Table of Contents
Conflicts of interest are discussed throughout the
Manual in relation to the other major sections. Conflicts of
interest, including self-dealing, are major sources of Contingent
Liabilities. These topics are therefore discussed together in this
section.
A fiduciary has a duty to avoid conflicts of interest and self-dealing.
However, total avoidance is not always possible. Furthermore, while the
terms conflicts of interest and self-dealing are somewhat
self-descriptive, they should not automatically be equated with
exploitation or abuse by the fiduciary. For example, the use of own-bank
deposits as a trust investment is by definition a conflict of interest and
self-dealing, since the bank is investing funds held as a fiduciary with
itself. Yet this action, in itself, is not necessarily abusive or
detrimental to the interests of account beneficiaries. Before such
investments are determined to be abusive or detrimental, an analysis of the
facts surrounding the investment must be made by the examiner.
This section of the Manual is organized into the following parts:
A. Conflicts
of Interest
1. Definition
2. Management of Conflicts
3. Management Documentation
Standards
B. Self-Dealing
C. Contingent Liabilities
D. Material Nonpublic Information
1. General Overview and
Management Actions
2.
Potential Consequences of Inappropriate
Administration
E. Common Instances of Conflict of Interests
and Self-Dealing
1. Fees Other than for the
Administration of an Account
a. Investment in
Proprietary Mutual Funds
b. Receipt of 12b-1 Fees
c. Receipt of Other Fees from Mutual
Funds
2. Securities-Related Activities
a. Soft Dollars
b. Use of Own-Bank or Affiliated
Brokerage Service
c. Securities Trading Practices
d. Proprietary Pooled Investment
Vehicles
e. Use of Only One Fund Family
f. Research Analyst
Affiliate Relationships
g. Proxy
Voting
h.
Trading During Blackout Periods
i.
Advertising Investment Performance
3. Use of Own-Bank or
Affiliate Bank Deposits
a. General Overview
b. ERISA, Deposit
Insurance, and Pledging
c. Suitability of Own-Bank
Deposits
4. Investment in Own-Bank or
Affiliate Company Securities
5. Sale or Purchase of Trust
Assets to or From the Bank, Bank Insiders, Agents, or Affiliates
6. Investment in Securities
Underwritten by Own-Bank or Affiliates
7. Relationships with Outside Service
Providers
8. Inter-Account Transactions
9. Multi-Account Transactions
10. Contravention of Terms of
the Governing Instrument
a. Ambiguous Language
b. Changing Circumstances
c. Unauthorized Commingling of
Assets
d. Nonconforming Investments
e. Failure to Invest
f. Acts Without Consent or Approval of a
Co-Fiduciary
11. Privacy
a. Privacy and On-line Banking
12. Prohibitions
Against Tying Arrangements
A. Conflicts of interest
A.1. Definition
Conflicts of interest
arise when a fiduciary's duty of loyalty to another opposes with
other interests of that fiduciary. Chief Judge Cardozo of the Court of
Appeals of the State of New York, in an often quoted passage from his
opinion in Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545, 546
(1928), described a fiduciary's duty of loyalty as follows:
"Many forms of conduct permissible in a
workaday world for those acting at arm's-length, are forbidden to those
bound by fiduciary ties. A trustee is held to something stricter than the
morals of the market place. Not honesty alone, but the punctilio of an honor
the most sensitive, is then the standard of behavior. As to this there has
developed a tradition that is unbending and inveterate. Uncompromising
rigidity has been the attitude of courts of equity when petitioned to
undermine the rule of undivided loyalty b the 'disintegrating erosion' of
particular exceptions. Only thus has the level of conduct for fiduciaries
been kept at a level higher than that trodden by the crowd."
The courts have long held that fiduciary
transactions not made at arms-length may be set aside at the request of a
beneficiary. This presumes the beneficiary was harmed by such transaction
and, therefore, the fiduciary assumes the consequences of that harm.
Consequently, a fiduciary effectively underwrites transactions
involving conflicts of interest.
A.2. Management of Conflicts
The prudent administration of conflicts of
interest includes management's (1) recognition that conflicts of interest
exist or potentially exist and (2) assurance that there are sufficient
procedural and supervisory guidelines to safeguard against breaches of the
fiduciary's duty of loyalty. The type and complexity needed and the depth
of the written policies governing conflicts of interest depend upon the
nature of trust activities conducted and the likelihood that conflicts of
interest will materialize. A typical policy may address any number of the
following areas:
- Standards governing employee ethics
- Self-dealing and other conflicts of interest such as:
With the exception of an ethics policy,
each of these points is addressed later in this section. An ethics policy
typically provides guidance with respect to the acceptance of gifts; serving
as (an individual) fiduciary under an appointment in which the bank serves
as the corporate fiduciary, extensions of credit from discretionary trusts
to directors, officers, and employees of the bank and its affiliates, etc.
At a minimum, the Board of Directors should receive prior
notification of such activities. The ethics policy should also include
guidelines for compliance with state and federal bribery statutes. The FDIC
has established guidelines pursuant to the Bank Bribery Amendments Act of
1985 to assist bank employees, officers, agents and attorneys in complying
with the law. These guidelines are located in the FDIC Statement of Policy,
"Guidelines for Compliance with the Federal Bank Bribery Law".
A.3. Management Documentation Standards
The absence of risk in a transaction does
not lessen or mitigate a conflict of interest. For example, investments in
own-bank deposits may seem to involve little risk and appear to be an
innocuous conflict of interest, but, as can be seen in
Subsection 8.E.3, there are numerous
considerations in making such an assessment. Where more onerous situations
are encountered, fiduciaries must exercise extreme caution in properly
discharging their duties. Examples include the purchase or retention of
own-institution stock or the sale of a trust asset to a bank insider.
Investments of this nature should not be made unless (1) lawfully authorized
by the instrument creating the trust relationship, or (2) a court order,
local law, or prior written approval has been obtained from all interested
parties. The latter option is not always available, as interested parties
may include: the unborn, minors or others lacking the legal capacity to
approve a transaction, or beneficiaries (whose interests are contingent in
some manner) who cannot be identified at the time of the transaction.
Furthermore, while retention of such securities when received in- kind may
be allowable under a general power of retention (as opposed to
retention that is directed by the instrument or court order), a
trustee should exercise caution when making the decision to retain.
Complete documentation supporting
management's actions with respect to transactions involving real or
potential conflicts of interest, including the prudence of such
transactions, is essential and should be readily available.
The documentation should include a statement supporting
the permissibility of the given transaction, as well as the prudence
and suitability for the account involved. It is not unusual for banks to
seek court approval for particularly sensitive transactions
involving self-dealing or conflicts of interest. Certainly, opinions of counsel
provide both guidance and supporting documentation. However, counsel's
opinion alone cannot insulate a bank from litigation and loss if management
has acted improperly or imprudently.
B. Self-Dealing
Self-dealing always involves a conflict of
interest, but not all conflicts of interest involve self-dealing.
Self-dealing occurs when a fiduciary is a party to a transaction with itself
or its affiliates. For example, in the sale of bank assets to a trust for
which the bank is trustee, the bank is both the seller and the purchaser,
and so is in fact dealing with itself. Other instances of self-dealing
include transactions involving own-bank stock or other own-bank obligations,
own-bank deposits, the sale of assets between trust accounts, and the
purchase of securities underwritten by the bank, an affiliate or a
subsidiary. Dealing with bank insiders is a conflict of interest, but is not
self-dealing, though the potential for abuse is no less serious.
A clear statement of law regarding
self-dealing was expressed by the U.S. Supreme Court in Michoud v. Girod,
11 L.Ed. 1076, 1099:
"The general rule stands upon our
great moral obligation to refrain from placing ourselves in relations
which ordinarily excite a conflict between self-interest and integrity.
. . . It therefore prohibits a party from purchasing on his own account that
which his duty or trust requires him to sell on account of another, and
from purchasing on account of another that which he sells on his own account. In
effect, he is not allowed to unite the two opposite characters of buyer and
seller, because his interests, when he is the seller or buyer on his own
account, are directly conflicting with those of the person on whose account
he buys or sells."
These types of transactions may be set
aside (considered null and void), after being brought to the attention of
the trustee by the beneficiary or the beneficiary's agent. Generally, a
court of law will decide these matters. If set aside, a trustee may be
liable for damages resulting from, among other things, depreciation, loss of
income, or the cost of lost opportunity. The prohibition against
self-dealing applies with equal force to affiliates.
As an additional remedy, a beneficiary may ask a court to
remove the administrator of a trust or will i the administrator acted under
a severe conflict of interest or engaged in intentional self-dealing.
C. Contingent Liabilities
Certain definite principles and rules
governing fiduciaries' actions have been laid down by statutes and court
decisions (Common Law). A violation of any of these principles or rules of
conduct, or the failure to carry out the terms of the trust instrument or a
court order, may constitute a breach of trust and create a contingent
liability. Whether a contingent liability becomes an actual liability,
in which actual losses are incurred, depends upon the actions of account
beneficiaries, the bank, and courts of law.
A breach of trust is a violation by the
fiduciary of any duty that a fiduciary owes to a beneficiary. Breaches may
occur either by an act of commission or omission. When a breach of trust
occurs, the fiduciary is generally charged with: any loss or depreciation
in the value of trust assets associated with the breach; any profit earned
by the trustee as a result of the breach; or any profit which would have
been earned by the account had the breach not occurred. For example, any
gains made from trading errors belong to the beneficiary. Conversely, a
fiduciary is not liable for any loss or depreciation in the value of trust
assets not associated with a breach of trust. This precept recognizes that,
when invested, trust principal is at risk and that a fiduciary is not a
guarantor of investment
results.
One of the primary purposes of examining
the trust activities of FDIC-supervised banks is to determine whether the
administration of trust accounts has resulted in liabilities against
the bank. The liabilities identified are those attributable to the bank, as
a result of its actions as a fiduciary, and are not the liabilities of the
individual accounts administered. To reflect the degree of likelihood that a
contingent liability may result in a charge to capital accounts of the
commercial department, the terms Potential Loss and Estimated Loss are
used.
The classification system begins with
Contingent Liabilities, increases to Potential Losses, and finally, to
Estimated Losses. Note that while the wording of the definitions may
appear to suggest an overlap of liabilities, there are no overlapping
liabilities among these classifications. While the liabilities assigned to
the administration of a particular account may include all three
classifications (Contingent Liabilities, Potential Losses, and Estimated
Losses), that portion of the liability which is assigned an Estimated Loss
classification is not also contained in Potential Losses and/or Contingent
Liabilities. Likewise, that portion of the liability that is assigned
Potential Loss, is not also contained in Contingent Liabilities. The
definition of each category of liability follows:
Contingent Liabilities represent an estimation
by the examiner o the gross possible liability of the institution
resulting from the purchase of nonconforming investments for trust
accounts, unwarranted retention of nonconforming assets, self-dealing,
questionable practices and procedures, or other acts of omission or
commission which appear not to comply with the terms of the governing
trust instruments or applicable provisions of law, and which on accounting
may be subject to objection by interested parties. Until appropriate
consents, waivers or releases of liability are obtained from interested
parties or no liability is determined to exist by a court of competent
jurisdiction, the liabilities are regarded as contingent.
