ties react differently (in direction or degree) to external events, such diversity substantially reduces aggregate portfolio risk.24 Thus, the total return concept is rendered meaningless by self-imposed investment restrictions in some trust instruments, but it is an intelligent and viable test of prudent investment for relatively unrestricted trust accounts.25

B. Conflicts of Interest, Interlocking Directorates,

Self-Dealing and the Like

Bank complexes provide a number of services for large corporations, and they may have a variety of relationships with corporate clients whose securities are held as portfolio investments by trust departments. As a result of the magnitude and variety of these relationships, banks may be faced with opportunities to abuse their potential economic power over their portfolio companies.27 Also, the presence of outside directors from industrial corporations on the banks' boards of directors, 28 and the internal power of industrial corporations having commercial relationships with the banks, gives corporations power

24. See, eg, H. Markovitz, PORTFOLIO SELECTION: Efficient DiversifICATION OF INVESTMENTS (1959); COHEN, supra note 19, at 1611-14. Beyond a certain point, however, increasing the number of holdings has no significant marginal effect on aggregate port. folio risk. Id. at 1613 n.42. Some economists doubt the "justification of increasing port. folio sizes beyond 10 or so securities .." Evans & Archer, Diversification and the Reduction of Dispersion: An Empirical Analysis, 23 J. FINANCE 761, 767 (1968).

This analysis, of course, does not take market liquidity in an individual security into account-investment of the assets of a large employee benefit plan fund or common trust fund in only ten securities would mean intolerably large positions in ten portfolio companies which could be extremely difficult to acquire or sell. Thus in prac tice, large institutional portfolios are commonly diversified beyond the minimum level dictated by diversification theory. IIS REPORT, supra note 2, pt. 2, at 436 (Table V-11). 25. For thorough discussions of present investment practice, see C. ELLIS, INSTITUTIONAL INVESTING 50-64, 142-53 (1971); Welles, The Beta Revolution: Learning to Live with Risk, INST. INv., Sept. 1971, at 21.

26. Bank officers and directors often serve as directors for corporations which have commercial relationships with the bank and whose securities are held by the trust department for various trust accounts. The bank may also serve as trustee for such a corporation's employce benefit plans, and as registrar, stock transfer agent, or bond indenture trustee for the corporation's stocks and bonds.

27. PATMAN REPORT, supra note 2, at 1-5.

28. The Patman Report, like the IIS Report, conducted a detailed survey of the forty-nine larger commercial banks in ten metropolitan cities. From this data base, the Patman Report found 768 interlocking directorates with 286 of the 500 largest industrial corporations. PATMAN REPORT, supra note 2, at 3. Similarly substantial interlocking di rectorates were found between the banks and the fifty largest_merchandising, transpor tation, utility and life insurance companies. Id. The Patman Report recommended that bank officials be prohibited from sitting on the boards of corporations if (1) the corporation's employee benefit plan was administered by the bank, (2) the bank held more than five percent of the outstanding securities of the corporation, and (3) the corporation was a similar competing financial institution. Id. at 9-10.

29. The IIS Report dealt with some of the possible reasons why the fifty largest trust departments would administer almost seventy percent of the total of all trust assets. While it could not establish cause and effect, the existence of employee benefit fund trust accounts was closely associated with aggregate demand deposits in the bank. In addition, large demand deposits (greater than $100,000) were more closely correlated with trust department assets than demand deposits as a whole. IIS REPORT, supra note 2, pt.

to affect trust department investment decisions. Although bank trust department officials deny that the bank's directors influence investment choices, or that the trust department knows which corporations have significant relationships with the commercial side of the bank,30 there is evidence that such relationships have been used to influence trust departiment decision-making.31

To prevent misuse of commercial credit information and potential conflicts of interest, many banks have sought to develop a "wall"32 separating the trust department from the bank's outside directors, and the commercial department. The Hunt Commission Report has recommended that a "wall" be required only for banks with more than 200 million dollars of trust assets. However, bank regulatory agencies

2, at 489. In other words, Ford Motor Co., for example, would typically have large deposits with the same bank to which it entrusted its employee benefit plan.

The IIS Report also attempted to measure the importance of the corporation's commercial relationship to the bank and determine whether the existence of commercial relationships between a corporation and the bank increased the likelihood of such corporations being a portfolio company of the bank. Using three dummy variables, which accounted for the existence of interlocking directorates, geographical proximity, and the bank's management of the corporation's employee benefit plan, the data indicated a positive relationship between the size of a corporation's demand deposits and the amount of its stock held by the bank, and a similar relationship involving loans and bank holdings. IIS REPORT, supra note 2, pt. 2, at 471-75 (Table V-26). For an analysis of the ties with the commercial bank and their relative importance to the company, see id., pt. 5, at ch. XV. The conclusion which the IIS Report data suggests is that corporate commercial relationships are important to the bank, that bank employees sensitive to the relative importance of certain commercial relationships may allow that fact to influence their buy, sell, or hold decisions, and that some statistical evidence exists to support this theory of behavior.

