For a brief period, the Illinois Comptroller posted a notice that sidestepped the inquiries made by funeral directors about the application of their Merrill Lynch settlements. The OIC website has since be revised.

One of the inquiries to the OIC may have involved whether the settlement funds could be applied to the litigation costs for pending lawsuits against Merrill Lynch. But for the litigation brought against Merrill Lynch, the funeral homes would not have received the settlements paid by the Department of Insurance. However, the settlement funds fall far short of the actual damages suffered by the funeral homes and consumers, and the argument may be that a portion of the funds could be used to continue the litigation.

Specifically, the Comptroller’s answered as follows:

It is the position of the OIC that we do not have the authority to instruct industry members on the proper disbursement of the funds.

In the following paragraph, the Comptroller warns:

During the review of future annual reports and audits, we will examine the method in which the funds are handled to assure that industry members acted in a good faith manner and in the best interest of consumers when determining the disposition of the funds.

While the litigation argument has merit, the Comptroller probably had concerns about the other uses funeral homes may have for the settlement funds. The notice may seem evasive to the industry, but it did not necessarily foreclose the application of funds to litigation that may benefit the consumer. But, funeral homes should pay heed to the warning that they will be held accountable for how settlement funds for active contracts are applied.
 

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.

 

A breakdown in communications between the CFDA and the Cemetery and Funeral Bureau has resulted in the California Attorney General filing a lawsuit that can be appropriately described as vitriolic. The “California lawsuit” could provide some valuable ‘what to avoid” lessons for regulators in other states.

In an unusual move, the Bureau went “public” last year by raising a number of issues with administration of the California Master Trust. Some of those issues did warrant an explanation. One issue involves the actions taken by the CFDA subsidiary in response to the 2000 market crash. The subsidiary implemented a plan to stabilize the master trust value after the collapse of a bond fund. Another issue regards the administration fees charged the master trust subsequent to the collapse of the bond fund. A third issue regards the subsidiary’s policy to pay a portion of the administration fees to participating funeral homes.

The CFDA countered with arguments of how its actions were within California law. Those arguments have merit, and were covered by this blog in July 2010. (See California Master Trust: serious missteps, but not another IFDA.) The CFDA proposed that the issues be reviewed in the context of relevant facts, having the Bureau apply thirty year old laws and regulations to the CMT’s circumstances. Instead, the California Attorney General adopted a “quick kill” strategy that employs a two prong attack: involve the consumer and apply the law strictly.

In taking the controversy to the consumer, the California AG has been disingenuous when using such terms as “conspiracy”, “concocted”, and “kickbacks”. In doing so, the AG may end up galvanizing the CMT membership, and getting anything but a quick kill.

The AG’s legal arguments are also somewhat disingenuous. As the title suggests, this blog entry will focus on the AG’s call for a truly independent trustee. In future entries, we will look at some of the AG’s other legal arguments.

In the “First Cause of Action” of the petition, the AG makes the argument for how the CFDA’s administrative subsidiary has assumed unlawful control over the preneed funeral trust. Granted, the CFDA may have gone too far in assuming control over the trustee’s appointment of agents (and discounted the interests of consumers with non-guaranteed contracts), but the AG ignores the fact the master trust consists of thousands of preneed contracts that originates in hundreds of funeral homes. This fact makes the fiduciary dependent upon the funeral home in a number of ways.

The trustee needs preneed contract data for accounting (much in the same way the regulator’s auditor is dependent on the same records to perform his job). As with other states’ master trusts, the association performed a vital role in providing crucial contract administration. Contrary to the AG’s citation to the California probate code, these are administrative functions the corporate fiduciary must delegate. The trustee cannot account for the preneed contract as a depository account.

The trustee also needs input when setting investment policies. The AG would suggest that the preneed trustee cannot look to the funeral home. This ignores that the vast majority of the preneed contracts are guaranteed, where the funeral home has assumed the risk of investment. It also flies in the face of the numerous “No Action Letters” issued by the Securities Exchange Commission.

The manner in which the trustee prepares trust tax returns impacts both the funeral home and consumer. The most efficient approach (Federal Form 1041QFT) has a cost to the funeral home. Consequently, the preneed fiduciary will want the funeral home’s approval.

The ‘independent preneed trustee’ may seem to be a quick and easy answer to regulators, but only if the courts ignore the facts and realities of administering a preneed trust.
 

