Maryland National Bank v. Cummins

RODOWSKY, Judge. In this class action the Circuit Court for Baltimore City held that investment practices for personal trusts followed by a corporate trustee for nearly ten years violated the prudent investor rule. We consider multiple issues relating to liability and to the relief granted. The corporate trustee is the appellant, Maryland National Bank (MNB).

Appellees, the plaintiffs below (Plaintiffs), are income beneficiaries of a testamentary trust administered by MNB which was funded in September 1972. Plaintiffs sued on April 6, 1983. The circuit court certified Plaintiffs as representatives of a class consisting of “the life tenants of all personal trusts (inter vivos and testamentary) where [MNB] was a trustee at any time between September 1, 1972 until July 26, 1982 [the Class Period].” The Class Period ends as of the date when, by retroactive adjustments, MNB modified the practices complained of in the complaint. During the Class Period MNB administered an average of 2,000 personal trusts under the policies hereinafter described.

Cash receipts for all personal trusts were initially deposited to a demand deposit account (DDA) which paid no interest. It was MNB’s policy to leave income cash in the DDA, after receipt and prior to distribution, for those trusts in which income was distributed on a regular schedule, usually quarter annually, but sometimes monthly. Also MNB’s policy was to invest only in increments of $1,000 the ⁵⁷⁴ principal cash of those trusts which had assets exceeding approximately $150,000. In these trusts principal cash left uninvested in the DDA at any given time could range from $0 to $999. 1 For a majority of smaller trusts, those having assets of roughly $150,000 or less, MNB’s policy encouraged investment in collective investment funds (CIFs) in increments of $500.

CIFs are in-house, mutual funds which provide diversification of investments, particularly by smaller trusts. 2 See 12 C.F.R. § 9.18 (1990). These policies were in effect at MNB in September 1972, were reduced to writing in early 1976, and were not substantially altered during the remainder of the Class Period. Plaintiffs contended that these practices were an imprudent failure to invest cash held in trusts. At trial MNB sought to justify its policies principally on the ground that investing cash more fully would not have been cost effective during the Class Period.

MNB never satisfied the trial judge that, as a practical matter, it could not have invested substantially all of the available cash. The heart of the trial court’s finding is “that although computers might have simplified the job, MNB had the ability, manually throughout the class period, to invest these monies for the benefit of the beneficiaries but chose not to. The result was there were high cash balances in the DDA account that the bank was able to use for its own gain.” (Emphasis added). The trial court entered judgment against MNB for $3,857,129.69, consisting of lost return to the Plaintiffs on uninvested trust cash, of compounded prejudgment interest, ⁵⁷⁵ and of a surcharge of ten percent of trustee’s commissions.

MNB appealed, and the Plaintiffs cross-appealed, to the Court of Special Appeals. We issued certiorari on our own motion prior to consideration of the case by the Court of Special Appeals. MNB contends that the circuit court erred, both in finding a breach of the trustee’s duty and in fashioning the relief. In computing its judgment the circuit court used as factors the stipulated average daily balances in the DDA for each calendar year of the Class Period.

The circuit court directed that, for the years 1972 through 1976, MNB pay an amount equal to five percent on those average DDA balances, an investment return analogous to passbook savings account interest earnings. For the years 1977 through the end of the Class Period in September 1982 the court ordered MNB to pay amounts to be determined, in the manner testified to by Plaintiffs’ expert, by applying to the respective average DDA balances certain percentages that represented the average dividend rate paid by a money market mutual fund in the particular year. The court directed that the end products so calculated for each year bear annual interest thereafter at the rate of ten percent and that that interest be compounded to the date of judgment. In this appeal MNB challenges liability, the base figures used in calculating damages, the rate of prejudgment interest, the compounding of prejudgment interest at any rate, and the surcharge against commissions.

The trustee also raises a laches defense. Plaintiffs, on the other hand, assert that the circuit court erred in using a hypothetical return to the Plaintiffs as the model for relief. They say that the court should have awarded Plaintiffs an amount representing the “profit” realized by MNB on the trusts’ uninvested cash. I This case, in large measure, concerns the banking business, trust accounting, and data processing systems.

Per ⁵⁷⁶ sonal trust accounting segregates principal and income. In an entirely manual system there would be separate ledger cards for each of those two components of a trust account. At MNB, trust accounting was automated throughout the Class Period. Further advances in automation for trust accounting later came about.

