Blind Trusts in the Private Sector: When and Why They Are Necessary
Blind Trusts in the Private Sector: When and Why They Are Necessary
By: Matthew E. Rappaport, Esq., LL.M. and Elizabeth Conklin
I. What is a Blind Trust?
A blind trust is a vehicle used most often by public officials designed to separate the official from the management and knowledge of her assets, which avoids a conflict of interest prohibited by law. State governments, for example, require their employees or their elected officials to “recuse themselves and disclose when public duties might impact their personal financial interests.” To illustrate, a person appointed to a position in the Securities and Exchange Commission might set up a blind trust to avoid owning stock in corporations she might have the responsibility to regulate. The grantor, therefore, places her personal assets into the blind trust, and she simultaneously hands over complete control to the trustee, who is permitted to buy or sell those assets without the grantor’s knowledge or consent. Importantly, the trustee, in this case, is not an agent of the grantor because the grantor has no control over the trustee’s actions. This transfer should “immunize” public officials and government employees from any conflicts of interest because the grantor has no idea what her trustee is doing with her assets. Thus, even if the grantor takes actions favoring the assets she used to fund the blind trust, she may come to find the trustee sold those assets anyway, lessening the incentive to take any improper action.
A blind trust agreement for a public official contains basic provisions that plainly explain what is expected and permitted by both parties. Under its “Ethics” section, the public government website for the United States Senate provides a template for blind trusts for its employees to use. This template provides language that states the primary purpose of such a trust, which is to give all decision-making power to its trustee—including where and when to sell or invest the assets, without the grantor knowing the specifics of any of the trustee’s decisions. The template also clarifies the roles of the grantor and trustee. The trustee is to administer the trust in compliance with all requirements listed in the Ethics in Government Act of 1978, and she should never inform the grantor or any other interested party as to her decisions, nor could she take advice as to what she should do with the trust assets from any interested party. The grantor cannot solicit or receive any information about the trust or its assets that is specifically prohibited by any provision in the agreement.
In order to make a blind trust, the Ethics in Government Act of 1978 requires the following elements:
- an independent trustee, who manages the assets in the trust without the knowledge of the grantor;
- freely transferable assets, which are defined as any assets that are transferred to the trust by an interested party (i.e., the grantor), which is free of all restrictions with respect to its transfer or sale, unless such restriction is expressly approved by the supervising ethics office of the reporting individual;
- statutory trust language, a sample of which can be found in its entirety in the Ethics in Government Act of 1978; and
- approval by the supervising ethics office of the grantor’s employment.
Additionally, at least for the United States Senate, the trustee of a qualified blind trust cannot be any layperson, nor can he be an employee, partner, or relative of the grantor. Rather, the trustee should be an independent person with expertise in a financial or legal field or a business, such as a bank, an attorney, an accountant, a broker, or an investment advisor.
Note that not every state has statutorily defined blind trusts. Furthermore, there is a noticeable lack of regulation on the subject by the Financial Industry Regulatory Authority. In fact, the term “blind trust” only appears twice in FINRA’s 2019 rules, which collectively take up almost 150 pages. The organization distinguishes the use of blind trust accounts from those instances where a “research analyst account” or a “debt research analyst account” exists.
As FINRA Rule 2241(a) explains, a research analyst is any person who is involved in the development of a research report which, in turn, can be defined as an analytic report regarding the equity securities of different industries which includes data-driven suggestions for investing. Similarly, a debt research report is the same as a research report, except where a research report analyzes a company’s equity security, the debt research report analyzes debt security. Therefore, a research analyst account—or its debt-related counterpart—is an account in which a research analyst or a member of her household has a financial interest or one where the analyst has discretion and control over its securities. By explicitly excluding blind trust accounts from the definition of a research analyst account, FINRA Rule 2241(a)(9) and Rule 2242(2) permit research analysts to put their assets into blind trusts, provided that no member of the research analyst’s household knows “of the account’s investments or investment transactions.”
II. Can a Blind Trust Exist in the Private Sector?
Blind trusts may also be used in the private sector for different reasons, including but not limited to executive compensation, risk diversification, corporate governance, and regulatory requirements. They may be necessary for fiduciary compliance with regard to the private grantor’s employment, or they may be used as a source of liquidity, for income or savings, or for professional management.
