RB-2002-03 Fiduciary Powers/Trust Activities

INTRODUCTION

The offering of limited fiduciary services has long been regarded as an ancillary service for credit unions. However, in recent years a number of forces have combined, with the result that fiduciary services are becoming a more dynamic and sought-after product line. In Texas, population trends have been a significant factor as the large post-World War II “baby boom” generation matures and accumulates wealth. The large size and influence of this group has created more emphasis on wealth management and transfer. While this has presented credit unions with more opportunities, it has also presented substantive challenges to credit unions as they try to offer trust services in a manner that is safe and sound.

While the Department may prefer that certain trust activities be conducted within a credit union service organization (CUSO), it is supportive of credit union involvement in trust services that are legal, prudent, and consistent with sound credit union principles. However, due to the more complicated nature and level of risk associated with certain trust services, it is necessary that the credit union’s board of directors and management ensure that sound policies and procedures are in place to govern its involvement in these activities.

This Bulletin was developed to provide guidance to credit unions on various issues associated with trust services. Any credit union involved in trust services should address these issues in a manner appropriate to the nature and extent of activities conducted within its organization.

FIDUCIARY RISKS

Risk associated with a credit union’s exercise of its fiduciary powers can be generally categorized as resulting from:

Reputation Risk – where the risk to the credit union arises from negative public opinion. Negative publicity can be caused by many factors, including failure to address and manage the other risks addressed below. Increased reputation risk can affect the credit union’s ability to establish member relationships and/or service existing relationships.
Strategic Risk – where the risk to the credit union arises from improper business planning, poor decision-making, failure to implement decisions, or inadequate responses to changes in the industry. This risk focuses on management’s ability to develop sound business strategic goals, implement processes compatible with these goals, and deploy appropriate resources to achieve them. Management should implement policies, procedures, and practices to ensure that the credit union’s fiduciary activities are conducted in compliance with applicable law. Management should also ensure that appropriate risk assessment and monitoring systems are in place to identify and control risks resulting from fiduciary activities.
Transaction/Operational Risk – where the risk to a credit union is unacceptable operating losses or legal liability arising from substandard policies or practices. This may include inadequate controls and other safeguards over fiduciary assets, erroneous recordkeeping, excessive costs, inadequate revenues, fraud, embezzlement, or other similar deficiencies in operations. Transaction risk is inherent in each product and service offered.
Compliance/Legal Risk – where the risk to a credit union is exposure and legal liability arising from noncompliance with applicable law, the trust instrument or other document establishing the fiduciary relationship, sound fiduciary principles, internal policies and procedures, or the failure to identify and manage conflicts of interest and ethical standards.
Financial Risks – where the risks are inherent in the fiduciary activities of the credit union, especially where the institution has discretion over account assets or provides investment management services for a fee. Financial risk has an adverse affect on the value of account portfolios, which could further impact the capital levels of the credit union. Financial risk includes: 1) credit risk, the risk to the value of the account portfolio arising from failure to meet the terms of any contract; 2) price risk, the risk to the value of the account portfolio arising from changes in the value of the underlying financial instrument; 3) liquidity risk, the risk to the value of the account portfolio arising from the accounts inability to meet obligations and achieve account objectives; and 4) interest rate risk, the risk to the value of the account portfolio arising from movements in interest rates.
The earnings and capital of credit unions with significant reliance on trust revenues may be adversely affected when financial markets experience a significant and sustained downturn. Since trust departments are dependent on transaction volumes and market values of assets under management; revenue, and hence earnings, may decline substantially during periods of adverse market movements. Credit unions could ultimately find themselves funding trust department capital when unfavorable market conditions exist.
Further, risks associated with fiduciary activities can be distinguished in part from those associated with commercial activities, in that the potential liability from fiduciary activities can exist for the life of the account, through successive generations of beneficiaries. Conversely, commercial risk lasts only as long as the commercial transaction lasts. In addition, fiduciary liability is not always as easily quantifiable as commercial liability, in that fiduciary liability can increase or decrease based on the market value of the account assets in question.

APPLICABLE LAW

Applicable law generally consists of common law and statutory law. The courts develop common law. Statutory law can consist of statutes adopted by legislative bodies or rules and regulations adopted by state or federal agencies. In Texas, trustees must be cognizant of and deal with the Texas Trust Code as it supplements and, in some cases, revises the common law. In addition, state and federal credit union and banking regulators may adopt various rules and regulations applicable to trustees. Consequently, it is most important that credit unions not only have competent legal counsel readily available to advise them, but also make sure that any staff or credit union officials involved in fiduciary activities are sufficiently educated in the vagaries of applicable law.

FIDUCIARY LIABILITIES

A credit union acting as a fiduciary can be held liable if it:

  • Violates any applicable law;
  • Does not comply with the terms of the will, trust or pension plan or, in some instances, court rulings and orders; or
  • Fails to properly discharge any of its duties or responsibilities or abuses any of its powers.

