Custody Issues for Advisers as Trustees

Since we've been having such a rip-roaring good time discussing custody issues, let's keep bringing up points made in NASAA's page-turner of a model rule. Often the trustee of a trust is an investment adviser and not just the trust department of a bank & trust company. Investment advisers like to get paid, and it's convenient to be paid directly by the custodian of the securities account. If the adviser can appropriate/receive his fees from the custodian, the adviser does have custody. But, the adviser can avoid the higher financial requirements and the CPA surprise audit if they follow certain safeguards. To avoid those requirements, the adviser must indicate on Form ADV that it does or may have custody. The adviser needs the written authorization of the grantor (if he's still alive) or the attorneys for the trust (if it's a testamentary trust, established upon death of the grantor), the co-trustee (other than the adviser or its employees or owners), or a beneficiary of the trust. The adviser needs to send a billing statement showing the asset values and the method used to compute the fee. And, the custodian has to agree to send at least quarterly to the attorneys/grantor/co-trustee/benefiary a statement of all disbursements from the account of the trust, including the amount of investment management fees paid to the investment adviser and the amount of trustees' fees paid to the trustee.
If all of these safeguards are taken, the adviser acting as trustee can receive advisory fees directly from the qualified custodian. The adviser would have custody but would have the minimum financial net worth/bonding requirement waived.

Types of Trusts

Here is a question very similar to what many of you will see on the Series 65 or Series 66:

What type of trust requires the trustee to distribute to beneficiaries immediately?

A. Simple

B. Complex

C. Irrevocable

D. Revocable

EXPLANATION: a simple trust distributes "DNI" (distributable net income) to the beneficiaries, while a complex trust can retain some of the income to build up the "corpus" or principal. The choices "irrevocable" and "revocable" have more to do with estate taxes and tax liabilities during the lifetime of the grantor.

ANSWER: a

Uniform Prudent Investor Act

Here is a question that looks very similar to something you might see on the Series 65 or 66:

According to the Uniform Prudent Investor Act, when may a trustee choose not to diversify the assets of the trust?
A. During a prolonged bear market for stocks
B. When choosing not to diversify best meets the needs of the beneficiaries
C. Under no circumstances
D. When the assets are 100% cash

Notice how a person who has not studied could easily talk himself into any of the four answers. Under no circumstances looks very tempting on a regulatory exam. Putting the assets all in cash seems pretty darned prudent, too. Hmm. Unfortunately, the Series 65/66 will pull sections out of various actual and model acts and expect candidates to be familiar with them. This question is pulling a section almost verbatim from the Uniform Prudent Investor Act, which states:

A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.

And that pretty well answers the practice question above, doesn't it? The answer, according to Section 3 of the Uniform Prudent Investor Act, is B, "When choosing not to diversify best meets the needs of the beneficiaries." As usual, the exam material seems to talk from both sides of its mouth. What it just told us is that a fiduciary/trustee should always diversify the assets of a trust, except when he shouldn't.

Oh well. That's what we're dealing with here on these exams. No need to get frustrated--we just have to deal with the exams on their own terms. Pass the test, and move on with your life.