Fiduciary Diligence Demanded as CITs Shine
A significant regulatory concern is that banks should not simply “rent their charters” to third-party registered investment advisers seeking to use the bank’s status as a fiduciary to sponsor one or more funds on their behalf.
Wilmington Trust recently published an in-depth report that examines the evolving collective investment trust marketplace. While written mainly for the benefit of CIT providers, the analysis also can help retirement plan fiduciaries ensure they are living up to their own responsibilities.
CIT Momentum Is Clear
As noted by report authors Thomas Roberts, a principal at Groom Law Group, Chartered, and James Bowlus, associate general counsel in the legal division at Wilmington Trust, plan sponsors and other fiduciaries responsible for 401(k) plan investment menu construction, including their advisers, are demonstrating growing interest in adopting CITs. The pair say several powerful market forces are driving this trend.
“First, the investment strategies and related teams of investment professionals available to 401(k) plans through mutual fund complexes are becoming increasingly available through CIT structures,” the report explains. “Second, the exemptions from registration under the federal securities laws available to CITs may afford them cost advantages relative to their mutual fund counterparts, because CITs can avoid the expenses associated with mutual fund registration, prospectus and annual report updating and mailing, and the like.”
Further, CITs are relatively flexible arrangements—a feature that is particularly compelling in today’s volatile and rapidly evolving equity and fixed-income markets.
As Roberts and Bowlus write, CIT structures can implement new investment strategies and approaches “quickly and easily.” Accordingly, banks and trust companies that offer CIT products are able to respond to market demand for customized products quite effectively, particularly in the target-date fund segment.
“With all of these advantages, it is unsurprising that CITs have attracted an ever-larger percentage of 401(k) plan assets over the past 20 years,” the pair write.
Of course, with this growth comes additional diligence demands. According to Roberts and Bowlus, the policies and procedures of banks and trust companies offering CIT products to retirement plans covered by the Employee Retirement Income Security Act may warrant additional consideration by plan fiduciaries when making investment option decisions. They note that modern CIT structures have been shaped by and reflect a triad of regulatory influences—arising, respectively, under the body of state and federal laws governing the exercise of trust powers by banking institutions, the federal securities laws enforced by the Securities and Exchange Commission, and ERISA.
Emerging Points of Scrutiny
After providing a detailed history of the role the Office of the Comptroller of the Currency and various state regulatory bodies played in the creation of the CIT marketplace, the Wilmington Trust paper highlights some of the current pressure points regulators are tracking.
In particular, with respect to the widespread use of sub-advisers by CIT providers, a significant regulatory concern is that banks should not simply “rent their charters” to third-party registered investment advisers seeking to use a bank’s status as a fiduciary to sponsor one or more funds on their behalf.
“The OCC has emphasized that a bank’s use of outside third parties to perform functions on its behalf does not diminish the responsibility of the bank’s internal management team to ensure that those functions are performed in a safe and sound manner and in compliance with applicable laws,” the report warns. “The OCC expects a national bank relying upon third parties, including CIT sub-advisers, to maintain risk management processes that are commensurate with the level of risk and complexity of the third-party relationship.”
Accordingly, the OCC expects that banks using the services of CIT sub-advisers will exercise periodic reviews of the sub-adviser’s performance, style consistency and the investment of fund assets in a manner consistent with applicable investment guidelines.
Retirement plan fiduciaries, like the regulators, should be sure that their CIT provider can demonstrate control over the documents that afford clients access to CIT investment funds, including the maintenance of original documentation in a secure, centrally controlled location. The bank or trust company also should maintain a system of internal controls, the analysis explains, including an effective audit program for assuring that the bank is adhering to the terms and conditions of CIT instruments.
What Can Go Wrong With CITs
As an example of how CIT providers can run afoul of such expectations and raise fiduciary concerns for retirement plans, the paper points to an enforcement action undertaken by the SEC back in 2006. The case involved a common trust fund claiming exemption from registration under SEC rules, specifically the rules requiring that CITs be “maintained by” a bank or trust company even when it has engaged a sub-adviser.
The SEC concluded that the “maintained by” requirement is not satisfied when a CIT serves as a de facto intermediary vehicle for investors to indirectly invest in privately offered investment funds that were otherwise unavailable for direct investment.
“In that case, the SEC expressed the view that the bank did not truly ‘maintain’ the common trust fund but was merely a directed investment arrangement, because investors in the fund instructed the trustee as to the ultimate investment of the common trust fund into underlying private investment vehicles,” the report explains.
More recently, in 2020, the SEC determined that a CIT trustee similarly failed to satisfy the “maintained by” requirement for both its common trust and collective trust funds. In that case, the trust company sponsoring the funds relied upon the services of an affiliated investment adviser to assist with the management of the funds. Ultimately, the SEC faulted the trust company for engaging in only “minimal oversight” of its investment adviser affiliate, alleging that the advisory affiliate performed virtually all investment activities on behalf of the funds, including investment due diligence, investment selection, purchases, sales activities and monitoring for performance and risk.
The SEC also noted that the trustee’s oversight of its adviser affiliate was “cursory,” largely limited to the passive receipt of information and reports submitted by the adviser that rarely resulted in any investment changes or feedback to the adviser in respect of the funds’ investment strategy.
“The federal securities laws compliance needs for well-designed and implemented CIT governance practices are clear and unmistakable,” Roberts and Bowlus write. “CITs are ‘maintained by a bank’ and therefore eligible for the federal securities laws exemptions that may allow for cost savings relative to mutual funds only where the bank exercises substantial investment authority, including through sub-adviser oversight and contemporaneous or advance approval of sub-adviser recommendations.”
CITs and ERISA
The paper concludes with a discussion of the intersection of CIT rules and ERISA requirements.
“Banks that maintain CITs are responsible as fiduciaries when they manage the assets of those plans,” the paper notes. “As such, banks are required to manage those assets prudently, solely in the interests of the plans and in a manner that avoids giving rise to a non-exempt prohibited transaction.”
According to Roberts and Bowlus, while the common practice of engaging one or more expert investment advisers to assist the bank in its management role is consistent with the principles of prudence, it is insufficient, in and of itself, to discharge that duty.
“Consistent with the duties of prudence and loyalty that ERISA imposes, where a fiduciary relies upon an expert, including a sub-adviser, it is obligated to evaluate and consider the expert advice and recommendations that it receives, including the qualifications of the provider(s) of that advice,” the analysis concludes. “Such a process would also seek to avoid non-exempt prohibited transactions. Well-governed bank CITs apply these principles by engaging in regular oversight of expert sub-advisers and of their recommendations and by taking appropriate steps to ensure ongoing compliance with applicable prohibited transaction exemptions.”
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