aba trust letter - k&l gates · aba trust letter february 2011 issue ... william p. wade 10...

ABA Trust LetterFebruary 2011 Issue No. 543 A Regulatory & Legislative Advisory for Trust Professionals

Inside

2 EB Trust Focus:

• “Fiduciary” Defi-nition Rulemaking

• EBSA Web Chat on Regulatory Agenda

3 Special Feature: Collective Invest-ment Funds: Regulatory Implica-tions of “Prudent Delegation” by William P. Wade

10 Swap Execution Facilities Rules and Practices Proposed

14 Group Trusts, IRS Guidance

15 Volcker Rule Con-formance Period, ABA Comments

16 FSOC Volcker Rule Study and Recom-mendations

18 Tax Return Preparer Registration, IRS Guidance

(continued on page 12)


Municipal Advisor Registration Proposal Would Encompass BanksThe Securities and Exchange Commis-

sion (SEC) proposed a rule on January 6, 2011 (76 Federal Register 824) to imple-ment a Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) provision requiring “municipal advisors” to register with the SEC. Section 975 of the legislation amended Section 15B of the Securities Exchange Act of 1934 to enlarge the scope of federal and self-regulatory oversight of municipal advisors. The statutory provision became effective on October 1, 2010. Pending promulgation of a final implementing rule, the SEC enabled municipal advisors to tem-porarily satisfy the registration requirement under an interim final temporary rule and

registration form. Rule 15Ba2-6T and Form MA-T will expire on December 31, 2011. The proposed rule would establish a permanent registration regime for munici-pal advisors and impose on them certain recordkeeping requirements. Comments on the proposal are due on or before Feb-ruary 22, 2011, and ABA intends to submit a comment letter. This article explains the proposal.

Municipal Advisors The DFA defines “municipal advisor” as any person that provides advice to a “mu-nicipal entity” with respect to “municipal

MMF Stability Options Critiqued

Having weighed the options identified by the President’s Working Group on

Financial Markets (PWG) in its report on mitigating systemic risk and reducing the susceptibility of money market funds (MMFs) to runs, ABA conveyed its recom-mendations to the Securities and Exchange Commission (SEC) in a comment letter dated January 10, 2011. As an initial matter, ABA made clear that it strongly opposes any policy change that would require MMFs to adopt floating net asset values (NAVs) instead of stable NAVs, or that would restrict investments in stable NAV funds to retail investors only. Trust departments invest in stable NAV funds on behalf of their institutional and personal trust clients and for important transactional purposes as fiduciaries and

service providers. Because the options identified in the PWG report are at the conceptual stage, ABA’s comment letter focuses primarily on arguing for the continued availability of stable NAV funds and against establishing a program of federal government support for MMFs. ABA expects to offer more extensive and specific comments once more detailed proposals are offered.

Breaking the Buck The PWG report on the stability of MMFs was prepared at the behest of the Treasury Department following the extraor-dinary events of September 2008, when the Reserve Primary Fund broke the buck after

American Bankers Association

2 • February 2011 ABA TRUST LETTER

EB TRUST FOCUS

“Fiduciary” Definition Rulemak-ing Adjusted The Employee Benefits Security Administration (EBSA) published a notice of hearing and extension of the comment period on its proposed definition of “fiduciary” in connec-tion with providing investment advice to employee benefit plans. Comments were due by February 3, 2011, and a public hearing will be held on March 1 and, if necessary, March 2. EBSA is contemplating a broader definition of “fiduciary” that would encompass those who advise a plan, the plan’s fiduciaries, or the plan’s participants. For example, an advi-sory firm hired by a bank trustee to provide expert advice on plan invest-ments would assume fiduciary duties under the proposed definition. Investment advisers who fall un-der the definition would have to ob-serve fiduciary standards of conduct under the Employee Retirement Income Security Act (ERISA) and would be prohibited from engaging in conflicts of interest, self-dealing, and other prohibited acts. By providing extra time for com-ments and holding a public hear-ing, EBSA appears to recognize the significance of the proposed rule for plans, participants, beneficiaries, and service providers. The notice was published on January 12, 2011 (76 Federal Register 2142) and can be found at http://edocket.access.gpo.gov/2011/pdf/2011-483.pdf

Previous article in ABA Trust Letter “Bank Trust Departments Gauge Impact of Broader Definition of “Fiduciary,” January 2011, page 1.

EBSA Web Chat Reveals Regulatory Plans As another means of commu-nicating with the employee benefit plan community, Assistant Secretary Phyllis Borzi and her staff held a live, hour-long web chat on January 4, 2011, to discuss EBSA’s upcom-ing regulatory agenda. The web chat was interactive and participants could submit comments and ques-tions and have them answered. Following are a few highlights:

• “Fiduciary” Definition. The EBSA proposal to clarify the circumstances under which a person will be con-sidered a “fiduciary” when provid-ing investment advice to employee benefit plans and their participants and beneficiaries “is intended to as-sure retirement security for workers in all jobs, regardless of income level, by ensuring that financial advisers and similar persons are required to meet ERISA’s strict standards of fiduciary responsibility,” Borzi said. The proposal would change a rule that “we believe may inappropriately limit the types of investment advice relationships that give rise to fiduciary duties,” she added.

• Service Provider Compensation Disclosure. EBSA hopes to finalize the interim final rule on Section 408(b)(2) by April 2011. It was not clear whether a delayed effective date would be provided. The rule, which will become effective on July 16, 2011, requires pension plan ser-vice providers to disclose the direct and indirect compensation they receive for plan services.

• 401(k) Plan Disclosures. EBSA expects to issue a request for infor-mation regarding electronic delivery

of required 401(k) plan disclosures under ERISA sometime during the next six to eight weeks. The EBSA will evaluate whether the current regulatory standards for electronic distribution of required plan disclo-sures should be updated to harmo-nize with, among other things, recent guidance from the Securities and Exchange Commission on the use of electronic channels for delivering proxy materials to shareholders.

• Investment Advice Arrange-ments. A final regulation on invest-ment advice arrangements for par-ticipant-directed individual account plans is expected to be issued by May 2011. The rule was re-proposed on March 2, 2010, and would imple-ment a new prohibited transaction exemption created by the Pension Protection Act of 2006. Under the rule, an “eligible investment advice arrangement” is one that uses fee-leveling or computer modeling to determine what advice to give partici-pants and beneficiaries.

• Target Date Fund Disclosures. EBSA has no plan at this point to develop a model format for the proposed disclosures for target date funds. The comment period on the TDF transparency rule closed on January 14, 2011.

Those who were unable to par-ticipate can replay the web chat by going to: http://www.dol.gov/regu-lations/chat-ebsa-201012.htm n

Previous articles in ABA Trust Letter “EBSA Proposes Target Date Funds Transparency Rule,” January 2011, page 11. “Plan Service Provider Fee Dis-closure Interim Final Rule,” October 2010, page 1. “EBSA Re-Proposes Plan Invest-ment Advice Rules,” April 2010, page 9.


ABA TRUST LETTER February 2011 • 3

Collective Investment Funds: Regulatory Implications of “Prudent Delegation”by William P. Wade*

R egulation 9 (12 C.F.R. Part 9) of the Office of the Comptroller

of the Currency (OCC) requires a bank maintaining a collective invest-ment fund (CIF) to have “exclusive management” of the CIF. However, Regulation 9 also permits the bank to delegate responsibilities as a “prudent person” might do.1 A bank considering a delegation of CIF investment responsibilities should consider two important questions: First, what are the expectations of the OCC and other bank regula-tors in regard to a “prudent delega-tion” of CIF investment responsibili-ties to an investment adviser?2

Second, what are the regulatory implications of a “prudent delega-tion” of CIF investment responsi-bilities under the Employee Retire-ment Income Security Act of 1974 (ERISA)? The Internal Revenue Code of 1986 (Code)? The federal securities laws? The answers require a review of the origins and purposes of the “exclusive management” and “pru-dent delegation” requirements under banking regulations, and consid-eration of how those requirements apply — or should apply — in the context of other applicable regulatory schemes. Not surprisingly, the U.S. Department of Labor (DOL), the In-ternal Revenue Service (IRS), and the Securities and Exchange Commission (SEC) have different perspectives on these requirements. However, certain fundamental principles suggest com-mon ground for reconciling relevant regulatory requirements.

