FIRMA 2007 FDIC Trust Update

1. FIRMA 2007FDIC Trust Update Common FDIC Exam Issues / High Risk Areas Best Practices – Risk Management FDIC Exam Initiatives Presented by Carla Walter-Clifton, CFIRS www.cwalter@fdic.gov 816-234-8085

2. Common Trust Exam Problems: For discussion purposes segregating some issues by large and small trust departments.

3. Experience Has Taught Me: • Interesting thing about being a regulator • See many ways to do things and just when you think you have seen it all, something new comes along. • Trust departments that draw on regulators’ knowledge of the multitude of different ways of achieving the same objective truly experience the the value added potential of examinations. • Big departments are not always using best practices.

4. Common Exam Issues:Large Trust Departments • Conflicts of Interest • Asset Management • Management

5. Conflicts of Interest (Large Departments) • Disclosures – everyone wants brevity but is it costing clarity? • Hotbed for EB Plan lawsuits as everyone claims they were not aware of the fees related to mutual funds. (not currently impacting bank trustees but how long???) • Protection is only as good as the disclosure. • The right parties have to get the disclosure and how to prove it was given. • Frequency of disclosure?

6. Conflicts of Interest (Large Departments) • Revenue Sharing: 12b-1 fees, shareholder service/administrative fees earned on EB and IRAs. • Beware might be getting fees inadvertently via mutual fund trading platforms. • Same rules apply to IRAs as ERISA accounts. • AO 2005-10A (any discretion – rebate) • Incorrect fee offset creates violation 4975c(1)(E) or (F) • Just when you think an institution has it figured out there is a personnel or procedural change and compliance falls through the cracks.

7. Conflicts of Interest (Large Departments) • Use of in-house or affiliated brokerage • FDIC Advisory Opinions State: • Can use and share in brokerage fees for transactions NOT involving employee benefit (ERISA accounts) if: • Fully disclosed and • Either: • Expressly authorized in the document or • Authorized in writing by all interested parties and beneficiaries or • Authorized by court • and • Not prohibited by state and federal law • Does not alleviate concerns over best execution or churning. • EB related activity governed by PTE 86-128

8. FDIC Advisory Opinions • 85-10 (I think is the most clear and straight forward language)The receipt of extra fees in connection with the execution of securities transactions on behalf of trust accounts will, in our opinion, most probably constitute improper self-dealing except where the self-dealing has been fully disclosed; is expressly authorized by the trust agreement, by all interested parties and beneficiaries, or by court order; and the self-dealing is consistent with applicable federal and state law. (In certain instances, local or federal law, e.g., ERISA, may prohibit any self-dealing whatsoever.) The fact that the trust department customer has consented to the use of the bank's discount brokerage department for the execution of securities transactions on behalf of his/her trust account may not necessarily {{4-28-89 p.4179}}mean that the bank has fully discharged its fiduciary obligation with respect to the transaction. The bank could still be subject to criticism for churning of accounts, failure to keep proper accounting records, failure to meet Part 344 of the FDIC's regulations which sets forth confirmation and recordkeeping requirements, or failure to meet its best execution obligations, etc.   Because of the above, we cannot simply say that customer authorization, in and of itself, resolves any potential conflict of interest. We will agree, however, that insofar as authorization is a factor in any exception to the general prohibition against self-dealing, express authorization in the trust agreement is not the only manner in which the authorization requirement may be satisfied.

9. FDIC Advisory Opinion • 83-17 • NON-DISCRETIONARY: In the absence of a statutory prohibition, however, and assuming no unusual facts, it would appear that where (1) a trust instrument expressly authorizes the bank trustee to share in commissions generated by securities transactions effected on behalf of the account, and (2) the settlor of the trust entered into the authorization after full disclosure of the facts, the sharing of the commission would not itself give rise to a breach of fiduciary obligation. This is not to say, however, that the administration of that trust account could not give rise to a breach of obligation or not be subject to criticism. For example, if * * * were to recommend the broker/dealer which acts as its clearing agent to the party directing the investment, it may subject itself to a conflict of interest charge. * * * would also need to avoid giving any advice to the unrelated party that would leave the bank open to a charge of "churning" accounts to generate fees. Additionally, a proper accounting must be kept for each account, other records maintained, and all necessary disclosure made in accordance with applicable law. If the broker/dealer is a related company of the bank and that fact is not properly disclosed, a breach of fiduciary obligation could be found.   If the authorization is based not on the trust instrument but on the consent of more than one beneficiary, the consent of all beneficiaries would need to be obtained. This in essence may preclude the commission split for trusts where the beneficial interests are not easily ascertained or where the beneficiary is a minor. Additionally, any securities transactions involving court supervised accounts would need court approval

