Death Care Law Blog : Kansas Death Care and Preneed Lawyer & Attorney : Stalter Legal Services Law Firm : Funeral Law, Elder Law : Kansas City

I stand corrected.

A representative of the Michigan Funeral Directors Association advises that their request for proposal for a new investment advisor for the master trust has resulted in the selection of a firm that will not only assume a true fiduciary relationship to funeral directors and consumers, but that will also guide the Association towards a target date investment strategy. Such an investment strategy would represent a true demarcation from the approach I was so critical of in a March post about the Michigan RFP.

Too often, the fiduciary's approach to preneed investment has been to offer three investment options to the funeral director. The fiduciary may even allow the funeral director to choose an asset allocation among the investment options. Little regard is given to the experience and sophistication the funeral director possesses with regard to financial and investment considerations. While Michigan law imposes a separate investment standard on non-guaranteed contracts, that is not the case in most states. Consequently, the two types of contracts are typically pooled in the same trust, and invested similarly. This presents a problem for the funeral directors that either take chances with the market or are ultra conservative. Another flawed investment approach is to allow income reporting to be the exclusive consideration.

Corporate fiduciaries have struggled with the delegation of investment responsibilities of the preneed trust. The uniform trust code contemplates the delegation of the investment responsibilities, and may even require such when the fiduciary lacks the expertise to properly invest the trust. But, it is virtually impossible to transfer the liability of that delegation. Applicable statutes contemplate notice and consent of the trust beneficiaries. The investment risk lies with the consumer who has purchased a non-guaranteed contract. With guaranteed contracts, the investment risk is assumed primarily by the funeral director. However, that risk is shifted to the consumer if the contract is 're-written' when the purchaser's survivors select a different arrangement at the time of need. The investment risk is also transferred when the funeral home goes out of business and the preneed contracts are not assumed by a successor entity.

Depending upon the factors incorporated by the investment strategy, the target date plan can provide a better model for the death care industry.

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If you haven’t noticed, there has been some turnover among the associations’ preneed fund managers. With the threat of additional litigation in Wisconsin, this trend could continue. But not all of the turnover has been as publicized as what we have seen in Illinois and Wisconsin. After 20 years at the helm, Merrill Lynch recently gave notice to the Michigan Funeral Directors Association of its resignation. There are no search protocols for preneed fund managers, and so Michigan borrowed from the retirement fund community by publishing a request for proposal (RFP). While the MFDA should be commended in their effort to bring transparency to their program’s asset management, they missed (or ignored) an opportunity to shift more investment responsibilities to the financial industry. Instead of using FINRA Rule 2111 (“know your client”) to their advantage, the MFDA structured the RFP to perpetuate (and extend) the funeral director’s controlling role in investment decisions.

Hidden investment charges have been ‘part of business’ in the death care industry for decades, and this author has contemplated whether ERISA’s fee disclosure requirements could ever be incorporated into preneed trusts by the Federal Trade Commission. The Michigan RFP focused on the same ERISA fee disclosure requirements, which could lead one to assume that association’s leaders did not want to make the same mistake again. The Michigan RFP also raised another ERISA concept worthy of the preneed industry’s consideration: the 401K approach to investment by individual contract. We too have wondered why larger programs have not looked at data from individual contracts and the sponsoring funeral homes to build an investment options matrix.

But, the Michigan RFP can be faulted for cutting off the diligence requirements of FINRA Rule 2111. To insulate the Association from solicitations, the RFP provided summary information about the program and required all inquiries to go through an ERISA consultant. Prospective fund managers were required to submit investment strategies on limited facts and without direct communications to the Association. It is understandable that the Association would want to narrow the field before initiating an exchange of confidential information with prospective managers, but the screening of candidates should have preceded the request for investment strategies. Subsequent to the screening, the MFDA should then have provided detailed information pursuant to a confidentiality agreement. Under FINRA 2111, this sequence would have expanded the fund manager’s diligence responsibilities regarding investment strategy recommendations. The nature of the questions posed by the candidates would also have helped the MFDA in its assessment of the candidates. Instead, the RFP narrowed the fund manager’s diligence to an old investment strategy with a history of mixed results and challenges.

Within the context of ERISA retirement funds, RFPs may take a formula approach to finding a replacement fund manager. But the preneed industry is fragmented by 50 different state laws, and by program issues such as whether non-guaranteed contracts are sold, the association’s role as a seller versus an agent, investment restrictions, and trusting percentages. Injecting preneed asset management with a dose of ERISA could help to discourage hidden fees and improve the quality of fund managers, but the industry also needs an alternative to the strategy of offering funeral directors three investment options to choose from.
 

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Both the Memorial Business Journal and the Funeral Service Insider commented last week on the Milwaukee Journal Sentinel’s February 7th article regarding the former executive director of the Wisconsin Funeral Directors Association. Several issues were raised that should be included in future industry debate, and in particular, I would agree with Mr. Isard’s questions whether association executives are qualified to manage a master trust. But the following comments beg an immediate response:

“The whole situation with [the] Wisconsin Preneed Trust went off the rails when the goal shifted from trusting funds to investing funds.”

“The assumption that these trust funds are in the investment business is a mistake. We’re not. We’re in the trust business. From my view, that is a presumption of a preservation of principle. With a trust, you have an obligation to be prudent.”

Those comments suggest that trusting funds and investing funds are somehow mutually exclusive. While the comments may reflect the views of much of the death care industry, they also reflect a failure to understand the fiduciary’s duties. When entrusted with the money of another, the fiduciary has a duty to invest those funds consistent with the purposes of the trust and the interests of the trust beneficiaries. The fiduciary’s investment duties are governed by other laws, and a majority of our states have adopted the Prudent Investor Act. Wikipedia provides the following explanation of that Act:

In enacting the Uniform 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 Uniform 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.

The majority of preneed trusts involve a single seller/provider and guaranteed preneed contracts. Under such circumstances, the funeral home operator has assumed the investment risk when the preneed contract is performed as written. Fiduciaries (and fund managers) have viewed the operator as the account beneficiary for purposes of the Prudent Investor Act. But depending upon state law, and whether the contract is ‘re-written’ at the time of death, the preneed purchaser may bear the investment risk. Accordingly, the fiduciary and fund manager should not completely ignore the preneed purchaser as the account beneficiary for purposes of the Prudent Investor Act.

Neither fiduciaries nor fund managers want to bring the preneed purchaser into the Prudent Investor equation for obvious reasons. But are suitability of investments for two that dissimilar? We would suggest not if the objective is to have investment performance track the prearrangement’s purchase price increases. As we noted in a March 2010 post about the IFDA master trust, the purchaser of a non-guaranteed contract was unhappy because the return on her non-guaranteed contract (1.7%) did not keep pace with the price increases of her planned funeral (4.2%).

Determining who to include as an account beneficiary in the Prudent Investor equation only gets more complicated when the preneed trust is an association master trust with dozens, or hundreds, of funeral home operators. If the master trust includes a healthy percentage of non-guaranteed contracts, the number of account beneficiaries could swell to the thousands. If the association is not the preneed seller (as is the case in Missouri, but not Illinois), what interest does the association have in the trust so as to justify being considered an account beneficiary? There are arguments in support of the association being such a beneficiary, but can those interests ever outweigh the funeral operator and the non-guaranteed contract purchaser?

One could argue that the Wisconsin Master Trust was never fully on the rails. The Association determined early on that a depository account could not keep up with rising funeral costs. Rather than seek legislation that would clarify the trust’s investment authority, the Association leadership sought regulatory permission to allow the master trust to embark on the path of investment diversification. The program derailed only after the executive director enmeshed his personal objectives with those of the association and then conspired with the fund managers to treat the association as the master trust’s primary account beneficiary.
 

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Fiduciary Partners, the corporate fiduciary for the Wisconsin and Illinois master trusts, broke its silence this week with a statement to the Funeral Service Insider. The statement was made in response to criticisms previously reported by FSI, and reflects the receiver and fiduciary working together to get their “message” out and avoid the kind of litigation that has hamstrung the IFDA, its membership and the Illinois funeral industry.

FSI commentators used Fiduciary Partners’ link to the two states to drive home with funeral directors various preneed problems* including the management and investment of preneed funds, and the state of the guaranteed preneed contract and its impact on funeral pricing practices. While the issues need to be incorporated into a national dialog, Fiduciary Partners interpreted the FSI report as encouraging Illinois and Wisconsin funeral directors to assign blame to Fiduciary Partners. Consequently, Fiduciary Partners and the receiver felt compelled to respond.

As reported in a prior post, the WFDA leadership had muzzled Fiduciary Partners with a very strict confidentiality provision through an amendment to the master trust. Accordingly, the statement given to FSI has been made with the receiver’s approval, and could be taken as having the WFDA’s endorsement.

To neutralize litigation over the trustee’s role in administering investments, Fiduciary Partners and the receiver sought to clarify that the company had a very limited role that never included the management of investments. The message goes on to reinforce the need for Fiduciary Partners to continue to provide administrative functions related to individual contract accounting and performance payments. The statement also conveys a tacit acknowledgement of the WFDA’s secrecy, with Fiduciary Partner’s commitment to a new transparency.