The Contingent Liability
category recognizes the possibility that department actions or omissions of
action may, depending on:(1) account circumstances, (2) management's corrective
measures, (3) ongoing litigation, and/or (4) future, or as yet unknown
events, make uncertain whether losses will ever be sustained by the bank.
Potential Losses represent the examiner's
estimate of those portions of the contingent liabilities that may develop
into losses to the institution. The amount of losses indicated is
potential rather than definite and fixed, pending resolution of the
dispute or settlement of the accounts.
The Potential Losses category
acknowledges that losses have an increased likelihood of being sustained.
However, due to some measure of uncertainty, such as: ongoing negotiations
with beneficiaries or their counsel, a decision not yet rendered by a
court, management's ability to appeal a lower court's ruling, etc., it is
not yet certain that losses will be sustained.
- Estimated Losses represent the amount of
losses that, in the examiner's opinion, appear certain to be sustained by
the institution as a result of its fiduciary activities.
The Estimated Losses category
recognizes the reasonable certainty that a known dollar amount of losses
will be, or has been, sustained. In such cases, management has:
(1) exhausted all of its legal appeals, or (2 agreed to reimburse an
account, or (3) is in some manner, beyond its scope of influence or
control, being compelled to reimburse an account or pay a known dollar
amount of surcharges, penalties, or damages.
Examiners are reminded that Estimated
Losses should be reflected as a reduction in Part 325 capital in the
commercial Report of Examination.
Contingent liabilities are based upon:
(1) known facts and circumstances, and (2) the likelihood that the fiduciary
will be required to make a monetary reimbursement to an account due to the
fiduciary's improper actions, whether intentional or negligent. To effectively and accurately
identify potential liabilities, contingent liabilities should not be
arbitrary or based on speculation, hunches, or guesswork, but based on all pertinent
facts available to the examiner. In determining the existence of
contingent liabilities, unlike the
assessment of Substandard, Doubtful, and Loss in the commercial Report
of Examination, the examiner is not being asked to determine the value of an
asset. Rather, it is the examiner's duty to determine whether: (1) the
fiduciary acted imprudently or negligently in the administration of a
fiduciary account, (2) the fiduciary's imprudent or negligent administration
caused demonstrable harm to the account, i.e. the account suffered monetary
losses or a depreciation in the value of some of its assets, (3) interested
parties have or are expected to petition either the fiduciary or the courts
for reimbursement for the harm caused by the fiduciary's imprudence or
negligence, or (4) the fiduciary has agreed to reimburse such accounts for
the harm the fiduciary has caused as a result of negligent or imprudent
administration.
Note: In many cases, the imprudent or negligent administration of an
account, including breach of trust, does not result in contingent
liability, potential losses or estimated losses, because the account
affected will not have suffered any demonstrable harm by reason of the
fiduciary's actions. Examiners must distinguish these instances from those
where the fiduciary's actions have caused, or likely will cause demonstrable
harm to the account, i.e., actual monetary harm such as the loss of
investment principal or the loss of income. Only when the fiduciary's
imprudent or negligent administration causes such demonstrable harm will a
contingent liability exist. For example, the purchase and/or retention of
a non-conforming asset that has not resulted in a monetary loss to an
account, is reversible without any monetary losses, and for which no legal
action is threatened or pending should not be scheduled as a contingent
liability since the account has not suffered any demonstrable harm. Such
matters should be described in detail in the Report of Examination, but
without any contingent liability assigned. Only those instances where a
fiduciary's imprudent or negligent actions have, or are likely to cause an
account to suffer monetary losses should be assigned an associated
contingent liability.
Examiners
should avoid speculating over such questions as: returns on
investment, lost opportunities, or what verdict a jury might render. Such
speculation is neither the purpose nor the intent of identifying
contingent liabilities in the report of examination. The examiner's
responsibility is, to the extent possible, to provide a reasonable
determination of contingent liabilities.
A meaningful supervisory analysis of the
bank's condition is not provided by simply extending the entire dollar value
of an investment, the entire dollar value of an account, or the outstanding
balance of corporate bonds as contingent liabilities, in place of a
reasonable and demonstrable assessment of dollar damages or harm to an
account. Nevertheless, where a market value cannot be obtained for an asset
because it is of such poor quality, clearly speculative, or of very limited
marketability, it is reasonable to extend the book value (cost) of the asset
as a contingent liability.
In some situations, a determination of the
dollar amount of contingent liabilities cannot be made. Examiners should
not refrain from criticizing weaknesses or faulty account administration due
to an inability to determine a dollar value of liability. These may include
situations where: (1) practices are in contravention of the governing
instrument, fiduciary principles, or common law precedents, or (2) the
dollar value of damages or potential court surcharges cannot be ascertained
because they will not occur until some unknown future date. An example of
such a situation would be the structuring of an investment portfolio in a
manner favoring current income beneficiaries over remainder men, thus
foregoing opportunities for capital appreciation by concentrating
investments in fixed income securities. Under these circumstances, the
examiner should fully discuss administrative and investment deficiencies,
warn management of the inherent risk of loss posed by such practices, and
recommend corrective action.
Examiners should be careful when
scheduling contingent liabilities arising from pending litigation against
the bank in its fiduciary capacity. All litigation should be discussed in
some manner in the Report of Examination. The assignment of contingent
liabilities with respect to litigation should be based upon: (1) fiduciary
management's candid assessment, including the opinion of legal counsel, of
the issues subject to the litigation, (2) a sound analysis of the facts and
circumstances, and (3) outstanding Division of Supervision Safety and
Soundness policies.
D. Material nonpublic information
D.1. General Overview and
Management Actions
Insider trading, while not defined by the
Federal securities laws, refers to the purchase or sale of securities while
in possession of material information that is not available to the general
public. Information is generally considered to be material when sufficient
to induce a person to either buy or sell a security based on that
information, e.g., the information is important to making an investment
decision with respect to that security.
Banks may come into possession of
material, nonpublic information in a number of ways:
through information developed as apart of normal
lending relationships with large commercial customers;
by a director or officer sitting on the
Board of Directors of an outside company;
through the financing of tender offers,
leveraged buy-outs, and management buyouts; or
when serving as advisor for private placements
and mergers and acquisitions.
In general, trust accounts maintained in
FDIC-supervised banks
do not invest in corporations for which the commercial
department has extended credit. The commercial department generally lends to local firms,
while most trust investments involve either large, national firms or smaller
firms that are located outside of the bank's trade area. However, it
is possible that a bank could lend to and invest in
the same company. This may occur should the bank originate or
participate in loans to a national company headquartered in, or with a
major facility in, the bank's trade area.
The prohibition against making investment
decisions based on material inside information also applies to investments
in small publicly traded companies. A bank insider may be aware of material
nonpublic information by operation of the first two factors above. Examiners
need to be aware of such instances.
Of particular concern is the availability
to bank insiders of material inside information concerning the condition of
and outlook for the bank itself, or the bank's parent company. It is
difficult for a bank insider to be unaware of material changes in his or her
own organization. Therefore, the investment in, and trading of, own-bank or
parent holding company stock or debt instruments is worthy of particular
scrutiny.
Financial institutions should adopt policies
and procedures, appropriate to its own circumstances, to prevent the flow of
material, nonpublic information from the commercial department to the trust department.
Policies and procedures should be established prohibiting the use of material, nonpublic
information, when deciding whether to buy or sell securities.
Appropriate procedures may include:
Denying trust personnel access to commercial credit
files;
Prohibiting trust personnel from attending internal
commercial loan meetings;
Prohibiting bank personnel from serving simultaneously
on a trust investment committee and a commercial lending committee; and
Physically separating trust department personnel from
commercial lending personnel.
D.2. Potential Consequences of Inappropriate Administration
The Insider Trading and Securities Fraud
Enforcement Act of 1988, which added Section 20A to the Securities Exchange
Act of 1934 [15 USC 78t-l], exposes a bank to substantial civil money
penalties if an employee is caught trading on insider information and the
"control person" has not taken adequate steps to prevent insider trading.
Criminal penalties for insider trading have also been substantially
increased, both in jail terms and monetary fines. Both the bank and the
individual supervising trading activity are also subject to civil penalties
should an employee be caught trading on insider information. As such, the
bank, in addition to having appropriate written policies and procedures,
should also be able to demonstrate that trading activities are adequately
supervised and monitored and that its employees have been apprised of the
penalties, both civil and criminal, for trading on material, nonpublic
information. Adherence to the letter and spirit of
Section 344.9 of the FDIC Rules and Regulations will aid the bank in
meeting its monitoring responsibilities.
SEC Section 240.14e-3 places similar
requirements on the purchase or sale of securities based on material,
nonpublic information with respect to tender offers. Refer to the FDIC
loose-leaf regulations service under the Miscellaneous Statutes and
Regulations tab for further guidance.
SEC Section 240.10b-5 relates to the
Employment of Manipulative and Deceptive Devices and provides that it is unlawful for any person to directly or indirectly use any
mechanism, make an untrue statement or omission, or engage in any act which
would be fraudulent in connection with the purchase or sale of any security.
This regulation can be applied to the use of material inside
information in making investment decisions for accounts. For instance, if
the bank acts on material inside information in making investment decisions,
then the actions could be considered manipulative and deceptive and
in contravention of SEC Rule 10b-5.
Notwithstanding that trading on material,
nonpublic information constitutes an illegal act subject to severe
civil and criminal penalties, it is important to keep in mind that
the bank, in exercising its discretionary investment authority, has
a fiduciary obligation to keep itself apprised of material public information
with respect to securities it buys and sells. Policies and procedures
should therefore be constructed in a manner to prevent unauthorized
individuals from having access to material, nonpublic information, but not
be designed in such a manner as to impede the flow of legitimate material
public information or restrict the institution's ability to meet the needs
of its customers by prohibiting all interaction between the trust department
and the commercial department.
E. Common Instances of Conflict of Interests and Self-Dealing
The most frequently encountered instances
of conflicts of interest and self-dealing (hereafter referred to as
conflicts) are discussed below. The coverage given is
not all-inclusive, but presents issues common to the vast majority of trust
institutions. If examiners encounter problems during the review of any
conflicts of interest they should be guided by the previous discussion of
Contingent Liabilities.
Examiners might encounter a possible
conflict situation considered to be an industry practice. Any such
situation should be viewed in light of all available information. However,
merely because it is an industry practice does not necessarily mean that a
fiduciary duty, law or regulation has not been violated. For example,
it was the practice of many banks in the 1960s to allocate brokerage
business based on demand deposit relationships; however, in 1969 the Justice
Department determined this practice to be in restraint of trade and
threatened to sue for injunctive relief unless the practice was
discontinued. It had been alleged that such banks often gave little or no
consideration to the strength and integrity of the broker, the ability to
execute orders efficiently, or the quality of research provided. Refer to
Asset Management Section, Broker Selection on Basis of Deposits for further discussion.