Exclusive ManagementRegulation F The “exclusive management” requirement originated with “Regu-lation F,” promulgated by the Fed-eral Reserve Board (FRB) in 1937 to govern the management and opera-tion of common trust funds. Regula-tion F provided, in pertinent part, that a bank must have the “exclusive management” of a common trust fund.3 This was consistent with trust principles prevailing at the time, which generally prohibited a trustee from delegating functions the trustee reasonably could be expected to perform itself.4

Accordingly, the FRB took a strict view of the “exclusive management” requirement, generally interpreting it to forbid delegation of common trust fund investment management functions. In a ruling issued in 1959, for example, the FRB concluded that the investment of common trust fund assets in shares of an “invest-ment trust” (i.e., mutual fund) would involve delegation of investment management “which would be both inconsistent with the stated purposes and uses of such funds and in viola-tion of the…[exclusive management requirement].”5

Regulation 9 The “exclusive management” re-quirement applicable to common trust funds under Regulation F techni-cally did not extend to collective trust funds for employee benefit trusts, which began to appear in the 1950s. However, when regulatory author-ity over national bank trust activities was transferred from the FRB to the

OCC in 1963, the OCC retained the requirement in Regulation 9 and extended it to all CIFs.6 The OCC indicated that the exclusive manage-ment requirement was:

designed generally to ensure that a national bank fiduciary has the requisite authority to administer a collective fund in satisfaction of all its fiduciary responsibilities, and to prevent delegations or reservations of authority which interfere with the bank’s fulfill-ment of these responsibilities.7

The OCC generally took the posi-tion that the “exclusive management” requirement did not preclude a bank from retaining an investment adviser to assist it in managing a CIF. If the investment adviser was not affiliated with the bank, the OCC typically required, among other things, that the bank retain authority to make “final” investment decisions for the fund, which meant that an unaffili-ated investment adviser was permitted only to make investment “recommen-dations” for the bank’s consideration and final decision.8 If the adviser was an affiliate of the bank, the bank was expected to establish specific investment guidelines the affiliated adviser would be obligated to follow, frequently review the adviser’s activi-ties, and retain contractual authority to terminate the adviser at will.9 The OCC also indicated that, if the adviser was affiliated with the bank through the bank’s holding company, the bank would need to approve each investment transaction before the af-filiate placed the trade.10


© Copyright William P. Wade 2010. All rights reserved.



“adequacy and effectiveness” of the bank’s due diligence procedures for selecting an investment adviser, in-cluding whether the bank conducts a thorough evaluation of “all available information” about the adviser and monitors the adviser on a “routine” basis.20 In regard to the monitor-ing function, OCC examination procedures focus on whether the bank: (i) reviews information reports provided by the adviser; (ii) reviews portfolios regularly to ensure adher-ence to established investment policy guidelines; (iii) analyzes the adviser’s financial condition at least annually; (iv) evaluates the cost of the rela-tionship; (v) reviews independent audit reports of the adviser; and (vi) performs on-site quality assurance reviews and tests the adviser’s risk management controls.21 It also gen-erally would be advisable to describe the respective roles and responsibili-ties of the bank and the adviser in any CIF marketing materials.22

Regulatory ImplicationsERISA When it enacted ERISA in 1974, Congress saw fit to include Section 408(b)(8), a statutory exemption from ERISA’s prohibited transaction restrictions for employee benefit plan investments in “a common or collective trust fund or pooled invest-ment fund maintained by a party in interest which is a bank or trust company supervised by a State or Federal agency,” if certain conditions are satisfied.23 Congress observed simply that “it is common practice for banks, trust companies and insur-ance companies to maintain pooled investment funds for plans.”24 Six years later, the DOL issued Prohib-ited Transaction Exemption (PTE) 80-51 (now designated as PTE 91-38), a class exemption that provides relief for transactions between “a

management” requirement of Regu-lation 9 to permit “prudent delega-tion” of CIF management responsi-bilities. The OCC explained that:

It is the OCC’s position that a bank may delegate CIF invest-ment responsibilities if the delegation is prudent. The bank should conduct a due diligence review of the investment advi-sor prior to the delegation. The board of directors, or its desig-nee, should approve the delega-tion and ensure an agreement setting forth duties and respon-sibilities is in place. In addition, the bank should closely monitor the performance of the invest-ment adviser.17

The OCC also made it clear that, even if a bank delegates investment authority (or receives delegated investment authority), the bank nonetheless is deemed to have invest-ment discretion for bank regulatory purposes.18 Thus, the OCC’s posi-tion is that:

[d]elegation decisions are mat-ters of fiduciary judgment and discretion. A bank must exercise care, skill, and caution in select-ing agents and in negotiating and establishing terms of del-egation, including investment responsibilities.19

The OCC’s handbook on “Invest-ment Management Services” sets forth detailed examination proce-dures focusing on the process by which a bank delegates investment management authority. Among other things, the OCC considers the

Prudent DelegationThe Restatement The law of trusts eventually evolved from where it had stood in 1937. In 1992, the “Prudent Investor Rule” of the Restatement (Third) of Trusts (Restatement) accepted mod-ern investment theories as part and parcel of basic trustee investment re-sponsibilities.11 Importantly, the Pru-dent Investor Rule authorized — and in some cases required — trustees to delegate investment responsibilities to others. However, any such delega-tion must be prudent and appropri-ate under the circumstances.12

The Restatement provides guid-ance as to when delegation is appro-priate and how a delegation should be implemented and monitored.13 The general principle, however, is that a trustee who delegates its responsibility to an agent should care-fully monitor the agent to confirm that the delegation continues to be appropriate and in the best interests of the trust. Among other things, the trustee has a duty to monitor the agent’s performance and compliance with the terms of the delegation and, upon discovering a breach of duty by the agent, the trustee must take rea-sonable steps to remedy the breach.14 The degree to which a trustee may rely on the agent’s decisions and ac-tions depends on what is reasonable under the circumstances. However, if the trustee acts prudently in regard to a delegation, it will not be liable for the decisions or actions of the agent to whom the function is delegated.15

Regulation 9 In 1997, as part of its compre-hensive amendments of Regulation 9, and to be “consistent with the modern prudent investor rule as set forth in the American Law Institute’s Restatement (Third) of Trusts,”16 the OCC formally revised the “exclusive

Special Feature: “Prudent Delegation”

(continued from page 3)



common or collective trust fund or pooled investment fund maintained by a bank” and “parties in interest” of employee benefit plans investing in the fund, if certain conditions are satisfied. The DOL stated that “regulation and oversight” by federal or state banking authorities under Regulation 9 and other regulations provided the basis on which relief under PTE 91-38 was granted.25

Neither ERISA Section 408(b)(8) nor PTE 91-38 (herein, the “ERISA Exemptions”) provides guidance as to what a bank must do to “maintain” a CIF for purposes of those Exemptions. However, in Advi-sory Opinion 96-15A (Aug. 7, 1996), issued shortly before the “prudent delegation” amendment of Regula-tion 9, the DOL concluded that several New Hampshire investment trusts established by a trust com-pany (Funds) would not fail to be “maintained” by the trust company where it hired its parent, a registered investment adviser, to exercise invest-ment discretion with respect to Fund investments.26 The DOL based its conclusion on, among other things, the trust company’s representations that the adviser would be subject to guidelines and restrictions specified by the trust company, and the trust company would retain exclusive authority and control over all aspects of the management and operation of the Funds and would monitor the adviser’s performance on an ongo-ing basis. The trust company also represented that it would at all times “remain responsible for the manage-ment and operation of each Fund and will retain liability under ERISA with respect to plans investing in the Funds for the consequences of the Adviser’s investment decisions.” The DOL reached similar conclusions, based on similar facts and repre-sentations, in subsequent advisory opinions issued after the “prudent

delegation” amendment of Regula-tion 9.27

The DOL does not appear to have issued an advisory opinion specifically addressing a situation in which a bank delegates responsibility for CIF investments to an investment adviser in reliance on Regulation 9’s “prudent delegation” provision. In such a case, however, it seems that the bank should be able to rely on the ERISA Exemptions and at the same time assert that it does not “retain liability” under ERISA for the consequences of the Adviser’s invest-ment decisions,” so long as the bank acts prudently with respect to the delegation.

In this regard, ERISA’s fiduciary standards — which are derived from the law of trusts28 — provide in per-tinent part that the trustee of a plan has exclusive authority and discre-tion to manage and control plan assets, except to the extent a “named fiduciary” of the plan (an ERISA term of art) delegates management authority to an “investment man-ager” (another ERISA term of art).29 In such case, if the named fidu-ciary acts prudently in selecting and continuing the use of an investment manager, the trustee and other plan fiduciaries generally (and subject to certain exceptions under ERISA’s “co-fiduciary” liability rules) will not be liable for the acts or omissions of the investment manager.30

Importantly, the DOL also indi-cated in Advisory Opinion 83-026A (May 26, 1983) that, where a CIF in-vests in other “plan-asset” investment vehicles, the trust company maintain-ing the CIF may designate institu-tions maintaining the other vehicles as ERISA “investment managers” with respect to ERISA plans partici-pating in the CIF, provided the CIF’s governing documents specifically authorize such investments and iden-tify the trust company as a “named fiduciary” of the ERISA plans with authority to appoint investment managers. The DOL was not asked in that situation to interpret the ERISA Exemptions. However, there do not appear to be significant practical or legal differences (from an ERISA point of view) between the case where a bank maintaining a CIF appoints the manager of a plan-asset investment vehicle in which the CIF invests as an investment manager, and that in which the bank appoints an investment manager to manage plan assets held in the CIF directly, provided, in either case, the bank acts “prudently” with respect to the appointment.