It is inevitable that comparisons will be made between Wisconsin and Illinois, and to conclude that litigation may also be inevitable. However, one stark difference exists between the two situations: Illinois funeral directors faced a recalcitrant board that refused to acknowledge and correct its mistakes. That leaves the question whether Wisconsin funeral directors will bring litigation to recover damages. As one FSI commentator points out, damages will be difficult to measure when the association reported inflated numbers (through the guaranteed rate of return). And as the other commentator points out, member funeral directors need to take responsibility for hiring executives and fund managers that are competent and professional. It was their hire of an inexperienced executive that ultimately directed the use of trust funds to establish an insurance company.

The multi-million dollar question to be asked is what if Fiduciary Partners had responsibility for investment oversight? Would the trustee have been able to check Mr. Peterson’s actions? In our next post, we will look at the hold harmless provisions so popular in the preneed trust agreement.

*Reprinted from the Funeral Service Insider – October 29, 2012
**Reprinted from the Funeral Service Insider – November 5, 2012

To obtain a full copy of the Funeral Service Insider, contact  www.funeralserviceinsider.com to subscribe.
 

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In the days that followed the Wisconsin Funeral Directors Association being placed into receivership, some of the WFDA’s sister associations were quick to point out they had ‘checks and balances’ that would protect consumers’ funds from the problems that tripped up the Wisconsin Funeral Trust. As we reported in our last post, a crucial ‘check and balance’ missing from the WFT was investment oversight. The fact that a trust has a corporate trustee does not necessarily mean that fiduciary has responsibility for monitoring the prudence of the investments. Corporate fiduciaries often look to uniform trust codes for the authority to delegate investment responsibilities. If a grantor wishes to use an outside asset manager, general trust laws will accommodate those wishes. The problem with preneed trusts (and cemetery endowment funds) is that there is more than one “grantor” to the preneed trust.

We have previously stated our support for allowing a relationship between preneed seller and a qualified fund manager. However, the fiduciary must provide a ‘check and balance’ to that relationship by maintaining responsibility for the investments. The ‘scandals’ from Missouri, Illinois, California and Wisconsin stem from a lack of investment oversight. Missouri’s regulators responded to NPS with a law that precluded any relationship between the advisor and the seller. Appropriately, the Missouri association obtained revisions to allow an agency relationship between its fund manager and the trustee. However, the Missouri law does not go far enough to require the disclosures we recommended in 2011. Funeral directors and consumers need to know that Missouri preneed fiduciaries ‘have their back’ when it comes to investment oversight.

Investment oversight is also a concern for cemetery regulators. Kansas’ cemetery regulators were dismayed to find that a corporate trustee had turned over the investment reigns to a Hutchinson cemetery operator. The operator hoped to cover declining revenues (and the failure to make trust deposits) with higher investment returns. For months, the operator attempted to hide the ball from the auditor, but eventually it was discovered that those investments had lost hundreds of thousands of dollars.

The investment supervision issue is also a concern for Nebraska regulators. As they prep the death care industry for legislation in 2013, they raise this issue:

Seller’s Power to Direct Investments

A question has arisen regarding the seller’s ability to direct the trustee’s investment decisions. Specifically, should the seller be able to instruct the trustee to deposit or invest funds in securities that do not meet the trustee’s own investment guidelines?

If it is determined that the trustee should be free from the seller’s investment influence, section 12-1107 should be amended to reflect this fact.
 

In what may be a perfectly legal arrangement, Illinois funeral directors have handed off investment oversight to their new fund managers. The master trust instrument carefully outlines the code provisions which authorize the delegation of investment authorities. But the document goes that extra step of exculpating the trustee from responsibilities for investment oversight. Where is the check and balance in that structure? Are the industry’s expectations so high that a trustee will not accept the fund without a hold harmless? If the industry does not establish its own ‘checks and balances’ with regard to investment supervision, the authority to participate in the investment decisions could be taken away.
 

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The Kansas Secretary of State’s office bore the brunt of the criticism for a Hutchinson cemetery that siphoned off hundreds of thousands of dollars from its trust funds. That office has the responsibility of auditing cemetery trust funds (preneed merchandise and care funds). But, poor record keeping on the part of the cemetery industry has made the auditor’s work difficult, if not impossible. Accordingly, the KSOS office implemented a new reporting system last year that requires cemetery corporations to file quarterly reports regarding their sales of preneed and interment rights. These new reports are intended to enable the office to more closely monitor the cemetery’s trusting requirements. This reporting mechanism has another requirement that went into effect on January 1st: corresponding reporting by the banks and trust companies that administer the cemetery’s trust funds.

House Bill No. 2240 amends the cemetery merchandise law and the permanent maintenance fund law to impose several reporting duties on the trustee. For each type of fund, the trustee must prepare quarterly reports on formats approved by the Secretary of State’s office. With regard to merchandise funds, the trustee must also report its allocation of income to the merchandise and services sold by the cemetery.

For many of those banks and trust companies serving as cemetery fiduciaries, these reporting requirements will come as a rude awakening. Few cemetery fiduciaries are aware that these accounts are subject to a separate set of Kansas laws. Consequently, these banks often price their services as a custodial relationship. Many will not want the fiduciary relationship and its new reporting requirements. With the first fiduciary reports due May 1st, the upcoming Memorial Day will be hectic for Kansas cemeteries for more than the usual reasons.

Click the following hyperlinks to view the HB 2240 sections on reporting: merchandise or permanent maintenance.
 

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Many state preneed regulators share the point of view that the payments made toward a preneed contract belong to the consumer until the prearranged funeral is provided. This perspective was adopted by the California Attorney General in its Eighth Cause of Action brought against the California Funeral Directors Association and its Master Trust. The AG criticizes the CFDA for investment decisions that are fairly representative of those taken by the industry as a whole.

Early on, the CMT relied upon bond funds that specialized in zero coupon government bonds. The AG points out that U.S. Treasury Bonds and similar bond funds outperformed the CMT at less risk and with lower fees.

When the bond market crashed in 2001, the CMT experienced substantial investment losses and changed investment course. The CMT began diversifying, and purchasing mortgaged back securities, foreign bonds and notes, corporate asset-backed securities and other types of securities. The AG criticizes these investments by stating “these types of investments are not insured bank accounts, are not bonds that are legal investments for commercial bank (sections 1001 et seq. of the Financial Code lists certain legal investments for commercial banks), are not government bonds, and do not comply with the Uniform Prudent Investor Act (as discussed below).”

The AG goes on to argue that the investment policies of the CMT should be set by the risk and return objectives of the preneed contract beneficiaries, and faults the defendants for having set investment policies based on their own needs.

Other states’ preneed regulators (and cemetery regulators) share the California AG’s point of view. It is common to hear a regulator characterize the preneed trust as a depository account or to express the belief the industry would be better off if preneed funding were left to the insurance companies. These regulators need to take the blinders off.

The CMT, like so many preneed trusts, went into tax exempt investments after 1988 because of Revenue Rul. 87-127. The Internal Revenue Service pushed for an income reporting method that proved impractical and burdensome. To compound the situation, the IRS applied the ruling retroactively to certain states. California was one of those states. Prior to the ruling, funeral homes had no reason to require the consumer’s social security number when selling a preneed contract. Consequently, many California trustees could not comply with the ruling with regard to existing contracts.

The ruling required grantor statements to be sent to consumers, and the consumers complained. So, funeral homes instructed their preneed fiduciaries to go into anything that didn’t require a grantor statement. While the CMT went to zero coupon bonds, the IFDA went into the poorly conceived key man insurance. Other trusts went into annuities. Various approaches were taken because the IRS could not provide reporting guidance once it changed the rules.

In stating that the preneed funds must be invested pursuant to the contract beneficiary’s objectives, the California AG has ignored the fact that a majority of these preneed contracts are probably guaranteed. Under that arrangement, the funeral home has assumed the investment risk. From a practical approach, how would the investment advisor determine the objectives of the thousands of preneed beneficiaries? In a prior post, this blog reported about an Illinois contract beneficiary’s complaint about the IFDA Master Trust. In contrast to the losses suffered by the member funeral homes, the beneficiary experienced a modest return on her non-guaranteed contract. Her complaint was that the return was not enough to keep up with rising funeral costs.

The California AG argument that the CMT must comply with the Prudent Investor Rule in a way that does not expose trust principal to risk is the equivalent to handcuffing both of the investment advisor’s hands behind his back.

Of the investment complaints made by the California AG, the one which would seem to merit the most attention would be the relationship between the former investment advisor and a CFDA board member. That CFDA board member also served as a trustee for one of the advisor’s funds, for which he received compensation. That relationship warrants an inquiry whether the relationship was disclosed and the compensation appropriate and reasonable.

The AG’s argument that the investment advisor must be independent from the seller is one shared by Missouri regulators. The Missouri regulators are quick to point to the abuses committed by NPS and its investment management firm. (See our post titled “The Zeal for Independence”). Those abuses were so bad that the Missouri legislature passed a provision prohibiting a relationship between the seller and the fund manager. This author thought the provision went too far. (See our post titled “Regulating Out of Context”). With the passage of SB 325, the Missouri Funeral Directors Association has convinced the Missouri legislature that it did go too far.

Regardless of whether the fund manager is a fiduciary employee or an independent investment advisor, that fund manager should appropriately look to the preneed seller for input about investment objectives. For the larger trust, the fiduciary and fund manager should adopt a written investment policy that, among other factors, considers the trust’s mix of guaranteed and non-guaranteed contracts. If the fund manager is an independent investment advisor, the relationship should be documented with an agreement that discloses all forms of compensation. Consistent with the SEC efforts to reform mutual funds, the disclosure should address any 12b-1 fees. The agreement with the fiduciary should also disclose all relationships the investment advisor has with the preneed seller.

