A. Trust Investment Principles

The management of property for others is one of the principal functions of a fiduciary. Fiduciaries administering personal or corporate accounts, either as trustee or agent, are guided by state statutes and the principles embodied in common law. For employee benefit accounts, ERISA, with its implementing Department of Labor (DOL) regulations and opinions, provides statutory and regulatory guidance.

The primary investment guidance given to fiduciaries is found in the terms of each account’s governing instrument. There are major differences in the fiduciary’s responsibilities under different types of accounts.

When the fiduciary has discretion to select investments for an account, or makes recommendations for the selection of investments, the investments selected must both follow the terms of the governing instrument and be suitable investments given the needs of the beneficiaries or the purpose of the trust. When the trust department has no discretion in choosing investments (such as for self-directed or custodial accounts), the institution’s sole responsibility is to follow the provisions of the governing account instrument.

Accounts subject to ERISA, diversification standards, parties in interest, and co-fiduciaries and investment managers are presented in Sections 404 through 406. Refer to specific sections of ERISA in Appendix E — Statute 404 through 406 and Section 5 of this Manual for further discussion.

In enacting the Prudent Investor Act, states should have repealed legal list statutes, which specified permissible investments types. (However, guardianship and conservatorship accounts generally remain limited by specific state law.) In those states which adopted part or all of the Prudent Investor Act, investments must be chosen based on their suitability for each account’s beneficiaries or, as appropriate, the customer. Although specific criteria for determining suitability does not exist, it is generally acknowledged, that the following items should be considered as they pertain to account beneficiaries:

financial situation; current investment portfolio; need for income; tax status and bracket; investment objective; and risk tolerance.

T here are two fiduciary standards governing the prudence of the individual investments selected by a fiduciary: the Prudent Investor Act and the Prudent Man Rule. The Prudent Investor Act. which was adopted in 1990 by the American Law Institute’s Third Restatement of the Law of Trusts (Restatement of Trust 3d), reflects a modern portfolio theory and total return approach to the exercise of fiduciary investment discretion. This approach allows fiduciaries to utilize modern portfolio theory to guide investment decisions and requires risk versus return analysis. Therefore, a fiduciary’s performance is measured on the performance of the entire portfolio, rather than individual investments. As of May 2004, the Prudent Investor Act has been adopted in 41 States and the District of Columbia. Other states may have adopted parts of the Act, but not the entire Act. According to the National Conference of Commissioners on Uniform State Laws, the most common portion of the Act excluded by states concerns the delegation of investment decisions to qualified and supervised agents.

The Prudent Investor Act differs from the Prudent Man Rule in four major ways:

A trust account’s entire investment portfolio is considered when determining the prudence of an individual investment. Under the Prudent Investor Act standard, a fiduciary would not be held liable for individual investment losses, so long as the investment, at the time of acquisition, is consistent with the overall portfolio objectives of the account. Diversification is explicitly required as a duty for prudent fiduciary investing. No category or type of investment is deemed inherently imprudent. Instead, suitability to the trust account’s purposes and beneficiaries’ needs is considered the determinant. As a result, junior lien loans, investments in limited partnerships, derivatives, futures, and similar investment vehicles, are not per se considered imprudent. However, while the fiduciary is now permitted, even encouraged, to develop greater flexibility in overall portfolio management, speculation and outright risk taking is not sanctioned by the rule either, and they remain subject to criticism and possible liability. A fiduciary is permitted to delegate investment management and other functions to third parties.

A copy of the model Uniform Prudent Investor Act, together with explanatory notes, is included in Appendix C. A list of states adopting the Uniform Prudent Investor Act is also included. States, however, may and often do, modify uniform model laws when enacting legislation. For states that have adopted a version of the Prudent Investor Rule, this portfolio management approach supersedes the Prudent Man Rule.

The Prudent Man Rule is based on common law, stemming from the 1830 Massachusetts court decision — Harvard College v. Armory. 9 Pick. (26 Mass.)446, 461 (1830). The Prudent Man Rule directs trustees to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested. Id. A copy of the Prudent Man Rule, also known as the Restatement of Trusts 2d. together with explanatory notes, is included in Appendix C.