Internal Revenue Code A bank seeking favorable tax treatment for a common trust fund under Code Section 584 is required to maintain the fund in conformity with Regulation 9. Until 1992, the IRS routinely issued determination letters confirming the status of com-mon trust funds under Code Section 584. Effective June 29, 1992, how-ever, the IRS announced that gener-ally it no longer would issue rulings or determination letters regarding whether a common trust fund met the requirements of Code Section 584.31 The IRS also issued Revenue Procedure 92-51 (RP 92-51) to pro-vide “guidance to banks that want to draft common trust fund plans


“Prudent delegation” is widely

accepted as a tenet of modern

trust and fiduciary law.




…the phrase “maintained by a bank” makes clear that the basis of the exception for collective funds under the 1940 Act is regu-lation by bank regulatory author-ities of trust and other fiduciary functions of banks….35

In the same letter, however, the staff also stated that the “maintained” requirement “ensures that other collective investment media are not excepted.” In that regard, the SEC’s 1980 release on “Employee Benefit Plans” (the “1980 Release”), which in part interpreted the CIF Exemptions applicable to collective trust funds, stated that:

the word “maintained” has been interpreted by the staff to mean that the bank must exercise “substantial investment responsi-bility” over the trust fund admin-istered by it. Thus, a bank which functions in mere custodial or similar capacity will not satisfy the “maintained” requirement.36

The “substantial investment responsibility” gloss on the “main-tained” requirement appears to derive from the SEC staff’s assump-tion that a bank exercising “substan-tial investment responsibility” over a CIF would be “regulated,” whereas a bank that did not exercise such responsibility for a CIF would not be “regulated” and, consequently, would not “maintain” the CIF for purposes of the CIF Exemptions. Although the legal basis for this assumption is not completely clear,37 the staff applied these principles in numer-ous no-action letters addressing the nature and extent of the investment responsibility a bank was expected to exercise with respect to a CIF. Where the bank hired an investment adviser, the staff explained that:

[t]he language of…[the Invest-

i.e., Regulation 9, “prevailing from time to time.” In the absence of changes to RP 92-51, however, there seems to be no legal or policy basis on which a common trust fund otherwise established and operated in compliance with Code Section 584, Regulation 9, and other “guide-lines” under RP 92-51 should be de-nied favorable tax treatment under Code Section 584, solely because the bank prudently delegates invest-ment responsibility to a non-bank person pursuant to Regulation 9.

Federal Securities Laws A CIF “maintained by a bank” is not considered an “investment company” for purposes of the Invest-ment Company Act of 1940, and interests in such a CIF are exempt from securities registration under the Securities Act of 1933 and the Securities Exchange Act of 1934.34 (These exceptions and exemptions are referred to for convenience as the “CIF Exemptions.”) The CIF Exemptions themselves and their legislative histories do not explain or elaborate the “main-tained” requirement and do not appear to place any particular or special importance on it, beyond the obvious requirement that a CIF be sponsored and operated by a bank. A tacit Congressional ac-knowledgment underlying the CIF Exemptions, however, is that banks maintaining CIFs are subject to significant regulation under banking and fiduciary laws, and that the CIF Exemptions are justified in order to avoid duplicative federal regula-tion of banks and CIFs. The SEC staff confirms this view in a relatively recent no-action letter, in which the staff stated that:

that will meet the requirements of Section 584 of the Internal Revenue Code.” The IRS stated that it would:

recognize a common trust fund plan drafted in accordance with the guidelines contained in this revenue procedure as meeting the requirements for qualifica-tion under section 584 and the regulations thereunder provided that the plan adopted does not contain any language that is inconsistent with the guidelines herein.32

The guidelines in RP 92-51 include, consistent with Regulation 9 as it existed at the time, the require-ment that the bank have “exclusive managerial and investment authority” over the common trust fund. RP 92-51 also states that, while a bank may delegate such authority to a commit-tee limited to bank officers, RP 92-51 expressly does not apply to a common trust fund that “permits the delega-tion of management and investment of the fund to non-bank persons.”33

The IRS appears not to have revised or updated RP 92-51 since 1992, and the delegation excep-tion described above remains unchanged, even though Regula-tion 9 has since been amended to permit “prudent delegation” of CIF investment and other responsibili-ties to non-bank persons. Assuming the IRS wishes to continue its policy of providing general common trust fund “guidelines” in lieu of issuing individual determination letters regarding common trust fund status under Code Section 584, the most logical solution would seem to be an update of RP 92-51 to conform to Regulation 9’s “prudent delegation” provision. That would be consistent with Code Section 584 itself, which requires that a common trust fund be maintained “in conformity with” rules and regulations of the OCC,





fund investment by a CIF since the “prudent delegation” amendment of Regulation 9 in 1997. In the spring of 2010, however, in the wake of widespread publicity about CIF arrangements between non-bank investment advisers and banks/trust companies unaffiliated with the ad-visers, the then Director of the SEC’s Division of Investment Management expressed “concern” about “collec-tive investment trust platforms” oper-ated by banks or trust companies, but managed by unaffiliated invest-ment advisers that also are respon-sible for marketing and distribution of the CIF. The Director noted that:

Collective investment trusts are regulated by the banking agen-cies, and may rely on an exclu-sion from registration under the Investment Company Act. The premise underlying this exclusion is that banks exercise full investment authority over the pooled assets, among other things. As collective investment trusts become more popular and their structures more varied, the Division is looking at whether, under certain conditions, this exemption is properly relied upon and consistent with the Act and whether it denies investors appropriate protections. For example, are banks operating merely in custodial or similar capacity while providing a place for an adviser to simply place pension plan assets of its clients? As we learn more about the structure and operation of these platforms, we will be considering this and other issues and wheth-er there may be a need for any regulatory recommendations.44

The Director’s “concern” ap-pears to be based in part on the fact that a bank may create a CIF at the

other pooled investment vehicles maintained by unaffiliated banks or insurance companies, if the bank appropriately evaluated the merits of investing in the other vehicles and retained full discretion to make or to liquidate the investments.41 The staff provided similar relief in con-nection with investments by separate accounts “maintained” by insurance companies in other pooled invest-ment vehicles, including CIFs and other separate accounts.42 In one such case, the insurance company proposed to invest “some or all” of its

separate account in “one or more” separate accounts maintained by a single unaffiliated insurance com-pany.43 Significantly, none of these letters mentioned, much less re-quired, pre- or post-trade approvals of investments made by the manag-ers of the underlying funds. Yet, the practical differences between these situations and that in which a bank directly retains an investment adviser to assist in the management of a CIF seem subtle at best. The SEC appears not to have issued a no-action letter or other significant interpretation dealing with a bank’s retention of an invest-ment adviser for a CIF or a fund-to-

ment Company Act exception for collective trust funds] effectu-ates a Congressional determina-tion to except the collective trust fund of a banking institution, which, for its own convenience, pools…plan assets and exer-cises full investment authority over such assets. Such a bank would be subject to regulation by banking authorities whereas…[a] collective trust… [managed by an outside adviser] would operate with a complete lack of regulation, absent registration under the [Investment Company] Act. Pension trusts…which have been commingled, in effect, by other than a bank, even if brought to a bank for mere custodian purposes, in our view are not entitled to rely upon the exception in the second clause of Section 3(c)(11).38

Thus, the staff took the position that a bank could, in the exercise of “substantial investment responsibil-ity” with respect to a CIF, hire an investment adviser. In such case, however, the staff expected that “the final decision whether or not to invest must be made by the bank.”39 The staff issued numerous no-action letters over a twenty year period ending in the early 1990s echoing this theme in various fact situations. While the details varied, the basic concept was that a bank generally could rely on an adviser’s advice and recommendations with respect to CIF investments. However, the staff typically conditioned favorable no-action relief on representations that the bank would approve or otherwise authorize all fund investments con-temporaneously or in advance.40

On the other hand, the staff also concluded that a bank would satisfy the “substantial investment responsibility” requirement where the bank invested CIF assets in


A bank that prudently delegates

CIF investment responsibilities is

subject to substantial regulatory

oversight under Regulation 9 and

general banking regulation, as

well as ERISA.




if, but only if, it fails to monitor and exercise appropriate oversight over the adviser’s investment decisions. Importantly, the bank has no obliga-tion to substitute its judgment, or otherwise make “final decisions,” for particular CIF investments. As described above, existing official pronouncements of other regulators, almost all of which pre-date the “prudent delegation” amendment of Regulation 9, have yet to reflect the prudent delegation concept. In the author’s view, both regulators and the regulated alike would benefit from the following basic, but important, clarifications and/or confirmations of the regula-tors’ existing positions: First, the DOL should clarify that a bank may, consistently with the ERISA Exemptions and ERISA generally, delegate CIF investment responsibility to an investment ad-viser. In such case, the bank remains liable for the adviser’s investment decisions only if the bank fails to exercise prudence and diligence in retaining and exercising oversight over an investment adviser. Second, the IRS, in the interest of conserving time and resources that otherwise might be expended in processing determination letters with respect to common trust funds that involve delegation of investment re-sponsibility, should update RP 92-51 to conform to the “prudent delega-tion” provisions of Regulation 9. Finally, the SEC should confirm that a bank that delegates CIF invest-ment responsibilities to an investment adviser — whether or not the bank and the adviser are affiliated, and regardless of whether the adviser initi-ates the creation of the CIF — will be considered to “maintain” the CIF for purposes of the CIF Exemptions, pro-vided the bank exercises the appro-priate level of prudence and oversight with respect to the delegation. n

that there are ample grounds for concluding that CIF arrangements between banks and investment advisers can fully satisfy the funda-mental principles announced in the 1980 Release and more recent SEC pronouncements. In particular, a bank that retains an investment adviser will be expected, as a matter of banking regulation and general fiduciary principles, to satisfy the requirements of a “prudent delega-tion” under Regulation 9, general trust law, and ERISA. In short, a bank that carefully selects an adviser, establishes appropriate parameters for CIF investments, and monitors and exercises diligent oversight over the adviser’s performance and ad-herence to those parameters seems far closer to the exercise of “substan-tial investment responsibility” than to acting as a “mere custodian” of a CIF.