To the extent the preneed contract is guaranteed, the regulator needs to recognize the seller’s economic interest in the trust’s performance. But, fiduciaries and sellers need to consider the growing number of non-guaranteed contracts and the possibility that the guaranteed contract may be serviced by a different funeral home. While the seller may have the prevailing economic interest, not all of the trust may be considered his for investment purposes.

 

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Regulators in California, Missouri and Kansas have already implemented strategies that are intended to make preneed fiduciaries more accountable to the consumer. Over the past few weeks, this blog has covered new reporting requirements in Missouri and the audit drama playing out in California. In Kansas, the fiduciary for a failed cemetery has been sued for various breaches of state law. Because the pool of experienced preneed fiduciaries is relatively small, the events transpiring west of the Mississippi River will influence many Illinois fiduciaries to spend some time with SB1682.

One SB1682 requirement that has already caused a rift between funeral homes and preneed fiduciaries is the annual statement requirement. Illinois law now requires the trustee to report to the preneed purchaser receipts, disbursements, and “an inventory of the trust” (including expenses).

Recent statements reflected substantial account decreases, and that has strained the relationship between the funeral home and some of its consumers. While funeral homes would rather avoid inflaming consumers with news about deteriorating accounts, the fiduciary is bound by law to provide the consumer an annual accounting.

IFDA members can deflect some consumer complaints, but eventually, the buck will stop with the funeral director. To regain consumer confidence, funeral directors should be prepared to show they have a plan for the funds entrusted with them.
 

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California funeral directors face a September 13th deadline that could have substantial financial consequences, including the repayment of trust distributions.

A July 1st letter sent by the California’s Cemetery & Funeral Bureau to funeral homes in the California Master Trust outlined the regulator’s rejection of the Association responses regarding the Master Trust audit. An impatient Bureau gave funeral directors 3 weeks to respond. That deadline was quickly extended to August 11th. Then the week before the August 11th deadline, the Bureau granted another extension to September 13th.  On the eve of the deadline, there is nothing on the Bureau's website to suggest another extension is in the offering.

The Bureau is demanding several significant changes to be made to the administration of the California Master Trust. But one demand that may prove problematic for the Association will be the Bureau’s demand that funeral homes repay to consumers’ trusts the administration fees that have been paid out over the years. The Bureau has rejected the Association’s proposal for prospective procedures to document the fees.

Within the past year, Nebraska preneed sellers were also called upon to replenish trusts for the method in which income taxes were paid. The Nebraska examinations also went back several years, and involved substantial amounts.

With new reporting requirements, Missouri funeral homes will also have to explain trust and joint account shortages. Some Missouri funeral directors have failed to appreciate how Missouri law distinguishes between trusting and joint accounts. Missouri’s old preneed law allowed sellers who used trusts to retain 20% of the consumer’s payments, and to withdraw income (subject to the mark to market) requirement. Those provisions don’t apply to joint accounts. With regard to the new Missouri law, sellers also need to grasp that the 10% sales expense is permitted only with regard to trust contracts that are guaranteed. With regard to Pre-SB1 trusts, sellers could be held accountable for income, taxes and expense distributions that cause the trust to drop below aggregate deposits.

Illinois preneed sellers have a similar limitation on their claim to the 5/15% permitted under their preneed law. While the lawsuits that have embroiled the IFDA claim about 1/3 of the master trust’s contracts were non-guaranteed, it’s not clear the funeral homes made that distinction when claiming their ‘administrative fee’.

For those funeral directors who participate in a master trust, the California drama is worth watching. While the Association is crucial to negotiating a resolution, the Bureau has taken its fight to the individual funeral homes. Will other state’s regulators follow suit?
 

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The Comptroller’s Office mailed out letters to funeral homes last week advising how to report the first contribution to the Pre-Need Funeral Consumer Protection Fund. The letter tracks the first few paragraphs of the “Senate Bill 1682 Information” page from the Comptroller’s website.

The funeral home letter includes two documents: a Fee Payment Record and a Bank Confirmation Form. For each contract sold, the funeral home must deposit $5 to the Consumer Protection Fund. The $5 may be funded out of the consumer’s payments. The Fee Payment Record will be used to record each pre-need contract for which the funeral home has made a deposit.

The Bank Confirmation Form is intended to establish an audit trail for the mass exodus of preneed funds from self trusted accounts, and from the IFDA master trust. This form serves to put funeral home’s pre-need trustee on notice that it will be required to provide records to the Comptroller’s Office.  

The Comptroller’s letter to funeral homes omits information that the website page provides consumers. Fiduciaries that are accepting Illinois pre-need trusts should take note of the Comptroller’s consumer information:

Notice to Consumers --- Your independent trustee must provide an annual notice to all consumers of the status of their funds including an explanation of any fees charged by the trustee, an explanation of the purchaser’s right to a refund and identification of the primary regulator of the trust or insurance company under state or federal law. Here are some suggestions for ensuring compliance with the new provisions:

· Be sure the corporate fiduciary or insurance company that you use is aware of this requirement.
· Be sure the corporate fiduciary or insurance company provides you with a copy of the annual notice.
· Retain a copy of this annual notice in your file.

Historically, preneed fiduciaries have defined their duties by treating the death care operator as the trust beneficiary, and the trust as a single account. The Comptroller’s trustee requirements reflect a trend that forces the fiduciary to factor the consumer into the beneficiary equation, and to provide an accounting on an individual contract basis.

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Within the past few years, state legislatures have significantly expanded the fiduciary duties of banks and trust companies that service death care trusts. Michigan, Indiana and Tennessee responded to cemetery trust frauds (including the Clayton Smart affair). The trend continued in Missouri and Illinois with laws aimed at funeral trusts (in response to NPS and the IFDA master trust). And, Kansas joined the movement with bills that are in response to cemetery trust failures.

At hearing for Kansas HB2712, the Kansas Bankers Association endorsed a provision that would require Kansas cemeteries to use fiduciaries that maintain a physical location within the state. The KBA reasoning is very simple: Kansas jobs. While the Kansas Secretary of State will accept the KBA’s support, the regulator wants the domicile requirement because the local fiduciary will be more responsive to the auditor’s inquiries and demands.

Regulators are not alone in their preference for the local bank. Funeral homes and cemeteries also take comfort in dealing with the bank that also handles their commercial accounts and their loans. Many funeral directors report that consumers also take comfort knowing their preneed funds are being supervised by the same banker who provides them checking services. Even consumer advocates recommend that individuals use the local bank to set up Totten trusts or POD accounts in lieu of preneed contracts.

However, the preneed trust and the cemetery perpetual care trust are not the type of accounts that most banks (or trust companies) handle with sufficient frequency to develop expertise. There is very little in the way of guidance to banks other than a 2000 memorandum issued by the Office of The Comptroller of the Currency to national banks.

Buried in the details of the OCC memo is the devil that trips up many preneed fiduciaries: the bank will be required to administer and invest the trust pursuant to the controlling instrument and applicable law. Applicable law would include the Internal Revenue Code, 12 CFR Part 9 and state death care laws.

The OCC memo warns national banks that:

Many banks serving as trustee in a preneed trust have only limited contact with the purchaser of the funeral contract and provider of the trust funds. The bank’s contact and business relationship is primarily with the funeral company. The consumer’s primary contract is with the funeral company or funeral director. Upon the death of the consumer, the bank remits the proceeds of the trust to the funeral company in accordance with the terms of the trust and contract, not to the individual’s family or heirs as is common in most trust relationships.

What makes this complicated and sensitive is that preneed funeral trusts are usually accounts established by funeral homes on behalf of individuals who are elderly or have limited financial resources. In addition, trustees manage these funds for a particularly sensitive and emotional event. Absent appropriate policies, procedures, controls and monitoring systems, this business line can create increased transaction, compliance and reputation risks.

Poor management of preneed funeral trusts, including weak internal controls over account acceptance and disbursements, noncompliance with trust agreements and applicable law, and inadequate due diligence on funeral homes and directors, can negatively affect a bank’s reputation. Banks that align themselves, or are affiliated, with funeral companies that have or subsequently develop reputation problems may themselves be tarnished, even if their internal practices are appropriate.

Preneed funeral trusts require the same level of supervisory oversight and risk management systems as other fiduciary activities in national banks. We expect banks that are active in this line of business to have appropriate strategic plans, policies and procedures, internal controls, MIS, and monitoring systems for this product. The administration of these accounts must comply with 12 CFR 9, Fiduciary Activities of National Banks, particularly the pre-acceptance, post-acceptance and annual review processes. It may be appropriate to have policies and procedures specific to this business line, and, if the business is significant for a bank, a separate administrative and investment review committee should be established.

It is imperative that national banks perform due diligence reviews on a funeral company before they enter a business arrangement with it. Bankers should also perform annual reviews of companies with which a bank has established a business relationship. Bankers should administer the use of third party service providers, such as investment advisors or managers, with appropriate controls and monitoring systems. National banks should also include preneed funeral trusts in internal compliance and audit programs.

While everyone from the consumer to the state death care regulator may take comfort in the local banker, few small institutions will have the revenues sufficient to warrant the costs associated with the compliance procedures recommended by the OCC.
 

