The management of property for others is
one of the principal functions of a fiduciary. Fiduciaries administering
personal or corporate accounts, either as trustee or agent, are guided by
state statutes and the principles embodied in common law. For employee
benefit accounts, ERISA, with its implementing Department of Labor (DOL) regulations and opinions,
provides statutory and regulatory guidance.
The primary investment guidance given to
fiduciaries is found in the terms of each account's governing instrument.
There are major differences in the fiduciary's responsibilities under
different types of accounts.
When the fiduciary has discretion to select investments for an account, or
makes recommendations for the selection of investments, the investments
selected must both follow the terms of the governing instrument and be
suitable investments given the needs of the beneficiaries or the purpose
of the trust.
When the trust department has no discretion in choosing investments (such
as for self-directed or custodial accounts), the institution's sole
responsibility is to follow the provisions of the governing account
Accounts subject to ERISA,
diversification standards, parties in interest, and co-fiduciaries and
investment managers are presented in Sections 404 through 406. Refer to
specific sections of ERISA
in Appendix E - Statute 404 through 406 and
Section 5 of this Manual for further discussion.
In enacting the Prudent Investor Act,
states should have repealed legal list statutes, which
specified permissible investments types. (However, guardianship and
conservatorship accounts generally remain limited by specific state law.) In
those states which adopted part or all of the Prudent Investor Act,
investments must be chosen based on their suitability for each account's
beneficiaries or, as appropriate, the customer. Although specific
criteria for determining "suitability" does not exist, it is generally acknowledged,
that the following
items should be considered as they pertain to account beneficiaries:
There are two fiduciary
standards governing the prudence of the individual
investments selected by a fiduciary: the Prudent Investor Act and the
Prudent Man Rule. The Prudent Investor Act,
which was adopted in 1990 by the American Law Institute's
Third Restatement of the Law of Trusts ("Restatement of Trust 3d"), reflects
a "modern portfolio theory" and "total return" approach to the exercise of
fiduciary investment discretion. This approach allows fiduciaries to utilize
modern portfolio theory to guide investment decisions and requires risk
versus return analysis. Therefore, a fiduciary's performance is measured on
the performance of the entire portfolio, rather than individual investments.
As of May 2004, the Prudent Investor Act has been adopted in 41
States and the District of Columbia. Other states may have adopted parts of
the Act, but not the entire Act. According to the National Conference
of Commissioners on Uniform State Laws, the most common portion of the Act
excluded by states concerns the delegation of investment decisions to
qualified and supervised agents.
The Prudent Investor Act differs from the Prudent Man Rule in
four major ways:
trust account's entire investment portfolio is considered when determining
the prudence of an individual investment. Under the Prudent Investor Act
standard, a fiduciary would not be held liable for individual investment
losses, so long as the investment, at the time of acquisition, is
consistent with the overall portfolio objectives of the account.
Diversification is explicitly required as a duty for prudent fiduciary
category or type of investment is deemed inherently imprudent. Instead,
suitability to the trust account's purposes and beneficiaries' needs is
considered the determinant. As a result, junior lien loans, investments in
limited partnerships, derivatives, futures, and similar investment
vehicles, are not per se considered imprudent. However, while the
fiduciary is now permitted, even encouraged, to develop greater
flexibility in overall portfolio management, speculation and outright risk
taking is not sanctioned by the rule either, and they remain subject to
criticism and possible liability.
fiduciary is permitted to delegate investment management and other
functions to third parties.
A copy of the model
Uniform Prudent Investor Act, together with explanatory notes, is included
in Appendix C. A list of states adopting the Uniform Prudent Investor Act
is also included. States, however, may and often do, modify uniform model
laws when enacting legislation. For states that have adopted a version of
the Prudent Investor Rule, this portfolio management approach supersedes the
Prudent Man Rule.
Prudent Man Rule is based on common
law, stemming from the 1830 Massachusetts court decision -- Harvard College v. Armory, 9 Pick. (26 Mass.)446,
461 (1830). The Prudent Man Rule directs trustees "to observe how men of
prudence, discretion and intelligence manage their own affairs, not in
regard to speculation, but in regard to the permanent disposition of their
funds, considering the probable income, as well as the probable safety of
the capital to be invested." Id. A copy of the Prudent Man Rule, also
known as the
Restatement of Trusts 2d, together with explanatory notes, is
included in Appendix C.
Under the Prudent Man
Rule, when the
governing trust instrument or state law is silent concerning the types of
investments permitted, the fiduciary is required to invest trust assets as a
"prudent man" would invest his own property, keeping in mind: the needs of
the beneficiaries, the need to preserve the estate (or corpus of the trust)
and the amount and regularity of income. The application of these general
principles depends on the type of account administered. This continues to be
the prevailing statute in a small number of states.
The Prudent Man Rule requires that each investment be judged on its own merits. Thus, a fiduciary
could be held liable for a loss in one investment, which when viewed in
isolation may have been imprudent at the time it was acquired, but as a part
of a total investment strategy, was a prudent investment in the context of
the investment portfolio taken as a whole. Under the Prudent Man Rule,
speculative or risky investments must be avoided. Certain types of
investments, such as second mortgages or new business ventures, are viewed
as intrinsically speculative, and, therefore, prohibited as fiduciary
Since the Prudent Man
Rule was last revised in 1959, numerous investment products have been
introduced or have come into the mainstream. For example, in 1959, there
were 155 mutual funds with nearly $16 billion in assets. By year-end 2000,
mutual funds had grown to 10,725, with $6.9 trillion in assets
(as reported by CDA/Wiesenberger). In addition, investors have become more
sophisticated is more attuned to investments, since the last revision. As
these two concepts converged, the Prudent Man Rule became less relevant.
Prudent Investments in Court-appointed
State statutes may
outline specific permissible investments for certain types of accounts, such
as guardianships for
minor children or incompetents. Under some state statutes, prudence is more
narrowly defined for guardianship accounts, than under the Prudent Man
Trust departments can be
appointed as a conservatorforveterans.
In general, prudent investments for veteran accounts are defined as an
interest or dividend paying account at a Federally-insured institution, or
in court-appointed cases, in securities issued or guaranteed by the United
States. Under 38 CFR13.103, veteran benefits paid to legal custodians on
behalf of a beneficiary may only be invested in U.S. savings bonds, pre-need
burials trusts, or interest or dividend paying accounts, which are Federally
insured. Department of Veterans Affairs benefits that are paid on behalf of
an incompetent veteran to an institution via an institutional award payment
arrangement may not be invested in any asset. Pursuant to 38 USC 501,
Section 13.106 states that court-appointed fiduciaries must invest income or
an estate derived from the Department of Veterans Affairs benefits only in
legal investments which have safety, assured income, stability of principal,
and ready convertibility for the requirements of the beneficiary and his or
As discussed more fully
Section 2 - Operations and Internal Controls,
there may exist
different classes of beneficiaries in a personal trust account that may only
be entitled to a trust's principal, or income, but not both. In these
situations, it is important that fiduciaries maintain accounting records
that clearly distinguish assets as either principal or income.
consists of cash and other property transferred to the fiduciary. Income is
the return derived from the investment of principal. Income must also be
distinguished from capital gains, which are not investment yields or returns
on principal, but gains or appreciation of the value of the principal
itself. Capital gains are added to the value of principal (capital losses
reduce the value of principal), and inure to the benefit of principal
beneficiaries. Depending on the terms of the trust, and a variety of other
factors including the needs of the beneficiaries, income may be distributed
as cash, or reinvested and held (for the benefit of income beneficiaries) as
invested income. Unless clearly distinguished from other investments,
invested income may appear to the observer to be principal. Consequently, it
is imperative that fiduciary records distinguish between the two, as failure
to do so could result in giving one set of beneficiaries funds that belong to
another set of beneficiaries, creating a Contingent Liability. Separate
records of principal and income are customary, and can be used for the
preparation of accountings and tax returns. A further discussion of
principal and income may be found in Principal
and Income, located in Section 2.
responsibility for establishing an overall investment policy remains with
the board of directors or a trust committee appointed by the board. The
basis of any investment policy should be sound fiduciary principles,
including "prudence", the preservation of capital, diversification, and a
rate of return commensurate with the level of risk assumed. The review of
the department's investment policies and practices are of major importance
in the trust examination.
Many trust departments
have a separate trust investment committee which develops and administers
investment policy, although smaller departments may utilize the board of
directors or the trust committee for this purpose. The committee reviews and
either approves or rejects recommendations made by a research division, an
outside investment advisor, or the department's investment officer. Often
the committee has the responsibility of reviewing individual account
portfolios and determining whether assets are invested in compliance with
the trust department's overall investment policy.
Accounts for which the
department exercises investment discretion should receive an investment
review in accordance with the
Statement of Principles of Trust Department Management.
An initial asset review should, in most cases, be conducted
promptly following acceptance, and should establish an investment program
for the account. Reviews should include securities and other types of assets
received with the account. The initial review is of great importance, as the
fiduciary may be required to act quickly to protect assets from loss or
erosion of principal, or to take immediate action to protect tangible assets
from creditors, insurable losses or physical damage. A fiduciary may have to
compensate accounts that sustain investment losses due to the
fiduciary's negligence such as a failure on the part of the fiduciary to act
in a timely manner.
The department's overall
investment policy should be flexible enough to accommodate the types of
fiduciary appointments accepted. For example, individual trusts under will
or agreement are usually established for the purpose of providing income to
the income beneficiary and leaving principal (corpus) to the remainderman at the termination of the trust. By contrast, employee benefit
trusts need to generate sufficient growth and income to provide the promised
retirement benefits to participants and their beneficiaries. Conversely,
investment management agency accounts normally desire capital growth rather
When the governing
instrument is silent, investment authority or directions default to state
law, which must be followed. When the governing instrument's language
concerning investments is unclear, court approval should be obtained.
E.1. Investment Policy Components Investment policies
should clearly set forth a framework for the selection, retention, review,
and management of assets over which the department holds investment
discretion. The policies should discuss the overall structure of the
department's investment management responsibilities. They should provide
for: appointing qualified officers to supervise daily investment activities;
the monitoring of discretionary transactions, including the reporting of
such transactions to the appropriate supervisory officers and committees;
procedures for handling exceptions; and, formal procedures for reviewing and
revising investment policies and practices. Depending on a department's
size, complexity, and the types of appointments accepted, the following
elements may also need to be addressed:
Management's investment philosophy and standards of practice.
code of conduct for employees, officers, and directors who by their duties
or supervisory roles have knowledge of, or access to: (1) discretionary
investment transactions; or (2) the department's approved list of
securities, or changes to the approved list of securities. FDIC Part 344
requires that bank officers and employees who make investment
recommendations or decisions for accounts of customers file a report with
the bank on a quarterly basis.
Investments and investment practices deemed appropriate, or inappropriate,
with regard to the management of discretionary accounts.
nature and size of accounts the department is qualified to administer, and
the minimum standards required for the acceptance of new accounts.
Pre-acceptance review of the transferred assets for new accounts.
initial review of newly accepted accounts.
Investment reviews of existing accounts.
Procedures for documenting investment reviews.
Whether the department will prepare its own research in-house, or purchase
investment research from outside investment advisors.
Justification for the selection of a load fund over a no-load fund.
Criteria for the selection of the mutual funds to be included on
Criteria for monitoring the mutual funds on the approved lists, and
Description of the approval process for adding or deleting mutual funds
from the approved lists.
Criteria for diverging from the approved lists.
Establishment of procedures for adopting and amending an approved list of
obligors (corporate and municipal) of fixed income debt investments, if
Criteria for evaluating the credit risk of the obligors to be included
on the approved lists,
Criteria for monitoring the credit risk of the obligors on the approved
Description of the approval process for adding or deleting obligors from
the approved lists, and
Monitoring purchases and sales to ensure compliance with the approved
Criteria for making exceptions to the approved list.
Guidelines for the development and use of asset allocation models,
Criteria or methodology for creating and modifying asset allocation
Description of the process for supervisory review and approval of the
Guidelines for the holding, purchasing, and managing of real property,
The evaluation of environmental risk, initially, and on an ongoing
Initial and periodic reappraisals/inspections of real property.
Guidelines and procedures for holding closely held businesses, including:
Identification of conditions under which the department would administer
Criteria for contracting with a third party to run a closely-held
Methods and procedures for the initial and periodic evaluation of such
Whether the trust officer should serve on the board.
Guidelines and procedures employed in the selection and use of money
market mutual funds, including:
Periodic reviews of fund performance,
Methods for monitoring the use of and reliance on derivative products by
such funds, and
Guidelines for the selection and use of funds paying 12b-1 fees,
including: the appropriateness of such funds for each type of account
administered, notification to customers of such fees, the solicitation
of customer approvals when appropriate, and the routine disclosure to
customers of such fees earned by investment of their accounts in such
Guidelines governing the use and monitoring of derivative investment
products, as outlined in the FDIC Office of Capital Markets Examination
Handbook and the FDIC Statement of Policy on Investment Securities and
End-User Derivative Activities.
Guidelines for the evaluation and management of assets deemed worthless.
Guidelines and procedures for evaluating and monitoring exceptions, such
as non-rated, or non-approved list, securities
held in accounts. Refer to the following section.
Guidelines and procedures governing loans from trust accounts (real
estate, unsecured promissory notes, etc.).
Guidelines and procedures regarding lending to, and permitted indebtedness
of, managed accounts.
Guidelines providing for the prompt investment of income and principal
cash, unless the governing instrument, local law, or parties properly
authorized to direct investments provide otherwise.
E.2. Discretionary Asset Review Policies It is generally acknowledged that trust departments are liable,
to varying degrees, for all assets held, whether or not they possess
investment authority. It also follows that greater authority imparts greater
risk. Trust departments which are otherwise well managed may sometimes lack
appropriate policies with respect to periodic reviews of
assets not contained on the approved list. Many departments hold at least some assets in discretionary accounts
that were not acquired through the exercise of discretionary authority.
These include directed purchases, assets acquired "in-kind," and assets
acquired through distributions, corporate re-organizations or liquidations.
This is especially true with respect to assets acquired as executor, trustee
under will, successor to previous fiduciaries, and through guardianship or conservatorship appointments. The value of these assets may
represent a significant percentage of the market value of an individual
Trust management should institute written
policies which affirmatively address the routine evaluation
all discretionary assets (refer to subsection G. Account
Review Program, of Section 1.
This is true whether or not the assets were acquired
by virtue of management's fiduciary authority. At least once during the
calendar year, all assets
held in discretionary accounts should be reviewed and evaluated in light of
governing instruments and individual account circumstances. Departments that
adopt a "passive" stance over assets received in-kind increase their exposure to
fiduciary risk. Trust management may believe it can eliminate this risk by
obtaining "direction letters." Although prudent and necessary, at best, this
reduces, but cannot eliminate, fiduciary risk. The beneficiaries may change or
may lack the legal capacity to release the fiduciary from liability, as in
the case of minors or the unborn. Likewise, account circumstances change and
economic factors vary over time, sometimes dramatically and with little or
no advance warning.
Also, asset management policies
should address the retention process for all discretionary holdings. Investment
policies should address minimally acceptable sources for outside research.
They should also outline the minimum acceptable standards for documenting
and approving the retention of assets and provide guidance for the sale of
underperforming assets. Trust departments may fail to include all
discretionary assets in their annual review function, thereby increasing
fiduciary risk. Trust departments that have adopted an "approved list"
approach may be at increased risk if they do not review discretionary assets
that are not on their approved list.
Trust departments may
hold assets for which they cannot obtain reliable valuations. Such assets
may include limited partnership interests, investments in closely held
businesses, the common stock of thinly traded or unlisted companies,
partnership agreements, hedge funds, royalties, patents and copyrights, oil
and mineral interests, etc. Asset pricing is an integral component of an
annual portfolio analysis. It is also necessary for the preparation of
estate tax returns (IRS Form 706), gift tax returns (IRS Form 709) and
annual IRA account filings (refer to Section 5, F.1.).
It is a key factor in the proper calculation of account fees and commissions
(department earnings). In these situations, and in situations where
management does not have the resources to adequately evaluate certain types
of assets, it should seek outside expertise. Management may not, however, be
able to pass the cost of these outside services through to the account,
particularly when the assets in question were purchased by the department
under its discretionary authority. Consequently, examiners should review
accounts for inappropriate charges in this context.
vehicles are available for the investment of trust funds. The more common
types of investments and some newer products are discussed below, along with
applicable regulations, examination procedures and other related matters.
The Capital Markets
Handbook defines products not outlined on the following pages and provides
examination guidance. The Capital Markets Branch in the Washington Office
can readily provide information concerning most investment products.
F.1.a. Money Market Funds Various money market
funds are offered for the short-term investment of idle cash. These funds
are mutual funds and have differing portfolios depending on the particular
fund. Investments in domestic or foreign certificates of deposits,
repurchase agreements, commercial paper, and short-term U.S. Government or
agency obligations are some of the more common portfolio components.