Conclusion This discussion necessarily rep-resents a substantial condensation of numerous statutory and regulatory interpretations and concepts that evolved over several decades, and omission of at least some relevant details and variations of those inter-pretations, although unintentional, is unavoidable. However, certain fundamental conclusions appear to be reasonably clear. “Prudent delegation” is widely accepted as a tenet of modern trust and fiduciary law. A bank that pru-dently delegates CIF investment re-sponsibilities is subject to substantial regulatory oversight under Regula-tion 9 and general banking regula-tion, as well as ERISA. In addition, the bank retains potential liability for the consequences of CIF investments

request of an adviser, which thereafter assumes primary responsibility for marketing the CIF to the adviser’s em-ployee benefit plan clients. Although plans and trusts participating in a CIF necessarily become “clients” (more aptly, beneficiaries) of the bank, as trustee of the CIF, the situation differs from that in which the bank initiates the CIF to manage investments of bank customers. However, whether this difference should be significant for purposes of the CIF Exemptions is not at all clear. The SEC staff’s traditional view has been that CIFs are created by banks for their own convenience to manage investments of fiduciary customers on a pooled basis. The staff, in fact, has stated that a primary basis for distinguishing between a CIF, which is “maintained by a bank,” and a non-CIF investment vehicle, which is not, is whether the vehicle is created by or at the instance of a bank (CIF) or a third party (non-CIF).45 The question remains, however, whether the initiation process is or should be, in itself, a hallmark of a CIF described in the CIF Exemptions. Although banks historically initiated the creation of CIFs, the rationale underlying the CIF Exemptions is, as described above, a desire to avoid overlapping or duplicative regulation. As also described above, a bank main-taining a CIF is subject to significant regulatory requirements, regardless of whether it initiates the creation of the CIF or whether the bank or the “initiating adviser” is involved in mar-keting interests in the CIF. The current Director of the Division has not as yet publicly stated her views on the subject. Although the staff has made various inquiries and obtained information about bank-adviser arrangements, there has been no indication as to how or whether the SEC intends to pursue these issues. It seems clear, however,





12(g) (interests in collective trust funds). The SEC and its staff have interpreted the “maintained by a bank” requirement discussed below consistently for purposes of all the CIF Exemptions.35 Honeywell International Inc. Savings Plan Trust, SEC No-Action Letter, at n. 5 (avail. Oct. 7, 2002).36 Employee Benefit Plans, Securities Act Release No. 6188 (Feb. 1, 1980), 45 Fed. Reg. 8960, 8972 (Feb. 11, 1980). Notably, the staff applied the same principles to both collective trust funds for employee benefit trusts and to common trust funds. See Bank of Delaware, SEC No-Action Let-ter (avail. Jan. 7, 1973).37 See Bank of America, SEC No-Action Letter (avail. Jan. 9, 1972); Gibson, Dunn & Crutcher, SEC No-Action Letter (avail. Apr. 18, 1974).38 Narragansett Capital Corporation, SEC No-Action Letter (avail. Feb. 26, 1975) (emphasis added).39 Employee Benefit Plans, Securities Act Release No. 6188 (Feb. 1, 1980), 45 Fed. Reg. 8960, 8973 (footnote omitted).40 See, e.g., First Liberty Real Estate Fund, SEC No-Action Letter (avail. July 14, 1975); State Street Bank and Trust Co., SEC No-Action Letter (avail. Dec. 31, 1991).41 Frank Russell Trust Company, SEC No-Action Letter (avail. Sept. 2, 1982).42 See Maccabees Mutual Life Insurance Company Separate Account, SEC No-Action Letter (avail. July 29, 1983); Mac-cabees Mutual Life Insurance Company, SEC No-Action Letter (avail. Aug. 1, 1990). Securities law exemptions applicable to a separate account “maintained by an insur-ance company” parallel the CIF exemptions and were enacted in recognition of the fact that insurance company separate accounts and CIFs “are very similar to each other and serve essentially the same purpose” and, therefore, the exemptions are “intended to grant banks and insurance companies equal treatment under the Federal securities laws to the extent that they compete with each other.” S. Rep. No. 91-184, at 23 (1969).43 Nippon Life Insurance Company of America, SEC No-Action Letter (avail. Nov. 2, 1992).44 Remarks of Andrew J. Donohue, Direc-tor, SEC Division of Investment Manage-ment, before the Practicing Law Institute’s Investment Management Institute 2010 (April 8, 2010).45 See, e.g., Communications Workers of America, SEC No-Action Letter (avail. Jan. 27, 1980).

17 OCC “Questions and Answers 12 CFR Part 9,” Q&A No. 15 (May 15, 1997). See also Investment management servIces (OCC 2001) (“Investment Management Hand-book”), at 117 (trustees have duty as well as authority under “prudent investor rule” to delegate investment authority as a prudent investor would).18 12 C.F.R. § 9.2(i) (2010) (definition of “investment discretion”).19 CIF Handbook, note 2, at 49.20 Investment Management Handbook, note 17, at 62.21 Id.22 See, e.g., Fiduciary Handbook, note 8, Fiduciary Precedent 9.5118 (collective trust advertisements subject to antifraud provi-sions of securities laws).23 Code § 4975(d)(8) is a counterpart exemption for purposes of the parallel prohibited transaction excise tax provisions of Code § 4975.24 H.R. No. 93-1280, at 316 (1974) (Conf. Rep.).25 DOL Advisory Opinion 2007-03A (June 8, 2007). See also DOL Advisory Opinion 2006-07A (Aug. 15, 2006) (regulation under Regulation 9 provided “a” basis on which PTE 91-38 was granted).26 The DOL also concluded, by implica-tion, that the “New Hampshire investment trusts,” which were not characterized as CIFs subject to Regulation 9, were “pooled investment vehicles” maintained by the trust company for purposes of the ERISA Exemptions.27 DOL Advisory Opinion 2007-03A (June 8, 2007); DOL Advisory Opinion 2006-07A (Aug. 15, 2006).28 H.R. No. 93-1280, at 295 (1974) (Conf. Rep.).29 ERISA §§ 402(c)(3), 403(a)(2). See also ERISA § 3(38) (definition of “investment manager”).30 ERISA § 405(d)(1); H.R. No. 93-1280, at 302 (1974) (Conf. Rep.).31 Rev. Proc. 92-50.32 Rev. Proc. 92-51, § 3. The IRS noted that it would “consider” a request for a ruling where the terms of a common trust fund did not fall within the “guidelines” in the Revenue Procedure 92-51 or the bank raised an issue under Code Section 584 that needed to be resolved. Id.33 Rev. Proc. 92-51, § 4.02.34 See Investment Company Act § 3(c)(3) (common trust funds) and § 3(c)(11) (col-lective trust funds); Securities Act § 3(a)(2) (interests in CIFs); Securities Exchange Act § 3(a)(12) (interests in CIFs) and §

Notes* Partner, K&L Gates LLP. The views expressed in this article are those of the author and do not necessarily represent the views of the firm or any other of its partners or clients. In addition, this article is intended for informational purposes only, and is not intended to convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.1 12 C.F.R. §9.18(b)(2) (2010) (footnote omitted). Unless indicated otherwise, references below to “CIFs” include both collective trust funds consisting solely of assets of employee benefit trusts and com-mon trust funds consisting solely of assets of trusts for which the bank acts as trustee.2 The OCC notes that Regulation 9 estab-lishes basic standards for CIF management and administration for federal and state banks. collectIve Investment Funds (OCC 2005) (“CIF Handbook”), at 3.3 12 C.F.R. §17(c)(8), 2 Fed. Reg. 2976 (Dec. 30, 1937).4 Restatement of Trusts (Second), § 171 (1959).5 12 C.F.R. §206.118, 24 Fed. Reg. 4906 (June 17, 1959).6 12 C.F.R. §9.18(b)(12), 28 Fed. Reg. 3309, 3313 (Apr. 5, 1963); now codified at 12 C.F.R. § 9.18(b)(2) (2010).7 See, e.g., OCC Interpretive Letter No. 696 (Nov. 28, 1995).8 Handbook For FIducIary actIvItIes (OCC 1990) (“Fiduciary Handbook”), Fiduciary Precedents 9.5317, 9.5785.9 Fiduciary Handbook, note 8, Fiduciary Precedent 9.5320.10 OCC Interpretive Letter No. 696 (Nov. 28, 1995) (designating affiliate to make in-vestment recommendations does not alter bank’s exclusive management of collective investment fund if bank “ultimately directs the fund’s investments”).11 The Prudent Investor Rule is now reflected in Restatement §90.12 Restatement §90(c)(2) (a trustee “must act with prudence in deciding whether and how to delegate [investment] author-ity and in the selection and supervision of agents”).13 See, e.g., Restatement §80, comments d, e, f(1), and §90, comment j.14 Restatement §80, comment d(2).15 Restatement § 80, comment g.16 60 Fed. Reg. 66163, 66169 (Dec. 21, 1995) (preamble to proposed amendment of Regulation 9).



