Converting Collective Funds to Mutual Funds

In recent years many banks have come to view the investment management business as an attractive source of fee revenues - and mutual funds as the preferred vehicle for delivering investment management services on a pooled basis.

This has led to the current phenomenon of converting collective funds into mutual funds.

In a conversion, the assets of a bank collective investment fund for trusts and other fiduciary accounts are transferred to or invested in a mutual fund for which the same bank serves as investment adviser. This type of mutual fund is commonly known as a private-label or proprietary mutual fund.

With investment policies, objectives, and strategies that substantially mirror those of the collective fund, the proprietary fund is presumably at least as appropriate an investment arrangement and as attractive to the fiduciary accounts.

Several variations on the basic theme are possible.

* A full conversion involves two transactions occurring more or less simultaneously: an inkind exchange of the collective fund's portfolio assets for shares of the proprietary fund; and the termination of the collective fund, with in-kind distribution of the proprietary fund shares to the collective fund participants.

* In a "partial" conversion, the collective fund continues to exist, but the interests of fiduciary accounts authorized to invest in the proprietary fund are withdrawn under normal withdrawal procedures and reinvested in the proprietary fund.

* Another possible variation is analogous to the recently popular "hub and spoke" mutual fund structure. Under this approach, an existing collective fund invests in shares of the proprietary fund and continues to hold them, subject to applicable legal or regulatory limitations.

The influx of collective fund assets may help a proprietary fund achieve the critical mass necessary for profitable operations more quickly than might otherwise be the case.

Industry estimates of portfolio size necessary to enable a bank to break even from proprietary fund operations range from $50 million to $100 million, depending on the type of fund (money-market or other) and other variables.

The size of collective fund portfolios typically is well within this range.

Reaching a Broader Market

Another important consideration motivating conversions is that though participation in collective funds must be limited to fiduciary accounts administered by the bank, there are essentially no eligibility limitations on mutual fund investors.

Thus, mutual funds can reach be larger and reach a broader market.

This, in turn, may produce benefits for fiduciary accounts and the bank alike in the form of increased diversification, economies of scale, and - for the bank - potentially greater fee revenues from investment management activities.

Legal Uncertainties

Although several banks have effected conversions and many more are considering them, a bank that decides to employ this technique still must navigate a relatively uncharted legal area.

Consequently, the key ingredients of a successful conversion are proper planning and a respectful awareness of the bank's obligations under laws and regulations governing fiduciary activities. These include Regulation 9, administered by the Office of the Comptroller of the Currency, and state and federal laws, including the Employee Retirement Income Security Act (ERISA).

Conversions also may involve tax consequences and issues under the Investment Company Act.

To Convert, or Not to Convert

Tradition, reputation, successful operation, and other intangibles may well dissuade a bank from converting its collective funds.

On the other hand, conversion may make sense in terms of organization and efficiency, unifying the bank's delivery system for investment management services by consolidating investment portfolios of all types of clients.

The decision on whether to convert will depend on each bank's assessment of these and other factors.

In-Kind Swap

A full conversion involves an in-kind exchange of portfolio assets for shares of the proprietary fund and a distribution of the proprietary fund shares to the collective fund participants.

One goal is to minimize transaction costs that would be incurred if the collective fund portfolio were liquidated and the proceeds invested in the proprietary fund, which in turn would reinvest in a substantially similar portfolio.

Full conversions, particularly those involving a collective fund for personal trusts and estates - a so-called common trust fund - tend to be more problematic than the other forms and are consequently attempted relatively infrequently.

Tax Question

An exchange of collective fund assets for proprietary fund shares may be a taxable event for fiduciary accounts that are not tax-exempt.

The Internal Revenue Code provisions dealing with reorganizations and tax-free incorporations do not clearly apply to a conversion. The Internal Revenue Service apparently has not ruled that a full conversion can be effected tax-free.

(Some pending proposals for banking reform legislation would clarify the matter. They would eliminate tax consequences to common trust fund participants arising from a transfer of fund assets to a mutual fund in connection with a "merger, conversion, reorganization, transfer, or other similar transaction or series of transactions.")