Although the trustee may have full investment discretion, it should be
satisfied that the investment of trust funds in money market funds is
permissible under state statutes. When trustees do not have full
discretion, sufficient authority should be sought in state statutes or court
decisions, the language of the account's governing instrument, or by
obtaining binding consents from all beneficiaries or written instructions
from the parties authorized to direct investment selection, before utilizing
these funds. In general, it would not be considered
appropriate to permanently place funds in this type of investment vehicle,
as money market funds are considered short-term investments.
Money market funds are
registered under the Investment Company Act of 1940 and as such, are
regulated by the Securities and Exchange Commission. Fund companies are
required to provide a prospectus to the investor prior to purchase. The
funds are required to have external audits. Prior to investing in a money
market fund, the prospectus of the fund and portfolio composition should be
reviewed to determine that the fund meets the objectives of the trust
account. Thereafter, the fund should be reviewed periodically to ensure that
the investment objectives continue to be met. In addition, there have been
instances where money market funds have "broken the buck", referring to
situations where the fund's net asset value falls below
$1 per share. This issue has
recently resurfaced and concerns may be found at in Appendix G,
Interagency Policy on Banks/Thrifts Providing Financial Support to Funds
Advised by the Banking Organization or its Affiliates . Therefore, various risks such as credit, liquidity,
concentration, operational, and reputation risks should be assessed by trust
department management. Examiners should determine that money market funds
have been properly analyzed prior to investment and that the funds are
periodically reviewed. Appropriate comments should be included in the Report
of Examination if such funds have not been properly analyzed or if such
investments are inappropriate for the accounts involved.
F.1.b. External Sweep Arrangements Money market funds
generally accrue interest daily and pay interest at the end of the month.
Many trust departments now have services which automatically invest
available cash exceeding predetermined dollar limits in a money market fund.
These are commonly called "sweep" arrangements.
Fiduciaries are obligated
to keep funds productive. Uninvested cash of discretionary appointments should be
invested "temporarily" until "permanent" investments are chosen, or pending
the implementation of an investment program or distribution to
beneficiaries. Uninvested principal cash, including cash not awaiting
immediate distribution or payment against a draft, are often "swept" at the
close of each business day into some form of interest-bearing investment
vehicle. Income cash should be treated in a similar manner. Current
technology makes possible, and prudent fiduciary investment philosophies
advocate, the full employment of all cash in some form of productive
investment. Management's failure to invest cash when appropriate and
practicable should be considered imprudent and a breach of fiduciary duty
subject to criticism. In those cases where the fiduciary is
responsible for the investment of cash, it is difficult for a fiduciary to justify permitting cash to
remain idle when it is possible to make it productive. It would be unusual,
given the current state of investor awareness, for customers to be
indifferent to a fiduciary's intentional failure to invest large cash
The investment of
nondiscretionary cash is largely governed by the terms of the account
agreement. There may be instances, however, when the account agreement lacks
specific directions concerning how cash is to be invested and the customer
has not provided any specific instructions. Examiners, in such cases,
should be careful when "interpreting" a trust department's investment
authority with respect to the investment of cash balances. In such cases,
management should be encouraged to modify the governing account agreements
in a manner to resolve any ambiguity concerning the department's
responsibility to invest cash.
In addition, faced with such uncertainty, the fiduciary should contact the
account principal and request direction concerning the investment of the
Examiners may encounter
situations in which the trust department charges an additional fee ("sweep
fee") for performing cash management services. The taking of such fees is
customarily governed by state law and examiners should determine the
permissibility of assessing additional fees under local statutes. If
permissible under state law and not prohibited by the account agreement, the
fee charged should be reasonable for the service performed. Additionally,
the department should fully disclose the imposition of the fee to interested
parties. The amount of fees charged relative to the sweep arrangement should
be disclosed periodically in the account statements sent to customers. The
charging of sweep fees inERISA accounts is
not strictly prohibited. Refer
Section 5, subsection H.7.f.(20). Sweep Fees for
additional guidance for ERISA accounts.
F.1.c. Deposits Deposits, whether time,
savings, or demand, are another common form of investment. The deposits
could be in another institution or in the commercial department of the bank
under examination. Oftentimes, such investments provide the safety and
liquidity needed by the account. However, given the availability of numerous
other investment vehicles providing similar safety and liquidity, examiners
should determine whether deposit holdings result from a lack of management
initiative to seek other investment opportunities. Large holdings of
non-interest bearing deposits should be scrutinized, since it is a
fiduciary's duty to make trust assets productive. Discretionary deposits
with the commercial bank should also be reviewed, given the conflict of
interest and self-dealing aspects of such investments.
Some trust departments
sweep cash to the commercial department's deposit accounts on an overnight
basis, rather than sweep to an external investment vehicle. In those
situations, bank management should have a strategic plan for the activity.
Within that plan, management should not view overnight trust funds as a
long-term funding source for the commercial department. Management should
have calculated the costs, including interest on deposits and the FDIC
deposit insurance assessment. More importantly, trust management should be
able to demonstrate that the customer is at least as well compensated, as he
would have been with an external sweep, usually a money market fund.
Care should also be taken to assure the deposit account is appropriated
titled in the commercial department's records to insure pass-through deposit
insurance coverage. Examiners should be aware thatSection 24 of the FDI
Act prohibits the pledging of bank securities to secure deposits of
trust accounts. However, an irrevocable letter of credit issued by an
agency of the U. S. Government or a surety bond, issued on behalf of the
bank or trust department, is allowable under the regulation.
F.1.d. Overdrafts Overdrafts occur for
numerous reasons, including timing differences related to cash receipts and
disbursements. Overdrafts should be short-term in nature, and rare in
occurrence. The department should not be funding securities purchases with
overdrafts. Such a practice reflects poor cash management of an account.
Likewise, the failure of the department to properly plan for recurring or
expected disbursements, resulting in a lack of liquid assets to fund
disbursements, reflects poor cash management. These and similar events, if
prevalent, should be criticized. The department should have a policy
governing overdrafts. The policy should include review procedures, methods
for curing overdrafts, and the action(s) that will be taken if an overdraft
cannot be cured within a reasonable time period. Overdrafts outstanding for
long periods of time should be treated as a loan to the account.
F.2. Fixed Income Products In those states where the
Prudent Investor Act has been adopted, the suitability of the entire
portfolio should be reviewed as a whole, and individual investments are not
considered inherently good or bad based solely on investment type or credit
In states which
operate under the Prudent Man Rule, investments are considered prudent or
imprudent on an individual basis. Therefore, investments can be considered
inherently prudent or imprudent based solely on investment type or credit
The following is a brief
overview of the more common investments and some newer products found in
trust departments. For particular products and
their risks not included on the following pages, examiners should refer to the Capital Markets Examination Handbook and the
Manual of Examination Policies, used for safety and soundness examinations.
F.2.a. Corporate Debt Issues Marketable debt
securities (bonds, debentures, etc.) generally comprise a significant
portion of a trust department's assets. The selection of acceptable debt
instruments for discretionary accounts should be based on research performed
in-house, acquired from outside sources, or a combination of the two. The
department may also rely on ratings provided by the nationally recognized
rating agencies. The rating bands for three of the rating services are
outlined in this section. As seen in recent events, highly rated debt
issues can decline into subinvestment quality rating bands or go into
default. Therefore, management should monitor investments on an on-going
basis to determine that the issue remains suitable for the account. As
previously stated, the Prudent Investor Act does not preclude the investment
in or continued holdings of subinvestment quality securities. However,
speculation is inappropriate for trust accounts.
are investment grade, medium-term notes, offered in minimum
denominations of $1,000 to retail investors. InterNotes represent the debt
of each respective issuer and are subject to credit and secondary market
risk. The notes are offered via a prospectus and issues are sold at par
value. Each week, new offerings from various corporations are made, and
include issues with varying maturities, coupons, and interest payment
schedules (monthly, quarterly, semi-annually.) InterNotes appear to have a
shelf registration, meaning that the amount offered in the prospectus is
registered once, and the issuer can offer amounts under that prospectus as
An example of an InterNote may be the following:
billion issue from a corporation under a prospectus dated August 2002.
Separate CUSIP numbers are assigned to specific terms, such as maturities,
coupons, and call provisions, which represent amounts used under the
offer as stated is valid for a week, and the minimum investment
(denomination) and increments are $1,000.
are rated by nationally recognized rating agencies and the ratings are
posted on the InterNotes' website, along with other information concerning
InterNotes are based on floating rates, indexed to short-term rates.
The products are directed
at small, retail investors, in lieu of certificates of deposits and may be
F.2.b. Municipal Bond Issues The department may invest
in debt obligations issued for the benefit of local municipalities, school
districts or other small governing authorities. Industrial revenue bonds
may be issued for the benefit of corporate entities. Frequently, municipal
bonds will be received in-kind rather than purchased by the department.
The issues may or may not be rated. The lack of a rating may result from
the expectation that the issue will be sold to a limited number of investors
in the local community, or, the cost of acquiring a rating may be expensive
in relation to the size of the issue. However, non-rated, does not
necessarily equate with investment quality. Trust management should analyze
prior to purchase and periodically thereafter to determine that the issuer
is creditworthy. Management should establish policies and procedures
including selection criteria and investment review procedures when non-rated
investments are purchased for discretionary accounts.
Municipal bond issues may
be appropriate for managing the customer's tax position, but normally the
investment should not be placed in tax-deferred accounts, such as employee
benefit accounts, as the accountholder does not gain any additional tax
benefit from the exemption. Private activity bonds used for funding
football stadiums, basketball arenas, etc., are subject to the Alternative
Minimum Tax and may affect the customer's income tax liability. In either
of these or other scenarios, management should determine and document the
suitability for the accountholder.
CORPORATE & MUNICIPAL BOND RATINGS
Standard & Poor's**
Upper medium grade
Poor to default
Lowest quality, no
In default, in
arrears, questionable value
* Moody's uses
numerical modifiers 1 (highest), 2 and 3 in the range Aa1 through Ca3.
** Standard & Poor's and Fitch may use + or - to modify some
F.2.c. Collateralized Mortgage Obligations (CMO)/ Real Estate Investment
Conduits (REMIC) CMOs are a mortgage
derivative security consisting of several classes secured by mortgage
pass-through securities or whole mortgage loans. Principal and interest
payments from the underlying collateral are divided into separate payment
streams that repay investors in the various classes at different rates. All
collateralized mortgage obligations now issued are in Real Estate Mortgage
Investment Conduit (REMIC) form. REMIC classes include sequential pay
tranches, planned amortization classes (PAC), and targeted amortization
classes (TAC). These tranches are generally more stable than some of the
tranches outlined below.
The following tranches are generally more
sensitive to changes in interest rates:
Stripped Mortgage-Backed Securities - The separation of interest or
principal cash flows from the underlying mortgage assets give I/Os and P/Os
vastly different risk profiles. These products are highly sensitive to
changes in interest rates.
Stripped Mortgage-Backed Securities- A pure I/O consists entirely of a
premium. The value of the I/O is the present value of the future
interest payments based on the underlying collateral.
Principal-Only Stripped Mortgage-Backed Securities- P/Os are generally sold
at a discount, and the investor realizes a return on investment, as
principal is returned at par and the discount is returned as income. (Refer
to the Uniform Principal and Income Act for a discussion on determining
Floaters- The coupon varies inversely to an index. As the floating rate
class of securities within the issue is larger than the inverse floating
rate tranche, leverage factors or multipliers are used to balance the
inverse tranche with the floating rate tranches. Leverage factors or
multipliers can magnify the effect of minor interest rate movements.
Prior to investing in any product, management should perform
the appropriate due diligence. A copy of the prospectus and pre-purchase
analysis should be retained in the trust files. Subsequent evaluations
consisting of total return screens, stress tests, or volatility analyses
performed by management should be retained for REMICs. This documentation
should support the continued investment in the product.
The trust investment officer should have expertise in
managing these instruments. Management should be fully aware of all
derivative holdings and be able to explain how these instruments benefit
the individual account. During account and investment reviews, management's
knowledge of the products should be documented and the use in a particular
account should be demonstrated through written comments or exhibits retained
in file. Trust departments that cannot adequately demonstrate a reasonable
level of knowledge of a derivative investment and its associated risks
should be criticized.
For employee benefit accounts, an apparent violation
Section 404(a)(1)(B) (prudence), which can be found in Section 5.H.5.c r) should be cited. The basis
for the apparent violation is detailed in the DOL advisory opinion letter
issued to the OCC on March 21, 1996, entitled "Investments in Derivatives."
Derivatives are defined in the letter as a financial instrument whose
performance is derived in whole or in part from the performance of an
underlying asset. Examples include futures, options, options on futures,
forward contracts, swaps, structured notes, and collateralized mortgage
obligations. In that letter, the DOL opined that the products are
permissible. However, trust management is responsible for assessing the
inherent risks of derivatives by "securing sufficient information to
understand the investment prior to making the investment." The letter
discusses the importance of performing stress simulations under normal and
abnormal market conditions, the effect of volatility on the plan's
portfolio, and the ability to properly analyze the investment. A copy of
this letter is contained in
The trust policy should provide guidance, as to when
investments in derivatives are appropriate and how investment risks will be
managed. Parameters should be established for the dollar volume and interest
rate risk that is acceptable for accounts, and formal monitoring and
reporting mechanisms should be established. Furthermore, management should
understand the types of risks involved in each derivative investment and
should not rely solely on the statements of the selling broker, as an
impartial analysis of such risks. A broker's job is to sell a product, and
often the riskier the product being sold, the greater the broker's
associated with such derivative investments consist of the following:
investment is bought in a large block and several accounts hold the
investment. An individual account's investment may not be liquid. For
example, when an individual account needs to liquidate the asset, the
question becomes how liquid is that individual account's investment. Also,
is the holding in a saleable lot and at what price for a relatively small
holding rather than a block transaction? Management may determine that the
particular account's portion is not liquid and may sell the asset to another
account. When inter-account transactions occur, self-dealing or conflicts
of interest are a major concern. Also, management should have documentation
supporting the transaction price. However, the pricing used may be matrix
pricing, which is a calculated price. While matrix pricing should be
reliable under normal circumstances, the pricing does not incorporate every
conceivable outside factor which may influence pricing.
accounting systems should provide for adequate, timely and accurate pricing
of derivative investments. Many pricing services do not have sufficient
capability in this area. In such cases, trust accounting systems often
default to the purchase price or face value of the investment. As products
return principal and income, the purchase price may greatly overstate to
the value, if the trust accounting system does not accept paydowns. Each CMO
tranche has a factor, indicating the amount outstanding as a percent of the
original face amount. Normally, these factors are available on the payment
of principal and interest ticket or for FNMA issued REMICs, on the agency's
website. The Capital Markets Branch in the Washington Office can provide
factors and other information regarding these and other products.
F.2.d. Asset-Backed Securities (ABS) Asset-backed securities
are debt instruments secured by installment loans or leases or revolving
lines of credit. Common ABS collateral includes credit card receivables,
automobile loans, automobile lease, mobile homes, and home equity loans.
The ABS can be in the form of a pass-through or in a REMIC. Depending upon
the structure, the investor either receives a pro rata share of the
principal and interest payment or a structured payment.
Notes These are hybrid
securities that combine fixed term, fixed or variable rate instruments, and
derivative products. Structured notes are debt securities issued by
corporations or government-sponsored enterprises, including the Federal
Home Loan Bank, the Federal National Mortgage Association, and the Federal
Home Loan Mortgage Corporation. Most corporate structured notes are issued
through shelf-registered medium-term note programs. The shelf-registration
allows the issuer to issue up to $1billion in debt over a two year period,
without re-registering with the SEC. Structured notes generally contain
embedded options and have cash flows that are linked to the indices of
various financial variables, such as interest rates, foreign exchange rates,
commodity prices, prepayment rates, and other financial variables.
Structured notes can be linked to different market sectors or interest rate
scenarios, such as the shape of the yield curve, the relationship between
two different yield curves, or foreign exchange rates.
Preferred Securities originated in 1993, with industrial and utility
companies being the primary issuers. Since then, both large and small bank
holding companies have issued the hybrid investment product: The securities
have characteristics that resemble both corporate debt and preferred stock.
The debt-like characteristics include the tax deductibility of
distributions, a fixed maturity date, a stated coupon or formula for the
calculation of the coupon, and the ability of investors to accelerate claims
against the company in the event of default. The securities rank behind
both senior and subordinated debt in terms of repayment priority. The
equity-like characteristics include resembling cumulative preferred stock,
subordinating to other obligations, and representing a minority interest in
a wholly-owned subsidiary. Currently, TPS issued by bank holding companies
are limited to 25 percent of Tier 1 capital. All TPS have an interest
deferral feature of up to 5 years. In general, TPS have a 30 year maturity,
although TPS can be issued with a maturity of up to 50 years. The
securities generally have a par value of $25 for retail investors, a $1,000
for institutional investor is the norm. A call provision of 5 or 10 years
is common for the institutional class investor.
