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Examiners’ View: A Fiduciary’s Responsibilities for Unique and Special Assets
by Matthew E. Rowland, Senior Examiner, Federal Reserve Bank of Kansas City, and Erin F. Connelly, Senior Examiner, Federal Reserve Bank of Philadelphia

More than 800 community banks exercise fiduciary powers in the United States; this does not include nondepository trust companies also exercising these powers. As fiduciaries, these organizations have a duty to manage assets in the best interests of their clients, including account beneficiaries (current and remaindermen).

Often a client brings into the fiduciary relationship unique and special assets, such as real estate (e.g., residential, farm, and commercial), closely held businesses (e.g., nonpublicly traded stocks and family businesses), mineral interests (e.g., oil, gas, and coal), commodities (e.g., timber and cattle), insurance products (e.g., policies and annuities), collectibles (e.g., artwork, stamps, and jewelry), promissory notes, and tangible assets (e.g., household goods and vehicles). These assets are held in any number of managed and nonmanaged accounts, including irrevocable and revocable trusts, individual retirement accounts, directed accounts, and irrevocable life insurance trusts.

Unique and special assets present particular challenges to the fiduciaries acting as the administrators and asset managers for these accounts. For example, unique and special assets are difficult to value because they are not traded on a financial market and, therefore, do not have readily determinable market values compared with more traditional assets, such as stocks and bonds. This article identifies the challenges and risks of retaining unique and special assets in fiduciary accounts and suggests practices to mitigate these risks.

Challenges with Administering Unique and Special Assets

The first and foremost challenge fiduciaries may face is that the retention of unique and special assets may not align with the organization’s basic fiduciary duties, such as return maximization or loyalty to the current beneficiaries and remaindermen. For example, in many instances, grantors will direct a fiduciary to retain a unique and special asset in an account to ensure the asset, such as farm property, closely held businesses, or collectibles, remains within a family. However, these assets may not provide an appropriate investment return for the account. Similarly, grantors may request that the fiduciary maintain insurance policies in a trust account to provide financial support for family members in the future. Because the intent of the insurance policy is to provide for a possible future event, this type of asset may not provide an appropriate return to an account. In addition, the fiduciary’s ability to transfer these assets outside of the trust account is limited because the governing documents require retention even if a fiduciary is of the opinion that an asset should not be retained. Therefore, fiduciaries should make every effort to obtain a retention letter from interested parties that provides specific direction to the fiduciary for the continued retention of the unique and special asset. While not a complete line of defense, the existence of retention letters, which should be renewed periodically, ensures that clients and beneficiaries are aware of and understand the risks associated with retaining a unique and special asset in an account.

Another potential challenge with retaining unique and special assets in accounts is the risk that a fiduciary will not be able to adhere to the prudent investor rule, which, in part, requires fiduciaries to diversify an account’s investments. When a unique and special asset represents a significant portion of the account’s holdings, the account will not be diversified. As a result, the administration of such an account could be criticized if a fiduciary does not appropriately document the permissibility of the holding and conduct appropriate periodic account reviews.

Risks Posed by Individual Unique and Special Assets

Unique and special assets may pose risks to an account that must be managed by the fiduciary. For example, real estate, mineral interests, and timberland pose environmental risks. Therefore, these types of assets may require studies to ensure environmental factors do not contribute to a decline in the value of the asset. The fiduciary must also manage the reverse and ensure that an asset does not cause environmental harm that may expose the account to liability, resulting in remediating damages. In certain instances, such as in the management of working mineral interests, the fiduciary can obtain environmental liability insurance for the account to protect against the risk of an asset causing harm to the environment.

Certain unique and special assets may require special safekeeping procedures for fiduciaries to guard against deterioration in the asset’s value or theft. For example, personal items must be held under dual control to prevent one party from misappropriating the asset. Certain assets, such as artworks or collectibles, may require temperature-controlled storage facilities to preserve their condition. In addition, for tangible assets that are physically held outside of the organization’s premises, the fiduciary must conduct periodic visits to confirm the asset’s condition and to reassess its value.