MNB now uses advanced systems to invest fully principal and income cash. This case, however, must be decided within the framework of circumstances during the Class Period. Under MNB’s policy of carrying trust cash in the DDA, MNB received the considerable advantage of having trust cash available for lending by MNB without incurring any interest cost. An internal study by MNB in 1981 computed the value of the use of uninvested trust cash to be $149,300 per $1 million of deposit balances.

This represented the then current Federal Reserve Bank interest charge to borrowing banks of 13.18% plus a processing fee of 1.75%. MNB’s system in effect treated separate trusts as one common trust in certain aspects of the receipt and disbursement of income and of the purchase, retention and sale of principal assets. In this system the DDA was a common, non-interest bearing, checking account for all personal trusts administered by MNB. 3 Securities in which individual trusts were invested, or in which a CIF invested for participating trusts, were held in the name of MNB as trustee, or of its nominee. If MNB’s investment decision were to move out of a given security, MNB would sell at one time a lot of that security held in MNB’s or its nominee’s name and representing holdings of a number of per ⁵⁷⁷ sonal trusts.

On the settlement date MNB would credit the selling trust accounts with principal cash in the amount of their respective net sales proceeds. On receipt of the check for the total sales proceeds, MNB would deposit it to the DDA for clearing. When purchasing securities to be held directly by trusts, principal cash of a number of trusts, to the extent available under MNB’s policy, could be pooled for the acquisition of a security in one lot. Principal cash of the buying trusts would be respectively debited on the settlement date by the amount of each trust’s proportion of the purchase price, and principal assets would be credited for each trust’s proportion of the lot.

On receipt of the certificate MNB would pay by a check drawn on the DDA which would in due course clear. The certificate was placed in MNB’s vault. From the standpoint of income, interest or dividends on given securities in which multiple trusts might be invested were received by MNB in the form of a check payable to MNB which was deposited to the DDA for clearance. In any particular trust, the portion of the income receipt representing that trust’s investment in the security was credited to the trust, automatically under a computer program, when the dividend or interest was scheduled to be paid by the security issuer.

Disbursements of income on behalf of a particular trust account were debited to that trust account when the disbursement was ordered, or programmed, to be paid. The check in payment was then drawn on the DDA and ultimately was presented for payment from the DDA. At all times during the Class Period, MNB furnished to members of the Plaintiffs’ class periodic statements reflecting, for each trust in which the beneficiaries were interested, the trust’s income receipts, its principal or assets, including principal cash, its disbursements, and its income cash on hand, if any. MNB was able to make all of the allocations to individual trust accounts necessary for the system to function.

MNB was also able to comply with 12 C.F.R. ⁵⁷⁸ § 9.13(b) (1990) which, throughout the Class Period, provided: “(b) The 11 investments of each account shall be either: (1) Kept separate from those of all other accounts, except [for CIFs], or (2) Adequately identified as the property of the relevant account.” This trust accounting was to an extent theoretical because of the differences in timing of debits and credits to the trust account in relation to cash in the DDA. Principal transactions were recorded in trust accounting when the transaction was scheduled to close. In sales by a trust, principal cash was credited in trust accounting on the settlement date but the check in payment would not have cleared. In purchases by a trust, principal cash was debited in trust accounting on the settlement date, but the check from the DDA was not issued until the security was received.

With respect to income, cash was credited in trust accounting on the date when the interest, dividend, or other income item was payable, although the check in payment would not have cleared. Income cash in trust accounting was debited when a distribution to an income beneficiary was scheduled to be made, or when payment of an expense was ordered, although cash in the DDA would not yet have been debited. As a consequence, the DDA ordinarily trails trust accounting. In transactions involving the receipt of principal or income cash the trust account reflects cash which may not have been received in the DDA.

In transactions involving the disbursement of principal or income cash from the DDA, the fact that the DDA trails trust accounting can result in the trust statement sent to the income beneficiaries reflecting less cash than is actually in the DDA. Receipts produce a float favorable to the trust beneficiaries, and disbursements produce a float favorable to the bank. 4 ⁵⁷⁹ Another benefit derived by MNB from invested trust cash carried in the DDA was a reduction of MNB’s reserve requirements. Under Federal Reserve and Office of the Comptroller of the Currency (OCC) procedures, this was accomplished by MNB classifying, for reserve purposes, part of the DDA as a time deposit, even though the deposit was non-interest-bearing. See E. Herman, Conflicts of Interest: Commercial Bank Trust Departments, at 111 (The Twentieth Century Fund, 1975) (Herman).

