Why the Trustee and the Investment Advisor Should Be Different Institutions
When someone at a registered investment advisory firm serves as trustee of a client's trust, the firm has custody of that client's assets. A directed trust puts the two roles where they belong.
Registered investment advisers increasingly want to offer trust services, and lawyers at firms that also run an advisory business are often asked to serve as trustee of a client's trust. The instinct is understandable: the family trusts the people it already works with. But the Securities and Exchange Commission's position is clear, and it is not aimed at any one firm. Once a firm is registered as an investment adviser, anyone at the firm who serves as trustee of a client's trust gives the firm custody of that client's assets, and custody brings a compliance burden that most advisory firms are not built to carry.
The answer is not to give up either line of business. It is to put the two roles in two different institutions, which is exactly what a directed trust is designed to do.
Why the two roles cannot sit together
The custody rule under the Investment Advisers Act lists trustee of a trust among the capacities that give an adviser custody.1 A supervised person's trusteeship is imputed to the firm, and the only exception is for a trustee appointed because of a family or personal relationship with the grantor or a beneficiary. The SEC staff has said that a relationship built through years of professional service does not qualify, which leaves no room for an attorney-client or adviser-client relationship. With custody come a qualified custodian, quarterly statements sent by the custodian directly to the client, and an annual surprise examination by an independent public accountant.
There is a trust law problem as well. A trustee that hires its own affiliate as investment adviser and sets that adviser's fee is on both sides of the transaction. That runs against the trustee's duty of loyalty and the adviser's own fiduciary duty to disclose and manage conflicts.
The structure that solves it
A directed trust splits the fiduciary job into parts and assigns each to the party best suited to it.
- A trust company serves as trustee and holds the assets. A state-chartered trust company supervised by a state banking regulator is a qualified custodian under the Advisers Act.
- The advisory firm is named in the trust agreement as investment trust advisor and directs the investments, earning its advisory fee on the trust assets. Because the firm's only access to the assets is the authority to have its fee deducted, it does not need a surprise examination.
- Distribution decisions sit with the trustee, a family member or an independent distribution advisor, and stay off the advisory firm's personnel. Authority to send a client's money to third parties is custody.
- A trust protector, who may be an attorney at the firm so long as that attorney is not an adviser representative, can remove and replace the trustee, change situs and correct administrative terms, but holds no distribution powers and no power to appoint the protector or the advisory firm as trustee.
- Counsel designs the plan, drafts the documents and remains the family's lawyer.
Why the trust law matters
Not every state's directed trust statute does the same work. Some protect a directed trustee only where the trustee has not acted in bad faith or with reckless indifference, which leaves the trustee with a residual duty to watch what the advisor does. South Dakota relieves the directed trustee of any duty to monitor the advisor and puts a clear and convincing burden on anyone who claims otherwise.2 That difference is what allows a trust company to accept the directed role at a directed trustee's price rather than a full trustee's price.
For a nongrantor trust there is a second reason to look at the statute. Several states treat a trust as a resident trust, and tax all of its income, if any fiduciary lives in the state, and some define fiduciary broadly enough to reach an investment advisor. The advisor's status needs attention in the drafting so that the trust does not become a resident trust of a high tax state by accident.
Existing trusts
Where an attorney at an advisory firm already serves as trustee of an advisory client's trust, the cure is orderly: the attorney resigns, the trust company is appointed, and the situs moves under the instrument, a trust protector, a decanting or a nonjudicial settlement agreement. The advisory firm keeps the account as investment trust advisor. For charitable remainder trusts, charitable lead trusts and GRATs, the trust company can serve as full trustee and engage the advisory firm as investment manager under a written delegation, with the firm's fee disclosed in the same way. Any firm adopting this structure should confirm it with its own compliance counsel against its custody policies.
Notes
Terry L. (T. L.) Turnipseed, J.D., LL.M., CTFA, is a tax, trust and estate attorney in Fort Lauderdale, Florida, and Head of Estate and Tax Planning at Alta Trust Company. He is a former tenured professor of law at Syracuse University. Reach him at tl@turnipseed.law or on LinkedIn. This article is general information, not legal advice.