Headnote

While they should not become overly cautious in this litigious society, corporate fiduciaries can effectively manage the litigation risks as a part of their overall quality management efforts and training. In so doing, the delicate balance needed to achieve "profitable fee income" can be more readily achieved with sensitivity to the potential litigation risks.

Abstract

One of the most dramatic changes affecting corporate fiduciaries that has evolved over recent years relates to their increased level of sophistication with respect to pooled investment vehicles, particularly affiliated mutual funds. Measures to take to reduce litigation risks are discussed. While they should not become overly cautious in this litigious society, corporate fiduciaries can effectively manage the litigation risks as part of their overall quality management efforts and training. In doing so, the delicate balance needed to achieve "profitable fee income" can become more readily achieved with sensitivity to the potential litigation risks.

Body

In a June 1, 1996 essay entitled "Incorporating Profitability into the Bank Trust Department," the commentator begins with a seemingly innocuous observation: "It has become increasingly important to go beyond mere fee income in the trust area - profitable fee income is now key."' The author then argues for the proposition that a bank's fee schedules, in a rapidly developing and sophisticated investment market, must be reviewed to "appropriately compensate the bank for its work." According to him, bank management must educate its trust staff "about which types of accounts are most profitable," and the sales staff "should sell what is most profitable to the bank not what is the easiest to sell." He concludes:

In order to meet the profitability levels bank management set for trust groups, we have to effectively manage all of these issues.We must price our products and services profitably and not be concerned about charging fairly for the services we provide.

For every corporate fiduciary enticed by the invitation to "price [your] products and services profitably and [don't] be concerned about charging fairly for the services," be warned: the courts and bank regulatory agencies will evaluate today's approach to investment services pursuant fiduciary standards developed years ago, which, the courts will remind you, are "higher than the morals of the marketplace."2

One of the most dramatic changes affecting corporate fiduciaries that has evolved over recent years relates to their increased level of sophistication with respect to pooled investment vehicles. Affiliated mutual funds, rather than traditional common trust funds, have emerged as the pooled investment vehicle of choice. Indeed, by recent count, 13 of the top 20 banks in the United States by discretionary assets had reportedly converted or were considering conversion of their common trust funds to affiliated mutual funds.

Today, in this era of financial supermarkets and rapid industry consolidation, there is no better opportunity to discuss effective litigation risk management than with respect to a corporate trustee's use of affiliated mutual funds, particularly in connection the conversion of common trust funds.

Now, since we are trial lawyers, we are not offering the roadmap for compliance with the maze of fee, disclosure and tax statutes which may be triggered by common trust fund conversions. For that, you should consult with our trust law colleagues.

We have been asked to address the means by which prudent fiduciaries faced with a desire to provide the benefits of mutual funds can reduce the risk that they will find themselves defending a class action complaint and, if they are sued, some measures that may increase the likelihood of a favorable outcome at the earliest possible stage of the litigation. Unfortunately, fiduciary compensation and other trust law issues may be decided by a court that lacks experience and expertise in the field, magnifying litigation risks. Corporate fiduciaries must be proactive in guarding against challenges by creative plaintiff attorneys who seek to have the wrong court decide such important cases.

Case Study: Conversion of Common Trust Funds to Mutual Funds

Several plaintiffs' class-action lawyers already have filed highly publicized complaints against First National Bank of Chicago ("First Chicago") in Illinois and First Union in Pennsylvania. Claims have ranged from breach of fiduciary duty to breach of contract to consumer fraud. They seek disgorgement of fees, compensatory damages for allegedly wrongful capital gains tax liability, rescissory relief and attorneys' fees.

In the first case, which was filed in Illinois state court, the complaint alleges that in early 1995 First Chicago converted plaintiffs' trust assets from common trust funds to mutual funds. The conversion allegedly involved $1.3 billion in assets. Plaintiffs claim that the bank was improperly motivated by its desire to use common trust fund assets as "seed money" to launch a family of proprietary mutual funds. They claim to have suffered damages in the form of capital gains taxes triggered by the conversion and by the assessment of higher fees.

In the second case, the plaintiffs sued First Union in state court in Philadelphia County, Pennsylvania - a burgeoning hotbed of plaintiffs' class action filings. The complaint alleges that in late 1997 and early 1998 First Union acquired Signet Bank and Corestates becoming the trustee of 21 common trust funds. Plaintiffs claim that the notices sent out by First Union in connection with a conversion promised that the conversion would be accomplished without any federal income tax liability.

Notwithstanding vigorous challenges to these complaints, the actions have survived dismissal and are heading toward battles over class certification.