Investment Company Act

Full conversions also raise several issues under the Investment Company Act.

The bank must ensure the exchange does not violate a provision that generally prohibits "affiliated persons" of a mutual fund from selling securities or other property to the mutual fund. Such affiliated persons would include a bank acting as fund adviser and would probably include any collective fund sponsored by the bank.

Other Investment Company Act issues relate to the status of the former collective fund as the "predecessor" of the proprietary fund. SEC rules generally require that a mutual fund's registration statement include financial statements and other information about a predecessor.

In addition, the bank may or may not wish to include information about the collective fund's past performance in the mutual fund's prospectus, sales literature, and advertisements.

Unfortunately, the rules do not deal with these Investment Company Act issues in the context of a conversion, and the SEC staff has not developed guidelines that apply in all cases.

Other Forms of Conversion

In a partial conversion, fiduciary accounts participating in a collective fund that wish instead to invest in a proprietary fund simply withdraw from the collective fund in accordance with the fund's normal withdrawal procedures and reinvest in the proprietary fund.

The collective fund continues to exist, though reduced in size, for fiduciary accounts unable or unwilling to switch to the proprietary fund.

Partial conversions occur more frequently in connection with common trust funds containing accounts that might incur adverse tax consequences if a full conversion were implemented, or accounts that lack someone in a position to give informed consent where required.

Perhaps the most attractive aspect of partial conversion is that it involves relatively few of the potential legal issues associated with the other forms. of conversion.

Investment by Collective Fund

The hub-and-spoke form of conversion essentially is a two-tiered arrangement in which an existing collective fund invests in a proprietary fund.

The main issues are fiduciary self-dealing and the extent to which the collective fund may invest in the proprietary fund under diversification requirements of Regulation 9 or ERISA.

In Trust Banking Circular No. 4 in 1976, the Comptroller's office made clear that a collective fund may invest in a mutual fund without creating an improper "delegation" of authority so long as mutual funds are a permissible investment under applicable law for all accounts participating in the collective fund.

However, Regulation 9 imposes a 10% limit on the amount of assets that a common trust fund (as opposed to other types of collective funds) may invest in a single mutual fund.

In Trust Examining Circular No. 19 issued in 1983, the Comptroller's office permitted common trust funds to invest up to 50% of their assets in any one "family" of mutual funds having the same investment adviser - as long as the amount invested in any one mutual fund did not exceed the 10% limit.

Retirement Plans

Other types of collective funds, such as those consisting solely of tax-qualified employee retirement plans subject to ERISA, are not subject to the common trust fund investment limitations described above.

ERISA requires that the investments of employee benefit plans and collective funds consisting of such plans be adequately diversified.

However, ERISA's legislative history makes clear that the diversification requirement may be satisfied even where a substantial portion of a plan's or a fund's assets are invested in an adequately-diversified mutual fund.

Fiduciary Self-Dealing Rules

A critical legal issue in any conversion is whether the bank can maintain its fiduciary obligations to the fiduciary accounts participating in the collective fund to be converted.

Traditional trust law principles applicable to fiduciary accounts not subject to ERISA generally prohibit fiduciary self-dealing. These rules, which are codified by the laws of many states, require that a trustee act solely in the interest of the trust beneficiaries.

A separate set of rules apply to accounts subject to ERISA.

A bank acting as trustee or investment manager of an employee benefit plan or a collective fund consisting of such plans generally is considered a "fiduciary" of those plans, as ERISA defines the term.

ERISA's fiduciary-responsibility rules require plan fiduciaries to carry out their duties and responsibilities solely in the interest of the plans for which they act, and to avoid engaging in various "prohibited transactions."

The prohibited-transaction rules include specific prohibitions against certain conduct by plan fiduciaries. These rules codify the basic elements of the self-dealing rules under trust law principles.


The self-dealing prohibitions are not absolute, however.

For non-ERISA accounts, transactions that would otherwise be impermissible are generally recognized as permitted if specifically allowed by law, the governing instrument, or court order. Another important exception applies where an adult competent beneficiary gives "informed consent" to the transaction.

