Trust Agreements Explained

Trust Agreements

Introduction A Trust Agreement permits a grantor to transfer property (sometimes referred to as the “corpus” or “trust estate”) to a trust managed by a trustee or board of trustees for the benefit of others. Trust Agreements are often also called Declarations of Trust, Trust Deeds, Deeds of Trust and Trust Instruments. The trust may or may not be treated for tax purposes as a separate entity. Normally, a grantor establishes a trust in order to hold and preserve property for another. The trust may provide for current use of property, such as real estate, or distributions of income from assets held in trust during its term. Typically, property held in trust remains in trust for a period of time tied to the trust's purpose. Access our Transactional Precedent Database for publicly filed Trust Agreements

Categories and Benefits of Trust Agreements In general, a trust that distributes income avoids federal income taxation, and the beneficiaries pay income tax on their respective shares of the income.1 Grantor Trusts avoid beneficiary and trust taxation regardless of whether income is distributed; the trust is not treated as a separate entity from the grantor, which is liable for tax on all of the income. Grantor Trusts, however, are subject to limitations on asset use and management under federal income tax rules.2 Tax rules treat certain other trusts as partnerships or corporations when their activities resemble those of business entities operating for profit.3 While individuals commonly employ trusts for estate planning and wealth management, trusts may serve a commercial purpose when parties seek beneficial tax treatment and asset conservation. For example, parties in a secured borrowing transaction may form a Collateral Trust to protect creditor interests in the underlying assets. Likewise, an issuer may create an Investment Management Trust to segregate and preserve a portion of the proceeds of an initial public offering for certain potential expenses connected to the offering. Parties, likewise, may use an Exchange Trust to facilitate execution of certain acquisitions where timing or regulatory considerations make direct exchange between the parties impractical. Trusts are also useful when parties wish to pool assets or rights. Financial institutions and others may transfer pools of assets to a trust and then offer shares of the trust as securities that pay distributions based on income from the assets held in trust. Many mutual funds and investment entities organize as state business trusts rather than as corporations to avoid entity-level taxation and the more formal requirements of corporate operation. Shareholders in corporations sometimes use Voting Trusts to pool their voting rights to reach the threshold for calling meetings and impacting important corporate decisions.

Key Types of Commercial Trust Agreements Declarations of Trust The owner of property seeking to place it in trust for the benefit of others uses a Declaration of Trust to authorize creation of the trust, convey property into the trust and to set rules for operating the trust and managing trust assets. The Declaration of Trust is the key formation document for the trust entity, akin to articles of organization for corporations and articles of formation for partnerships or limited liability companies. Declarations of Trust are used both in the traditional noncommercial setting and in a variety of commercial contexts.

Collateral Trust Agreements A Collateral Trust Agreement governs a trust created to hold collateral that secures a borrower's loan repayment obligation. The trust benefits the borrower's creditors. The Collateral Trust Agreement references or incorporates relevant provisions of the loan agreement giving rise to the creditor's secured interest. Issuers of secured debt may be required to deposit collateral into a Collateral Trust under a note indenture or similar loan document. The Collateral Trust Agreement charges the trustee with holding, preserving and protecting the debt collateral for as long as the debt obligation remains outstanding and subject to lien. A Collateral Trust Agreement generally addresses issues of priority among creditors, if any, and may reference or incorporate provisions from existing intercreditor agreements for this purpose. Investment Management Trust Agreements Corporate issuers use investment management trusts, most often in the context of an offering of stock and stock warrants of the issuer, to set aside a portion of the proceeds received in an initial public offering for the benefit of the public shareholders. Under the terms of an Investment Management Trust Agreement, the segregated monies fund certain expenses related to the offering, including deferred discounts offered to underwriters, redemption rights granted to shareholders or the issuance of stock for warrants or conversion of debt. An Investment Management Trust Agreement allows a portion of the interest earned on the trust proceeds to be applied to the company's working capital requirements or certain other expenses. The trustee must normally liquidate the trust and distribute the trust proceeds to shareholders based on conditions stated in the Investment Management Trust Agreement. One condition might be consummation of (or failure to consummate) a business reorganization within a certain period of time after the initial public offering.