E.1. Fees Other than for Account Administration
With an increased emphasis on
profitability, many fiduciaries have sought and will continue to seek
additional sources of revenue. With this focus there is the potential that
the fiduciary may fail to act in the best interest of beneficiaries. The
fiduciary may be tempted to place its interests before those of the
beneficiaries, when it benefits from the investment of trust assets, hence
the conflict of interest.
One way to augment revenue is through
the receipt of fees beyond the customary trustee fee (fee for
account administration). The additional fee is often associated with a mutual
fund investment, but with changes in the industry it could occur in
other investments as well. Set forth below are some typical situations
currently being encountered regarding mutual funds. However, the examiner should
be alert to and explore any type of fees a bank receives other than the
usual and customary fee for the administration of an account. Such fee(s)
should be reviewed with the knowledge of all surrounding circumstances, considering
the fiduciary principles and any applicable laws and regulations.
E.1.a. Investment in Proprietary Mutual
Funds Receipt of additional fees beyond the
traditional trustee fee is often encountered when investing in proprietary
mutual funds. For example, the fiduciary or an
affiliate receives a fee for serving as investment advisor to a proprietary
fund. The receipt of this additional fee is not necessarily prohibited.
Some states have enacted legislation that
makes certain conflict activities such as this permissible. The laws often
govern whether both a trust account fee and a mutual fund investment
advisor fee can be charged. They also may identify certain customer
disclosure requirements and require the fee to be reasonable. Refer to
Appendix C for a
recap of state statutes authorizing fiduciary investment in proprietary
mutual funds.
In receiving this additional fee, a trustee
should do the following.
Ensure that all applicable legal and regulatory
requirements are met. If reasonableness is an element of the governing
law, the reasonableness of fees associated with the investment in a
proprietary mutual fund is a critical issue that a fiduciary should
resolve prior to using such funds as discretionary investment vehicles.
Determine that the investment is authorized by the
governing trust instrument, is appropriate for the purpose of the account
and/or the needs of the beneficiaries, and is prudent.
Guidance on investing in
proprietary mutual funds is found in
proprietary mutual funds. Additional conflicts regarding the use of
proprietary mutual funds are discussed in
Subsection 8.E.2.d.
E.1.b. Receipt of 12b-1 Fees
The receipt of 12b-1 fees from mutual
funds is not unusual. The existence of this fee is disclosed in a fund's
prospectus. The receipt of 12b-1 fees and how they affect ERISA and
non-ERISA accounts is discussed in the Asset Management section of the
Manual,
Section E, and the Employee Benefit section of the manual
Subsection 5.H.7.f(13). Also refer to Appendix D and the
Southeastern Growth Fund, Inc. request for a No-action letter, regarding
the rebating of 12b-1 fees.
Department of
Labor Advisory Opinion 2003-09A, dated June 25, 2003, indicated that a
trust company's receipt of 12b-1 fees from mutual funds, the investment
advisers of which are affiliates of the trust company, for services in
connection with investment by employee benefit plans in the mutual fund,
would not violate section 406(b)(1) and 406(b)(3) of ERISA when the decision
to invest in such funds is made by an employee benefit plan fiduciary or
participant who is independent of the trust company and its affiliates. The
opinion also allows for the use of proprietary funds of an affiliate, so long as
the trustee does not provide investment advice to the participants and the
participants are free to choose non-proprietary funds.
The receipt of 12b-1 fees are required to be disclosed in
the prospectus of all mutual funds. However, even if adequate disclosure is
given and no regulations are violated in connection with these fees, trust
departments must continually perform due diligence procedures to ensure
that all investments are chosen with the interest of the beneficiaries in
mind. Furthermore, trust departments must be aware of state laws regulating
securities.
One issue expected to receive the scrutiny of Congress
and the SEC is the charging of 12b-1 fees by mutual funds who have closed
their funds to new investors. Since the purposes of 12b-1 fees are to
promote and distribute the funds to new investors, the need to charge these
fees to existing investors is questioned
E.1.c. Receipt of Other Fees from Mutual
Funds
General Overview
There is the increasing potential for
fiduciaries to receive other fees from mutual funds beyond the traditional
12b-1 fee. These are often incentive based fees and may include payments
structured as reimbursement for services (e.g. sub accounting fees,
shareholder service fees, or shareholder administration fees) or payment for
the bulk transferring of business to another mutual fund provider.
A reimbursement for service
arrangement offers compensation in the form of fees to the fiduciary that invests
assets in a particular fund. Information on this type of fee is found in the mutual
fund's prospectus. The fee is structured as a payment reimbursing the
fiduciary for performing standard recordkeeping and accounting functions, on
behalf of the mutual fund, for the fiduciary accounts invested in the mutual
fund. Generally, there is a master or omnibus account (sub-transfer agent)
with the mutual fund's transfer agent and the sub-accounting is on the
bank's recordkeeping system. There is typically an electronic interface
between the omnibus account and the fiduciary's recordkeeping system for
individual client accounts. It may also cover ancillary services such as
responding directly to questions or requests from customers whose funds have
been invested in the mutual fund, forwarding shareholder communication, etc.
Regardless of the source of the fee,
the decision to pace a fiduciary asset in a particular investment should
be consistent with governing laws. Many states have modified laws to allow
such fees, but have placed certain restrictions requiring compliance
with standards of prudence, such as the quality of the investment and
its suitability for an account. State laws may also require that fees
be reasonable. State law, however, may not define what constitutes
a reasonable fee. Whether or not state law requires fees to be
reasonable or defines what is reasonable, management should consider
the reasonableness of the fees received. State law often provides a
good framework within which to evaluate the administration of this conflict
of interest. Other pertinent issues include the permissibility of such
fees under the governing document (the document may be silent) and whether
the investment is in the best interest of a particular trust
account. Documentation supporting all of these issues should be maintained by the
fiduciary.
Caution: There
is no uniform law requiring that such arrangements be disclosed to trust
customers, but disclosure is encouraged. State statues may require
disclosure and there are ERISA requirements to be considered. (See next
subsection) In some states, the disclosure requirement is met by providing
the client with a copy of the fund's prospectus, which includes a reference
to shareholder service fees. Some states also require annual disclosure of
the fee arrangement.
From a risk management perspective, it is
essential that the fiduciary conduct a thorough due diligence review prior
to receiving such fees from any mutual fund provider. The due diligence process should include the following: (These procedures
also are contained in
Board of Governors of the Federal Reserve System, Division of Banking
Supervision and Regulation SR99-7, "Supervisory Guidance Regarding the
Investment of Fiduciary Assets in Mutual Funds and Potential Conflicts of
Interest", March 26, 1999.)
- Reasoned Legal Opinion - Receipt of a
legal opinion or citations of law that address the legality of this form
of compensation. This includes Federal and State regulations. Examples of
issues to be addressed include permissibility of the investment and
compensation under applicable laws, trust agreement, or court order, as
well as any applicable disclosure requirements or reasonableness
standard for fees found in the governing law.
- Policies and Procedures - Policies
and procedures should be developed to specifically address the acceptance
of fees and other compensation from any mutual fund. Ideally, the policies
would address who has the authority to accept the fee and what type of
analysis and documentation are required to support the investment decision
when such fees are received. It should also address monitoring the receipt
of the fee to ensure compliance with governing law(s), and reporting
compliance with the established policies to the appropriate authority.
- Analysis and Documentation of Investment
Decisions - Minimum investment criteria should be established
to support the investment decision-making process. Refer to
Section 3.F.4 for discussion of the asset management aspects of
investing in mutual funds.
ERISA Accounts Receipt of any such fee for employee
benefit accounts subject to ERISA would appear to be a violation of
Sections 406(b)(1) and 406(b)(3). ERISA Section 406(b)(1) prohibits a
fiduciary from dealing with plan assets in its own interests or for its own
account. ERISA Section 406(b)(3) provides that a fiduciary with respect to a
plan shall not "receive any consideration for his own personal account from
any party dealing with such plan in connection with a transaction involving
the assets of the plan."
The Department of
Labor (DOL)
has not issued any definitive statement on the subject
of the retention of "sub-accounting fees" by fiduciaries.
Trust management should be
encouraged to obtain a favorable ruling from the DOL prior to accepting any such fees
for accounts subject to ERISA. DOL has, however, issued Advisory Opinions
(AO) 97-15A and
97-16A, respectively referred to as the "Frost" and "Aetna" opinions,
which provide useful guidance. These AO's are discussed in
detail in
Subsection H.7.f.(13). Mutual Funds, Receipt of 12b-1 Fees, located in
Section 5.
In
AO 97-15A, "Frost", the DOL took the position that a bank
with discretionary authority to invest in a mutual fund that pays the bank
a 12b-1 fee would appear to violate
ERISA Section 406(b)(1) because it involves a conflict of interest.
Even if a fiduciary does not administer or control investments in a plan,
but has authority to delete or substitute mutual funds, the fiduciary may
be able to cause 12b-1 fees to be paid to itself. In both situations,
however, DOL took the position that if the fees were used to offset the
plan's liability to the trustee (e.g., reduced the expense of
administering the plan and thus not retaining the fees), the fiduciary
would not violate
Sections 406(b)(1) or (b)(3).
In
AO 97-16A, "Aetna", the
DOL restated that the mere
receipt of a fee or other compensation from a mutual fund in connection
with a plan's investment would not in and of itself violate
Section 406(b)(1) or (b)(3) if a service provider did not advise or
otherwise exercise authority or control to cause a plan to invest in a
mutual fund. Service providers, however, retaining the authority to delete
or substitute the mutual funds made available to plan participants might
be deemed to exercise the necessary discretionary authority to cause the
payment of fees to themselves. Once again, he DOL took the position that
if the fees were used to offset the plan's liability to the trustee, the
fiduciary would not violate Sections 406(b)(1) and (b)(3).
It is important to note, however, that the
practice of receiving fees for "secondary" shareholder services from
proprietary mutual funds has not been determined by the DOL to violate any of the prohibitions of
DOL PTE 77-4. "Secondary" shareholder services could include transfer
agent, custodial, administrative, and accounting services provided to the
mutual fund for which the plan fiduciary also serves as an investment
advisor.
In those cases where an institution, as a
plan fiduciary, improperly accepts mutual fund servicing fees, examiners
should recommend that the fees either be returned to the individual accounts
invested in the mutual funds providing the fees or that the servicing fees
be used to offset plan expenses.
E.2. Securities-Related Activities
There is the potential that conflicts that
are not readily evident may occur with various securities-related
transactions. Included in this section are some of the more common
situations that may be encountered. For each, there are unique reasons to
consider it a conflict, but the underlying concept is that the bank receives
a benefit from the transaction and the benefit is usually in a form other
than cash/fees.