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The ICCFA’s November Magazine included an article by Craig Martin that provides good advice for all death care trusts. Death care trusts are notoriously bad performers, and if operators are to improve investment performance they need to work more closely with their fiduciaries and portfolio managers. Mr. Martin offers 5 tips that are equally applicable to preneed trusts and endowment care trusts:

1. Know your investment guidelines (and statutory limitations)
2. Communicate with the investment manager on a regular basis
3. Use a professional fund manager
4. Include growth in the asset allocation
5. Explore the availability of a master trust

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One criticism of Missouri’s prior preneed law was that the Attorney General’s office was dependent upon the State Board to refer complaints for legal enforcement. If the State Board didn’t refer a Chapter 436 violation, the AG’s only enforcement alternative was to pursue an action under Missouri’s Merchandising Practices Act (Chapter 407). During the 2008 hearings on Chapter 436 and National Prearranged Services, it was generally recognized that the Attorney General’s office needed independent authorities to pursue Chapter 436 violations. But, the Attorney General also expressed the desire for authority to hold fiduciaries more accountable for their funeral home client’s actions.

The AG’s fiduciary recommendations drew concerns from both funeral homes and the Missouri Division of Finance. The Division of Finance questioned whether the requested powers would make the AG a de facto bank regulator on par with the Division and the bank’s federal regulators. Consequently, the final recommendations for Chapter 436 legislation conditioned the AG’s authority to take action against a fiduciary on having received the consent of the fiduciary’s primary regulator.

However, the Chapter 436 Working Group recommendation regarding this limitation on the Missouri Attorney General did not survive the Senate Bill No. 1 revision process.

Section 436.470.12 of SB1 grants the Attorney General the authority to bring action against a preneed fiduciary whenever an “inspection, investigation, examination or audit” reveals a violation of Chapter 436. A prior subsection provides for information sharing among the relevant Missouri agencies, and arguably, the AG’s authority over preneed fiduciaries could be triggered by the AG’s own investigation or examination.

And, there seems little doubt that the AG may be inclined to apply this new authority with regard to preneed trusts that existed prior to August 28th. Accordingly, Missouri’s preneed fiduciaries should evaluate their accounts with the knowledge that Big Brother may be looking.
 

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Rather than defend the legality of its master trust, the IFDA sought to enforce the gentlemen’s agreement that the association perceived it had with the Comptroller. The 2006 exchange of correspondence reported by the State Journal-Register underscores the risks that death care operators take when they structure arrangements that exceed the parameters of applicable law.

When the applicable law is ambiguous, operators may be forced to go outside the four corners of the law. In those situations, the operator should do exactly as the IFDA did: personally work with the regulator. But it becomes incumbent upon the operator to ‘work with’ the regulator when circumstances force changes to the arrangement.

Reading between the lines, the SJR article suggests that as more IFDA funds were put into insurance, the more the IFDA relied upon its ‘declared’ 2% increase as justification for the fees charged the trust. As that domino fell, next went the IFDA’s authority to act as the trust’s fiduciary.

Rather than continue to ‘work with’ the Comptroller’s office, the IFDA sought to enforce their gentlemen’s agreement. Unfortunately for consumers and funeral directors, that agreement was flawed from the start.
 

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For twenty-five years, Missouri funeral directors have had it easy with regard to accounting for consumers’ preneed payments. Chapter 436 required the preneed seller to maintain 80% of the preneed contract sales price in trust. The Missouri law also allowed the preneed seller to withdraw income so long as the 80% threshold was maintained. Consequently, the seller’s trust accounting was fairly simple. However, Senate Bill No.1 has rewritten Chapter 436, and in doing so, will impose a substantial change of accounting upon the Missouri preneed industry.

To establish an audit trail, SB1 requires every payment made on a trust-funded contract to be deposited with the fiduciary institution. The law will also require the preneed trust to accrue income, which the consumer may transfer to an alternative funeral provider. Consumers can also request account information. All of this will require the preneed fiduciary to make monthly allocations to the trust’s individual preneed accounts.

To an extent, the new accounting requirements will also be incorporated into annual regulatory reports required of preneed sellers.

A new era of accountability begins in Missouri.
 

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Finding a fiduciary institution that is both knowledgeable and receptive has proven a challenge to funeral directors. Until a few years ago, the larger operators could rely upon the size of their trust to at least generate interest from prospective institutions. However, litigation exposures are now causing institutions to hesitate with even the largest of trusts, and the Illinois Comptroller’s proposed legislation would raise the fiduciary bar even higher for Illinois funeral homes.

If given the choice, state preneed regulators prefer that sellers use a ‘domiciled’ fiduciary institution. It is easier to hold domiciled institutions accountable under the preneed law. However, the preneed regulator’s jurisdiction begins to ‘cloud’ with regard to a foreign state-chartered institution, or a federally chartered institution that is not “located” within the state.

The Illinois Funeral or Burial Funds Act, like other states’ preneed laws, has an ambiguity that opens a ‘back’ door for foreign fiduciaries. While paragraph (b) of Section 225 ILCS 45/2 contains language stating the preneed fiduciary is to be domiciled in Illinois, paragraph (f) authorizes the use of foreign fiduciaries without the institution subjecting itself to the jurisdiction of state regulators. The Comptroller is now looking to close that ‘back’ door by deleting paragraph (f). The consequence to the Comptroller’s proposal would be to require the foreign fiduciary to comply with the Illinois Corporate Fiduciary Act.

Each state has a law governing the fiduciary activities of foreign institutions, and some are more liberal than others. State chartered institutions have no choice but to comply with these laws if it is deemed that the fiduciary services are being rendered within the state. In contrast, OCC and OTS chartered institutions will generally assert federal preemption arguments. With regard to both state chartered and federally chartered institutions, the language of the preneed law and the preneed contract are relevant to the issue.

The Texas Department of Banking addressed these issues in a 2001 opinion, with a compromise of sorts. In reaching that opinion, the Texas attorneys were mindful of the 1998 OTS opinion obtained by Forethought Financial Services. While on its face, the OTS opinion reads as a “Pass Go” and Collect $200 card, certain representative facts undermine the opinion’s value. State preneed regulators will invariably dispute the facts asserted by the “Association” at the bottom of page 7 of the opinion.

Following the Texas lead, state preneed regulators need to be flexible with foreign fiduciaries willing to comply with their state’s preneed law without ‘locating’ within the state.

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Missouri’s preneed reform legislation will be amended on the House floor in the next day or so, and some of the Representatives have heard that old phrase about legislating morality. There is some truth to that phrase, and to some of the other objections raised against the reform legislation.

Preneed oversight will impose a substantial financial burden on a strapped state government and regulators lack the requisite experience to define the future course of preneed. However, these objections seem to wither when read in conjunction with the ‘excuses’ of the IFDA member funeral homes.

In a nutshell, Illinois funeral directors did not perform due diligence with regard to the management of their master trust. Instead, funeral directors placed their trust in their elected leadership, who then placed their trust in an investment advisor.

For those of us who work in this industry there is one given fact: funeral directors are caregivers by nature, and would rather spend their time with a family than the preneed trust’s accountant, attorney and investment manager. Well respected industry leaders are calling the current preneed situation “nuts”, and recommend that funeral directors focus on what they do best: serve the family. This advice resonates with most funeral directors, but they also know that families have come to expect the preneed option. But if preneed is to be offered, funeral directors must begin doing their homework.

Two years ago, Sue Simon wrote about Missouri’s triple-dipping trusts. One might have thought NPS’ demise brought this issue to an end, but that is not the case. A program utilizing a variable annuity product is being marketed to Missouri funeral directors. The promises made with regard to this product seem familiar to those made to the IFDA.

Depending on the final version of Missouri’s preneed reform legislation, funeral directors and fiduciaries may be forced to explain the condition of their preneed trusts. It would be best to put the Illinois Secretary of State’s questions to the investment advisor before the investment is made, rather than after.

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Many preneed trusts either experienced significant capital losses last year or are sitting on assets that have unrealized losses. For those trusts that have taken a Section 685 election, these losses may be carried into future years as a capital loss carryover. While everyone would prefer to avoid realizing those losses, that loss can be used to offset future trust income. With the proper individual contract accounting, the loss could be extended for a longer period than the aggregate reporting followed by many trustees. For an explanation of Section 685 and the differences between aggregate reporting and composite reporting see our August 9, 2008 post titled “The Section 685 QFT amendment: Supporting Soldiers’ Survivors”.

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As new allegations surface about the Merrill Lynch broker associated with the IFDA master trust, some may appropriately ask why a preneed trust would ever invest in an insurance product. There was a time when the twain shall never meet. That all changed in January 1988, and specifically when the IRS and Treasury decided to apply Rev. Rul. 87-127 retroactively to states ‘that should have known’ the funeral home/grantor method of income reporting was inappropriate.

Prior to the ruling, preneed trustees were taking different approaches to reporting the income earned by the trust. With regard to states such as California and Illinois, the trust was required to accrue income and the Service believed trusts from those states lacked authority for electing the grantor method with the preneed seller as grantor.

Consequently, the Service leveled the boom by serving notice that the ruling would be applied retroactively in certain states. This posed a genuine problem for existing trusts because most lacked the requisite consumer information to report income in compliance with the ruling. Thus started a mad scramble to find an alternative to income reporting, and thus began the exodus to insurance.

Today, preneed trustees can avoid the burden of Rev. Rul. 87-127 by electing taxation pursuant to IRC Section 685. While a few legitimate reasons for preneed trusts to hold an insurance product remain, the insurance transaction merits close scrutiny, particularly when a conversion of existing assets to insurance is involved (NPS and its Missouri trusts).