30. One bank executive repeatedly stated that it was absurd for anyone to think he would risk criminal sanctions just to give a specific trust a limited, temporary boost in performance by raiding commercial department files. For a specific statement of one bank's policy on these matters, sec INVESTMENT Management Group, First NATIONAL CITY BANK, THE ANATOMY OF AN INVESTMENT 11 (1971) [hereinafter cited as CITIBANK 1971 REPORT]:

However, analysts and portfolio managers in [the trust department] are specifically prohibited from seeking confidential customer information which may be provided to the commercial banking areas of First National City Bank in conjunction with lending activities, just as lending officers are prohibited from providing such information to [trust department] employees. The [b]ank scrupulously main tains complete isolation of the [trust department] investment activities from the traditional banking functions.

31. See, e.g., Patman Report, supra note 2, at 775-83: IIS REPORT, supra note 2. pt. 5, at 2271-2843. The case studies in the Patman and IIS Reports may generally be charac terized as examples of instances where bank management was willing to ignore its fi duciary duties to its trust customers to further the interests of its important commercial customers. For example, in one case, when an attractive offer was made for the stock of a railroad company held in trust by a Delaware trust company, the trust company sought to sell the stock for a lower price to two other competing railroad bidders with which it had interlocking directors. PATMAN REPORT, supra note 2, at 775-79.

32. See Herman & Safanda, Commercial Bank Trust Departments and the "Wall," 14 B.C. IND. & COM. L. REV. 21 (1972). Bank efforts to create effective "walls" were un questionably accelerated in the 1960's after the Merrill Lynch/Douglas Aircraft Co. inside information case. Merrill Lynch, Pierce, Fenner & Smith, SEC Securities Exchange Act Release No. 8459, [1967-69 Transter Binder] CCH FED. SEc. L. REP. ¶ 77,629 at 83, 347 (1968).

33. HUNT COMMISSION REPORT, supra note 5, at 101. It was apparently felt by Hunt Commission members that the "wall" was impractical in smaller banks where just one or two persons had line responsibilities in both the commercial and trust départments.

should consider basing the "wall" requirement on a more effective criterion: the functional separability of the commercial and trust departments. If a bank officer with line responsibility over both the trust and commercial departments has subordinates in each department who exercise lending or investment discretion, a "wall" between those subordinates should be automatically required regardless of the amount of trust assets. The trust examination should show the trust examiner whether or not the bank has sound procedures which actually prohibit communication between the outside directors, the commercial departments, and the trust departments. In this regard, the trust examiner can educate each bank as to the "wall" policies followed by other banks.

Moreover, in scrutinizing potential conflicts of interest, trust examiners usually receive from banks a list of interlocking directorates involving corporation and bank officers or directors. While that list may roughly identify trust department holdings subject to improper external pressure, trust examiners generally are not given a list of those corporations which have significant commercial relationships with a particular bank. Except for those bank examiners who may also examine the commercial side of a bank, trust examiners must rely on rumor and their own "feel" to assess the potential influence of commercial relationships on trust department securities transactions.

The trust examiner should receive a list of all portfolio corporations having interlocking directorates or "significant" commercial relationships with the bank. Identification of the trust accounts which hold the securities of these corporations and which grant the bank investment discretion would be the second step.38 The trust ex

Others have suggested that since there is less possibility of material inside information in the credit files, and less potential impact of investment actions based upon such information, the adverse effect of not having a wall would arguably be minimal. Miller, Current Developments in Trust Supervision, 111 TRUST & Estates 268 (April 1972) [hereinafter cited as COMPTROLLER Developments].

34. COMPTROLLER'S MANUAL, supra note 16, at 87-94. The national bank'examiner is required by the Comptroller's Manual to list "significant" (more than ten percent of the shares outstanding) bank holdings of stock in accounts where the bank has investment responsibility.

35. The bank's commercial department, with review by the commercial department examiners, could prepare a list of all significant commercial customers. The bank's board of directors, officers, and employees could submit the names of corporations with which they have officer or directoral responsibilities. Trust examiners could then collate the data submitted to create the list.

36. It would seem reasonable to develop a sliding scale of "significance" (rather than some absolute dollar amount) which would select out for extended trust examiner analysis only those accounts, whether the bank be large or small, which might have the potential to influence trust department investment decisions in the particular bank.

37. In computerized banks, it may be possible to get a "printout" of such accounts. If, instead, labor-intensive methods of selection are necessary, the banks, trust examiners, and regulatory agencies will need to work out a method of selection which minimizes labor costs and lost man-hours.

38. Because trust accounts over which the bank has no investment discretion cannot be "influenced" in any event, they should not be included on such a list.

aminer should then focus on the relative performance of such accounts. Their relatively poor performance, if attributable to the securities of the identified corporations, would strongly suggest improper influence on trust department investment choice.

