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Two-Step Suitability Standard for UITFs

(Article published in the June 28, 2006 issue of Manila Standard Today)

Last week, at the risk of confirming my being a tempus laudator acti (literally translated, one who praises time gone by) and therefore one getting on in years, I suggested that anchoring our thinking on the historical genesis of the Unitized Investment Trust Fund (UITF) is key to achieving constructive coherence and consistency in current policy and practice relating to UITFs.  Conversely, not making the primary rationale for allowing UITFs at all will result, I submit, in an identity crisis of the UITF and make possible, if not provoke, a new wave of client withdrawals and regulatory counter measures  that, in conjunction, could eventually cause the UITF’s unwanted demise.

Today, let me show how insisting on using as platform the UITF’s original justification provides the strength and substance to what I surmise will be the inevitable incorporation in trust vocabulary of a current mantra in the mass marketing of financial instruments, namely, “suitability”.

I understand that, among other measures which the Bangko Sentral ng Pilipinas is considering, by way of response to the UITF meltdown last May, is the imposition on trust entities offering  UITFs to their clients of the obligation to conduct some sort of a so-called “suitability test”.  The idea is to require that before a trust entity proposes to a client participation in a specific UITF, it must first determine whether that UITF is a suitable to him. 

         Of course, I wholeheartedly agree with the suggestion. For, who can argue against making sure that investing in an UITF is suitable before putting any money in one?  “Suitability” is like the word “fitness”.  And, who can argue against being fit?

The problem, however, is that “suitable”, like “fitness”, is a relational word, i.e. it describes a situation of congruence, or appropriateness, or harmony between one thing to another.  Like being “fit”, being “suitable”, by itself, does not say what for.  Just to stress the obvious, it is precisely because fitness is so generic a concept that fitness centers espouse a whole range of activities and non-activities in one work day, ranging from Mua Thai to Meditation.  But not one proposes to guarantee that, after a time of faithfully spending time and money, you will actually fit into your old clothes.

The devil is in the details and it is important right at the very beginning to be very clear on what the suitability test will mean for UITFs.  On the one hand, it is reckless to dismiss the concept as simply a new dress for the old “Prudent Man Rule”. On the other, it is an exaggeration to think that it is going to be the final nail on the coffin of the trust industry’s foray in the investment market.

As presently understood, the “Suitability Test” is part of the whole slew of regulations that was ushered in by the Securities Regulation Code.  Rule No. 30.2, Item 4 in implementation of Section 30 of SRC.  It requires that “in recommending to a customer the purchase, sale or exchange of any security, a Broker Dealer or an associated person or salesman of a Broker Dealer shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts disclosed by such customer as to his other security holdings and as to his financial situation and needs.”  To ensure compliance, it is generally required that “prior to the execution of a transaction recommended to a customer, a Broker Dealer shall execute a customer account information form which complies with SRC Rule 52.1, paragraph 6.”

The obvious purpose of imposing the Suitability Test on broker dealers is to somehow mitigate the unforgiving impact of caveat emptor. It is a recognition that there might be a gap between the emptor’s ability to be aware of the dangers lurking in a security purchase and the vendor’s enthusiasm, undoubtedly driven by commissions in some form or another, to sell it.

It would be folly, I suggest, to incorporate  the Suitability Test found in SRC Rule 30.2, item 4, in UITF regulations by simply substituting “trust entity” for “broker dealer” and providing a counterpart listing of what ought to be contained in the customer account information sheet.  That, in my view, would not only be an exercise in uncritical thinking but also a confirmation that a UITF is no more and no less than a mutual fund.  As pointed out last week, the latter is erroneous.

 Because the UITF is primarily a facility for investing funds held in trust, I submit, that the Suitability Test, when applied to the marketing of UITFs, ought to have two standards.  First, the client must, independently of his being desirous, or not, of investing in a UITF, be shown to need a trust.  And second, the proper investment of the funds of that trust, among other trust administration imperatives, must suggests placing part or all of the funds in a UITF.

 The first standard is not as easy to meet as it seems.  There are trusts and there are trusts.  Because of its inherent flexibility, a trust can answer a myriad of needs and fulfill a variety of requirements, personal and corporate.  It takes a thorough understanding of a client’s financial and personal objectives,  present circumstances and future prospects, appetite or aversion to risk, to determine whether he in fact would benefit from a trust, and, if so, what particular type of trust.  To make a long story short, the conclusion that ought to give the go-signal to proceed to the second standard is “yes, this specific client would benefit substantially from this specific type of trust.” 

 The second standard, for its part, will require the trustee itself to make a determination (on its own if the trust is fully discretionary, or in consultation with the client, if directory or directional) of whether a particular UITF, with its pre-determined configuration of risk and reward features as laid out in the particular UITF’s declaration of trust, is suitable to the trust.

 This suitability of a UITF placement ought to consider not only the investment outlet profile of the trust but also the role that the trust is playing in meeting the needs of the client.  For instance, a savings-type trust that is set up by a young parent, primarily to receive small monthly contributions from his salary, for a new-born’s college education may obviously be invested in a UITF loaded with long-term instruments.  The aim is periodic capital accumulation and steady internal appreciation within a reasonably long time period.   However, some provision still needs to be made for unplanned eventualities that might require diversion, for the time being, of the funds to other uses, akin to the primary purpose.

 Human life being what it is, many things could happen, such as a sudden change in the parent’s career, like retrenchment resulting from his employer’s merger with a competitor, that could wreck havoc on his family cash-flow, or an unfortunate illness, to name only a few.   These occurences make it necessary to have the flexibility to use the funds sooner, such as for the child’s nursery tuition, than intended.  The trustee ought to take those too into consideration.

 Add to this already difficult scenario the constancy of change, even in normal circumstances, of living, and you have the need to apply the Suitability Test not just once, at the inception of the trust relationship and decision to invest in UITF, but from time to time at reasonable intervals.  Like the Know-your-client rule, the Suitability Test make it important to know the client not just at the beginning but also periodically thereafter during the lifetime of the trust relationship.

 The benefits of the enhancements of the Suitability Test I am proposing for UITFs, over that found in SRC Rule 30.2, item 4, are obvious.  Rigorous compliance with the first standard will ensure that there is a reasonably perfect fit between the client and the trust service that is being proposed.  Unflinching adherence to the second will cement the trust entity’s role as, to use a term from one of the late Jose B. Fernandez’s addresses to the trust industry, the client’s incorporated friend.  Together, the standards will make the trust entity a true fiduciary, i.e. someone in whom trust can be reposed.

 To those less receptive to my pedantic perorations, I propose for their contemplation the business way of my tailor, Boy Nalus of Naluzzi, who has mastered the art of marketing a very specialized product.  When you walk into his shop, and tell him you want a suit made, his first question is “what will you use it for?”  Only if he has your response and, with what he already knows of you, will he start to show you different materials and recommend a particular cut. After you have chosen, he takes your measurements, and proceeds to make you your specially custom-made suit.

 After you have received your suit, to your satisfaction, he leaves you alone to enjoy yourself.  But later on, he reminds you to drop by, preferably in the suit he made for you, and, in his gentle way, makes known if he thinks some alterations (or even an entirely new suit) is called for on account of some changes, particularly in your anatomy, like breadth and width, weight and girth.   That is how pardon the press, the Suitability Test should be applied to UITFs.

 Invariably, you get the satisfaction that you have a suit that is, well, suited to you.