10. FDIC Advisory Opinion • 84-10 (in-house brokerage) • We do not mean to flatly prohibit a bank trust department from dealing with the bank's brokerage department but merely to remind banks of their duty to do so within the confines of their fiduciary obligation. If the relationship and costs associated therewith (including any fee or commission retained by the trust department) are fully disclosed and the transactions are expressly authorized under the trust instrument, authorized by all the beneficiaries, or authorized by court order or applicable local or federal law, the relationship itself should not be subject to criticism. This is not to say, however, that the bank could not be subject to criticism for "churning" of accounts, failure to keep proper {{4-28-89 p.4153}}accounting records, failure to meet Part 344 of FDIC's regulations which sets out confirmation and recordkeeping requirements, or failure to meet its best execution obligations, etc.

11. Conflicts of Interest • Own-bank deposits: Trend – many banks want to keep the most $ in-house as possible. • What is the interest rate tied to? • Combining trust/NDIP under wealth management umbrella. (dual employees) • As lines of business cross, conflict risk increases and management vigilance must increase. • Cross selling affiliated products

12. Asset Management(Large Departments) • Common/Collective Funds – resurgence • IRAs can NOT invest in (SEC requirement) • Must be true fiduciary relationships – • no agencies and no “mini-trusts” • Life Insurance with mutual fund components • Mutual funds must be analyzed and managed like any other. Frequently see overlooked. • Proprietary Mutual Funds • Underperforming but still feeding $ into, how to defend as acting in best interest of benys?

13. Management - Pitfalls(Large Departments) • Fragmented infrastructure – no one at any level has a true working knowledge of how it all comes together (business line tunnel vision) • Greater instances as trust becomes a segment of “wealth management” and start getting managers with no trust background.

14. Management – Pitfalls(Large departments) • Multi-State Trust Locations • Strong compliance officer a must • Madrid of different state laws • No equivalent to OCC Reg 9 for state chartered banks • Keeping track of remote officers and actions • Escalation policies ultra important, as management can only make as good of decisions as the information it gets. • Strong policies with strong monitoring and enforcement. • Does internal audit actually review a sample of accounts from each location for policy adherence?

15. Management - Pitfalls(Large Departments) • Vendor Relationship / Outsourcing • Lax on-going due diligence of vendor • Lax evaluation of product risks • If entity approaches trust department about partnering to deliver a certain product.

16. Common Exam IssuesSmall Departments • Lack of Training • Asset Management • Conflicts of Interest • Irrevocable Life Insurance Trusts (ILIT) • Operations

17. Lack of Training(Common Issues Small Departments) • Account Administrator: • Use commercial bank employees to fill trust jobs or use as dual trust/loan officers. • If handle only very basic trusts may get by • Bookkeeping/Operations: • Untrained in trust accounting can result in significant problems. • Do they know & use full functionality of the trust specific software?

18. Asset Management(Common Issues Small Departments) • Not taken seriously • Holding received in-kind Assets: • Little investment analysis and determination of how fits within investment objective. • Permitted vs. Directed Document Language: Most documents “permit” retention; therefore, trustee still has full investment discretion. • Invest solely in own-bank/bank deposits • Allot of investments available without materially changing investment risk profile & allow for tax consideration.

19. Conflicts of Interest(Common Issues Small Departments) • Use of NDIP Personnel • FDIC Advisory Opinions apply same to small or large trust department regarding trades through affiliate brokerage. (on previous slides). • Conflict not appropriately disclosed. • Is there a formal investment process incorporating the NDIP person or is the trust officer just informally asking the NDIP person for recommendations? (trades may or may not be executed through NDIP) • Management monitoring for any inappropriate use of trust beneficiary information by the NDIP person?

20. Irrevocable Life Insurance Trust(Common Issues Small Departments) • Crummey Letters still required • IRS has NOT changed its position on procedures to comply with the gift tax exclusion requiring benys be granted a present interest in the “gift”, which is the insurance premium deposited into the trust. • Do not include “influencing” language in the Crummey Letter. • Do trustees appropriately review policies?

21. Operations(Common Issues Small Department) • Internal Controls may be non-existent • Could achieve dual control by using some commercial bank operations personnel for reconciling and such as many concepts are the same.

