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dogsml.jpg (3902 bytes)Common trust fund – what animal is this?

(Article published in the June 18, 2001 issue of TODAY, Business Section)

Before anyone could take notice, the tail started wagging the dog and then proceeded to become the dog. Presently it is beginning to look like a wolf and the leaders of the trust industry and their regulators are frantically seeking to tame it. That, in short, is the story of common trust funds in the Philippines.

The revered rule is that a trustee cannot commingle funds held in trust with his own funds nor with funds of other trusts. "The trust business and all funds, properties or securities received by any trust entity", says Section 87 of R.A. No. 8791, "shall be kept separate and distinct from the general business including all other funds, properties, and assets of such trust entity".

The rationale for the rule dates back to old common law and is founded on the idea that trust is impressed on specific properties. Beneficiaries of trusts should be able to point to the court exactly what items they claim are held by the trustee in their behalf. If beneficiaries cannot point to the specific items over which they claim beneficial ownership, all they have is a right of enforcement against the person of the trustee, just like a clean creditor’s claim on a debtor’s assets in general.

Strict legal theory, however, has always been vulnerable to economic realities. When, in the United States, administering trusts became a lucrative trade rather than, as was in England, an honorary and gratuitous service, commercial trustees were able to convince the lawmakers to allow them to commingle trust funds, primarily the small ones, for investment purposes. This resulted in a win-win situation. Beneficiaries of small trusts enjoyed the otherwise unattainable advantage of diversification. Corporate trustees reduced the cost of administration and benefited from the economies of scale.

In the Philippines, common trust funds started as ad hoc commingling of idle funds put together to comply with the minimum lot requirements of a money market placement while waiting for a suitable investment in the stock market.

Sporadic attempts at more permanent commingling, thus taking the form of a fund, were made mostly in the area of tax-exempt retirement funds, primarily to skirt the issue of whether the fund is a taxable corporation within the meaning of the Tax Code, and in the glorious days of the Far East Bank and Trust Company’s trust department, which was busy managing portfolios while the rest of the trust industry was administering real estate properties.

For the most part, however, a common trust fund was essentially an auxiliary service to maximize the earnings of odd funds here and there of corporations and the individuals who had other substantial funds invested with the bank.

The legal quantum leap came in the 80s. On January 16, 1981, Presidential Decree No. 1828 permitted trust departments to establish and manage common trust funds in accordance with the rules of the then Central Bank. Coupled with the imposition of a final tax on the yield of trust funds (a byproduct of a dubious compromise between the need to collect taxes and the secrecy of bank deposits), participation in common trust funds became a financial product in itself.

In no time, the common trust fund became the bank’s preferred vehicle for investing other people’s money. Funds then spilled out of the money market which was plagued by the scarcity of good commercial papers due to what were perceived as stringent (but definitely necessary) registration requirements imposed by the SEC. Like water, common trust fund money flowed to the area of least resistance, corporate loans. For officials of corporate banking departments, common trust funds began to be new way of sourcing money from the public to fund their lending commitments than deposits and deposit-substitutes, which were subject to reserves.

As early as 1989, the regulators saw with alarm the steady growth of trust accounts, dominated by common trust funds, outpacing the increase in deposits and deposit-substitutes. More and more funds, therefore, were effectively going into banking, i.e. borrowing from savers for lending to users. Meanwhile, the need of the users, usually long term, remain unmet because of the usually short term availability of funds from savers. In horror, the monetary authorities saw huge funds serving the function of deposits from the public outside the prudential restrictions of reserves and ratios imposed on bank funds.

It is a law of nature that when a regulator sees something that walks like a duck and quacks like a duck, he will shoot it like a duck. In rapid volleys of fire, the Central Bank imposed DOSRI requirements on trust operations, which were primarily crafted to restrict a bank owner from lending to himself. A 15-percent limit, based on the market value of a common trust fund, was imposed on its exposure to a single issuer, akin to the Bank’s dreaded Single Borrower’s Limit. And a whole slew of reserves, liquidity reserves, loan loss reserves, on top of the bond for the faithful performance of trust duties, were also required.

To some of us, like the venerable Larry Jocson, trust officer of Prudential Bank and President of Trust Institute Foundation of the Philippines, who could still remember institutions like Bancom, Congeneric, Filcapital, and recognize names like Dewey Dee, the common trust fund looked like a dead duck.

But, to use what is by now Mark Twain’s very tired quip, the news of the common trust fund’s demise was a bit exaggerated. Instead of keeling over, common trust funds continued to fiercely dominate trust investments. And in April 2000, URCOIN, the common trust fund operated by Urbancorp Investments Inc., turned around and killed its mother, Urban Bank, Inc. At the bidding of Teodoro C. Borlongan, URCOIN violated almost all prudential rules of trust operations and dumped on Urban Bank billions of receivables, at prices unacceptable and terms unconscienable, had the transactions been conducted at arms length. Details of this wanton rampage are laid out in court cases filed against Urban Bank officials.

Leaders of the trust industry and their regulators are currently engaged in efforts to tame the beast. At the Trust Officers Association of the Philippines’ annual convention, held at Fontana during the first weekend of June, significant measures, such as marking to market common trust fund investments, were presented and discussed. The reforms deliberated on are in the right direction, but the industry and the central bank should realize that time is not on their side.

A drastic approach, perhaps an out-of-the-box strategy, is needed to ensure that "trust" remains the focus and stands out larger than "common" or "fund". The country cannot afford another URCOIN debacle.