Fiduciary Conflicts: What (or Where) are they now??

1
Fiduciary Conflicts What (or Where) are they
now??

• Clint Lackey
• Director of Compliance Oversight,
• Fiduciary and Insurance Activities
• Wells Fargo Bank, N.A.

2
Disclaimer

• The views expressed today are my own and do not
  necessarily reflect the views of Wells Fargo
  Bank, N.A.

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Topical Objectives

• Review conflicts and self-dealing
• Risk and regulatory concerns
• Where might we find conflicts now?
• How do we prevent or address conflicts?

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Starting Point Common Law Duty of Loyalty
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The Duty of Loyalty
the most fundamental duty owed by the trustee to
the beneficiaries of a trust.

• Not imposed by the terms of the trust, but by the
  nature of the relationship which arises from
  the creation of the trust.
• The trustee must administer the trust solely in
  the interest of the beneficiaries.
• The trustee must not put himself in a position
  where it would be for his own benefit to violate
  his duty.

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Duty of Loyalty (Cont.)

• Chief Judge Cardozo in his opinion rendered in
  Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545,
  546 (1928), described a fiduciary's duty of
  loyalty as follows
• "Many forms of conduct permissible in a workaday
  world for those acting at arm's-length, are
  forbidden to those bound by fiduciary ties. A
  trustee is held to something stricter than the
  morals of the market place. Not honesty alone,
  but the punctilio of an honor the most sensitive,
  is then the standard of behavior. As to this
  there has developed a tradition that is unbending
  and inveterate. Uncompromising rigidity has been
  the attitude of courts of equity when petitioned
  to undermine the rule of undivided loyalty by the
  'disintegrating erosion' of particular
  exceptions. Only thus has the level of conduct
  for fiduciaries been kept at a level higher than
  that trodden by the crowd."

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What is Self-Dealing? (Cont.)

• A clear statement of law regarding self-dealing
  was expressed by the U.S. Supreme Court in
  Michoud v. Girod, 11 L.Ed. 1076, 1099
• "The general rule stands upon our great moral
  obligation to refrain from placing ourselves in
  relations which ordinarily excite a conflict
  between self-interest and integrity. . . . It
  therefore prohibits a party from purchasing on
  his own account that which his duty or trust
  requires him to sell on account of another, and
  from purchasing on account of another that which
  he sells on his own account. In effect, he is not
  allowed to unite the two opposite characters of
  buyer and seller, because his interests, when he
  is the seller or buyer on his own account, are
  directly conflicting with those of the person on
  whose account he buys or sells."

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Conflicts of Interest Self-Dealing

• Duty of Loyalty the interest of your client is
  paramount.
• Statutory/Regulatory citations of interest
• 12 USC 92a(h)
• ERISA
• State statutes
• 12 CFR 9
• Contrast with conflicts under the fiduciary
  standards for others in financial industry.

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Permissive Exceptions toDuty of Loyalty

• The duty of undivided loyalty can only be waived
  if
• Authorized by applicable law
• Governing Instrument
• State Law
• Federal Law
• Court Order

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Permissive Exceptions toDuty of Loyalty

• Beneficiary Approval
• Must fully disclose the conflict.
• Must not be in contravention to local law.
• Revocable Trust Grantor Approval
• Written direction of the grantor required.

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Regulatory Perspectives

• Common Law
• Federal Law (US Code)
• State Statutes (Uniform Trust Act?)
• Federal Regulation
• Policy and Procedure

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Federal Laws

• 12 USC 92a(h) - Loans of Trust Funds to Officers
  and Employees Prohibited Penalties
• National bank is strictly prohibited from lending
  funds from the fiduciary accounts it administers
  to the banks officers, directors, or employees.
• If any bank officer, director, or employee makes
  or receives any such loan, that person may be
  fined up to 5,000, imprisoned, or both.
• The regulators may bring enforcement actions
  against the bank and its officers, directors, and
  employees, including the imposition of civil
  money penalties.
• No exceptions to this prohibition are allowed
  under 12 USC 92a(h). The statute prevails over
  any instrument authority, beneficiary consent, or
  court order purporting to authorize the
  transaction.
• The strict statutory prohibition (carrying
  criminal sanctions) against lending trust assets
  to bank employees and insiders does not extend to
  their related interests or to bank affiliates.
• Obligations of directors, officers, or employees
  received in kind are not prohibited by 12 USC
  92a(h) unless they are renewed or carried past
  due at the banks discretion.
• Demand loans of directors, officers, or employees
  received in kind should be paid within a
  reasonable time.

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Federal Laws (Cont.)