22. Common Trust Issues(All Trust Departments) • Administrative & Investment Reviews • Documentation • Self-Directed IRAs • FDIC Part 344 – Securities Recordkeeping • Own-Bank or Holding Company EB Plan • Church Bonds – Southwestern US

23. Administrative & Investment Reviews(All Trust Departments) • Should not be a formality to get FDIC/State examiners off your back!!!! • Administrative and Investment Reviews are two very distinctly different reviews. • Trend to check-the-box forms: • Do the “boxes” actually highlight appropriate risk issues? • Seeing boxes checked denoting red flags but no further discussion. • Generally lack comments on material, on-going issues that impact risk.

24. Investment Reviews(All Trust Departments) • Inappropriately doing for non-discretionary accounts. • Reviews are failing to address: • Investment objective source and continued applicability? (do they even have enough information to know?) • Does the asset mix meet the objective? • Unique/miscellaneous assets • See ignored with automated system generated review forms as they are usually designed to deal with marketable securities so frequently leave off unique assets and therefore may not even mention in review. • Note the type of unique asset but nothing else. • Asset concentrations • Have seen some good “check-the-box” investment reviews but once again only as good as the comments supporting the red flag indicators.

25. Documentation!!(All Trust Departments) • Universally the most frequent weakness, which in my opinion,generally does NOT get commented on in reports anymore unless horrible. • Documentation IS the trustee’s defense in the event of a lawsuit. • Courts focusing on “thought process” rather than the outcome of the action. • Thought process is generally proven with documentation of conversations and extenuating/influencing circumstances existing at the time of the decision.

26. Documentation!!(All Trust Departments) • Best Practice – uniform use of electronic comments facility. • Do not have to worry about readability or paper not getting into the file. • Make sure examiners are aware of electronic memo/comments facilities in use at the BEGINNING of the exam.

27. Self-Directed IRAs(All Trust Departments) • Unique Assets (you name it we are starting to see it) • Account pre-acceptance on all self-directed IRAs has been universally lax • Monitoring for prohibited transactions – how far does the custodian/trustee go? • Best Practice: If custodian has reservations about potential prohibited transactions, have the client establish separate IRAs and place questionable assets in so if something wrong will not cause all IRA assets to be subject to tax penalties. • Unrelated Business Income Tax (UBIT) • Valuation: • Pension Protection Act of 2006 added IRC 6695A holding “appraisers” accountable for valuations used for tax purposes. • Especially important at RMD time but legally required by IRS each year end when custodian reports on Form 5498.

28. Self-Directed IRAs(All Trust Departments – Unique Assets Cont.) • Documentation of investment directions – essential to have in writing. • Best Practice: standardized form which encompasses numerous representations by IRA owner, such as: • Owner recognizes risk in the investment. • Custodian gave no investment advice. • No determination made by custodian/trustee regarding prohibited transaction and if later determined to be prohibited, custodian/trustee held harmless. • Consulted with outside counsel regarding all aspects including UBIT issues and their responsibility to report if applies. • Valuation requirements– owner responsible for providing necessary assistance to allow custodian to determine fair market value as of December each year.

29. Self-Directed IRAs(All Trust Departments) • Policies: • What assets and when such assets will be accepted? • How will value? • What will happen if customer or other parties are uncooperative in valuing asset? • Option: – Obtain legal assistance to determine if and how to distribute the assets to the IRA owner. Make sure to do letter pre-notifying IRA owner of forthcoming forced distribution.

30. Self-Directed IRAs(All Trust Departments) • IRAs owning bank/bhc stock. • Specific emphasis on bank officers/directors • AO 88-09A • Permits self-directed IRAs to purchase stock of the fiduciary bank's parent holding company if: • (1) the fiduciary bank is directed in writing to do so by the participant, who is authorized to direct investments, • (2) the seller is not a "disqualified person" (the fiduciary bank or a bank insider), and • (3) the participant is not a director or officer of the fiduciary bank. • Purchases and holding of Parent stock by the self-directed IRAs of officers and directors of the Bank raise questions under section 4975(c)(1)(D) and (E) of the Code, depending on the degree (if any) of the participant's interest in the transaction. The IRA participants, as officers and directors of the Bank, may have interests in the proposed transactions which may affect their best judgment as fiduciaries of their IRAs.

31. FDIC Part 344Securities Recordkeeping(All Trust Departments) • 344.9 Disclosure of Personal Investment Transactions aggregate > $10M (excluding governments & mutual funds) in a quarter must be reported. • Who should disclose? • Anyone with department pending investment decision/transaction knowledge. • Purpose, employee using investment decisions for personal gain. • Who should review? • Senior level due to personal financial information. • Someone who does not have to personally report. • How to review? • Comparison to actual investment transactions of the department for the reporting period.

