Alternative Investments: An Investment Dream – A Planning Nightmare

Mar 10, 2020 | Art & Alternative Assets, Business Planning, General Estate Planning, IRS / Tax Guidance, Podcasts, T&E Administration

“Alternative Investments: An Investment Dream – A Planning Nightmare,” that’s the subject of today’s ACTEC Trust and Estates Talk.

Transcript/Show Notes

This is Connie Tromble Eyster, ACTEC Fellow from Boulder, Colorado. This program explains the characteristics of alternative investments, the risks associated with them, and how the risks can be addressed in the estate planning process. To give us more information on this topic, you will be hearing today from ACTEC Fellows Dave Blickenstaff from Chicago, Mark Parthemer of Palm Beach, Florida, and Robert Weylandt of Houston. Dave, Mark, and Robert, welcome.


What do we mean by alternative investments? Essentially, what we are talking about is any investment outside the traditional investment classes of stocks, bonds, cash, and cash equivalents. Most commonly, what we are talking about when we talk about alternative investments are private equity funds and hedge funds. The investment thesis behind alternative investments is that they provide full portfolio diversification, enhanced returns, and moderation of volatility. Therefore, when you are working with high-net-worth individuals, you should expect that their investment portfolio is going to consist of some portion of hedge funds or private equity or other forms of alternative investments.

Additionally, when we’re talking about the fiduciary account, we all know that the Uniform Prudent Investor Act has underlying it, the Modern Portfolio Theory (MPT), which says that you evaluate the investment performance not based upon any single asset but on the performance of the portfolio as a whole. Therefore, a fiduciary has two main obligations or objectives, and that is proper asset allocation and diversification within the portfolio, including hedge funds and private equity. Therefore, as estate planners, it is important for us to understand the concepts around alternative investments, and most importantly, where the entities that we create for our clients are going to be eligible to invest in alternative investments. That doesn’t mean we have to be securities laws experts, but merely to have a good, broad understanding so that we can spot issues and be aware of potential pitfalls that we may fall into.

Federal Securities Laws

For the purposes of our conversation today, we are going to focus specifically on the federal securities laws and not on the state Blue Sky Laws. When we talk about the federal laws, there are really four acts that become relevant: The Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and then finally, the Hart-Scott-Rodino Antitrust Improvements Act. The three securities acts were intended to protect the investing public not by regulating the security themselves, but by regulating the information that’s required to be disclosed with respect to the security. The theory behind that is that if we provide the public with enough information to make educated decisions, then they are fully protected in their investment decisions.

The 40 Act regulates the organization and activities of what are referred to as regulated or registered investment companies. Commonly, you will see this as mutual funds, exchange traded funds, and real estate investment companies or REITs. The 33 Act imposes a certain securities registration process, and the 40 Act imposes a registration process for investment companies. However, both of those acts provided exemptions or safe harbor from the registration requirement. Under the 33 Act, the securities don’t have to be registered if the investors in the securities are only accredited investors. Similarly, the 40 Act provides an exception for registration if the investors in the securities of the investment company are offered only for sale to qualified purchasers. The requirements to be AI (Accredited Investor) and QP (Qualified Purchaser) are based upon two concepts: the level of the wealth and the sophistication of the person or entity making the investment decisions. Further, if an entity is involved, including trust, then you have to look at what is the purpose for the formation of that entity.

Under the 33 Act, there are eight categories of accredited investors, but for our purposes, only four, I think, are most important.

  • A bank serving as fiduciary, in a fiduciary capacity;
  • a public charity, corporation, partnership, or business trust with assets exceeding $5 million and not formed for the specific purpose of acquiring the securities;
  • trusts with assets in excess of $5 million, again, not formed for the purpose of acquiring the securities and whose investment decisions are made by a sophisticated person;
  • and finally, entities in which all equity owners are accredited investors under one or the other rules.

Interestingly, for purposes of a revocable trust, the grantors of the trust are considered to be equity owners in the entity or the trust.

Unfortunately, the categories of qualified purchaser are different than the categories for accredited investors, which makes for a complex maze that you have to work through to make sure that the investor is both an accredited investor and a qualified purchaser. There are four categories of qualified purchasers. For our purposes, the most important to focus on are:

  • Certain family owned companies, including trusts owning at least $5 million in investments;
  • trusts where all trustees or all grantors are themselves qualified persons; and
  • persons acting on behalf of the account of other qualified persons who are investing, on a discretionary basis, $25 million in assets or more.