Other unique and special assets held in fiduciary accounts, such as closely held businesses, have limited marketability. Given that these interests tend to be held among a few individuals, the ability to liquidate such an interest is limited, especially for a minority interest or if contentious situations arise. In addition, with a closely held business, the fiduciary is required to complete financial evaluations periodically to assess the appropriateness of retaining the asset given the account’s overall investment objective. Also, depending on the percentage of the business that is held in the account, the fiduciary may have to attend the company’s board meetings or appoint an officer of the trust department or trust company as a voting member to the board of the closely held company to protect the interest of the trust. The fiduciary’s policies on the management of unique and special assets held in accounts should address the level of its participation in the management of closely held companies.

Additional Risks to Consider

Unique and special assets can also increase the fiduciary’s operational, legal, and reputational risks. Operational risk is increased because the organization will have to retain staff who have the specialized expertise necessary to administer and manage unique and special assets, which may require the completion of asset evaluations, financial analyses, or industry certifications. The fiduciary or a third party should perform regular asset valuations to confirm the value of an account’s assets and assist with the regulatory reporting of asset values. Further, fiduciaries should implement appropriate safeguards to preserve and protect an account’s assets.

The organization’s legal risk increases since it must comply with all fiduciary duties and laws as well as with an account’s governing documents that outline the procedures for administering unique and special assets. Any deviation from legal obligations places a fiduciary at risk for potential liability if challenged by an account holder, beneficiary, or remainderman. As a result, an organization’s legal fees can increase quickly when an organization has to defend itself from actual or potential claims of mismanagement.

Mismanagement of an account, including an account with unique and special assets, can negatively impact an organization’s reputation. Therefore, the ability of staff to appropriately manage and administer these assets is essential to the organization’s reputation, and failure to do so may result in the loss of current and potential clients and referrals. The organization’s reputation is also at risk if a third party retained by the organization to oversee the assets fails to exercise its duties in accordance with the appropriate standards of care.

Examiners' Expectations of a Fiduciary's Administration of Unique and Special Assets

During fiduciary examinations, examiners will review a fiduciary’s oversight of unique and special assets.¹ The examiners will rely on the board of directors, which is ultimately responsible for the oversight of the organization’s fiduciary activities, to address the challenges of administering and managing unique and special assets by implementing policies that require appropriate internal controls and risk management practices. Risk management practices should generally align with the value, number, and types of unique and special assets that the fiduciary manages and administers for its clients. For example, risk management efforts may include reporting to the appropriate committee and/or board of directors, completing internal audit reviews of accounts holding unique and special assets, and reviewing these assets during initial and periodic account review processes.

Policies and Procedures

Policies and procedures should define the extent to which a fiduciary will accept unique and special assets in an account. Further, administrative practices and documentation standards should be defined within the policies and/or procedures. At a minimum, appropriate policies and procedures should:

• assign a board or senior management committee with the oversight responsibility for unique and special assets, whether as part of the review processes or otherwise;
• identify the types of assets that the fiduciary will or will not accept;
• establish account acceptance standards when unique and special assets are involved;
• require that these assets align with the fiduciary’s investment policy standards;
• require insurance policies for certain assets;
• outline the frequency and methods for obtaining asset valuations; and
• identify how these assets are included in the fiduciary’s administrative and investment reviews.

Pre-acceptance Reviews

The fiduciary should ensure that the pre-acceptance account review process includes an evaluation of the unique and special assets in order to understand the nature, risks, and condition of these assets. For example, the pre-acceptance review process for real estate assets may include environmental inspections to identify potential risks. During the pre-acceptance review, the fiduciary is expected to review the account’s governing instrument to understand any explicit responsibilities and expectations for retaining a unique or special asset as well as to determine whether the fiduciary has the appropriate expertise to administer and manage the asset. The pre-acceptance review should clearly document the reasons for retention of any unique or special asset in the account.