Under the Prudent Man Rule, w hen the governing trust instrument or state law is silent concerning the types of investments permitted, the fiduciary is required to invest trust assets as a prudent man would invest his own property, keeping in mind: the needs of the beneficiaries, the need to preserve the estate (or corpus of the trust) and the amount and regularity of income. The application of these general principles depends on the type of account administered. This continues to be the prevailing statute in a small number of states.

The Prudent Man Rule requires that each investment be judged on its own merits. Thus, a fiduciary could be held liable for a loss in one investment, which when viewed in isolation may have been imprudent at the time it was acquired, but as a part of a total investment strategy, was a prudent investment in the context of the investment portfolio taken as a whole. Under the Prudent Man Rule, speculative or risky investments must be avoided. Certain types of investments, such as second mortgages or new business ventures, are viewed as intrinsically speculative, and, therefore, prohibited as fiduciary investments.

Since the Prudent Man Rule was last revised in 1959, numerous investment products have been introduced or have come into the mainstream. For example, in 1959, there were 155 mutual funds with nearly $16 billion in assets. By year-end 2000, mutual funds had grown to 10,725, with $6.9 trillion in assets (as reported by CDA/Wiesenberger). In addition, investors have become more sophisticated is more attuned to investments, since the last revision. As these two concepts converged, the Prudent Man Rule became less relevant.

Prudent Investments in Court-appointed Accounts

State statutes may outline specific permissible investments for certain types of accounts, such as guardianships f or minor children or incompetents. Under some state statutes, prudence is more narrowly defined for guardianship accounts, than under the Prudent Man Rule.

Trust departments can be appointed as a conservator for veterans. In general, prudent investments for veteran accounts are defined as an interest or dividend paying account at a Federally-insured institution, or in court-appointed cases, in securities issued or guaranteed by the United States. Under 38 CFR13.103, veteran benefits paid to legal custodians on behalf of a beneficiary may only be invested in U.S. savings bonds, pre-need burials trusts, or interest or dividend paying accounts, which are Federally insured. Department of Veterans Affairs benefits that are paid on behalf of an incompetent veteran to an institution via an institutional award payment arrangement may not be invested in any asset. Pursuant to 38 USC 501, Section 13.106 states that court-appointed fiduciaries must invest income or an estate derived from the Department of Veterans Affairs benefits only in legal investments which have safety, assured income, stability of principal, and ready convertibility for the requirements of the beneficiary and his or her dependents.

Prudent Investments in Employee Benefit Accounts

Employee benefit accounts subject to ERISA are governed by the prudence requirement of ERISA Section 404(a)(1)(B). as well as by DOL Regulation 2550.404a-1. Also see recap of ERISA prudence interpretations and opinions. In implementing ERISA requirements, the Labor Department has generally followed the Prudent Investor approach outlined above.

As discussed more fully in Section 2 — Operations and Internal Controls, there may exist different classes of beneficiaries in a personal trust account that may only be entitled to a trust’s principal, or income, but not both. In these situations, it is important that fiduciaries maintain accounting records that clearly distinguish assets as either principal or income.

Principal (corpus) consists of cash and other property transferred to the fiduciary. Income is the return derived from the investment of principal. Income must also be distinguished from capital gains, which are not investment yields or returns on principal, but gains or appreciation of the value of the principal itself. Capital gains are added to the value of principal (capital losses reduce the value of principal), and inure to the benefit of principal beneficiaries. Depending on the terms of the trust, and a variety of other factors including the needs of the beneficiaries, income may be distributed as cash, or reinvested and held (for the benefit of income beneficiaries) as invested income. Unless clearly distinguished from other investments, invested income may appear to the observer to be principal. Consequently, it is imperative that fiduciary records distinguish between the two, as failure to do so could result in giving one set of beneficiaries funds that belong to another set of beneficiaries, creating a Contingent Liability. Separate records of principal and income are customary, and can be used for the preparation of accountings and tax returns. A further discussion of principal and income may be found in Principal and Income, located in Section 2.