Any present or future beneficiary, other interested person (as defined in the Texas Trust Code), or a co-fiduciary, may be able to institute legal action against a fiduciary. The remedies that can be sought are several, depending upon the alleged violation but commonly include compelling the fiduciary to perform its duties; compelling the fiduciary to provide an accounting of the managed assets; enjoining the fiduciary from committing a further violation; compelling the fiduciary to make restitution for the violation; removing the fiduciary; and/or disallowing the fiduciary from ever serving in another fiduciary capacity. If found liable, the fiduciary is said to have committed a “breach of trust.” If the fiduciary is found to have committed a breach of trust, it will be held liable: for any loss or depreciation of the account that results from its actions or inactions; for any profit made by the fiduciary through its actions; or any profit that would have accrued to the account if there had been no breach. The amount by which the fiduciary is required, by a court of law, to pay the “breached” fiduciary account is known as a “surcharge.” Attorney’s fees will also be awarded and, in some severe cases, punitive damages are possible.

While there are numerous sources of fiduciary liability, the most significant ones generally involve:

Imprudent management of account investments, including: the purchase or sale of speculative securities such as naked put options or fixed income securities that are rated below an investment grade quality; unreasonable retention of nonincome producing assets such as vacant land and/or a noninterest bearing note; undue concentrations and/or failure to properly diversify account assets, such as investing a majority of the account assets in one type of security; or imprudently investing in affiliated products.

Failure to manage cash, including: leaving large amounts of cash uninvested for an unreasonable length of time and/or allowing or creating overdrafts.

Imprudently engaging in self dealing or other conflicts of interest, including: making investment decisions not in accordance with applicable law, particularly investments such as the purchase of credit union’s own mortgages; investing in corporations in which directors have an interest; engaging in insider trading; or imprudently using an affiliate’s investment products or brokerage service.

Failure to properly manage real property, including: the failure to insure the property, the failure to pay taxes, or the failure to maintain properties in proper repair.

Mismanagement of an account, including: making improper or unauthorized distributions; the failure to make timely court accountings or tax filings; and the improper allocation of principal and/or income receipts.

Improper delegation of duties, including: allowing or delegating the investment discretion to someone such as an investment advisor without appropriate oversight and the failure to supervise acts of agents such as property managers.

Taking actions without approval, including: those actions that require the consent of beneficiaries, prior approval of the grantor or co-fiduciaries or from a local court with jurisdiction.

CURRENT LIABILITY ENVIRONMENT

The trust business continues to come under increasing scrutiny due to the applicability of certain federal and/or state laws. For example, the Employee Retirement Income Security Act of 1974 (ERISA) generally imposes the highest standard of fiduciary liability on fiduciaries administering assets of employee benefit plans. As another example, environmental liability issues are a matter of increasing concern due to the potential risk and substantial liability that may arise in connection with the enforcement of state and federal laws and regulations applicable to real estate interest held by trust accounts.

The trust industry itself continues to undergo dramatic change. Fiduciary services were historically offered by financial institutions in order to provide full-service financial services and were thus viewed as a “loss-leader.” While the motivation has not disappeared, the trust industry has largely shifted to a fee-based, profit-center type of industry with increased competition. This increased competition has increased the potential for exposure, in that service might be sacrificed to cut expenses. Due to cost cutting measures, risk from operations-related areas such as clerical and processing functions has increased.

Another reason for increased loss potential is that society itself has changed. Members are more informed and sophisticated regarding a credit union’s responsibilities and are more apt to initiate legal actions. Illustrative of the new attitude is the increase in the number of class-action suits being brought against financial institutions by trust account beneficiaries.

RISK MANAGEMENT

Risk management plays an increasing role in trust departments due in large measure to the risks and liabilities discussed above. Standards of fiduciary responsibility and potential liability continue to evolve under new legislation and legal theories. Management decisions, whether they are legal, operational, or administrative in nature, seldom have predictable outcome. Thus, each decision involves some degree of risk or uncertainty. Credit unions should consider risk, and the management of risk, in developing its organizational structure and as part of the decision-making processes. The Department strongly encourages credit unions to develop strong risk management programs to identify and control fiduciary risks.

Effective risk management guards against liability that can result from lawsuits or poor administrative practices and/or supervision. A risk management program identifies those areas where there is potential for exposure and then attempts to quantify the risks associated with that area or practice. Through such a program, credit unions have identifiable criteria by which to evaluate the consequences of a decision. Thus, for example, the degree of risk associated with offering a new trust service may play a significant role in deciding whether or not to offer that service. An effective risk management program can act as an early warning system to anticipate and, hopefully, prevent potential problems from arising that may result in unanticipated loss to the credit union.

RESPONSIBILITIES OF THE BOARD OF DIRECTORS

The board of directors is ultimately responsible for all aspects of the credit union’s trust duties. Directors are responsible for retaining and performing general supervision over the exercise of fiduciary powers. In discharging its authority, the board of directors may delegate duties and responsibilities to such committee(s), director(s), officer(s), or employee(s) as it deems appropriate. However, the board retains ultimate responsibility for all delegated matters and must maintain the proper degree of control and supervision over those it has empowered.