Herman estimates that “for the large banks, between about 50 percent and over 90 percent of all in-bank trust deposits seem to be classified as non-interest-bearing time.” Id. It has long been settled under Maryland law, however, that a bank-trustee does not commit a per se breach of trust by depositing with itself, on the banking side of its operations, cash which it holds as trustee in its trust department operations. See Newark Distributing Terminals Co. v. Hospelhorn, 172 Md. 291 , 191 A. 707 (1937); Corbett v. Hospelhorn, 172 Md. 257 , 191 A. 691 (1937); Ghingher v. O’Connell, 165 Md. 267 , 167 A. 184 (1933); Real Estate Trust Co. v. Union Trust Co., 102 Md. 41 , 61 A. 228 (1905); Safe Deposit & Trust Co. v. Magruder, 34 F.Supp. 199 (D.C.Md.1940). 5 No party to this action challenges, at least directly, the continued vitality of this rule of Maryland law. The Plaintiffs do not urge, and the trial court did not find, that MNB engaged in prohibited self-dealing by lending, as trustee, trust cash to itself, as banker.

Rather, the liability issue is whether MNB, by failing to obtain or pay a reasonable return on the trust cash, violated its duty prudently to invest on behalf of the class. ⁵⁸⁰ II “Maryland follows a ‘prudent person’ standard for investment by fiduciaries.” Attorney Grievance Comm’n v. Owrutsky, 322 Md. 334 , 350 n. 7, 587 A.2d 511 , 519 n. 7 (1991). In Board of Trustees of the Employees’ Retirement Sys. v. Mayor & City Council of Baltimore City, 317 Md. 72, 103 , 562 A.2d 720, 735 (1989), cert. denied, — U.S. -, 110 S.Ct. 1167 , 107 L.Ed.2d 1069 (1990), and in Shipley v. Crouse, 279 Md. 613, 621 , 370 A.2d 97, 102 (1977), we quoted G. Bogert, The Law of Trusts and Trustees § 541 (2d ed. 1960) for the principle that in all management of the trust a trustee is required to manifest “the care, skill, prudence, and diligence of an ordinarily prudent [person] engaged in similar business affairs and with objectives similar to those of the trust in question.” This duty “is not necessarily to maximize the return on investments but rather to secure a ‘just’ or ‘reasonable’ return while avoiding undue risk.” Board of Trustees, 317 Md. at 107 , 562 A.2d at 737 . Judicial decisions rendered over the years preceding the Class Period, and during the Class Period, presented ample illustrations of fiduciaries who were liable to surcharge for failure to invest funds entrusted with them to the extent required by the duty undertaken. See Cheyenne-Arapaho Tribes of Indians of Oklahoma v. United States, 512 F.2d 1390 , 206 Ct.Cl. 340 (1975) (summary judgment for Government denied where Indian funds left in Treasury at no interest, or at four percent, when outside investments available at higher returns); Manchester Band of Pomo Indians, Inc. v. United States, 363 F.Supp. 1238 (N.D.Cal.1973) (summary judgment on liability against United States where Indian funds remained in Treasury at four percent between 1938 and 1959 when short term government bonds paid higher rate); Estate of Orrantia, 36 Ariz. 311 , 285 P. 266 (1930) (self-depositing without interest for six months by executor bank); New England Trust Co. v. Triggs, 334 Mass. 324 , 135 N.E.2d 541 (1956) (self-deposit without interest by trustee bank for over two years); In re ⁵⁸¹ Doyle’s Will, 191 Misc. 860 , 79 N.Y.S.2d 695 (1948) (testamentary trustee deposited in commercial bank account paying approximately .75% when savings banks paid 1.5%, compounded semi-annually); In re Haigh’s Estate, 133 Misc. 240 , 232 N.Y.S. 322 (1928) (executor bank self-deposited at 2% and 2.25% funds which decedent had had invested at four percent); Reid v. Reid, 237 Pa. 176 , 85 A. 85 (1912) (bank trustee of security in commercial transaction self-deposited funds without interest and was chargeable with interest rate paid by it to third parties depositing in similar accounts).