Trust Agreements Exchange Trust Agreements For regulatory, timing or other reasons, some transactions may require use of an intermediary entity to hold property or rights for the benefit of parties to the transaction. Often the entity is a trust and is referred to as an Exchange Trust. An Exchange Trust Agreement delineates the rights and obligations of the respective parties and the trustee. Exchange Trust Agreements may be used in U.S. acquisitions of Canadian target companies where Canadian tax rules would deny beneficial tax treatment to the target shareholders if they received ownership of a non-Canadian acquirer. The exchange trust holds voting and exchange rights meant to replicate direct ownership of the U.S. corporation while allowing the Canadian target shareholders to receive tax-deferred treatment on the transaction. The Exchange Trust Agreement, which might also be called an Exchange and Voting Trust Agreement, describes the trustee's obligation to exercise voting rights as well as certain exchange rights triggered by insolvency of the U.S. corporation. Tax-free exchanges of like-kind real property under I.R.C. §1031 (exchange of property held for productive use or investment) also require use of an intermediary account or entity through which parties transfer property. Where the intermediary entity is a trust, an Exchange Trust Agreement generally governs the parties’ respective duties and obligations. In certain securitizations, parties may use an Exchange Trust Agreement to govern the transfer of a pool of acquired assets into the issuing trust in exchange for notes and certificates of beneficial interest. The Exchange Trust Agreement details the conveyance of assets into trust, the rights and obligations of the depositor, duties of the trustee and other delegates and the issuance of securities, among other provisions. Access our Transactional Precedent Database for publicly filed Exchange Trust Agreements Trust Agreements in securities offerings Financial institutions and other parties frequently deposit assets into a trust in order to create asset-backed securities, which are investment securities representing a beneficial interest in the underlying assets. For example, mortgage lenders, credit card issuers, lessors of equipment and vehicles, and originators of student loans, car loans and home equity lines of credit may deposit their loans, leases or other assets creating receivable payment rights into a trust which then sells securities backed by, and representing a proportionate interest in, these pooled assets to investors. The Trust Agreement for an asset-backed securities transaction contains complex provisions about the priority of distribution of interest and principal to security holders. Investment banks use trusts to offer securities based on pools of commodity futures, royalties and other assets as well. Examples of other collective investment vehicles that use trusts to own property for the benefit of investors include Unit Investment Trusts and Commodity Trusts, both of which frequently use the grantor trust structure. Other pooled investment entities, like Real Estate Investment Trusts and certain registered investment companies, may use a trust structure but are normally characterized as business entities rather than trusts under applicable tax rules, because of their active management of trust investments.4 Real estate investment trusts and entities qualifying as regulated investment companies, nonetheless may enjoy favorable tax treatment under Subchapter M of the tax code.5 Access our Transactional Precedent Database for publicly filed Trust Agreements Prior to elimination of favorable capital treatment under the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, bank holding companies used trusts to issue trust-preferred securities – hybrid instruments with characteristics of debt and equity – to investors. These generally were issued through a Declaration of Trust. Access our Transactional Precedent Database for publicly filed Trust Agreements • Grantor Trust Agreements Many asset-backed securities are offered through tax-advantaged Grantor Trusts. The tax rules require that these types of trusts significantly restrict the trustee's ability to vary the investments held in the trust (e.g., sell or acquire assets, take actions that impact revenue yield or otherwise change the underlying asset portfolio).6 Trusts that qualify as Grantor Trusts do not need to make distributions to avoid taxation of the trust and all income, whether or not distributed, is taxable to the owner. Access our Transactional Precedent Database for publicly filed Grantor Trust Agreements • Master Trust Agreements Issuers selling securities through trusts frequently employ a Master Trust Agreement, which allows for the creation of multiple sub-trusts, each with its separate pool of assets and beneficiaries. Credit card, home mortgage and other loan issuers with ongoing debt programs often package multiple pools of assets, using serial security offerings. At the onset of the loan securitization program, the issuers authorize the creation of multiple trusts in a single Master Trust Agreement that provides rules of operation and administration applicable to all of the sub-trusts. Future supplements to the Master Trust Agreement provide terms specific to the individual sub-trusts as they are created and securities are issued. Voting Trust Agreements Shareholders in widely-held corporations may use voting trusts to create unified voting blocks that allow them to call general meetings, prevent hostile takeovers, resolve conflicts of interest or facilitate reorganization. Parties to a merger, acquisition or reorganization may require a Voting Trust Agreement as a condition to the transaction. Voting Trust Agreements require participating shareholders to transfer their voting rights for a defined period of time to the trustee who, in return, issues a voting trust certificate to the shareholder. The shareholder generally remains entitled to distributions during the trust term but is limited in its ability to sell or acquire shares during the period in which share rights are held in trust. In addition to voting rights, the trustee may have additional rights and obligations similar to those in other types of trust agreements, such as investment authority and reporting, accounting and record keeping requirements.7 Access our Transactional Precedent Database for publicly filed Voting Trust Agreements

Common Characteristics of Trust Agreements Although there are many types of trusts and corresponding Trust Agreements, they all typically (1) describe the purpose of the trust; (2) reference any transactions and documents that impact the purpose of the trust; (3) identify the assets transferred into the trust; (4) identify the grantors or other parties transferring assets into the trust and (5) name one or more trustees (or a board of trustees) who will administer the assets in trust on behalf of the beneficiaries. Trusts may be revocable or irrevocable by the grantor. If the trust is revocable, the grantor retains the power to amend or undo the establishment and funding of the trust. In an irrevocable trust, the grantor cannot undo the trust and retains only limited rights and powers, as set forth in the Trust Agreement. Commercial Trust Agreements vary widely and some, like the Voting Trust Agreement and Investment Management Trust Agreement, do not include all of the provisions or sections contained in other agreements. For example, trust beneficiaries may or may not be designated in the Trust Agreement. In the public securities context, a Trust Agreement may name a class of securityholders with a beneficial interest in trust assets, such as secured note holders that have an interest in collateral held in a Collateral or other Trust securing the trust's obligation to make payments to them. In smaller private transactions, one or more specific parties are likely to be identified as beneficiaries. A Trust Agreement typically contains detailed guidelines for the trustee's management of trust assets, including when and how assets may be sold and how sales proceeds and income should be invested. The Trust Agreement also includes rules the trustee must follow for the distribution of income to beneficiaries and administrative provisions related to the trust's operation. While the trustee may delegate duties to others, the trustee remains ultimately responsible for operating the trust in accordance with the Trust Agreement.

Key Sections • Definitions  • Stated purpose of the trust • Legal name of the trust • Description of assets deposited into the trust • Designation of trustee • Trustee's powers, duties and limitations • Resignation, removal and replacement of trustee • Designation of beneficiaries • Federal income tax allocations; tax treatment • Amendment and revocation of trust • Limitations on, or conditions to, making distributions • Compensation and reimbursement of trustee • Terms of the trust securities (certificates) purchased by investors, if applicable • Provisions related to the registration of securities and transfer of interests, if applicable • Certificate holder voting rights, if applicable • Trust administrative mechanics, including disbursements • Term of trust, including termination provisions