The preneed trustee should ask certain fundamental questions of those who seek to have the trust invest in insurance:

· How will this product be taxed upon maturity?
· Does this product provide the requisite liquidity to fund cancellations?
· Is a commission paid, and to whom?
· How strong is the policy’s issuer?
 

To the extent a life insurance policy is utilized, the decision invariably becomes an irrevocable election. The policy’s cash value generally precludes getting back out.

Generally, annuities provide a more flexible alternative to life insurance, but pitfalls still exist. In recent years, funeral directors have received solicitations to have their preneed trusts invest in a group, variable annuity product. Trustees still need to ask these fundamental questions, particularly when an investment broker is advising the funeral director.

With regard to the taxation of the insurance product, few seem to realize that the trust is dependent upon Rev. Rul. 87-127 for the desired tax consequence.

For those interested in the history of Rev. Rul. 87-127, and its alternative reporting method (Section 685), Professor Joel Newman provided a fair and accurate account in 80 Tax Notes 711.

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In naming the IFDA officers and board of directors as individual defendants in their lawsuit, the Calvert group sought to make these individuals accountable for management of the association’s master trust.  Members of a board of directors have a duty to act in the best interests of the organization.  Defenses against personal liability are afforded the board member so long as he/she has acted reasonably, diligently and in good faith, even when the organization suffers a catastrophic loss as a result of the board’s decisions.  However, what defenses were afforded the IFDA board members are now compromised by the lawsuit filed by the Association’s liability carrier, and the outcome could have a chilling effect on new board members’ efforts to do the right thing.

Funeral Service Insider and Chicago Tribune have reported a limited number of facts, but the liability carrier seems to be challenging coverage of the IFDA for the Association’s failure to provide timely notice of “the claim”. Federal Insurance Company cites the June 21, 2006 letter from the Illinois Comptroller’s office as the event that gave rise to the claim.

The IFDA has valid issues to raise in opposition to the carrier’s assertions, but litigation moves slowly.  In the meantime, prospective candidates to the IFDA board of directors must weigh their personal exposure to this situation.  Doing the right thing may not be enough for some who have been injured by the master trust's decline in value.

Other state associations should take from this latest IFDA development the need to review their liability insurance policies and to timely report all potential claims.

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John Duggan has a point, and that’s what concerns regulators in Illinois, Missouri and Texas. Who will be blamed when the consumer does not get the benefit of their preneed contract?

While the overwhelming majority of NPS’ preneed contracts will be honored by the funeral home named in the contract as the “provider”, it is not because of regulators’ threats. Most funeral directors cannot afford to abandon their preneed families. The same can be said for the IFDA members and their preneed contracts. But there will be some funeral directors who eventually decide that they cannot afford to honor those contracts. To protect the consumer, the regulator will be called on to enforce a contract that should exist between the funeral home provider and the third party preneed seller.

Many funeral homes rely upon third party sales organizations to provide preneed documents, administration, sales forces and economies of scale. While funeral directors typically relate the term “third party preneed seller” to entities such as National Prearranged Services, the term also includes those entities formed by state associations to service member funeral homes that do not want, or cannot afford, to maintain their own preneed operation. While this relationship involves the delegation of crucial responsibilities, regulators have discovered that the seller and provider have done little to document their respective rights and obligations in a formal agreement.

When the Texas Insurance Department took control of NPS and its sister insurance companies in early 2008, the initial press releases advised funeral directors that they were obligated to honor those contracts regardless of the circumstances. Texas authorities subsequently narrowed such statements to their Texas funeral directors because Missouri’s Chapter 436 does not have such a requirement.

NPS was notorious for selling preneed contracts in the absence of an agreement with provider funeral homes. Some funeral directors discovered these sales after the fact. To the extent NPS had authority to represent a provider funeral home, the agreement was often cursory in nature. Consequently, Missouri funeral homes have some justification for challenging the obligation to honor NPS contracts. In response, Missouri’s reform bill includes the following provision:

436.415. 1. Except as otherwise provided in sections 436.400 to 436.520, the provider designated in a preneed contract shall be obligated to provide final disposition, funeral or burial services and facilities, and funeral merchandise as described in the preneed contract.

2. The seller designated in a preneed contract shall be obligated to administer all payments made by, or on behalf of, a purchaser of a preneed contract and ensure the preneed contract is managed and fulfilled, and payments remitted, in compliance with sections 436.400 to 436.520 and as provided by the contract. 

 But what if the seller does not fulfill its obligations to the funeral home provider and the consumer? Is it fair to impose strict liability upon the funeral home provider?

Regulators, such as the Illinois Comptroller’s Office, seem be indicating that preneed regulation is a bigger, more complicated, task than what they are prepared for. In that vein, Missouri is warning funeral homes that they must assume the risks associated with third party sellers. Texas seems to think that consumers would be best served by the prohibition of trust-funded third party preneed contracts (154.1013). I disagree.

Insurance funded preneed is not an option for many elderly consumers. If faced with trust funding or POD/joint accounts, smaller funeral homes will be squeezed out of the trust arrangement by the expense of establishing and maintaining their own trust. Funeral homes will also have to comply with the seller licensing requirements.

Despite the allegations made against the IFDA, the state association trust may represent the only competitive preneed product available to the smaller funeral operator.

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A trade newsletter recently reported on funeral homes forming buying groups to negotiate better terms with casket vendors. Through cooperative alliances, the funeral homes can achieve the numbers required to negotiate better discounts from vendors. Those same economies of scale also benefit preneed programs that utilize trust funding. The larger trust not only provides the operator leverage in negotiating terms with a fiduciary, the trust provides the asset manager the critical mass required for a sophisticated asset allocation model for proper diversification.

However, state laws are often a hurdle to independent funeral homes or cemeteries seeking to form a master trust that would commingle funds from multiple sellers. Laws such as Missouri’s Section 436.031 authorize collective investing by preneed trustees, so long as the funds deposited belong to a single preneed seller. This restriction reflects a legislative concern for the trust’s accounting of deposits, distributions, income and expenses.

Rather than close the door completely on collective investment trusts, the Michigan cemetery law signed into law last week left the door open to a new breed of master trusts.

Section 16 of SB 674 establishes a transition period for Michigan cemeteries to transfer their endowed care trusts to corporate fiduciaries. Subparagraph (2) of that section addresses the traditional master trust established by a single cemetery that has multiple trusts or a master trust among multiple cemeteries with common ownership. The subparagraph also references preneed trusts. The opening for pooling among unrelated trusts comes in subparagraph (3) where Michigan’s cemetery commissioner is given the authority to approve ‘other comparable methods of bundling or pooling of trust or escrow funds for investment purposes’.

The fiduciary services provided by national banks are subject to Federal regulations set out in 12 CFR Part 9 (“Reg 9”), and more specifically, collective investment funds are subject to 12CFR 9.18. State chartered fiduciaries and Office of Thrift Supervision chartered fiduciaries are subject to similar requirements. The fiduciary’s authority to pool preneed trust accounts is derived from 12 CFR 9.18(c)(4). The regulation sends the fiduciary back to state law for its authority, and prohibitions. In the absence of express authority (and express prohibitions), the fiduciary is in ‘no man’s land’ with whether it is required to follow the requirements of Reg 9, which include a written plan, audits and asset valuations.

The Michigan law seems to appreciate that Reg 9 requirements go beyond what should be required of a preneed master trust, and appropriately, make the non-traditional master trust subject to a case-by-case approval. The test will be whether the proposed pooling arrangement has sufficient accounting procedures to protect participating operators and their consumers. Missouri is particularly sensitive to this issue in light of the NPS failure, and its procedures for trust rollovers.

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Two class action lawsuits were filed last year over the mismanagement of Grandview Memorial Gardens (Madison, Indiana), and a settlement has been reached in the suit involving the cemetery’s preneed trust funds. Over the course of about 14 years, the cemetery went through three changes of ownership, four trustee changes and sold several million dollars of preneed contracts. When Indiana regulators examined the Grandview preneed trust in 2006, they found $144,000 of assets. Then the regulators began to tally the cemetery’s preneed liabilities, but found those obligations exceeded the trust’s balance before they got to the purchasers whose names began with “B”.

With regard to the fiduciaries that administered the Grandview trust, the plaintiffs’ attorneys included one basic discovery request that may have proved damaging to the banks: show us your policies and procedures for administering a preneed account. The Office of the Comptroller of the Currency has issued written guidance to national banks advising of the need for internal controls, and policies and procedures for the preneed account. Taking a page from the OCC memorandum, the Grandview attorneys focused their discovery on the banks' oversight of Grandview's preneed trust.

Specifically, the discovery sought to confirm that each fiduciary had accounting procedures to determine whether: (1) distributions exceeded an account’s deposits and income, and (2) deposits could be identified by a particular preneed purchaser.

While the settlement does not represent an admission by the defendants, the fiduciaries agreed to pay $216,000 to the plaintiffs. 

 

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Why did you agree to that?

That's the question I have been getting to the Chapter 436 Working Group recommendations regarding i) the deposit of all purchaser payments to trust, and ii) some form of periodic statement to the consumer.   One answer would be that we see too many news reports like this one.  

The primary objective for these two recommendations is the establishment of an audit trail.  Require all payments to go through the fiduciary's hands, and require the fiduciary to give the consumer some form of notice.  If the regulator does not have the resources to monitor the transaction, give the consumer the opportunity to do so.  The recommendation does not deny the seller the right to recover sales expenses.

