Issue #17        July 18, 2005
 

THE HIDDEN DANGERS OF POOLED MEDICARE SET ASIDE ADMINISTRATION

 

By John J. Campbell, Esq., CELA, MSCC

 

Introduction

 

          A Medicare Set Aside Arrangement (MSA), created as part of a worker's compensation (WC) settlement, is designed to reasonably consider Medicare's future interest as secondary payer to WC regarding the claimant's post-settlement, work injury-related medical expenses.  The Centers for Medicare and Medicaid Services (CMS) requires settling claimants to submit their WC settlements and a MSA for approval whenever the settlement meets CMS' review criteria.[1]  Failure to comply with this requirement can result in a loss of the claimant's Medicare benefits for future work injury-related medical care. 

 

          In recent years, an entire industry has grown around the process of MSA creation, submission, funding and administration.  Due to the importance of preserving the claimant's Medicare coverage, it is vital to ensure that each professional involved in the process understands his or her duties, responsibilities and legal obligations.  Nowhere is this more true than in the case of professional MSA administrators.

 

          When the use of MSA's first began in 1995, administration was usually performed by professional, licensed trustees under formal Medicare Set Aside Trust (MSAT) agreements.  For the most part, these trustees were banks or federally or state regulated trust companies.  However, as Medicare Set Aside practice has evolved, the use of MSAT's and Medicare Set Aside Custodial Arrangements (MSAC's), administered by non-bank, professional trustees or custodians, has become a prevalent practice.

 

          It seems to be a common misconception that proper MSA administration only requires adherence to CMS' somewhat sparse administration guidelines.  However, professional MSA administrators must also comply with state trust and fiduciary laws, as well as state and federal tax laws.  What may come as a surprise to some professional MSA administrators is that, due to the manner in which they carry out their administrative duties, they may be subjecting themselves to federal and state laws which one does not usually associate with trust or custodial account administration.

 

          One MSA administration strategy is of particular concern.  This strategy involves the "pooling" of assets from numerous MSA accounts for purposes of investment.  Pooled investing is usually done to facilitate MSA administration; to allow access to more lucrative and less risky investment portfolios for the various participating MSA accounts; and to reduce the costs involved in separate account investment management.

 

          At first glance, the practice of "pooling" sounds like a good idea.  It is a trust administration strategy that has been employed by banks and regulated trust companies for decades.  However, it is a practice that is subject to strict and harsh federal regulation.

 

Applicable Federal Law

 

          Whenever a professional fiduciary managing multiple MSA's engages in the pooling of assets from the various MSA's for investment purposes, that fiduciary has created a "common trust fund."  It matters not whether the MSA's are called "trusts" or "custodial agreements."  The effect is the same under federal law.

 

          For any MSA administrator, a significant portion of its exercise of fiduciary powers and duties involves asset investment.  A significant portion of its MSA administration fees, initiation fees and set-up fees are derived in connection with the exercise of these powers and duties.  Further, the purpose for pooling MSA assets in a common trust fund is the investment of monies from multiple MSA accounts as a common fund, with an expectation of returns or profits solely from the efforts of persons other than the individual MSA beneficiaries.

 

          As a result, any time a professional MSA trustee or custodian creates a common trust fund to facilitate asset management, at least three separate bodies of federal law will come into play: 1) The Securities Act of 1933 ("the 1933 Act," codified at 15 U.S.C. §§77a, et seq.); 2) The Securities Exchange Act of 1934 ("the 1934 Act," codified at 15 U.S.C. §§78a, et seq.); and 3) The Investment Company Act of 1940 (15 U.S.C. §§80a-1, et seq.).  The reason is that a common trust or investment fund such as described above falls squarely within the definition of a "security" under each of these federal laws.  (15 U.S.C. §77b(a)(1); 15 U.S.C. §78c(a)(10); 15 U.S.C. §80a-2(a)(36); SEC v. Howey, 328 U.S. 293 (1946); United Housing Foundation v. Forman, 421 U.S. 837, 852 (1975); and Deutsch Energy Co. v. Mazur, 813 F.2d 1567, 1569 (9th Cir. 1987).)

 

          If the MSA administrator is a bank, the creation of a common trust fund is exempt from all three federal acts if the bank is exempt from treatment as an "investment company."  (15 U.S.C. §77c(a)(2); 15 U.S.C. §78c(a)(12)(A)(iii); and 15 U.S.C. §80a-3.)   To be exempt from treatment as an investment company, a bank must meet the following criteria:  1) the common trust fund is maintained by a bank exclusively for the collective investment and reinvestment of moneys contributed thereto by the bank in its capacity as a trustee, executor, administrator, or guardian; and 2) the common trust fund is employed by the bank solely as an aid to the administration of trusts, estates, or other accounts created and maintained for a fiduciary purpose; 3) except in connection with the ordinary advertising of the bank's fiduciary services, interests in such fund are not - (i) advertised; or (ii) offered for sale to the general public; and 4) fees and expenses charged by such fund are not in contravention of fiduciary principles established under applicable Federal or State law.  (15 U.S.C. §80a-3(c)(3).)  

