Why This ETF Company Got Sued and What It Means for You

Many Wall Street firms believe the way to get rich is by using other people's money. Two pension funds think that's exactly what BlackRock (NYSE: BLK  ) is doing with the money they've invested in iShares ETFs, and rather than passively letting it happen, they've decided to take action to stop it.

In their lawsuit, which was filed about two weeks ago in federal court in Tennessee, the pension funds covering two local union groups from Nashville and Cincinnati made allegations against BlackRock and its iShares ETF division, naming BlackRock's president and iShares' chairman personally in the suit. Let's take a closer look at the lawsuit and find out why these pension funds think that they deserve justice.

Understanding securities lending
The rationale behind the lawsuit deals primarily with the proceeds that iShares ETFs get from securities lending. As I looked at last month, securities lending involves institutional investors like ETFs or pension funds taking the stocks, bonds, and other securities that they own and seeking borrowers who are willing to pay them to borrow securities. The borrower posts collateral and pays interest on the loan, generating small but significant amounts of additional income.

These small amounts of securities lending income add up to big money. For custodial giants Northern Trust (NASDAQ: NTRS  ) and Bank of New York Mellon (NYSE: BK  ) , providing services related to securities lending is a major part of their overall business. With fund managers like iShares, however, the question becomes who's truly entitled to the income that securities lending programs generate.

What's at stake
In their lawsuit, the pension funds argue that iShares violated fiduciary duties to their shareholders by keeping too much of the revenue that securities lending generated. According to the suit, various entities controlled by BlackRock ended up collecting 40% of the overall proceeds from securities lending, fees that the suit claims were "grossly excessive," characterizing the practice as "looting."

The lawsuit's claims are fairly consistent with the findings of previous looks at iShares practices. IndexUniverse found last year that iShares kept about 35% of securities lending proceeds for its own account, which was a reduction from past practices closer to a 50-50 split a few years ago. All told, BlackRock earned nearly $400 million from securities lending fees in 2011.

For its part, BlackRock argues that the lawsuit is "without merit" and plans to fight it "vigorously."

Vote with your feet
Lawsuits are useful for captive investors who don't have choices about where to invest their money. For workers whose pension plans or 401(k) providers choose iShares ETFs exclusively, their only recourse is to fight back in the courts.

But if you have the latitude to choose your own ETF providers, you may find more equitable splits of securities lending revenue among iShares' competitors. According to The Wall Street Journal, State Street (NYSE: STT  ) keeps just 15% of the revenue it generates from securities lending, while Vanguard doesn't retain anything, returning all the proceeds to its participating funds.

Before you do so, though, make sure you're comparing apples to apples. BlackRock spokeswoman Caroline Hancock told Reuters that BlackRock runs its own securities lending program internally, bearing all the costs of operating the program. By contrast, Hancock claimed that other institutions outsource their programs to third parties, thereby masking costs as third-party payments rather than securities-lending proceeds retained by the institution itself.

Keep your eyes open
Unfortunately, regardless of the outcome of the lawsuit, this episode is only the latest example of how you have to keep a close eye on the financial services providers that you work with. With so many obscure avenues by which disreputable financial professionals can skim off the top of your hard-earned assets, you can't assume that anyone is looking out for your best interests other than yourself -- even if you're paying them to do so.

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