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United States v. Bank of New York Mellon

United States District Court, S.D. New York

April 24, 2013

UNITED STATES OF AMERICA, Plaintiff,
v.
THE BANK OF NEW YORK MELLON and DAVID NICHOLS, Defendants

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[Copyrighted Material Omitted]

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[Copyrighted Material Omitted]

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For The Bank of New York Mellon, Defendant: Pierre G. Armand, Lawrence H. Fogelman, James Nicholas Boeving, Assistant United States Attorneys, PREET BHARARA, UNITED STATES ATTORNEY; Reid M. Figel, Rebecca A. Beynon, David L. Schwarz, Derek T. Ho, Gregory G. Rapawy, KELLOGG, HUBER, HANSEN, TODD, EVANS & FIGEL, P.L.L.C.

For David Nichols, Defendant: Stephen Fishbein, Daniel H.R. Laguardia, SHEARMAN & STERLING LLP.

OPINION

Lewis A. Kaplan, United States District Judge.

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Table of Contents

Background

I. Facts

A. Overview of Standing Instruction Trading

B. Representations About Standing Instruction Pricing

1. Best Execution

2. Other Representations

C. Pricing Practices

D. Effects on Bank

II. Procedural History

Discussion

I. Legal Standard

II. " Affecting" a Financial Institution.

A. Claim Against Nichols

1. " Victimizing"

a. Text

b. Statutory Structure

c. Legislative History and Purpose

2. " Indirect Harm" by a Third Party

3. Sufficiency of the SAC

B. Claim Against BNYM

III. Sufficiency of Fraud Allegations

A. Basic Principles

B. Representations Relating to Quality of Traditional Standing Instruction

Pricing

1. " Best Execution"

a. Materially False or Misleading

b. Intent to Deceive

c. Intent to Harm

2. Generally Reflecting Interbank Rate at Time of Execution

3. Free of Charge and Minimizing Costs

4. " Best Rate of the Day" .

C. Netting

D. Same Pricing

1. Non-ERISA Clients

2. ERISA Clients

E. Fraudulent Omissions

1. Superior Knowledge

2. Heightened Level of Trust

Conclusion

The United States brings this civil fraud suit against defendants The Bank of New York Mellon (" BNYM" or the " Bank" ) and one of its employees, David Nichols. The second amended complaint (" SAC" ) alleges that defendants engaged in a scheme to defraud the Bank's custodial clients by representing, among other things, that the Bank provided " best execution" when pricing foreign exchange (" FX" ) trades under its " standing instructions" program. In Southeastern Pennsylvania Transportation Authority v. Bank of New York Mellon Corp . (" SEPTA " ),[1] this Court held

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that one such custodial client had stated legally sufficient claims for breach of contract and breach of fiduciary duty based on similar alleged misrepresentations. This matter is before the Court on defendants' motions to dismiss the SAC for failure to state a claim upon which relief may be granted.

The government sues under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (" FIRREA" ).[2] Section 951 of that statute[3] permits the Attorney General to bring an action for civil penalties against anyone who violates any of a number of criminal statutes, including those prohibiting mail and wire fraud when the fraud is one " affecting a federally insured financial institution." [4] Although Section 951 has existed for nearly 24 years, it seems not to have been applied much. In fact, this decision marks the first occasion upon which a court has been called to interpret the meaning of the phrase " affecting a federally insured financial institution" under that section.

In particular, this case presents the following question of first impression by any court: whether a federally insured financial institution may be held civilly liable under Section 1833a for allegedly engaging in fraudulent conduct " affecting" that same institution. This question currently is presented in two other cases in this district.[5]

BNYM contends that it cannot be held liable on such a theory, arguing that the affected institution must be the victim of or an innocent bystander to the alleged fraud, not the perpetrator. The Court disagrees. In passing FIRREA, Congress sought to deter fraudulent conduct that might put federally insured deposits at risk. Where, as alleged here, a federally insured financial institution has engaged in fraudulent activity and harmed itself in the process, it is entirely consistent with the text and purposes of the statute to hold the institution liable for its conduct.

Regarding the merits of the fraud allegations, the complaint generally suffices to allege the principal claim here--that defendants fraudulently misrepresented their standing instruction service as providing best execution. As in SEPTA, the complaint plausibly alleges that the Bank priced its trades inconsistent with the industry understanding of the term, rendering defendants' representations at least misleading. While the government here has a burden to plead facts giving rise to a strong inference of fraudulent intent, the complaint does so. It contains allegations that, if proven, would permit the conclusion not only that Bank employees knew their practices were inconsistent with an industry understanding of " best execution," but also took active steps to mislead their clients about how trades were being priced.

