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Banking Interpretations

NYSBL 96(1) and 100

New York State Banking Department
Memorandum

To: Deputy Superintendent Cofsky 
cc: A. Gottlieb
  C. Weintraub
From: Assistant Counsel Sullivan 
Date:

August 10, 2009 

Subject:

[---] - Ability of Trust Company to Acquire Special Interests in Investment Funds 

Issue

Whether a New York-chartered trust company ("Trust Company") may, pursuant to its investment management powers, establish investment funds (the "Funds") and acquire the special interests in those Funds (the "Special Interests") in the manner described below?

Answer

Yes, a Trust Company may establish the Funds and may acquire the Special Interests in such Funds under its authority to provide investment management services but only to the extent necessary to enable the Trust Company to offer investment management services in the same manner as its competitors.

Conditions

The acquisition of the Special Interests by the Trust Company should be subject to the condition that:

Background

[---] ("Advisors") is an investment adviser registered under the Investment Advisers Act. Advisors is seeking to broaden its services by establishing a New York-chartered trust company ("Trust Company"). It is contemplated that the investment management business of Advisors will be transferred to the Trust Company or a subsidiary thereof.

In connection with conducting such investment management business, the Trust Company will establish, or continue to maintain, one or more Funds. Such Funds will be exempt from registration under the Investment Company Act ("Company Act").1 The investors in the Funds ("Investors") will be clients of the Trust Company or its affiliates.2 The economic interest in the Funds -- the net income, gains and losses of the Funds -will be allocated to such Investors.  The Funds will be formed as limited partnerships or limited liability companies in order to achieve "pass-through" tax treatment -i.e., Federal income taxes will not be incurred at the level of the Fund but only at the level of each investor.3  The Investors will be limited partners if the Fund is established as a limited partnership or members if the Fund is established as a limited liability company.

The Trust Company or a subsidiary thereof will act as a discretionary investment manager to the Funds.4  In order to facilitate its management of each Fund, the Trust Company will hold a Special Interest in the Fund -a general partnership interest if the Fund is a limited partnership and a managing member interest if the Fund is a limited liability company. To insulate the bank from liability, the Trust Company will own an entity or entities with limited liability which, in turn, will own each such Special Interest.5 Each such limited liability entity will be wholly-owned by the Trust Company, and such entities will not be engaging in activities other than those in which the Trust Company could engage.  Accordingly, such entities will be wholly-owned operating subsidiaries of the Trust Company.

Each Special Interest will enable the Trust Company to control the Fund for all purposes. The Trust Company will be able to act by virtue of the status of its wholly-owned subsidiary as general partner or managing member. This structure will reduce the administrative burdens that would be present if the Funds were managed by the Trust Company on a contractual basis.

Each Special Interest will entail neither the Trust Company's making an investment in, nor its obtaining a direct economic interest in, a Fund.6  The Trust Company will not invest or contribute monies or assets to such a Fund. Further, the Trust Company will not purchase assets from a Fund nor extend credit to, or guarantee the obligations of, the Fund. Conversely, the Trust Company will not share in the income, gains, profits, losses or expenses of the Fund. Moreover, the Trust Company will not charge investment management or other fees to the Funds, but rather receive its compensation by charging fees to the Investors in the Funds. Advisors asserts that each Fund will pay its own expenses.7

Advisors points out that the structure of the Funds is necessary in order to compete with the products available from other investment managers. As noted above, the Funds will be either partnerships or limited liability companies so that the investors will receive pass­through tax treatment. If, e.g., a Fund were formed as a corporation, income would be taxed at the Fund level, and again, when distributed to the Investors. An entity which incurred such "double taxation" would not be competitive.

Because each Fund will be formed as a limited partnership or limited liability corporation, it will be necessary for the Fund to have either a general partner or member or members with authority to control the Fund ("Control Person").  Splitting the function of the Control Person from that of the investment manager of each Fund would entail having the Control Person contract with the Trust Company or an affiliate thereof for investment management and, perhaps, administrative services. Such bifurcation would add to the complexity and costs of maintaining each Fund.

Finally, investors are accustomed to seeing investment vehicles similar to the Funds structured as limited partnerships or limited liability companies. If the Trust Company had to use unfamiliar investment structures, it would be placed at a competitive disadvantage.

Reasoning

A New York-chartered trust company or a bank with trust powers may provide discretionary investment management services.8 The Banking Department has permitted such a trust company through a subsidiary to sponsor, organize and advise open-end mutual funds9 registered under the Company Act. In November, 2008, the Banking Department issued an interpretation (the "November Interpretation") that permitted a wholly-owned operating subsidiary of a New York-chartered savings bank with trust powers10 to serve as the managing partner and investment manager of an investment fund structured in a manner similar to the Funds.11  The operating subsidiary was allowed to hold a special general partnership interest in the investment fund in order that the subsidiary could receive an allocation of the net gains of the investment fund in lieu of a performance-based fee for acting as investment manager.