Yes, the procedure is burdensome, will add cost to the transaction, and will require change.   What are the alternatives?

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 While the completion of the document may have felt like a birthing process to the staff of Missouri's Division of Professional Registration, the Chapter 436 Working Group Recommendations more accurately reflects an industry position paper that has yet to be completed.   Faced with a deadline imposed by the Missouri legislature, the Division 'finalized' the Recommendations in an 11th hour meeting of the State Board of Embalmers and Funeral Directors.  The State Board meeting underscored that many industry members have yet to grasp how the preneed transaction is structured and administered by competitors.  This is best demonstrated by the State Board vote to revise the Recommendations to include the following:

 

·         The board recommended a 100% trusting requirement with no administrative or trustee expenses by a vote of 4-2.

 

 During various meetings, the issues of preneed sales expenses and trustee administration expenses having been erroneously interchanged by Committee members.  This confusion is due in part from Chapter 436 allowing all income to be distributed currently.  If the trust does not accrue income, the law requires the seller to assume responsibility for trust expenses.  Trustees normally look to trust income for administrative expenses.  If the trust has no income, the trustee is dependent upon the seller for reimbursement.  This aspect  compromises the fiduciary's duty to the trust. By its action, the State Board would perpetuate a major flaw in Chapter 436 (if trust funding is to survive at all). 

The State Board's objective is to protect the consumer, and to do so it must think comprehensively about the three forms of funding: insurance, joint accounts and trusts.   Is the consumer better served if trust funding is effectively precluded?   Of course not. 

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The American Funeral Director recently published Curtis Rostad’s rebuttal letter to a prior story titled “Debunking the Trust Myth”. That same story earned a post on this blog site. While I agree with Mr. Rostad’s views, the sad truth is that many death care trusts do not perform as well as the Indiana Master Trust. It speaks volumes when many Missouri funeral directors prefer insurance funding despite a state law that permits a 20% sales expense to be retained from trust funded contracts. While several reasons exist for the Missouri situation, expense, time demands, poor trust performance, and risk aversion are key factors. 

Until a critical mass is reached, death care trusts can be too expensive. Funeral directors are an independent lot, and most want to retain control of their preneed funds. (NPS will serve to reinforce this.) While pooling of preneed trusts would help address this hurdle, some state laws discourage the commingling of accounts because of the industry’s history of poor recordkeeping. 

 

Trusts require a commitment in time that many death care operators are often unwilling to provide. Fiduciaries need input from their death care clients about investment and compliance issues. Funeral directors and cemeterians are care-givers by nature, and many would rather delegate these responsibilities. In the absence of clear instructions, fiduciaries will default to more conservative investments.

 

It is difficult to provide quality asset management to small trusts. As a consequence, the small trust is often relegated to mutual funds or cash equivalents.   Even when the trust has sufficient assets to warrant a diversified portfolio, some operators are risk adverse and park the trust in conservative, but low yielding investments.  

 

Diversification is an important ingredient to improving trust performance. Today’s asset managers use diversification to guard against market risks, and to seek out growth and new sources of income such as dividend producing stocks.  To obtain the benefits of diversification, regulators and death care operators need to consider the economies of scale that pooled administration can provide. 

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In response to a proposal that preneed trustees be required to provide periodic account statements to contract purchasers, a funeral director asked what liability he would have to consumers who question the trust’s performance during a year such as 2008.   Legally speaking: none. But ultimately, death care companies should be accountable to their families for the decisions they make with regard to preneed funds, including where those funds are placed and how well they are invested. With regard to certain contracts, NPS providers may not be responsible for the promised funeral, but consumers will punish the funeral home that turns its back on those contracts. The funeral home put the consumer at risk by agreeing to do business with NPS. Similarly, if a funeral home fails to devote the time and resources required for proper management of its preneed trust, consumers should ask if they are assuming too great a risk that the facility will be in business when the funeral is needed. 

Realistically, periodic trust statements to individual purchasers provide a ‘tickler’ that alone will not flag a troubled preneed program. A systematic trust reporting system is needed. Such a trust reporting system must also afford the public sufficient information to assess the financial strength of the preneed program. Yes, there will be a cost to both consumer and the funeral home, but a trust reporting system will reward the funeral home that devotes the energy and resources required to properly administer their families’ preneed funds.   

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The Special Deputy Receiver for NPS recently reported the company’s “negative net worth” to be just short of one billion dollars. Rightfully, regulators are looking at the NPS fiduciaries for culpability in the losses that will be sustained by consumers and funeral homes in the years to come. In the meantime, Missouri state officials are working with industry representatives to reform Chapter 436. As they consider how to better safeguard consumers’ funds, regulators and legislators need to appreciate that preneed sellers and fiduciaries have overlapping responsibilities that are affected by a state’s trusting requirements. 

In states with lower trusting requirements, the preneed seller typically assumes responsibility for individual preneed contract accounting. Besides the ability to report to consumers, this function is also crucial to the fiduciary’s income tax reporting. In states with higher trusting percentages, the trust often assumes greater responsibilities for the accounting and reporting functions. 

Historically, preneed laws have restricted preneed trust expenses to the fee that was typically charged by banks or trust companies for estate planning business. Some state laws also restrict the trustee’s ability contract with the preneed seller for administrative services.   While restrictions are needed to avoid a circumvention of the trusting requirements, more latitude should be afforded the fiduciary. In exchange, preneed sellers and fiduciaries should be required to make disclosures about those who provide the trust services, and the fees paid for the various services. 

The Texas Department of Banking and the Texas Funeral Directors Association broached these issues ten years ago.    In Opinion 98-15, the TDOB found that the preneed trustee fees could be used to pay for marketing expenses, outside recordkeeping for preneed contracts, and investment advice. (It is generally recognized that the trustee can incur expenses for trust accounting, legal expenses and tax reporting on behalf of the trust.)

 Eventually, Texas may review its preneed law in light of the fraud committed on its consumers and funeral directors by NPS. I suspect NPS exploited the Texas provisions allowing for a depository.   Before eliminating the authority to use the depository arrangement, the Texas legislature needs to appreciate the difficulty the industry has in attracting quality fiduciary services.   

Allowing the trust to bear the expense of compliance does not come without the risk of abuse. Services must be necessary to the trust, and reasonable in cost. One check against such abuse would be the requirement that services must be performed pursuant to a contract with the fiduciary. Transparency of the relationships among the parties, and the fees paid could serve as another check.   The IRS will likely require such transparency within the next few years as fiduciaries are required to ‘unbundle’ their fees for income tax reporting purposes.

Eventually, we may see death care fiduciary fees being broken down by the following services:

Asset management (investment)

Sub account administration

Tax reporting

Legal (contracts/compliance)

Legal (liability/litigation)

Custodial services

Regulatory and consumer reporting

Marketing

Ten years later, the TDOB opinion may be dated in terms of what constitutes a reasonable fee. Sub account administration can run as high as 85 basis points. Asset management fees will differ on the manager’s expertise, and 50 basis points is a fairly common fee. Tax reporting expenses can differ substantially based on the diversification of the trust assets.   Distribution oversight may require periodic examinations, and the expense that accompanies on-site reviews. Periodic statements to consumers and regulators will require administrative enhancements. However, economies of scale are crucial to minimizing these costs, and pooled administration will be key to providing the requisite economies of scale. Several years ago, the Office of the Comptroller of Currency recognized the role national banks could play in meeting the needs of the death care industry.

The death care trust is a different breed of animal from a bank’s staple trust business of estate planning.   Consequently, legislators need to allow fiduciaries to contract for those services crucial to enhancing the compliance that the preneed transaction so desperately needs.

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Here is a twist on the “Another theft from a death care trust”: this one does not involve a cemetery operator or a funeral director. Last week, an Indiana grand jury indicted a banker, an investment advisor and an attorney. What may sound like the beginning of a joke that most funeral directors and cemeterians can relate to, this story actually involves a trio of fiduciaries who worked with both Clayton Smart and Robert Nelms.  

Prior industry reporting helps connect the dots between David Becher, Mark Singer and Sherry Katz-Crank.  Ms. Katz-Crank is the co-founder and general counsel for Security Financial Management Company, a Michigan firm. Mr. Becher was an officer with Community Trust & Investment, an institution based in Noblesville, Indiana. Mr. Singer worked for Smith Barney in Philadelphia. 

While it does not come as a surprise that prosecutors from Michigan and Tennessee are looking at these connections, other states may also be conducting related investigations.    

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A bank client recently asked that I provide some standard of accountability for administration provided to a master preneed trust. As I struggle to provide the client a concise answer, I can’t help but to think that the issue will also become a crucial concern to consumers and funeral directors alike. As news reports reach consumers about the regulatory actions taken against the preneed programs maintained by NPS and by the Illinois Funeral Directors Association, families will begin to contact their funeral directors for reassurances about their preneed payments. Unfortunately, many state associations have not made accountability a priority, and their members may be ill prepared to respond to consumers’ concerns. 

For the independent funeral home, the state association can be a valuable resource to understanding the requirements imposed upon the profession by federal and state laws. As the preneed transaction grew in acceptance, most state associations formed master trusts to serve their member funeral homes.   These master trusts came to reflect not only the respective state’s preneed law, but also the attitudes and values of the association leadership.