POLICIES, PROCEDURES AND INTERNAL CONTROLS

The board of directors should formulate and implement suitable policies, procedures, and internal controls (collectively referred to below as “policies”) to promote sound trust administration. Comprehensive, well-developed policies, assuming they are followed, monitored, and enforced, are one of the most effective methods of promoting operating efficiency, ensuring compliance with laws and fiduciary principles and deterring losses. The scope and detail of policies adopted by the board of directors for the trust department should take into account the credit union’s size, complexity and trust risk profile. While the need for and content of policies will therefore vary between credit unions, written policies should ordinarily be in place for the following areas:

Federal Securities Laws: Written policies and procedures should ensure that any decision or recommendation to purchase or sell any security is not made by fiduciary officers and employees using material inside information.

Conflict of Interest: Polices should be established to cover those areas where the interest of the fiduciary account might conflict with those of the credit union itself (i.e. in its role as lender), it directors, employees or its affiliates.

Asset Management: Policies should be established to demonstrate compliance with applicable state “prudent investor” laws or applicable federal law such as ERISA when the credit union makes investment decisions for trust accounts. Investment policies should exist that are designed to promote preservation of principal, diversification of portfolios, establishment of individual account investment objectives, production of income (including prompt investment of income and principal cash), and to prevent speculation. The board should also ensure that any delegation of investment activity (e.g., investment advisory services) is pursuant to a written agreement, whereby the credit union retains ultimate investment oversight and responsibility.
Account Administration: Policies should be established to assure that all trust accounts are administered in a consistent manner and in accordance with the terms of the governing instrument and applicable law. Examples of such policies include, acceptance of accounts; account set-up; account reviews; overall administration; and account termination procedures.
Operations: Policies should be established to assure the integrity and accountability of the trust department’s systems and internal controls. Examples of such policies include, storage and handling of assets; separation of duties; processing and reconcilement of transactions; document filing and maintenance; outsourcing; and standards for information technology systems.
Personnel: Policies should be established regarding the appropriate size and qualifications of staff, organizational structure, and employee ethics. The latter policy should address the acceptance of gratuities and bequest from members or other interested parties and any personal services rendered, benefits gained and/or influences exerted by the employee to or from the member.
Business Development and Profitability: Policies should address the nature and type of the trust business to be solicited, fees to be charged, marketing strategies, and the overall goals and objectives of the credit union in offering and providing trust products and services.

CONCLUSIONS

Credit unions should recognize the additional risk inherent in trust services and determine if these risks are acceptable and controllable given the credit union’s staff, financial condition, size, and level of capital.
The minimum requirements to provide for sound credit union practices in the operation of a trust department and to provide safeguards for the protection of members, fiduciary beneficiaries, creditors, and the public, should include:
  • Involvement by the board of directors in providing for the establishment and continuing operation of a trust department;
  • Operation of the trust department separate and apart from every other activity of the credit union, with trust assets separated from other assets owned by the credit union, and the assets of each trust account separated from assets of every other trust account; and
  • Maintenance of separate books and records for the trust department in sufficient detail to properly reflect all trust department activities.
Although authorized to delegate duties, the board continues to be responsible for the oversight of all trust activities. Sufficient reporting and monitoring procedures should be established to fulfill this responsibility. The board of directors, by proper resolution included in its minutes should:
  1. Designate an officer, qualified and competent, to be responsible for and administer the activities of the trust department. In addition, the board should define the officer’s duties.
  2. Name a trust committee consisting of at least two directors to be responsible for and supervise the activities of the trust department.

The trust committee should:

    1. Meet at least quarterly, and more frequently if considered necessary and prudent to fulfill its supervisory responsibilities;
    2. Approve and document the opening of all new trust department accounts; all purchases and sales, and changes in, trust assets; and the closing of trust accounts;
    3. Provide for a comprehensive review of all new accounts for which the credit union has investment responsibility promptly following acceptance;
    4. Provide for a review of each trust department account at least once during each calendar year. The scope, frequency, and level of review should be addressed in appropriate written policies which give consideration to the department’s fiduciary responsibilities, type and size of account, and other relevant factors. (Generally, discretionary account reviews should cover both administration of the account and suitability of the account’s investment, and non-discretionary account reviews should address account administration);
    5. Keep comprehensive minutes of meetings held and actions taken;
    6. Make periodic reports to the board of its actions; and
    7. Establish and maintain a continuing education program for members of the committee and appropriate credit union staff.
  1. Provide comprehensive written policies which address all important areas of trust department activities.
  2. Provide competent legal counsel to review trust instruments or other fiduciary related documents prior to acceptance by the credit union and advise trust officers and the trust committee on legal matter pertaining to fiduciary activities.
  3. Provide for adequate internal controls including appropriate controls over trust assets.
  4. Provide for an adequate audit of all fiduciary activities, annually. The findings of the audit, including actions taken as a result of the audit, should be recorded in its minutes.
  5. Receive reports from the trust committee and record actions taken in its minutes.
  6. Review the examination reports of the trust department and record actions taken in its minutes.
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