TPS Structure and Flow of Funds
Underlying Structure First,
the parent company establishes a wholly-owned special purpose subsidiary (a
grantor trust), whose sole purpose is to issue the securities. The holding
company then acquires all of the special purpose trust's common stock.
Next, the trust issues preferred stock to the public, representing an
undivided interest in the trust's assets. The holding company guarantees, on
a subordinated basis, that the trust preferred securities holders will
receive interest payments. The trust then lends the proceeds back to the
parent company to purchase junior subordinated deferral debenture with
identical terms. The interest that the trust receives from the funds lent
to the parent company is used to pay the dividend on the trust preferred
securities. In general, TPS are considered a variable interest entity
and subject to FIN 46 - Special Purpose Entity accounting..
preferred securities (MIPS)
income preferred securities (QUIPS)
Trust Preferred Securitization -
a pooled trust preferred offering, an additional trust is added to the
structure and is referred to as a business trust. The business trust issues
securities to investors and uses the proceeds to purchase all of the trust
preferred securities from the grantor trust, as described above. The trust
preferred securities are then securitized, as the business trust is the sole
investor of the securities. A pooled trust preferred security is a form of
a collateralized debt obligation backed by various trust preferred
securities. The pooling crosses geographical lines and therefore, limits
preferred securities are issued by bank or financial holding companies,
whose subsidiaries' deposits are FDIC insured. The individual holding
company must have assets of at least $200MM or deposits of $100MM. The
entity must have been in operation for at least 5 years, and have a Tier 1
risk-based capital ratio of 10 percent or more.
Deferral Period TPS can
defer interest payments for 20 consecutive quarters, unless the deferral
would extend beyond the stated maturity. While the deferral period is not
considered a default, the reputation of the issuer is harmed. Further,
while the interest may be deferred, it still must be paid. Therefore, the
deferral period is also an accumulation period for interest. The issuer can
enter into a deferral period, pay investors income due, and enter back into
another deferral period. As long as there is a clean-up period, successive
deferral periods are allowable.
Investment Considerations TPS
with fixed rate coupons and lives of 30 to 50 years are sensitive to
interest-rate fluctuations. Coupons for these products are normally high in
relation to market rates for long-term Treasury securities and generally
yields are higher than those of corporate bonds or preferred stock issued by
the same corporation. While the products contain call provisions, there is
usually a lock-out period on the call.
alternative to the fixed rate TPS is the floating rate TPS. The coupon for
the floating rate issues may be based on a short-term rate, such as
three-month LIBOR plus a spread. By reducing the interest-rate risk, these
products have significantly less attractive coupons than the fixed rate
preferred securities are rated by nationally recognized rating firms. For
the pooled trust preferred issuance, only the senior notes and mezzanine
notes are rated, with the senior notes carrying a higher rating. The income
notes are not rated and are similar in concept to a residual.
Payments may be deferred for up to five years, but that action is not
considered a default. However, TPS are not immune to default. For example,
Enron issued TPS that have since defaulted. In the event of bankruptcy, the
TPS are below all senior and subordinated debt, but above equity securities
the previously mentioned deferral period may harm the issuer's reputation,
from an investor's point of view, the deferral period can be significant,
also. During the deferral period, the investor is liable for including the deferred
income in gross income for federal income tax purposes, where it is
original-issue discount. To collect the accrued but
unpaid income, the investor must own the security on the date dividends are
Employee Benefit Account Considerations
Investments in affiliated holding company trust preferred securities should
be carefully reviewed. The transactions may be considered a "party in
interest" under ERISA or a "disqualified person" within the meaning of
Section 4975 of the Internal Revenue Code with respect to employee benefit
plans and individual retirement accounts. The purchase of trust preferred
securities by an employee benefit plan or IRA that is subject to the
fiduciary responsibility provisions under ERISA or prohibited transaction
provisions under Section 4975(e)(1) of the Internal Revenue Code may
constitute a prohibited transaction. Prior to investing in trust preferred
securities issued by the parent company, management should consult with
legal counsel knowledgeable of ERISA and the Internal Revenue Code.
prohibited transaction may occur when employee benefit accounts or IRAs are
transferred from one institution to another. If the account held a TPS of
the second holding company and transferred the asset into an account at a
subsidiary of the second holding company, a prohibited transaction may
Church Bonds Church
bonds are certificates of indebtedness issued by churches, and proceeds from
the sale are used primarily to fund acquisition or expansion of the church
property. Churches use the funding when conventional borrowing is not
available; the bonds are secured by mortgages. In general, the bonds are
held by members of a particular church. Maturities range from 6 months to
15 years, with interest paid or compounded every 6 months. The bonds are
promoted as acceptable investments for Individual Retirement Accounts,
although the ability to accurately value the bonds is questioned.
Furthermore, the bonds most likely will not be rated, due to the nationally
recognized rating agencies not analyzing this type of investment, nor are
the churches willing to pay for a rating, especially when the rating may be
less than investment quality.
F.3. Equity Securities Marketable equity
securities may comprise a significant portion of a trust department's
assets. Equity investments selected for accounts where the trust department
exercises investment discretion should be based on research that is either
performed in-house, acquired from outside sources, or a combination of the
The department may also
consider equity ratings assigned by rating agencies and services. In recent
months, various financial service organizations, such as Charles Schwab,
have established proprietary equity ratings, in addition to those
established by the better known national rating agencies. While the rating
scales used by either the rating agencies or the financial service
organizations appear similar to the bond rating scales, equity ratings do
not have the same purpose as bond ratings. The stock rating represents the
expected performance of the stock and/or its risk level, while a bond's
rating is based on perceived creditworthiness. Therefore, a "C" rated
equity may be considered as a hold, whereas a debt rated "C" is indicative
of a security at or nearing default. Given the numerous entities issuing
equity ratings, trust management should maintain a copy (paper or
electronic) of the rating criteria and definitions used by the particular
The department may
develop its own "approved list" based on in-house research; it may adopt the
approved list of an outside investment research firm; or it may modify the
"approved list" provided by an outside research firm. If the department uses
in-house research or adopts its own version of an outside research firm's
"approved list," there should be policies describing the criteria used to
include investments on the "approved list," as well as procedures for
reviewing such selections. Investments in equity securities should be
suitable for the purpose and investment objectives of the account.
securities are not subject to registration under Federal securities laws.
The securities certificates usually contain a "legend" stating that they are
transferable only upon certain conditions, such as after a certain date or
after "x" years. The securities must have been obtained in a transaction
not involving a public offering. Normally a trust department acquires such
securities in-kind rather than by purchase. To sell such securities, the
trust department must comply with the requirements of SEC Rule 144, issued
under the Securities Act of 1933 (refer to SEC regulations at
17 C.F.R. Section 230.144). For additional information, refer to
Section 3.k.2. Restricted Equity
F.3.a. Financial Derivatives The following are the
four types of Interest Rate Derivative Instruments: interest rate options;
interest rate futures and forwards; interest rate swaps; and, interest rate
caps, floors, and collars. These instruments are principally designed to
transfer price, interest rate, and other market risks without involving the
actual holding or conveyance of balance sheet assets or liabilities.
Examiners are unlikely to find these types of instruments in a trust
department unless the investment portfolio is exposed to some risk that can
be mitigated by the use of one of these instruments. Some examples of how
these vehicles could be used include: using foreign currency swaps to reduce
foreign exchange risk, purchasing a call option to lock in the price of a
security which the department expects to purchase in the future, purchasing
a put option to establish a future selling price, and writing covered call
options to enhance the yield of a portfolio.
Some trust departments
use over-the-counter put and call options for accounts as a means of
increasing trust account revenue. The writer of put and call options is paid
a fee for selling these contracts. The purpose of using exchange traded
options would be to take advantage of price fluctuations. Whether engaging
in options transactions is legally permissible for trust accounts depends
upon the terms of the agreement, and the applicable state law governing the
investments permitted for specific types of accounts. Employee benefit
trusts are governed by the prudent investment standards in
Section 404(a)(1)(B) of ERISA
and in DOL regulations at 20 C.F.R.
Many departments have
restricted option writing activity to covered call options. However, it is
recognized that under certain conditions, the writing of put options, within
clearly defined policy parameters, may be an acceptable and appropriate
investment strategy for some accounts. Prior to approving the utilization of
options as an investment strategy, the board of directors, or an
appropriately designated committee thereof, should ensure that adequate
policies and procedures are established to measure, monitor and control the
risks involved. The policies should: address the propriety of option writing
for different types of fiduciary accounts; define the permissible option
strategies that may be employed; define the dollar volume of options that
may be written by individual accounts; establish procedures for reporting
and approving such transactions; and prescribe control and record keeping
practices. The policies should be reviewed on a regular basis, no less
frequently than annually. The trust department should also obtain an opinion
from bank counsel as to the legality of these activities.
When a department writes
a covered call option on stock held in its trust accounts, it sells to a
third party the right (option) to purchase that stock (call) at a specified
price until a specific date. Possession of the stock by the trust account
makes the written option "covered."
Receipt of cash (fee)
paid by the third party for the option provides an additional return on the
stock if the market price remains the same, and cushions the potential loss
if the market value declines. An element of risk is involved if the market
value of the stock rises above the strike price, in which case the holder of
the option will exercise the right to purchase the stock at the previously
agreed upon price. In such instances, by granting of the option, the trust
account foregoes any price appreciation over the strike price of the option.
If the option contract is written and exercised on a bond, the trust account
will receive the cash proceeds resulting from the sale, but reinvestment of
these funds in a rising market will likely result in a reduced yield
(income) to the account.
The following guidelines
should be followed by examiners in reviewing investments in call options:
(1) Sufficient authority must exist to make such investments. Such
authority might consist of specific authority in the governing instrument,
specific or express authority in applicable state law, the written and
binding consent of all account beneficiaries, an order from a court of
competent jurisdiction, or in those cases where the governing instruments
and state law are silent, applicable Prudent Man or Prudent Investor Rules;
(2) Such an investment must be prudent for each trust account involved,
coupled with a determination that employment of an option writing strategy
is consistent with the needs and investment objectives of the account; and
(3) The trust department should have the necessary technical expertise to
monitor and execute such transactions, which should be documented in
accordance with approved policy by appropriate records, reviews and
The Securities and Exchange Commission (SEC)
and National Association of Securities Dealers (NASD) regulate the sale of
variable annuities, as the products are registered with the SEC as
securities. The variable annuity is a contract between a purchaser and an
insurance company, where the latter makes periodic payments to the purchaser
beginning either immediately or at some future time. The purchase can be
made by a single, lump-sum payment, or by multiple payments. All
investments in variable annuities should be viewed as a long-term
A range of investment options are offered,
although investments in mutual funds are the most common. The underlying
assets are generally invested in stocks, bonds, or money market funds. The
rate of return varies with the investments selected. While the investment
options may consist of mutual funds, variable annuities differ significantly
from mutual funds, by the following:
Variable annuities provide periodic payments and protect the owner from
outliving his assets.
beneficiary is guaranteed a specified amount, if the purchaser dies before
income and gains are tax-deferred until withdrawn.
When withdrawing funds, income is taxed at the ordinary rate, and not the
lower capital gains rate.
Variable annuities should not be used in lieu
of 401(k)s or other similar plans, as the contributions are not excluded
from current income. Once a 401(k) or similar plan is funded to the legal
maximum contribution, variable annuities may be an investment option.
Generally, variable annuities should not be held in retirement accounts,
such as 401(k) or IRA, as those accounts are already tax deferred. There is
no additional advantage to owning tax deferred products in such accounts
(this would be the same for municipal bonds.) However, examiners should
determine if there are any other reasons to hold such products.
product has two phases. The first phase is the accumulation phase. During
that time, the purchaser allocates investments amongst various investment
options. Just like a mutual fund, the investment selected will increase or
decrease in value based on the fund's performance. During this phase, funds
can be transferred between investment options, without a tax consequence.
However, withdrawing funds during this time may result in "surrender
charges." Withdrawals prior to age 59 ½ are also subject to a 10
second phase is the payout phase. The payout may be a lump-sum payment or
multiple payments, usually monthly. The purchaser, not the insurance
company, selects the number of payments under the multiple payment option.
Some annuity contracts are structured as immediate annuities, which provide
protection against market downturn, and, which, upon purchase, provide
payments that are guaranteed for life. In this form, there is no
accumulation. Since 2001, sales of the immediate annuities have experienced
substantial growth, while variable annuities in general were on the
decline. Several financial service providers have entered the immediate
annuity market. Finally, the payout phase may be structured as a deferred
annuity, where payments are delayed into the future.
Cost and Fee Structure The
cost and fee structure of variable annuities can be high. First, a
surrender charge is assessed when funds are withdrawn (surrendered) prior to
the end of a set period of time. This period may be as long as ten years.
The sales charge is used to pay a commission to the representative who sold
the product. Each year the surrender charge percent decreases. In
addition, a mortality and expense risk charge is assessed annually. This
charge covers the guaranteed death benefit, payout options that are
guaranteed for life, or administrative charges. Administrative fees are
charged to cover recordkeeping and other expenses. Other fees, known as
underlying fund expenses, such as an initial sales load, transfer fees, and
fees for stepped-up death benefits, may also be charged. Fees should be
fully disclosed in the prospectus. The annual fees can reach two percent of
the annuity's value.
Individuals can exchange their current variable annuity for a different
variable annuity without paying tax on the income or gains under Section
1035 of the US Tax Code. While this allows a tax-free exchange, other fees
such as surrender charges may still apply.
F.3.c. Insurance Company Ratings The
guarantee provided by the insurance company is only as good as the insurance
company that offers the product. Insurance companies are rated by
nationally recognized rating services, such as A. M. Best Company, Moody's
Investor Service, Fitch Ratings, Standard & Poor's Insurance Rating
Services, and Weiss Ratings. Each service provides ratings, but ratings
from one rating service to another are not comparable, without knowing the
rating agency's definitions. The following are the ratings and definitions
from A. M. Best Company.
A+ (Superior) Assigned to companies that have, in our
opinion, a superior ability to meet their ongoing obligations to
A and A- (Excellent) Assigned to companies that have, in our
opinion, an excellent ability to meet their ongoing obligations to
B++ and B+ (Very Good) Assigned to companies that have, in our opinion, a
good ability to meet their ongoing obligations to policyholders.
Vulnerable Best's Ratings
B and B- (Fair) Assigned to
companies that have, in our opinion, a fair ability to meet their current
obligations to policyholders, but are financially vulnerable to adverse
changes in underwriting and economic conditions.
C++ and C+ (Marginal)
Assigned to companies that
have, in our opinion, a marginal ability to meet their current obligations
to policyholders, but are financially vulnerable to adverse changes in
underwriting and economic conditions.
C and C- (Weak) Assigned to companies that
have, in our opinion, a weak ability to meet their current obligations to
policyholders, but are financially very vulnerable to adverse changes in
underwriting and economic conditions.
D (Poor) Assigned to companies that,
in our opinion, may not have an ability to meet their current obligations to
policyholders and are financially extremely vulnerable to adverse changes in
underwriting and economic conditions.
E (Under Regulatory Supervision) Assigned to
companies (and possibly their subsidiaries/affiliates) that have been placed
by an insurance regulatory authority under a significant form of
supervision, control or restraint, whereby they are no longer allowed to
conduct normal ongoing insurance operations. This would include
conservatorship or rehabilitation, but does not include liquidation. It may
also be assigned to companies issued cease and desist orders by regulators
outside their home state or country.
F (In Liquidation) Assigned to companies that
have been placed under an order of liquidation by a court of law or whose
owners have voluntarily agreed to liquidate the company. Note: Companies
that voluntarily liquidate or dissolve their charters are generally not
S (Rating Suspended) Assigned to rated
companies that have experienced sudden and significant events affecting
their balance sheet strength or operating performance whose rating
implications cannot be evaluated due to a lack of timely or adequate
Not Rated Categories (NR)
NR-1 (Insufficient Data) Assigned predominately to small companies for which
A.M. Best does not have sufficient financial information required to assign
rating opinions. The information contained in these limited reports is
obtained from the several sources, which include the individual companies,
the National Association of Insurance Commissioners (NAIC) and other data
providers. Data received from the NAIC, in some cases, is prior to the
completion of the cross-checking and validation process.
NR-2 (Insufficient Size and/or
Operating Experience) Assigned to
companies that do not meet A.M. Best's minimum size and/or operating
experience requirements. To be eligible for a letter rating, a company must
generally have a minimum of $2 million in policyholder's surplus to assure
reasonable financial stability and have sufficient operating experience to
adequately evaluate its financial performance, usually two to five years.
General exceptions to these requirements include: companies that have
financial or strategic affiliations with Best's rated companies; companies
that have demonstrated long histories of financial performance; companies
that have achieved significant market positions; and newly formed companies
with experienced management that have acquired seasoned books of business
and/or developed credible business plans.