 

          Any activities by a professional MSAC custodian or MSAT trustee in administering a common trust fund are done as part of that professional's regular business; these activities include investing, reinvesting, holding or trading in common trust funds, which are securities; and the assets in the fund usually represent more than 40% of the administrator's total assets.  Further, professional MSA custodians and non-bank trustees are not "banks."  (15 U.S.C. §78c(a)(6)(A); 15 U.S.C. §80a-2(a)(5).)  Therefore, MSAC custodians and non-bank MSAT trustees who pool MSA assets for investment purposes are almost certainly "investment companies" under 15 U.S.C. §80a-3(a). 

 

          As a result, all of the MSAC custodian's and non-bank MSAT trustee's actions in connection with the management of the pooled MSA assets are subject to the provisions and requirements of the 1933 Act, the 1934 Act and the Investment Company Act of 1940.

 

          Virtually all professional MSAC custodians and non-bank MSAT trustees advertise their services.  Most maintain Internet sites; pass out marketing materials from vendor tables at trade shows, MSA conferences or conventions; send marketing materials and custodial agreements through the U.S. Mail; and conduct other activities to encourage the public to choose their services over those of other available MSA administrators.  Because these companies market on a national level, they are engaged in the use of "instrumentalities of communication in interstate commerce."  (15 U.S.C. §77b(a)(7); 15 U.S.C. §78c(a)(17); and 15 U.S.C. §80a-2(a)(18).)    

 

          Further, all of these activities in connection with pooled MSA administration constitute "offers to sell securities;" and the opening of each separate MSA for a WC claimant will constitute a "sale of securities."  (15 U.S.C. §77b(a)(3); 15 U.S.C. §80a-2(a)(34).)  The actions of these professional MSA custodians and non-bank trustees in selling their securities brings them under the definition of an "issuer," (15 U.S.C. §77b(a)(4); 15 U.S.C. §78c(a)(8); and 15 U.S.C. §80a-2(a)), and may also bring them under the definition of a "dealer."  (15 U.S.C. §77b(a)(12); 15 U.S.C. §78c(a)(5); and 15 U.S.C. §80a-2(a).)     

 

          Virtually every professional, non-bank MSA administrator participating in these offers and sales of securities is considered an investment company; advertises its custodial account services to the general public; does business nationally; and does not limit its offers or sales to "accredited investors."  Such MSA administrators are not exempt entities; their common trust funds are not exempt securities under either the 1933 Act or the 1934 Act or any of the SEC regulations; and their offers and sales of securities to the general public constitute "public offerings" under federal securities laws.

 

          Generally, such MSA administrators are required to register their common trust funds as securities with the Securities and Exchange Commission (SEC) through the filing of a registration statement.  (15 U.S.C. §77e(c).)  These custodians and non-bank trustees may also be required to register with the SEC as "dealers."  (15 U.S.C. §78o(a)(1).)  Finally, they are required to register with the SEC as "investment companies."  (15 U.S.C. §§80a-7(a) and 80a-8.)  Any failure to properly register these entities or their securities violates federal laws that can subject these MSA administrators to severe civil, administrative and even criminal penalties.

 

          The marketing activities of professional MSA custodians and non-bank trustees have an additional implication under federal securities and investment company laws.  Each item in written form that is used in connection with the offer or sale of a security, (e.g., marketing brochures; advertisements in industry publications; or written materials on Internet sites), constitutes a "prospectus."  (15 U.S.C. §77b(a)(10); and 15 U.S.C. §80a-2(a)(31).)  A prospectus is required to contain extensive, mandatory disclosures and information.  (15 U.S.C. §77j; and 15 U.S.C. §77aa.)  The marketing materials used by non-bank, professional MSA administrators virtually never comply with these requirements. 

 

          The marketing materials of these MSA administrators with common trust funds invariably omit some, if not most, of the disclosures and information required in a prospectus.  Further, most advertise the MSA administrator's expertise or experience in MSA fund administration, which would include MSA asset investment, even though the administrator's investment experience and expertise may be quite limited; and most only highlight the positive aspects of opening an MSA with the particular custodian or non-bank trustee without discussing the potential risks in any significant detail.  Finally, these materials seldom, if ever, disclose the fact that MSA funds are pooled for investment purposes, or that the opening of an MSA under pooled administration constitutes the sale of a security.

