be cognisant of the associated risks and conflicts of interest.
Nowhere is this more acute than in the public sector, where the procurement process almost forces trustees to accept the lowest-cost provider. Overall, the transition management industry has emerged from the storm in a more transparent form with better oversight.
Meanwhile the regulator has drawn a clear line in the sand, which investors should take comfort from. Investors are also moving in the right direction, increasing their focus on key areas of conflict. This more transparent, informed and clearly regulated market is a silver lining, but the clouds of conflict remain. Those conflicts should remain top of investors’ agenda as their duties in ensuring good transitions has also been highlighted by the FCA.
As Roger Mattingly, director of Pan Trustees and president of the Society of Pension Consultants, warns: “It is incumbent on trustees to make sure the process is as smooth as physically possible.”
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