Seal of the Board of Governors of the Federal Reserve System
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM

WASHINGTON, D. C.  20551

DIVISION OF BANKING
SUPERVISION AND REGULATION

SR 99-7 (SPE)
March 26, 1999

TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE
          SUPERVISORY AND EXAMINATION STAFF AT EACH FEDERAL
          RESERVE BANK AND TO EACH DOMESTIC AND FOREIGN
          BANKING ORGANIZATION SUPERVISED BY THE
          FEDERAL RESERVE


SUBJECT: Supervisory Guidance Regarding the Investment of Fiduciary Assets in Mutual Funds and Potential Conflicts of Interest

Summary

                    Increasingly, banks and trust institutions are encountering various direct or indirect financial incentives to place trust assets with particular mutual funds.  These incentives range from payments structured as reimbursements for services or for transferring business to an unaffiliated fund family, to the financial benefits arising from the use of mutual funds that are managed by the institution or an affiliate.  In some cases, such as service fees for administrative and record-keeping functions performed by the trust institution, the permissibility of such payments may be specifically addressed under state law.  In the case of other financial incentives, guidance under applicable law may be less clear.  In all cases, however, decisions to place fiduciary assets in particular investments must be consistent with the underlying trust documents and must be undertaken in the best interest of the trust beneficiary.

                    The primary supervisory concern is that an institution may fail to act in the best interest of beneficiaries if it stands to benefit independently from a particular investment.  As a result, an institution may expose itself to an increased risk of legal action by account beneficiaries, as well as to potential violations of law or regulation.  The Federal Reserve is issuing this guidance to help institutions minimize these risks and to help ensure that their activities meet fiduciary standards. 


Background

                    Certain mutual fund providers offer compensation in the form of "service" fees to institutions that invest fiduciary assets in particular mutual funds.  These fees, referred to variously as shareholder, sub-accounting or administrative service fees, are structured as payments to reimburse the institution for performing standard recordkeeping and accounting functions for the institution's fiduciary accounts, such as maintaining shareholder subaccounts and records, transmitting mutual fund communications as necessary, and arranging mutual fund transactions.  These fees are typically based on a percentage or basis point amount of the dollar value of assets invested, or on transaction volume.

                    In recent years, nearly every state legislature has modified its laws explicitly to allow the acceptance of such fees by fiduciaries under certain conditions.  These conditions often include compliance with standards of prudence, quality and appropriateness for the account, and a determination of the "reasonableness" of the fees received by the institution.  The Office of the Comptroller of the Currency (OCC) has also adopted these general standards for national banks.1  However, the Employee Retirement Income Security Act of 1974 (ERISA) generally prohibits fee arrangements between fiduciaries and third parties, such as mutual fund providers, with limited exceptions.2  ERISA requirements supersede state laws and guidelines put forth by the bank regulatory agencies.

                    While there has been no comprehensive review of the extent to which these types of incentive payments are presently being offered by mutual fund providers, the practice appears to have become more common in recent years.  In addition to the service fees cited above, another form of compensation reportedly offered by some mutual fund providers is a lump-sum payment based on assets transferred into a mutual fund. 

                    Similar conflict of interest concerns are raised by the investment of fiduciary account assets in mutual funds for which the institution or an affiliate acts as investment adviser (referred to as "proprietary" funds).  In this case, the institution receives a financial benefit from management fees generated by the mutual fund investments.  This activity can be expected to become more prevalent as banking organizations become more active in offering proprietary mutual funds.3


Supervisory Guidance

                    Although many state laws now explicitly authorize certain fee arrangements in conjunction with the investment of trust assets in mutual funds, institutions nonetheless face heightened legal and compliance risks from activities in which a conflict of interest exists, particularly if proper fiduciary standards are not observed and documented.  Even in the case of investments where the institution does not exercise investment discretion, disclosure or other requirements may apply.  Therefore, institutions should ensure that they perform and document an appropriate level of due diligence before entering into any fee arrangements similar to those described above or placing fiduciary assets in proprietary mutual funds.  The following measures should be included in this process:

    • Reasoned Legal Opinion - The institution should obtain a reasoned opinion of counsel that addresses the conflict of interest inherent 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.

                    Please distribute this letter to the appropriate supervision staff, particularly all examiners of fiduciary and securities activities, and to all domestic and foreign banking organizations with fiduciary activities supervised by the Federal Reserve.  A suggested transmittal letter is attached.  To the extent that examiners identify issues and concerns pertaining to the acceptance of fees from mutual fund providers or investments in proprietary mutual funds, please forward such information to the Manager, Specialized Activities Section, Mail Stop 182, at the Federal Reserve Board.  Any matters of significant concern should be noted in examination reports and corrective action pursued as appropriate.

                    Questions concerning this letter may be addressed to Michael G. Martinson, Deputy Associate Director, at (202) 452-3640 or Heidi Richards, Manager, at (202) 452-2598.


Richard Spillenkothen
Director


Attachment

Supersedes:   "TRUST SERVICES - Extra Fees in Connection with 12b-1 Funds or Cash Sweep Systems," FRRS 3-1596



Notes:

1.   In general, national banks may make these investments and receive such fees if the practice is authorized by applicable law and if the investment is prudent and appropriate for fiduciary accounts and consistent with established state law fiduciary requirements.  This includes a “reasonableness” test for any fees received by the institution.  OCC Interpretive Letter No. 704, February 1996.  Return to text

2.   ERISA section 406(b)(3); Department of Labor, Pension Welfare and Benefits Administration Advisory Opinion 97-15A and Advisory Opinion 97-16A.  Return to text

3.   A Board interpretation of Federal Reserve Regulation Y addresses investment of fiduciary account assets in mutual funds for which the trustee bank's holding company acts as investment adviser.  In general, such investments are prohibited unless specifically authorized by the trust instrument, court order, or state law.  FRRS 4-177.  Return to text




Attachment

Suggested Transmittal Letter


TO THE CHIEF EXECUTIVE OFFICER AT DOMESTIC AND FOREIGN
          BANKING ORGANIZATIONS SUPERVISED BY THE
          FEDERAL RESERVE


SUBJECT:   Supervisory Guidance Regarding the Investment of Fiduciary Assets in Mutual Funds and Potential Conflicts of Interest

                    Increasingly, banks and trust institutions are encountering various direct or indirect financial incentives to place trust assets with particular mutual funds, including fees for use of nonaffiliated fund families as well as incentives to use their proprietary mutual funds.  The primary supervisory concern is that an institution may fail to act in the best interest of beneficiaries if it stands to benefit independently from a particular investment.  As a result, an institution may expose itself to an increased risk of legal action by account beneficiaries, as well as to potential violations of law or regulation.  The Federal Reserve is issuing the attached supervisory guidance to help institutions minimize these risks and to help ensure that their activities meet fiduciary standards.

                    Institutions should ensure that they perform and document an appropriate level of due diligence before entering into any compensation arrangements with mutual fund providers or placing fiduciary assets in their proprietary mutual funds.  The enclosed supervisory guidance discusses the type of measures that should be included in this process, including a reasoned legal opinion addressing the activity, appropriate policies and procedures, and documented analysis and ongoing review of investment decisions.

                    Questions regarding this matter may be addressed to [INSERT NAME OF RESERVE BANK CONTACT].


Enclosure


SR letters | 1999