 

          Each of these statements or omissions made in connection with the purchase or sale of a security constitutes either: a) "an untrue statement of material fact [or an] omi[ssion] to state a material fact necessary in order to make the statements, under the circumstances under which they were made, not misleading;" or b) "an act, practice or course of business which operates as a fraud or deceit upon any person.”  As such, these MSA marketing materials would likely subject the MSA custodian or non-bank trustee to liability under SEC Rule 10b-5 (17 C.F.R. §240.10b-5). 

 

          Violation of Rule 10b-5 not only subjects the MSA administrator to liability from suit by the SEC, but also subjects the MSA administrator to private causes of action for damages in federal court by any MSA beneficiaries who may suffer losses as the result of the actions of the MSA administrator.  Further, a judgment against an MSA administrator under Rule 10b-5 is based upon fraudulent conduct and is not dischargeable in a bankruptcy proceeding.

 

          "Common trust funds" can receive special treatment under the Internal Revenue Code (IRC).  If the fund complies with the requirements of IRC §584, the fund is not taxed separately and is not treated like a corporation.  However, if the fund is not administered by a bank, it will not qualify for special treatment under IRC §584.

 

          Any common fund being administered by a professional, non-bank MSA administrator is a separate taxable entity; and it is taxed as though it were a corporation.  Further, any income or capital gains realized through participation in the common fund by each individual MSA account are taxed to the account's beneficiary, as with a grantor trust.  Thus, income from non-exempt common trust funds is subject to double taxation. 

 

          Double taxation of non-qualifying common trust fund income will result in financial losses to each participating MSA account beneficiary.  Further, if the MSA administrator has not filed separate tax returns and paid taxes on income from common investments at the fund's applicable corporate rate, the administrator could be guilty of tax evasion. 

 

          MSA administrators should also be aware that, although this article focuses on federal laws applicable to common trust funds, state securities and tax laws may also apply.  Administrators should take steps to determine whether their state laws impose additional restrictions or obligations.

 

          From the standpoint of the professional, non-bank MSA administrator, there are serious consequences for using a pooled investment strategy in administering multiple MSA accounts without the proper compliance with federal securities, investment company and tax laws.  The criminal and civil penalties that can be imposed through SEC or IRS actions are severe; and any MSA beneficiary whose account loses money as a result of any administrative act can sue the MSA administrator in state and federal court. 

 

          There are also consequences to the beneficiaries of the MSA accounts under illegal pooled administration.  When the SEC or the IRS decides to take action against a business, such as a professional MSA administrator, one of their first actions is to freeze all of the business' liquid assets and financial accounts.  This would likely include a freeze of all MSA assets in the common fund, resulting in a significant interruption of payment from these MSA accounts for the beneficiaries' Medicare-type medical services; and an interruption in those medical services themselves.

 

          The costs of litigation with either the SEC or the IRS can be enormous.  Further, any fines, civil damages or criminal penalties that might be imposed upon the MSA administrator could be financially devastating.  If the administrator should go into bankruptcy, it could result in financial losses and the significant interruption of medical services to the beneficiaries.  Any financial loss to the MSA, other than expenses for approved medical expenses, could also result in Medicare denying future coverage for work injury-related care after the MSA has been exhausted.

 

What to do?

 

          Professional MSA custodians and trustees who are not banks should not engage in the practice of pooling assets from multiple MSA accounts for investment purposes unless they are prepared to comply fully with all applicable federal and state laws.  The costs and the restrictions on marketing activities associated with compliance usually outweigh any benefits that might be derived from pooled administration.  In most cases, the best decision may be to forego or discontinue the practice of pooled MSA administration and administer each MSA as a completely separate account with a completely separate investment portfolio. 

 

          If a professional MSA custodian or non-bank trustee has operated a common trust fund for some time, it is important to file amended tax returns for the years of operation.  Any additional taxes or penalties due must be paid.

 

          MSA administrators who have been pooling MSA assets for investments should make immediate disclosure of that fact to every one of their MSA beneficiaries.  They should also clarify whether this practice will continue; that the creation of the beneficiaries' MSA's with participating interests in the common fund constituted a sale of a security; and whether the administrator has fully complied or is exempt from compliance with federal and state securities and investment company laws. 

 

          Finally, it may be a good idea to consider refunding any fees paid by the beneficiaries to set up or initiate their MSA's, as well as any losses due to poor investment performance or double taxation.  If the administrator can effectively reverse any financial harm that may have been suffered by its MSA beneficiaries, this could prevent lawsuits, complaints and prosecution regarding the MSA administrator's activities.

 

          MSA beneficiaries should become informed consumers.  Those with MSA's currently under professional administration should demand full disclosure of all trustee's or custodian's fees and commissions; as well as complete disclosure of all administrative and investment practices.  If a beneficiary discovers that his or her professional, non-bank administrator engages in asset pooling for purposes of MSA investments, the beneficiary should carefully consider whether keeping his or her MSA account with the current administrator is worth the substantial risks involved.

