BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 97-3 (SPE)
February 26, 1997
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Conversion of Common Trust Funds to Mutual Funds
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.
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.
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 the directors and 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 Directors and Senior Management
The banking organization's directors should be apprised of the 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. The directors should authorize or ratify management's decision to convert or transfer common trust funds to mutual funds. 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.
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.
Howard A. Amer
Small Business Jobs Protection Act of 1996
Investment Company Act of 1940
12 C.F.R. 225.125
OCC Interpretive Letter 722 - May 12, 1996
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
SR letters | 1997