ERISA also recognizes some exceptions from the otherwise absolute prohibited transaction rules.

However, ERISA does not recognize exceptions permitted by the governing instrument or informed consent. The rules can be waived only by an administrative exemption issued by the Department of Labor.

One of the first prohibited transaction class exemptions issued by the Labor Department was intended to address concerns about the prohibited transaction implications of an investment of plan assets in shares of a mutual fund managed or advised by a plan fiduciary.

Though the class exemption was designed primarily to accommodate the needs of nonbank investment advisers, its terms appear to be broad enough to cover a bank acting as a plan fiduciary.

In essence, the exemption is the ERISA equivalent of the "informed consent" exemption to self-dealing under general trust law.

ERISA Accounts and Others

It is generally understood that a conversion of a collective fund consisting of ERISA accounts can be effected quite straightforwardly by compliance with the specific conditions of that early class exemption or an equivalent individual exemption obtained from the Labor Department.

Whether any of the recognized exceptions will be available or helpful in situations involving non-ERISA accounts, however, will depend primarily on various practical considerations.

The most useful exception for conversions involving non-ERISA accounts would be a law expressly permitting a bank to invest fiduciary assets in a mutual fund to which the bank provides services for compensation. However, though a few states have enacted such laws and several others are considering them, most states have not yet done so.

Provisions in the governing instrument expressly permitting such investments are helpful, at least initially, but may not offer complete protection with respect to subsequent investment decisions made by the bank in the exercise of its fiduciary discretion.

Court orders provide substantial protection but may be impractical to obtain in most cases.

Comptroller's Interpretation

The potential problems associated with conversions involving collective funds for non-ERISA accounts were illustrated in Trust Intrepretation No. 217, issued by the Comptroller's office on May 18, 1989.

This is the only comprehensive federal regulatory public pronouncement to date on the subject of non-ERISA account collective fund conversions.

Interpretation 217 involved a national bank that apparently had effected full conversions of its collective funds for ERISA and non-ERISA accounts.

The bank had obtained consents from the "directed" accounts for which it had no investment discretion. However, the bank had given no notice to the accounts for which it had discretionary investment authority, nor had consents been obtained from those accounts.

The bank had apparently taken the position that any potential self-dealing or conflict-of-interest concerns would be eliminated if mutual fund advisory fees were deducted from regular trustee fees, so conversion would not result in receipt of double fees.

Focusing on the non-ERISA accounts, the Comptroller's office questioned the bank's conclusion that fees and expenses payable by fiduciary accounts would not increase as a result of the conversion.

Fees Aren't the Only Issue

The office warned that even if the bank had taken adequate steps to avoid the receipt of additional fees as a result of the conversion, there might be conflict of interest considerations "apart from fees" whenever fiduciary accounts are invested in a proprietary mutual fund.

This tentative position was subsequently confirmed in Trust Interpretation No. 234 (September 21, 1989), which asserted:

"Establishing the mutual fund may be dependent upon the availability of the fiduciary assets. The presence of the fiduciary assets improves the market-ability of the mutual fund. . . . The use of fiduciary assets results in the direct financial benefit to the corporate fiduciary."

The Comptroller's office reaffirmed its position even more decisively in Interpretative Letter No. 525 (Aug. 8, 1990). It was issued in response to a bank trade association that had sought reversal of the informed-consent requirement of interpretations 217 and 234. The reversal was sought particularly in cases where a bank had obtained an opinion of counsel confirming that applicable state law, including case law, permits proprietary fund investments without informed consent - for example, where no double or increased fees are charged.

The Comptroller's office refused to modify the prior interpretations. The refusal means that in the agency's view and in the absence of some other exception, a national bank must obtain informed consent from any fiduciary account - directed or discretionary - whose assets may be invested in the bank's proprietary mutual fund, regardless of whether the investment results in any fee increase.

Though this view is not binding on state-chartered banks, other federal and state regulators may be inclined to take the same approach.

Mr. Wade is in the investment management practice of the Los Angeles law firm of Paul, Hastings, Janofsky & Walker.

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