Fiduciary Conflicts: What (or Where) are they now??

1. Fiduciary Conflicts:What (or Where) are they now?? Clint Lackey Director of Compliance Oversight, Fiduciary and Insurance Activities Wells Fargo Bank, N.A.

2. Disclaimer • The views expressed today are my own and do not necessarily reflect the views of Wells Fargo Bank, N.A.

3. Topical Objectives • Review “conflicts” and “self-dealing” • Risk and regulatory concerns • Where might we find conflicts now? • How do we prevent or address conflicts?

4. Starting Point – Common Law Duty of Loyalty

5. The Duty of Loyalty …the most fundamental duty owed by the trustee to the beneficiaries of a trust. • Not imposed by the terms of the trust, but by the nature of the “relationship” which arises from the creation of the trust. • The trustee must administer the trust solely in the interest of the beneficiaries. • The trustee must not put himself in a positionwhere it would be for his own benefit to violate his duty.

6. Duty of Loyalty (Cont.) Chief Judge Cardozo in his opinion rendered in Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545, 546 (1928), described a fiduciary's duty of loyalty as follows: "Many forms of conduct permissible in a workaday world for those acting at arm's-length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the 'disintegrating erosion' of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd."

7. What is Self-Dealing? (Cont.) A clear statement of law regarding self-dealing was expressed by the U.S. Supreme Court in Michoud v. Girod, 11 L.Ed. 1076, 1099: "The general rule stands upon our great moral obligation to refrain from placing ourselves in relations which ordinarily excite a conflict between self-interest and integrity. . . . It therefore prohibits a party from purchasing on his own account that which his duty or trust requires him to sell on account of another, and from purchasing on account of another that which he sells on his own account. In effect, he is not allowed to unite the two opposite characters of buyer and seller, because his interests, when he is the seller or buyer on his own account, are directly conflicting with those of the person on whose account he buys or sells."

8. Conflicts of Interest & Self-Dealing • Duty of Loyalty – the interest of your client is paramount. • Statutory/Regulatory citations of interest: • 12 USC 92a(h) • ERISA • State statutes • 12 CFR 9 • Contrast with “conflicts” under the fiduciary standards for others in financial industry.

9. Permissive Exceptions toDuty of Loyalty • The duty of undivided loyalty can only be waived if: • Authorized by applicable law • Governing Instrument • State Law • Federal Law • Court Order

10. Permissive Exceptions toDuty of Loyalty • Beneficiary Approval • Must fully disclose the conflict. • Must not be in contravention to local law. • Revocable Trust Grantor Approval • Written direction of the grantor required.

11. Regulatory Perspectives • Common Law • Federal Law (US Code) • State Statutes (Uniform Trust Act?) • Federal Regulation • Policy and Procedure

12. Federal Laws • 12 USC 92a(h) - Loans of Trust Funds to Officers and Employees Prohibited; Penalties • National bank is strictly prohibited from lending funds from the fiduciary accounts it administers to the bank’s officers, directors, or employees. • If any bank officer, director, or employee makes or receives any such loan, that person may be fined up to $5,000, imprisoned, or both. • The regulators may bring enforcement actions against the bank and its officers, directors, and employees, including the imposition of civil money penalties. • No exceptions to this prohibition are allowed under 12 USC 92a(h). The statute prevails over any instrument authority, beneficiary consent, or court order purporting to authorize the transaction. • The strict statutory prohibition (carrying criminal sanctions) against lending trust assets to bank employees and insiders does not extend to their related interests or to bank affiliates. • Obligations of directors, officers, or employees received in kind are not prohibited by 12 USC 92a(h) unless they are renewed or carried past due at the bank’s discretion. • Demand loans of directors, officers, or employees received in kind should be paid within a reasonable time.

