The reader is cautioned that the statutes and regulations referred to in this article may have been updated or revised after this article was written. Readers should be sure to consult the most recent statutes or obtain further counsel prior to reliance on the information contained herein.

Investment Law:
Maine's municipal investment laws afford
municipal officers two options for making "prudent" investment decisions
(from Maine Townsman, January 1996)
By Geoffrey F. Herman

Investment law governing Maine municipalities is laid out in ten fairly concise sections of statute in Title 30-A of Maine's law books. From all appearances, it has nested quietly there for over 30 years with little change to either structure or substance. Since the early 1960's the law has been amended about once every ten years either for the purpose of catching it up with the world of investment practice or to rein in municipal activities by "clarifying" types of investments municipalities may and may not engage in.

In 1995 the law was amended to accomplish both goals, and in light of these amendments we are provided with an opportunity to both review what was changed and revisit the requirements that were left unchanged. Periodic review of investment practice and performance is always strongly recommended. When the investment return is achieving or outperforming expectations, a review of local investment practice can all too easily slip out of the range of scrutiny.

You don't have to dig very deep to find the legislative intent behind municipal investment law--it jumps off the page. The law can be generally characterized as an attempt to ensure the safety and availability of public funds. Even small towns, after all, can have many hundreds of thousands of dollars available from time to time, depending on the ebb and flow of tax revenues and expenditures, and the equivalent amount or more in various trust funds and reserve accounts as well. Investment capital available to larger communities can easily climb into the six, seven, and eight figure range. The enhanced returns associated with higher-risk investment of these funds can be very appealing to the selectmen, councilors, and municipal financial officials fighting to lower the property tax burden. During times of phenomenal stock growth and uninspired bank interest, higher-risk investment can be too appealing, perhaps, so the Legislature has ordained levels of acceptable risk.

It is, first of all, the municipal officers-the selectmen or councilors of a municipality-who are responsible for all municipal investments. With regard to trusts, the municipal officers are the trustees and responsible for the management of the trust unless the language of the trust document names someone other than the municipal officers as trustees. Financial advisory committees or boards can be created, or the municipal officers may choose to rely on the knowledge, skills or advice of the municipal treasurer, finance officer, manager, or other advisors, but when the municipal officers are the trustees the bottom line responsibility will rest with them and therefore, ultimately, the liabilities for trust fund losses related to illegal investment practice.

The structure of municipal investment law provides the municipal officers with two fundamental investment options.

Option #1. The municipal treasurer, at the direction of the municipal officers, is authorized to invest municipal money in a statutorily supplied menu of safe investment instruments. Any municipal funds can be invested this way, whether trust funds, reserve accounts, or simply cash on hand or surplus capital. These permitted investment opportunities run anywhere from the deep safety of deposits in federally insured financial institutions (safe, at least, to the extent of FDIC protection), to repurchase agreements backed by U.S. obligations, mutual funds that invest in U.S. bonds, or a menu of specific investments options that are either very heavily secured by governmental obligation or of limited availability with respect to the overall portfolio of the reserve account, trust fund, or lump sum of cash being invested. For example, no more than 10% of the invested fund can be in the stock of well-performing Maine corporations, and no more than 1% of the total assets of the fund can be invested in any one of these Maine corporations.

It is worth noting that the statutory limits which cap the extent a municipality can invest in a specific type of investment instrument or a specific stock or bond issuer only apply when the investment in that security or type of security exceeds $20,000. This does not mean that municipal money managers can break an investment up into $20,000 pieces and then explore high-risk options. Even when the investment value is small, the menu of permitted options does not change. It is only that specific investments of less than $20,000 are considered small enough so the statutory goal of diversification if achieved even when those small investments are exempted from the percent-of-total-asset limitations.

By reviewing the schematic that accompanies this article, Municipal Investment Law (at a glance), it can be seen that Maine law requires these municipalities that want to manage their own investments but leave the security of government bonds to maintain a portfolio with a maximum of 62% of the fund's total assets in highly diversified, heavily preferred stocks. Only 10% of the total assets of the fund being directly managed by the town or city can be invested in securities outside the mandated parameters, and only then if the municipal officers determine those outside investments to be "prudent".

Option #2. Allows the municipal officers to formally place any trust funds or reserve funds in the "safe-keeping" of a financial institution with trust powers authorized to do business in the state. Institutions of this kind are defined in Maine law. The obvious disadvantage to choosing this option rather than directly in vesting long-term or permanent fund' is that banks charge management feel which come off the top of investment income. Some advantages are equally obvious. To name three, professions money managers would be providing investment advice, the work of money management would be lifted from the selectmen's shoulders, and the liabilities associated with imprudent investment management would be shifted toward the professionals and away from the municipal officers as long as properly executed management agreements are in place.

Another reason this second option may be attractive is that the financial institutions and the investment managers who are on the other end of any safekeeping and investment management agreements are not constrained by the limited menu of investment options available to the municipal officers. Instead, they are governed only by two "rules of prudence" that require the management of the funds to be accomplished with prudence, discretion, and intelligence, the appropriate application of advertised special skills, and with the further requirement that the fore-most considerations in all investment decisions must be safety, maintenance of liquidity, and the derivation of income.

THE 1995 CHANGES

The four significant changes that made up the 1995 legislative sweep of municipal investment law hit the four points of the investment law compass.