The proposal elaborates on this basic definition by indicating that an acceptable SEF platform or system must provide at least a basic func-tionality to give market participants the ability to make executable bids or offers and indicative quotes, and to display them to multiple parties, including all other parties participat-ing in the SEF, if the market partici-pants wish to do so. The CFTC is also proposing that the SEF must provide market participants with the ability to make a bid, make an offer, hit a bid, or lift an offer, and may pro-vide the ability to request a bid and request an offer.

Coverage of Trade Processing Functions Under new Section 5h(b) of the CEA, a registered SEF may (a) make available for trading any swap, and (b) facilitate trade processing. The proposal release acknowledges that these provisions could be read to require the registration as SEFs of entities that engage in trade process-ing (but not trade execution). Banks that process post-execution trades are concerned that their processing activities could be captured under the rule’s description of regulated SEF activities. According to the rule release, however, the CFTC states its belief that “entities that operate exclusively as swap processors do not meet the SEF definition and should not be required to register as SEFs because: (1) they do not provide (as required by the definition) the ability to execute or trade a swap; and (2) the definition does not include the term “process.” In a letter to the CFTC and SEC, dated December 7, 2010, BNY Mel-lon reiterated a point also made by State Street. According to the letter, “BNY Mellon agrees with State Street Corporation’s view, expressed in its

market (DCM) or an SEF any trans-action involving a swap that is subject to the clearing requirement. Section 733 of the Dodd-Frank Act added new Section 5h to the CEA to require SEFs to register, maintain registration, and comply with 15 enumerated core principles (see the box on page 11 for a sum-mary) and any other requirements the CFTC might establish by regula-tion. New Section 5h gives the CFTC authority to prescribe rules govern-ing the regulation of SEFs. The proposed regulations, guid-ance, and acceptable practices would implement the regulatory obligations that each SEF must meet in order to comply with Section 5h, both initially upon registration and on an ongoing basis.

SEF Definition The proposal defines an SEF as “a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facil-ity or system through any means of interstate commerce, including any trading facility, that (a) facilitates execution of swaps between persons; and (b) is not a DCM.

T he Commodity Futures Trading Commission (CFTC) proposed

new rules, guidance, and accept-able practices that will apply to the registration and operation of a new type of regulated entity called a “swap execution facility” (SEF). The proposal, published on January 7, 2011 (76 Federal Register 1214) imple-ments amendments to the Commod-ity Exchange Act (CEA) made by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank amendments to the CEA establish a comprehen-sive new regulatory framework for swaps and security-based swaps. The overarching purpose of the new framework is to create a regulated marketplace for swaps and security-based swaps that will function to reduce risk, increase transparency, and promote market integrity. The banking industry is closely watching the development of the new regulatory framework. In par-ticular, banks want to make sure that post-execution processing activities, such as middle-office and back-office functions, do not expose them to registration and regulation as SEFs. Comments on the proposed rules are due on or before March 8, 2011.

Statutory Trade Execution Requirements Section 723(a) of the Dodd-Frank Act amended Section 2(h) of the CEA to establish an exchange trading requirement for swaps. The provision requires counterparties to execute on a designated contract

Swap Execution Facilities Rules and Practices ProposedBanks Seek to Clarify “Processing of Swaps” Under Rule Proposal

The Dodd-Frank amendments to

the CEA establish a comprehen-

sive new regulatory framework for

swaps and security-based swaps.



The proposed regulations, guidance, and accept-able practices are built on a foundation of 15 core principles for implementing and operating SEFs. The core principles are as follows:

1. Compliance with the core principles and the CFTC implementing rules is a condition for ob-taining and maintaining registration as an SEF.

2. An SEF must establish rules to deter abuses and must have the capacity to detect, investigate, and enforce its rules.

3. The swaps that SEFs offer for trading must not be readily susceptible to manipulation.

4. An SEF must take an active role in preventing manipulation, price distortion, and disruptions of the delivery or cash settlement process.

5. An SEF must have the ability and authority to ob-tain information necessary to perform its obliga-tions.

6. An SEF must adopt, for each swap, position limits or position accountability. For any contract subject to a federal position limit under the CEA, the SEF must set its position limits at a level no higher than the position limitation established in the CFTC’s regulations.

7. An SEF must establish and enforce rules to ensure the financial integrity of swaps entered on or through its facilities, including the clearing and settlement of the swaps.

8. An SEF must provide for emergency situations, in-cluding participating in cross-market coordination and establishing alternate lines of communication and approval procedures to address emergencies in real time.

9. An SEF must make available to the public timely information on price, trading volume, and other trading data on swaps to the extent required by the CFTC.

10. All SEFs must adhere to a three-part recordkeep-ing and reporting requirement that includes investigatory and disciplinary files and that also observes minimum retention periods.

11. An SEF must comply with antitrust obligations.

12. An SEF must maintain procedures for identify-ing and mitigating conflicts of interest (rules of conflict of interest mitigation are proposed in separate releases; see the box on page 12).

13. An SEF must have adequate financial resources to discharge its responsibilities.

14. An SEF is responsible for safeguarding its systems by establishing and maintaining a program of risk oversight capable of identifying and minimizing sources of operational risk. An SEF should devel-op appropriate internal controls and procedures and automated systems that are reliable, secure, and have adequate scalable capacity. SEFs must also establish and maintain emergency proce-dures, backup facilities, and a disaster recovery plan and should periodically conduct tests to verify that backup resources will ensure continued order processing and trade matching, price re-porting, and market surveillance. An SEF’s systems should also be able to create a comprehensive and accurate audit trail.

15. SEFs must have an internal regulatory framework headed up by a chief compliance officer who serves as a focal point for compliance with the amended CEA and implementing rules.

ance on third-party vendor data;• Reconciliation, involving the

matching and identification of discrepancies between trade de-tails on executed trades provided to the bank by its clients and/or their investment managers and their counterparties;

• Lifecycle management, involving the capture and processing of

performed by banks for their clients. According to the BNY Mellon let-ter, middle-office or back-office func-tions might include, for example:

• Affirmation and confirmation of trades executed with counterpar-ties by bank clients and/or their investment managers;

• Valuation of transactions in reli-

November 24 letter to the Commis-sions, that “processing of swaps” in this context should be read to mean trade execution matching and com-parison functions that occur before a trade is submitted for clearing.” The phrase should not be interpreted as covering other post-execution activities, including middle-office or back-office processing functions

Core Principles for SEFs




The DFA defines “municipal entity” to include governmental bod-ies and “any plan, program, or pool of assets sponsored or established by [governmental bodies].” The DFA excludes registered investment advisers (RIA), but not banks, from the definition of mu-nicipal advisor. The RIA exemption extends only to activities that require registration under the Advisers Act.

swap market participants and will not further any of the goals of Dodd-Frank,” the letter asserted. The letter concluded with a request that the meaning of “pro-cessing of swaps” be clarified in the regulation to exclude banks’ middle-office and back-office processing functions and other post-execution processing activities. n

events occurring in the lifecycle of a particular derivative transac-tion; and

• Collateral management, involv-ing the determination of ap-propriate collateral posting and management of the collateral process based on the criteria agreed upon by the parties to the trade in connection with execu-tion of the trade.

The BNY Mellon letter agreed that trade execution matching and comparison functions are a necessary part of the ability to execute or trade swaps by accepting bids and offers. As a result, oversight of these activities, as part of the regulation of trade execu-tion platforms, is “logical and consis-tent with the aims of Dodd-Frank.” But, the letter continued, “mid-dle-office and back-office processing activities are often not performed by trade execution platforms and, as a result, do not neatly fit into regulato-ry regimes for the oversight of trade execution.” In fact, many middle-office and back-office activities may fall under other regulatory schemes, such as the CFTC and SEC author-ity over clearinghouses, swap data repositories, swap dealers, and major swap participants. “Subjecting these activities to the regulatory regime for SEFs and exchanges will lead to unnecessary dual regulation that will be costly to

Related Proposed Rules on SEF Conflicts of Interest and Governance Standards

The CFTC is separately proposing related rules to further implement the core principles under the Dodd-Frank Act that are applicable to SEFs, derivatives clearing organizations (DCOs), and DCMs. The propos-als have been published as follows.

• Mitigation of conflicts of interest requirements for DCOs, DCMs, and SEFs, published October 18, 2010 (75 Federal Register 63732). Com-ments were due November 17, 2010. In the proposal, the CFTC states that it “anticipates conducting at least one other rulemaking that may impose requirements on DCOs, DCMs, and SEFs with respect to gov-ernance and mitigation of conflicts of interest. That proposal follows.