In the instant matter the Plaintiffs’ proof of the policy practiced by MNB throughout the Class Period is legally sufficient to support the allegation that MNB did not act as a prudent investor. Reasonable persons do not, as a matter of policy, continuously leave uninvested sums up to $999 (if principal cash in a trust account is viewed in isolation) and perhaps ranging in six figures (if principal cash in the trust accounts is considered in the aggregate). 6 Reasonable persons do not, as a matter of policy, leave uninvested for up to nearly three months income cash aggregating hundreds of thousands of dollars. 7 ⁵⁸² The burden was therefore on the trustee to persuade the trial court that a prudent investor would not invest the trust cash which MNB left in the DDA. See Goldman v. Rubin, 292 Md. 693, 713 , 441 A.2d 713, 724 (1982); Lopez v. Lopez, 250 Md. 491, 501 , 243 A.2d 588, 594 (1968). The circuit judge found that MNB had available a number of feasible modes of investment.

A master passbook savings account or individual passbook savings accounts could have been used for trust cash during the Class Period at a return of approximately five percent. CIFs could have been used more fully and, in lieu of a minimum participation of $500, the price of a unit could have been greatly reduced, for example, to $3.00. By using a lower minimum participation, more trust cash could have been invested in master notes. MNB invested in this form of commercial paper by pooling principal cash from various trusts, but MNB did so only in minimum participations of $1,000 per trust.

A further fact-finding was that, as early as 1976, trust cash lying in the DDA could have been invested in money market mutual funds. This could have been done after the checks for receipts had been cleared through the DDA. Thereafter, the mutual fund could have transferred cash periodically to an MNB disbursement account to cover income distributions and expense disbursements of trusts. MNB advances to us four reasons why it says the circuit court clearly erred in finding a breach of duty.

They are (A) benefits to the beneficiaries of the DDA system justified the non-payment of interest; (B) MNB’s policy complied with OCC requirements; (C) MNB’s policy conformed to the virtually universal practice of the trust industry; and (D) ⁵⁸³ investing trust cash would have required a prohibitively expensive allocation of the investment income to individual trust accounts. MNB produced sufficient evidence to support the findings which it now urges us to make. Witnesses who opined that MNB’s policy was reasonable include the former Chief National Trust Examiner of the OCC and the chief executive officer of a leading developer of software for trust department accounting, in addition to various trust department officers from MNB. Fatal to MNB’s appeal are that the totality of the evidence does not present a question of law and that MNB’s witnesses never persuaded the fact finder that MNB’s policy was that of a prudent investor.

A MNB submits that its cash management policy provided significant benefits to the income beneficiaries of personal trusts. One might expect MNB’s analysis to focus on those benefits which would have been lost to the class members had MNB invested trust cash which lay in the DDA. MNB, however, presents a check list of some nine benefits, most of which describe economies of scale manifested in the bulk trading of securities, in the use of nominees, and in arrangements for the physical custody of securities. These benefits result from management of many trusts, and not from foregoing paying interest on trust cash.

MNB asserts that the beneficiaries received free checking and interest-free coverage of overdrafts which, it submits, alone are sufficient to make MNB’s policy reasonable. As explained above, under the dual accounting system, depending on the transaction, there could be in the DDA cash originating with a given trust which was not reflected on that trust’s account, or there could be cash reflected on a trust’s account which had not yet reached the DDA. The result is not, however, simply a wash, because MNB sought to control overdrafts. MNB’s audit report of January 15, 1976, on uninvested trust cash sets forth MNB’s cash ⁵⁸⁴ management policy.