NR-3 (Rating Procedure
Inapplicable) Assigned to companies that
are not rated by A.M. Best, because our normal rating procedures do not
apply due to a company's unique or unusual business features. This category
includes companies that are in run-off with no active business writings, are
effectively dormant, underwrite financial or mortgage guaranty insurance, or
retain only a small portion of their gross premiums written. Exceptions to
the assignment of the NR-3 category to run-off companies relate to those
that commenced runoff plans in the current year or are inactive companies
that have been structurally separated from active affiliates within group
structures that pose potential credit, legal or market risks to the group's
NR-4 (Company Request) Assigned to companies that were assigned a Best's Rating
but request that their ratings not be published because the companies
disagree with Best's rating conclusion. The NR-4 will be assigned at the
request of the company following the dissemination by A.M. Best of the
latest letter rating assignment.
NR-5 (Not Formally Followed) Assigned to insurers that request not to be formally
evaluated for the purposes of assigning a rating opinion. It is also
assigned retroactively to the rating history of traditional U.S. insurers
when they provide prior year(s) financial information to A.M. Best and
receive a Best's Rating or another NR designation in more recent years.
Finally, it is assigned currently to those companies that historically had
been rated, but no longer provide financial information to A.M. Best because
they have been liquidated, dissolved, or merged out of existence.
Rating Modifiers and
Affiliation Codes Under Review (u)RatingModifiersare assigned to Best's Ratings to
identify companies whose rating opinions are Under Review and may be subject
to near-term change. Best's Public Data (pd) Rating Modifiers may be
assigned to Health Maintenance Organizations (HMOs), Canadian, UK and other
European insurers that do not subscribe to our interactive rating process.
Best's Public Data Ratings reflect both qualitative and quantitative
analysis using publicly available data and other public information.
Syndicate (s) Rating Modifiers are assigned to syndicates operating at
Lloyd's.AffiliationCodes are based on a Group (g),
Pooling (p) or Reinsurance (r) affiliation with other insurers.
pd -Public Data
For a complete
definition of Best's Ratings, please refer to the Preface of Best's
Insurance Reports or Best's Key Rating Guide. Best's Ratings reflect our
independent opinion, but are not a warranty of a company's financial
strength and ability to meet obligations to policyholders.
Assigned to all companies
and reflects their size based on their capital, surplus and conditional
reserve funds in millions of U.S. dollars, using the scale below.
To enhance the usefulness
of our ratings, A.M. Best assigns each company a Financial Size Category (FSC).
The FSC is designed to provide the subscriber with a convenient indicator of
the size of a company in terms of its statutory surplus and related
accounts. Many insurance buyers only want to consider buying insurance
coverage from companies that they believe have sufficient financial capacity
to provide the necessary policy limits to insure their risks. Although
companies utilize reinsurance to reduce their net retention on the policy
limits they underwrite, many buyers still feel more comfortable buying from
companies perceived to have greater financial capacity.
F.3.d. Exchange Traded Funds An Exchange Traded Fund
(ETF) is an index-linked portfolio of securities. ETF portfolios are
purposely structured to replicate as nearly as possible the performance of a
specific index. Precise replication is not possible due to expense factors
in operating the trusts which hold the securities and other factors. This
form of investing is sometimes referred to as "passive," since the portfolio
of an EFT is not actively managed by any investment manager. Their
composition is dictated by securities comprising the index itself, and they
typically do not change unless the composition of the index changes. As with
all investments, the inclusion of ETFs in any portfolio should conform with
the requirements of local law, the governing instruments, the needs and
requirements of both current beneficiaries and remainder interests, and the
overall investment strategy and investment objectives of the particular
accounts. Individual account records and trust management's investment
records should document the basis for investing in an ETF, both initially,
and on a continuing basis.
Most ETFs are structured
as unit investment trusts and listed on the American Stock Exchange. ETFs
can be purchased and sold like stocks. They are similar to mutual funds in
that they consist of a diversified portfolio of stocks, but are dissimilar
in that they are typically concentrated in a single industry, market, or
based on some economic benchmark. Consequently, the performance of some ETFs
may be more volatile than those which are based on broader indices. They are
also dissimilar to mutual fund operated index funds in that they can be
traded throughout the day. ETFs are traded on an exchange, and prices are
available continuously throughout the trading day. Investors must also pay
broker commissions on ETF purchases and sales. Most mutual funds can only be
purchased and sold at the end of a trading day at the fund's Net Asset
The more common of the
Exchange Traded Funds are:
The NASDAQ-100 Index
Tracking Stock (ticker symbol QQQ) is designed to track the
performance of the 100 largest non-financial U.S. and non-U.S. companies
listed on the National Market tier of NASDAQ. It was created March 10, 1999.
NASDAQ-100 Index Tracking Stock Options are standardized put and call
options on the underlying index. These options are also available for
covered call writing.
The NASDAQ-100 Index
Tracking Stock is structured as a regulated investment company trust. It is
an index based unit investment trust and is sponsored by NASDAQ Investment
Product Services, Inc., a wholly owned subsidiary of The NASDAQ Stock
Market, Inc. ALPS Mutual Funds Services, Inc. is the Distributor of the
trust. The Bank of New York is its Trustee.
The Standard & Poors
Depositary Receipts (referred to as SPDRs, with a ticker symbol of
SPY) is designed to track the performance of the Standard & Poors 500
Index. SPDRs are listed and traded on the American Stock Exchange. Trading
began on January 29, 1993.
The Standard & Poors
MidCap 400 Depositary Receipts (referred to as MidCap SPDRs, with a
ticker symbol of MDY) is designed to track the performance of the
Standard & Poors MidCap 400 Index. MidCap SPDRs are listed and traded on the
American Stock Exchange. Trading began on May 4, 1995.
SPDRs and MidCap SPDRs
are structured as regulated investment company trusts. They are index based
unit investment trusts. PDR Services Corporation, a wholly owned subsidiary
of the American Stock Exchange, sponsors these trusts. ALPS Mutual Funds
Services, Inc. is the Distributor of the trusts. State Street Bank and Trust
Company is Trustee of the SPDR trust, and The Bank of New York is Trustee of
the MidCap SPDR trust.
Select Sector SPDRs
are nine individual sector SPDR funds which comprise all of the companies in
the Standard & Poors 500 Index. They are listed on the American Stock
Exchange and began trading on December 22, 1998. Their trading symbols are:
Sector XLU Utilities Sector XLE Energy Sector
Select SPDR Funds are
structured as a regulated investment company trust. The funds are index
based unit investment trusts. State Street Bank and Trust Company is
Adviser, Administrator, and Custodian of the Select SPDR Trust. ALPS Mutual
Funds Services, Inc. is its Distributor.
(ticker symbol DIA) tracks the performance of the 30 stocks
comprising the Dow Jones Industrial Average. The DIAMONDS trust is listed on
the American Stock Exchange and began trading on January 20, 1998.
DIAMONDS is structured as
a regulated investment company trust. It is an index based unit investment
trust. Its Sponsor is PDR Services LLC, a Delaware limited liability company
whose sole member is the American Stock Exchange, LLC. ALPS Mutual Funds
Services, Inc. is the Distributor of the trust.
Most investors who
purchase and sell ETFs do so in the secondary market. Purchasers of ETFs
acquire an investment in a unit investment trust holding shares of the
companies comprising a specific index. Initial units in the investment trust
are generated by large or institutional investors through "creation units."
These "creation units" consist of large blocks (generally 50,000 shares) of
securities of the companies comprising the index. Each "creation unit" can
only be created and redeemed in aggregates of these blocks of securities.
Only investors who have executed a participating agreement with the trust's
distributor and trustee, and who deposit the requisite number of shares of
the securities making up the index, plus cash for accumulated dividends and
transaction costs, are eligible to create "creation units." These investors
act as arbitrageurs who trade "creation units," keep the trust's net asset
value close to index target levels, and attempt to profit from differences
between "creation unit" prices and index levels.
WEBS Index Fund, Inc.
consists of funds trading on the American Stock Exchange. WEBS index funds
consist of 17 country-specific stock portfolios structured to replicate as
closely as possible the performance a specific Morgan Stanley Capital
International index. Trading began in March, 1996. The trading symbols are:
EWA Australia EWQ France EWJ
Japan EWS Singapore EWO Austria EWG Germany
EWM Malaysia EWP Spain
EWK Belgium EWH Hong Kong EWW Mexico EWD Sweden
WEBS Index Fund, Inc. is
an investment company registered under the Investment Company Act of 1940
and is organized as a series fund. Barclays Global Fund Advisors is the
investment manager of each WEBS Index series. Morgan Stanley Trust Company
is the fund's global custodian. Portfolio securities are held by various
sub-custodians throughout the world.
Most investors who
purchase and sell WEBS do so in the secondary market. These index based
funds hold shares of the companies comprising one of the 17 foreign equity
securities sectors tracked by the Morgan Stanley Capital International
indices. Initial units in the funds are generated by certain investors
through "creation units." These "creation units" consist of a large number
of shares of the companies comprising each WEBS sector. Only investors who
deposit the requisite number of shares of the securities of the companies
that make up a sector, plus cash for accumulated dividends and transaction
costs, are eligible to create "creation units."
Economically Targeted Investments (referred to as ETIs or Social/Ethical
Investing) Social investing is an
investment approach whereby the investor considers non-investment criteria
in the investment decision making process. Normally, the investment manager
desires to either promote or endorse a non-investment criterion, or attempts
to avoid investing in companies with certain negative criteria. The
screening process may deal with individual companies or entire countries or
industries. A potential investment may be reviewed through multiple criteria
to determine whether the non-investment goals can be achieved.
Social investing is known
by any number of other terms. Sometimes it is referred to as ethical
investing. The Labor Department's term is "Economically Targeted
Investments", or ETIs.
Examples of such criteria
Oil companies or
large users of energy
employees with certain types of desirable benefits (company-paid health
benefits, non-contributing pension plans, day care facilities, etc.)
records of repeated labor strife, those with large amounts of unfunded
pension liabilities, etc.
Companies with high
products are shoddy, subject to forced recalls, lawsuits
those which manufacture and/or sell products made locally or in certain
Companies which do
business in countries engaging in human-rights abuses, or sell products
made by forced-labor or prison inmates
Low Cost) Housing
Luxury Hotels or
The concept behind ETI
investing is that the investment manager can identify investments that meet
the desirable attributes (or screen out the undesirable investments) without
sacrificing investment quality or returns. This is often difficult.
Companies that meet one or more desirable criteria may also contain negative
The social investing
approach became fairly well-known in the early 1980's. There are now several
mutual funds which have as their basic premise social investing. Results of
social investing portfolios have been mixed to date. Refer to
Section 5.H.5.c.(3)l for additional
information on this form of investment philosophy with respect to ERISA
Mutual Funds Mutual funds are open-end
funds registered under the Investment Company Act of 1940 and regulated by
the Securities and Exchange Commission. (A closed-end fund is often
referred to as a mutual fund, but is an investment trust. ) The mutual
fund raises money from investors, and, in return, investors receive an
equity position in the fund. The proceeds from the shareholders are
invested in a group of assets. The primary benefit of investing in mutual
funds is diversification. Funds offer choice, liquidity, and convenience,
but for a fee and for a minimum investment. The price of a share of an
open-end fund is determined by the net asset value (NAV), which is the total
value of the securities owned divided by the number of shares outstanding.
The NAV is the price at which you buy or sell shares when commissions and
loads are not involved.
There are many types of
mutual funds, but most are a variation on the following general types:
Bond Funds U. S. Government and
Agency issued bonds - These funds primarily invest in notes and bonds issued
by the U. S. Treasury or Federal Government or Government Sponsored
Agencies. Credit risk is not an issue, although returns are usually below
those of other bond funds. These funds do have interest rate risk,
especially those investing in long-term bonds.
Corporate bonds - Most
corporate bond funds invest in highly rated bonds issued by corporations.
High-yield or junk bonds
- These funds invest in the debt of corporations which are in weakened
financial condition or in unproven small firms. The potential that any
individual corporation will default is much higher compared to corporate
bond funds, but due to a large number of bonds held, the fund does not have
a concentration that would impact the overall fund.
Municipal bonds - These
funds invest in tax-exempt bond issued by state, county, or municipal
governments. The advantage of these funds is the income earned is exempt
from Federal taxation and, in some instances, state and local taxation.
Trust management should
consider the expense ratios based on the type of fund, the length of
maturities, and yields. However, management should not be solely focused on
the yield, but the composition of the fund. To boost yields, many funds
invest in bonds other than those expected in the fund.
Stock funds Value funds - These funds
invest in stock, that the fund manager believes are undervalued based on
their low price/earnings ratios or the value of the underlying assets. The
large-cap versions look toward corporations whose stocks are selling at
discounted prices, while small-cap fund managers look for stocks which have
the potential to increase in value.
Growth Funds - The
managers of these funds may have vastly different approaches to managing the
funds. Some are rather conservative, while others are aggressive. In
general, growth funds do not generate the highest returns in bull markets,
but maintain their position better in a downturn. This type of fund
generally focuses on appreciation rather than income.
Growth and income,
Equity-Income, and Balanced Funds - These funds provide steady long-term
growth while generating an income stream. All invest in dividend or
income-producing securities, such as bonds or convertible securities.
Growth and income funds normally have lower yields, as the funds are more
focused on growth. Each fund maintains its NAV better during a downturn,
but lag the market in a bull market. These funds are suitable for investors
who are risk-averse or need a constant level of income.
Specialty or Sector Funds
- These funds invest in particular market segments. By diversifying with
the numerous stocks held in the funds, the investor reduces the risk of
holding an individual stock, but still subject to the sector risk.
Before investing in any
mutual fund, trust management should consider the expense ratios for the
type of fund, the investment style and consistency therewith, risk profile,
past performance, and, tax consequences for the account. To generate higher
returns, some fund managers will make trades in fund assets, especially at
year-end. If the asset is sold at a sizeable gain, that may affect the
trust account's tax position.
F.4.a. Investing in Proprietary Mutual Funds Banks and their holding
companies have increasingly become more involved in sponsoring their own
mutual funds, known as proprietary
mutual funds. Characteristically, the funds' names include the name of the
In general, trust department investment in proprietary mutual funds is
permitted only when certain requirements are met. The applicable
requirements depend on the type of trust account and whether the trust
department holds investment discretion. As with all trust investing,
the use of a proprietary mutual fund must be: (1) authorized by the
governing instrument, (2) suitable for an account's
investment objectives, and (3) authorized under state law.
Although investments in
proprietary mutual funds are permissible, such investments pose conflict of
interest and self-dealing issues. Therefore, these investments should also
be reviewed with these concerns in mind. Refer to
Section 8, Investment in Proprietary Mutual Funds for additional
discussion of this topic.
proprietary mutual funds by nondiscretionary accounts are not restricted by
the above requirements.
F.4.b. Due Diligence Standards Prior to investing trust
account assets in proprietary or affiliated mutual funds, or mutual funds
which are advised by the bank or its affiliates, trust management should:
Conduct and document a due diligence review of the legality of investing
fiduciary accounts under Federal and state law.
Establish written investment policies outlining acceptable standards for
investments in such funds. These standards should be consistent with the
minimum acceptable standards adopted by management for the investment of
trust account assets in non-proprietary funds.
Establish procedures for the periodic review, including the documentation
thereof, of the fund's performance in comparison to indexes or other available
funds. The analysis should employ performance criteria published by independent
companies and include a comparison of mutual fund expense ratios.
Establish an arms-length process for evaluating the prudence of investing
trust accounts in proprietary or bank advised mutual funds rather than in
non-proprietary alternative investments.
criteria for investment in mutual funds (whether proprietary, affiliated,
advised, or non-proprietary) should be adopted by the Board of Directors.
Acceptable performance criteria may include provisions addressing the
An investment record with well-defined and discipline investment styles
A comparison of the fund to peer group performance and peer group fees
investment performance which tracks the peer group; the peer group used
should be adequately defined, since there are different performance
measurements for the same class of funds. For example, the
performance of a small-cap fund may be compared to the Russell 2000, the S
& P Small Cap 600 index, or to the Morgan Stanley U. S. Small Cap 1750.
Depending on which benchmark is used, the small cap fund performance may
be above one benchmark and below another, since each were designed
expense ratio which is consistent with the peer group
funds appearing on the approved list should also be periodically reviewed for the
The inclusion of any
mutual fund in the trust department's investment mix should be documented by
the trust investment, or similar, committee. The performance of proprietary,
affiliated, or bank advised mutual funds should be reasonable in comparison
to other available funds. If the proprietary funds' performance is
significantly below benchmark indicators (poorly performing funds),
management's decision to retain the investments should be reviewed regularly
and supported by appropriate documentation. The Board of Directors or a committee thereof, which reports to
the Board of Directors, should review and approve the decision to retain
poorly performing proprietary funds.