C. Cash Management

Balanced against a bank trust department's fiduciary duty to invest the trust account's assets,3o overriding liquidity needs may sometimes require leaving parts of the trust account uninvested. Such needs result, for example, from preparing for imminent trust account distribution requirements or postponing investment decisions in anticipation of a better overall market situation. Banks in major money centers have resolved the dilemma of productivity versus liquidity by creating internally managed short-term securities funds with a corpus of corporate commercial paper or U.S. government short-term securities."1 Administratively, bank trust departments subdivide these short-term securities funds into units of participation which are "sold" to individual trust accounts.42 Some banks have set a floor on participation in the funds by pricing each unit at $1000; other banks allow a unit to be purchased only if it will earn enough trust account profit (generally, $100) to offset the bank's costs. Since the return on commercial paper and U.S. government securities has generally been a point or so less than the prime bank lending rate, short-term securities funds have earned a significantly larger return than the use of savings accounts would have afforded."

39. 2 SCOTT, supra note 15, at § 181.

40. A trust account may temporarily have parts of its corpus uninvested for other reasons: Such parts may be proceeds from the sale of a trust asset awaiting reinvestment; incoming trust corpus from, for example, life insurance awaiting investment; income earned on corpus investments awaiting reinvestment or distribution; and periodic contributions from a corporation to fulfill its funding requirements under an employce benefit pension or profit-sharing plan awaiting investment.

41. See, e.g., Butler, Starting a Short-Term Securities Fund, 109 TRUST & ESTATES 490 (June 1970); Schneider, Setting Up A Cash Asset Fund: One Bank's Experience, 110 TRUST & ESTATES 372 (1971). Unfortunately, there are only a few viable vehicles available for shortterm cash investment which provide instant liquidity. United States Treasury bills, which would have liquidity, are currently issued only in round lots of $10,000 and thus are unavailable for most individual accounts. Dept. of the Treasury Release, Feb. 25, 1970. 42. The unit's price is kept constant for bookkeeping purposes during the term of the short-term securities fund, so that external fluctuations in the interest rate prevailing on the open market do not affect the unit's value and thereby do not cause the unit holder to realize a taxable gain or loss on the unit as a specific investment.

43. The rationale advanced for this price is that participation of at least $1000 is necessary to cover the "round trip" cost of getting units of participation in and out of the short-term securities fund. Different banks estimate this cost to be between $10 and $25 for a "round trip.

44. Besides having a lower rate of return, savings accounts result in a greater measure of illiquidity, since cash must generally be kept in such accounts for a period of one to three months before interest accumulates. 12 C.F.R. § 217.7 (1972).

45

For trust accounts which do not meet the short-term securities funds participation standards, and for banks without the computer time or mechanical equipment necessary to administer short-term securities funds, the alternative employed most frequently has been to deposit the “uninvestable” cash in the trust department's demand deposit account on the commercial side of the bank complex. Because banks are prohibited from paying interest on demand deposits, the bank complex "saves" the interest on the cash which might otherwise be deposited in a savings account, ́and has significantly more money available for commercial department operations. The bank complex sometimes gives the trust department, not the individual trusts, credit for the amount saved, thereby increasing the profitability of trust department operations. Thus, those banks lacking short-term securities funds arrangements sacrifice trust income for liquidity while enjoying the use of the uninvested cash. The Hunt Commission Report has expressed concern that more frequent analysis and review of bank policy may be desirable whenever a bank lacks short-term securities funds or sets minimum participation requirements for such funds at levels too high for some accounts to qualify.48

47

In a bank with short-term securities funds, a bank trust department account manager faces a potential conflict of interest: placing the cash in a short-term securities fund to earn the trust account a return, or placing the cash in the trust department's demand deposit on the commercial side of the bank to improve his department's profitability. Since the trust department's commissions for managing accounts will not be affected, while the net profitability of the trust department

45. 12 U.S.C. § 371a (1940). The Federal Reserve Board has determined in its Regu lation that "demand deposits" are deposits where the depositor has a legal right to receive his deposit back in full in less than thirty days. 12 Č.F.R. §§ 217.1, 217.2 (1972). See Hexter, That Which We Call A Deposit 26 BUS. LAW. 69 (1970).

46. The IIS Report found that, for 1969, the indirect value of demand deposits at tributable to trust department relationships, e.g., broker balances, portfolio company balances, and trust department deposits, amounted to thirty percent of direct commission income, or approximately .06 percent of trust department assets. IIS REPORT, supra note 2, pt. 2, at 480, 482, 483. For trust department deposits alone, the IIS Report estimated that the value of the deposits was worth 26.6 percent of direct commission revenues. Id., pt. 2, at 481.

47. Credit received from the commercial department can substantially affect the trust department's profitability. According to a survey taken by the Federal Reserve Bank of New York, the trust departments of ten large New York City banks received commercial department credit for deposits for 1971 in the amount of $114.1 million, bringing adjusted net earnings to about $95.7 million. Big New York Banks' Corporate Trust Losses Shrank Sharply in 1971, Wall St. J., Sept. 7, 1972, at 21, col. 2.

48. HUNT COMMISSION REPORT, supra note 5, at 102. On the other hand, there is a long tradition in trust examinations of focusing heavily on cash management. NEILAN, supra note 11, at 54. Uninvested cash is also one highly visible item in a trust customer's monthly statement from the bank to which all statement recipients can relate, whether they are sophisticated corporate treasurers monitoring pension trusts or housewives monitoring grandparents' legacies.