• 29 USC Ch. 18 - Employee Retirement Income
  Security Act (ERISA)
• The primary objective of ERISA is to protect the
  rights and interests of employee benefit plan
  participants and their beneficiaries.
• Two government agencies are primarily responsible
  for administration and enforcement of ERISA.
• The Department of Labor is responsible for
  interpreting and enforcing fiduciary provisions
  of ERISA and also interprets those sections of
  the Internal Revenue Code dealing with fiduciary
  requirements for employee benefit plans.
• The IRS is responsible for IRAs, Keogh accounts
  that cover only the individual/employer, and
  various tax-related provisions of the Internal
  Revenue Code.
• Commonly referenced sections of ERISA
• Section 1104 - Fiduciary duties
• Section 1105 - Liability for breach of
  co-fiduciary
• Section 1106 - Prohibited transactions
• Section 1107 - Limitations on acquisition and
  holding of employer securities
• Section 1108 - Exemptions from prohibited
  transactions
• Section 1109 - Liability for breach of fiduciary
  duty

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Federal Regulations

• 12 CFR 9.5 Policies and Procedures
• Must adopt and follow written policies and
  procedures addressing
• Brokerage placement practices 12 CFR 9.5(a)
• Methods for ensuring that officers and employees
  do not use material inside information in
  connection with any decision or recommendation to
  purchase or sell any security 12 CFR 9.5(b)
• Methods for preventing self-dealing and conflicts
  of interest 12 CFR 9.5(c)
• Selection and retention of legal counsel to
  advise the bank and its officers and employees on
  fiduciary matters 12 CFR 9.5(d)
• Investment of funds held as fiduciary and the
  treatment of fiduciary funds awaiting investment
  or distribution 12 CFR 9.5(e)

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Federal Regulations (Cont.)

• 12 CFR 9.10 Fiduciary Funds Awaiting Investment
  or Distribution
• Funds awaiting investment or distribution in
  discretionary accounts shall not remain
  uninvested and undistributed for an unreasonable
  amount of time and should be invested at a rate
  consistent with applicable law 12 CFR 9.10 (a)
• Funds of a fiduciary account awaiting investment
  or distribution can be placed in an interest
  bearing account in the fiduciary bank, unless
  prohibited by applicable law 12 CFR 9.10(b)(1)
• Funds of a fiduciary account awaiting investment
  or distribution can be placed in an interest
  bearing account in affiliated bank, unless
  prohibited by applicable law 12 CFR 9.10(b)(1)

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Federal Regulations (Cont.)

• 12 CFR 9.12 Self-Dealing and Conflicts of
  Interest
• Discretionary investments in the stock or
  obligations of the bank or an affiliate
  (including their respective directors, officers
  and employees) are only permitted if authorized
  by applicable law 12 CFR 9.12(a)(1)
• Discretionary loans, sales or transfers of assets
  from fiduciary accounts to the bank or an
  affiliate (including their respective directors,
  officers and employees) are only permitted if
  authorized by applicable law 12 CFR 9.12(b)(1)
• Loans from fiduciary accounts to bank directors,
  officers, or employees are strictly prohibited
  12 CFR 9.12(b)(1)
• Loans from the bank to fiduciary accounts are
  permitted if the transaction is fair to the
  account and not prohibited by applicable law 12
  CFR 9.12(c)

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Federal Regulations (Cont.)

• 12 CFR 9.15 Fiduciary Compensation
• Fiduciary may charge a reasonable fee for its
  services if not set or governed by applicable law
  12 CFR 9.15(a)
• Fiduciary may not permit officers or employees to
  earn compensation for acting as a co-fiduciary,
  except with approval of the board of directors 12
  CFR 9.15(b)

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Consider the Cimex Lectularius

• Commonly known as the Bed bug!
• Thought to have been significantly eradicated in
  the early 1900s. Started seeing a resurgence
  after 1995.
• Resurgence is generally attributed to a change in
  habits of the primary hosts.
• More foreign travel, exchange of bedding
  materials, focusing on other pests and ignoring
  them!

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Bed bugs and conflicts

• Cant readily see them coming so you have them
  before you know it.
• When they bite, they hurt!
• Embarrassing to acknowledge and address.
• Requiring a re-focus in order to eliminate.
• New tools available to look for them!

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Where are we today?

• Law and regulation much the same.
• Fundamental nature of conflicts still the same.
• Basic transaction types that cause concern -
  still the same.
• Perhaps there is more complacency toward
  potential conflict situations?

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Where are we today?(Cont.)

• Size and complexity of our financial
  institutions responsibility is the same.
• Technical knowledge and depth of understanding
  about conflicts of interest.
• The primary change in perspectives has occurred
  in how, where, and why we see conflicts of
  interest emerging. They come at us in some
  different ways!