E. Trust Investment Policies

The ultimate responsibility for establishing an overall investment policy remains with the board of directors or a trust committee appointed by the board. The basis of any investment policy should be sound fiduciary principles, including prudence, the preservation of capital, diversification, and a rate of return commensurate with the level of risk assumed. The review of the department’s investment policies and practices are of major importance in the trust examination.

Many trust departments have a separate trust investment committee which develops and administers investment policy, although smaller departments may utilize the board of directors or the trust committee for this purpose. The committee reviews and either approves or rejects recommendations made by a research division, an outside investment advisor, or the department’s investment officer. Often the committee has the responsibility of reviewing individual account portfolios and determining whether assets are invested in compliance with the trust department’s overall investment policy.

Accounts for which the department exercises investment discretion should receive an investment review in accordance with the Statement of Principles of Trust Department Management. An initial asset review should, in most cases, be conducted promptly following acceptance, and should establish an investment program for the account. Reviews should include securities and other types of assets received with the account. The initial review is of great importance, as the fiduciary may be required to act quickly to protect assets from loss or erosion of principal, or to take immediate action to protect tangible assets from creditors, insurable losses or physical damage. A fiduciary may have to compensate accounts that sustain i nvestment losses due to the fiduciary’s negligence such as a failure on the part of the fiduciary to act in a timely manner.

The department’s overall investment policy should be flexible enough to accommodate the types of fiduciary appointments accepted. For example, individual trusts under will or agreement are usually established for the purpose of providing income to the income beneficiary and leaving principal (corpus) to the remainderman at the termination of the trust. By contrast, employee benefit trusts need to generate sufficient growth and income to provide the promised retirement benefits to participants and their beneficiaries. Conversely, investment management agency accounts normally desire capital growth rather than income.

When the governing instrument is silent, investment authority or directions default to state law, which must be followed. When the governing instrument’s language concerning investments is unclear, court approval should be obtained.

E.1. Investment Policy Components

Investment policies should clearly set forth a framework for the selection, retention, review, and management of assets over which the department holds investment discretion. The policies should discuss the overall structure of the department’s investment management responsibilities. They should provide for: appointing qualified officers to supervise daily investment activities; the monitoring of discretionary transactions, including the reporting of such transactions to the appropriate supervisory officers and committees; procedures for handling exceptions; and, formal procedures for reviewing and revising investment policies and practices. Depending on a department’s size, complexity, and the types of appointments accepted, the following elements may also need to be addressed:

Management’s investment philosophy and standards of practice. A code of conduct for employees, officers, and directors who by their duties or supervisory roles have knowledge of, or access to: (1) discretionary investment transactions; or (2) the department’s approved list of securities, or changes to the approved list of securities. FDIC Part 344 requires that bank officers and employees who make investment recommendations or decisions for accounts of customers file a report with the bank on a quarterly basis. Investments and investment practices deemed appropriate, or inappropriate, with regard to the management of discretionary accounts. The nature and size of accounts the department is qualified to administer, and the minimum standards required for the acceptance of new accounts. Pre-acceptance review of the transferred assets for new accounts. The initial review of newly accepted accounts. Investment reviews of existing accounts. Procedures for documenting investment reviews. Whether the department will prepare its own research in-house, or purchase investment research from outside investment advisors. Guidelines governing the use of outside investment advisor r efer to Section 10.G.6) including:

Procedures for adopting and/or amending an approved list of investments recommended by outside advisors, if appropriate, Procedures for diverging from outside advisor recommendations when appropriate, and Procedures for monitoring purchases and sales to ensure compliance with the approved lists.

Procedures for adopting and amending an approved list of equity investments based on in-house research, including:

Criteria for selecting the investments to be included on approved lists, Criteria for monitoring the investments included on approved lists, Description of the approval process for adding or deleting investments from approved lists, including specifying the person(s) having authority to make such additions or deletions, and Monitoring purchases and sales to ensure compliance with the approved lists. Procedures for making exceptions to the approved lists.