One of the phrases that we heard as we went through those various categories is that the entity cannot be formed for the specific purpose of making the investment. So, what do we mean when we’re talking about that? Well, the SEC (U.S. Securities and Exchange Commission) has given us some guidance by indicating it’s a facts and circumstances test. In the moment, the factors that they focus on are centralized management, does the entity have centralized management; does the entity engage in activities other than the investment in the unregistered security; the relative percentage of that investment versus the overall capitalization of the entity; and the extent to which the equity owners and the entity participate in equity investments outside of the entity.

Estate Planning and Alternative Investments

So how does this apply in the situation of estate planning? Well, for revocable trusts, which we see pretty commonly, the test, typically, if you think about the three concepts that we have talked about before, is more than $5 million worth of investments. For most of our clients, if they form a rev trust and they are going to hold the majority of their wealth, that’s probably not an issue. The second question is, is the trust directed by a sophisticated person? Again, if the individual would have qualified as an accredited investor or a qualified person and they are serving as trustee, that is also not going to be an issue.

Then finally, for the purposes of forming the trust, we all know that we form revocable trusts for many purposes beyond just making an investment; so that shouldn’t be an issue. But if you flip over to the context of an irrevocable trust, the test becomes slightly different. Again, if you start with the amount of the investments, if it is a small trust, that is, less than $5 million in investments, it can only qualify as an accredited investor if it has a financial institution. If the trust has more than $5 million in investment assets, then you can have either a sophisticated person as an individual trustee or a bank, provided that the trust has at least two related person beneficiaries, and it was not formed for the purpose of making the investment. So that’s just a brief overview of the requirements for accredited investor and qualified purchasers.

Additional Statutes

Thank you, Bob. It’s important to recognize the primary statutes are the 33, 34 and the 40 Acts. But there are some additional statutes that come into play in the intersection of estate planning and alternative assets. I am going to refer to a few of those, and really five in particular. First, the Hart-Scott-Rodino Act, which is a premerger notification structure that’s in place. And you think, “Well, how does a premerger notification and an antitrust type law apply in the estate planning world?” Well, there are exemptions for the funding of an irrevocable trust. There is an exemption for a gift. There is an exemption for funding an entity such as an LLC or FLP. On the other hand, there are not exemptions for distributions out of trusts or distributions out of entities, and they can be ensnared.

So Hart-Scott-Rodino requires that if there is a three-prong test that is met, the businesses affect US commerce, prong one; prong two, they are of a certain size and that’s based on a measurement of the acquiring and acquired parties, but it is deemed met if the transaction is in excess of $359,900,000. Otherwise, one party needs to have $180 million in assets or revenue and the other party $18 million. The third prong of the test is the size of the transaction where the acquirer ends up with at least $90 million of assets. This is not a statute to be ignored. We often think it may not apply, but it is painful not just as the filing fee — substantial can be as high as $280,000 — the penalty for noncompliance is quite severe. It is indexed every year. This year it is $41,484 per day, which is about a $15 million annual clip. Distribution out of a trust that goes unreported and not really recognized until a year or two later when the gift tax return is being filed, could trigger severe penalties.

A second statute that could be impacted through traditional estate planning strategies or control share statutes. About half of the states in the United States have an anti-hostile takeover statute in place referred to as a control share statute, and these statutes have the implication, when triggered, of not only eliminating voting rights of the shares of stocks of an issuing public corporation, but they also provide a redemption opportunity where the corporation can call the shares and those calls typically are done at well below fair market value. The concept here is that if the transfer of voting shares of an issuing public corporation is done in such a manner that the control would be shifted, then the control share statute will be impacted.

There are a few states that exempt some estate planning strategies. I think Pennsylvania, we’re here in Philadelphia, is probably the most embracing of estate planning strategies. But if not, we need to pay attention to this because we may go about just simply trying to make a sale or a gift into a grantor trust and, lo and behold, your client is going to get a letter from General Counsel saying, “Thank you very much; your shares no longer have a voting right, and we are going to pay you pennies on the dollar for those shares.” And, that’s a problem.