Consumers need to appreciate that master preneed trusts are an important source of income to the sponsoring association. Because there are costs to providing contracts, administration, compliance, and asset management, the master trust provides the smaller funeral home the economies of scale necessary to reducing costs that would otherwise be prohibitive. However, the Illinois situation suggests that former association leadership may have exploited both members and consumers. While the association’s website is finally acknowledging the issue, the response lacks in terms of accountability. 

Getting back to my client’s question, how should accountability be measured for preneed administration from state to state? The diversity in the approaches taken by the state legislatures in regulating the preneed transaction is the single greatest hurdle to a comprehensive, national evaluation of preneed accountability. But perhaps transparency in terms of disclosures to both members and consumers would be one measure of accountability. On this standard, I would give kudos to the New Jersey Funeral Directors Association. It may be a sad reflection on the industry, but many funeral directors do not know what they are being charged for preneed services. The NJFDA provides this information for all to see.

If consumers do call for reassurances, funeral directors should have some basic information available to provide:

• How the preneed contract is funded (insurance vs. trust).
• The name of the insurance company or trustee.
• If the contract is trust funded, whether the trust holds deposit accounts, investments dictated by statute, diversified investments or insurance.
• Contact information for the person who can provide more information about the account.

When funeral directors begin to call for reassurances, association leadership should be prepared to provide the following information:

• The name and address of the trustee.
• The costs and expenses of the master trust.
• The master trust’s written investment policy.
• The fees paid to the trustee and account administrator.
• The taxes paid by the trust.
• A summary report of the trust’s performance and asset description.
• A disclosure of related party transactions (loans, discounts, service agreements, etc.)
• A summary of all trust expenses (excluding distributions for preneed contract performances and cancellations).
• The sponsorship fee paid the association. 

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The preneed bill that angered the Funeral Consumers Alliance in February continues to advance within the Tennessee legislature. SB 2705/HB 2763 has been placed on the calendar for the Commerce Committee for April 1^st. If passed, the legislation may well make Tennessee the first state to lower its preneed trusting requirement. Despite the need for better consumer protections, I anticipate other states may eventually follow suit. 

Preneed is evolving from a transaction of accommodation to becoming an essential element of each funeral home’s business. Funeral directors in 100% trusting states such as Tennessee are feeling the need to control their own preneed programs, and have come to appreciate the costs of establishing, and maintaining, a trust funded preneed program. 100% trusting laws have historically dictated that insurance be used as the principal method for funding, with trust funding as a backup for purchasers who were too old or could not qualify. With insurance companies coming and going within the preneed market, funeral homes want the alternative to offer consumers a trust-based product.

Why will legislators be willing to decrease 100% trusting laws: the guaranteed preneed contract has been, and continues to be, viewed as a sale of goods and services. Legislators are likely being told that if consumers want a product that provides a full refund right, and portability, then they can choose a non-guaranteed preneed contract. Tennessee’s law provides that option. But is the non-guaranteed preneed contract really a viable alternative?

The vast majority of laws and regulations aimed at regulating the preneed transaction are in response to the guaranteed preneed contract. This is true regardless of whether the issue is securities regulation, income taxes or trusting requirements. Preneed has been defined as a purchase transaction, not a dedicated savings account transaction. As a consequence, criticism that attempts to re-characterize the preneed transaction as a savings plan can often be deflected by the death care industry. 

The Tennessee Prepaid Funeral Benefits Act has several excellent features, and could serve as a reference for other states. But, as with most preneed laws, it has some provisions which leaves one to scratch his or her head (like Section 62-5-408(d)). Yet, SB2705/HB2763 provides a reasonable remedy to the hole left in the 2007 effort to repair the Smart damage: funding the protection fund from the funds retained by sellers on guaranteed preneed contract sales.  

Fiduciaries also need to consider that the Act authorizes civil penalties of up to $1,000 for each violation of the Act committed by the preneed trustee. 

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It's always an ugly scene when a party to a fiduciary relationship gets caught with his/her hand in the cookie jar.  Unfortunately, this has been happening with alarming frequency in the death care community, and Indiana has had enough.  In a relationship that requires mutual cooperation, the death care industry has taken the position that "someone should have stopped us by saying no", and the Indiana legislators have agreed.   With the legislation signed into law last week, Indiana has initiated a major shift in the responsibilities of the death care fiduciary.  Like the tree falling in the forest, was there anyone from the banking/fiduciary community around to here it?

The Indiana legislature moved quickly in response to the trust frauds committed at Grandview Memorial Gardens and at the cemeteries owned by Robert and Debra Nelms, and Governor Daniels followed suit by signing HB 1026.  The new law will go into effect July 1, authorizing the Indiana State Board of Funeral and Cemetery Service to promulgate regulations that will determine the distribution documentation that must be reviewed and approved by death care fiduciaries.  Failure to comply with these new requirements will expose the fiduciary to criminal charges and liability to cemetery customers. 

 To understand the gravity of the issue, fiduciaries need not go any further than their clients for input.  The general counsel for the Indiana Cemetery Association put it this way:

The people who own the trusts could do almost what they wanted. We've given the trust companies the incentive not to pull the wool over their eyes.

Cemetery association members were aghast to learn of the case because they did not understand the extent that the current law left cemetery trusts vulnerable. People really weren't aware. 

It would be safe to say that most death care fiduciaries are still unaware how vulnerable these trusts are.

What should death care fiduciaries do?  The knee-jerk reaction would be to terminate such accounts and run as far away as possible.  However, the fraudulent character of the charges leveled in recent class-action suits bring into question whether the statute of limitations has even begun to run.  The class-action lawsuit brought on behalf of Grandview Memorial Gardens lot owners will likely turn on whether preneed contracts were performed pursuant to their terms, and that will require the distasteful act of opening gravespaces.  The trust frauds committed by the Nelms have already snared one fiduciary and a major brokerage firm when a $20 million class-action lawsuit was filed in late January on behalf of cemetery lot owners. 

Fiduciaries with a federal charter may be tempted to play the federal preemption card that has been used to keep state regulators at bay with regard to the sub prime mortgage crisis, but history is not on the national fiduciary's side with regard to death care regulation.  State death care regulators in Florida and Texas have taken OTS preemption opinions, rolled them up and slapped thrift chartered fiduciaries into submission.  Frankly, the legal arguments advanced by the state regulators were on point.

Indiana chartered fiduciaries need to become engaged in the procedures that will be unfolding before the Indiana State Board of Funeral and Cemetery Service later this Summer.  The death care industry will be there in force providing their comments about the forms and procedures to be covered by the regulations authorized by the new law.  Fiduciaries will have no one but themselves to blame if they miss this dance. 

Federally chartered fiduciaries will need to determine how significant a block of business Indiana represents to their death care business.  These fiduciaries will also need to monitor other states to see whether the Indiana law represents a trend that other state legislatures will follow. 

Death care companies and consumers will need to anticipate an increase in the cost of fiduciary services.   The old adage "you get what you pay for" has a double-edged application to the death care fiduciary environment.  The security sought by consumers and cemeteries/funeral homes will come at a cost.  To minimize the cost of the new obligation to provide distribution oversight, death care companies and fiduciaries will need to explore standardized examination procedures or the reliance on established audit procedures.   Death care companies will also have to be more receptive to trust instrument provisions intended to provide fiduciaries the power to say no, and protections when they do.

 

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It must be spring: preneed reform bills are sprouting like crocus. 

 

The direction taken by the Maryland and Tennessee legislatures in proposing protection funds drew recent criticism from the Funeral Consumers Alliance. While consumer advocates have some valid points regarding these legislative efforts, the obstacles facing states are far more complex than what most outsiders understand. For purposes of this blog entry, lets focus on Maryland and put Tennessee off to another day.

 

First, a distinction needs to be made between a state’s industry board and a state trade association. Some times the two cooperate to get legislation introduced and passed, and then sometimes the two are on very different pages. Most state industry boards are understaffed and under funded. A casual survey of the website for the Maryland State Board of Morticians & Funeral Directors reflects the Board has one inspector, excuse me, had one inspector, for all of the state’s funeral homes.   While the Board’s principal purpose is the “protection of the public's health and welfare through proper credentialing, examination, licensure, and discipline of morticians, funeral directors, surviving spouses, apprentices and funeral establishments in Maryland”, its newsletter suggests preneed has become its pressing problem.

 

Preneed accounts for most of the Board’s complaints, and the number of funeral homes that are late in filing their reports to the Board are substantial. Yet any thoughts the Board may have regarding enforcement actions must be tempered with the realities of its budget. As a self-supported entity, the Board’s resources are those fees it charges the state’s funeral homes and morticians, and there lies the first rub with the state’s trade association. What businessman doesn’t complain about the fees charged for licenses? Those complaints are invariably directed to the trade association, which in turn applies pressure on the board. 

 

But the fact something is broken with regard to preneed is not lost on either the Board or Maryland’s funeral director association. The association position for scrapping the CPA certification in favor of a protection fund probably signals the industry’s acknowledgment that this oversight approach is ineffective and a waste of resources. I have experienced the same frustration working with CPAs and auditors who held themselves as having experience with the death care industry. If each funeral home has to find a CPA to certify compliance with a state law like Maryland’s, HB 1090 may well represent a better application of the funeral home’s funds. However, the real problem with Maryland preneed is its preneed law and the lack of effective oversight. 

