Recent SEC enforcement raises questions for bank collective trust funds1
The SEC, just a few days ago, announced an enforcement action against a trust company for failure to exercise substantial investment authority over their collective trust funds.2
According to the SEC, because of this failure, the trust was not entitled rely on the Section 3(c)(11) under the Investment Company Act and was therefore operating unregistered investment companies. This SEC’s action is curious to say the least; it is first statement by the SEC in recent memory which addresses Section 3(c)(11)’s bank-maintained requirement. The action does not allege client harm and does not serve to advance any stated concern by the SEC regarding bank collective trust funds which are bank-regulated products. By bringing last week’s case, the SEC raises the question of what constitutes "substantial investment authority" for purposes of the "maintained by a bank" requirement, but offers no sense of the SEC’s expectations or where the SEC may be headed more generally with respect to bank collective trust funds.
The SEC’s action even led one of its Commissioners to publish a dissent—something we do not see that often. In her dissent, Commissioner Peirce asserts that an enforcement action is not a proper vehicle to address the conduct at issue, noting the lack of formal SEC guidance as to what constitutes the exercise of substantial investment responsibility by a bank with respect to a collective trust fund. Commissioner Peirce also points to the lack of collaboration with banking regulators.
In this Legal Alert, we provide a brief overview of collective trust funds. We then discuss the current guidance related to the bank-maintained requirement in Section 3(c)(11). Finally, we address the SEC’s recent enforcement action.
Bank-sponsored collective trust funds (CTFs), a first cousin of the mutual fund, have been around for more than seventy years. Offered to both defined benefit and defined contribution plans, collective trusts today compete with mutual funds and other pooled investment vehicles as a mainstream product in the retirement plan marketplace.
At one time, mutual funds overshadowed CTFs as funding vehicles in the defined contribution plan marketplace for a number of reasons, including perceived advantages offered by mutual funds in the areas of administration, daily pricing, record-keeping, and performance advertising. However, CTFs have significantly increased their share of the retirement plan market in recent years by competing successfully in these areas.
But perhaps even more important, CTFs have generally been able to weather the regulatory scrutiny of retirement plan fees and expenses, as CTFs are seen as having lower expense levels than comparable mutual funds. CTFs also are gaining attention as vehicles that allow for a good amount of flexibility with respect to product design and the ability to avail themselves of certain alternative investments, and pricing flexibility.
CTFs may be advised by a bank itself, an affiliate of the bank or by a third-party investment adviser. Over the last decade or so, an increasing number of third party investment advisers have shown interest in accessing the retirement marketplace through collective trust funds.
Regulatory framework applying to collective trusts
Collective trust funds are subject to a myriad of regulations including those administered by:
- state and federal bank regulatory agencies, and in particular the OCC;
- U.S. Department of Labor (DOL);
- Internal Revenue Service (IRS);
- Securities and Exchange Commission (SEC);
- Financial Industry Regulatory Authority (FINRA), to the extent the collective funds are marketed by a broker-dealer; and
- Commodities Futures Trading Commission (CFTC), to the extent the collective funds invest in futures.
Federal banking laws: OCC
Practically speaking, the OCC’s collective investment regulations are the primary banking regulations relevant to collective trust funds. While the OCC’s collective investment regulations apply only to national banks that organize and maintain collective trust funds, many states apply the OCC’s rules either by statute, rule, other guidance, or as best practices in examining state bank collective trust activities.
The OCC’s collective investment regulations are codified to 12 C.F.R. § 9.18. Those regulations require, among other things that:
- the bank sponsoring a fund has “exclusive management” of the fund, subject to prudent delegation;
- funds are valued at least quarterly (illiquid assets may be valued annually) subject to market/fair valuation;
- management fees satisfy the limits set forth in the requirement; and
- the funds are subject to risk management requirements.
In addition to 12 C.F.R. § 9.18, the OCC has provided guidance with respect to CTFs through bulletins and banking circulars, interpretative letters, and through handbooks issued by the OCC’s Asset Management Group. We reference some of this guidance below.
OCC bulletins and banking circulars
- 2011-11—Risk Management Elements: Collective Investment Funds and Outsourcing Arrangements.
- 2004-2—Banks/Thrifts Providing Financial Support to Funds Advised by the Banking Organization or its Affiliates.
- 2001-47—Risk Management Principles: Business Relationships with Third Parties.
- Banking Circular 196—Securities Lending (1985).