This said, while the government adequately pleads a number of other alleged misrepresentations closely related to the notion of best execution, its theories of fraud on some other grounds are insufficient. Accordingly, defendants' motions to dismiss are granted in part and denied in part as detailed below.

Background

I. Facts

The Court briefly provides an overview of BNYM's standing instruction program

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and the central representations and practices at issue in this case. Additional allegations, particularly those pertaining to the government's theory of fraudulent intent, are introduced in the discussion section as they become relevant. Further details about the standing instruction program from one customer's perspective may be found in this Court's decision in SEPTA .

A. Overview of Standing Instruction Trading

BNYM is one of the world's largest custodial banks, holding on behalf of its clients domestic and international financial assets, including currency and securities.[6] Its clients often need to engage in currency transactions in connection with the assets BNYM holds on their behalf.[7] This occurs, for example, when a client earns dividends or other foreign currency income from its foreign assets or buys or sells a security in a transaction denominated in a foreign currency.[8]

BNYM has provided certain foreign exchange services to these custodial clients in two principal ways.[9] First, the client may contact BNYM directly and execute a currency trade with BNYM at a price agreed upon at the time.[10] Second, under its standing instruction service, BNYM automatically provides currency exchange as the needs arise.[11] The standing instruction service relieves clients from having to negotiate individual FX trades in such circumstances, as BNYM handles the trade " from start to completion," setting the price itself.[12] Only after the fact does the client learn the rate at which the exchange was executed.[13]

B. Representations About Standing Instruction Pricing

This case is about how the Bank set its prices for standing instruction trades. As this Court discussed in greater detail in SEPTA, the principal policies and procedures of the standing instructions program provided limited information about BNYM's pricing practices. They noted that the pricing would be no worse than certain prices set forth in a daily schedule each morning and deviate no more than three percent from the relevant interbank rate--the latter guarantee apparently to ensure compliance with ERISA requirements.[14] The procedures did not state how BNYM would price the transactions aside from fulfilling these two guarantees, nor did they state expressly that BNYM otherwise was free to price the trades however it wished.[15]

1. Best Execution

The SAC alleges that defendants filled this void through various representations to clients conveying the impression that BNYM in fact was providing its clients the

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best prices it could obtain in the market at the times it executed the standing instruction trades.

The most important of these alleged representations was " best execution." " Best execution" allegedly is a term with an " industry definition" and is " commonly understood to mean that the client receives the best available market price at the time that the currency trade is executed." [16] The SAC alleges that the Bank used this term on its website, in its responses to clients' requests for proposals (RFPs), and in other communications with clients.

In particular, the SAC alleges that BNYM's website--to which clients were referred--stated that one of the " benefits" of the service was " 'FX execution according to best execution standards.'" [17] The website stated also, " 'Operationally simple, free of charge, and integrated with the client's activity on the various securities markets, FX standing instruction is designed to help clients minimize risks and costs related to the foreign exchange and concentrate on their core business.'" [18]

In addition, defendant David Nichols, a managing director and the head of products management at BNYM, drafted a three-paragraph " standard comment" (the " Standard Comment" ) on best execution that was disseminated to the Bank's clients.[19] In light of the alleged industry understanding of the term, the SAC alleges that the Standard Comment furthered the impression that the Bank was providing the best available market price through the following statements:

o " 'Understanding the fiduciary role of the fund manager, it is our goal to provide best execution for all foreign exchange executed in support of our clients' transactions.'" [20]
o " '[W]e price foreign exchange at levels generally reflecting the interbank market at the time the trade is executed by the foreign exchange desk.'" [21]
o " 'Best execution encompasses a variety of services designed to maximize the proceeds of each trade, while containing inherent risks and the total cost of processing.'" [22]
o " 'We also support post-trade analysis comparing our trade execution to recognized industry benchmarks to assist the fund manager in demonstrating that the execution of each trade was consistent with the goal of maximizing the value of the client portfolio under the particular circumstances at the time.'" [23]

The Standard Comment was provided in responses to requests for proposals (" RFPs" ), responses to client inquiries, and was submitted also to a trade magazine.[24]

Other RFP responses contained different language that, the SAC alleges, strengthened the impression that the Bank provided best execution in accordance with the alleged industry definition of the term. In one response, the Bank stated that it " 'ensure[d] best execution'" by, among other things, " 'actively engag[ing] in making

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markets and taking positions in numerous currencies so that we can provide the best rates for our clients.'" [25] It stated also, " 'Clients benefit from our attractive rates because we aggregate all client income in any given currency to obtain the " best rate of the day." That " best rate of the day" is applied to all of the income conversions that we execute for that day, regardless of amount.'" [26]