A third statute that can apply is Regulation U, set up by the Federal Reserve Board. Reg U applies to loans that are based on margin stock. Since 1974, there’s been a cap where the government’s trying to avoid a situation where individuals over-borrow against publicly traded securities, and they limit margin against publicly traded securities at 50 percent. You may have a client who is engaging in a sale to a grantor trust and the client decides that since the trust is going to pay in part, at least, with a note that your client wants secured in that note and so they want the security interest in the securities, and that is going to create a potential Reg U application. One thinks, “Well, wait a minute, I am not a bank. Why would this apply to us?” Well, Reg U not just covers commercial banks, but also non-banks. Thus, an individual or a trust could trigger a Reg U filing, and while there is a penalty for noncompliance, the bigger issue for most of our clients is the fact that if one is forced to comply with Reg U, there is a public disclosure of the balance sheet and so financial information is put out in the general public, something that our clients typically want avoided.

A fourth aspect, and this is a “Congratulations, the Federal Government has deputized each of us in the fight against terrorism.” So the Bank Secrecy Act of 1970 was expanded by the USA Patriot Act to include anti-money laundering, so the Bank Secrecy Act, we often refer to it as BSA, now includes AML, anti-money laundering, and it applies not just to banks, but all financial institutions. And, the Financial Crimes Enforcement Network broadly defines financial institutions to include those in the money service business such as attorneys. Interestingly, under BSA is that you are geographically specific and certain regions of the country have higher scrutiny that applies than others. New York, New Jersey, South Florida, all have higher security than most of the, say, Midwestern states.

What it Means to Estate Planners

What this means is that there is both know your customer (KYC) and customer due diligence (CDD) that applies. The institutions, in order to open an account, are going to have to get a lot of information. This is not a marketing or a phishing expedition by the banks. They are simply following the federal mandate to get this information, and they also need to figure out and determine the level of funding of accounts as well as the anticipated activity.

Where we will see problems in this could be, for example, when the settlor of a revocable trust starts to lose capacity, the management of the trust is shifted to a family member, and now, in addition to that, you are finding that the expenses and the volume of activity inside the rev trust is now changed because there are lots of medical expenses and other things. So, the bank is going to be monitoring the account and, all of a sudden, recognize that the account activity is different than what was anticipated. They are going to reach out to the decision maker on the account and if they don’t get the requisite information, they are very likely going to have to file a Suspicious Activity Report (SAR) with the Department of Justice, or IRS, or other law enforcement agencies; and among some of the remedies will be the closure of that account. So it’s important that we advise our clients that if there is a shift and the bank is asking for information about the account, that we cooperate, because failure to do so could have just a draconian impact of the account being shut down and a SAR being filed.

Finally, I would like to just mention that the use of alternatives in IRAs is something that is growing in self-directed IRAs. We have $8.4 trillion in IRAs these days, and so asset allocation, including alternatives, is important. There is a labyrinth of qualifications that we need to ensure that it is a valid investment, and we need to ensure that there is not a prohibited transaction. The result of either of these can be painful to clients. If it is an invalid investment, for example, that investment will be deemed distributed and if there is a prohibitive transaction, then the entire IRA will be deemed to have been distributed as of January 1st of that year.

Alternative Investments and Litigation

Thank you, Mark. I am a fiduciary litigator and I am going to focus on how alternatives are challenged and can raise risk issues for fiduciaries down the road. They would obviously help returns, improve returns, and reduce investment risk, but they can increase fiduciary risk. When you are talking about something other than the publicly traded stock or a bond or cash, you are talking about assets that are less familiar to your judges, your juries, the people who are going to assess your conduct and also less familiar to your beneficiaries, and also less familiar to your fiduciaries in many cases. The folks in the room with me at the moment are experts and do this every day, but lots of fiduciaries don’t have that luxury. Alternatives tend to be more difficult to handle for many of the reasons that you have already heard, and those apply to the investments that have been discussed as well as the wide variety of other alternative investments as well, real estate, art, LLP, or LLC interests and the like; all of which are more difficult to manage for a fiduciary.