E.2.a Soft Dollars The term soft dollars refers to
an arrangement in which a discretionary money manager (for example,
a trust department or investment advisor) receives, in addition to
transaction execution, investment research services from a broker/dealer in exchange
for the brokerage commissions from executing transactions for
discretionary client accounts. Hence, the money manager receives investment research
that is purchased with the funds of discretionary client accounts, i.e.
those accounts which actually pay the broke/dealer's commission. Hard dollars, on
the other hand, involve the money manager purchasing investment research
services with its own funds. In a soft dollar arrangement, the money
manager is said to be paying up, i.e. paying more than the actual cost of
executing a transaction.
Soft dollar arrangements present a conflict
of interest since the money manager personally benefits from transactions
involving trust assets. The purchase of investment research services with
the commission dollars of a beneficiary or client, even if used for the
benefit of the beneficiary or client, could be viewed as also benefiting the
money manager in that the money manager is relieved of the obligation to
produce the research himself or to purchase it with hard dollars. This is
not to imply, however, that soft dollar arrangements are necessarily
improper, since broker/dealers often provide an important service in
producing and distributing investment research. Congress acknowledged as
much when it added Section 28(e) to the Securities and Exchange Act of 1934,
which permits money managers to consider the provision of investment
research, as well as trade execution services, in evaluating the cost of
brokerage services without violating their fiduciary responsibilities.
Section 28(e) provides a safe harbor that permits, in certain circumstances,
money managers to use commissions paid by discretionary accounts to acquire
investment research as well as trade execution services. Excluded from the
safe harbor provisions are transactions in futures or transactions done on a
principal basis.
The acquisition of investment research services
paid for by the commission paid by non-discretionary accounts, i.e.
non-managed accounts, is not protected by Section 28(e).
Non-discretionary accounts do not benefit from the investment research
provided by the broker/dealer. The purchase of investment research services
with the commissions paid by non-discretionary accounts should be explicitly
permitted in the written agreement governing these accounts and disclosed to
all interested parties.
A fiduciary exercising investment discretion
is under the general duty to obtain best
execution, which generally includes considerations such as the
most favorable price for the securities, the lowest commission, the prompt
and accurate execution of orders, the prompt and accurate confirmation
of orders, and the prompt and accurate delivery of securities or
proceeds. Prior to1975, when brokerage commissions were fixed and nonnegotiable this
was not an issue. Since the advent of fully negotiable brokerage commissions
on May 1, 1975, a fiduciary exercising discretion has been legitimately
able to pay more than the lowest available brokerage commission if it also
receives research services. As noted above, this limited safe harbor
protection is provided by Section 28(e)(1) of the Securities Exchange Act of
1934.
The identification of
soft dollars compensation is difficult. While brokerage commissions are generally
readily identifiable, problems have arisen when non-research items have been
claimed to represent research. The SEC has issued an interpretative
release focusing on whether the product or service provides lawful and
appropriate assistance to the money manager's investment decision making. If
the service provided has a "mixed use" - meaning research and non
research components (such as computer hardware) - the money
manager should make a reasonable allocation of the cost according to its
use. The portion of the service used in the investment decision-making
process can be paid with commission dollars, while those services that
provide administrative or other non-research assistance should be paid with
hard dollars. Refer to Appendix D -
Securities Exchange Act of 1934 Release No. 34-23170 Section 28(e) and Soft
Dollars.
Potential conflicts of interest related to
use of soft dollars include:
-
Investment advisers may choose
broker-dealers based on a business-related association. Additionally, the
choices may be made solely on the basis of soft dollar products and
services, to the exclusion of execution quality. The resulting trades
could have both higher commissions and lower quality trade execution.
-
Soft dollar arrangements could encourage
increased transaction orders to pay for more soft dollar products and
services. These arrangements might cause advisers to "over-consume"
research because of the indirect nature of the transaction.
-
Fiduciaries might be tempted to purchase
products and services with only marginal research applications, such as
periodical subscriptions, computer terminals or communication services,
such as telephone, fax, etc.
-
The lack of adequate controls could
allow mixed uses for soft dollars, including products and services not
used for research and not protected by safe harbor provisions of the
Securities and Exchange Act of 1934. When different types of products are
bundled together, management must be aware of any tendency to over-pay for
the research portion of the bundled services, in order to pay with
commission dollars.
-
Products and services purchased with
soft dollars are often bundled together in such a way that a manager does
not know what he/she is paying for each service.
Before an institution begins to receive
soft dollar benefits, policies and procedures governing the proper use and
monitoring of soft dollars transactions should be in place. Management
must be able to demonstrate that soft dollar benefits constitute bona fide
investment research. In complex operations, this may be done with a budget
that identifies the soft dollar benefits to be received and how they will
be used. General guidelines for the use of soft dollars include:
A fiduciary may retain
soft dollar services and materials from a broker (or other source)
for investment transactions generated by discretionary accounts, if the soft
dollar payments are (1) not prohibited by the governing account instrument
and (2) comply with the SEC's safe harbor requirements.
A fiduciary may not retain soft
dollar payments from a broker (or other source) for investment
transactions generated by nondiscretionary accounts, since a
nondiscretionary account cannot justify paying higher brokerage
commissions to receive investment research which would not benefit the
account. Nondiscretionary accounts may, however, agree to soft dollar
transactions if specifically permitted in the instrument, or by the
grantor, or, after full disclosure, by all account beneficiaries.
A fiduciary must disclose specific types of
products, research, or services obtained with soft dollars so that
customers understand what is obtained with the commissions.
This is required whether or not the product is subject to the safe
harbor provisions of Section 28(e).
There are also specific requirements for
different types of fiduciary accounts. Refer to
Subsection 5.H.7.f.(19). for employee benefit
accounts subject to ERISA. Also refer to the
SEC's Release No. 3423170 in Appendix D for additional information on soft
dollar arrangements.
E.2.b. Use of Own-Bank or Affiliated Brokerage Service
A conflict of interest arises when a
fiduciary uses its own or an affiliate brokerage service to execute the
trust department's securities transactions. It may also arise if a discount
broker located in the commercial department is used (typically the
third-party provider of non-deposit products). The problem is not
the payment of commissions, provided they meet the concept of best
execution and follow the concepts outlined in
Section 3. The problem concerns other fee sharing arrangements, such as
splitting of commissions or the payment of rent based upon the volume of
transactions.
FDIC General Counsel's Opinion No. 6, states,
in part, "If the bank intends to utilize the contractual arrangement with
the broker/dealer for transactions executed in connection with trust
department accounts, the bank should not receive any additional compensation
from the broker/dealer with regard to those transactions, i.e., the bank
trust department should not share in any commission associated with the
transaction. To do so would raise possibilities of a breach of fiduciary
obligation toward the bank's trust account customers." Several FDIC Advisory
Opinions address some limited situations in which it might be proper to
share in such commissions. However, in background discussions, those
opinions generally stress that best execution objections can be raised when
only one broker is used, and the bank may be open to a charge of churning,
if it has discretion and the commission-splitting arrangement is dependent
upon the volume of trades. See FDIC Advisory Opinions 83-14, 83-15, 83-17,
83-18, 84-10, and 85-10 for further guidance.
Since the bank may profit indirectly
through paying brokerage fees to an affiliate, the use of an affiliated
brokerage service raises many of the same issues discussed in
Subsection 8.E.1 - Fees Other than for the Administration of an Account.
Also, the use of an affiliated brokerage service would appear to constitute
a prohibited transaction under
Section 406(b) of ERISA. While there is an apparent exception allowing
reasonable transaction fees, the Department of Labor, in practice, has
approved this exception only under very narrow conditions. Refer to the
discussion in
Subsection 5.H.7.f.(1) and
Prohibited Transaction Class Exemption (PTE) 86-128.
The use of an own-bank or affiliated municipal
brokerage department raises additional issues. It is a conflict for
the fiduciary to direct discretionary transactions to an own-bank or
affiliated municipal securities broker. This is particularly the
case, when securities are purchased from the dealer's inventory
(securities in which the dealer has taken a market position). When
securities are purchased from the dealer's inventory, rather than on
the open market, the possibility exists that the securities are
being sold at above market prices, or that securities which cannot
otherwise be sold profitably on the open market are being sold to
the trust department. The purchase of any security at an above
market price is an abusive self-dealing practice. Arrangements
should be made for the reimbursement of any losses suffered by
accounts that purchased any security at an above market price.
Realized losses and depreciation should be extended as Contingent
Liabilities. Refer also to the discussion of underwritten securities
later in this section.
Appropriate policies and procedures should be
in place prior to entering into a brokerage service arrangement, regardless of whether the
bank's brokerage services, an affiliated brokerage firm or a discount broker
providing nondeposit products will be used. Other considerations include:
Whether brokerage services must be performed on a
nonprofit basis, requiring documentation of transaction costs;
Whether
best execution is being obtained; and
Whether accounts are protected from potential
churning.
In view of these and other fiduciary and
legal requirements, the bank should be able to conclusively demonstrate,
preferably through the opinion of competent legal counsel that any such use
conforms to all applicable laws and regulations and that no fiduciary duty
has otherwise been violated.
E.2.c. Securities Trading Practices
Problems arise when an employee puts his/her
interests ahead of the interests of the beneficiaries in executing trades.
A classic example is front
running, which is an illegal practice whereby an individual knows that
a block trade will influence the price of the security; the individual
places his trade to profit from the effects of the block trade.
Policies or procedures should prohibit such transactions. Furthermore,
policies and procedures should prevent employees from trading under the auspices of the bank, e.g., the employee
should not be allowed to use the trust department's accounts with brokerage
firms to effect personal trades.
Another potential conflict arises when trading errors
result in a potential profit or loss to the beneficiary of a trust or
participant in a defined-contribution retirement plan such as a 401(k).
Given that a fiduciary must put the beneficiary's interests first, losses
resulting in trading errors must be absorbed by the bank, and any profits
must flow through to the account or beneficiaries thereof.
Part 406(b)of ERISA prohibits a fiduciary from dealing with the assets
of the plan in his own interest or for his own account; consequently, any
gains acquired by a fiduciary resulting from trading errors would result in
an apparent error of the regulation.
Market Timing Trading in Mutual Funds
Market timing is the frequent purchase and redemption of mutual fund
shares, exchange-traded funds (EFTs), or variable annuity or life contract,
in an attempt to take advantage of a lag between a change in value of a fund
or contract, and the reflection of that change in the fund or contract's
share price. For example, time zone arbitrage is the buying of
mutual funds that own securities in a foreign market at the previous day's
net asset value, knowing that subsequent events occurred since that market
closed will likely assure a profit. This practice may
dilute the value of shares held by long-term shareholders; interfere with
the management of the portfolio; and increase brokerage and administrative
costs.
Management of defined-contribution plans such as 401(k)s
must be aware of market timing trades by plan participants. An
indication of such trading may be frequent trades. By
allowing a few participants to benefit by taking temporary profits,
participants interested in long-term gains may be armed.
An illegal form of market timing trading is late
trading, which allows individuals to purchase mutual fund shares
after 4:00 p.m. Eastern Time at the net asset value (NAV) for that day,
when regulations require those shares to be priced at the NAV of the next
day's close. Traders profit by trading on positive or
negative after-hours news of major holdings of the mutual funds.