• Governance fitness standards, composition of governing bodies, and additional requirements for resolving conflicts of interest in the operation of certain DCOs, DCMs, and SEFs, notice of proposed rulemaking, published January 6, 2011 (76 Federal Register 722). Com-ments are due by March 7, 2011.

The Dodd-Frank Act statutory deadline for completing these rulemakings is July 15, 2011.

Municipal Advisor Registration Proposal(continued from page 1)

financial products or the issuance of municipal securities.” Municipal financial products are defined as: (1) municipal derivatives; (2) guar-

anteed investment contracts (GIC); or (3) “investment strategies” that include plans or programs for the investment of the proceeds of mu-nicipal securities that are not munici-pal derivatives or GICs or municipal escrow investments.

Related articles in ABA Trust Letter “SEC and CFTC Propose Defi-nitions for Swap Market; Establish Framework for Forthcoming Regula-tion of Swaps,” January 2011, page 5. “Swap Definitions Must Be Care-fully Crafted to Exclude Financial End Users,” November 2010, page 6.




When the legislation was being considered, all believed it was intend-ed to cover heretofore unregulated financial advisors, not other entities in the municipal market that are already subject to regulation by the SEC or the bank regulators. The actual language of the statute turned out to be much broader. Accordingly, the SEC bases its registration proposal on the fol-lowing analysis of the scope of the registration requirement:

Depending on their role with re-spect to investment strategies for municipal entities, commercial banks subject to regulation by various federal and state regula-tors may also engage in activities that would subject them to reg-istration as municipal advisors. Such commercial banks may act as trustees with respect to an issuance of municipal securities or otherwise provide advice with respect to municipal financial products. Other persons that are subject to registration as munici-pal advisors include those who solicit municipal entities on be-half of…municipal advisors…as well as on behalf of brokers, deal-ers, municipal securities dealers, and other parties.

The Proposed Permanent Rule Section 975 of the Dodd-Frank Act requires the registration of “municipal advisors” both with the SEC and with the Municipal Securi-ties Rulemaking Board (MSRB). SEC registration is free, but MSRB regis-tration will impose ongoing costs. In addition, the MSRB will write rules of conduct, education require-ments, and fiduciary standards that will apply to registered municipal advisors. Importantly, registration will be required not only of the entity itself, but each employee who

provides municipal advisory services.

Functional Enforcement Unlike the MSRB rules or the municipal securities provisions of the Exchange Act, enforcement of the registration and associated requirements would be by the SEC or the Financial Industry Regulatory Authority (FINRA) — not the bank regulators in the case of banks. In addition, there is no provision for examining a “separately identifi-able department of a bank” (SID) as there is for municipal securities deal-ers that are banks. As a result, the SEC could come in and examine the bank directly if municipal advisory activities are conducted in the bank.

Rule Proposal’s Impact on Bank Activities As previously noted, Section 975 of the DFA expressly links registra-tion to the provision of advice about the proceeds of municipal securities. However, neither the statute nor the proposal defines “advice.” Significantly, the SEC’s pro-posal has expanded the registration requirement beyond advice about “proceeds” of municipal securities. Rather, the proposal would require registration if advice is given about “funds held by or on behalf of a munici-pal entity.” The proposal acknowledges that municipal pension plans and 529 college plans are not funded by “proceeds,” but yet the SEC has determined that advice to such entities would require registration. The proposal further states that this treatment would eliminate the need to determine the point at which “proceeds” that are commingled with other funds no longer are “pro-ceeds.” Among other things, the pro-posal could affect the following bank activities:

• Bank deposits, cash manage-ment tools, and other traditional bank products. Because “advice” is not defined, it is unclear whether letting a municipality know it can get better interest on a money market deposit account instead of a check-ing account constitutes “advice.” The proposal references advice by “money managers,” but again this is undefined and appears only in the preamble.

• Bank advisory activities exempt under the Advisers Act. The statute provides no exemption for activities conducted pursuant to the statu-tory exception from the Investment Advisers Act for banks and trust companies, thus potentially requir-ing registration by bank advisers to municipalities.

• Advice to municipal pension plans. Such advice is now covered because the requirement for “pro-ceeds” has been eliminated. This provision could also encompass di-rected trustees to employee benefit plans.

• Liquidity facilities for municipal bond issuances. The proposal would exempt from registration banks and other liquidity providers that offer letters of credit and other instru-ments to back bonds. However, if a bank will not provide a letter of cred-it unless the municipality structures the issuance in a certain manner, the bank may be subject to registration for providing advice about “structur-ing” the issuance.

• Corporate trust. The proposal cites its potential applicability to cor-porate trustees for bond issuances.

Comments Sought The SEC is seeking input on a se-ries of questions about the proposal’s




are scattered among its departments and geographical locations. n

Previous articles in ABA Trust Letter “Municipal Advisor Registration Rule Creates Uncertainty for Banks and Trust Companies; ABA and ABA-SA Submit Comment Letter Seeking Clarifications,” November 2010, page 1. “Now in Effect: Temporary Mu-nicipal Advisor Registration,” No-vember 2010, page 2.

IRS Offers Up Guidance on Group Trusts

impact on banks, including whether there should be exemptions for:

• Banks exempt under the Advis-ers Act;

• Bank deposit accounts;• Banks responding to requests for

proposals from municipalities for investment products offered by banks, such as money market funds or exempt securities;

• Banks that provide a list of op-tions available from the bank for

short-term investments and that negotiate the terms of an invest-ment; and

• Banks providing the terms to a municipal entity upon which it would buy the entity’s securities for the bank’s own account.

The SEC is also requesting input on whether it should permit regis-tration only of SIDs and whether registration would work where a bank’s municipal advisory activities

I n Revenue Ruling 2011-1, the Internal Revenue Service (IRS)

made several modifications to the rules governing “group trusts” — which are tax-exempt pooled invest-ment vehicles consisting of tax-qualified employee benefit trusts, governmental employee plans, and other eligible plans and trusts. The revenue ruling, which is of interest to banks that maintain collective trust funds for employee benefit plans, became effective on January 10, 2011. The rules for group trusts are de-scribed in Revenue Ruling 81-100, as clarified by Revenue Ruling 2004-67. Revenue Ruling 2011-1 revises these rules to clarify the conditions under which the assets of qualified plans under § 401(a), individual retire-ment accounts under Section 408 (including Roth IRAs), and eligible governmental plans under § 457(b) may be pooled in a group trust with the assets of custodial accounts (§ 403(b)(7)), retirement income accounts (§ 403(b)(9)), and govern-mental plans (§ 401(a)(24)) without affecting the tax status of these enti-ties or the group trust. The Revenue Ruling states that, to ensure that the assets of a

group trust are commingled only with the assets of similar plans or arrangements, each entity must be tax-exempt under § 501(a) of the Internal Revenue Code and be part of a plan that satisfies an exclusive benefit rule. Each group trust must also keep separate records of each adopting entity’s interest in the group trust. Under the Revenue Ruling, a custodial account under § 403(b)(7) must be invested in the stock of a regulated investment company, and any group trust in which the assets of a § 403(b)(7) custodial ac-count is invested must comply with this restriction. As a result of this investment restriction, the assets of a custodial account under § 403(b)(7) generally will be commingled in a group trust that consists solely of the assets of other § 403(b)(7) custodial accounts. If the requirements enumerated in the Revenue Ruling are satisfied, the tax-exempt status of the group trust will be derived from the tax-exempt status of the participating entities to the extent of their equi-table interests in the group trust. Revenue Ruling 2011-1 also sets forth two model amendments for

group trusts to use. The first one is for a group trust that received a determination letter from the IRS before January 10, 2011, that the group trust satisfies Revenue Rul-ing 81-100 but does not satisfy the separate account requirement under Revenue Ruling 2011-1. The second amendment is for group trusts that received a determination letter from the IRS before January 10, 2011, that the group trust satisfies Revenue Ruling 81-100 and intends to permit custodial accounts (§ 403(b)(7)), re-tirement income accounts (§ 403(b)(9)), or governmental retirement plans (§ 401(a)(24)) to participate in the group trust. According to the revenue ruling, both model amendments should be adopted by group trusts that do not satisfy the separate account require-ment but do intend to permit the aforementioned types of plans to participate in the group trust. Revenue Ruling 2011-1 also extends the transition relief provided in Revenue Ruling 2008-40 to Puerto Rico retirement plans participating in group trusts from January 1, 2011, to January 1, 2012. Revenue Ruling 2011-1 may be found at http://www.irs.gov/pub/irs-drop/rr-11-01.pdf. n




of such extensions if it defines the statute’s terms too narrowly. Accord-ingly, the letter stated, “ABA believes the Board should preserve its statuto-ry authority and more broadly define the important terms in the statute.”

