Clarification on the Responsibilities of the Board of Directors February 26, 2021: As described in SR letter 21-4/ CA letter 21-2, "Inactive or Revised SR Letters Related to Federal Reserve Expectations for Boards of Directors," this SR letter was revised as of February 26, 2021 to better reflect the Federal Reserve's guidance for boards of directors in SR letter 21-3 / CA letter 21-1, "Supervisory Guidance on Board of Directors' Effectiveness," and SR letter 16-11, "Supervisory Guidance for Assessing Risk Management at Supervised Institutions with Total Consolidated Assets Less than $100 Billion." No other material changes were made to this letter. TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
A recent new law has facilitated conversions of common trust funds into
mutual funds, which has raised several issues and concerns associated with the
practice. It will be important for Federal Reserve examiners to review anticipated or
completed conversions to assess a banking organization's decision-making and risk
management processes, its policies and procedures and its documentation supporting
the conversion decision.
Background
On August 20, 1996, legislation was passed permitting the tax-free
conversion of common trust funds to mutual funds effective after December 31, 1995.1
The new law provides that participants in a common trust fund recognize no gain or
loss from the transfer of substantially all of the assets of the common trust fund into
one or more mutual funds.
A conversion of a common trust fund into a mutual fund may have
important benefits to fiduciary customers because, unlike common trust fund units,
mutual fund shares are portable and may be transferred to another trustee or to the
customer directly, if the situation warrants. Moreover, mutual funds are subject to
specific requirements and restrictions pertaining to formation, investments, liquidity and
disclosure under the Investment Company Act of 1940, that are intended to safeguard
the investor but are not applicable to common trust funds.
The change to the tax laws that now permits a tax-free conversion has
enabled banking organizations to eliminate some of the duplicative administrative and
operational costs associated with offering common trust funds to fiduciary customers
and mutual fund investment products to other customers. Some banking
organizations may also recognize that conversion provides an opportunity to generate
additional income by charging fees for providing trustee services to customers and
additional fees for rendering investment advisory services to the mutual fund in which
their fiduciary customers have invested. Income can also be generated from shared
fee arrangements with unaffiliated mutual fund providers.
Supervisory Concerns
Conversion of common trust funds to mutual funds can raise supervisory concerns if not conducted properly. These concerns, discussed below, focus on the involvement of senior management, the potential for conflicts between the best interests of the banking organization and those of its fiduciary customers, and the possible need for outside technical expertise, all of which need to be addressed by examiners.
Role of Senior Management
The banking organization's senior management should understand the risks and issues associated with conversion of common trust funds into mutual funds. Such analysis should consider customer needs and how the conversion will satisfy those needs, as well as any legal or other risks such action poses to the organization. Examiners should carefully review the organization's decision-making process, its stated reasons for converting its common trust funds to mutual funds, its choice of funds, and its procedures for obtaining customer approval and accomplishing the conversion.
Senior management should be responsible for ensuring that such
conversions comport with federal and state law, as well as with the organization's
policies and the individual trust customer's objectives. Senior management should
also be aware of the potential problems and risks involved that will often require the
advisory services of outside professionals knowledgeable about the requirements and
restrictions contained in the Investment Company Act of 1940, and implementing
regulations of federal and state securities industry supervisors. The qualifications and
experience of any professionals engaged by the organization to assist in the decision-making or conversion process should be considered by management and reviewed by
examiners.
Conflicts of Interest and Suitability
In determining whether to convert common trust funds to mutual funds, a
banking organization must address the possibility that the conversion could result in
conflicts between the best interests of the organization and the best interests of its
fiduciary customers. The banking organization must also determine that the mutual
fund shares are suitable for accounts which previously held common trust fund units.
Banking organizations that convert or transfer common trust funds to mutual funds
may face questions from current and future beneficiaries with respect to these two
issues.
Potential conflicts can arise if a banking organization were to charge a
direct fee to the trust customer for serving as trustee while also charging an advisor's
fee to the mutual fund. Investment advisor fees are not ordinarily permitted to be
charged to common trust funds, and so it may appear that the organization's primary
motive for the conversion was a self-interest in generating greater fee income. State
law may preclude charging of both fees. Moreover, in cases where they are not
prohibited, the organization should review its discretionary fiduciary responsibilities for
each account in order to determine the extent to which it may mitigate the appearance
of a conflict through proper disclosure and subsequent authorization by beneficiaries
who have appropriate powers under the instrument.
Another possible conflict of interest could arise from the use of
proprietary mutual funds when there are unaffiliated mutual funds or alternate
investment opportunities available that may be equally appropriate for the participant's
portfolio. Again, the appearance that the organization put its own interests above
those of its fiduciary customers may cause concern particularly if investments are
made in a newly established proprietary fund with no history or track record. It is
important that the organization thoroughly document its decision to transfer common
trust funds into proprietary mutual funds.
The investment objectives and attributes of the organization's common
trust funds that made them suitable and authorized investments do not necessarily
carry over to the mutual funds that replace them. Accordingly, management must
demonstrate that it has determined that the governing trust instrument for each
affected customer authorizes investment in mutual funds and that the mutual funds
were suitable investments for the particular accounts. For certain types of trust
accounts, such as a conservatorship or guardianship, court approval may be required
to invest in mutual funds. For other accounts, amendments to agreements or letters
of direction authorizing investments in mutual funds may be necessary. Prior
investment decisions that approved the purchase of common trust fund units for an
account's portfolio must be reconsidered to verify suitability for all accounts about to
receive mutual fund shares. Management should maintain, and examiners should
review, documentation supporting the decision to invest in or hold specific mutual
funds.
State Tax Laws
Although federal tax law now provides for tax-free conversions of
common trust funds in most cases, any tax consequences that may arise under
particular state tax laws must be considered. This applies not only to the state tax law
that governs the individual common trust fund, but also to the law governing each of
the different types of common trust fund investors that may be affected by the
conversion. Although many state laws are consistent with federal law, there may be
discrepancies requiring resolution through the courts or through the legislative
process. Accordingly, examiners should confirm that the organization has been
advised by competent, experienced experts on state tax law requirements applicable
to such conversions to assure they conform with state law.
Supervisory Follow-up
To the extent that examiners identify significant issues or concerns
pertaining to common trust fund conversions, it is requested that the respective
Reserve Bank forward such information to the Manager, Trust/IS Supervision Section,
stop 407, at the Board. This will facilitate the collection and dissemination of
information on industry practices throughout the System.
Please distribute this letter to the appropriate supervision staff including
all examiners of fiduciary and securities activities. Staff may find it of interest to refer
to two interpretations on related subjects: 12 C.F.R. 225.125 issued by the Board,
which pertains to a banking organization's investments in a proprietary mutual fund,
and OCC Interpretive Letter 722 - May 12, 1996, which pertains to national banks.
Should there be any questions regarding this letter, please contact Don R. Vinnedge at (202) 452-2717.
Assistant Director
Cross References:
Investment Company Act of 1940 12 C.F.R. 225.125 OCC Interpretive Letter 722 - May 12, 1996
Footnotes 1. The Small Business Jobs Protection Act of 1996, includes Section 1805(h), Nonrecognition Treatment For Certain Transfers By Common Trust Funds To Regulated Investment Companies, which amended the tax treatment of conversions into mutual funds under Section 584 of the Internal Revenue Code of 1986. Return to text |
||||||||||