Interpretive letters (IL)
- IL #1121—CIF Distribution Delay due to Illiquid Assets (2009).
- IL #1119 and 1120—Withdrawal Fees and Benchmarks—Model-Driven Funds (2009).
- IL #920—Annual Admissions and Withdrawals (2001).
- IL #919—Allocation of Costs in Model-Driven Funds to Participants (2001).
- IL #884—Nondiscretionary Custodian in a Collective Fund (2000).
Collective Investment Funds Handbook
In addition, the OCC’s Asset Management Group has issued a Collective Investment Funds Handbook
which is a very valuable reference to CTF industry participants, as well as these other handbooks that also are relevant to the following CTF operations:
- asset management;
- asset management operations and controls;
- conflicts of interest;
- custody services;
- investment management services;
- personal fiduciary services; and
- retirement plan services.
Collective trust funds are subject to the Employee Retirement Income Security Act (ERISA) and therefore are subject to DOL scrutiny. Collective trust funds are considered to be an ERISA “plan asset” vehicle.4
As a plan asset vehicle, when a plan invests in a collective trust fund, the underlying investments of the fund are considered to be plan assets. The fund’s trustee and any investment adviser are generally considered to be ERISA fiduciaries. Transactions of the fiduciaries and transactions between the fund and third parties are subject to ERISA’s prohibited-transaction rules. Also, the fund will be subject to various reporting and disclosure requirements. For further discussion, see section 49B:3.7.
Most CTFs are structured as tax-exempt “group trusts” qualified under Revenue Ruling 81-1005
as modified by Revenue Ruling 2004-67,6
Revenue Ruling 2011-01,7
and Revenue Ruling 2014-24.9
(Technically, each of the Revenue Rulings replaced its predecessor, but the industry still tends to refer to CTFs as 81-100 trusts.) By way of background, the Internal Revenue Code (IRC) treats as tax-exempt the trusts funding a variety of retirement or employee benefit plans subject to, among other things, an exclusive benefit requirement—generally, that the trust assets be used only for the exclusive benefit of plan participants and their beneficiaries. In Revenue Ruling 81-100, the IRS continued a ruling position dating to 1956 that, subject to specified conditions, certain types of retirement plans may pool their trust assets for investment in a group trust, without violating the exclusive benefit rule, and the group trust would enjoy the same tax exemption as the trusts for the participating plans. The subsequent authority generally expanded the types of retirement plans that can join the group trust, and refined the requirements for the group trust.
CTFs structured as group trusts, while generally tax-exempt, are subject to the unrelated business income tax provisions of the Internal Revenue Code.10
At a high level:
- Passive investment income earned by the trust, such as interest, dividends, and capital gains, is not subject to income tax.
- The trust is, however, taxed on income from the operation of an “active” trade or business unrelated to its exempt purposes.
- Income from certain “debt-financed” property is also taxable, in proportion to the amount of borrowing.
The tax-exempt group trust is not the only tax structure utilized for CTFs. They are also sometimes organized for tax purposes as either:
- An I.R.C. § 584 common trust fund, if appropriate to the purposes and structure of the arrangement. Such trusts are pass-through entities for tax purposes; or
- Least often, as a taxable business trust treated as a partnership for tax purposes, which is another form of pass-through entity.
Interests in collective trust funds are considered to be “securities” for purposes of the Securities Act of 1933, as amended (the Securities Act),11
but are exempt from Securities Act registration under section 3(a)(2) of the Securities Act if the fund is “maintained by a bank” and participation in the fund is limited to certain investors, such as a pension or profit sharing plan qualified under Internal Revenue Code section 401 or a governmental plan as defined in Internal Revenue Code section 414(d).12
While exempt from registration, the offer and sale of collective investment trusts are subject to the anti-fraud provisions of the Securities Act.13
Most collective trusts avoid registration as investment companies under the Investment Company Act by relying on an exclusion from the definition of an investment company found in section 3(c)(11) of the Investment Company Act. Section 3(c)(11) excludes, among other entities, collective trusts maintained by a bank the assets of which consist solely of assets of specific types of retirement plans.
To the extent that a CTF is marketed by a broker-dealer, FINRA rules applying to member firm sales of exempt securities would apply. FINRA Rule 0150 sets forth those rules that are applicable to transactions in and business activities relating to exempt securities (other than municipal securities), such as interests in CTFs, conducted by member firms.