F.4.c. Other Mutual Fund Considerations In addition to typical
investment considerations, including the needs of beneficiaries, the account's
investment objectives, and the potential for capital appreciation, etc.,
trust management should consider other investment criteria that are unique
to mutual fund investing.
Mutual Fund Fees
The fees associated with all mutual fund operations pose
fiduciary concerns for both
overall investment performance and potential conflict of interest, with
respect to proprietary funds. Investment in
proprietary mutual funds poses a conflict of interest, since investment in
these funds is linked to increased bank fees and profitability through fund
Nevertheless, investment in any mutual fund imposes additional fees on trust
accounts, unless trust management reduces trust fees for assets invested in
mutual funds on a dollar for dollar basis. The resolution of these issues,
and justification for passive investment management (mutual fund investing)
vs. active investment management, should be articulated in trust policies
and at the account level itself.
All mutual funds charge fees in one form or another. Mutual
fund fees affect a shareholder's overall investment performance, because
they are deducted from the investor's return. Some of the fees represent
investment management fees, while others represent marketing expenses.
Mutual funds are required to disclose fees in a standardized fee table,
which is divided into two sections: (1) shareholder fees and (2) annual
operating expenses. The table is required to be placed in the front of the
fund prospectus. Transaction commissions are not included in the disclosed
expense ratio, but can materially impact the investor.
http://www.fundexpenses.com for the year
2002, investors paid $35.2 billion in mutual fund fees. Of that amount,
$9.2 billion or 26.1 percent represents 12b-1 fees; $6.1 billion or 17.3
percent represents administrative fees; and, $19.9 billion or 56.5 percent
represents advisory/management fees.
Approximately 38 percent of all funds, excluding money market funds,
are "no load" funds sold directly to the investor. The remaining 62
sold through financial advisors, brokers, or insurance agents, who may have
a vested interest in generating fee income for themselves. Shareholder fees
may consist of purchase charges (front-end load fees), sales charges
(back-end load fees), redemption fees, exchange fees, etc. Shareholder fees
may also include "class" fees, depending on which "class" of shares the
investor buys. For example, Class A shares may include front-end sales or
"load" charges and may include 12b-1 fees, but at a lower rate than those of
Class B and C shares. The front-end load potentially can be reduced or
eliminated by breakpoint discounts, which are based on the size of the
investment. The larger the investment, the lower the sale load. Class B
shares may include an annual 12b-1 fee and/or deferred "back-end load" sales
charges. Usually, contingent deferred sales charges decline each year the
investor remains in the fund. Furthermore, most Class B shares convert into
Class A shares after a certain number of years. At that point, the fund
begins charging the same annual fund operating expenses as Class A shares.
Class C shares may charge higher 12b-1 fees, but no front-end or back-end
sales charges. Class C shares may be less expensive than either Class A or
Class B shares, if the investment time horizon is short-term. However, if
the investment is long-term, Class C shares can be more expensive.
Purchasing different classes of a mutual fund may be optional for the buyer,
or dependent on the "class" the buyer falls into as defined by the mutual
fund's plan of operation (such as institutional, individual, etc.).
In June 2003, the NASD censured a brokerage firm, suspended
its chairman, and directed restitution be paid to customers for
recommending the purchase of large positions in Class B shares, when the
customers would have qualified for lower sales charges through the Class A
Short-term redemption fees are assessed against those who
move in and out of funds in under 90 days. These fees are intended to
hinder those who attempt to time the market, resulting in increasing
investor costs and decreasing returns. Short-term redemption fees can
represent up to 2 percent of assets.
Annual Operating Expenses
Annual operating expenses include all on-going fees paid by
shareholders as long as they hold shares in the fund, including: investment
management fees, 12b-1 fees, oversight fees paid to a fund's board of
directors, custodial fees, transfer agent fees, and other administrative
expenses. "Distribution expenses" up to 0.75 percent of a fund's net
average assets per year may be paid in the form of 12b-1 fees. Even
"no-load" mutual funds may pay up to (but no more than) 0.25 percent of
average net assets each year in 12b-1 fees.
In general, the annual operating expenses increase with the
funds risk profile. For example, funds consisting of investment-grade bonds
or large or mid-size U. S. stocks will have lower expense than funds
invested in small-cap stocks or foreign stocks. Index funds will have lower
annual operating expense than managed funds. However, some managed funds
fairly closely tract index funds, yet assess much higher fees. [The degree
of mirroring the index funds is called "R-squared". Funds with an R-squared
over 90 fairly closely track an index fund.]
During 2003 and 2004, mutual funds came under scrutiny for a
variety of potential abuses, including hidden fees. The following are three
major types of hidden fees that may be used by a mutual fund:
Directed Brokerage - Fund
advisers direct brokerage commissions from fund portfolio securities
transactions to selling brokers. A mutual fund company agrees to do a certain volume of trades with a
brokerage firm, if that firm agrees to distribute the funds. In essence,
the mutual fund company pays commissions to brokers to distribute the
funds. This should have been accounted for in the 12b-1 fee, but may not be
included. At the August 18, 2004, Commission meeting, the SEC
unanimously agreed to end the practice of directed brokerage, as the
arrangements create conflicts of interest, and potentially increase fees
mutual fund investors pay.
Revenue Sharing -
A mutual fund company pays brokers part of its own profits to
push the funds, usually to smaller, non-institutional investors. Currently, this is not disclosed
in the prospectus or by the broker.
Soft-Dollars Embedded in
Commissions - A mutual fund company pays a brokerage firm, reportedly for
research, but may also cover costs such as subscriptions to magazines,
compute software and hardware, and attorney fees. The commissions are not
included in the disclosed expense ratio (discussed below), but are deducted
from the fund's assets. Commissions are higher, as significantly lower cost
trades may be done on electronic trading exchanges. The research provided
may be very little or useless, but can be maintained to justify their
usage. As long as the mutual fund achieves "best execution," the practice
Mutual Fund Expense Ratio
A mutual fund's "expense ratio" is its total annual operating
expenses as a percentage of the fund's assets. The expense ratio must be
disclosed in the mutual fund prospectus. Although it is a good gauge of a
mutual fund's ongoing fees, there is no link between high or low expense
ratios and a mutual fund's performance. Consequently, neither trust
management nor examiners should evaluate the "prudence" of investing in one
mutual fund versus another upon a fund's expense ratio alone.
Mutual Fund Tax Considerations
Mutual funds generally make both ordinary dividends and
capital gains distributions each year. Ordinary dividends are reported as
dividend income. Capital gains distributions are reported as capital gains,
regardless of how long the investor owns shares in a mutual fund. Both
dividend and capital gains distributions affect a fund's net asset value
(NAV), which declines by the amount distributed. Despite any lower
post-distribution NAV to the investor, the investor's investment basis
remains unchanged. (NAV is the per share value of a mutual fund. It is
equal to fund assets less liabilities, divided by the number of shares
outstanding. The NAV calculation is a daily regulatory requirement.)
Investors are also liable for any taxable capital gains on the sale of
mutual fund shares. An investor's gain or loss on the sale of mutual fund
shares is computed as the difference between a share's "cost basis" and its
Although mutual funds generally make capital gains
distributions during the last calendar quarter, attempting to "time"
purchases to avoid capital gains treatment, or capture a lower NAV after
capital gains distributions, also subjects the investor to the uncertainties
of market. Increases in a fund's NAV may be greater than the potential tax
liability incurred by purchasing a fund before its capital gains
While the tax-efficiency of a mutual fund is not relevant to
investors in tax-deferred accounts, the tax consequences may be significant
to the investor in a taxable account. Effective April 16, 2001, the SEC
adopted rules and amendments under the Securities Act of 1933 and the
Investment Company Act of 1940 requiring the disclosure to investors of the
effect of taxes on the performance of mutual funds. The rules and
amendments require mutual funds to disclose in the prospectus after-tax
returns based on standardized formulas comparable to the formula used to
calculate before-tax average annual total returns. The standardized
presentation requires after-tax returns for the 1-, 5-, and 10-year periods,
and will accompany before-tax returns in fund prospectuses. The disclosure
must be presented in two formats: (1) after taxes on fund distributions
only and (2) after taxes on fund distributions and a redemption of fund
shares. While the after-tax returns generally will not be required in fund
advertisements and sales literature, any fund that either includes after-tax
returns in these materials or include other performance information or that
represents that the fund is managed to limit taxes, is required to include
after-tax returns in the literature. Money market funds are exempt from
this disclosure, as are fund shares used exclusively by defined contribution
plans ( i.e., qualified under Section 401(k), 403(b), 457 of the IRC) or
similar arrangements (i.e., Section 817(d) of the IRC concerning variable
contracts; entities that are not subject to the individual federal income
tax , such as tax-exempt foundations, colleges, and corporations; or, a
similar plan or arrangement for which an investor does not pay tax on the
investment until sold.)
F.4.d. Mutual Funds: Receipt of 12b-1 Fees
SEC Rule 12b-1, promulgated under the Investment Company Act
of 1940, permits mutual funds to adopt a plan which uses fund assets to
finance, or promote, a fund's sales. The expenses associated with this plan
are referred to as "distribution costs." These costs may take the form of
commission-like payments (termed "12b-1 fees") to organizations which
generate a high volume of transactions in the mutual fund.
Distribution activities include:
advertising; the compensation of underwriters, dealers, and sales personnel;
the printing and mailing of prospectuses to other than current shareholders;
and the printing and mailing of sales literature. The rule is contained in
17 C.F.R. Section 270.12b-1(a)(2).
Approximately ⅔ of all funds assess 12b-1 fees, including
some funds that are closed to new customers. According to an industry
survey, approximately 63 percent of the fees go to brokers, while 32 percent
covers administrative costs, and 5 percent is used for advertising. Another
recent survey found that 19 percent of no-load funds charge 12b-1 fees,
compared with 92 percent of load funds.
Whether a fiduciary may accept and retain 12b-1 fees for its
own benefit depends upon the type of account, together with certain
characteristics of the account, such as the fiduciary's investment
authority, and the nature of customer disclosures. The following provides
general guidance regarding the retention of 12b-1 fees for ERISA covered
employee benefit accounts, non-ERISA employee benefit accounts, and personal
F.4.d.2. Personal and non-ERISA Employee Benefit Accounts
Guidelines governing the receipt and retention of 12b-1 fees
associated with the administration of personal and employee benefit accounts
depend on the level of discretionary investment authority exercised by the
fiduciary, together with the nature of the disclosures provided to the
A standard fiduciary principle under state law and ERISA is
that all decisions to place fiduciary assets in particular investments must
be in the best interest of the trust beneficiaries. This fiduciary
principle reflects the trustee's duty of loyalty under state law. All such
investments must also be consistent with the provisions of an account's
governing documents. An institution may fail to act in the best interests
of its beneficiaries in certain situations in which it receives duplicate
fees for identical investment management services from a trust account and
from the mutual fund provider in which it invests on behalf of the trust
account. As a result, an institution may face increased legal risk due to
potential litigation on behalf of account beneficiaries claiming that the
institution placed its interest ahead of the interest of beneficiaries.
In certain situations, the receipt by a fiduciary of 12b-1
fees from a mutual fund provider for distribution services regarding trust
accounts may be a potential violation of state law or regulation. However, nearly every state legislature has
now modified its laws to
explicitly permit fiduciaries, under certain conditions, to accept such
fees. The conditions imposed typically require investments to be prudent
and permitted by the governing documents. The fees that the institution
receives must also be "reasonable".
Reasoned Legal Opinion -
The institution should obtain a reasoned legal opinion of counsel that
addresses the conflict of interest in the receipt of fees or other forms
of compensation from mutual fund providers in connection with the
investment of fiduciary assets. The opinion should address the
permissibility of the investment and compensation under applicable state
or federal laws, trust instrument, or court order, as well as any
applicable disclosure requirements or "reasonableness" standard for fees
set forth in the law.
Establishment of Policies
and Procedures - The institution should establish written policies and
procedures governing the acceptance of fees or other compensation from
mutual fund providers, as well as the use of proprietary mutual funds. The
policies must be reviewed and approved by the institution's board of
directors or its designated committee. Policies and procedures should, at
a minimum, address the following issues: (1) designation of
decision-making authority; (2) analysis and documentation of investment
decisions; (3) compliance with applicable laws, regulations and sound
fiduciary principles, including any disclosure requirements or
"reasonableness" standards for fees; and (4) staff training and methods
for monitoring compliance with policies and procedures by internal or
external audit staff.
Analysis and Documentation
of Investment Decisions - Where fees or other compensation are received in
connection with fiduciary account investments over which the institution
has investment discretion or where such investments are made in the
institution's proprietary mutual funds, the institution should fully
document its analysis supporting the investment decision. This analysis
should be performed on a regular, ongoing basis and would typically
include factors such as historical performance comparisons to similar
mutual funds, management fees and expense ratios, and ratings by
recognized mutual fund rating services. The institution should also
document its assessment that the investment is, and continues to be,
appropriate for the individual account, in the best interest of account
beneficiaries, and in compliance with the provisions of the Prudent
Investor or Prudent Man Rules, as appropriate.
Agency and Non-discretionary Accounts
Even in the case where the institution does not exercise
investment discretion, disclosure or other requirements may apply.
Therefore, the institution should implement due diligence processes
appropriate for the duties and responsibilities performed. Due diligence
procedures should include a reasoned legal opinion in order to ensure
compliance with applicable state and federal laws and regulations, as well
as sound fiduciary principles. As part of the due diligence process,
management and the board should establish adequate policies and procedures
governing such fee arrangements for non-discretionary accounts. The
institution, in addition, should document the "reasonableness" of the fees
Except as noted in the following paragraph, a violation of
general fiduciary duties resulting from the receipt of 12b-1 fees by a
fiduciary from a mutual fund can be cured if the fiduciary rebates the 12b-1
fees back to the trust accounts that generated the transactions. Where the
bank has retained 12b-1 fees without the authorizations or directions noted
above, examiners should recommend that the fees be returned to the accounts
that generated them. If there is a difference over the interpretation of
state law, a general criticism of the matter should be presented together
with a request for a legal opinion.
Financial institutions that operate proprietary mutual funds
may attempt to resolve the conflict of interest and self-dealing concerns
that result when a proprietary mutual fund collects 12b-1 fees from trust
accounts that the institution administers in a discretionary capacity by
rebating or waiving such fees for trust account shareholders. The
proprietary fund, however, collects 12b-1 fees from non-trust account
shareholders. The SEC has indicated that the waiving or rebating of 12b-1
fees for some shareholders, but not others, may violate the proprietary
mutual fund's obligation to treat all shareholders impartially. See
Southeastern Growth Fund, Inc.'s 1986 request for a No-action letter.
Although the term has not been formally defined, hedge funds refer to an
entity that holds pools of securities or that does not register those
securities under either the Securities Act of 1933 or the Investment Company
Act of 1940.
funds are exempt from the Investment Company Act due to the sales of the
funds being limited to 100 or fewer investors. Also, the funds are only sold
to highly sophisticated investors. To qualify for either exclusion, the
funds must restrict the offerings, and by not selling to the general
public. As a result, solicitation and advertising of hedge funds is
prohibited. This includes advertising in written or verbal form, articles
or other notices published in a newspaper or magazine, information on the
Internet or via email, or at any meeting or seminar where the participants
were invited by general solicitation or advertising.
funds may be sold to an unlimited number of "accredited investors." (In
determining compliance with Rule 501(a) of Regulation D under the Securities
Act of 1933, accredited investors are not included in the 35 limit.) To
qualify as an accredited investor, the individual must have a minimum annual
income of $200,000 ($300,000 when combined with spouse), or $1,000,000 in
net worth. Most hedge funds require $5,000,000 in assets as a minimum. In
order to avoid Investment Company Act registration, the fund may only be
sold to "qualified purchasers," which is a standard with significantly
higher financial requirements than "accredited investors." Hedge fund
investment advisors avoid registering under the Investment Advisors Act by
relying on the de minimis exemption for registration, which is limited to 14
or fewer clients. Under SEC rules, each hedge fund counts as one client.
recent years, hedge funds have grown significantly both by the number of
hedge funds and the dollar amount invested in the funds. Much of the growth
is associated with institutional investing by large plans, such as state
teacher retirement plans, endowments, foundations, and other charitable
organizations. Although the amount of media attention given to the funds
gives the impression that hedge funds are a new investment product, the
funds have actually been available for quite some time. The first hedge
fund was established over 50 years ago.
recently, the funds actively avoided registration under the above Acts.