To address these and other concerns, the SEC issued the final rule
for Disclosures Regarding Market Timing and Selective Disclosures of
Portfolio Holdings. The effective date of the rule is May 28, 2004, with
implementation on or after December 5, 2004. The rule requires mutual funds, EFTs, and variable annuity or life contracts to describe their policies and
procedures for deterring frequent purchases and redemptions of the shares.
The rule also allows a fund to reserve the right to reject a purchase or
exchange request for any reason, as long as the fund discloses this ability
in the prospectus. The fund disclosure must state whether the
restrictions on frequent purchases and redemptions will be uniformly applied
to trades occurring in omnibus accounts at intermediaries, such as
investment advisers, broker dealers, transfer agents, third party
administrators, and insurance companies. In disclosing the entities making
frequent purchases and redemptions, mutual funds will be required to
identify the group rather than the individual group member for 401(k) plans;
this will be disclosed in the Statement of Additional Information (SAI),
rather than in the prospectus.
The rule requires mutual funds and managed separate accounts that
offer variable annuities, other than money market funds, to explain their use
of fair value pricing. The rule states that funds are to use fair value
pricing any time that market quotations for their portfolio securities are not
readily available, including when they are unreliable. For domestic large
cap funds, fair value pricing will be used under very limited circumstances,
such as when the stock exchange closes early or trading is halted in a
specific security. Conversely, for mutual funds that have securities which
are traded overseas, then the use will be more common. Disclosures for
either circumstance will be included in the prospectus.
For fund of funds, the SEC requires the disclosure to refer the investor
to the underlying fund prospectuses.
Banks should have policies and procedures which address
trading in mutual fund shares. Management must review and understand mutual
fund prospectuses to determine what practices related to trading are
allowed. Furthermore, for employee benefit accounts, managers should have
programs to detect and prevent plan participants from engaging in market
timing trading. The management of bank-sponsored proprietary mutual funds
must prohibit any practice that could prove detrimental to the shareholders.
E.2.d. Proprietary Pooled
Investment Vehicles
Conflicts involving the use of proprietary investment
products are frequently tied to the generation of additional fee income.
When a bank, as fiduciary, invests fiduciary assets in proprietary products,
a key consideration is whether the bank is acting in the best interest of
the beneficiary or in its own interest. A common example is the continued
use of a poor-performing proprietary investment product in order to maintain
a critical mass of assets under management. In doing so, the fiduciary
benefits from economies of scale and earns additional fee income at the
expense of the beneficiary, who sacrifices the potentially higher return
that could be obtained from investing in better performing mutual funds.
This is a particularly sensitive situation if trust accounts own a majority
of the shares of a proprietary mutual fund.
Important
guidance regarding investment in proprietary mutual funds is found in Asset
Management,
Section 3, and in the Employee Benefit section,
Subsection H.7.f.(11).
Subsection 7.F.12 - Section 9.18(b)(8) Self-Dealing and Conflicts of
Interest,
Subsection 7.K - Proprietary Mutual Funds, and
Subsection 7.L - Conversion of Collective Investment Funds to Mutual Funds discuss potential conflicts of
interest regarding duties of loyalty and prudent investment
management. Special coverage of this topic may also be found in
state law.
E.2.e. Use of Only One Fund Family
Fiduciaries sometimes offer only one
family of funds as its mutual fund investment option. Management may feel
that it is easier to obtain reliable information and that they receive
specialized attention due to the volume of the department's aggregate
investment. This rationale is used in addition to the fee incentives
previously discussed. Management may feel that these benefits compensate for
the continued inclusion of a poor-performing fund as an investment option.
However, the benefits of the use of only one fund family does not justify
holding a poorly performing investment; and may represent a conflict of
interest if the department is placing its interest, i.e. easing the
administration of an account, ahead of the interest of the beneficiaries. To
the appearance of such conflicts, management should ensure that all
investments meet the trust department's approved investment criteria. Refer
to
Section 3 - Mutual funds, for a discussion of the investment selection
process.
E.2.f.
Research Analyst Affiliate Relationships
Potential conflicts of interest arise in a trust
department affiliated with an investment company that conducts securities
research. The conflicts occur when research analysts work for firms that
have investment banking or other business relationships with issuers of the
recommended securities, or when the analyst or firm owns securities of the
recommended issuer. The recommendations must not be influenced by the
relationships that affiliates have with the company being analyzed,
including relationships related to investment banking and trust activities.
In 2002, the SEC approved rule changes made by the New York Stock Exchange (NYSE) and
the National Association of Securities Dealers (NASD) which are
designed to improve the objectivity of investment research provided by
research analysts. Provisions in these rule changes include:
-
Research analysts
may not be subject to the supervision or control of the firm's investment
banking department.
-
Disclosures are
required of any investment banking relationship with any company that was
subject to an investment report.
-
Research analysts employed by members of the
NYSE or NASD may not receive compensation based on specific
banking services transactions.
-
The manager or co-manager of a
subject company's offering may not publish research about the issuer for
40 days following an initial public offering and 10 days following a
secondary offering.
-
Member firms must disclose in
research reports whether the firm or its affiliates, including banks and
trust departments, own 1 percent or more of the common equity
securities of the company being analyzed.
-
Research analysts have
prohibitions on purchasing or receiving pre-IPO shares, trading in
recommended securities 30 days prior and 5 days after issuance of a
report, and trading contrary to the analyst's own recommendations.
While these regulations only apply to registered
investment advisors, the above rules provide guidelines for the conduct of
research analyst affiliates. Please refer to
NASD Rule 2711, Amendment to Research Analysts and Reports.
E.2.g. Proxy Voting
As discussed in Chapter 3, Asset Management, trust department management
should establish policies regarding casting proxy votes for shares of stock
held in a discretionary capacity. The purpose of these policies is to ensure
proxies are voted in the best interest of the clients, and that all
conflicts of interest are disclosed. An example of a conflict of interest is
when a Trust Department votes on proxies for shares of stock of a
corporation that it holds in discretionary accounts, and at the same time
performs investment banking or other services for this corporation.
In 2003, the SEC adopted
new rule 206(4)-6 [17 CFR 275.206(4)-6] and amended rule 204-2 [17 CFR
275.204-2 [17CFR 275.204-2] under the Investment Advisers Act of 1940
relating to proxy voting. These rues and rule amendments require advisors
registered with the SEC to adopt policies and procedures to ensure that the
adviser votes proxies in the best interest of clients, to disclose to
clients information about those policies and procedures, to disclose to
clients how they may obtain information on how the adviser has voted their
proxies, and to provide clients with information about how their proxies are
voted. Furthermore, the rules require advisers to maintain certain records
relating to proxy voting.
Violations of the proxy voting regulations in the Investment Advisers Act
of 1940 can result in substantial civil penalties. For example, on August
19, 2003, the SEC imposed a civil money penalty of $750,000 on Deutsche
Asset Management, Inc., the investment advisory unit of Deutsche Bank AG,
for failing to disclose a material conflict of interest in its voting of
client proxies for the 2002 merger between Hewlett-Packard Company (HP) and
Compaq Computer Corporation.
E.2.h.
Trading During Blackout Periods
The term
blackout period refers to an interval of time of more than 3
consecutive business days during which employees may not adjust the
investments in their employee benefit pension plans, e.g. 401(k) plans.
These blackout periods occur most frequently when the plan is undergoing
certain changes, such as modification of investment options or replacement of
plan record keepers. During a blackout period, the participants cannot make
changes to the investments. The fiduciaries have effectively taken control
away from the participants resulting in potential conflicts of interest;
fiduciaries may be held liable if something goes wrong.
One of the most newsworthy conflicts of interest that
caused substantial injury to beneficiaries occurred in 2001 at Enron
Corporation. During a blackout period in which the pension plan trustee was
changed, employees were not allowed to sell their Enron stock held in their
401(k) plans, and the stock lost much of its value. Corporate insiders, who
had information regarding the deteriorating condition of the company, were
able to sell their stock outside of the plan at much higher prices than employees
who were required to wait until the blackout period ended.
In the wake of the Enron scandal, Congress passed the
accounting reform bill known as the Sarbanes-Oxley Act of 2002
(Sarbanes-Oxley). Section 306(a) of the Act makes it "unlawful for any
director or executive officer of an issuer of any equity security (other
than an exempted security), directly or indirectly to sell, or otherwise
acquire or transfer any equity security of the issuer (other than an
exempted security) during any blackout period with respect to such equity
security if such director or officer acquires such equity security in
connection with his or her service or employment as a director or executive
officer."
Section 306(b) of Sarbanes-Oxley requires a thirty-day
advance notice of any blackout period. The notice must be written in a
manner calculated to be understood by the average plan participant and
include the following:
- The reasons for the blackout period,
- An explanation of the investments and other rights
affected;
- A statement informing the participants and
beneficiaries that they should evaluate their investment selections in
light of their inability to direct or diversify their investment choices
during the blackout period.
- The name, address and telephone number of the plan
administrator or other person responsible for answering questions about
the blackout period.
- Such other matters the Department of Labor may
require by regulation.
Sarbanes-Oxley provides three exceptions to the
30-days' advance notice requirement:
- The first exception applies when a
fiduciary, acting with care, skill, prudence and diligence, determines
that deferral of a blackout period would undermine the plan's exclusive
purpose of providing benefits to participants and their beneficiaries and
of defraying reasonable expenses of administering the plan.
- A second exception applies when the
inability to provide the notice timely is caused by unforeseeable events
or events out of the control of the plan administrator.
- A final exception applies if the blackout
occurs in connection with a merger, acquisition, divestiture, or similar
transaction involving the plan where individuals either become or cease to
be plan participants.
Fiduciaries must document
all exceptions to the 30-days' advance notice requirement.
Please refer for more information to Section 306 of Sarbanes-Oxley.
E.2.i. Advertising Investment Performance
Trust
Departments that publicize the investment performance of their discretionary
accounts must ensure the advertisements do not contain misleading,
inaccurate, or exaggerated claims. Even factually correct statements may
be inappropriate, if these statements lead clients or potential customers to
believe extraordinarily strong performance achieved in the past can be
expected in the future. Types of misleading advertisements include:
-
Publicizing superior returns achieved over a period of time, implying that
investors can be reasonably assured that these returns can be expected in
the future.
-
Identifying selective stocks that have performed well, without identifying
all the stocks in the portfolio being managed or when these stocks were
purchased.
-
Comparing stocks to a dissimilar index. For example, a portfolio may
contain numerous high-tech or small cap stocks and the advertisements will
compare results to an index of large cap stocks, such as the S & P 500.
-
Advertising performance without identifying the risks involved. All ads
promoting investment performance should indicate that future
recommendations may not be profitable or equal past performance.
SEC Rule 206(4)-1 under the Investment Advisors Act of 1940
prohibits the distribution of several types of advertising
considered fraudulent or misleading. Additionally, the SEC Rule 482 under
the Securities Act of 1933 and Rule 34b-1 under the Investment Company Act
of 1940 require disclosures when mutual fund performance is presented in
sales material. While these rules only apply to Registered Investment
Advisors, these rules can be used as guidelines in developing policies and
procedures designed to preclude misleading advertising. Furthermore,
management must be careful not to portray itself as an investment advisor.