13. Federal Laws (Cont.) • 29 USC Ch. 18 - Employee Retirement Income Security Act (ERISA) • The primary objective of ERISA is to protect the rights and interests of employee benefit plan participants and their beneficiaries. • Two government agencies are primarily responsible for administration and enforcement of ERISA. • The Department of Labor is responsible for interpreting and enforcing fiduciary provisions of ERISA and also interprets those sections of the Internal Revenue Code dealing with fiduciary requirements for employee benefit plans. • The IRS is responsible for IRAs, Keogh accounts that cover only the individual/employer, and various tax-related provisions of the Internal Revenue Code. • Commonly referenced sections of ERISA • Section 1104 - Fiduciary duties • Section 1105 - Liability for breach of co-fiduciary • Section 1106 - Prohibited transactions • Section 1107 - Limitations on acquisition and holding of employer securities • Section 1108 - Exemptions from prohibited transactions • Section 1109 - Liability for breach of fiduciary duty

14. Federal Regulations • 12 CFR 9.5 – Policies and Procedures • Must adopt and follow written policies and procedures addressing • Brokerage placement practices – 12 CFR 9.5(a) • Methods for ensuring that officers and employees do not use material inside information in connection with any decision or recommendation to purchase or sell any security – 12 CFR 9.5(b) • Methods for preventing self-dealing and conflicts of interest – 12 CFR 9.5(c) • Selection and retention of legal counsel to advise the bank and its officers and employees on fiduciary matters – 12 CFR 9.5(d) • Investment of funds held as fiduciary and the treatment of fiduciary funds awaiting investment or distribution – 12 CFR 9.5(e)

15. Federal Regulations (Cont.) • 12 CFR 9.10 – Fiduciary Funds Awaiting Investment or Distribution • Funds awaiting investment or distribution in discretionary accounts shall not remain uninvested and undistributed for an unreasonable amount of time and should be invested at a rate consistent with applicable law – 12 CFR 9.10 (a) • Funds of a fiduciary account awaiting investment or distribution can be placed in an interest bearing account in the fiduciary bank, unless prohibited by applicable law – 12 CFR 9.10(b)(1) • Funds of a fiduciary account awaiting investment or distribution can be placed in an interest bearing account in affiliated bank, unless prohibited by applicable law – 12 CFR 9.10(b)(1)

16. Federal Regulations (Cont.) • 12 CFR 9.12 – Self-Dealing and Conflicts of Interest • Discretionary investments in the stock or obligations of the bank or an affiliate (including their respective directors, officers and employees) are only permitted if authorized by applicable law – 12 CFR 9.12(a)(1) • Discretionary loans, sales or transfers of assets from fiduciary accounts to the bank or an affiliate (including their respective directors, officers and employees) are only permitted if authorized by applicable law – 12 CFR 9.12(b)(1) • Loans from fiduciary accounts to bank directors, officers, or employees are strictly prohibited – 12 CFR 9.12(b)(1) • Loans from the bank to fiduciary accounts are permitted if the transaction is fair to the account and not prohibited by applicable law – 12 CFR 9.12(c)

17. Federal Regulations (Cont.) • 12 CFR 9.15 – Fiduciary Compensation • Fiduciary may charge a reasonable fee for its services if not set or governed by applicable law – 12 CFR 9.15(a) • Fiduciary may not permit officers or employees to earn compensation for acting as a co-fiduciary, except with approval of the board of directors 12 CFR 9.15(b)

18. Consider the Cimex Lectularius • Commonly known as the Bed bug! • Thought to have been significantly eradicated in the early 1900’s. Started seeing a resurgence after 1995. • Resurgence is generally attributed to a change in habits of the primary hosts. • More foreign travel, exchange of bedding materials, focusing on other pests and ignoring them!

19. Bed bugs and conflicts • Can’t readily see them coming so you have them before you know it. • When they bite, they hurt! • Embarrassing to acknowledge and address. • Requiring a re-focus in order to eliminate. • New tools available to look for them!

20. Where are we today? • Law and regulation – much the same. • Fundamental nature of conflicts – still the same. • Basic transaction types that cause concern - still the same. • Perhaps there is more complacency toward potential conflict situations?

21. Where are we today?(Cont.) • Size and complexity of our financial institutions; responsibility is the same. • Technical knowledge and depth of understanding about conflicts of interest. • The primary change in perspectives has occurred in how, where, and why we see conflicts of interest emerging. They come at us in some different ways!

22. Investments Revenue Affiliated Products And Services Sources of Potential Conflicts Personal Interests Cash Management Third Party Services Indirect Conflicts Sources of Emerging Conflicts

23. Investments • New and increasingly complex investment vehicles provide opportunity – both for benefitting the client and for additional underlying conflicts. • Banks and affiliates are assuming additional duties relative to financial instruments. • Management of fiduciary cash – remember the fundamentals.

