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Common and Collective Investment Funds: SEC Action Warrants Attention but Offers Limited Guidance

December 09, 2020

A recent enforcement action (Proceeding) by the US Securities and Exchange Commission (SEC) against a state-chartered trust company (Trust Company) has attracted attention in the banking and asset management industries. The essence of the SEC’s charges was that the Trust Company operated Trust Company-sponsored common trust funds (CTFs) and collective investment funds (CIFs, and with CTFs, Trust Funds) that it maintained without satisfying the applicable exemptive conditions under the Investment Company Act of 1940 (Investment Company Act) and the Securities Act of 1933 (Securities Act) for such trust funds.

We believe that the SEC's Proceeding, which was announced without great fanfare and generated a dissent by one of the five SEC commissioners, is interesting, but does not portend any major change in position by the SEC regarding the operations of bank-sponsored Trust Funds. The SEC’s chief complaint in the Proceeding was that the Trust Company failed to “maintain” the Trust Funds within the meaning of the applicable securities law exemptions as interpreted by the SEC staff. In our view, the Proceeding cited activities by the respondent that the SEC viewed as “bad facts.” However, without any indication of broader regulatory concerns over the reliance on the Trust Fund statutory exemptions, we believe that the Proceeding does not signal a substantive change in SEC positions on the applicability of these exemptions. In turn, the Proceeding should not have a substantial general impact on banking institutions and their advisers that establish and operate Trust Funds, but it nonetheless serves as a useful reminder that the management of Trust Funds requires due care and meaningful oversight by their bank and trust company managers.

A Short Primer on CTFs and CIFs

CTFs and CIFs are vehicles that pool the assets of multiple clients and are exempt from registration and regulation under the Investment Company Act and the Securities Act if they comply with certain specific exemptive conditions. In the case of CTFs, they must (i) be organized as an aid in the administration of a bank or trust company’s fiduciary accounts, (ii) be operated in compliance with the collective investment regulations of the Office of the Comptroller of the Currency, (iii) not be publicly offered or advertised, and (iv) only charge fees in accordance with applicable state law.[1] CIFs must be organized and offered exclusively for the management of employee pension assets that are qualified under Sections 401 and 501 of the Internal Revenue Code (Code) or certain similar Code provisions.[2] In turn, CTFs and CIFs enjoy favorable tax pass-through treatment under the Code.[3] They are also subject to regulation and oversight by federal or state banking authorities through the banks and trust companies that sponsor and maintain such Trust Funds. CTFs and CIFs have been a popular means for banks and trust companies to manage collectively the assets of their trust and retirement clients, and the CIF market in particular has grown very substantially in recent years.

Importantly, to qualify for the relevant federal securities law exemptions, both CTFs and CIFs must be “maintained” by the sponsoring bank or trust company, which the SEC in the past has interpreted to mean that the sponsoring banking organization must exercise "substantial investment responsibility" over the CTF or CIF.[4] In practice, many banks and trust companies routinely look to affiliated or unaffiliated investment advisers to assist in the management of their Trust Funds, but do so in a manner that assures that the banking organization has ultimate investment authority for their management.[5] By the same token, SEC guidance on the contours and conditions of the relevant federal securities law exemptions for Trust Funds is generally aged and infrequent, so any SEC activity in this subject area warrants close attention to determine whether the SEC is providing any significant new guidance, or is departing from prior guidance, on how banks and trust companies must maintain Trust Funds in order to avoid registration and regulation under the federal securities laws.

The Proceeding

On September 30, 2020, the SEC brought an administrative cease-and-desist action against Great Plains Trust Company, a Kansas-chartered trust company, and imposed a consent cease-and-desist order and $300,000 civil penalty on the Trust Company. The basis of the SEC’s allegations was that the Trust Company was operating unregistered investment companies, and making unregistered public offers and sales of securities, through its operation of a series of Trust Company-maintained Trust Funds (both CTFs and CIFs). The substance of the SEC's allegations, however, was that the Trust Company failed to comply with the relevant conditions for exemption from Investment Company Act and Securities Act registration and regulation available to CTFs and CIFs, in particular the “maintained by a bank” condition.

The specific substance of the SEC's allegations were:

  • The Trust Company retained an affiliated investment adviser (Adviser) to provide management services with respect to the Trust Funds, but failed to exercise more than "minimal oversight" over the activities of the Trust Funds. The actual SEC allegations supporting this conclusion are worth reading in their entirety:

[The Trust Company received quarterly reporting materials from [the Adviser] for each of the Trust Funds and also met once a year with a representative from [the Adviser] to discuss the Trust Funds. However, the reviews of the quarterly materials were cursory and the annual meetings with an [Adviser] representative were focused on receiving information rather than having an active role in managing and exercising investment responsibility for the Trust Funds. Those annual reviews rarely resulted in any changes to the Trust Funds or any feedback regarding [the Adviser’s] management strategy. In those cases where it requested changes (such as requiring reduced concentrations of an investment in certain of the Trust Funds), [the Trust Company’s] board repeatedly failed to act in a timely manner so that the changes were actually implemented. The board’s failures to require [the Adviser] to comply with concentration limits mandated by the investment policies of the Trust Funds within a reasonable timeframe resulted in substantial losses in certain of the Trust Funds.