A pre-acceptance review also identifies any potential risks associated with administering the specific asset. During the pre-acceptance review, a fiduciary has the opportunity to accept or decline the asset and/or account as well as to adjust the fees appropriately to reflect the risks associated with managing the account. For example, the risks associated with holding mineral interests in a fiduciary account differ depending on whether the asset is a royalty interest or a working mineral interest. In the former, the fiduciary is simply collecting payments, while in the latter the fiduciary has additional duties, including obtaining environmental insurance, performing physical inspections, and monitoring the operating agreement.

During examinations, examiners will evaluate whether the retention of a unique or special asset complies with the fiduciary’s established policies and procedures as well as the account’s governing instrument. Further, examiners will verify that the account file contains all documentation to support a fiduciary’s decisions and actions in administering and managing the asset.

Expertise for Ongoing Management and Administration

A fiduciary should retain experienced and knowledgeable staff to administer and manage accounts with unique and special assets. These individuals should have the knowledge and experience to manage a particular asset as well as the industry expertise for that asset. For example, account officers may be required to negotiate lease terms for mineral or gas assets, complete financial analyses for closely held businesses, or conduct periodic inspections of real estate properties. In certain instances, the individual may have to maintain an industry certification to demonstrate this expertise. Industry certification programs also provide employees with educational and training opportunities to stay abreast of industry developments and asset management practices.

When a fiduciary recognizes additional experience is needed, the fiduciary may engage a qualified third-party service provider that possesses the expertise to assist with certain responsibilities and roles. As with any outsourcing or third-party arrangement, an organization needs to comply with supervisory guidance for the monitoring and periodic review of the relationship.²

Account Review Processes

Unique and special assets should be evaluated during the initial and periodic reviews of fiduciary accounts, including investment and administrative reviews. Any fiduciary account, whether with traditional or unique assets, must have an established investment objective. In some cases, the retention of unique or special assets may go against the account’s established investment objective. In these situations, the fiduciary needs to consider how to retain the asset(s) and still meet the investment objective. Therefore, during the annual investment review, a fiduciary needs to document the reasons for the continued retention of the unique and special asset.

Administrative reviews should consider the fiduciary’s handling of the asset in the account and evaluate any concerns relating to the asset. The account review process should be customized to the type of asset involved and may include:

• On-site visitations of real estate, mineral interests, or other tangible items. Visitations allow a fiduciary to confirm an asset’s existence and to evaluate any deferred maintenance or damage.
• Valuations. The nature and scope of valuations vary depending on the asset type. Valuations determine the market values for assets held, which in turn affect the account’s asset value and the fiduciary’s account management fees. Valuations should be obtained periodically to ensure values remain current and useful.
• Evaluations of insurance companies when an account holds an insurance product. These reviews evaluate the insurance company’s continued viability and financial condition and also confirm that the policy is still in place, coverage is adequate, and the account’s policy premium is paid on time.

During an examination, examiners will assess the initial and annual account review processes, including whether unique or special assets are considered. Examiners will evaluate how unique or special assets within an account are considered during periodic administrative reviews and annual investment reviews. These account reviews should highlight, among other areas, the existence of the assets, actions taken with respect to the assets, any changes in the condition and value of the assets, client discussions about the account’s holdings, and confirmation of continued asset retention.

Internal Controls and Safekeeping

The organization’s board of directors should adopt policies that require management to implement internal controls to ensure the safekeeping of unique and special assets. Assets held by the fiduciary should be properly safeguarded to prevent loss and damage by segregating administrative duties and requiring dual control over assets.

During examinations, examiners will evaluate vault procedures and assets maintained therein as well as review the results from the organization’s own vault audits. Also, examiners will review operational functions to determine the existence of segregation of duties.

Conclusion

The administration and management of unique and special assets are common activities in most institutions with trust and fiduciary powers. However, fiduciaries should understand that administering and managing these assets entail greater risks. Accordingly, these institutions should invest in the necessary staff resources and implement the appropriate risk management practices to mitigate the risks. During examinations, examiners will review all account assets, including unique and special assets, to ensure they are being appropriately administered and managed.