It states flatly that “[tjhere shall be no principal overdrafts in any accounts,” and that “[tjhere shall be no income overdrafts, except those caused by the payment of accruals on the purchase of securities.” B Throughout the Class Period 12 C.F.R. § 9.10 (a) (1982) provided: “Funds held in a fiduciary capacity by a national bank awaiting investment or distribution shalí not be held uninvested or undistributed any longer than is reasonable for the proper management of the account.” The evidence is uncontradicted that MNB was regularly examined by the OCC and that the examiners took no exception to MNB’s policy. Indeed, OCC’s former Chief National Trust Examiner testified that retention of principal cash below $1,000 was in compliance with the regulation. This is evidence that MNB acted prudently, but it neither compels that finding nor renders the trial judge’s contrary conclusion clearly erroneous. In this respect the instant matter is analogous to Ellsworth v. Sherne Lingerie, Inc., 303 Md. 581 , 495 A.2d 348 (1985), a products liability case involving flammable fabrics, where we reversed a verdict for the defendant based on misdirection of the jury and on the erroneous exclusion of evidence.

Significant here is that, although the fabric involved in Ellsworth complied with the federal standard for the flammability of clothing textile, that factor was not determinative on liability — not even as to the plaintiff’s cause of action sounding in negligence. C MNB relies on what it characterizes as the “virtually universal practice of the trust industry.” The trustee also acknowledges, however, that “industry practice cannot control legal obligation.” Appellant’s Brief at 16. Consequently, this argument likewise is to be evaluated under the clearly erroneous standard. ⁵⁸⁵ In support of its position MNB emphasizes the 1975 study for The Twentieth Century Fund, see Herman, supra, at 112-13, and the testimony of the former OCC official, both to the effect that, among banks, the minimum for investment of principal cash was most frequently $1,000, and that income cash need not, and perhaps could not, be invested. At MNB the origins and continuation of the cash management policy do not reflect conscious attention to the duty prudently to invest.

The trust department’s legal counsel explained that in trusts “where the income was paid out on a regular basis, it was felt that income was a sacrosanct item during this class period, [and] that it had to be there on call for beneficiaries who may call up in the middle of the month and say, T need my income.’ ” We have neither been cited to, nor found, any judicial authority supporting that notion. A corollary of this notion was that MNB did invest the income of trusts, referred to as “complex” trusts, in which income was accumulated for discretionary payment. As to principal cash, MNB’s policy of investing in increments of $1,000 antedated the Class Period. It arose when investment officers were expected to invest short term principal cash in the commercial paper of Sears, Roebuck and of General Motors Acceptance Corporation which was only available in $1,000 multiples.

The leading Maryland case on self-depositing by a trustee of trust funds, decided in 1905, casts doubt on MNB’s policy. Real Estate Trust Co., 102 Md. 41 , 61 A. 228 , involved a bank which, as trustee, was mortgagee of real estate securing corporate bonds. After default on the bonds, a portion of the realty was condemned, and the trustee deposited the condemnation proceeds with itself in a non-interest bearing account. In rendering a court accounting of these funds, counsel for the trustee directed the court auditor to charge the bank, as trustee, with two percent per annum interest.

The circuit court increased the rate to six percent. Before this Court the unarticulated concession was that the bank-trustee should pay interest on the self-deposited funds, and the dispute was limited to the ⁵⁸⁶ proper rate between the alternatives presented by the record. For many years preceding, and during most of, the Class Period national banks were prohibited by federal law from paying interest on demand deposits. See 12 U.S.C. § 371a.

It was not until Public Law 96-221, effective December 31, 1980, 94 Stat. 146 -47, that authorization to pay interest on “NOW” (negotiable order of withdrawal) accounts was extended to depository institutions nationwide. “Nevertheless, it remains hornbook [trust] law that cash should not be left unproductive except for overriding liquidity needs.” Lybecker, Regulation of Bank Trust Department Investment Activities: Seven Gaps, Eight Remedies, Part I, 90 Banking L.J. 912, 929 (1973). Thus, the prohibition of interest on the DDA is not defensive. The issue here is whether MNB should have invested funds which it allowed to remain in the DDA or whether, as MNB contends, its cash management policy satisfied its duty prudently to invest. In answering that issue the trial court was not required to accept as controlling the practices of even a majority of commercial banks which operated trust departments, because of the inherent conflicts of interest.

Writing in 1973, Lybecker said: “For trust accounts which do not meet the short-term securities funds participation standards’, and for banks without the computer time or mechanical equipment necessary to administer short-term securities funds, the alternative employed most frequently has been to deposit the ‘uninvestable’ cash in the trust department’s demand deposit account on the commercial side of the bank complex. Because banks are prohibited from paying interest on demand deposits, the bank complex ‘saves’ the interest on the cash which might otherwise be deposited in a savings account, and has significantly more money available for commercial department operations. The bank complex sometimes gives the trust department, not the individual trusts, credit for the amount saved, thereby ⁵⁸⁷ increasing the profitability of trust department operations. Thus, those banks lacking short-term securities funds arrangements sacrifice trust income for liquidity while enjoying the use of the uninvested cash.