To the extent that a CTF invests in commodities, the CTF’s sponsor and adviser have to comply with applicable CFTC rules and regulations. CTFs and their trustees, however, are expressly excluded from the definition of “commodity pool operator” in the rules of the CFTC, and thus do not need to register with the National Futures Association (NFA). In order to claim that exclusion, each of the CTF and trustee must file a notice of eligibility with the NFA.
"Maintained by a bank" requirement
Probably the most unique aspect of CTFs for an adviser, and most pressing for a third-party adviser, is the requirement that a CTF be “maintained by a bank.” A “bank” for these purposes is broadly defined as any banking institution or trust company doing business under state or federal law, as long as “a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks, and which is supervised and examined” by a state or federal banking regulator and is not operated for the purpose of evading the Investment Company Act. As a practical matter, this requirement means that an adviser will have to concede some of its investment authority to the bank. At one time, this requirement acted as a disincentive for advisers interested in penetrating the retirement market through CTFs. Now, more advisers have found that the “maintained by a bank” requirement is not insurmountable and can be achieved with certain adjustments to their day-to-day operations.
As mentioned above, section 3(c)(11) of the Investment Company Act provides that a collective trust fund “maintained by a bank” will not be considered an “investment company” for purposes of the Investment Company Act. However, section 3(c)(11) and its legislative history provide no gloss or explanation on what it means to be “maintained by” a bank; instead, that guidance has been provided by numerous SEC releases and interpretative letters, which we discuss below.
A 1980 SEC Release (1980 Release) provides the following discussion with respect to the maintained by a bank requirement:
The word “maintained” has been interpreted by the Staff to mean that the bank must exercise “substantial investment responsibility” over the trust funds administered by it. Thus, a bank which functions in mere custodial or similar capacity will not satisfy the “maintained” requirement.
Numerous no-action letters followed the SEC’s 1980 Release that collectively established a framework in which a bank could delegate investment management to a third-party adviser. Under this framework, the bank would still be required to exercise “substantial investment responsibility” with respect to the fund’s investments to satisfy its statutory requirements. In other words, the final determination whether or not to invest rested with the bank. More specifically, some of the letters indicated that the bank would approve or otherwise authorize all fund investments contemporaneously or in advance.
However, other no-action letters approached the “substantial investment responsibility” differently. In one letter, the SEC staff provided no-action assurance with respect to insurance company separate accounts seeking to rely on the section 3(c)(11) exclusion for separate accounts “maintained by” an insurance company, where the separate account invested in other pooled investment vehicles, including other collective investment funds and other separate accounts. In another letter, the SEC staff agreed that a collective fund set up as a single stock fund was maintained by the bank. The bank’s mandate was limited to purchasing GM stock to match the stock’s performance and short-term investments necessary to meet daily liquidity needs. Arguably, the SEC staff reasoned that even though the mandate was very narrow, the bank had full investment discretion and investment responsibility.
For the past thirty or so years, there has not been any further SEC or staff interpretative guidance provided with respect to a bank’s retention of a third-party investment manager. This means that most of the guidance in this area pre-dates today’s sophisticated electronic trading and related compliance and surveillance systems; the emergence of the modern adviser/sub-adviser business model; and the refinement of the legal basis under which an adviser delegates investment management to a third-party investment manager.
Prior to last week’s SEC enforcement action, the most recent SEC development of note was the April 8, 2010, informal remarks (2010 Remarks) of the then-SEC’s Director of Investment Management to attendees of the Practising Law Institute’s 2010 Investment Management Conference. In these remarks, the then-Director revealed that members of the SEC staff had begun looking into the activities of certain types of collective trusts that operate in a manner similar to mutual funds. In particular, he indicated that his staff was looking at whether such trusts are properly relying on exclusion from regulation under the Investment Company Act. The then-Director stated:
I briefly want to mention one investment practice that I am increasingly concerned about. And that is the use of collective investment trust platforms. In these platforms, although consisting of pooled trust accounts operated by a trust company or bank, each fund in the collective trust may be managed by an outside adviser that will also be responsible for marketing and distribution. . . . Collective investment trusts are regulated by the banking agencies, and may rely on an exclusion 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 whether there may be a need for any regulatory recommendations.
These 2010 Remarks surprised many industry observers because neither the SEC nor its staff has made mention of, much less expressed an interest in, collective trusts over the past couple of decades.