Now, some hedge funds have registered under the Investment Company Act as
closed-end investment companies, while others registered under the
Securities Act of 1933. Registration makes the funds available to a larger
number of potential investors, including trust and employee benefit
funds, whether registered or unregistered, invest in various financial
instruments to achieve a positive return, and may take on speculative
trading positions. Ironically, hedge funds may or may not engage in
hedging or arbitrage activities. Some hedge funds adopt strategies
similar to mutual funds, while others are extremely flexible in their
approach. Hedge funds may or may not be as risky as other available
investment options. However, hedge funds are constantly changing.
substantial volume of hedge funds use leverage to increase an investment's
value, without increasing the amount of funds invested. In many instances,
the leverage factor is greater than 2:1. The ratio equals total absolute
dollars invested divided by total dollars of equity. Therefore, leverage
magnifies a position, so gains or losses are greater than they would
otherwise have been without leverage. In addition, leverage may increase
the risk of owning assets that are illiquid or those that are saleable, but
at a price less than expected. In the end, leverage is only limited by
margin or collateral requirements imposed by lenders and the willingness of
lenders to provide credit to the funds.
Common traits of hedge funds
structure usually pays the adviser based upon a percentage applied to the
fund's capital gains and appreciation.
or more brokers may be involved in providing trade clearance and settlement,
financing, or custody services.
The funds do
not have specific time horizons, although the life may be shorter than other
cannot liquidate their assets during lock-up periods; redemption frequently
allowed only quarterly.
repurchase their own interests from investors on a limited, periodic basis.
provide potential investors with a private placement memorandum that
discloses information about the investment strategies and operations.
The funds may
have the legal structure of a limited partnership, a limited liability
company, or business trust. All three forms limit taxes and liability.
If the fund is
a limited partnership, the investment adviser normally serves as the general
partner. If the fund is a limited liability company, the investment
adviser normally serves as the managing member.
funds are originated outside of the United States, but are affiliated with
United States-based funds.
are not subject to any law or provision requiring financial statement
often invest heavily in their own fund.
Legal Structures There are two different
legal structures, depending on whether the funds are "Domestic" or
"Offshore." The manager of a domestic fund may also operate an affiliated
offshore fund, either as a separate fund, or through a master fund, which is
a non-US corporation. Domestic hedge funds typically do not have a board of
directors or any comparable corporate body.
Offshore hedge funds are
typically organized in countries considered tax havens. These funds attract
investment by pension funds, as well as charities and foundations. While
the fund may employ the same US entity to serve the offshore as well as
domestic fund, most operational activities are performed at the offshore
location. These funds generally have a board of directors. Offshore hedge
funds may have over 100 investors, although Section 3(c)(1)of the Investment
Company Act of 1940 limits investors
to 100. The statute was interpreted to exclude non-US investors in
determining the number of investors.
Supervision and Regulation
In general, the SEC does not
examine or supervise hedge funds, as the funds can be exempt from the three
SEC Acts previously described. While hedge fund regulations and supervision
are under consideration, there is no definitive action in that direction at
The most significant reason
for establishing supervision, is the manner in which hedge funds are
valued. There is no independent oversight of the valuation and performance
results are not required to follow a standardized format and calculation.
This may directly or indirectly affect the investor. First, the manner of
presenting performance results may be inconsistent or inaccurate. With
registered funds possibly investing in hedge funds, the net asset value of
the mutual funds may be inaccurate and may result in violations for the
registered mutual fund.
While the funds are not
subject to supervision by the SEC, the funds are subject to the antifraud
provisions of the federal securities laws. The identified frauds have been
similar in nature to those fraudulent acts, such as misappropriation of
assets or misrepresentation of performance, committed by other types of
investment advisers. However, the frequency of outright theft, or
misappropriation of investors' funds is greater.
ERISA ConsiderationsAn investment advisor to a
hedge fund is a plan fiduciary, if it exercises discretionary authority over
the management of plan assets. The hedge fund is considered a plan asset,
when the plan's investment in a particular hedge fund is significant. This
is defined to be more than 25 percent of the value of any class of equity
interests in the hedge fund is held collectively by the employee benefit
plan investors. Some hedge funds disclose in the private placement
memorandum that a subscription may be denied, or a redemption may be forced,
to maintain ownership at less than the 25 percent limitation. Once the
ownership by an employee benefit plan exceeds 25 percent, the hedge fund is
subject to regulation as an ERISA fiduciary. Conversely, some hedge funds
accept regulation under ERISA to make their funds more attractive to
Fund of Hedge Funds (FOHF) Typically, FOHFs invest in
15 to 25 hedge funds to diversify the risks associated with an individual
hedge fund. The minimum investment may be as low as $25,000. In concept,
it is similar to a mutual fund investing in numerous stock or bond issues.
FOHFs are generally not registered as investment companies under the
Investment Company Act and use private placement to sell the funds. Some
FOHFs are registered, but are not listed or traded on any exchange or
September 29, 2003, the SEC issued a paper entitled "Implications of the
Growth of Hedge Funds." The paper provides a detailed explanation of the
products, their usage, and the SEC's concerns that the product remains
unregulated. To read this paper, go to
F.6. Notes and Mortgages Notes and mortgages can
be acquired in many ways, including: received in-kind, from the sale of real
estate from a trust account in return for a mortgage, and the outright
purchase of notes and mortgages. There are three basic types of notes and
mortgages: unsecured loans, loans secured by real estate, and loans secured
by assets other than real estate.
The repayment of an
unsecured note depends solely on the willingness and ability of the borrower
to repay. Unsecured loans are, therefore, rarely seen in trust departments
as they may be considered inappropriate.
Real estate loans are
appropriate fiduciary investments for an account when the loans are
secured. Prior to investing in loans, trust management should consider the
liquidity needs of the account and how illiquid the loan may be. A trust
department should not purchase loans or participations from the commercial
department of the bank. Nevertheless, the trust department may participate
in the origination of a loan, using the expertise of commercial loan
officers to finalize the terms of the loan. Under the Prudent Man Rule, it
is ordinarily improper to invest in second or junior mortgages unless the
same account holds all senior mortgages. Although a sufficient margin of
safety exists, a junior lienholder cannot control the foreclosure of
collateral in the case of default.
Obtaining an appraisal is
a common and prudent real estate lending practice. Examiners should be
aware that the Corporation's appraisal regulation, Part 323 of FDIC's Rules
and Regulations, does not generally apply to mortgages made by or to
fiduciary accounts. Part 323 does apply, however, if an appraisal is
required through the action of another law.
All mortgages should be
held in some form of trust capacity unless otherwise permitted by the terms
of the trust instrument or state statute. In addition, the mortgage should
be accompanied by all the documentation necessary to establish the priority
of the lien, an appraisal, and evidence of adequate insurance payable to the
corporate fiduciary. The ratio of loan to appraised value should provide an
adequate margin of collateral protection. Adequate credit information
should be obtained to substantiate the borrower's ability to pay. Ticklers
or checklists may be used by the bank to monitor payment of taxes,
assessments, and insurance.
For notes secured by
assets other than real estate, the bank should have a perfected security
interest in the collateral. All states and the US Virgin Islands have
adopted the requirements for secured transactions under Article 9 of the
Uniform Commercial Code. For negotiable property, the key to security is
physical possession. For physical property which is titled, such as
automobiles and some machinery, filing is the key to perfecting security.
Procedures should be
established to determine payment status and collect delinquent loans.
Delinquencies should be reported on a regular basis to the board of
directors, the trust committee, or another appropriate committee.
Notes and mortgages, like
other investments, should be analyzed periodically to determine whether they
should be retained. Collateral should be evaluated periodically to
ensure it continues to exceed the balance due. Reappraisal reports
should be obtained in limited circumstances, when it is in the best interest
of the account. Also, if the security is real estate, it should be
inspected periodically to ensure that it is being adequately maintained.
Inspections should be standardized and documented. .
loans between the trust department and a potential borrower, sometimes
referred to as "private placements" are also potential trust department
investments. Since the loan is privately negotiated, the instrument may be
highly illiquid. Therefore, the highest degree of confidence should be
placed on the financial strength of the borrower. Private placements, like
other banking activities, should be subject to adequate safeguards and
policy considerations. Special care should be exercised to ensure that
self-serving practices or conflicts of interest are avoided. Policy
constraints should prohibit placing private issues with funds the bank
manages in a fiduciary capacity, especially when the issuer is a bank loan
customer. A serious conflict of interest could result if the bank were to
use or permit the use of proceeds from a placement to reduce criticized
loans, or accommodate borrowers who are not creditworthy.
F.7. Real Estate Real estate is generally
acquired as a trust account asset as a result of the personal activities of
the grantor or testator. Real estate holdings may include personal
residences, residential income properties, commercial properties, unimproved
lots, and acreage. The real estate may be added to the trust as part of an
overall estate plan, or left to a beneficiary under the will. In some
instances, real estate may be added to trust accounts as an investment
vehicle. However, in the absence of special circumstances or specific
authority granted in the trust instrument, management should be cautious
when investing trust funds in real estate. Under common law, the purchase
of property for resale is not considered prudent unless specific provision
has been made in the terms of the trust. The Prudent Investor Rule,
however, does not consider such an investment inherently imprudent.
In considering the
purchase or retention of real estate, management should first determine
whether such investments are authorized in the governing instrument. Other
factors to consider include: the types of accounts for which real estate may
be appropriate; the current or planned use of the property; the geographic
location; the size of the parcel and its future marketability; the risks
involved in any planned construction or development of the property; the
risks and liabilities from any potential environmental pollution or hazards;
price comparisons with similar properties; the net yield from investing in
the property; and the potential cash flow from and appreciation in the real
Decisions to retain real
estate should be governed by the requirements of the trust instrument.
Appropriate consideration should be given to the current yield and the ease
of marketability, if funds are needed to terminate the account or provide
for principal withdrawals. Appropriate guidelines should also be in place
for selling real estate, including appraisals by competent and impartial
appraisers. It should be remembered that trustees have a duty of
impartiality in dealing with beneficiaries and that capital gains generally
accrue to remaindermen.
Investments in real
property can sometimes be speculative in nature, especially when the
assumption of risk and the hope of gain are much greater than the investment
returns available from other investment vehicles. Real estate of all kinds
is burdened with poor liquidity. Raw land generally bears an even higher
degree of risk. Although long-term growth potential and possible tax
benefits may be positive factors, the illiquid nature of real estate
investments has limited their use to large or special purpose accounts
(e.g., pension trusts).
The variety of real
property investments requires different degrees of management knowledge and
expertise. For example, farms are not managed in the same manner as a
commercial income property. Every property held by the trust department
should be reviewed at least annually, to determine whether the investment
meets the needs and objectives of the account and its beneficiaries. When a
property is received in kind, it should be physically inspected as soon as
possible to determine its condition, verify leases and renters, and to
ensure that adequate insurance is in force. In addition, the bank should
have a program for reviewing the condition of the real estate through annual
inspections, or through personal knowledge of the property obtained by bank
personnel or agents, where inspections are not feasible. Each property
should be evaluated periodically to ensure that adequate insurance is
maintained, and to enable the department to decide whether the property
should be retained or sold. The nature and estimated value of the property
should be taken into consideration when deciding between an in-house or
outside appraisal. For example, property of nominal value may not require
an outside appraisal, whereas, a large shopping center would require an
in-depth appraisal by a qualified appraiser. Appraisal review procedures
should be established to evaluate the reasonableness of the overall
conclusions and the assumptions employed by appraiser. At a minimum, most
properties should have a current outside appraisal made prior to sale.
As noted under the
previous section related to Notes and Mortgages, Part 323 of the FDIC's
Rules and Regulations does not generally apply to real estate investments
which are made by or for fiduciary accounts. The regulation would apply if
an appraisal is required through the action of another law.
All parcels of real
estate should appear on the books at some value, preferably market value,
but the institution may, if reasonable, use historical cost or some other
value. The bank should maintain appropriate documents for each parcel of
real estate. Instruments, or copies of instruments, that should be on file
are: deeds; mortgages (deeds of trust); liens and/or releases; owner's title
policy or title opinion; leases; contract of sale and closing statements;
receipted tax bills; fire and liability insurance policies; contracts for
improvements; and instruments conveying interests to the bank.
Procedures should be
established to provide for the maintenance of adequate income and expense
records covering the properties held. Ticklers or other methods should be
used to monitor timely payment of insurance premiums, mortgages, and real
estate taxes. Procedures should also be established to monitor payments and
collect delinquent rent.
When property is managed
by others, a management agency agreement should establish the agent's duties
and responsibilities, the frequency of reporting, and the commission paid.
Management contracts or leases of farms should include guidelines governing
the authority for the sale of crops or livestock, the payment of operating
expenses, basic repairs and maintenance of buildings, the fees charged by
the bank, etc. In addition, procedures should be established for verifying
the amount of farm commodities stored in elevators or warehouses.
Exchanges This product is named for
the Internal Revenue Code Section which authorizes the exchange of
qualifying property and is commonly referred to as "Starker", "Exchange", or
"Like-Kind Exchange." The most common examples of qualifying property are
commercial, industrial, or residential investment property or heavy
equipment or collectibles. Personal residences, partnership interests, and
financial assets held for sale or resale are generally non-qualifying
property, although exchanging one variable annuity product for another may
qualify. A bank may serve in one of three capacities, but cannot serve in
more than one capacity for any one transaction. The three capacities are
lender, qualified intermediary (custodian), or property buyer/exchanger.
The latter two may be found in trust department activities. When a trust
department serves as a qualified intermediary, the trust department is
responsible for holding the funds until the transaction is complete or the
time limits expire. These accounts should be reflected as a non-managed
personal agency account. From an asset viewpoint, these exchanges may be
used for personal accounts, where there is a desire to exchange one form of
income-producing property for another, without incurring a tax liability.
For example, a personal account may hold farmland and exchange it for a
strip-shopping center. The shopping center may provide a level of cashflow
that the farmland does not provide. However, if the farm was sold outright,
there may be a substantial tax liability to the beneficiary. The goal of
these transactions is to shield the owner from incurring a large tax
Section 4, Personal and Charitable Trust Accounts provides a
detailed explanation of the exchange itself.
When a trust department
account invests in real estate or operates a business, compliance with
Federal and State environmental protection laws must be considered.
Resource Conservation and Recovery Act
Congress passed the
Resource Conservation and Recovery Act (RCRA) in 1976 to complement laws
governing other forms of pollution and environmental hazards. RCRA
addresses solid waste disposal (superseding a 1965 Act which dealt with the
issue) and encourages recycling and the use of alternative energy sources.
The primary focus, however, is the control of hazardous waste disposal.
Amendments added in 1984 regulate underground storage tanks (USTs, or LUSTs,
if the tank was leaking).
In September 1995, the
Environmental Protection Agency (EPA) issued regulations effective
December 6, 1995, clarifying the liability of secured creditors holding as
collateral properties with USTs. The EPA considered the question of trustee
and fiduciary liability, as requested by commenters on the proposed
regulation, but declined to include exemptions similar to those provided
secured creditors. The EPA concluded that the 1959 Restatement of Trusts
2d adequately addresses the issue of fiduciary liability and affords the
trustee indemnification from the trust estate for the expenses properly
incurred during the administration of the trust.
Comprehensive Environmental Response, Compensation and
Liability Act of 1980
Congress enacted the
Comprehensive Environmental Response, Compensation and Liability Act of 1980
(CERCLA), as amended by the Superfund Amendments and Reauthorization Act of
1986, to govern the financial responsibility for cleaning up toxic waste.
CERCLA is generally considered to be the primary environmental cleanup and
liability law. The Environmental Protection Agency administers the Act and
has issued numerous implementing regulations. Many states have also issued
similar toxic waste cleanup regulations. CERCLA does not address liability
for petroleum wastes. Petroleum wastes include the wastes generated by oil
or gas production, refining, storage and retailing. However, there are
other Federal and State laws which may apply to petroleum products.
In 1996, Congress amended
CERCLA, under an amendment known as the Asset Conservation, Lender
Liability, and Deposit Insurance Protection Act (Asset Conservation Act).
In short, under the amendment, a fiduciary's liability is limited to the
assets held by that fiduciary in trust. However, this does not apply to the
extent that a person is liable under the Act independently of the person's
ownership of a facility as a fiduciary or actions taken in a fiduciary
capacity. Also, if negligence of a fiduciary causes or contributes to the
release or threatened release of hazardous substance, there is no
The Asset Conservation
Act defines fiduciary as trustees; executors; administrators; custodians;
guardians of estates or guardians ad litem; receivers, conservators,
committee of estates of incapacitated persons, personal representatives,
trustee (including successor trustees) under an indenture agreement; trust
agreement; lease or similar financing agreement for debt securities or other
forms of indebtedness as to which the trustee is not acting in the capacity
of trustee, the lender or, representative in any other capacity that the
administrator, after providing public notice, determines to be similar to
the capacities previously described.
The Asset Conservation
Act states that a fiduciary shall not be held liable for the following:
Undertaking or directing another person to cleanup a site
Terminating the fiduciary relationship
Including in the terms of the fiduciary agreement a covenant, warranty, or
other term or condition that relates to compliance with an environmental
law, or monitoring, modifying or enforcing the terms or condition
Monitoring or undertaking one or more inspections of the facility
Providing financial or other advice or counseling to other parties to the
fiduciary relationship, including the settler or beneficiary
Restructuring, renegotiating, or otherwise altering the terms and conditions
of the fiduciary relationship
Administering, as fiduciary, a facility that was contaminated before the
fiduciary relationship began; or
Declining to take any of the above actions
This amendment was tested
in the courts by Canadyne-Georgia Corporation. In 1996, the corporation
sued a bank for its fiduciary capacity seeking damages for clean-up costs.