E.3.
Use of Own-Bank or Affiliate Bank Deposits
E.3.a. General Overview When a fiduciary allows investments in proprietary
investment products, there is an inherent conflict between the best
interests of the account beneficiary and the interest of the fiduciary. Investments in own-bank and affiliate-bank deposits (hereafter referred to
as own-bank deposits) provide a benefit to the commercial department, by generating revenue from fiduciary deposits. For example, the commercial
department may purchase a short-term
investment, such as selling Federal funds, or a medium-term investment, such
as a loan or a security. The choice depends upon the aggregate size and
maturity of fiduciary deposits. Own-bank deposits may be used on a deposit
by deposit basis or on a pooled basis, such as in sweep or master deposit
accounts. Refer to the
master deposit account discussion in Section 7.
Investment in own-bank deposits is a common practice,
legally permitted by almost all states. Many governing agreements include
standardized language allowing the fiduciary to invest in own-bank deposits.
The language may be narrow and reference only time deposits, or very broad
and allow any type of deposit. Fiduciaries often claim that a low risk
tolerance and the relative safety of principal are valid considerations when
choosing federally insured deposits as trust investments. There are,
however, many alternative investment options that provide current income
with comparable safety. Therefore, investment decisions based purely on
these factors should be evaluated critically.
If management uses own-bank deposits as an investment
option for the trust accounts it administers, basic guidelines and
monitoring procedures should be established. These include appropriate
policies, the monitoring of historical trends, and documentation that
management has satisfactorily resolved the inherent conflict of interest
posed by such investments. Written policies should address the use of
own-bank demand and interest-bearing deposits. Documentation should include
a review of alternative investment vehicles, the competitiveness of the
interest rates paid o own-bank deposits, and appropriate approvals for such
investments. Management should document that the bank has acted in the
best interests of the account beneficiaries.
There are no specific guidelines addressing the propriety
of various deposit terms, such as the maturity of the deposit, the rate of
interest, the dollar size of own-bank deposits, or the percentage of total
account assets invested in own-bank deposits. Therefore, examiners must
determine whether the deposit(s):
-
Are permitted under local and
Federal law;
-
Are permitted under the
governing instrument;
-
Met the objectives and needs of
the account at the time of the investment;
-
Provide the best investment
alternative, considering alternate investment options available;
and
-
Provide a documented
competitive rate of return.
E.3.b. ERISA, Deposit Insurance, and Pledging In assessing such conflicts, there are issues to be
considered beyond the broad concepts of permissibility under state statue
and the governing agreement. Such issues include ERISA prohibitions,
Federal deposit insurance, and pledging requirements. Management should have
knowledge of and appropriate policies for each of these areas.
1. ERISA Considerations
Section 408(b)(4) provides an exemption from the prohibited
transactions provisions of Section 406(a) that would otherwise prohibit
the investment of plan assets in the deposits of a bank that is also a
fiduciary to a plan. Therefore, both own-bank pension plans and the
pension plans of other institutions may invest in such deposits provided
that "(A) the plan covers only employees of such bank or other institution
and employees of affiliates of such bank or other institution, or (B) such
investment is expressly authorized by a provision of the plan or by a
fiduciary (other than such bank or institution or affiliate thereof) who
is expressly empowered b the plan to so instruct the trustee with respect
to such investment." Refer to Section 5,
Subsection H.9 for additional discussion.
Therefore, investing employee benefit funds in own-bank
interest-bearing deposits is a conflict that is not prohibited, but must
be carefully managed to ensure that the interests of beneficiaries are
protected. Even if authorized by the governing instrument and/or permitted
by statute, such transactions must be made in good faith, e.g., permissive
authority does not relieve the fiduciary of its duty of care and skill in
the investment selection process. This requires interest rates to be
competitive, and the fiduciary o have considered alternative investments
and determined that the investment are both prudent and proper in light of
the investment options available.
2. Deposit Insurance
Another consideration is the overall volume of
discretionary investments in own-bank deposits held by an account.
Generally, the amount of own-bank deposits held by an individual account
(non-municipal account) should not exceed Federal deposit insurance
coverage, unless the excess is adequately secured by other means.
Section 24 of the FDI Act prohibits the pledging of bank assets to secure
investments in non-public deposits, unless specifically approved via a
Part 362 application.
In general, deposit insurance of fiduciary and other
trust department accounts operates on a pass-through basis, with coverage
provided to each beneficiary of each account. In most employee benefit
accounts, deposit insurance is provided to the plan participant. It
should, therefore, be uncommon for uninsured deposits to exist as long as
each beneficiary's interest in fiduciary deposits does not exceed
$100,000. The fiduciary institution must, however, adhere to certain
requirements and there are some exceptions to the general rules. See
Section 10 - Deposit Insurance of Trust Funds of the manual for
further discussion.
3. Pledging Requirements
The pledging of bank assets to
secure private deposits, generally for amounts not covered by FDIC
insurance, is not a permissible activity for national banks, except for
funds awaiting investment or distribution. In order for a state nonmember bank to pledge assets
to secure private deposits, the bank must file an application for approval
under Part 362 of the FDIC's Rules and Regulations.
E.3.c. Suitability of Own-Bank Deposits
In establishing policies and procedures, management
considers if the pattern of use of own-bank deposits exposes the institution
to claims that the deposits in general were not made in good faith or were
not chosen with the requisite care and skill. This is especially important
if fiduciary funds are swept daily to a own-bank interest bearing deposit
account. For individual accounts, the policies and procedures should focus
on the amount of own-bank time deposits, non-interest bearing demand
deposits, the reasonableness of the interest rate received and whether
these deposits are allowed by the governing instrument and state law..
1. Maturity and Size/Volume
To demonstrate that management is effectively
monitoring this activity, policy and procedures should set parameters to
guide the length of time own-bank deposits may be used and the level
invested, such as a dollar amount or percentage of account assets. These
parameters may be
general in nature, but should include all own-bank deposit products used.
There should be a method to report and monitor exceptions, with the level
of detail depending upon the extent of use. For example, if an own-bank
deposit product is used for daily sweeps, monitoring would be more
extensive than for the infrequent use of time deposits. The monitoring of
sweep activity should be on the same basis as the monitoring of similar
investments with a third party.
Unless authorized by the governing instrument,
court order or local law, trust funds should not be
permanently invested in own-bank deposits. In general, discretionary funds that
are awaiting investment or distribution should not be invested in
own-bank time deposits. The short-term nature of deposits does not relieve
fiduciary institutions from their duty of loyalty, or the principles of care and
skill when making investment decisions.
2. Uninvested Funds, Demand Deposits
Management must establish a
formal system of monitoring uninvested funds. The combined income
and principal cash of all the department's accounts are generally
deposited into one account. The key consideration is not the aggregate
amount on deposit, but rather, the reasonableness of the uninvested
balances of the individual accounts, considering both the individual
account's liquidity requirements and the fiduciary's duty to make trust
property productive.
To properly manage the conflict inherent in own-bank
demand deposits, the amount held in demand balances of each account should
be restricted to the minimum necessary. There have been a number of
lawsuits in the past based on the fiduciary's management of demand
deposits and its concurrent use of the funds for lending and investments,
together with the benefit gained on the float of demand deposits. For
employee benefit accounts subject to ERISA, of particular note is the
Labor Department's position regarding Float Management; refer to
Section 5, Subsection H.7.f.(3) and
Advisory Opinion 93-24A.
3. Reasonableness of Interest Rates Paid
After taking into consideration the amount, term and
type of deposit, management should be able to demonstrate that own-bank
deposits pay a competitive rate of interest. In assessing the
reasonableness of the interest rates offered on own-bank deposits,
management should not rely solely on comparisons with interest rates
offered by local depository institutions. Management should endeavor to
obtain the highest prudent rate of return possible. Generally,
national money market rates, as well as the interest rates offered by
depository institutions nationwide, should be considered as a comparative
benchmark when making such investment decisions. This is especially
important when management uses own-bank deposits as a cash sweep vehicle.
The decision to use own-bank interest-bearing deposits
should take into consideration the term of the deposit and the
competitiveness of the interest rate paid. Each decision to invest in
own-bank deposits must be properly supported and documented in the bank's
records. Management must demonstrate that a valid basis existed for the
use of own-bank or affiliated bank deposits.
E.4. Investment in Own-Bank or Affiliate Company Securities
Section 23A and 23B of
the Federal Reserve Act are made applicable to the activities of insured
state nonmember banks by Section 18(j) of the FDI Act. These statutes are
primarily directed toward the prevention of abusive relationships between
banks and their affiliates in the area of commercial banking. These
sections do, however, have applicability to several types of fiduciary
activities.
Careful review of the
definition of "affiliate" in each section, and the differences in the
definition between the two sections, is necessary when reviewing trust
related transactions. Section 23B specifically excludes banks from
its definition of affiliates. The term "bank" is defined in both
sections 23A and 23B to include trust companies. Thus, bank-to-bank
transactions and bank-to-trust company transactions are outside the scope of
Section 23B. Examiners should be alert to the applicability of these
statutes in all types of transactions with affiliates.
Fiduciaries are required to take an active shareholder
role with respect to the companies whose securities it holds in a
discretionary capacity. By exercising their shareholder right to vote in an
informed and responsible manner they are afforded the opportunity to
influence the management of those firms. Fiduciaries cannot readily claim a
passive investor defense for not actively performing their role as
shareholder. Doing so would evidence both imprudence and negligence as a
fiduciary. Based upon the foregoing discussion, a fiduciary is required to
vote own-bank stock held in a discretionary capacity, which places the
fiduciary in a position of divided loyalty - it must place the interests of
the account beneficiaries ahead of its own interest (which may not be the
same), thus presenting a conflict of interest.
The voting of own-bank stock is further complicated when
the fiduciary possesses, but is prevented from using, inside information
(refer to Material Nonpublic Information). The
fiduciary's ability to vote own-institution securities may also be
influenced or restricted by local law or Federal law (e.g., ERISA, and Title
12 USC Section 61 with respect to National Banks).
In order to avoid the appearance of divided loyalty, many
management teams have made a decision not to invest discretionary fiduciary
funds in own-bank or affiliated company securities. However, many have not
taken this same strong stance on securities that are received in-kind.
There are a number of actions that management may take to
manage such conflicts of interest. The measures center primarily on the
investment decision making and voting processes.
Investment Decision
- Management should fully document its rationale for retaining own-bank
stock or obligations. For example, did management made the decision to
purchase the shares or were the shares received in-kind. If shares are
received in-kind, management should use diligence in selling such assets
at an early date, unless the trust instrument, court order, or local law
authorizes their retention. Typically, the retention of such securities is
directed by the governing instrument or specific authority to retain such
investments is obtained from all interested parties. Since state laws vary
considerably with respect to the retention of own-institution stock
received in-kind, it is important that the examiner be aware of the
applicable state law.