Following the concerns expressed in 2010, the SEC staff undertook a review of certain collective investment trust fund platforms that provide for third-party investment advisers. Reportedly, this review was conducted with a view to exploring the concerns expressed by the then-Director. That review did not result in any rulemaking or other action by the SEC.
Notably, OCC rules require that a bank be the “exclusive” investment manager for the CTF. Following the 2010 Remarks, in March 2011, the OCC issued guidance with respect to the OCC’s expectations for a national bank that outsources collective trust fund functions, particularly investment management. The OCC guidance arguably was a reaction to the statements made in 2010 by the then-Division Director.
The OCC’s 2011 guidance expands previous guidance with respect to the OCC’s expectations for a national bank that outsources any collective trust fund’s functions, particularly when outsourcing investment management functions. The OCC Bulletin 2001-47, “Third-Party Relationships: Risk Management Principles,” (the Bulletin), emphasizes the importance of a bank’s risk management practices related to collective trust funds, and that a bank must take special care in the selection and oversight of third parties, including those performing investment management.
The guidance also points out that a national bank’s board of directors must ensure that a third party performs its functions in a safe and sound manner and in compliance with applicable laws and policy guidance. The 2011 guidance notes that the Bulletin provides that national banks should adopt a third-party risk management process that includes, at a minimum:
- A risk assessment to identify the bank’s needs and requirements;
- Proper due diligence to identify and select a third-party provider;
- Written contracts that outline duties, obligations, and responsibilities of the parties involved; and
- Ongoing oversight of the third parties and third-party activities.
Finally, as relevant to our discussion here, the Bulletin notes that the decision to delegate investment management functions to a third-party adviser is a matter of fiduciary judgment, and requires a determination by a bank’s board, or designee, that the delegation is prudent. To the extent a bank CTF is offered by third parties directly to customers, the bank shall ensure that the third party clearly and prominently discloses in its advertising and marketing materials that the CTF is ultimately offered and maintained by the bank.
While the OCC guidance does not purport to address section 3(c)(11) of the Investment Company Act, it is understood that in developing its guidance, the OCC staff conferred with SEC staff on a regular basis. Given this, the OCC guidance arguably helps inform one’s consideration regarding the “maintained by a bank” requirement under section 3(c)(11) and could be seen as an indication that the SEC staff today in evaluating whether a CTF is “maintained by a bank,” would look comprehensively at the manner in which the bank delegates investment management to a third-party investment adviser.
In this regard, we note that in the course of its 2010 review of third-party collective trust fund platforms, the SEC staff appears to have focused on the overall manner of investment management delegation as opposed to specific indicia of “substantial investment responsibility,” such as trade pre-approval.
The SEC’s enforcement action
As noted above, on September 30, 2020, the SEC instituted and settled a cease and desist proceeding against a trust company, Great Plains Trust Company, Inc. (Great Plains), for the operation of unregistered investment companies in violation of the Investment Company Act. Great Plains sponsored and organized the trust funds, and acted as their sponsor, trustee, administrator, and custodian. According to the SEC’s order, Great Plains’ board, consisting of five members, had ultimate investment responsibility for the trust funds.
The SEC’s order notes that since the trust funds’ inception, Great Plains hired an affiliated investment advisory firm (IAF), registered as an investment adviser with the SEC, to provide investment advisory services to the trust funds. IAF performed all investment activities for the trust funds, including performing due diligence, selecting investments, purchasing and selling investments, monitoring the investment portfolios for performance and risks, and making changes in investment strategies. Ultimately, while Great Plains was responsible for the oversight of IAF, the SEC found that Great Plains engaged in minimal oversight (e.g., quick review of quarterly reports) and thus did not exercise substantial investment authority over any of the trust funds. In the regard, the SEC action notes that:
“(f)rom the Trust Funds’ inception through 2018, Great Plains’ board engaged in minimal oversight of IAF and failed to exercise substantial responsibility over the Trust Funds. It received quarterly reporting materials from IAF for each of the Trust Funds and also met once a year with a representative from IAF to discuss the Trust Funds. However, the reviews of the quarterly materials were cursory and the annual meetings with an IAF representative were focused on receiving information rather than having an active role in managing and exercising investment responsibility for the Trust Funds. Those annual reviews rarely resulted in any changes to the Trust Funds or any feedback regarding IAF’s management strategy. In those cases where it requested changes (such as requiring reduced concentrations of an investment in certain of the Trust Funds), Great Plains’ board repeatedly failed to act in a timely manner so that the changes were actually implemented. The board’s failures to require IAF to comply with concentration limits mandated by the investment policies of the Trust Funds within a reasonable timeframe resulted in substantial losses in certain of the Trust Funds.”