After a lengthy legal process, in 2001, the district court held for the bank
on the final issue.
Fiduciaries should have
adequate written policies and procedures covering environmental risks and
such policies should include:
Pre-acceptance review of potential CERCLA and any state liability by
identifying assets which could contain hazardous waste. If possible, the
specific asset should not be accepted as part of the account. Potential
accounts where the risks are too great or where the risks can not be
managed properly should not be accepted;
existing accounts, a written evaluation of the potential environmental
hazards for land and businesses held in trust accounts;
Corrective action to clean up any hazardous wastes identified;
Periodic inspection and appraisal practices should be amended to include
coverage for hazardous and toxic wastes; and
Required reporting to EPA and/or state pollution control agencies.
Trust counsel should
review the department's policies to ensure that they provide adequate
guidance for and oversight of the management of potential environmental
Land Trusts A land
trust is a grantor-directed type of trust, where the title to real estate is
held by the trustee on the customer's behalf, while all rights and benefits
of ownership are retained by the grantor/beneficiary. The trustee only
holds title to the property and has no responsibility for its care and
maintenance. Several states recognize land trusts, including Illinois,
Indiana, Florida, Virginia, North Dakota, and Arizona. In some states, the
land trust is treated as personal property rather than real estate, during
legal judgments. The benefits of a land trust are the following:
probate expenses and delays
of the property is recorded in the trustee's name, and provides privacy to
the actual owner.
administrative difficulties related to multiple ownership and multiple
can be pledged as collateral.
can be terminated at any time by either party.
the trustees duties are extremely limited, there are several areas of
potential exposure, including the following:
Internal policies should require the verification of signatures and
Tax Bills -
Internal procedures should include the prompt forwarding of special
assessments, reassessments, delinquency and/or redemption notices.
Interest - The bank can be both a lender and a trustee for these
transactions. Case law has generally permitted serving in two capacities,
as long as the bank acts fairly and reasonably.
The bank may become a party to lawsuits involving foreclosure proceedings,
building code violations, IRS tax liens, and environmental liability
issues. It appears that the more active and discretionary the trustees'
powers are, the more likely the trustee is considered an "owner or operator"
or "responsible party."
To mitigate these concerns,
trust management should review title searches and other public records to
determine if the person representing ownership actually has ownership of the
property and the current and prior uses of the property.
Real Estate Investment Trust Act of 1960 allows companies dedicated to
owning and, in most cases, operating income-producing real estate to operate
as a real estate investment trust. The REIT
structure qualifies as a pass-through entity under IRC and is exempt from
corporate taxes, as long as its activities are restricted to certain
commercial and real estate activities. Most states also exempt REITs from
state income taxes. The underlying real estate may be concentrated in a
specific geographic region or in a certain type of property. Some REITs are
more diversified and own property nationwide and/or in a wider variety of
property types. The majority of the underlying real estate consists of
retail, residential, and industrial/office. REITs provide current income,
as they are required to pay out 90 percent of their income to investors.
There is also the potential for long-term appreciation. The majority of
REIT shares can be bought through brokers and can be purchased in small
lots; the shares of REITs are traded on stock exchanges. The unsecured debt
of a REIT is also rated by nationally recognized rating agencies. Some
mutual funds invest entirely in REITs.
three major types of REITs are described as follows:
Equity REIT -
The vast majority of the
REITs are Equity REITs, which invest in and owns properties through a corporation
or trust that uses the invested funds to purchase and manage the
properties. The rent from those properties is the income. Equity REITs are
traded on major exchanges, which provide liquidity. The underlying property
usually consists of commercial property, such as shopping centers and
hotels. There is no minimum investment amount.
Mortgage REIT -These REITs loan funds to
the owners of real estate (and obtain a mortgage), or invest in or purchase
mortgages or mortgage-backed securities. Interest income on the mortgage
loans serves as the source of income.
Hybrid REIT -
This form is a combination
of the above two forms. Therefore, both properties and mortgages are held.
general, the evaluation of a REIT should include an assessment of those who
manage the real estate held by the REIT; the perceived access to debt or
equity financing sources; and the REIT's earnings potential. To determine
the latter, the industry adopted the methodology of "Funds from Operations (FFO)" to address
valuation problems and performance. FFO excludes the following from the net
income figure: depreciation and amortization costs; gains and losses from
extraordinary items; gains or losses from debt restructuring; and, gains or
losses from sales of real estate. The allocable portions of funds from
operations of unconsolidated joint ventures based on ownership interest are
added back to net income under FFO. While this should be more
accurate, the figure can be somewhat misleading in the analysis of older
properties with high required maintenance expenditures.
Terms Associated with REITs
Payout Ratio -The ratio of a REIT's
current annual dividend rate per share divided by its annual FFO per share.
Purgatory -This is an unofficial industry term
that means the REIT is shut-off from capital
sources. This may occur due to reputation or growth. The most common
reasons that a REIT is so designated are for providing misleading financial
information; increasing leverage for growth, if the acquisitions would
otherwise be unjustified under the REIT's strategy or portfolio composition;
or taking actions that public companies would not make. REIT Purgatory is
reserved for companies that have long-term structural, systemic, or
Taxable Rent Subsidiary (TRS) -
Created by the REIT
Modernization Act of 1999, a TRS is a subsidiary of a REIT that provides
services to the REIT's tenants and others and is required to pay Federal
Income Tax, without disqualifying the tax-exempt status of the REIT. These
are similar in concept to the affiliated relationships in mutual fund
Umbrella Partnership REIT (UPREIT) -Generally, the partners of
one or more existing partnerships and a newly formed REIT become partners in
a new partnership termed the Operating Partnership. For their interest in
the Operating Partnership (OP Units), the partners contribute the properties
from existing partnerships and the REIT contributes the cash proceeds from
its public offerings. The REIT typically is the general partner and
majority owner of the Operating Partnership. Partners may sell their OP
Units, usually in convertible format, for shares of the common stock of the
REIT. When an OP Unit partner dies, the estate tax rules permit the
beneficiaries to tender the Units for cash or REIT shares without paying
F.7.e. Mineral Interests Investments in natural
resources such as oil, gas, and mineral interests, may be found in some
trust departments. Such investments require special expertise. Policies
for the management of these assets should be established. The authority for
acquiring and/or retaining these assets should be evidenced either by
specific language in the governing document, or by the consent of all
interested parties. Holdings of this type should be reviewed regularly in
terms of performance and appropriateness. Evidence of title, such as copies
of deeds and title opinions should be maintained. Usually, title to land is
a surface right and does not include mineral rights. Therefore, two or more
different parties may have an interest in a parcel of real estate, with one
having surface rights and the other mineral or subsurface rights. A review
of the title should clearly show which interest is held. The status of the
property, whether leased or unleased, and producing or nonproducing, should
be determined by the trust management immediately upon accepting an
account. When properties are placed in trust, the instrument conveying the
property to the trustees should be recorded in the county or parish of the
state in which the property is located. Copies of any leases should also be
maintained. If working interests are involved, the trust department should
have a copy of the operating agreement. If necessary, adequate property and
liability insurance should be obtained. Proper bookkeeping and information
systems should be established, including: ticklers covering delayed rentals
on nonproducing interests, expiration of all leases and royalties, and
income and expense records. Appropriate checks should be established to
identify omitted or significant changes in regular lease income payments.
In order to hold title to mineral interests in another state, the bank may
have to qualify to do business as a fiduciary in that state, or arrange for
the appointment of an ancillary trustee.
F.8 Limited Partnerships Limited partnerships
usually consist of a general partner, who manages the project, and limited
partners, who invest funds in the project. The limited partners are not
normally involved in the day-to-day management and usually cannot lose more
than their capital contribution. Limited partners normally receive income,
capital gains and tax benefits, while the general partner collects fees and
a percentage of capital gains and income.
partnerships are sold through brokerage firms, typically for relatively
small investments. Private limited partnerships are generally comprised of
fewer than 35 limited partners, and require much more substantial
investments than public limited partnerships. Both types of limited
partnerships may have limited marketability. Limited partnerships may be
difficult to value, which has led to the emergence of companies specializing
in valuing limited partnership interests.
Limited partnerships are
involved in real estate management and development, oil and gas exploration
and recovery, and equipment leasing. They also finance movies and research
and development projects. The limited partnership form of ownership is used
extensively for venture capital and leveraged buyout funds. All types of
investors participate in such investments.
In the early to
mid-1980's, when real estate was booming and oil and gas prices were strong,
$130 billion in limited partnerships were sold to an estimated 10 million
investors. Tax laws initially allowed deductions of limited partnership
losses from ordinary income, but this was eliminated by the Tax Reform Act
One major advantage of
limited partnerships is that they are excluded from corporate taxation by, as its
name suggests, qualifying for taxation as a partnership. The principal
disadvantages are that partnership tax accounting must be used and that the
sponsor must provide a corporate general partner to hold 1 percent of the aggregate
assets. General partners must make significant cash investments and they
retain unlimited liability for the partnership's obligations.
Many limited partnerships
have little or no market value. In 1995, one source estimated that fair
market prices were only 20 percent to 60 percent of a partnership's net asset value. The
same source concluded that of approximately 2,000 limited partnerships, only
an estimated 300 traded with regularity -- and then only by independent
dealers using their own clearinghouses for such transactions. These
conditions do not contribute to high or competitive selling prices.
The proper valuation of
such investments is especially important. Examiners should ascertain that
the institution has the ability to obtain reasonably current fair market
values for such investments and that customer statements reflect market
values. The failure to properly value limited partnerships may lead to
overcharging accounts if management or account fees are based on the market
value of assets and, as noted in the following paragraphs, can cause
difficulties for ERISA plans.
investments of employee benefit plans subject to ERISA must be reported by
the plan administrator as a plan asset on the plan's Annual Report
Form 5500 found in Section 5. J. Form 5500 requires plan assets
to be valued at a reasonable market value. If the bank acts as plan
administrator, or is responsible for furnishing market values of plan assets
to a plan administrator, it must have appropriate procedures for valuing
limited partnerships. Since limited partnerships are not traded on a
regular basis, it may be difficult for the plan administrator to arrive at a
reasonable market value. Since many limited partnerships reportedly have
little value, it is particularly important for plans to obtain accurate
market values for these assets.
Formal annual appraisals
are not required, but the plan administrator must be able to demonstrate
that a reasonable approach was taken in valuing the asset.
IRS Revenue Ruling 59-60 provides general guidance on valuing
non-traded assets. It outlines the general factors that must be taken into
consideration and requires a written report detailing the valuation. It
indicates that the assets must be more than simply valued. The valuation
should also reflect any "lack of control" or "lack of marketability." While
the Revenue Ruling is specifically directed toward valuing estate assets, it
is widely acknowledged as a general standard for valuing non-traded assets.
IRS Announcement 92-182, "Employee Plans Examination Guidelines," provides the following guidance in
valuing limited partnership interests and applying
Revenue Ruling 59-60:
accurate assessment of fair market value is essential to a plan's ability
to comply with the requirements set forth in the [Internal Revenue] Code
and in Title I of ERISA."
"Plans must value their trust investments at least once a year, on a
specified date, in accordance with a method consistently followed and
Ruling 59-60 provides guidance for determining the value of plan
assets. Although 59-60 provides methods for valuing shares of stock for
closely-held corporations for estate and gift tax purposes, the factors
may be used to determine values of assets in qualified plans ..."
detail of the plan's valuation should be examined in light of the plan
assets involved. For example, the valuation should contain substantial
detail if it values a limited partnership or a closely held corporation."
Under IRC Section 408)(i),
IRA trustees/custodians are required to report the fair market value of
assets to the IRS and IRA owners on an annual basis on Form 5498.
In an information letter
dated February 24, 1993, the IRS provided guidance on how limited
partnerships in IRA accounts should be treated. In addition to generally
affirming the above points, it indicated that the IRA trustee "or issuer" is
responsible for proper valuations, and that the trustee or issuer cannot
waive, or be released or indemnified by the participant, from such valuation
As a result, original
cost or an amortized original cost would not normally be considered a
reasonable valuation. Since most limited partnerships are not readily
traded, the Net Asset Value (NAV) of each partnership unit may be available
only on request of the general partner. Since the general partner may have
a financial interest in the partnership, either as an investor or as a
sponsor, the NAV obtained from the general partner should not automatically
be considered the market value.
The plan administrator
should attempt to evaluate the reasonableness of the NAV by, for instance,
comparing it against other recent trades of the limited partnership's units,
consulting a limited partnership valuation service or some equivalent
Family Limited Partnerships (FLP)
or Limited Liability Companies FLP are a form of limited
partnerships, formed to manage and control family property. All of the
requirements for a limited liability partnership must be followed. In general, there are two types. One is the discounted
technique, where assets are "discounted" in value, which ultimately reduces
estate taxes. In order to receive this treatment, the principal must
relinquish control, prohibit partners from withdrawing from the entity, and
place severe limitations on transfers. Collectively, these restrictions
allow the discounted limited partnerships to leverage wealth. The second
form freezes the value of an individual's estate and shifts future
appreciation to the next generation.
F.10. Master Notes Master note arrangements,
also known as "variable amount notes", are borrowing arrangements whereby
trust accounts provide short-term cash to large companies. These types of
investments may be operated in place of, or in addition to, a bank's Short
Term Investment Fund. With the increased use of commercial paper and other
sources of capital, this form of borrowing has lost much of its popularity.
The documentation of the
borrowing arrangement includes the note evidencing the maximum amount of the
loan, which may be on a demand basis or have a fixed maturity. Either the
note or a separate loan agreement will detail the terms of the credit. The
interest rate is usually adjusted monthly based on commercial paper rates.
The note is payable to the bank or a nominee, and may be repaid by the borrower(s) in whole or in part at any time. The amount of the loan may
fluctuate daily as increases or decreases are made in the participation. If
an account acquires (increases) a participation, a buy order is executed; if
the account withdraws (reduces) a participation, a sell order is executed.
Buy and sell orders are combined at the end of the day, resulting in a net
adjustment to the loan. This is communicated to the borrower on the
following business day, and may be accepted or rejected. Interest, at an
agreed upon rate, must be paid monthly on the daily amount of the loan
outstanding during the preceding month.
A separate investment
control is maintained for each master note. A participant record for each
account should be maintained and appropriate accounting entries made by the
bank each time the loan balance changes in order to ensure that participant
records reconcile to the amount outstanding. Asset records for each
participating account must reflect the investment in the master note.
Broad investment powers in the governing
instrument are sufficient authority for such investments. However,
investments by accounts for which the bank does not have full investment
responsibility must have letters of direction from parties authorized to
direct each purchase or sale. Custodial and agency accounts may invest in
master notes if the terms of the governing instrument permit.
All master notes should be issued by
companies classified as "prime credits", i.e., an issuer rated in one of the
two highest rating categories by at least two nationally recognized
investment rating organizations. The bank should have full information on
the capital, debt structure, and financial condition of the issuer,
including: total amounts borrowed on master notes, total long and short-term
borrowings, and the most current financial statement. Additionally, the bank
should obtain quarterly certifications that the notes are: not subordinated
to any other debt of the company, there is no litigation pending or
threatened which would affect such notes, and the issuer is not in default
on any of its outstanding obligations.
As a guideline, if the
total amount of variable or master notes exceeds 10 percent of the market value of
the assets held by the trust department, the examiner should question the
prudence of such investments. A bank which has notes issued by any one
company in excess of 5 percent of the market value of the department's total assets
should be requested to justify the prudence of such investments. Where a
note has both a demand and fixed term component, the examiner should comment
upon the arrangement when the fixed term is in excess of 50 percent of the
principal amount of the note. As with other types of investments, the bank
should have appropriate written policies and procedures governing the use of
master notes, including the maximum amount of funds to be extended, the
submission of current financial information, periodic credit reviews of the
borrower and the submission of corporate borrowing resolutions.
A conflict of interest
may exist if the commercial department of the bank also has loans
outstanding to the master note obligor.
F.11. Business Interests The primary types of
business interests encountered in a trust department are: (1) Stocks or
other securities of closely held corporations, i.e., a corporate entity
whose stock is not actively traded, (2) Partnership interests, either
general or limited, (3) Sole proprietorships, and (4) Joint ventures. The
management of business interests is often demanding, time consuming and
Family business interests
can pose administrative problems to the trust department. One of the
greatest problems in holding the securities of a closely-held business is
the limited marketability due to concentrated ownership. This is
particularly true if an accounts holds a minority interest. The illiquid
nature of a minority interest, when combined with a lack of investment
diversification, may cause concern. When the bank as fiduciary holds a
minority business interest, it may attempt to identify other shareholders
with whom it can jointly control or influence the management of the
closely-held business. The surcharge potential is perhaps the most important
concern with fiduciary appointments involving family business interests.