Extended Transition for Illiquid Funds The rule proposal defines an “il-liquid asset” as one that is not a “liq-uid asset” (that is, not cash, an asset traded on an exchange or market, an asset with a ready market, and so forth) or one that may not be sold to a person unaffiliated with the bank-ing entity. In addition, the statute also refers specifically to “portfolio companies, real estate investments, and venture capital investments” as illiquid assets. The proposed rule implement-

ABA Comments

Scope of Definitions The intent of Congress was for the Volcker Rule to allow for the liq-uidation of long-term interests with-out hurting the safety and soundness of the very institutions the rule seeks to protect and without harming fund investors or bank clients. Congress also vested significant authority in the FRB to consider and grant appli-cations for extensions of the general conformance period. ABA pointed out, however, that the FRB will undermine the utility

A BA submitted comments to the Federal Reserve Board (FRB) on

its proposed rule implementing the Volcker Rule conformance period, as provided in the Dodd-Frank Wall Street Reform and Consumer Protec-tion Act. The comment due date, January 10, 2011, prompted ABA to caution the FRB to take a measured approach and be prepared to revisit the Volcker Rule conformance period rule in light of two relevant matters:

• The ongoing efforts by the fed-eral banking agencies, Securities and Exchange Commission, and Commodity Futures Trading Commission to propose a rule to implement the substance of the Volcker Rule; and

• The Financial Stability Oversight Council’s (FSOC) study of the Volcker Rule, which was released after ABA submitted the letter (see page 11).

“In particular, the coordinated rulemaking may address such vital issues as the scope of the terms “banking entity,” “hedge fund,” and “private equity fund,” ABA noted. Furthermore, given the parallel Vol-cker Rule implementation activities, “it is extremely difficult to foresee and comment on all the concerns that may arise with the conformance period proposal when it operates in conjunction with the other not-yet-issued implementing rules.” Nevertheless, in the specific context of the proposed confor-mance period rule, ABA did offer a number of recommendations. The remainder of this article summarizes ABA’s comments.

ABA Comments on Proposed Volcker Rule Conformance Period

Overview: The Volcker Rule Conformance Period for Banking Entities

Section 619 of the Dodd-Frank Act, commonly referred to as the “Volcker Rule,” generally prohibits banking entities from engaging in proprietary trading or from investing in, sponsoring, or having certain relationships with hedge funds or private equity funds. Under the Vol-cker Rule, banking entities must come into conformance with its require-ments two years after the earlier of one year after the issuance of final rules under the section or two years after enactment of the Dodd-Frank Act. The proposed rule would implement the statutory conformance period. The rule would also implement the authority in the Volcker Rule that allows the Board to extend the conformance period for up to three additional one-year periods if such an extension is consistent with the purposes of Section 619 and not detrimental to the public interest. The Board may also extend the conformance period for up to five years for holdings of illiquid funds to the extent necessary to fulfill a contractual obligation that was in effect on May 1, 2010. The Dodd-Frank Act requires the conformance period rules to be issued within six months of the law’s enactment, or January 21, 2011. This statutory deadline is the reason the Board pursued an accelerated schedule for proposing a rule that addresses only the Volcker Rule con-formance period. As of the time of publication, the Federal Reserve had not issued the final conformance period rule.




recognize, as a factor governing its determinations, these duties to the fund and its investors and not adopt rules or interpretations that in effect would not be in the best interests of the investors,” ABA recommended.

Conclusion ABA concluded its comments by noting that the need for flexibility under the conformance period rule is paramount. “We strongly urge the Board to instill more flexibility into the rule so that it may consider a po-tentially wide variety of scenarios that legitimately need additional relief from the Volcker Rule.” n

Previous article in ABA Trust Letter “ Volcker Rule Conformance Pe-riod Fleshed Out in Proposed Rule,” January 2011, page 4.

interest in, or otherwise provide ad-ditional capital to, an illiquid fund.”

Bank-Managed Funds Banks routinely establish funds that potentially may fall within the broad definition of “hedge fund” or “private equity fund.” Such bank-managed funds provide investment opportunities to institutional, gov-ernment, charitable, or trust cus-tomers. Bank sponsors often invest side-by-side in these funds, at least for the initial years of the fund. This co-investment may be significant and larger than the 3 percent de minimis investment allowed as a permitted activity in the statute. “Given the fiduciary and other obligations of a bank that is acting as trustee, general partner, or man-aging member, the Board should

ing the conformance period should be modified to accommodate assets that initially meet the definition of liquid but, given the particular circumstances of the investment or market, subsequently become illiquid. One example is large holdings in the securities of one particular issuer that may prohibit the fund from selling the asset without material losses. Consequently, ABA recommended specifying in the proposal that other circumstances may exist that make a typically or historically liquid asset il-liquid in the present circumstances. ABA also urged the FRB to con-sider a more moderate interpreta-tion of the term “principally invest-ed” than the “substantially invested in illiquid assets” standard used in the proposed rule. As proposed, an illiquid fund would be “principally invested in illiquid assets if at least 75 percent of the fund’s consolidated assets are illiquid assets or related risk-mitigating hedges.” At a minimum, ABA suggested, the FRB should reduce the threshold to a simple majority of the assets in the fund, if not a lower amount. The proposed rule would also adopt a narrow interpretation of the meaning of “contractual obligation” that was in effect on May 1, 2010. In the rule, the term means only certain contractual obligations in which the banking entity is (1) prohibited from redeeming or selling its interest; or (2) contractually obliged to provide additional capital; and (3) either prohibited from terminating the ob-ligation or, if the obligation may be terminated, required to use “reason-able best efforts” to obtain consent to terminate. ABA recommended a simpler reading of the term “contractual obligation” as any contractual obliga-tion or agreement in effect on May 1, 2010, “to take or retain its equity, partnership, or other ownership

FSOC Releases Study and Recommendations on Volcker Rule

A t its second meeting on January 18, 2011, the Financial Stability

Oversight Council (FSOC) released its study report and recommenda-tions on the Volcker Rule (Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act). The study weighs the impact of, and makes suggestions for imple-menting, the Volcker Rule’s two gen-eral mandates applicable to banking entities:

• Prohibits them from engaging in proprietary trading activities in which they act as a principal in order to profit from near-term price movements;

• Prohibits them from investing in, or having certain relationships

with, hedge funds and private equity funds.

The bank regulatory agencies are currently engaged in a joint rule-making process to implement the Volcker Rule and will use the study report to assist them in developing the rules.

Highlights of the Report Overall, the FSOC recommends “robust implementation” of the Volcker Rule’s prohibitions ap-plicable to banking entities. The report sets forth ten specific recom-mendations and contains detailed discussions of the intention of the Volcker Rule and the principles that should guide the agencies in their rulemaking.




recommends that the agencies ad-dress this possibility in the rules and include safeguards against this sort of incidental proprietary trading.

Hedge Funds and Private Equity Funds. With respect to the prohi-bition involving hedge funds and private equity funds, the FSOC is recommending that the agencies prohibit banking entities from in-vesting in or sponsoring any hedge fund or private equity fund, except as part of its services to bona fide trust, fiduciary, and investment advisory customers (see the adjacent box for a list of conditions for this excep-tion). The Volcker Rule allows a bank-ing entity to organize and offer a fund to its bona fide trust, fiduciary, and investment advisory customers. However, the entity is not permitted to invest in hedge funds or private equity funds, beyond a specified de minimis amount, in order to establish funds and attract unaffiliated inves-tors in connection with its customer-related business. To define hedge funds and pri-vate equity funds, the Volcker Rule relies on two commonly used exclu-sions from the definition of the term “investment company” under Section 3(c) of the Investment Company Act. The report notes that these Section 3(c) exclusions were not designed to apply only to traditional hedge funds and private equity funds. “In implementing the Volcker Rule, agencies should consider criteria for providing exceptions with respect to certain funds that are technically within the scope of the “hedge fund” and “private equity fund” definitions in the Volcker Rule but that Congress may not have intended to capture in enacting the statute,” states the report. The report makes the following recommendations in regard to the

permitted and prohibited activities as they design the Volcker Rule imple-mentation framework.” Although these core banking functions will be permitted, the Rule includes a prudential “backstop” that prohibits the functions if they would result in a material conflict of interest, material exposure to high-risk trading strategies, a threat to the safety and soundness of the banking entity, or a threat to the financial stability of the United States. The report notes that, even though a banking entity may have shut down its proprietary trading op-erations, impermissible proprietary trading may continue to occur within the permitted activities. The report

Proprietary Trading. The re-port addresses the carve-out in the Volcker Rule’s proprietary trading prohibition for certain “permitted activities” that represent core bank-ing functions, such as certain types of market making, asset management, underwriting, and transactions in government securities. According to the report, “These permitted activities — in particular, market making, hedging, underwrit-ing, and other transactions on behalf of customers — often evidence outwardly similar characteristics to proprietary trading, even as they pursue different objectives, and it will be important for the agencies to carefully weigh all characteristics of

Permitted Activities Under the Volcker Rule

Banking entities are permitted to organize and offer or invest in hedge funds and private equity funds to facilitate customer-focused advi-sory services if they meet the following conditions:

• The banking entity must provide bona fide trust, fiduciary, or invest-ment advisory services as part of its business.

• The fund must be organized and offered only in connection with such services and only to customers of such services.

• The banking entity may not acquire or retain an equity interest, part-nership interest, or other ownership interest in the funds except for a de minimis investment.