Procedures for adopting and amending an approved list of mutual fund investments (inclusive of proprietary mutual funds, refer to subsection F.4.a, if appropriate) including:

Justification for the selection of a load fund over a no-load fund. Criteria for the selection of the mutual funds to be included on approved lists, Criteria for monitoring the mutual funds on the approved lists, and Description of the approval process for adding or deleting mutual funds from the approved lists. Criteria for diverging from the approved lists.

Establishment of procedures for adopting and amending an approved list of obligors (corporate and municipal) of fixed income debt investments, if applicable, including:

Criteria for evaluating the credit risk of the obligors to be included on the approved lists, Criteria for monitoring the credit risk of the obligors on the approved lists, Description of the approval process for adding or deleting obligors from the approved lists, and Monitoring purchases and sales to ensure compliance with the approved lists. Criteria for making exceptions to the approved list.

Guidelines for the development and use of asset allocation models, including:

Criteria or methodology for creating and modifying asset allocation models, and Description of the process for supervisory review and approval of the models.

Guidelines for the holding, purchasing, and managing of real property, including:

The evaluation of environmental risk, initially, and on an ongoing basis, and Initial and periodic reappraisals/inspections of real property.

Guidelines and procedures for holding closely held businesses, including:

Identification of conditions under which the department would administer such assets. Criteria for contracting with a third party to run a closely-held business. Methods and procedures for the initial and periodic evaluation of such assets Whether the trust officer should serve on the board .

Guidelines and procedures employed in the selection and use of money market mutual funds, including:

Periodic reviews of fund performance, Methods for monitoring the use of and reliance on derivative products by such funds, and Guidelines for the selection and use of funds paying 12b-1 fees, including: the appropriateness of such funds for each type of account administered, notification to customers of such fees, the solicitation of customer approvals when appropriate, and the routine disclosure to customers of such fees earned by investment of their accounts in such funds.

Guidelines governing the use and monitoring of derivative investment products, as outlined in the FDIC Office of Capital Markets Examination Handbook and the FDIC Statement of Policy on Investment Securities and End-User Derivative Activities. Guidelines for the evaluation and management of assets deemed worthless. Guidelines and procedures for evaluating and monitoring exceptions, such as non-rated, or non-approved list, securities held in accounts. Refer to the following section. Guidelines and practices for securities lending. Refer to F.15 . Guidelines and procedures governing loans from trust accounts (real estate, unsecured promissory notes, etc.). Guidelines and procedures regarding lending to, and permitted indebtedness of, managed accounts. Guidelines providing for the prompt investment of income and principal cash, unless the governing instrument, local law, or parties properly authorized to direct investments provide otherwise.

E.2. Discretionary Asset Review Policies

It is generally acknowledged that trust departments are liable, to varying degrees, for all assets held, whether or not they possess investment authority. It also follows that greater authority imparts greater risk. Trust departments which are otherwise well managed may sometimes lack appropriate policies with respect to periodic reviews of assets not contained on the approved list. Many departments hold at least some assets in discretionary accounts that were not acquired through the exercise of discretionary authority. These include directed purchases, assets acquired in-kind, and assets acquired through distributions, corporate re-organizations or liquidations. This is especially true with respect to assets acquired as executor, trustee under will, successor to previous fiduciaries, and through guardianship or conservatorship appointments. The value of these assets may represent a significant percentage of the market value of an individual account.

Trust management should institute written policies which affirmatively address the routine evaluation of all discretionary assets (refer to subsection G. Account Review Program, of Section 1. This is true whether or not the assets were acquired by virtue of management’s fiduciary authority. At least once during the calendar year, all assets held in discretionary accounts should be reviewed and evaluated in light of governing instruments and individual account circumstances. Departments that adopt a passive stance over assets received in-kind increase their exposure to fiduciary risk. Trust management may believe it can eliminate this risk by obtaining direction letters. Although prudent and necessary, at best, this reduces, but cannot eliminate, fiduciary risk. The beneficiaries may change or may lack the legal capacity to release the fiduciary from liability, as in the case of minors or the unborn. Likewise, account circumstances change and economic factors vary over time, sometimes dramatically and with little or no advance warning.