24. Potential Conflicts - Investments • Roles related to investment vehicles (sales, service, underwriting) • Fees and other financial benefits associated with investing • Underlying purpose of the investment • Failure to take actions on behalf of client interests (contrary interests) • Proxy voting (must vote clients’ interest; not that of the bank)

25. Potential Conflicts - Investments • Soft dollar arrangements not meeting requirements of Section 28(e).

26. Potential Conflicts - Investments Private Equity Fund Proposal • Investment opportunity for “select” fiduciary accounts • New fund for company; “incubation” • Bank affiliate to manage • Executive employees are investing partners • Fiduciary accounts – limited partners

27. Potential Conflicts - Investments • Proprietary Investment Managers (who are also investors) – get “gain sharing”, incentive compensation, and management fees • Fund allowed to incur debt from own bank • Management team indemnified for financial loss • Shared Counsel with waiver of conflict

28. Potential Conflicts - Investments • Bank may act as investor, investment banker, investment manager, advisor, agent and principal in the deal. • Bank to have multiple relationships with portfolio companies and other parties – lender, advisor, servicer, shareholder, underwriter, or trustee. • Officers of bank may be directors of portfolio companies.

29. Potential Conflicts - Investments • Fund cash may be invested in bank instruments. • Warehoused investments to be transferred from bank balance sheet to the fund.

30. Revenue • Structure of fees and fee schedules • Layers of fees (performance fees, enhanced services fees, etc.) • Unfair or unreasonable fees • Extra fees for routine, traditional fiduciary services • Additional revenue received due to fiduciary appointment

31. Revenue (Cont.) • Revenue from serving in multiple capacities • Placement fees • Sweep fees • Sales incentives (internal and external) • Revenue share (internal and external) • Commissions • Account or Transactional fees • Service fees

32. Affiliated Products and Services Everyone wants their piece of the (very “proverbial”) pie!

33. Affiliated Products and Services • Lending relationships • Insurance products and services • Brokerage services • RE Sales/Servicing • Investment vehicles (Alternatives and other internal investment products) • Deposit and cash management instruments

34. Third Party Services • Goods, services, and other benefits that may be made available by vendors to the bank (or DOE’s) in return for: • Investing money • Using account or professional services • Potential for interlocking relationships

35. Indirect Conflicts • An action taken with respect to a fiduciary account that could indirectly benefit the bank or any of its DOE’s. • Corporate benefits from service arrangements. • Price breaks or gratuities in return for full retail pricing (or more) for servicing fiduciary accounts. • A fiduciary can’t do anything indirectly that he is prohibited from doing directly.

36. Cash Management • OCC Bulletin 2010-37 • Deposits or Investment of Cash Balances • Don’t leave cash uninvested • May deposit in own bank if properly pledged • Don’t “invest” cash in own-bank deposits • Consider the rates of return available • Sweep vehicles – basis of selection

37. Potential concerns involving personal interests • Transactions involving DOE or affiliated business interests • Bequests and gifts to DOE’s • Family accounts – transactions and decisions by DOE’s • “Benefits” in return for services from clients OR 3rd parties

38. Leveraging Consent • Must get informed consent – both the specifics of the transaction and the conflict itself must be disclosed. • Consent is not direction • Full beneficiary consent • Negative consent does not fully mitigate a conflict

39. Risk Perspectives • Regulatory Risk – punitive action by regulators can include formal agreements, civil money penalties, and potential loss of fiduciary powers. • Financial Risk – conlfict transactions are voidable; loss of revenue and potential damages • Reputation Risk- significant public risk for the professional fiduciary

40. Recommended strategies • Education programs • Strong Policies and Procedures at multiple levels • Effective preventive AND detective controls • Leverage technology and accounting system capabilities; encourage development of additional tools

41. Recommended strategies • Effective Risk Analysis • Refocus and identify areas of potential problems; consult with legal counsel • Limit mitigation of conflicts through “papering” the account. • Consider using screening processes or checklists designed to identify potential conflicts in new accounts, new products, and in relevant transactions.

42. Recommended strategies • Consider language that will protect the bank in transactional contracts. • Include conflicts screening in all vendor due diligence programs.

43. Final wish… Good night, sleep tight, and don’t let the bed bugs bite!