Continuing the theme that effective preneed regulation requires the occasional update, the Missouri legislature is poised to pass the first ‘patch’ to SB1, the 2009 legislation that ‘re-wrote’ Chapter 436. Senate Bill No. 340 will make four noteworthy changes to Chapter 436.

Concerned that preneed sellers would use variable annuities to fund preneed contracts, Missouri’s insurance regulators sought to have SB1 limit the use of annuities to the single premium variety. This proved burdensome to funeral homes committed to insurance funded preneed. The single premium requirement denied the funeral home the use of variable pay annuities for consumers who either do not qualify for life insurance, or who cannot afford the premium of a life insurance policy. SB340 appropriately allows variable pay annuities to be used to fund preneed contracts so long as death benefits are never less than the premiums paid.

While SB1 preserved the use of joint account funded preneed, small operators encountered problems with banks and the Patriot Act. SB340 will allow POD accounts to be used in funding preneed contracts.

SB1 provided for retroactive application in certain respects. But, with regard to preneed trusts in existence prior to August 28, 2009, SB1 provided for historic law treatment with regard to income distributions to sellers and the use of income to pay trust expenses. Section 436.031 authorized the distribution of trust income to the seller provided the mark to market requirement was satisfied. The section also obligated the seller to pay trust expenses and taxes because of trust income withdrawals. SB340 will delete that provision, and it isn’t clear the intent for this change.

Section 436.031 of the prior law also allowed a preneed seller to designate an investment advisor, and in doing so, relieve the trustee of all asset management responsibilities. This provision was exploited by NPS, and was pivotal in conversion of millions of dollars of preneed trusts to worthless insurance. Seeking a completely independent trustee, SB1 imposed restrictions on who could serve as an investment advisor to the trust. While the NPS experience proved the need to keep the fiduciary responsible for asset management, SB1 went too far in driving a wedge between the asset manager and the seller. SB340 will create an exception to that restriction for the “external” investment advisor who satisfies Section 436.440.

 

Microsoft’s early efforts to force regular program updates were a nightmare. Like a gremlin that visited at night, the update often changed default settings that you never completely understood in the first place. Sometimes the update would impact the compatibility of other critical programs. To avoid the hassle of these updates, I toggled off the Microsoft updates for several years. And then when a drive failed, dozens and dozens of MS patches and updates had to be downloaded and installed, costing me time and expense.

The preneed regulatory systems set up by various state legislatures in the 1980’s have begun to crash for the same reason: a failure to update. Preneed has changed since the days when bonds paid double digit returns and preneed programs were the fad. California was no different from most states where preneed opponents outnumbered preneed proponents. Legislative compromises favored the traditional operators who opposed preneed, and the resulting law was disjunctive and confusing.

As time passed, more and more California funeral homes began to offer preneed. In most cases, it started as an accommodation to the consumer who sought to put funds aside. Eventually, competition not only drove all funeral homes to offer some form of preneed, it also drove them to factor preneed into their business plan. The investment markets also became more complex.

But, the California funeral industry left the preneed law update toggled off, and instead, stretched the law’s ambiguities the best it could to “authorize” new business practices. And, the preneed regulators (first the State Board, and now the Bureau) often played the same game. The Bureau and the CFDA are now locked in a lawsuit (over an antiquated law) that will leave both sides bruised and defensive. The posture taken by the AG suggests the fight could be nasty. But the facts suggest, the State should look to make prospective changes.

NPS exploited the weaknesses of Missouri’s 1986 law, and that company’s collapse gave Missouri regulators the ammunition required to force a new preneed operating system on its funeral industry. The 2009 law has its flaws, and needs changes (other than those in SB340), but preneed life continues in Missouri. Missouri regulators would like to go back in time to change some of the prior law’s flaws, but the push to make retroactive changes has been measured.

In Illinois, the IFDA put together a master trust and an insurance program that pushed the envelope beyond the Comptroller’s tolerance. The Comptroller’s responded much in the same vein as the California regulators did. While entrenched in a lawsuit, the Comptroller pushed his legislative agenda through the legislature. But, Illinois got more of a preneed system patch than a new operating system. Eventually, Illinois is due for a significant preneed system upgrade.