Also, asset management policies should address the retention process for all discretionary holdings. Investment policies should address minimally acceptable sources for outside research. They should also outline the minimum acceptable standards for documenting and approving the retention of assets and provide guidance for the sale of underperforming assets. Trust departments may fail to include all discretionary assets in their annual review function, thereby increasing fiduciary risk. Trust departments that have adopted an approved list approach may be at increased risk if they do not review discretionary assets that are not on their approved list.

Trust departments may hold assets for which they cannot obtain reliable valuations. Such assets may include limited partnership interests, investments in closely held businesses, the common stock of thinly traded or unlisted companies, partnership agreements, hedge funds, royalties, patents and copyrights, oil and mineral interests, etc. Asset pricing is an integral component of an annual portfolio analysis. It is also necessary for the preparation of estate tax returns (IRS Form 706), gift tax returns (IRS Form 709) and annual IRA account filings (refer to Section 5, F.1.). It is a key factor in the proper calculation of account fees and commissions (department earnings). In these situations, and in situations where management does not have the resources to adequately evaluate certain types of assets, it should seek outside expertise. Management may not, however, be able to pass the cost of these outside services through to the account, particularly when the assets in question were purchased by the department under its discretionary authority. Consequently, examiners should review accounts for inappropriate charges in this context.

F. Types of Investments

Various investment vehicles are available for the investment of trust funds. The more common types of investments and some newer products are discussed below, along with applicable regulations, examination procedures and other related matters.

The Capital Markets Handbook defines products not outlined on the following pages and provides examination guidance. The Capital Markets Branch in the Washington Office can readily provide information concerning most investment products.

F.1.a. Money Market Funds

Various money market funds are offered for the short-term investment of idle cash. These funds are mutual funds and have differing portfolios depending on the particular fund. Investments in domestic or foreign certificates of deposits, repurchase agreements, commercial paper, and short-term U.S. Government or agency obligations are some of the more common portfolio components. Although the trustee may have full investment discretion, it should be satisfied that the investment of trust funds in money market funds is permissible under state statutes. When trustees do not have full discretion, sufficient authority should be sought in state statutes or court decisions, the language of the account’s governing instrument, or by obtaining binding consents from all beneficiaries or written instructions from the parties authorized to direct investment selection, before utilizing these funds. In general, it would not be considered appropriate to permanently place funds in this type of investment vehicle, as money market funds are considered short-term investments.

Money market funds are registered under the Investment Company Act of 1940 and as such, are regulated by the Securities and Exchange Commission. Fund companies are required to provide a prospectus to the investor prior to purchase. The funds are required to have external audits. Prior to investing in a money market fund, the prospectus of the fund and portfolio composition should be reviewed to determine that the fund meets the objectives of the trust account. Thereafter, the fund should be reviewed periodically to ensure that the investment objectives continue to be met. In addition, there have been instances where money market funds have broken the buck, referring to situations where the fund’s net asset value falls below $1 per share. This issue has recently resurfaced and concerns may be found at in Appendix G, Interagency Policy on Banks/Thrifts Providing Financial Support to Funds Advised by the Banking Organization or its Affiliates. Therefore, various risks such as credit, liquidity, concentration, operational, and reputation risks should be assessed by trust department management. Examiners should determine that money market funds have been properly analyzed prior to investment and that the funds are periodically reviewed. Appropriate comments should be included in the Report of Examination if such funds have not been properly analyzed or if such investments are inappropriate for the accounts involved.

F.1.b. External Sweep Arrangements

Money market funds generally accrue interest daily and pay interest at the end of the month. Many trust departments now have services which automatically invest available cash exceeding predetermined dollar limits in a money market fund. These are commonly called sweep arrangements.