Separately, a recent press report suggests that the son of a famed diamond jeweler in New York has hired David Boies, who represented the government in its antitrust case against Microsoft, to pursue a class action against Bankers Trust in connection with an alleged practice of liquidating equities and transferring the proceeds into higher fee, proprietary mutual funds. By seeking class-action status, plaintiffs hope to turn what might be a small dispute into a case potentially involving millions of dollars.

In recent years, bank trust departments have often determined that they desire to improve service and results for their clients by capturing the advantages of mutual funds over common trust funds. in doing so, the bank has a legitimate and proper interests in serving the interests of the beneficiaries, providing the beneficiaries with the benefits of mutual funds and in obtaining appropriate compensation. Typically, the bank serves as a fiduciary for the common trust funds and, accordingly, must discharge its common-law fiduciary duties.

In all but two states, statutory exceptions to the strict common law duty of loyalty have been enacted which permit fiduciary investment in affiliated mutual funds. While such statutes may vary widely, each typically permits fiduciary funds to be invested in an affiliated mutual fund if the compensation received by the trustee or other fiduciary from the mutual fund is "reasonable" and the fiduciary makes adequate disclosure to the beneficiaries.

This authorization, however, should not be viewed as a blanket waiver of a fiduciary's duty of loyalty in this context, but rather as a relaxation of the common law's traditional per se ban on such investments. In evaluating the prudence of such investments, the corporate fiduciary should consider the appropriateness of mutual funds as an investment and the advantages of proprietary funds over third-party funds. The touchstone issue is the best interests of the beneficiaries.

Assuming that associated fees are reasonable, which will be briefly discussed below, affiliated mutual funds provide significant benefits to fiduciary accounts and beneficiaries. Such benefits include, but are not necessarily limited to: 1) low-cost diversification, 2) economies of scale, 3) daily public pricing, and 4) specialized management, and unlike common trust funds, 5) greater availability of information, including performance data, and 6) the ability to distribute such investments in kind to the beneficiaries.

So, if you are a corporate fiduciary considering a conversion or a similar decision, what can you do to reduce the risk that the bank will be sued?

Anticipate the Attack

Experienced corporate fiduciaries likely can anticipate and plan to counter the hindsight allegations of plaintiffs' lawyers. However, the fiduciary must develop a process for addressing the various considerations and to do so in a manner that is credible and believable. The corporate fiduciary should adopt a policy for investment in mutual funds with the guidance of experienced counsel.

The minutes of meetings of pertinent committees should document the nature and extent of services provided, the expertise of the relevant personnel, the cost of providing the services, comparable fees charged by fiduciaries and non-fiduciaries for money management services and other relevant factors.

Where possible, the governing instruments should include provisions specifically authorizing investments in affiliated mutual funds and the institution's receipt of related fee income. To demonstrate the continued propriety of investing fiduciary accounts in affiliated mutual funds, the trust department should periodically compare performance and expenses charged by its funds with those of other available mutual funds, and review such performance and expenses in a manner consistent with its review of other investments held by or available to fiduciary accounts generally.

Carefully Document Decision-Making

In the real world as opposed to the world alleged by plaintiffs' classaction lawyers, decisions are almost always multi-faceted. They involve practical business and service issues. When a decision includes consideration of the potential for increasing profitability, a skilled plaintiff lawyer will likely characterize the outcome as entirely profit-driven, even when the outcome is a win-win for the institution and the customer or beneficiary.

Management and staff must be made aware that most documentation and internal communications (with the exception of advice from counsel) will be turned over to opposing counsel during litigation, as required by the rules of civil procedure governing discovery. Since the standard for determining whether a document is "discoverable" is lenient, most documents will be turned over to the other side during the course of a lawsuit. Therefore, every internal memo, trust account file, electronic mail message, phone message and note must be created and maintained with an eye toward this possibility. A corporate fiduciary must "speak" at all times in a voice that acknowledges its legal obligations to its trust beneficiaries, and in a voice that is not easily distorted by those who would challenge it.

Under present law, reasonable trustee compensation is determined primarily by an analysis of the labor and services rendered and the responsibility assumed by the trustee. Additionally, courts may consider evidence of prevailing competitive rates. Courts have been reluctant to state that any particular percentage is per se reasonable.

The successful defense of an alleged class action may turn on the bank's ability to effectively marshal evidence showing the individualized nature of the reasonableness of compensation at the trust level. Such fact-specific inquiries may include the gross income of the trust estate, the success or failure of the administration and the results obtained, the unusual skill or experience of the trustee, the time expended by the trustee and the complexity and character of the work performed. The corporate fiduciary also must document costs, including both fixed and incremental costs.