Nebraska is another state that may be due for some form of a preneed update. With a reporting system based on tax cost basis, preneed regulators want to introduce market value into the computation for income distributions. The objective has merit, but the 1987 law can only be stretched so far.

Getting a preneed law that works for both operators and regulators will never be a “one and done” project. Occasional updates will be required.
 

When news of the indictment of 6 National Prearranged Service officers was reported last November, many newspapers picked up the AP version that included a quote from the Internal Revenue Service criminal investigator. The fact is that the Federal investigation of NPS involves investigators from the IRS, the FBI and the U.S. Postal Inspection Service. An FBI press release regarding the NPS indictments includes comments from investigators with the three Federal agencies. To understand how NPS’ actions triggered the jurisdiction of the three agencies, a 2009 FBI press release concerning the indictment of Randall Sutton provides an explanation of the underlying facts.

The main thrust of the IRS investigation will be to determine whether the NPS officers committed income tax evasion with regard to what they individually received, or with regard to what the company received. The investigation will need to determine how the distributions from insurance, and from trusts, should have been reported by NPS. The investigation will also need to examine how NPS’ sister corporation, Lincoln Memorial Life, reported its income. And, the investigation will look at how the preneed trusts controlled by NPS reported their income.

Shortly after the Federal investigation of NPS was initiated, the Springfield Journal-Register reported that a Federal investigation of the Illinois Funeral Directors Association master trust had been initiated. As with NPS, Federal investigators will look closely at whether the reports mailed to funeral homes, and the statements mailed to consumers, were fraudulent, and thereby, violated mail fraud statutes. However, another line of investigation will be whether the master trust violated the Federal tax code.

What does the IRS’ role in these investigations mean to funeral homes and consumers? If these entities failed to accurately report income, the IRS (and state authorities) will view the unreported income as lost revenue to government. Preneed trust income must either be reported to the consumer or taxed by the trust. NPS trusts may have had annual tax liabilities in the tens of millions of dollars. No small potatoes considering the plight state coffers currently face.

Consequently, consumers and funeral homes may see taxing authorities become more aggressive in the enforcement of preneed income reporting requirements. With fewer agents due to budget constraints, the IRS may begin promoting its whistleblower program. If the situation reported this past weekend is an indicator of the future, non-compliant preneed companies may have more to fear from the disgruntled employee than being selected for a random audit by the IRS or state department of revenue.
 

The 2010 calendar year proved a welcomed change for many trust funded preneed programs. The 2008 collapse of the home mortgage market triggered a melt down of bonds that lingered well into 2009. The press provided extensive coverage of how the situation impacted our 401k accounts. Stories about value declines of 25% to 33% were fairly common. But, most preneed trusts suffered a similar experience. Preneed fiduciaries were forced to examine fixed income portfolios for impaired assets, and some mortgage backed securities (long the staple of preneed trusts and endowed care trusts) had to be sold off.

In 2008 and 2009, many preneed trusts experienced capital losses that exceeded realized income. For the preneed trust reporting pursuant to a Federal Form 1041QFT, this black cloud had a silver lining: capital losses could be carried over to future years. With trusts seeing 2010 returns in the high single digits (and some double digit returns), the capital loss carry over provides fiduciaries an opportunity to reduce (or eliminate) the trust’s tax liability in 2010.

The manner in which a fiduciary applies the capital loss carry over (or CLCO) depends on how the 1041QFT was prepared in prior tax years. The QFT return contemplates individual trust accounts with a composite return, but IRS commentary suggests that a significant portion of QFT returns is prepared as a single, unified trust (see our August 9, 2008 post titled “The Section 685 QFT amendment: Supporting Soldiers’ Survivors”). With a composite return, the tax rate rarely exceeds 15%. With the unified trust, the tax rate will generally be 35% (when the trust income as a whole exceeds $11,200).

With the composite return, the CLCO is allocated among the individual accounts, and may be carried over in multiple years. With unified trust, the CLCO will be applied to the entire trust. In either case, the tax savings could be substantial.

Getting the 2010 return right may be more important than ever. As we will report in an upcoming post, the NPS collapse (and perhaps the IFDA/Merrill Lynch debacle) has caught the IRS’ attention. After twenty years of slumber, our tax regulator has reason to take a closer at how preneed is taxed.
 