Fiduciaries are obligated to keep funds productive. Uninvested cash of discretionary appointments should be invested temporarily until permanent investments are chosen, or pending the implementation of an investment program or distribution to beneficiaries. Uninvested principal cash, including cash not awaiting immediate distribution or payment against a draft, are often swept at the close of each business day into some form of interest-bearing investment vehicle. Income cash should be treated in a similar manner. Current technology makes possible, and prudent fiduciary investment philosophies advocate, the full employment of all cash in some form of productive investment. Management’s failure to invest cash when appropriate and practicable should be considered imprudent and a breach of fiduciary duty subject to criticism. In those cases where the fiduciary is responsible for the investment of cash, it is difficult for a fiduciary to justify permitting cash to remain idle when it is possible to make it productive. It would be unusual, given the current state of investor awareness, for customers to be indifferent to a fiduciary’s intentional failure to invest large cash balances.

The investment of nondiscretionary cash is largely governed by the terms of the account agreement. There may be instances, however, when the account agreement lacks specific directions concerning how cash is to be invested and the customer has not provided any specific instructions. Examiners, in such cases, should be careful when interpreting a trust department’s investment authority with respect to the investment of cash balances. In such cases, management should be encouraged to modify the governing account agreements in a manner to resolve any ambiguity concerning the department’s responsibility to invest cash. In addition, faced with such uncertainty, the fiduciary should contact the account principal and request direction concerning the investment of the cash.

Examiners may encounter situations in which the trust department charges an additional fee (sweep fee) for performing cash management services. The taking of such fees is customarily governed by state law and examiners should determine the permissibility of assessing additional fees under local statutes. If permissible under state law and not prohibited by the account agreement, the fee charged should be reasonable for the service performed. Additionally, the department should fully disclose the imposition of the fee to interested parties. The amount of fees charged relative to the sweep arrangement should be disclosed periodically in the account statements sent to customers. The charging of sweep fees in ERISA accounts is not strictly prohibited. Refer to Section 5, subsection H.7.f.(20). Sweep Fees for additional guidance for ERISA accounts.

F.1.c. Deposits

Deposits, whether time, savings, or demand, are another common form of investment. The deposits could be in another institution or in the commercial department of the bank under examination. Oftentimes, such investments provide the safety and liquidity needed by the account. However, given the availability of numerous other investment vehicles providing similar safety and liquidity, examiners should determine whether deposit holdings result from a lack of management initiative to seek other investment opportunities. Large holdings of non-interest bearing deposits should be scrutinized, since it is a fiduciary’s duty to make trust assets productive. Discretionary deposits with the commercial bank should also be reviewed, given the conflict of interest and self-dealing aspects of such investments.

Some trust departments sweep cash to the commercial department’s deposit accounts on an overnight basis, rather than sweep to an external investment vehicle. In those situations, bank management should have a strategic plan for the activity. Within that plan, management should not view overnight trust funds as a long-term funding source for the commercial department. Management should have calculated the costs, including interest on deposits and the FDIC deposit insurance assessment. More importantly, trust management should be able to demonstrate that the customer is at least as well compensated, as he would have been with an external sweep, usually a money market fund. Care should also be taken to assure the deposit account is appropriated titled in the commercial department’s records to insure pass-through deposit insurance coverage. Examiners should be aware that Section 24 of the FDI Act prohibits the pledging of bank securities to secure deposits of trust accounts. However, an irrevocable letter of credit issued by an agency of the U. S. Government or a surety bond, issued on behalf of the bank or trust department, is allowable under the regulation.

Refer to Section 8. E.3. Use of Own Bank or Affiliate Deposits, of this Manual for additional guidance in this area.