Therefore, according to the SEC, the Trust Funds were not “maintained” by the Trust Company, thus disqualifying the Trust Funds from reliance on the relevant Investment Company Act and Securities Act exemptions.

  • The Trust Company failed to maintain the CTFs solely as an aid in the administration of trust accounts maintained for fiduciary purposes, and for several years separately advertised the CTFs for sale to the general public by advertising them on a public (presumably non-password protected) web site.

In a separate dissent, SEC Commissioner Hester Peirce objected to the institution of the SEC’s Proceeding.[6] Her specific objection was that the SEC's order did not provide adequate guidance on what it means for a bank or trust company to “maintain” a Trust Fund, noting that there has been “enormous uncertainty” about precisely what constitutes “substantial investment responsibility” over a Trust Fund. In turn, she stated that the use of an enforcement action was an “inappropriate” way for the SEC to communicate its interpretation of the law. Further, Commissioner Peirce questioned the wisdom of using enforcement actions to address entities that are not directly supervised by the SEC, adding that the SEC should consult with its federal and state bank regulatory sister agencies on the scope of the “maintained by a bank” requirement for Trust Funds.

The Significance of the SEC’s Action

The infrequency of SEC actions and pronouncements on Trust Fund regulatory and compliance matters[7] naturally results in the SEC's Proceeding standing out, and certainly invites consideration of the Proceeding’s significance. Our views on this Proceeding are influenced by the fact that, although not discussed in the Proceeding itself, the facts and actions leading to this Proceeding had already resulted in SEC regulatory action against the Trust Company’s affiliate, the Adviser, as well as earlier private litigation which may have helped prompt the SEC’s interest in this matter. Approximately one year ago, the Adviser and its principal were cited in an administrative cease-and-desist action for violations of the antifraud provisions of the Investment Advisers Act of 1940, specifically Sections 206(2) and 206(4) thereof and Rule 206(4)-7 thereunder, for (i) allowing the Trust Funds for which the Adviser was the manager to acquire excess concentrations in the securities of a single issuer, and (ii) failing to reduce those concentrations despite the specific request of the Trust Company, thus causing the Trust Funds to incur losses when the stock price of the “overconcentrated” issuer dropped significantly.[8] Further, the Adviser and the Trust Company earlier were defendants in litigation brought by several pension plans alleging violations of the Employee Retirement Income Security Act of 1974 (ERISA) arising out of their Trust Fund concentrations in the same issuer’s securities, actions that might have encouraged the SEC’s regulatory interest in the Adviser’s and Trust Company’s activities.[9]

The Trust Company also was charged with the advertisement and marketing of its CTFs to the general public on a public website – an activity that, if true, would be plainly inconsistent with the “no public marketing” condition of the CTF exemption under the Investment Company Act and the Securities Act – and using the CTFs for a purpose other than solely as an aid in the administration of fiduciary accounts. Overall, the confluence of events involving the Adviser and the Trust Company that resulted in the 2019 administrative proceeding, and the multiple alleged misdeeds of the Trust Company in the management and oversight of the Trust Funds that led to investor losses would, without more, readily explain why the SEC instituted the Proceeding.

So, is there "more" here? Is the SEC sending any messages about the general oversight and management of Trust Funds that warrant particular attention in the banking and asset management industries? The facts alleged by the SEC that evidenced what it deemed a material lack of oversight by the Trust Company over the Trust Funds, and in particular an alleged failure to supervise the activities of the Adviser that managed the Trust Funds, plainly would fall well short of the mark in terms of good business oversight and risk management practices, let alone regulatory compliance. Nevertheless, the SEC’s factual statements supporting the conclusion that the Trust Company did not “maintain” the Trust Funds do provide a mildly useful concrete benchmark on what falls short of the “maintained” requirement.

Unfortunately, the SEC did not go farther to discuss the basic prerequisites of satisfying the “maintained” exemption under the Investment Company Act and the Securities Act. Thus, the Proceeding did not shed any light on where the line might be drawn with respect to the "maintained” requirement, nor did it provide guidance as to the acts and practices that constitute properly "maintaining" a Trust Fund under the Investment Company Act and Securities Act exemptions. In turn, this lack of detail led to Commissioner Peirce’s concern that the Proceeding failed to provide substantive guidance on the “maintained by a bank” requirement underpinning both the CTF and CIF exemptions.