For most Illinois funeral homes, March 15th is the due date for the filing of their preneed data with the Comptroller’s office. For those funeral homes that bolted from the IFDA after the master trust melt down, this has been an extremely frustrating process. The majority of funeral homes must file on line, with supporting documentation to be mailed no later than March 16th. Those funeral home operators of Irish descent will have reason to hoist an extra brew come St. Patty’s day: the Comptroller’s office has ample reason to change the contract reporting requirements yet again.

The 2010 reporting forms were changed to reflect SB1682’s elimination of depository accounts. However, the annual reports are still premised on the old IFDA master trust structure that credited consumer accounts with an amount of fixed interest. For each consumer preneed contract the funeral home is required to report beginning principal and interest, additions of principal and interest, withdrawals of principal and interest, and ending totals of principal and interest. In essence, the annual report views each consumer account as a passbook saving account.

No need to beat a dead horse, but the IFDA master trust was wrestled away from the association because the Comptroller determined the trust could not sustain itself. Contracts were being credited with interest rates greater than the trust’s investment return.

In response to the situation, the IFDA selected Fiduciary Partners to succeed Merrill Lynch as the master trust fiduciary. The switch to Fiduciary Partners includes a needed change in the investment strategy of the IFDA master trust: diversification through pooled funds.

To determine whether the IFDA master trust (or score of master trusts spawned in the mass exodus) will be self sustaining, the Comptroller’s office will need to revamp its annual report to track such contract issues as sales price, deposits to trust, and market value allocations. In light of the IFDA’s past use of insurance vehicles, Illinois fiduciaries should anticipate providing detail of their trusts’ investments and transactions.

Other states’ preneed regulators are also drilling down to the individual contract with new reporting requirements. Most notably, Nebraska revised its 2010 annual report to include new disclosures regarding market values, with all preneed sellers to provide individual contract data in an Excel format. The data must also be backed up with trust asset listings and transaction reports. Missouri has also implemented individual contract reporting, and Kansas has legislation pending that will impose similar requirements on cemeteries that sell preneed.
 

The Springfield Journal-Register reported last week on the latest lawsuit to hit Merrill Lynch, the IFDA and the law firm that represented the Association.

One aspect of the lawsuit focuses upon the claim that the key man insurance policies sold to the master trust were not suitable investments. Without an insurable interest, the policies could not provide the tax consequences sought for participating funeral homes. Piercing through the “it’s an insurance policy argument”, the allegations are directed at whether Merrill Lynch has violated securities laws. With the implication of securities laws, the Illinois Secretary of State’s jurisdiction has been triggered.

The article also reports on the lawsuit’s allegations against the law firm that represented the IFDA. Concerns over the investments date back to 1987 (which coincides with the issuance of Rev. Rul. 87-127), when the lawyers sought regulatory approval of the plan. While that approval was never provided, the IFDA moved forward, and the law firm is now being blamed for ‘giving the green light’.
 

Maybe it’s a response to shrinking state budgets, or the fact that the tracking of preneed funds is becoming more effective, but state and local prosecutors are assuming an expanding role in the enforcement of preneed laws.

While a recent report released by the Missouri State Board of Embalmers and Funeral Directors reflects a drop in the number of preneed complaints that it handled in 2010 (44 complaints after a spike in 187 complaints in 2008 and 127 complaints in 2009), the Missouri Attorney General’s Office reports having handled 887 preneed complaints in 2010. One of those complaints ended with a former Butler, Missouri funeral operator being sentenced to seven years in prison.

As previously reported in this blog, the new Illinois Comptroller responded very quickly to a preneed complaint by referring a funeral home to the State Attorney’s office for prosecution. In 2009, the Kansas cemetery regulator worked with local prosecutors when a Hutchinson cemetery acknowledged that funds were missing from both a preneed trust and a permanent maintenance trust.

Here in the Midwest, a death care operator could go years without an audit. While some states required some form of preneed reporting, there was little evidence those reports were being reviewed. Consequently, the operator who may have had trouble making payroll had little fear of prosecution so long as the preneed contracts were being serviced. That is changing.

Illinois, Missouri, Kansas and Nebraska have implemented (or will implement) new reporting requirements (and in some cases, audits). If trusts are found to be deficient or empty, regulators seem to be more willing to turn the matter over to a prosecutor who has a vested interest in protecting voters with an empty preneed account.