Voting Responsibility - When co-fiduciaries or
others hold specific legal authority to exercise voting rights over such
securities, management should permit such individuals or entities to vote
the securities. When no other individuals or entities hold such authority,
trust management should vote the securities exclusively in the best
interests of the account beneficiaries, and document the rationale for how
it voted the shares. Failure to exercise voting rights or continued voting
with management (without exception or reason) can be viewed as a breach
of trust. The reasons supporting a decision not to vote fiduciary shares
should be fully documented. In order to ensure that shares are being
voted independently, several trust departments have contracted with
independent third parties to review all proxies and vote them in the best
interest of the beneficiaries.
E.5. Sale or Purchase of Trust Assets to or From the Bank, Bank
Insiders, Agents, or Affiliates The sale or purchase of assets
between an account and the bank, bank insiders, agents, or
affiliates is an inherent conflict of interest. Inevitably,
management is confronted with the dilemma of serving two
diametrically opposed interests, one interest seeking the highest
sales price and the other seeking the lowest sales price. Such
transactions pose serious risk to both the account and the
fiduciary, and should be scrutinized as to permissibility and
fairness. The fiduciary, as arbiter and beneficiary of these
transactions, may also be compelled to stand behind them as
guarantor. Below are examples of such transactions, with suggested
risk management procedures.
Own-bank or affiliate repurchase agreements - Refer to
Section 3 for a discussion of this activity.
Management purchasing own-bank, parent or affiliate
stock held in an account. Such transactions may, or may not, be permitted
under local law and the governing instrument. If permitted, the
transactions should always be effected through non-affiliated third party
brokers. Such transactions should always be covered by adequate written
policies and documented as to the legal authority to engage in the
transaction. Written approvals should also be obtained from all interested
parties. Caution: this option is not always available, as interested
parties may include the unborn, minors or others lacking the legal
capacity to approve transactions, or beneficiaries who cannot be
identified at the time of the transaction.
Sale of assets to an account. This type of transaction
must always receive careful evaluation by trust management. In addition to
permissibility and fairness considerations, management must document the
necessity for purchasing assets from itself or insiders when, as
investment manager, it has numerous investment alternatives. When the
legal authority to engage in the transaction is absent, and/or
documentation as to the fairness and necessity of the transaction is
either lacking or insufficient, such transactions should be scheduled for
criticism. Consideration should be given to scheduling a Contingent
Liability as discussed in the previous portion of this Section under
Contingent Liabilities.
Section
23B(b)(1) of the Federal Reserve Act provides certain restrictions on
fiduciary purchases of securities or other assets from an affiliate of the
bank or its subsidiary. This provision is not directed toward transfers
of trust departments (the "fiduciary book of business"), but is noted here
because it is contained in Section 23B and it impacts the conduct of trust
department business. Such purchases are prohibited unless permitted by the
governing trust instrument, governing law, or court order. It is important
to note that the term "permitted" is used in the statute, suggesting that
Congress did not intend to require that express authorization for
such purchases be incorporated into trust agreements.
E.6. Investment in Securities Underwritten by Own-Bank or Affiliates
Banks purchasing, as a fiduciary, securities for which
the bank or an affiliate of the bank serves as an underwriter, is engaging
in a self-dealing transaction. This traditionally occurred with municipal
bonds. With the enactment of the Gramm-Leach-Bliley Act in 1999, the
potential for such self-dealing transactions will increase, due to increased
securities underwriting activity by financial subsidiaries of banks and
bank holding companies.
Underwriting syndicates are composed of dealers that buy
newly issued securities from issuers at a fixed price and sell them to the
general public. Therefore, banks or bank affiliates participating in an
underwriting syndicate have a vested interest in selling at a profit the
securities underwritten. Failure to sell the securities in the open market
at a price at least equal to the price paid by syndicate members (or the
underwriting bid) constitutes a loss to the broker/dealer. Undivided
syndicates are composed of dealers that share in the overall profits or
losses on the sale of all securities sold by the entire syndicate.
The following policies and procedures should be in place
to govern such purchases.
Use of the same investment decision criteria for
purchases of securities underwritten by the fiduciary or by its affiliates
as is used when purchasing securities from non-interested parties (e.g.,
the normal investment criteria associated with any purchase decision).
Compliance with the applicable law(s) and regulations
governing such purchases. In particular, consideration to the relevant
aspects of Section 23(b)(1)(B) and 23(b)(2) of the Federal Reserve Act.
Assurance that the fiduciary is not making a market for
the security and did in fact purchase the security at open market value.
Examiners
should also be aware that the purchase of securities underwritten by the
bank, its affiliates, or a member of an undivided syndicate in which the
bank or affiliate is a member during the existence of the syndicate, is an
apparent violation of Section 23B(b)(1)(B) of the Federal Reserve Act.
Section 23B(b)(1)(B) states that a member bank "whether acting as principal
or fiduciary shall not knowingly purchase or otherwise acquire, during the
existence of any underwriting or selling syndicate, any security if a
principal underwriter of that security is an affiliate of such bank."
However, Section 23B(b)(2), as amended by Section 738 of the GLBA,
provides an explicit statutory exception "if the purchase or acquisition of
such securities has been approved, before such securities are initially
offered for sale to the public, by a majority of the directors of the bank
based on a determination that the purchase is a sound investment for the
bank irrespective of the fact that an affiliate of the bank is a principal
underwriter of the securities."
Consequently,
if a trust department held full investment discretion over an account and
purchased securities during the existence of a syndicate, the transaction
would not be a violation of Section 23B as long as a majority of the Board
(who are neither officers nor employees of the bank) approved the
transaction prior to the initial offering. Nevertheless, the
transaction would be considered a conflict of interest and self-dealing.
Any abusive situations or apparent violations of Section 23B should be
discussed with management and appropriately noted in the Report of
Examination.
E.6.a. Other Transfers
and Agency Relationships between Affiliates
Instances
may be encountered where, in lieu of an outright sale transaction, fiduciary
business has effectively been transferred via written agreement. If a trust department enters into an agency relationship with certain
affiliated entities, Section 23B(a)(2)(B) may apply. This requires the
relationship to be on terms comparable to those existing for similar
relationships where no affiliation exists. As previously noted,
bank-to-bank and bank-to-trust company transactions are not covered by
Section 23B. Where a sale transaction has not occurred, but an agency
relationship has arisen, the discussion on
Outside Contracting for Fiduciary Services
in section G of this manual also applies.
In
FDIC Legal Opinion on FRB Section 23B Fees and Affiliated Employee Benefit
Plans, dated
March 10, 1995, the FDIC has opined that a bank holding company's profit sharing plan
may be an affiliate of the bank within that holding company.
The opinion indicates that plans meeting certain prerequisites would
be subject to both sections 23A and 23B. Therefore, dealings
between a bank and such a plan, or a trust department and such a
plan, should be reviewed in light of this opinion. (In
particular, the definition of "affiliate" and "covered transaction"
in Section 23A(b)(1) and (7) and 23B(d)(1) and (3) should be
reviewed for purposes of this determination). Also, refer to Compliance - Employee benefits, Prohibited Transactions, for additional comments on this subject.
E.7. Relationships with Outside Service Providers
As with all other fiduciary activities, management's
selection of outside service providers should be based exclusively upon the
best interest of account beneficiaries, and not on the ancillary services or
benefits that service providers may provide to the bank or trust department.
Basing such relationships upon such ancillary services represents a breach
of the duty of loyalty and a conflict of interest. Trust department
management should support the reasonableness of the trust department's
relationships with the outside service providers through a properly
documented due diligence analysis. Refer to
Section 10 - Outside Contracting for Fiduciary Services for further
discussion.
Banks may have standing relationships or commitments with
securities brokers, mutual funds, insurance agents, real estate agents,
accountants, etc. Such relationships may include some form of rebate or
reimbursement, whereby the bank receives a financial incentive for directing
business to the service provider. The rebates and reimbursements may take
various forms. Some may be based on a percentage of broker commissions
(e.g., equity trades), or a percentage of the total dollar value of
transactions executed (e.g., fixed income securities or mutual fund
purchases). Some rebates may b hidden as a reduction in the price of a good
or service due to the volume of assets invested, the number of items held in
safekeeping, or the extent of services purchased. An example of the later
would be to use the bank's external audit firm to perform audits for closely
held businesses held in trust accounts or in the preparation of taxes for
the trust customers, with the bank receiving a reduction in the cost of its
annual audit and the trust customers assessed a full fee.
Regardless of the form of such compensation, the
following guidelines should govern such financial reimbursement
arrangements. The arrangement must be (1) in the best interests of the
account beneficiaries and (2) permitted by applicable laws and the governing
instrument. With respect to agencies and revocable trusts, prior written
approval should be obtained after a full disclosure of the financial
arrangement s made to the customer. Periodic account statements should
provide either a line item disclosure of the fees associated with such
arrangements or a disclosure of the total annual fees associated with an
account's usage of such services. Account statements should not
report income, or gains/losses, on a "net" (net of applicable fees) basis.
Net reporting is considered misleading and deceptive, and should be
criticized by the examiner.
E.8. Inter-Account Transactions
Inter-account transactions occur when assets are sold
directly from one account to another, bypassing a non-affiliated third party
broker. While attractive from the standpoint of reducing or eliminating
commissions paid to third parties, the fiduciary must demonstrate that the
transactions' terms were as advantageous to all parties, involved had these
transactions been conducted through a third party. Management must:
Comply with Applicable Laws and Regulations -
Applicable regulations include
Section 344.8 of the FDIC's Rules and Regulations, which requires
investment managers to have written policies governing the crossing of buy
and sell orders on a fair and equitable basis.
Establish Adequate Written Polices.
Develop Procedures to Monitor and Report
Inter-Account Transactions - Inter-Account transactions should be
reported to the appropriate supervisory level. Management should
be alert to situations where trust officers may be engaging in
such transactions in an effort to dispose of assets, either
because they were erroneously or improperly purchased, or because
they have depreciated in value. The sale of assets between
accounts under these circumstances would constitute a breach of
trust and result in a Contingent Liability on the part of the
bank. It may also involve a violation of FDIC Section 344.8(a)(4).
An example of a situation where an inter-account
transaction would be appropriate is the transfer of assets between related
accounts. For example, the sale of an interest in a closely held business
from one trust account to another related trust account (where the
accounts share the grantor, beneficiaries, remaindermen, etc., and (1) where the sale is directed or authorized by the grantor, or
the governing instrument, or (2) where the written approval of all
beneficiaries and, if necessary, remaindermen, is obtained, or (3) where the
transaction is approved by a court of law). Also, as noted above, the department
should have written policies governing this type of transaction. As with
all conflicts of interest, fiduciaries should seek to avoid
inter-account transactions, and limit them to instances that provide demonstrable benefits
to all accounts involved.