On balance, we do not think that the Proceeding is an effort by the SEC or its staff to rewrite the contours of the “maintained by a bank” condition under the relevant Investment Company Act and Securities Act exemptions. That said, the Proceeding does indicate that the SEC continues to pay attention to the Trust Fund exemptions and the “bank maintained” requirement, and that the SEC is prepared to enforce the terms of the CTF and CIF exemptions where it views the facts to be sufficiently offensive. The Proceeding, however, does not offer any significant new insights into the SEC's views on the contours of the CTF and CIF exemptions, nor does it suggest any material changes in the SEC’s position on the bank-maintained requirement for Trust Funds. Thus, for example, a bank/trust company manager’s use of an investment adviser to assist in the management of a Trust Fund is not per se objectionable from the SEC standpoint,[10] provided that the Trust Fund manager exercises sufficient oversight and control over the adviser’s actions, including the enforcement of investment guidelines and providing substantive and knowledgeable feedback on the adviser’s activities. What is not answered, however, is the level of oversight and control that would be sufficient to satisfy the requirements of the relevant exemptions.

Put another way, the Proceeding does not point to the need for Trust Fund managers in general to take dramatic action to change their Trust Fund governance and management policies and activities. At the same time, it may behoove Trust Fund managers to review their policies and activities to assure themselves that they are comfortable with their existing guidelines, and that their policies and activities are properly supported and documented.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Washington, DC
Charles M. Horn
Steven W. Stone
W. John McGuire
Thomas S. Harman
Christopher D. Menconi
Daniel R. Kleinman

Boston
Paul B. Raymond
Roger P. Joseph

Chicago
Marla J. Kreindler

Philadelphia
Timothy W. Levin



[1] See, Investment Company Act Section 3(c)(3) and Securities Act Section 3(a)(2); Internal Revenue Code Section 584.

[2] See, Investment Company Act Section 3(c)(11) and Securities Act Section 3(a)(2).

[3] See, Code Section 584, and IRS Rev. Ruls. 81-100, 2011-1 and 2014-24, respectively.

[4] In a series of well-aged no-action letters and interpretive releases, the SEC staff has discussed what it means to be “maintained by a bank” for purposes of Section 3(c)(11)’s exemption from the registration requirements of the 1940 Act. The staff has taken the position that a bank does not “maintain” a trust within the meaning of Section 3(c)(11) if it maintains mere custody of pension fund assets and delegates investment responsibility to a non-bank third party. See Morgan Management Corporation, SEC No-Action Letter (June 29, 1980). Rather, the bank must maintain “substantial investment responsibility” with respect to trust assets. See First National Bank of Akron, SEC No-Action letter (Feb. 2, 1976). The SEC staff also has addressed the situation where a trustee of a collective investment trust fund retains a registered investment adviser to provide investment recommendations to the trustee, and found that such an arrangement would not impair the collective investment trust’s ability to rely on the exemption set forth in Section 3(c)(11) as long as the trustee maintained final investment authority. See, e.g., National Bank of Commerce Investment Fund, SEC No-Action Letter (October 10, 1986) (a trustee may enter into an arrangement with a registered investment adviser as long as it “expressly retain[s] final and complete authority over all transactions”).

[5] In the National Bank of Commerce letter, the SEC staff acknowledged that the trustee would “generally accept the adviser’s recommendations,” but still found that this arrangement fell within the Section 3(c)(11) exception as the final decisionmaking authority for every transaction was retained by the trustee. See also OCC Bulletin 2011-11, “Risk Management Elements: Collective Investment Funds and Outsourced Arrangements.”

[6] See Statement of Commissioner Hester M. Peirce - Great Plains Trust Company.             

[7] The last prior public action taken by the SEC was In Re Dunham, Securities Act Rel. No. 8740 (Sept. 22, 2006). In 2010, then-Director of the SEC’s Division of Investment Management Andrew “Buddy” Donohue did raise public concerns over the practice of investment advisers “renting the charter” of a bank or trust company that the bank/trust company sponsored as “trustee” but did not actually “maintain.” See Speech by SEC Staff: Remarks Before the Practising Law Institute's Investment Management Institute 2010. Director Donohue’s concerns, however, did not lead to further SEC or SEC staff public action at the time. (See also OCC Bulletin 2011-11, “Risk Management Elements: Collective Investment Funds and Outsourced Arrangements” (setting forth OCC views on trustee obligations for risk management and oversight when delegating responsibilities to third parties, including investment managers).

[8] In the Matter of Kornitzer Capital Management, Inc. and John C. Kornitzer, SEC Administrative Proceeding File No. 3-19615 (Dec. 10, 2019).

[9] See, e.g., Motl v. Kornitzer Capital Mgmt. Inc. (W.D. Mo., No. 4:18-cv-00316-BP, complaint filed 4/26/18).

[10] See National Bank of Commerce, nn. 4 and 5 supra.