The SAC alleges that the representations set forth above generally were made by the Bank from 2000 through 2011 and by Nichols from 2004 to 2011.[27]

2. Other Representations

Separate from these various representations about the quality of standing instruction pricing in the ordinary course, the Bank allegedly made representations about " netting." [28] Netting of trades means that to the extent a client may need to buy and sell the same currency on the same day, the bank aggregates those needs to calculate a single amount of the currency that the client would buy or sell that day, and then execute only that one trade with the client.[29] Netting can result in significant cost savings for the client, because the client does not pay spreads on transactions that otherwise would cancel out.[30]

The SAC alleges that BNYM's website stated that standing instruction clients benefitted from " '[a]ggregation and netting of trades based on guidelines tailored to clients needs." [31] Moreover, a policy and procedures document from BNYM's predecessor stated that " 'Currency purchases and sales effected pursuant to these Procedures in the same currency and having the same trade and value date may be netted for pricing purposes within a customer account.'" [32] The SAC alleges that the predecessor represented to one particular client, the Florida Retirement System Trust Fund (" FRSTF" ), that " '[o]ur system automatically nets foreign exchanges when trades are routed to our trading desk.'" [33]

Finally, defendants allegedly represented that all standing instructions clients received the same pricing. In particular, the Bank had a policy for its ERISA clients that provided that the " 'terms of FX transactions with any [ERISA plan] shall not be less favorable to the [ERISA plan] than the terms offered by BNY to unrelated parties in a comparable arm's

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length FX transaction.'" [34] This policy mimicked a statutory requirement necessary to permit transactions between BNYM and ERISA plans.[35] Defendants emphasized this point to various clients in other communications, with BNYM telling one that " 'all clients in our SI [standing instruction] program are executed at the same rate (We are required to do this to fulfill ERISA requirements,'" and Nichols telling another that " 'all clients receiv[ed] the same spot price.'" [36]

C. Pricing Practices

Allegedly contrary to the impression conveyed by the above representations, BNYM priced standing instruction trades as follows. It collected standing trade requests for various currencies throughout the trading day until the early afternoon (around 1:30 p.m. Eastern time).[37] At that time, it determined at an aggregate level the amount of each currency it needed to buy or sell in order to accommodate all of its clients requests, and executed the necessary transactions on its own behalf in the spot market.[38] Later in the afternoon (typically around 4:00 p.m. Eastern time), BNYM assigned prices to the standing instructions trades it would execute with its clients.[39] To do so, the Bank examined the full range in which a given currency had traded in the interbank market that day and priced each standing instruction trade with a client at the rate within that range least favorable to that client.[40] For example, BNYM might sell euros to a client at the highest price at which the euro had traded that day, while buying euros from another client at the lowest price at which the euro had traded. The SAC alleges that BNYM frequently applied a " slight modifier" so that the rate charged was not quite the worst intraday interbank rate.[41]

The SAC alleges that the customer later learned the exchange rate at which its trades occurred.[42] The Bank did not provide time stamps--that is, information about when in the day a particular trade was executed.[43] The customer received a monthly report providing information about their currency trading, but this monthly report did not indicate which trades were negotiated directly and which occurred under standing instruction.[44]

As to netting, whether the Bank actually netted customer trades allegedly varied depending on which trading desk executed the order. While the New York and Brussels

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trading desks did net trades for the clients' benefit, the Pittsburgh trading desk allegedly did not.[45] Rather, the Pittsburgh trading desk allegedly priced the larger side of the transaction (e.g., the purchases if the client was a net buyer of the currency that day, and the sales if the client was a net seller) at or near the worst interbank rate of the day, and then priced the opposite side of the transaction at a different price at least a half percentage point apart.[46]

Finally, the Bank allegedly did not provide the same pricing to all standing instruction clients. Instead, when a client complained about the pricing it had received, when BNYM had reason to believe that the client was likely to scrutinize its pricing more carefully, or when the client was of " 'substantial market stature,'" BNYM switched the client to a benchmarking pricing model for standing instruction trades.[47] Under benchmarking, BNYM charged only a fixed, specific price spread to the standing instruction trade on top of a particular industry benchmark rate published that day, resulting in much better pricing to such clients than others received.[48] The SAC alleges also that the Bank's netting practices resulted in different prices to different clients, as the pricing varied depending on which trading desk executed a particular client's transactions.[49]