E.9. Multi-Account Transactions
Multi-account transactions are intrinsically neither good
nor bad. When permissible under local law or the governing instrument, they
can, and in some instances, would be expected to occur in the normal course
of business. In a typical multi-account transaction, the fiduciary purchase
or sell shares in large blocks and allocate the shares purchased or sold
among accounts. If the block was purchased at different prices from more
than one broker, management must take extraordinary care to ensure that all
aspects of the allocation, including the price of the security, number of
shares, and commissions charged is fair for all parties.
Management must ensure that all accounts are treated
fairly in the allocation process and that proper policies are in place to
govern such transactions. Accounts, by virtue of their size or other
consideration, must not be permitted to benefit unfairly at the expense of
other accounts. FDIC Section 344.8(a)(3) requires investment managers to
have written policies governing fairness in the execution of multi-account
securities transactions.
E.10. Contravention of Terms of the
Governing Instrument
Failing to act according to the terms of the agreement or
deviating from the governing terms of the agreement without proper authority
may give rise to a contingent liability. The contravention may be due to
circumstances beyond the fiduciary's control, such as an unforeseen event,
or may be due to breaches of the fiduciary's duties. The latter might
involve an investment decision or a failure to consult with a co-fiduciary.
Contraventions due to unforeseen circumstances are an inherent risk of
fiduciary activity. However, contraventions caused by the failure of the
fiduciary to properly administer an account are unacceptable.
E.10.a. Ambiguous Language
Contraventions may occur when the terms of the instrument
are ambiguous. In such instances, the fiduciary may be permitted
to consider circumstances and conditions outside of the instrument to
determine the settler's intent. One method of limiting such risks is to
carefully review the governing agreement prior to accepting an account in order
to ensure that the language of the agreement is precise and that all of the
fiduciary's powers and duties are clearly defined in the agreement. This
applies to both revocable and irrevocable trusts, since, due to future
events, a revocable trust may become irrevocable.
E.10.b. Changing Circumstances
Frequently circumstances regarding either the settlor,
the beneficiary or conditions affecting the administration of the trust will
result in contraventions of the governing instrument. An example is the
receipt of instructions from the settlor that contradict the terms of the
original agreement. Management must be cautious when following the settlor's
directions subsequent to the creation of the governing agreement. Unless the
instrument permits the revocation or the modification of the agreement, the
terms may not be changed. If the trust is revocable, it should be amended to
permit the otherwise impermissible act. Another example occurs when required
actions become impossible, illegal, or due to a change of circumstance,
defeat the original purpose of the trust. For example, older trusts were
written with very restrictive investment directions, such as only permitting
investments in the direct obligations of the United States. Years later the
trust, which may be small, may need to generate income and principal growth
for an incapacitated remainderman. A mutual fund investing in U.S.
Government and Agency securities may be a suitable investment, except for
the very restrictive investment provisions of the original trust agreement.
In the absence of an emergency, the trustee should first obtain
authorization from a court of competent jurisdiction before deviating from
the terms of a trust. A trustee who deviates from the letter of the trust
without the sanction of the court and/or beneficiary does so at the peril of
afterward having to provide evidence that the deviation was both necessary
and appropriate.
E.10.c. Unauthorized Commingling of Assets
There should be no unauthorized commingling of assets by
a fiduciary. In the following instances, however, commingling is allowed:
State law permits a trustee to deposit uninvested funds
belonging to several fiduciary accounts into a single deposit account.
Assets are held in a special form of partnership,
called a nominee, to facilitate the purchase, sale, and collection of
income. Most governing agreements (personal, agency, and employee benefit)
allow for assets to be held in a nominee name.
Funds are invested in collective investment funds. Most
modern trust agreements allow for this type of investment.
In all other respects, unless specifically permitted by
law, assets of each fiduciary account should be kept separate from both the
assets of other fiduciary accounts and the assets of the bank. In carrying
out this responsibility, the bank should identify all assets with the name
of the fiduciary account. For example, mortgages, deeds, stocks, and
registered securities should be in the name of the bank as fiduciary for the
account. If the bank is acting in a agency or custodial capacity,
registration would be in the name of the principal, unless otherwise
directed or authorized by the governing agreement. Such authorization,
however, is common.
E.10.d. Nonconforming Investments
Accounts must not hold nonconforming assets. For personal
trust accounts, nonconforming investments are those that do not conform to
state law, the terms of the governing instrument, or, in the case of
employee benefit plans subject to ERISA, investments that do not conform
with the plan documents (refer to
Subsection 5.H.3.), do not meet the prudence and diversification
requirements of ERISA, or which result from transactions prohibited by ERISA
(refer to
Subsection 5.H.7.).
E.10.e. Failure to Invest
All funds, including income and principal cash, should be
made productive, unless the trust instrument, local law, court order, or a
party empowered to direct investments provides otherwise. A fiduciary's
failure to invest may result in liability for the loss of income. When
required to invest in a particular investment vehicle, the failure to do so
will result in liability for the loss of any increase in value if the
investment appreciates. Any decision to leave cash uninvested should be
properly documented
E.10.f. Acts Without Consent or
Approval of a Co-Fiduciary When there is more than one trustee, the general rule is
that they cannot exercise the powers conferred upon them unless they agree.
As such, co-fiduciaries should execute the duties of their office in their
joint capacity. Where discretion is required, as distinguished from
purely ministerial acts, the joint action of the trustees is required
unless the trust instrument or applicable statute provides otherwise.
The decision to purchase, sell, or distribute (invade principal) trust
property involves the exercise of discretion requiring the joint action of
the co-fiduciaries, and should have the written approval. Absence of
documentation evidencing joint approval may expose the bank to the risk of
loss in the event actions are subsequently challenged.
In certain instances, Section 405 of ERISA makes a
fiduciary liable for the wrongful acts of co-fiduciaries. Refer to
Subsection 5.H.6.a. for a discussion on how proper allocation procedures
will permit one fiduciary to insulate itself the actions of
co-fiduciaries..
E.11. Privacy
Conflicts of interest related to privacy include
breaches of loyalty due to the sale of confidential information to third-parties
and to maintain control over trust property. The first breach may occur when the
sale of non-public customer information to increase fiduciary revenue
supersedes the beneficiaries' need or desire for confidentiality. The second
breach may occur when the fiduciary fails to adequately safeguard
confidential information. The current concern in this area focuses on
information aggregators. Information aggregators assemble client
information, often financial in character, from various on-line sources and
present the client's information in a single convenient interface. The
activity is sometimes referred to as screen scraping, and is addressed in
the next subsection. Regardless of the cause of the breach, adequate
policies and procedures are required to control conflicts arising from
consumer privacy issues. Refer to
Section 10 of the Manual for a discussion of the required contents of a
privacy program.
E.11.a. Privacy and On-line Banking
When a fiduciary offers on-line access to client
information, the potential exists that an unauthorized entity or person may
access the information. Even when done with the permission of the client,
such on-line access can expose the fiduciary to liability for failing to
properly safeguard confidential information. Essentially, the client
provides the information aggregator with pin numbers and passwords to all
their financial accounts and the aggregator enters each entities system,
collects the client's data, and presents it to the client in a combined
format. In many cases, trust and agency agreements do not allow the sharing
of information with parties other than the beneficiaries. Methods for
managing the risk to the fiduciary include:
Separating fiduciary customer information from general
customer information on on-line systems, e.g., separate pin and password
to access fiduciary information;
Informing customers of the potential risks of screen
scraping and adding language to written on-line user agreements to address
this activity;
Modifying the language of governing documents (trust
and agency agreements) to allow for this activity;
Including cautionary disclosures on the fiduciary's
website which request customers to notify the fiduciary if they have
provided an information aggregator with on-line access to account
information; and/or
Establishing procedures for monitoring screen scraping
activity.
E.12 Prohibitions against Tying Arrangements
Trust departments and banks must be aware of potential conflicts of
interest when they condition the price or availability of one product on a
requirement that the customer also obtain another product from the bank or
an affiliate of the bank. Although Section 106 of the Bank Holding
Amendments of 1970 prohibits this type of activity, the regulations
specifically permit tying arrangements if the customer is required to obtain
a "traditional bank product" such as a "loan, discount, deposit or trust
service". Section 106 also prohibits a bank from preventing a customer from
obtaining a product or service from a competitor, unless the condition is
imposed in a credit transaction to ensure the soundness of the credit.
Tying arrangements are prohibited by the Sherman and Clayton Anti-trust
Acts; however, these acts require showing that a practice harms the public,
while Section 106 has no such requirement.
The difficulty for a bank or its trust department is understanding what
is a traditional bank product. The Board of Governors of the Federal Reserve
System has provided the following specific examples of traditional bank
products as guidance:
- All types of extensions of credit,
including loans, lines of credit, and backup lines of credit;
- Lines of credit and financial guarantees;
- Lease transactions that are the
functional equivalent of an extension of credit;
- Credit derivatives where the bank or
affiliate is the seller of credit protection;
- Acquiring, brokering, arranging,
syndicating and servicing loans or other extensions of credit;
- All forms of deposit accounts, including
demand, negotiable order of withdrawal (NOW), savings and time
deposit accounts;
- Safe deposit box services;
- Escrow services;
- Payment and settlement services, including
check clearing, check guarantee, ACH, wire transfer, and debit
card services;
- Payroll services;
- Traveler's check and money order
services;
- Cash management services;
- Services provided as trustee or guardian,
or as executor or administrator of an estate;
- Discretionary asset management services
provided as fiduciary;
- Custody services (including securities
lending services); and
- Paying agent, transfer agent and registrar service.
Several other types of arrangements are allowed under Section 106. The
regulations do not prohibit a bank from imposing conditions in order to
enhance the credit of its borrowers, such as requesting additional
collateral, requiring insurance on collateral or restricting a borrower's
total debt, even at a competing institution. Section 106 also does not
restrict non-bank affiliates from requiring a customer to use bank's
services. Furthermore, a bank may require a customer, in accepting bank
services, to choose from a combination of traditional and non-traditional
products, so long as the customer can fulfill its obligation to the bank
solely through traditional products.
Some specific examples of violations are cited by the Federal Reserve.
A bank may not require a borrower to do any of the following in order to
obtain a loan:
- Purchase an insurance product from the
bank or an affiliate of the bank (a prohibited tie);
- Obtain corporate debt or equity
underwriting services from an affiliate of the bank ( a prohibited
tie);
- Sell the bank or an affiliate of the bank
a piece of real estate unrelated to the requested loan (a
prohibited reciprocity arrangement); or
- Refrain from obtaining insurance products or securities underwriting
services from a competitor of the bank or from the competitor of an
affiliate of the bank (a prohibited exclusive dealing arrangement).
As tying arrangements can be very complicated, it is imperative that management establish policies and procedures to ensure that bank employees
comply with the anti-tying prohibitions of Section 106. The procedures
should include education and training, particularly for personnel that have
direct contact with customers for purposes of marketing and selling the
bank's products, especially in the bundling of traditional and
non-traditional products. Trust department employees should be aware that
securities underwriting, insurance products and securities advisory services
are not considered traditional banking services for the purposes of Section
106. Furthermore, employees should be free to seek legal advice in the
event of a potential violation of Section 106.
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