Some of the issues that arise, there may be conflicts because the fiduciary may have a personal interest in the asset or it may be a closely held business where some family member works and some others don’t, and that may ruffle people’s feathers. You may have a significant expertise problem. These are complicated questions, as you have heard from Bob and Mark. Do you know enough to make this investment, to understand what the investment is, and the rules that you have to follow? Are you able to examine it all, and do you have that expertise in-house? These investments sometimes require a significant upfront investment. In other words, you have to pay a fair amount of money to buy in, so it could be a significant portion of your portfolio, depending on the size of your trust. You could be putting a lot at risk, and there are transaction costs associated with these investments because you have to evaluate them, sometimes with the help of lawyers.

There are liquidity problems, potentially, once you are in an alternative investment. It is not like a publicly traded stock where you can exit at any time. It may be hard to get out. You may not be able to sell for years. You may be able to sell only to certain people, and if you have to distribute your trust on a termination, or if you are severing your trust into shares, you may not be able to divide the alternative investment in the way that you would like. It may be something that’s restricted to a whole package that you can’t split up. There are potentially control issues, lots of alternative investments you may have an interest in but somebody else may be calling the shots, and that leads to a transparency issue. You may not be able to get the information that you need about the investment. I am imagining a closely held enterprise where somebody else is running the show, the trust owns a minority interest and they may not be giving you the information that you may be entitled to. But, if you are not going to sue them, you may not see that information. So how are you valuing that asset? How are you monitoring its performance? How are you reporting out to your beneficiaries about it?

In practice, alternatives are often handled by delegating to someone with expertise if the trustee lacks that expertise, or by giving someone else the power to direct, again, hopefully someone with expertise. That can improve the administration and reduce the risk for the primary fiduciary. But it is not a panacea. If you delegate, you still need to be choosing the person to whom you are delegating carefully and with a fiduciary hat on, and then you have to monitor that person’s performance to make sure that they are doing what they should be doing. Directed trust structures are very common and often useful in reducing risk, but with any occasion on which we are dividing responsibility along various players, we are potentially leaving gaps about who is doing what and there can be a lack of clarity about that. If something goes wrong, you can be assured that the folks who are complaining will complain about everybody and try to bring everybody into the mix and there will be a dispute about who was supposed to do what.

Managing Risk

What do we do to manage all these risks? To break it down into a drafting process versus administration, and I actually think the administration is probably the more important of the two. Drafting wise, if the settlor of the instrument is okay with a conflict of interest and, as I said, lots of alternatives involve conflicts, say so in the instrument to relieve that burden. The same with the concentration. A lot of trusts are starting with a concentration because there is a closely held business that has created the family wealth. If it is okay to hold that, if the settlor is okay with that, make sure that that’s clear in the trust instrument. Because these alternative investments tend to be more difficult for the fiduciary to manage, consider including exculpation or exoneration language, language that lowers the burden for the fiduciary by making them liable only on a limited basis. So, that might look like a good faith type of standard or an anything but gross negligence kind of standard, something that relieves them from some of their responsibility, to give them some flexibility, and especially to protect them if challenged.

If you do use a directed trust structure, be sure to select somebody as your directing party, who has expertise, the kind of expertise that you need, and be as clear as you can about the roles and responsibilities as between the directing party and the directed trustee. Statutes often help with that, but you can be clear in your instrument as well. Then finally, on the administration side, I mentioned, to me this is the more important of the two, drafting, if you haven’t done it, often you can amend, you can decant, you can modify, but the administration process is something you have got to be on top of at all times. If you are the fiduciary, the process that you follow is your best friend. You have to do that carefully. If you do do it carefully, you can stand behind it. You are not the guarantor of the investment’s performance, but you are the guarantor of the process that was followed to get into that investment and to monitor it along the way.

So you want to make sure that you are evaluating that investment carefully; that you have got the right people, who know what they are looking at, involved in that process; that you are aware of any conflicts that may exist; that you are looking at restrictions on liquidity, on control restrictions, on information restrictions that may affect that investment; and if you can communicate with your beneficiaries about what you are doing and why, that’s always helpful. It makes them feel a little better about what’s going on, and it makes it harder for them to complain later if something goes awry. They at least knew what you were doing and presumably were okay with it. So, bottom line, alternatives have real benefits and have all kinds of investment advantages, but they are harder for judges and juries and beneficiaries to understand. They are easier for fiduciaries to screw up, so be careful out there.

Mark, Bob and Dave, we so appreciate your willingness to share your knowledge with us on this complicated and interesting topic.

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