The purpose of reviewing
the administration of closely-held business interests is to evaluate both
the institution's expertise and its actual management of such business
interests. Due to the relatively high surcharge potential, the bank should,
prior to accepting such an appointment, thoroughly review all the potential
risks and disadvantages associated with administering a closely-held
business. If bank policy permits, it may be desirable for the fiduciary to
represent the account by having a bank officer serve as an officer or
director of the company. However, a directorship involves a certain degree
of potential liability to the bank and the individual serving as a director.
Therefore, consideration should be given to obtaining appropriate indemnity
insurance to cover these situations.
Occasionally banks are
appointed executor or administrator of an estate which includes a
sole proprietorship or a partnership interest. As a general rule, such businesses
terminate upon the death of the proprietor or partner, but it usually takes
considerable time to settle outstanding business matters. The bank should
work closely with estate counsel and others interested in the business, as
conveyance of such business property is complicated and may be disruptive to
the beneficiaries. It is important to determine that the bank has limited
its liability in administering such property.
Conflicts of interest may
be present when the bank is lending to the business. The bank should
approach this area cautiously and seek outside financing sources first.
Additionally, the bank should prohibit its personnel from acquiring an
interest, financial or otherwise, in the company, other than representing
the beneficiaries and the bank.
The examiner should
review and evaluate the adequacy of the department policies governing the
administration of business interests. The expertise of the bank in
administering such interests should be evaluated through a review of board
minutes, trust committee minutes, account files, and the qualifications of
its personnel. Compliance with laws, governing instruments and standards of
prudence should be determined, the possibility of conflicts of interest
ascertained and the potential for liability to the bank assessed. Trust
departments that actively manage business interests should be familiar with
Federal Statutes that could impact the operation of the business. An example
would be the Americans with Disabilities Act, which prohibits discrimination
in private employment, transportation, telecommunications, and public
determine the extent to which the trust department monitors these
investments. The department should periodically request financial
information from the business, develop a method of evaluating the business'
financial condition and document its findings. Additionally, these assets
should be carried on the books of the trust department at some value that is
supportable based on the available documentation.
F.12. Worthless Securities On occasion, the trust
department will receive securities which are or become worthless, particularly in
estates and guardianship accounts. In determining if securities are indeed
worthless, the department should obtain documentation, from the corporation
commission or the secretary of state of the state in which the corporation
that issued the security was chartered, evidencing that the corporation is
no longer in business. Frequently, this documentation will state that the
securities are worthless. Once such a determination has been made, the
information should be presented to the trust committee with a request for
approval to write-down the carrying value and identify the securities as
worthless on the department's records.
worthless securities should be returned to the trustor or distributed to the
account beneficiary. Those securities remaining in the trust department's
control can be listed among the account's assets, or carried in a house
account with a reference to the account holding the asset. For control
purposes, the department should continue to carry the securities on its
records at a nominal value.
A complete list of
worthless securities should be maintained and the securities kept in the
trust securities vault under dual control. Periodically, the list should be
reviewed to determine if any of the issues have become marketable, since
they occasionally regain value. Protective measures are recommended to guard
against neglect or misappropriation of any securities that regain value.
F.13. Tangible Assets and "Collectibles" Tangible assets include
works of art, antiques, stamps, coins and bullion, and diamonds and
gemstones. Such assets often appeal to individuals who do not need current
income from all their investments, and, therefore, can allocate a portion of
their assets to tangibles in an effort to provide long-term capital gains
with no current income tax consequences. Assets of this type are often
viewed as an inflation hedge.
An examiner has several
objectives in reviewing the management of tangibles. First, the examiner
needs to determine that the department has adequate control over the assets
and has made provisions for proper storage and adequate insurance.
Management should attempt to verify ownership of the assets, as the grantor
can't acquire good title to stolen property. Stolen artwork has resurfaced
years later and has been returned to the rightful owner. However, discovery
and demand for the return of stolen art must be made. The recovery period
can extend well beyond the statute of limitations. In one case, the court
ruled that the statute of limitations didn't begin until a museum demanded
the item be returned. That was 30 years after discovery.
Rare stamps and coins
should be authenticated by an expert (such as the Philatelic Foundation of
New York for stamps and the American Numismatic Association for coins). For
diamonds and other gemstones a certificate should always be obtained. It is
essential that such assets be maintained under dual control. Separate
storage of tangible assets that might suffer significant damage, such as
stamps, should be considered.
The purchase and
retention of tangible assets should be permitted in the governing
instruments. Appraisals should be obtained periodically. With some notable
exceptions, tangible investments may be difficult to liquidate. A national
auction market exists for investment grade stamps. Gemstones are usually
sold by consignment through a major dealer. Some risks can be minimized by
permitting such investments only in directed, i.e.
non-discretionary, accounts, and by using reliable dealers and auction
The Economic Recovery Tax
Act of 1981 essentially eliminated the option of investing in tangibles for
self-directed employee benefit accounts (IRA, Keogh, Pension and Profit
Sharing) after December 31, 1981. Under the law, any funds of a
self-directed retirement plan used to purchase tangible assets must be
treated as a taxable distribution of the plan's assets to the participant(s).
Section 5 for further discussion of this
topic. However, if an independent trustee or qualified investment manager,
vested with investment discretion, selects tangibles as an investment, the
participants of the plan would not be similarly penalized.
F.14. Repurchase Agreements A repurchase agreement is
an acquisition of funds through the sale of securities, with a simultaneous
agreement (commitment) by the seller to repurchase the securities at a later
date. The owner of a U. S. Government or agency security transfers
possession of the obligation for a percentage of its market value, but
retains ownership and the inherent rights to receive the interest and
principal of the obligation. At an agreed upon future date, the owner
(seller) repurchases the obligation to repay the amount borrowed plus the
agreed upon interest. A repurchase agreement, regardless of the terminology
used, is a secured borrowing by which an owner (seller) leverages existing
positions in securities by pledging these holdings against the repurchase
Some trust departments
engage in repurchase agreement transactions as a temporary investment
vehicle for cash balances awaiting permanent investment or distribution. In
this context, a trust account becomes the lender of funds to a financial
institution or a broker/dealer. Although the trust account acquires an
asset, it will generally be identified on the trust department's records as
a repurchase agreement. Repurchase agreements are collateralized by U. S.
Government or agency securities, bear a fixed or variable rate of interest,
are payable at a fixed maturity (one day or longer) and may be subject to
other terms and conditions.
bought from the bank's commercial department or from bank affiliates
represent loans by trust account(s) to the fiduciary bank and involve a
conflict of interest and self-dealing. The purchase of repurchase agreements
from the bank's commercial department, affiliates of the bank or other
organizations, where there exists an interest which might affect the best
judgment of a fiduciary, should not be made unless specifically authorized
either in the instrument creating the trust relationship, by court order, by
local law or unless prior written approval is obtained from all interested
parties. If appropriate authorization is contained in the instrument or
local law, or obtained from a court or all interested parties, the examiner
should review the investment in light of normal investment considerations,
e.g., rate of return, diversification, adequacy of pledged securities
(collateral margin), maturities, etc. The bank must pay a competitive rate
of interest and the terms must be no less favorable than those granted to
others purchasing the same types of repurchase agreement.
In those cases where such
investments are not authorized, the examiner should fully discuss the matter
with management, obtain a commitment to take corrective measures, and detail
the situation in the Report of Examination.
The Department of Labor,
Prohibited Transaction Class Exemption 81-8,
dated January 23, 1981, "Short-Term Investments", allows employee benefit
plans to acquire repurchase agreements with maturities of one year or less
from parties-in-interest. However, the obligor financial institution or its
affiliate(s) cannot hold discretionary authority or control over the
investment of assets of the plan purchasing its obligation. If the
department has purchased own-bank or affiliate bank repurchase agreements for discretionary
accounts, or directed employee benefit plans subject to ERISA prohibited
transaction provisions without obtaining proper written direction, the
examiner should fully discuss the matter with management and schedule the
investment(s) as an apparent violation(s) of ERISA Section 406 (prohibited
transactions with a party-in-interest) and/or
ERISA Section 404 (fiduciary standards).
bought from other financial institutions or broker/dealers may be an
acceptable short-term investment provided this type of investment is
authorized by the governing instrument and/or state law, and is appropriate
to the investment needs of an account's beneficiaries. Repurchase
transactions represent a form of lending. Consequently, the considerations
normally associated with granting secured credit should be made by the trust
department. Repayment of repurchases by the selling institution or
broker/dealer is a major consideration. The trust department should satisfy
itself that the seller will be able to generate the funds necessary to
repurchase the securities on the maturity date of the contract. In assessing
the propriety of these transactions, the examiner must determine if the
trust department has considered the ability of the seller to meet its
commitment to repurchase on the prescribed date.
agreement transactions are considered a form of secured lending, the bank
should have written policies governing their use as trust investments and a
written agreement for each transaction outlining specific provisions
pertaining to collateral margins. Acceptable margins, the percentage by
which collateral securing the loan exceeds the credit, should be determined
by considering the maturity and the volatility of the securities pledged,
along with the maturity of the repurchase agreement. The collateral should
be priced on a regular basis to assure maintenance of the required margin.
Monies should not be lent until acceptable types of securities are delivered
into the bank's custody or to an independent safekeeping agent designated by
the bank. Trust department management should not make such investments
without the account(s) acquiring a perfected security interest in the
collateral securities. Registered securities should be endorsed in such a
manner to ensure negotiability. In other respects, collateral coverage
arrangements should be controlled by procedures similar to the safeguards
used to control any type of liquid collateral. The examiner should determine
that proper procedures have been established for the control of collateral
and the maintenance of collateral margins.
Other areas that should
be addressed in policies governing repurchase transactions include: setting
a maximum amount to be extended to a single firm by any one account and by
all accounts in the aggregate; requiring borrowing firms to supply corporate
borrowing authorizations; requiring the submission of current financial
information; and obtaining periodic credit reviews of the borrowing
Additional guidance is
also provided in: the February 17, 1994 Interagency Statement on Retail
Sales of Nondeposit Investment Products (FIL-9-94) and the Government
Securities Act of 1986. The FDIC adopted the FFIEC Supervisory Policy on
Repurchase Agreements on February 10, 1998. This policy statement appears in
Appendix C. The discussion of ERISA requirements is located in
Section 5.H.7.f.16 Repurchase Agreements.
F.15. Securities Lending A number of financial
institutions and their trust departments are involved in securities lending
activities in the capacity of either principal or agent. This is a fee-based service whereby the trust department lends
customers' securities held in custodial, safekeeping, personal trust or
employee benefit accounts. Collective investment funds and mutual funds
whose investments are managed by the trust department may also engage in
primarily involves loans of large blocks of U.S. government and Federal
agency securities held in corporate employee benefit plans. Corporate trust
accounts, personal trust and agency accounts are involved to a lesser
degree. The primary borrowers of securities are brokers and commercial
banks. The primary reasons for borrowing securities are to cover securities
fails (securities sold but not delivered), short sales, and option and
arbitrage positions. On occasion, securities may be borrowed to meet
pledging requirements. Securities lending is conducted through open-ended
agreements which may be terminated on short notice by either the lender or
borrower. The objective of such lending is to increase a portfolio's yield
by receiving fee-based income in addition to interest or dividends.
Securities loans are
generally collateralized by U.S. government or Federal agency securities,
cash or letters of credit. Each loan is initially collateralized at a
predetermined margin. When the loan is terminated, the securities are
returned to the lender and the collateral is returned to the borrower. Fees
received are divided between the institution as lender/agent and the customer
account that owns the securities.
While securities lending
is similar to a repurchase agreement program, repurchase agreements have the
following distinguishing characteristics:
sale and repurchase of U. S. Government or Federal agency securities,
received by the seller and the party supplying the funds receives the
agreement is for a fixed period of time,
is negotiated and established for the transaction at the outset and no
rebate is given to the borrower for interest earned on the cash collateral,
confirmation received classifies the transaction as a repurchase agreement.
lending has been viewed as a low-risk activity which enhances a trust
account's investment return. This has changed in more recent years, as a
number of major losses have occurred due to securities lending activities.
Previously, collateral was generally invested in very short-term
investments. When interest rates were low, the returns on short-term
investments were not attractive. To boost investment results further,
high-grade but longer-term collateral was accepted. When interest rates
suddenly rose, the value of this collateral dropped sharply.
address those concerns, the FFIEC adopted a Supervisory Policy concerning
Securities Lending in 1997. The Policy Statement includes the following
guidelines for participation in a securities lending program.
implement written policies, procedures, and a system of controls which
enables the department to comply with applicable laws and regulations, and
minimizes the potential risks associated with securities lending.
knowledgeable and experienced staff before engaging in any securities
- Management should be able to readily determine which securities are lent,
outstanding loans by borrower, outstanding loans by account, new loans,
returns of loaned securities, and transactions by account.
procedures - All securities lent and all securities used as collateral must
be marked to market daily.
analysis of the borrower - Securities lending activities involve risk of
loss, normally from malfeasance or failure of the borrowing firm or
institution. Therefore, the lender should approve transactions with the
borrower in advance of lending securities. The review should include at a
minimum: an analysis of the borrower's financial statements, management, and
any other material evidence of the borrower's creditworthiness
limit approvals should be based on a credit analysis of the borrower. This
analysis should be performed by individuals who normally perform credit
analyses of borrowers, not the individual responsible for the securities
concentration limits - A credit line should be established for specific
borrowers and should be based on the market value f the securities to be
borrowed. This does not violate material inside information. . Lending
concentrations with any one borrower should be avoided.
Conduct a due
diligence analysis and review of the borrower. Enter into a securities
lending arrangement only pursuant to a written agreement delineating the
duties and responsibilities of each participant. The agreement should
specifically address: the types of and the minimum margins acceptable for
collateral, procedures to maintain adequate margin levels, custody of
collateral, procedures for the collection of dividend and interest payments
on securities lent, and procedures in the event of default. If securities
are used as collateral, the trust department should review regulations for
applicable requirements relating to the pledging, the perfection of the
security interest, and the custody of the securities.
management - Securities borrowers pledge and maintain collateral at least
100 percent of the value of the securities borrowed. However, the minimum
initial collateral on securities loans is at least 102 percent of the market
value of the lent securities plus any accrued interest for debt securities.
Collateral must be maintained at the agreed upon margin. A daily
"mark-to-market" or valuation procedures must be in place to ensure that
calls for additional collateral are made on a timely basis. The valuation
procedures should take into account the value of accrued interest on debt
securities. Securities should not be lent unless collateral has been
received or will be received simultaneously with the loan.
collateral - When cash is used, the lender is responsible for making it
productive, by investing in repurchase agreements, master notes, shot-term
investment fund, certificates of deposit, commercial paper or some other
money market instrument. For fiduciaries lending securities, the governing
customer agreement should outline how cash collateral is to be invested.
Investing in own-bank deposits or repurchase agreements, or investments in
the bank's parent company would be a conflict of interest, unless
specifically authorized in writing by the owner of the lent securities.
credit as collateral - Letters of credit are allowable as collateral for
certain securities lending transactions.
Since trust departments
are not investing for their own accounts, but rather for the beneficiaries
of trust or agency accounts, any securities lending must also take into
Authorization by the governing account instrument. Any discretionary
management of the cash collateral should be subject to clearly delineated
risk tolerance guidelines between the lending account and the trust
accounts over which the bank exercises investment discretion, the decision
to lend securities represents an investment decision. This decision should
be subject to normal fiduciary standards of lending. The following
considerations should be documented:
The appropriateness of the transaction with respect to account
objectives and beneficiary needs;
The prudence of the investment.
The Department of Labor
has issued two class exemptions which address securities lending programs
for employee benefit plans covered by ERISA. Prohibited Transaction
Exemption 81-6 (46 FR7527) issued January 23, 1981, supplemented by (52 FR
19754) issued May 19, 1987, and Prohibited Transaction Exemption 82-63 (47FR
14804) issued April 6, 1982, and corrected by 47 FR 16437 on April 16,
1982. The exemptions authorize transactions which might otherwise
constitute prohibited transaction under ERISA. Prohibited exemption 81-6
permits the lending of securities owned by employee benefit plans to persons
who could be a "party in interest" with respect to such plans, provided
certain conditions specified in the exemption are met. Under those
conditions, neither the borrower nor an affiliate of the borrower can have
discretionary control over the investment of plan assets, or offer
investment advice concerning the assets, and the loan must be made pursuant
to a written agreement. The exemption also establishes a minimum acceptable
level for collateral based on the market value of the loaned securities.
Prohibited Transaction Exemption 82-63 permits a fiduciary to receive
compensation for service rendered in connection with loans of plan assets
that are securities.