The acquisition of the special general partnership interest by the operating subsidiary was permitted under the authority of the savings bank to provide investment management services rather than on its authority to make investments. Because the acquisition was based on this investment management authority, a number of conditions were set forth in the November Interpretation. Among other things, the acquisition was allowed only to the extent necessary enable the operating subsidiary to receive its performance-based compensation in the form of a profit allocation and only so long as the total loss exposure of the operating subsidiary was limited to the minimal amount that the subsidiary it had invested in the investment fund.12

The November Interpretation reviewed the investment management activities that the Comptroller of the Currency (the "OCC") had found permissible for national banks and their operating subsldiarles.13 In this regard, the OCC has on a number of occasions permitted an operating subsidiary of a national bank to own limited interests in investment funds that the operating subsidiary manaqed.14 In those cases, the OCC found that the operating subsidiaries had held such limited interests in order to structure their compensation like that of their competitors in the investment management industry. Such interests had not been acquired for investment purposes but rather to enable the operating subsidiaries to provide investment management services in the same manner as conducted by their competitors.

The rationale of the November Interpretation and that of the determinations by the OCC are applicable in the current case. In each instance, the special interest structure was dictated by the need to meet competition.

The Trust Company and its operating subsidiaries will have no direct interest in the income, gains or losses of the Funds. Indeed, the interest of the Trust Company is obviously less than that approved in the November Interpretation. There, the special interest in the investment fund entailed a minimal investment and the receipt of a profit allocation.

Noted: MEG

.                                       

  1. It is anticipated the Funds will be excluded from the definition of "investment company" by either Section 3(c)(1) or Section 3(c)(7) of the Company Act, Section 3(c)(1) excludes from the definition of investment company certain issuers whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 investors. Section 3(c)(7) excludes those issuers whose outstanding securities are owned exclusively by persons who, at the time of their acquisition of such securities, are "qualified purchasers," Section 2(a)(51) of the Company Act defines "qualified purchaser" as including, inter alia, any natural person who owns not less than $5,000,000 in investments.
  2. Such clients could include owners, directors, officers or employees of the Trust Company in their individual capacities.
  3. Funds organized in jurisdictions outside the United States may be formed as corporate entities.
  4. The Trust Company could select the investments of Fund directly or it could select other investment managers for a Fund -  In which case, the Trust Company will set investment parameters, evaluate the performance of the managers etc -  A Fund might also invest in other investment funds including Funds managed by the Trust Company.
  5. Each such entity will be a corporation or limited liability company.
  6. It is assumed that the investment management fees charged to Investors in the Funds would be impacted by the performance of the Funds. For example, if the Trust Company charged an asset­based fee, the positive performance of an Investor's Fund would cause an Investor's assets under management, and therefore, the fee of the Trust Company to increase.
  7. Notwithstanding the foregoing, it is anticipated that the Trust Company or an affiliate would make advances to cover the costs of establishing each Fund.
  8. A bank lacking such powers may provide investment advice only on a nondiscretionary basis ­ i.e., where all investment decisions are made by the clients to whom the bank provides advice. Letter dated January 11, 1993 from Raymond L. Bruce of the Banking Department to Benjamin Raphan of Tenzer, Greenblatt, Fallon & Kaplan.
  9. Letter dated September 24, 1981 from Paul L. Lee of the Banking Department.
  10. Generally, the authority a New York-chartered savings bank with trust powers or an operating subsidiary thereof to provide investment management services is the same as that of a New York State-chartered trust company or bank with trust powers and the operating subsidiaries of such a trust company or bank. Unless the grant of powers is limited by the New York Banking Board, the fiduciary powers of a savings bank under Section 234-b of the Banking Law are identical to those of a trust company or of a bank with trust powers chartered under Article III of the Banking Law.
  11. Letter dated November 14, 2008 from Deputy Superintendent Martin D. Cofsky of the Banking Department.
  12. This minimal amount would be the amount that would be reasonably sufficient to support the treatment of the performance-based compensation as a profit allocation under the Internal Revenue Code.
  13. The investment management powers of a New York trust company are analogous to those of national banks. A national bank may provide investment management services as part of the business of banking authorized under 12 U.S.C. §24 (Seventh) and pursuant to its fiduciary powers under 12 U.S.C. §92a. Moreover, an operating subsidiary of a national bank may engage in those "activities that are permissible for a national bank to engage in directly either as part of, or incidental to, the business of banking, as determined by the OCC, or otherwise under other statutory authority." 12 C.F.R. § 5.34(e)(1). Moreover, under Section 24 of the Federal Deposit Insurance Act ("FDI Act"), 12 U.S.C. §1831a(d)(1), subject to limited exceptions, a subsidiary of an insured state bank may not engage as principal in an activity that is not permissible for a subsidiary of a national bank.
  14. OCC Conditional Approval No. 842 (March 13, 2008) (the "MB Financial Approval"); OCC Conditional Approval No. 755 (August 26, 2006) (the "HSBC Approval");' OCC Conditional Approval No. 643 (June 16, 2004) (the "Blackrock Approval"); OCC Conditional Approval No. 578 (February 27, 2003) (the "B of A Approval"); OCC Interpretive Letter No. 940 (May 24, 2002 ("Interpretive Letter No. 940"); OCC Interpretive Letter No. 897 (October 23, 2000) ("Interpretive Letter No. 897").