D. Effects on Bank

The SAC alleges that BNYM's pricing practices permitted it to earn " enormous" spreads on standing instruction trades compared to the " modest" spreads it earned in negotiated transactions.[50] Thus, a Bank analysis allegedly concluded that from January to November 2009, its spreads on standing instruction trades were approximately 22.33 basis points, while transactions negotiated by phone call provided spreads of 2.80 basis points and electronic transactions provided spreads of 1.18 basis points.[51] Standing instruction trades in 2009 allegedly represented approximately 12 percent of the Bank's overall FX trading volume, but accounted for approximately 69 percent of its FX profits.[52] The SAC alleges that BNYM's sales margins for its top 200 standing instructions clients totaled over $1.5 billion from 2007 to 2010.[53]

Over time, and particularly after a lawsuit against State Street Bank alleging similar practices was made public in late 2009, BNYM's clients became more interested in BNYM's pricing practices, and a number complained about the pricing they were receiving.[54] These matters came to a head in 2011, when various lawsuits were filed by customers, investors, and others, and the Bank disclosed further information about its pricing practices, including that it " 'tend[ed] to price our purchases of currencies at the low end of the daily interbank

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range, and to price its sales at the high end, regardless of trade size.'" [55]

As clients have learned more about the Bank's practices, the SAC alleges, the Bank has suffered various negative consequences. It asserts that numerous lawsuits have been filed against the Bank in both state[56] and federal[57] courts, which collectively expose it " to billions of dollars in potential liability, ongoing and mounting legal expenditures, as well as immediate and ongoing reputational harm which has and could continue to affect its stock price." [58]

The SAC further alleges that the revelations have affected the Bank's FX business. Some clients have become dissatisfied with BNYM, and some have left it altogether.[59] Of those who have stayed, a number have switched to a defined spread or benchmarking pricing model, which provides lower margins.[60] The corresponding reduction in FX revenue, inter alia, allegedly caused BNYM's credit rating to be downgraded by Moody's in March 2012.[61]

II. Procedural History

The initial complaint in this case was filed in October 2011[62] and sought civil penalties under FIRREA as well as an injunction injunctive relief under the fraud injunction statute.[63] In January 2012, the parties entered into a partial settlement pursuant to which the government dismissed its claim for injunctive relief and BNYM agreed, inter alia, no longer to use the terms " best execution," " free," or " netting" in describing standing instructions, no longer to represent that all standing instruction clients receive the same pricing, and to describe its pricing practices on its website.[64]

The SAC was filed in June 2012.[65] Count One alleges that BNYM violated

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the mail and wire fraud statutes[66] by fraudulently representing that the standing instruction service (1) provided " best execution," (2) " price[d] foreign exchange at levels generally reflecting the interbank market at the time the trade is executed by the foreign exchange desk," (3) was " free of charge" and " minimiz[ed] costs," (4) provided " 'the best rate of the day,'" (5) provided " netting," (6) provided the same pricing to all standing instruction clients and (7) used the interbank range to price certain restricted currencies.[67] In addition, the SAC alleges that the Bank (8) fraudulently failed to disclose further information about its pricing practices.[68] BNYM is alleged to be liable civilly under 12 U.S.C. § 1833a. Count Two of the SAC alleges that Nichols violated the mail and wire fraud statutes and is liable under Section 1833a with respect to (1), (2), (4), (6), and (8). As required by Section 1833a, the SAC alleges that defendants' fraud affected a federally insured financial institution--to wit, BNYM itself, as well as a number of other clients that are federally insured financial institutions.

Defendants move to dismiss,[69] contending that the SAC fails to allege any federally insured financial institution was affected by the alleged fraud under the meaning of Section 1833a and that the allegations fail sufficiently to plead claims of fraud against either of them.[70]

Discussion

I. Legal Standard

To survive a Rule 12(b)(6) motion, a plaintiff must plead facts sufficient " to state a claim to relief that is plausible on its face." [71] A claim is facially plausible " when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged." [72] In resolving a Rule 12(b)(6) motion, the Court accepts as true all well-pleaded factual allegations and draws all reasonable inferences in the plaintiff's favor.[73] It may " rely upon documents attached to the complaint as exhibits and documents incorporated by reference in the complaint." [74] " Moreover, when a plaintiff chooses not to attach to the complaint or incorporate by reference a document upon which it solely relies and which is integral to the complaint, the court may nevertheless take the document into consideration in deciding the defendant's motion to dismiss, without converting the proceeding to one for summary judgment." [75] Finally, the SAC's allegations

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of fraud are subject to the heightened pleading requirements of Fed.R.Civ.P. 9(b), discussed below.

II. " Affecting" a Financial Institution

A. Claim Against Nichols

Section 1833a provides that " [w]hoever violates any provision of law to which this section is made applicable by subsection (c)" shall be civilly liable in an action for civil penalties brought by the Attorney General. Section ...


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