 

          MSA beneficiaries who suffer damages due to the improper administration of their MSA accounts do have legal recourse.  They may be able to recover these damages by filing suit in state court under state trust and/or fiduciary laws; or by filing suit in federal court if SEC Rule 10b-5 has been violated.  Finally, if common trust investment is involved and the non-bank trustee or custodian has failed to comply with federal securities and investment company laws, or if the trustee or custodian has failed to comply with federal tax laws, the beneficiary could file an official complaint with the SEC or the IRS.

 

          WC claimants who are settling their WC claims under circumstances in which a MSA will be required should conduct a due diligence investigation before choosing the appropriate form of MSA and the appropriate MSA administrator. 

 

          The safest choice will almost always be a trust administered by a professional trustee who is a bank or regulated trust company.  Either should meet the definition of a "bank" under the 1933 Act, the 1934 Act and the Investment Company Act of 1940; and would likely be exempt from the federal securities and investment company registration provisions.  Any common trust that might be used also would likely qualify for special tax treatment under IRC §584.  Further, if MSA assets will be pooled for purposes of investment, the trustee's authority to do so must be contained in the trust document itself and must otherwise be fully disclosed.

 

          If the settling claimant decides to use a non-bank professional to act as a trustee or custodian, the claimant should require complete disclosure of the trustee's investment practices and, in particular, whether assets from multiple MSA's are pooled.  If the trustee or custodian does pool assets for investments, the claimant should demand copies of the SEC registration statement and prospectus[2] for the common trust fund, as well as copies of the documents demonstrating proper registration of the trustee or custodian with the SEC as an "investment company" and, if applicable, as a "dealer."  If the fiduciary cannot demonstrate full compliance with federal law and any applicable state law requirements, that fiduciary should not be utilized.

 

          Finally, any attorneys or other professionals who may be representing or assisting the claimant in the settlement process should undertake to ensure that a full due diligence investigation is conducted regarding any potential professional trustee or custodian.  In addition to ensuring that the fiduciary's investment practices are in compliance with securities and investment company laws, the investigation should look into other areas, including but not limited to:  the financial soundness of the fiduciary; whether the fiduciary is bonded or insured; whether the claimant's MSA funds will be fully insured; the performance history of the fiduciary's investments in other MSA's; and whether the fiduciary has had any legal or financial problems in the past. 

 

Conclusion

 

          Pooling assets from various MSA's for purposes of investment may seem like an attractive administration strategy to professional MSAT trustees and MSAC custodians.  However, by pooling assets from various MSA's, the trustee or custodian is creating a "common trust fund" and is therefore engaging in the offer and sale of regulated securities.  As a result, pooled MSA administration implicates some very strict compliance requirements under federal law; and may also implicate similar requirements under applicable state law. 

 

          Professional custodians and trustees who are not banks or regulated trust companies will likely not be able to claim exempt status for themselves or for their common trust funds.  Even those who may be able to successfully claim exempt status for their common trust funds will be subject to SEC statutes and regulations prohibiting fraud or deceit and requiring full disclosure in connection with the offer, purchase or sale of securities.

 

           Professional trustees and custodians who fail to fully comply with applicable federal laws are exposed to civil, administrative and criminal penalties under prosecution by the SEC or the IRS.  Further, they may be exposed to civil liability under lawsuits from MSA beneficiaries who have been harmed. 

 

          Beneficiaries whose MSA's are administered by non-bank professionals who use a pooled investment strategy are also exposed to the risk of financial loss; and the interruption or loss of medical coverage for their work injury-related medical expenses of the type normally covered by Medicare.  Further, if losses reduce or deplete the MSA account on other than approved medical expenses, Medicare may deny future coverage upon exhaustion of the account.

 

          As the old saw goes: "an ounce of prevention is worth a pound of cure."  Best practices for WC claimants, their attorneys and other professionals working with the claimant require that a full, due diligence investigation be conducted before choosing the appropriate MSA and the appropriate MSA administrator.  For those who already have MSA's under administration, a similar due diligence inquiry now could alert the beneficiary to potential risks and prevent significant harm to the claimant in the future.

 

          MSA administration is no simple matter.  It certainly involves more than merely placing MSA funds into an interest bearing account.  When MSA assets are pooled in common trust funds, complex state and federal laws will come into play, governing the manner in which MSA funds are marketed, administered and taxed.  WC claimants, their attorneys, structured settlement professionals, MSA administrators and other MSA professionals should become aware of these laws and their application to protect themselves from the hidden dangers of pooled MSA administration.

 

End Notes