First, on the restrictive side, a new section of municipal investment law was enacted to make it absolutely clear that municipal investment practice is strictly limited to the investment instruments authorized by statute. Municipalities may not use their home rule authority to develop an investment policy that allows for riskier investment.

Second, and also on the restrictive side of the compass, derivatives were put on the taboo list. The statutory proscription on derivatives reads: "Investments made pursuant to this section (dealing with bond purchases) are limited to direct obligations of the issuer in which the municipality directly owns the underlying security." Since typical derivative investments provide returns on the basis of the performance of underlying obligations that are not directly owned by the investor, the investment collateral is too far removed from the municipality to effectively safeguard the investment if it needs to be called up in the short term.

The third change is not a restrictive change by nature; rather, it was intended to clarify the sometimes triangular relationship between the municipality, the financial institution where the trust or reserve fund is held in custody for investment, and third-party investment advisors who may or may not be associated with the financial institution.

As has been discussed, the municipal officers may elect to invest municipal funds according to the statutory menu of investment options or place some or all of the municipal trust or reserve funds in the custody of a financial institution, which can be authorized to manage the investment. Until the 1995 amendments became law, it was only "financial institutions with trust powers authorized to do business in the state" that were allowed to enter into investment agreements with municipalities. The recent amendments break apart the two functions that were being performed by the financial institutions into a custodial function and an in-vestment management function. There remains a requirement that the funds be placed with a "financial institution" (i.e., a bank) to perform the custodial function. It is important to understand this piece of the option. If the municipal officers want to delegate financial management to others who have access to investment opportunities outside of the limited statutory menu, the municipal reserve or trust funds may not be placed directly with an investment manager where there is no custodial arrangement with a financial institution. Provided such a custodial, "safekeeping" arrangement is in place, however, the investment management function can either be performed by the bank or an investment advisor registered with the National Association of Securities Dealers, the federal Securities and Exchange Commission, or other similar agencies or associations.

Given this clarification of the law, it would be to the benefit of every municipality that has farmed out some investment management to secure the following paperwork from the entities that are managing municipal reserve or trust funds.

First, if there is any question about the status of the outfit managing the municipal funds, there should be a letter from the legal counsel of that entity which expressly states that the company is a "financial institution with trust powers authorized to do business in Maine" as defined by 9-B M.R.S.A.131 (17-A) [Note: the applicable statute is now 18-B M.R.S.A. §§ 802-807 and ch.9.]. If it is not, either a financial institution that meets that definition must be found to perform a custodial function or the fund must be invested according to the limited investment menu available by statute.

Second, with such a financial institution, there should be a "safekeeping agreement", signed by both the municipal officers and the financial institution. That agreement, at a minimum, should describe the fund being managed, the safekeeping, interest and dividend collection practices, the management fees, and any other services provided by the financial institution. The safekeeping agreement should also reference the fact that the funds are being held in the custody of the financial institution pursuant to Title 30-A, Subchapter III-A (municipal investment law) and that the financial institution is governed by the two "rules of prudence" defined there.

Finally, either as part of the safe-keeping agreement if the financial institution is going to invest the municipal funds, or as a separate agreement with a registered investment advisor with whom the municipality is contracting, there should be an "investment advisory agreement", also signed by both the municipal officers and the registered investment advisor. At a minimum, the investment agreement should describe the fund being invested, lay out the municipality's needs, goals and policies with regard to the investment, determine the management fee, and provide for periodic review of portfolio investments. This agreement, if separate from the safekeeping agreement, should also reference municipal investment law and the fact that the investment advisor is governed by the rule of prudence.

The last 1995 change to municipal investment law of any significance is with regard to the rule of prudence. A new, somewhat more substantive rule of prudence was enacted and made to apply to virtually all municipal investments, whether performed under the direction of the municipal officers or by financial institutions or investment advisors. At the same time, the old rule of prudence, which applied only to financial institutions, was not replaced. So now there are two rules of prudence in municipal investment law, both of which apply to financial institutions and investment advisors working with municipal investments.

Municipal Investment Law (at a glance)

With respect to any municipal revenues, the Municipal Treasurer may, at the direction of the Municipal Officers, invest in:

All of these investments must be direct obligations of issuer in which municipality directly owns the underlying security (Anti-Derivative Clause)

LIMITATIONS ON OTHER PERMITTED SECURITIES INVESTMENTS

*(total assets of a single fund)

Up to 30% In stock of financial institutions (with certain limitations) with no more than 5% in any single, non-Maine bank
Up to 20% In bonds of Maine corporation (meeting certain performance level) with no more than 2% in and single corporation
Up to 10% In bonds of religious, charitable, educational or fraternal associations or corporations with no more than 1% in any single entity
Up to 10% In Maine corporate stock (meeting certain performance level) with no more than 1% in any single corporation
Up to 10% In preferred stock of any public corporation (meeting certain performance level), such as a public utility, with no more than 1% in any single entity
Up to 10 % In securities that may not otherwise be authorized but are determined prudent by the municipal officers
Up to 2% In U.S. or Canadian corporate bonds
Up to 1% In stock of the Maine Capital Corporation
Up to 1% In stock of licensed small business investment companies

*applies to investments over $20, 000

or

With respect to municipal Reserve and Trust Funds, the Municipal Officers may enter into formal agreements with a Financial Institution with Trust Powers for custody and "safekeeping" of the fund:

(1) Safety (2) Liquidity (3) Income