32. Own-Bank or Holding Company EB Plan Administered In-House(All Trust Departments) • Fees Charged to the Plan • Only allowed reimbursement for direct expenses (no profit margin). • DOL AO 2001-10A; 93-06A; 89-09A • If bank provides bank holding plan administrative services without charge technically violates FRB 23B for transactions with affiliates.

33. Premium Financed ILIT • New twist on an old concept. • OCC has seen one business that is putting together the deals and establishing referral relationship with a bank to trustee. • Does the bank truly understand the risks within this new concept before getting in the business?

34. Church Bonds(Southwestern USA) • Default is the issue: • Banks (as corp trustee) advancing funds under “reimbursement lien” language for legal and other fees in relation to default. • instances where bank is out $ • Defaulted church putting church funds into individual members’ bank accounts so trustee cannot access. • Seeing bonds in self-directed IRAs of church members.

35. Too Early to Comment On: • Pension Protection Act 2006 • Regulation R – Broker Exemption for Financial Institutions

36. Trust Best Practices • Complaints and Administrative Errors • Customer Communication • Account Pre-Acceptance • Account Risk Rating System • Staffing: Account Administrator vs Sales

37. Complaints & Administrative Error Resolution(Best Practices) • Corporate Culture Key! • Takes issue serious with formal escalation process. • Personnel trained for courteous, quick response even if cannot do what client desires. • What is the reimbursement policy?

38. Customer Communication(Best Practices) • Good communication is more than: • just the obligatory twice a year contact • an impersonal newsletter or • account statement • Do not just talk to them when things go wrong. • Experienced department heads tell me that the better the level of communication throughout the relationship the more likely clients are willing to work through issues rather than jump to legal remedies. • Particularly important on the asset management side in a market downturn.

39. Account Pre-Acceptance(Best Practice) • Single best risk management tool when appropriately used. • To be considered BEFORE saying yes to the business: • If existing business, where is it coming from and WHY is it moving? • Has someone actually read the entire legal document? • What and Where are all assets or potential assets? • Dynamics of beneficiaries/families?

40. Account Risk Rating SystemBest Practice • Best I have seen involved: • Numerical assignment for a set criteria and then via mathematical equation determine the risk category. This allows management to risk weight certain criteria. • Criteria may include: • Account size • Asset mix/diversification • Unique assets • CIP concerns • Client relationship • factoring in frequency of communication • Inter-beny/family conflicts • Volume of discretionary distribution requests • Complexity of account • Key is actually using the information for internal monitoring.

41. Account Adm vs. Sales Person(Best Practice) • Good administrators may not be best sales person and vice versa – • psychology generally shows different personality types excel in each area. • If someone good at both, generally do not have the time to do both jobs well.

42. FDIC Examination Initiatives • BSA/Anti-Money Laundering & USA Patriot Act • Self-Directed IRAs • Undefined Report Format

43. BSA/Anti-Money Laundering • Insure trust department is incorporated in bank’s overall BSA program. • Usually best to have trust personnel on BSA Committee. • Make sure trust personnel are getting training. • Is trust department data being searched for names when bank gets request from law enforcement?

44. BSA/Anti-Money Laundering • Customer Identification Program (CIP) in place? • Everyone trying to figure out how to apply to trust department. • Remember CIP was written from the perspective of a commercial bank opening a deposit account for a trustee – not for a bank operating as trustee.

45. Self-Directed IRAs • Represents largest dollar volume of retirement accounts and growing w/ baby boomer rollovers from qualified plans. • Covered the issues previously.

46. FDIC Trust Report Format • Undefined Report Format • Fewer separate cover trust reports. • Trust report likely embedded within S&S report. • Written report may contain minimal details. • Best information will come from the management exit meeting.

47. FDIC Trust Contacts • Atlanta– Jeff Perry 678-916-2212 • AL, FL, GA, NC, SC, VA, WV • Chicago– Joe List 312-382-7532 • IL, IN, KY, MI, OH, WI • Dallas/Memphis– M. Dale Martin972-761-2046 • TX, NM, CO, LA, MS, OK, AR, TN • Kansas City– Carla Walter-Clifton 816-234-8085 • MO, KS, IA, NE, MN, SD & ND • New York/Boston • Walter Fluhr or Rich Cinquina917-320-2522 • NY, PA, DE, MD • Marcia Clevenger781-794-5520 • MA, NH, VT, RI, CT, ME • San Francisco– Diana Brannon 503-598-0835 x4530 • CA, OR, WA, UT, AZ, NV, MT, ID, WY, AL & HI