The Hunt Commission Report has expressed concern that more frequent analysis and review of bank policy may be desirable whenever a bank lacks short-term securities funds or sets minimum participation requirements for such funds at levels too high for some accounts to qualify.” 8 Lybecker, Regulation of Bank Trust Department Investment Activities, 82 Yale L.J. 977 , 985 (1973) (footnotes omitted). In the 1975 study for The Twentieth Century Fund, Herman presented the following analysis concerning bank practices generally: “Most telling, perhaps, is the slowness with which banks have developed and improved machinery for keeping trust cash to a minimum, and even within banks the application of these improvements has lagged. Master Note plans spread rather slowly in the 1950s and 1960s, and more sophisticated vehicles for investing trust cash in bank-managed pools of money market instruments have developed even more slowly. Computerization has made it possible for the larger trust banks to keep their trust accounts pretty close to fully invested.

Although progress along these lines was significant after the mid-1960s, some billion dollar trust banks did not even have Master Note plans in 1973. The tendency to apply the most sophisticated cash management techniques (such as liquidity pools) to pension funds, while preserving the distinction between income and principal cash for personal trusts, can be explained in part by the smaller size and more complex demands of trust accounts, by statutory limits on personal trust fees, and by legal obstacles to a ⁵⁸⁸ more efficient handling of their cash. But it is also evident that trust founders and beneficiaries are weaker bargainers, less well informed, and less aggressively pursued by the banks, and that the banks have a stake in preserving such distinctions as that between income and principal. A truly ‘undivided loyalty’ to beneficiaries would have resulted in a more rapid advance in the cash management of personal trust accounts.” Herman at 116 (emphasis added; footnote omitted).

Similarly, Lybecker recommended that trust examiners “should serve as a focal point for the accumulation of technical information, thereby making it possible to lower the floor for short-term securities fund participation to zero and to extend the possibility of collective cash investment to all sizes of cash balances.” Lybecker, Regulation of Bank Trust Department Investment Activities: Seven Gaps, Eight Remedies, Part II, 91 Banking L.J. 6, 13 (1974) (footnote omitted). In the only recent decision dealing with issues of the type presented here, the bank trustee self-deposited “cash awaiting permanent investment or distribution and not needed for immediate disbursements ... in passbook savings accounts____” Van de Kamp v. Bank of America Nat’l Trust & Savings Ass’n, 204 Cal.App.3d 819, 841 , 251 Cal.Rptr. 530 , 538 (1988). This practice had existed for a period of time, unspecified in the opinion, prior to January 1976 when the defendant implemented an advance in electronic data processing which permitted automatic daily investment of principal cash. 9 An internal MNB report of September 3, 1982, surveyed nine competitors’ trust department investment increment practices. The report does not disclose how long the reported practices had been in effect.

Philadelphia National Bank ⁵⁸⁹ was investing principal and income cash down to the last dollar. Four banks invested principal and income cash in increments of $100, one bank in increments of $500 as to both sources, and one bank in increments of $1,000 each. An eighth bank did not invest income cash but invested principal cash in increments of $100. Only one other bank in the study failed to invest income cash at all and invested principal cash only in $1,000 increments.

Thus, although the practices followed by MNB may well have been widespread in the banking industry, particularly in the early years of the Class Period, the trial court did not err by declining to go along with the crowd. D The major theme of MNB’s explanation of its practices is that doing otherwise would have been prohibitively expensive. During the Class Period to November 1979 data processing for the MNB trust department was a batch system which produced written reports. That system was capable of producing a report, within twenty-four hours, of the uninvested cash in any given account, or in a number of accounts.

It could produce a report of uninvested cash in all personal trust accounts in a turnaround time of somewhat more than one day. In contrast, “cash sweeping” of trust accounts is the instantaneous, computerized investment and disinvestment of cash. A program for principal cash sweeping was designed in 1975 and became available for banks of MNB’s size around 1977 when MNB contracted for that system. The system