 

The dynamics of preneed reform are complicated, but there certain generalities that apply from state to state. No matter how bad your state law is, no one wants to open the law for the donnybrook that is sure to follow if all bars are removed. It doesn’t matter if the trusting is 100% or 80%. If you work in a 100% state, there will be a strident element that argues a lower percentage will open the floodgate to the unsavory characters of preneed (and the criticism of FCA). If you work in state such as Missouri, there is the position that opening the preneed law will invite restrictions that cut into the revenue streams that funeral homes have become dependent upon. However, these arguments are beginning to pale in the face of growing frauds and abuse. Most funeral directors understand that oversight is needed, but the challenge is how to achieve it efficiently on the limited resources available. Shifting the responsibility, as Indiana’s legislature is considering, to the fiduciary will not work. 

 

With regard to Maryland’s preneed law, I would offer the following recommendations:

 

1. Require an independent, corporate trustee that can invest pursuant to the Prudent Investor Rule. Scrap the concept of letting a funeral home serve as a trustee (or escrow agent).   (And what is a trust that is insured by the FDIC?)
2. Require a combination of flat fees and per preneed contract fees that are divided between a protection fund and the Board’s costs to monitor annual reports and to take enforcement actions. The per contract fees should be assessed equally from the funeral home and the consumer (perhaps $10 each). 
3. Each preneed seller should be required to file an annual report that sets out new contract information, deposits to trust, distributions from trust, the trust’s market value and the trust liability. 
4. Each preneed seller should be subject to a tri-annual inspection that may last between 1 to 3 days. The inspection reviews the funeral home’s records, accounting controls, a sampling of transactions (deposits, distributions) and the annual reports filed with the Board. The inspection should be conducted by a CPA firm pursuant to agreed upon procedures developed by the Board, with the cost of the inspection being assessed against the funeral home. The better the funeral home’s records and procedures, the more likely the inspection can be completed in a day (and the lower the fee). With a fixed number of inspections per year, the Board should be able to negotiate a fee that is substantially less than the CPA certification required by the current law.
5. Inspections that reflect violations or deficiencies can be the basis for full audits (which are assessed against the funeral home).
6. Final inspection reports should be a matter of public record so that consumers can investigate funeral homes before making a preneed contract purchase.
7. Preneed sellers should have to obtain trustee certifications of new contract deposits, and then provide documentation to the new contract holders of the deposit of their funds to trust.
8. Preneed trustees should provide annual summary statements (transactions and asset listings) directly to the Board. 
9. Trust transfers should be documented to the Board.

Protection funds have merit, and should not be discounted as a ploy. However, preneed oversight is becoming a national issue. Documentation and disclosure will be fundamental to providing an adequate audit trail for regulators. Maryland funeral directors may have legitimate complaints for dropping their current oversight, but they should not opt for a protection fund in lieu of oversight. 

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The families of those buried at Grandview Memorial Gardens are angry.  First they are advised that the trusts meant to fund future burials and the care for those graves are not properly funded. Next, they learn that some of the cemetery’s gardens have a problem with grave spaces flooding with water. When Indiana regulators and prosecutors reported there was nothing they could do to correct the situation, plaintiff attorneys filed a class action suit naming several entities as defendants, including three banks and the consolidator that sold the cemetery in 2001. The Indiana legislature has also reacted to the situation with a bill intended to eliminate the ability of the death care industry to use a custodial arrangement for these funds, and to place a greater burden on fiduciaries to police fund distributions. 

Are Grandview’s problems the fault of the three banks named as defendants in the lawsuit?  Of course not.  Should the preneed fiduciary be required to police distributions to the extent required to determine if the vault delivered is a 'sealer' or not?  Of course not.  The Grandview situation may be more indicative of the problems facing the death care industry than the irregularities facing the Illinois Funeral Directors master trust.  There are several factors that have contributed to the Grandview situation. Consequently, there are no simple answers, and shifting the blame/responsibility to the financial institutions that serve the death care industry is short sighted and counterproductive. 

Indiana’s death care laws are a hodge-podge of sections spread among different chapters, with different effective dates. If funeral directors and cemeterians cannot accurately cite the legal requirements for their trust funds, should legislators pass the responsibilities over to the financial institutions? 

It doesn’t take much speculation to guess why Indiana’s regulators have not taken any actions. More than likely, the Grandview accounts complied with the Indiana laws (albeit they were likely set up as custodial accounts). This won’t stop the class action attorneys from pursuing the deeper pockets of the banks and Carriage. 

If the death care industry should decide to take steps to improve the image of preneed and perpetual care, death care fiduciaries have to be afforded the resources and procedures required to provide meaningful oversight to account distributions. Fiduciaries are completely dependent upon the death care company for the documentation required for substantiating distributions. Many fiduciaries rely upon certifications from the death care company that a contract has been performed pursuant to its terms. But such procedures cannot ensure that a family receives a ‘sealer’ vault, if that is what the preneed contract called for.  HB 1026 will not solve Indiana’s preneed woes. The problem is deeper than the water that filled Grandview’s vaults. 

The approach taken by Grandview’s class action attorneys reminds me of the search for the infamous Keyser Söze.  As if they were reading from the script for The Usual Suspects, the attorneys advise they think they have it figured out but that legal process will have to grind out justice slowly.  For the sake of the Grandview families, we hope there will be a different ending than what happened in the movie. In real life, there is no Keyser Söze to whom all blame can be attributed.  Instead there are only some bit players who followed the twisting trail of Indiana law, and the only characters likely to profit from this drama are the attorneys. 

To help the Grandview families, the first course of action needs to be the repair of the cemetery’s drainage system. If the cemetery’s perpetual care fund was depleted through improper distributions, determine who did so. There has been little press coverage about the prior owner’s response to the perpetual care issues. Did Madison Funeral Services understand the requirements of cemetery maintenance when it purchased Grandview from Carriage in 2001?   Did the more stringent perpetual care law govern Grandview’s fund?   How much of a perpetual care fund did Madison receive from Carriage? 

With regard to whether the Grandview families were defrauded with inferior vaults, what did the preneed contracts provide? If one reads between the lines, the Jefferson County Prosecutors are indicating there is no basis for a fraud prosecution. The statute of limitations excuse sound like, ah, an excuse.  Doesn’t the statute of limitations start from the point of the discovery of the fraud? If consumers were promised a ‘sealer’ vault, and an investigation does not prove the fraud for 8 years, has the statute of limitations just been triggered? The danger for the Grandview families is that the contracts don’t call for a ‘sealer’ vault. Someone may have planted the ‘sealer’ seed in their minds, and we should hope it wasn’t someone looking to profit from the families’ emotional distress.

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Whether it is because of state law restrictions or preneed purchaser demographics, death care trusts have unique requirements when it comes to investments.  Consequently, it is fairly common for a death care trust to utilize an investment advisor who has experienced with the industry.  However, the deductibility of the fees paid to outside advisors by death care trustees will now be more closely scrutinized in light of a January 16th decision handed down by the US Supreme Court in the case titled Knight vs. Commissioner.   

The conflict over the deductibility of investment advisor fees developed within the context of estate planning trusts, and has been brewing since 1993 when the Sixth Circuit rejected the IRS' position in O’Neill vs. Commissioner of Internal Revenue, 994 F.2d 302.  In subsequent cases in other circuits, the IRS prevailed in its application of IRC Section 67(a) and the 2% floor.    Like side catch in a commercial fishery net, death care trusts are being pulled into a controversy based on estate planning facts. 

The impact of this issue on some death care trusts is felt not so much by the 2% floor, but by a collateral issue: the alternative minimum tax.  For maintenance trust returns, the characterization sought by the IRS renders the advisory fees fully taxable. And, the arguments forwarded by the IRS in its briefs to the Supreme Court and the lower courts suggest that the Service may look at other types of services outsourced by the fiduciary.   

The Supreme Court left the door cracked for the full deductiblity of fees paid to trust service providers, but the death care companies will have to work with their fiduciaries to justify the deduction of such fees.  To defend the deduction, the parties have to start with their trust instrument and administration documents to define the services and justify their need.   

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The Clayton Smart debacle has been, and will continue to be, the subject of articles calling for preneed reform. A recent AARP article titled R.I.P. Off  will be one of the more controversial (leading to frequent citations by consumer advocates).   While the article is biased and should be rebuked by the death care industry for its various flaws, the industry should examine the Smart affair and the public's reaction to Mr. Yeoman's issues (including the comments posted to the AARP website). 

Mr. Smart exploited the Tennessee laws to divert millions of dollars of trust assets.  While Forest Hill's new owners should be applauded for taking steps to minimize the loss to consumers, the industry should not ignore the magnitude of the fraud committed.  Over the next few months, I plan to revisit the Smart affair and the issues it spawns.  But for this post, consider the missing fiduciary.

In its April 2007 edition, the American Funeral Director reported in detail about Mr. Smart, including his appointment of a small Indiana institution as Forest Hill’s preneed trustee and the revision of the governing trust instrument.   While another of Forest Hill’s trustees discharged its duties to consumers by refusing Mr. Smart’s distribution instructions, the Indiana institution followed Smart's instructions to terminate life insurance policies that would result in millions of dollars of loss to the trust.  Too frequently, funeral directors exhibit the similar business ethics by shopping for a trustee that will do what it is told.   

Many of our country’s larger banks now refuse to accept death care trusts either because the laws are ambiguous or because of the industry’s reputation.   Death care companies need to develop procedures and controls to ensure compliance, accountability and transparency.  Restoring the confidence of  financial institutions and consumers will take time.   

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