As noted above, Commissioner Peirce’s dissent questions whether an enforcement action is warranted, in light of the lack of any precise standards regarding the exercise of substantial investment responsibility by a bank sponsoring a collective trust fund. In this regard, the Commissioner notes that the SEC’s guidance in this area “leaves an enormous amount of uncertainty as to precisely what constitutes ‘exercising substantial investment responsibility,’ especially in those instances where the bank employs an investment adviser to assist it in managing the trust’s investments.” The Commissioner further asserts that an enforcement action is not a proper vehicle to address the conduct at issue or to communicate the SEC’s interpretation of the law. Commissioner Peirce also points to the lack of collaboration with banking regulators.
As noted above, this SEC enforcement action is first significant statement by the SEC in recent memory which addresses Section 3(c)(11)’s bank-maintained requirement.14 However, it leaves open the question of what constitutes "substantial investment authority" for purposes of the "maintained by a bank" requirement, and offers no sense of the SEC’s expectations or where the SEC may be headed more generally with respect to bank collective trust funds.
CTF assets have increased considerably in recent years. At the same time, over the last decade or so, an increasing number of third party investment advisers have accessed the retirement marketplace through collective trust funds. Banks sponsoring collective trust funds and advisers accessing the retirement marketplace through these vehicles should be aware of the SEC’s recent case and should carefully review applicable guidance that the SEC and OCC have provided over the years regarding “bank-maintained” and the exercise of substantial investment management by a bank.
This Legal Alert is adapted from Clifford E. Kirsch & W. Mark Smith, Advisers to Collective Trust Funds, in INVESTMENT ADVISER REGULATION: A STEP-BY-STEP GUIDE TO COMPLIANCE AND THE LAW, ch. 49B (Clifford E. Kirsch, ed., PLI Press, 3rd ed. 2011 & Supp. Oct. 2019).
In the Matter of Great Plains Trust Company, Inc., SEC Release No. 10869 (Sept. 30, 2020). (In addition, the SEC’s action dealt with common trust funds. The SEC notes that with respect to such funds, in addition to failing to exercise substantial investment responsibility, the trust company did not employ the funds solely as an aid to the administration of trust accounts maintained for a fiduciary purpose, and advertised and offered them for sale to the general public.)
The most recent version of the OCC’s Collective Investment Funds Handbook is dated May 2014.
29 C.F.R. § 2510.3-101(h)(l).
Rev. Rul. 81-100, 1981-1 C.B. 326.
Rev. Rul. 2004-67, 2004-2 C.B. 28.
Rev. Rul. 2011-01, 2011-2 I.R.B. 251.
Notice 2012-6, 2012-3 I.R.B. 293.
Rev. Rul. 2014-24, 2014-37 I.R.B. 529.
See I.R.C. §§ 511–14.
Employee Benefit Plans, Securities Act Release No. 33-6188 (Feb. 11, 1980) (collective bank trusts deemed to be “securities” under the Securities Act).
See, e.g., In re Street Bank and Tr. Co., Securities Act Release No. 9107 (Feb. 4, 2010) (SEC enforcement action brought alleging misstatements about the extent of sub-prime mortgages held in CITs.).
The section 3(c)(11) exclusion includes “(a)ny employee’s stock bonus, pension, or profit-sharing trust which meets the requirements for qualification under section 401 of the Internal Revenue Code of 1986, 26 U.S.C. § 401; or any governmental plan described in section 3(a)(2)(C) of the Securities Act of 1933 [15 U.S.C. § 77c(a)(2)(C)]; or any collective trust fund maintained by a bank consisting solely of assets of one or more of such trusts, government plans, or church plans, companies or accounts that are excluded from the definition of an investment company under paragraph (14) of this subsection.”
Another case, almost fifteen years old, Dunham & Associates Holdings, Inc. et al., Rel. No. 33-8740, (Sept. 22, 2006) was brought against a common trust fund for failure to meet the “maintained by a bank” requirement because the trust company “exercised no investment responsibility over the Fund. In that case, cited by Commissioner Peirce in her dissent, the investors in the fund made the relevant investment decisions and the trust company simply carried out those instructions. Given the extreme circumstances alleged, that case offers no meaningful guidance regarding the “maintained by a bank requirement.”