Private blind trusts typically possess the same core features as blind trusts for the public sector, such as an independent trustee, independent management of the trust, and mutual blindness provisions. They may even follow the private business equivalents of the requirements of blind trusts in the Ethics in Government Act; more specifically, a blind trust may require approval by the compliance office of the grantor’s employer, and the language may mirror that of a public blind trust. While provisions regarding the grantor’s role as a government employee or direct references to the Act may not apply, a private trust can still use the statutory language in the sections that explain what the grantor and the trustee can and cannot do. Both public and private blind trusts have the same “underlying principle [of] fairness or equitable conduct;” namely, the businessperson, “as a corporate fiduciary, must be fair and loyal to the company and its shareholders and must not compromise that fiduciary duty with self-interest.” As one would expect, these vehicles allow businesspeople to avoid insider trading by allowing them to profit off of business decisions involving their companies or employers without violating their fiduciary duties of loyalty, care, and good faith.
A person is guilty of insider trading if he buys or sells a security based on material nonpublic information about the security in question or its issuer. Generally, the “insiders”—that is, businesspersons in possession of the material nonpublic information or those generally connected or related to the businesspersons to whom the information is disclosed—are limited to buying or selling company securities only when they are not in possession of the material nonpublic information. These times are usually specifically scheduled during what is called “open window periods”—essentially once per quarter for a limited time following the public disclosure of the material information. A blind trust allows the business insider—or rather, his trustee—to operate outside these open window periods. The blindness provisions in place ensure that the trustee cannot receive any inside information from the grantor. Consequently, any actions taken by the blind trustee cannot be based on insider information and, therefore, those actions cannot constitute insider trading.
Additionally, a blind trust can qualify as an affirmative defense against insider trading. SEC Rule 10b5-1 explains that a blind trust can protect the insider grantor so long as the grantor satisfies the following three requirements:
(1) Before becoming aware of the material nonpublic information, the person, in good faith and not as part of a scheme to evade the insider trading prohibitions, had entered into a contract, provided instructions to another person, or adopted a written plan for trading securities;
(2) The contract, instructions, or plan specified or provided a written methodology for determining the amounts, prices, and timing for the trades, or alternatively, did not permit the insider to exercise any subsequent influence over how, when, or whether to effect purchases or sales, provided that any other person who did exercise such influence, such as an independent trustee, must not have been aware of the material nonpublic information when doing so; and
(3) The purchase or sale that occurred was made according to such contract, instruction, or plan.
III. What Kinds of Trusts are Used in the Private Sector?
Private blind trusts differ from those in the public sector in that there is no statutory or regulatory definition for a private blind trust. Because of this, attorney draftsmen throughout the years have jury-rigged private blind trusts using language from other standard trust templates.
Some experts recommend using blind domestic asset protection trusts (“DAPTs”) for businesspersons to properly abide by securities law regulations without relinquishing the ability to benefit from the trust assets. DAPTs are expressly designed so the grantor can also be the beneficiary but has no ability nor responsibility to manage the assets placed within the trust. As the name suggests, these trusts are primarily used to protect the grantor’s assets from creditors—perhaps during a lawsuit or audit—by taking the assets out of the grantor’s control and thereby out of the control of the creditors, too. The same logic would apply to, for example, insider trading penalties. If the grantor has no control over the assets, he cannot be held liable for insider trading.
Some states have alternative methods. In Virginia, for example, businesspersons may use a particular vehicle known as a “business trust” or a “domestic business trust” to form their business in a way that also protects them from conflicts of interest. According to the court in Williams v. Equity Holding Corp., a business trust is “defined as an unincorporated business, trust, or association that:
(A) is governed by a governing instrument under which:
(1) Property is or will be held, managed, administered, controlled, invested, reinvested, or operated by a trustee for the benefit of persons as are or may become entitled to a beneficial interest in the trust property; or
(2) Business or professional activities for profit are carried on or will be carried on by one or more trustees for the benefit of persons as are or may become entitled to a beneficial interest in the trust property; and
(B) Files articles of trust under § 13.1-1212.”
Since most private uses for blind trusts are still unregulated, there are many options available for the average businessperson who wants to customize them to serve whatever aims he seeks to achieve.
IV. Specific Uses of Private Blind Trusts
A high-ranking employee of any financial institution can establish a blind trust so she can take advantage of investment opportunities without violating any insider trading laws. For example, if the chief financial officer of Coca-Cola initiates a merger with PepsiCo, she would know before the public that her company’s stock prices might increase. Because of this, it would be rather suspicious if she bought shares of Coca-Cola the day before the companies publicized the merger. However, if the trustee of her blind trust happened to buy those shares, there would not be any violations of insider trading law because the CFO and her trustee cannot communicate regarding the trustee’s investments decisions. Additionally, a blind trust in this scenario would allow the CFO to buy and sell stock in her own company outside the regularly scheduled open window periods.
Alternatively, as stated above, an individual involved in the analytics of a company’s securities and debts can use this type of trust for the same purpose—that is, investing in the company in question without violating any regulations.
DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.