Federal deposit insurance coverage of trust account deposits is discussed in Section 10, subsection L. Deposit Insurance of Trust Funds

F.1.d. Overdrafts

Overdrafts occur for numerous reasons, including timing differences related to cash receipts and disbursements. Overdrafts should be short-term in nature, and rare in occurrence. The department should not be funding securities purchases with overdrafts. Such a practice reflects poor cash management of an account. Likewise, the failure of the department to properly plan for recurring or expected disbursements, resulting in a lack of liquid assets to fund disbursements, reflects poor cash management. These and similar events, if prevalent, should be criticized. The department should have a policy governing overdrafts. The policy should include review procedures, methods for curing overdrafts, and the action(s) that will be taken if an overdraft cannot be cured within a reasonable time period. Overdrafts outstanding for long periods of time should be treated as a loan to the account.

In those states where the Prudent Investor Act has been adopted, the suitability of the entire portfolio should be reviewed as a whole, and individual investments are not considered inherently good or bad based solely on investment type or credit rating.

In states which operate under the Prudent Man Rule, investments are considered prudent or imprudent on an individual basis. Therefore, investments can be considered inherently prudent or imprudent based solely on investment type or credit rating.

The following is a brief overview of the more common investments and some newer products found in trust departments. For particular products and their risks not included on the following pages, examiners should refer to the Capital Markets Examination Handbook and the Manual of Examination Policies, used for safety and soundness examinations.

Marketable debt securities (bonds, debentures, etc.) generally comprise a significant portion of a trust department’s assets. The selection of acceptable debt instruments for discretionary accounts should be based on research performed in-house, acquired from outside sources, or a combination of the two. The department may also rely on ratings provided by the nationally recognized rating agencies. The rating bands for three of the rating services are outlined in this section. As seen in recent events, highly rated debt issues can decline into subinvestment quality rating bands or go into default. Therefore, management should monitor investments on an on-going basis to determine that the issue remains suitable for the account. As previously stated, the Prudent Investor Act does not preclude the investment in or continued holdings of subinvestment quality securities. However, speculation is inappropriate for trust accounts.

InterNotes are investment grade, medium-term notes, offered in minimum denominations of $1,000 to retail investors. InterNotes represent the debt of each respective issuer and are subject to credit and secondary market risk. The notes are offered via a prospectus and issues are sold at par value. Each week, new offerings from various corporations are made, and include issues with varying maturities, coupons, and interest payment schedules (monthly, quarterly, semi-annually.) InterNotes appear to have a shelf registration, meaning that the amount offered in the prospectus is registered once, and the issuer can offer amounts under that prospectus as needed.

An example of an InterNote may be the following:

• $6 billion issue from a corporation under a prospectus dated August 2002.
• Separate CUSIP numbers are assigned to specific terms, such as maturities, coupons, and call provisions, which represent amounts used under the registration.
• The offer as stated is valid for a week, and the minimum investment (denomination) and increments are $1,000.
• The products are rated by nationally recognized rating agencies and the ratings are posted on the InterNotes’ website, along with other information concerning terms.
• Some InterNotes are based on floating rates, indexed to short-term rates.
• The products are directed at small, retail investors, in lieu of certificates of deposits and may be received in-kind.

The department may invest in debt obligations issued for the benefit of local municipalities, school districts or other small governing authorities. Industrial revenue bonds may be issued for the benefit of corporate entities. Frequently, municipal bonds will be received in-kind rather than purchased by the department. The issues may or may not be rated. The lack of a rating may result from the expectation that the issue will be sold to a limited number of investors in the local community, or, the cost of acquiring a rating may be expensive in relation to the size of the issue. However, non-rated, does not necessarily equate with investment quality. Trust management should analyze prior to purchase and periodically thereafter to determine that the issuer is creditworthy. Management should establish policies and procedures including selection criteria and investment review procedures when non-rated investments are purchased for discretionary accounts.

Municipal bond issues may be appropriate for managing the customer’s tax position, but normally the investment should not be placed in tax-deferred accounts, such as employee benefit accounts, as the accountholder does not gain any additional tax benefit from the exemption. Private activity bonds used for funding football stadiums, basketball arenas, etc. are subject to the Alternative Minimum Tax and may affect the customer’s income tax liability. In either of these or other scenarios, management should determine and document the suitability for the accountholder.

CORPORATE & MUNICIPAL BOND RATINGS