97-18
July 30, 1997
Re: Investment of Fiduciary Funds in ___________
Dear Mr. __________:
This relates to the comments in the report of our examination of ________ as of March 10, 1997, regarding ________’s investment of trust assets in the ________. Your response to the report of examination indicates that you disagree with our comments.
As we understand it, ________ organized ________ as a Delaware limited liability company for the purpose of functioning as a collective investment fund. ________ is the investment manager of ________ . As compensation for this service, ________ receives a base fee and may receive an incentive fee depending upon the fund’s performance. Some of the funds invested in ________ represent money held by trusts for which ________ serves as trustee with discretionary investment authority (“fiduciary funds”). The agreement relating to management of ________ indicates that at least 1% of the funds invested in ________ must be corporate funds of ________ . The remaining funds invested in ________ come from sources with respect to which ________ is not a trustee.
On the basis of the information obtained during our examination of ________ and after review of your response to the report of examination, it appears that ________ ‘s receipt of fees for management of a collective investment vehicle in which it invests fiduciary funds violates fundamental principles of trust administration. Specifically, the trustee of a trust has a duty to administer the trust solely in the interest of the beneficiaries (Subdivision (a), Section 16002, Prob. C.) Also, a trustee has a duty not to use or deal with trust property for the trustee’s own profit or for any other purpose unconnected with the trust, or to take part in any transaction in which the trustee has an interest adverse to the beneficiary (Subdivision (a), Section 16004, Prob. C.).
The above cited provisions of the Probate Code codify general principles of trust administration. Applying these principles, the Office of the Comptroller of the Currency (the “OCC”) has held that, if a national bank as trustee invests trust funds in a mutual fund, it is a breach of the duty of loyalty for the national bank to accept an administrative fee from the mutual fund, and a national bank may not engage in such a practice unless it is specifically authorized by local law, court order, the trust instrument, or the consents of all parties in interest given after full disclosure. OCC Banking Circular No. 219, October 31, 1986, CCH Federal Banking Law Reporter, Par. 35-572. See, also, OCC Trust Interpretation Letter No. 234, September 21, 1989, CCH Federal Banking Law Reporter, 1989-1990 Transfer Binder, Par. 83,072 (funds held by a national bank as to fiduciary should not be invested in a mutual fund for which the bank serves as investment advisor) and OCC Interpretive letter No. 525, August 8, 1990, CCH Federal Banking Law Reporter, 1990-1991 Transfer Binder, Par. 83-326 (confirming OCC Trust Interpretation Letter No. 234).
In October 1990, the OCC issued Interpretive Letter No. 519 (CCH Federal Banking Law Reporter, 1990-1991 Transfer Binder, Par. 83,230), which found that a conflict of interest is likely to occur in an arrangement whereby a bank receives credits for investing custodial fund balances in a mutual fund when the bank may also invest fiduciary balances in the same fund. These conclusions were reaffirmed in Interpretive Letter No. 525 in November 1990.
Interpretive Letter No. 519 contained the following significant language:
“A conflict of interest may exist in circumstances in which a national bank receives credits based on the investment of custodial balances, even though the bank does not exercise discretion in the investment of such funds, if the same bank, with investment discretion, also invests fiduciary funds in the same mutual fund. A conflict of interest arises when a bank trustee’s duty to make investment decisions based exclusively on the best interests of trust customers is compromised or clouded by the potential for receipt of collateral benefits. For example, a bank may be tempted to invest discretionary funds in the mutual funds in order to provide the minimum investment necessary to warrant the mutual fund’s establishment and maintenance and thereby receive credits for eligible investments. Moreover, a bank may be influenced to invest discretionary funds as a means of maintaining the contractual arrangement which provides credits related to the custodial investments.
“The conflict of interest is not cured by disclosing the credit arrangement to investors or by withholding credits based on the maintenance of fiduciary fund balances. Notwithstanding such precautions, national banks still may have an incentive to invest fiduciary funds in order to support the funds. Consequently, a bank’s trust department would be inhibited from making a disinterested investment decision based solely on the best interest of its discretionary customers. Accordingly the receipt of credits for custodial funds invested in a mutual fund into which trust funds are also invested may violate 12 C.F.R. Section 9.12(a), unless lawfully authorized by the underlying trust document, a court order or local law.” (Emphasis added.)