• The banking entity may not guarantee or otherwise assume or insure the obligations or performance of the fund.

• The banking entity may not share the same name, or variation of the same name, with the fund.

• No director or employee of the banking entity may have an owner-ship interest in the fund unless he or she is directly engaged in pro-viding services to the fund.

• Certain other conditions must be met, such as that the banking entity must comply with the restrictions on affiliate transactions with any fund it sponsors, consistent with Sections 23A and 23B of the Federal Reserve Act.




permitted hedge fund and private equity fund activities:

1. Definition of customer. The Vol-cker Rule requires that organized or sponsored funds be offered only to “customers” of a banking entity, but it does not define the term “customers.” The agencies should consider certain factors outlined in the report when defining who is a customer and the necessary nature of the relationship.

2. De minimis investment calcula-tion. The Volcker Rule restricts the exposure of a banking entity to 3 percent of any single fund and limits the entity’s aggregate exposure to 3 percent of Tier 1 capital. These limits should be calculated in a man-

IRS Gives Guidance on Tax Return Preparer RegistrationNo Relief for Bank Trust Department Employees

I n Notice 2011-6, the Internal Revenue Service (IRS) provides

guidance on how to implement new regulations governing tax return preparers. The regulations, issued in 2010, create a new “registered tax return preparer” designation and require tax return preparers to obtain a preparer tax identification number (PTIN), pass a competency examination, and complete qualify-ing continuing education credits in order to maintain their registration. The regulations do not affect banks and their employees when they prepare tax returns for trusts and estates in their fiduciary capac-ity. However, the IRS did not include a carve-out from the examination and education requirements for bank employees who assist in tax re-

turn preparation in other capacities. Such capacities in which a bank employee might contribute to the preparation of a return include, for example, assisting in tax preparation services for trusts with third-party trustees or making routine determi-nations about the tax treatment of corporate actions (such as reorganiza-tions, redemptions, and dividends). Notice 2011-6 provides an ex-emption that relieves employees of law firms, certified public accountant (CPA) firms, or other “recognized firms” from the testing and continu-ing education requirements if they engage in return preparation under the supervision of attorneys, CPAs, or enrolled agents who sign the returns. This exemption does not reach employees of a bank or bank

ner that will require full accounting of the banking entity’s risk, and the limits should be monitored through-out the life of the fund.

3. Accountability. Agencies should consider requiring banking entities to establish internal programmatic compliance regimes that will involve strong investment and risk oversight of permissible hedge fund and private equity fund activities. An entity’s board of directors should be engaged in oversight, and the CEO should publicly attest to the adequacy of the compliance regime. The agen-cies should also consider requiring banking entities that invest in a hedge fund or private equity fund in order to facilitate customer-related business

to disclose the nature and amount of the investments. n

Editor’s Note: To obtain a copy of the FSOC study report, use the link:http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.pdf

Previous articles in ABA Trust Letter “Volcker Rule Conformance Pe-riod Fleshed Out in Proposed Rule,” January 2011, page 4. “FSOC’s Volcker Rule Study Draws Comment,” December 2010, page 1. “FSOC Commences Operations: Nonbank Supervision and Volcker Rule,” November 2010, page 15.

trust department, even though such employees may also be supervised by lawyers, CPAs, and banking experts. ABA will recommend to the IRS to expand this exemption to the em-ployees of well-regulated and exam-ined banking entities. Note that Notice 2011-6 provides an exemption from the tax preparer registration requirements for em-ployees who prepare certain forms, such as the Form 5500 series for em-ployee benefit plans. The regulations include a list of tax-related forms that do not have to be prepared by a registered tax return preparer, but the list does not include trust or estate tax returns. The list does, however, include the forms for Power of Attorney and Declaration of Representative and several forms relating to employee benefit plans besides the Form 5500 series. n

Previous articles in ABA Trust Letter “ABA Seeks Narrowing of Tax Return Preparer Requirements,” November 2010, page 9.




plans and municipal bond issues. In addition, trust departments that sweep idle cash into MMFs on an overnight or longer basis must have the certainty that enough cash will be available to fund the day’s transactions. Also, certain trust inves-tors may face legal or other con-straints that require them to invest their cash balances in funds that maintain a stable NAV, ABA pointed out. At least three states specify stable NAV MMFs as permissible investments under bond indentures. For these reasons, it is impera-tive that stable NAV funds remain available to institutional investors. It is true that institutional investors are better informed and equipped to re-deem their shares when a fund begins to lose value and that retail investors in the same fund are disadvantaged in this respect. “ABA believes, however, that the recently adopted SEC rules have diminished the vulnerability of stable NAV funds to runs and that other policy options are available to ameliorate further the risks from runs,” asserted the letter.

Mandatory Redemptions in Kind ABA also opposes requiring institutional investors to make large redemptions in kind. The option is not well defined and “is fraught with both equitable and operational dif-ficulties,” ABA wrote.

Public Insurance for MMFs ABA’s comment letter also as-serted strong opposition to any form of public insurance for MMFs, as the federal deposit insurance system does for bank deposits. First, the de-posit insurance system was intended to forestall runs on banks by small deposit account holders and is justi-fied by the fact that small savers are generally not well informed about the financial condition of a bank. In contrast, MMFs are more vulnerable

2. Creating a two-tier system of stable and floating NAV funds with enhanced protections for stable NAV funds, such as access to a private liquidity facility; and

3. Creating a two-tier system in which stable NAV funds are re-stricted to retail investors.

MMF Stability Options

the Lehman Brothers bankruptcy. As a result, mostly institutional investors began redeeming their shares from MMFs because of fears that those funds would follow suit. Overall, investors withdrew approximately 15 percent of the assets of prime MMFs in a single week. To stanch the outflow, the Treasury took the unprecedented step of providing a temporary full guarantee of inves-tors’ assets in any MMFs that agreed to participate in the program. A year ago, SEC amended its regulations to shore up the stability of MMFs by, among other things, imposing additional credit quality standards, reducing the weighted average maturity of funds’ portfolios, and permitting a fund that is break-ing the buck to suspend redemp-tions and liquidate its portfolio in an orderly manner. Despite these regulatory mea-sures, discussion continues whether more action is needed. In any case, ABA wrote, bank collective and com-mon funds are not exposed to any systemic risk issues similar to those experienced in 2008 by MMFs. Be-cause collective and common funds are comprehensively regulated and examined by the federal bank regula-tors, “we believe that no additional remedial actions need be taken with respect to such entities.”

Stable NAV Funds ABA’s letter addressed three of the policy options identified in the PWG report:

1. Replacing all stable NAV MMFs with floating NAV MMFs;



ABA made clear that it strongly

opposes any policy change that

would require MMFs to adopt

floating net asset values instead

of stable NAVs, or that would

restrict investments in stable NAV

funds to retail investors only.

Retaining the option of funds with a stable NAV in which both retail and institutional investors may invest is paramount, ABA pointed out. Stable NAV funds have great utility as cash management vehicles and for transactional stability, as evi-dence by the large number of funds that invest in them. Any attempt to further reduce the potential risk of a broad run on MMFs should be ap-proached in another manner. “A stable NAV fund provides a level of simplicity for investors who wish to keep their assets fairly liquid for some period of time and gives them confidence that the value of the fund will remain constant no matter which day they may purchase or redeem shares,” ABA asserted. This attribute is particularly impor-tant for accounts that are used for transactional purposes rather than as investments — for example, MMFs used to fund transactions that occur over the course of the day, as would be necessary for employee benefit



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A Regulatory & Legislative Advisory for Trust Professionals

to redemptions by large investors — “the very ones with better informa-tion to judge the financial condition of the fund,” ABA explained. Another reason not to create an insurance system for MMF invest-ments is that any such protection car-ries the moral hazard that it will re-duce market discipline. To offset this moral hazard, the banking industry is subject to a very intrusive regula-tory system of safety and soundness supervision and examination. If a federal insurance program were to be established to insure large-scale MMF investments, it would carry a correspondingly greater reduction of market disci-pline, in turn requiring a greater and

more intrusive regulatory program than the one that applies to insured depository institutions. The costs of creating such a public insurance sys-tem for MMFs would make these in-vestments significantly less attractive. Moreover, any such insurance system would have to preserve competitive fairness and be constructed so as not to provide advantages to investors in MMFs over owners of bank deposit accounts. “We believe it unwise, given the current fiscal crisis, even to con-template the task of creating a new government agency to design an insurance program and develop the regulations and structure necessary to implement such a program.” n

Editor’s Note: For a copy of the let-ter, go to http://www.aba.com/NR/rdonlyres/DC65CE12-B1C7-11D4-AB4A-00508B95258D/70308/cl_WG_MoneyMarketReform2011Jan.pdf

Previous articles in ABA Trust Letter “SEC Seeks Input on Money Mar-ket Fund Reform Options,” Decem-ber 2010, page 8. “SEC Adopts MMF Stability Rules,” March 2010, page 6. “ABA Cautions SEC on Proposed MMF Stability Rules,” October 2009, page 11. “Money Market Fund Stability Rules Proposed,” August 2009, page 6.