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Sources of Emerging Conflicts
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Investments

• New and increasingly complex investment vehicles
  provide opportunity both for benefitting the
  client and for additional underlying conflicts.
• Banks and affiliates are assuming additional
  duties relative to financial instruments.
• Management of fiduciary cash remember the
  fundamentals.

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Potential Conflicts - Investments

• Roles related to investment vehicles (sales,
  service, underwriting)
• Fees and other financial benefits associated with
  investing
• Underlying purpose of the investment
• Failure to take actions on behalf of client
  interests (contrary interests)
• Proxy voting (must vote clients interest not
  that of the bank)

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Potential Conflicts - Investments

• Soft dollar arrangements not meeting requirements
  of Section 28(e).

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Potential Conflicts - Investments
Private Equity Fund Proposal

• Investment opportunity for select fiduciary
  accounts
• New fund for company incubation
• Bank affiliate to manage
• Executive employees are investing partners
• Fiduciary accounts limited partners

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Potential Conflicts - Investments

• Proprietary Investment Managers (who are also
  investors) get gain sharing, incentive
  compensation, and management fees
• Fund allowed to incur debt from own bank
• Management team indemnified for financial loss
• Shared Counsel with waiver of conflict

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Potential Conflicts - Investments

• Bank may act as investor, investment banker,
  investment manager, advisor, agent and principal
  in the deal.
• Bank to have multiple relationships with
  portfolio companies and other parties lender,
  advisor, servicer, shareholder, underwriter, or
  trustee.
• Officers of bank may be directors of portfolio
  companies.

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Potential Conflicts - Investments

• Fund cash may be invested in bank instruments.
• Warehoused investments to be transferred from
  bank balance sheet to the fund.

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Revenue

• Structure of fees and fee schedules
• Layers of fees (performance fees, enhanced
  services fees, etc.)
• Unfair or unreasonable fees
• Extra fees for routine, traditional fiduciary
  services
• Additional revenue received due to fiduciary
  appointment

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Revenue (Cont.)

• Revenue from serving in multiple capacities
• Placement fees
• Sweep fees
• Sales incentives (internal and external)
• Revenue share (internal and external)
• Commissions
• Account or Transactional fees
• Service fees

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Affiliated Products and Services

• Everyone wants their piece of the (very
  proverbial) pie!

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Affiliated Products and Services

• Lending relationships
• Insurance products and services
• Brokerage services
• RE Sales/Servicing
• Investment vehicles (Alternatives and other
  internal investment products)
• Deposit and cash management instruments

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Third Party Services

• Goods, services, and other benefits that may be
  made available by vendors to the bank (or DOEs)
  in return for
• Investing money
• Using account or professional services
• Potential for interlocking relationships

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Indirect Conflicts

• An action taken with respect to a fiduciary
  account that could indirectly benefit the bank or
  any of its DOEs.
• Corporate benefits from service arrangements.
• Price breaks or gratuities in return for full
  retail pricing (or more) for servicing fiduciary
  accounts.
• A fiduciary cant do anything indirectly that he
  is prohibited from doing directly.

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Cash Management

• OCC Bulletin 2010-37
• Deposits or Investment of Cash Balances
• Dont leave cash uninvested
• May deposit in own bank if properly pledged
• Dont invest cash in own-bank deposits
• Consider the rates of return available
• Sweep vehicles basis of selection

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Potential concerns involving personal interests

• Transactions involving DOE or affiliated
  business interests
• Bequests and gifts to DOEs
• Family accounts transactions and decisions by
  DOEs
• Benefits in return for services from clients OR
  3rd parties

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Leveraging Consent

• Must get informed consent both the specifics of
  the transaction and the conflict itself must be
  disclosed.
• Consent is not direction
• Full beneficiary consent
• Negative consent does not fully mitigate a
  conflict

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Risk Perspectives

• Regulatory Risk punitive action by regulators
  can include formal agreements, civil money
  penalties, and potential loss of fiduciary
  powers.
• Financial Risk conlfict transactions are
  voidable loss of revenue and potential damages
• Reputation Risk- significant public risk for the
  professional fiduciary

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Recommended strategies

• Education programs
• Strong Policies and Procedures at multiple levels
• Effective preventive AND detective controls
• Leverage technology and accounting system
  capabilities encourage development of additional
  tools

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Recommended strategies

• Effective Risk Analysis
• Refocus and identify areas of potential problems
  consult with legal counsel
• Limit mitigation of conflicts through papering
  the account.
• Consider using screening processes or checklists
  designed to identify potential conflicts in new
  accounts, new products, and in relevant
  transactions.

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Recommended strategies

• Consider language that will protect the bank in
  transactional contracts.
• Include conflicts screening in all vendor due
  diligence programs.

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Final wish

• Good night,
• sleep tight,
• and dont let the bed bugs bite!