In the end, to support the reasonableness of the fees received, it is critical that the nature of these services and their value be documented. And, such documentation should preferably be performed in a manner that evidences the variations across trust accounts.

Disclose, Disclose, Disclose

Litigation often involves the adequacy of disclosure. Were important facts disclosed? Did the trustee misstate important facts? Was the beneficiary told about certain fees? When the disclosures are clear and conspicuous, receipt of the disclosures is acknowledged, preferably in writing, and there are multiple layers of disclosure, through periodic updating, institutions have a much better opportunity to defeat the claims at an earlier, less costly stage. Moreover, the existence of superior disclosure documents improves dramatically the opportunities to defeat a plaintiffs request that the case be treated as a class action.

Fee income from affiliated mutual funds should be clearly disclosed. Recommended steps to ensure proper disclosure include: 1) the distribution of prospectuses to all interested parties upon the initial investment of each fiduciary account in an affiliated mutual fund; and 2) the disclosure of all fees to be received through the mutual funds and the basis on which such fees are calculated in such prospectuses, on the corporate fiduciary's fee schedule, as well as on periodic statements rendered to interested parties of each fiduciary account invested in the mutual funds. Such disclosures should also be updated on a timely basis if there are any material changes in the information disclosed.

Cross-Examine Internal Practices

Review internal training materials and compliance manuals to verify that they appropriately instruct personnel to make the requisite disclosures. While training may necessarily involve sales methods, including the notion of cross-selling, such training should not minimize compliance obligations or the need to communicate important disclosures effectively. The corporate fiduciary should implement training sessions so that the trust department personnel are familiar with the advantages and disadvantages of mutual fund investing and the related fiduciary issues.

Review and Organize Records

Maintain and enforce a document retention policy, including policies concerning electronic mail and personal files. Organize and maintain key records, such as agreements, disclosures, account statements and correspondence. Additionally, financial institutions and insurance companies must comply with various emerging obligations pertaining to the privacy of personal information.

Respond to Customer Complaints

Manage customer complaints effectively and directly, even if they involve relatively minor customer service issues. Numerous putative class actions have been initiated by individuals dissatisfied with the handling of customer service complaints.

Handle Ex-Employees With Care

When dealing with former employees, particularly disgruntled ex-employees, be sensitive to the possibility that they may testify adversely and recall events selectively. Maintain policies prohibiting disclosure of confidential or privileged information. Adopt and enforce policies prohibiting employees from discussing business information in Internet chat rooms, particularly if and to the extent that they are identifiable as an employee. Some groups have posted "help wanted" advertisements seeking to recruit trust professionals to assist them as trust litigation consultants or expert witnesses.

Use Counsel Effectively

The corporate fiduciary should obtain an opinion of counsel addressing the relevant legal considerations regarding receipt of fee income from affiliated mutual funds in each state in which the fiduciary operates. The opinion should be shared with and considered by appropriate trust committees. Additionally, the corporate fiduciary should be sensitive to the need to involve counsel in the review process and to preserve applicable privileges.

Conclusion: Wariness, Not Paralysis

Obviously, one cannot function as an efficient, profitable business entity if thoughts of litigation loom foremost in the minds of management and staff. We do not advocate placing an undue emphasis on the fear of some hypothetical future lawsuit. Instead, corporate fiduciaries can effectively manage the litigation risks as a part of their overall quality management efforts and training. In so doing, the delicate balance needed to achieve "profitable fee income" can be more readily achieved with sensitivity to the potential litigation risks.

ENDNOTES

1. Incorporating Profitability into the Bank Trust Department, Trusts & Estates June 1,1996.

2. Meinhard v. Salmon, 249 MY 458, 464 (1928).

Gregory B. Jordan (gjordan@reedsmith.com) is the managing partner of Reed Smith LLP, one of the nation's largest law firms with more than 670 lawyers. His practice has encompassed a broad array of financial services and trust litigation.

Perry A. Napolitano (pnapolitano@reedsmith.com) is a partner in the Pittsburgh office of Reed Smith LLP whose practice focuses on financial services litigation, including complex trust and fiduciary litigation. ;

Roy W Arnold (rarnold@reedsmith.com) is a senior associate in the Pittsburgh office of Reed Smith LLP whose practice includes financial services litigation and class action defense.

The authors gratefully acknowledge the assistance and contributions of their colleagues, Mark Bookman and Daniel M. Miller.