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Mutual Fund Securities Lending Programs - Who earns the Revenue?

Bloomberg News and Reuters reported on Sunday, February 3 about a lawsuit filed by two U.S. pension funds on January 18, 2013 against an ETF Manager alleging that the manager had “looted” securities-lending revenues from ETF investors and breached its fiduciary duties.

The Complaint filed in the United States District Court for the Middle District of Tennessee, names the ETF Trust, various portfolios/funds in the Trust and all of the ETF Trusts’ Directors individually. The Complaint states: “Defendants engaged in a scheme arranging for affiliates of the ETF to take at least 40% of securities lending revenues for themselves at the expense of investors – a fee entirely disproportionate to the performance of those affiliates which amounted to “money for nothing”, as described by one Wall Street Journal commentator.”

The Complaint further alleges that the “Investment Company Act of 1940…requires not merely that mutual funds disclose fees paid to affiliates but that they ensure such payments are fair and reflective of what would be paid in arms-length transactions.”

The pension plans bring the case derivatively and on behalf of all similarly situated ETF investors. A recent academic study is cited “Affiliated Agents, Board of Directors and Mutual Fund Securities Lending Returns” by John C. Adams (http://papers.ssrn.com/5013/papers.cfm.abstract_id=1947503) An SEC study is also cited that quotes “In just about every circumstance where the funds lent securities through an affiliated agent, the SEC found problems” (Tom Lauricella, “SEC discovers breaches in lending securities", Wall Street Journal online ed. 12/4/2012.)

The Complaint alleges violations of Section 36(a) and (b), Section 47(b) and Section 17(e) of the Investment Company Act. Their request for relief includes (1) an injunction enjoining Defendants from using affiliated lending agents; (2) Disgorgement; (3) attorneys fees and other remedies available.

The manager gave comments to Reuters that “the complaint was without merit and it will contest it vigorously".

This action should give rise to an industry-wide review of their securities lending arrangements.

http://www.reuters.com/article/2013/02/03/blackrock-lawsuit-ishares-idUSL1N0B31TM20130203

http://www.mfdf.org/images/uploads/about_files/Laborers_Local_265_v_iShares.pdf

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