Receipt by ________ of both fixed rate and incentive fees from ________ for providing investment management services presents an even greater potential for conflict of interest than discussed in the above cited OCC opinions.
As indicated above, there are four conditions under which the subject investments might be permissible, namely, if the investments were permitted by (1) court order, (2) the trust instruments, (3) the consents of all parties in interest to the trust funds, or (4) local law. Our review indicated that neither the trust instruments nor court orders relating to any of the fiduciary funds ________ has invested in ________ specifically authorized investment in a fund from which ________ receives investment management fees. You claim that prior to investing fiduciary funds in ________ , ________ furnished a prospectus on ________ to the income beneficiaries of each of the involved trusts. Such disclosure does not constitute the consent required by law.
In addition, the subject investments are not, so far as we can determine, authorized by state law. Under Financial Code Section 1564, a trust company may establish a common trust fund. However, you concede that ________ does not qualify as a common trust fund. Also, subject to certain conditions, Financial Code Section 1561.1 permits a trust company to invest fiduciary funds in an investment company registered under the Investment Company Act of 1940 which is sponsored by the trust company or for which the trust company acts as a manager or investment advisor. However, ________ is not registered under the Investment Company Act of 1940, and, therefore, does not qualify under Section 1561.1.
Of particular note is the introductory language to Chapter 581 of the Statutes of 1995, pursuant to which Section 1561.1 was added to the Financial Code. Section 1 of Chapter 581 states in pertinent part:
“(b) Without this legislation, California trust companies cannot offer this investment service [investment of trust funds in a mutual fund advised, managed or sponsored by the trust company] to their existing fiduciary trust accounts without a court order or specific consent or authorizing language in the trust instrument.”
We have reviewed the letter from Paul, Hastings, Janofsky & Walker dated April 10, 1997, which opines that Section 1564 of the Financial Code does not imply that a common trust fund is the exclusive means by which a trust company may provide pooled investment management services. However, our concerns focus primarily on the issues of conflict of interest discussed above. Accordingly, we do not consider it necessary at this time to address the question of whether a trust company is limited by statute to providing pooled investment management services through a common trust fund. Inasmuch as your attorneys’ letter does not address the primary issue at hand, we have not evaluated it in depth.
In sum, it is our view that ________ ‘s investment in ________ of trust funds with respect to which ________ has discretionary investment authority violates fundamental principles of fiduciary administration set forth in Probate Code Sections 16002 and 16004.
Your response to our report of examination states that you propose to alleviate our concerns about ________ as follows:
“Given the many criticisms raised concerning the ________ , ________ proposes to sell its interest in the ________ to a newly formed subsidiary (“________ “) of its parent, (“________”) and have ________ assume the role of Manager of the ________ . It is further proposed that ________ would provide certain administrative and investment services to the ________ under a management contract.”
This proposal does not appear to cure the problem for at least two reasons. First, ________ would presumably receive a fee for the investment services it would continue to provide to ________ under the proposed management contract. ________ would, therefore, continue to violate the conflict of interest principles already discussed. Second, even shifting all responsibility for and economic benefit of managing ________ to ________ would not appear to solve the problem, because ________, which owns and controls ________ , would receive the benefit of any fees paid to its subsidiary ________ . Whether ________ receives the fees itself or is caused by ________ to deal with fiduciary funds in a manner that generates fees which inure to ________, ________ ‘s obligation of undivided loyalty to its trust customer is compromised.
We consider ________ ‘s relationship with ________ to be a serious violation, which requires prompt corrective action. We, therefore, request that you submit to us not later than August 28, 1997 a plan, which is acceptable to us, for correcting the situation.
We would, of course, consider anything further you may wish to present regarding the issues discussed above. Any such communications should be furnished in time to enable us to fully evaluate your positions and not interfere with the deadline specified above.
Other issues raised in your response to the report of examination will be addressed in a separate letter from our Examination Division.
If you have any questions regarding this letter, please feel free to contact me at (415) 263-8512.
Very truly yours, CONRAD W. HEWITT
Commissioner of Financial Institutions
By,
THOMAS M. LOUGHRAN
Senior Counsel
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