ACTEC Journal - Practical Guidance For Trustee Risk Management

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  • 1. Practical Guidance for Trustee Risk Management by Lauren J. Wolven, Chicago, Illinois, and Jeffrey A. Zaluda, Chicago, Illinois* 1 I. THE ROLE AND RESPONSIBILITIES OF can lead to difficulties. Even a cautious and conserva- TRUSTEES OF PERSONAL TRUSTS tive fiduciary will find that when real life circum- A. Introduction stances and people are thrown into the mix, the text- Serving as a trustee used to be an honor book line that a fiduciary may not cross can become bestowed by a longtime client or friend. It demon- blurry rather quickly.4 strated that the grantor trusted you to take care of his B. Trends In Fiduciary Liability family and his finances. Trustees rarely were ques- The duties and liability of a fiduciary are gov- tioned with respect to their actions in administering erned generally by state law. Federal law does inter- the trust, and trustees hardly gave a thought to person- play with the duties defined by state law, particularly al liability for administering a trust. with respect to taxation of trusts and, in certain cir- It is an increasingly risky business to serve as cumstances, investment of trust funds and distribution trustee, however, as fiduciary litigation is on the rise.2 of income. There is much variation among the states, The Center for Fiduciary Analysis reports a twenty- and therefore it is imperative to understand the applic- two percent compounded annual increase in fiduciary able law of the jurisdiction governing the fiduciary’s litigation cases based on figures from the National actions. It is critical for a fiduciary to be familiar with Association of Securities Dealers.3 Beneficiaries have both the statutes governing the fiduciary’s conduct, as discovered that they, like the rest of society, can seek well as the common law that inevitably intertwines redress in the courts for actual or perceived wrongs. with the statutory duties. Many law firms now prohibit attorneys from accepting Trust law generally evolves in a reactionary such positions or require that the decision be vetted by manner, adjusting in response to external stimuli such a special committee assigned with the task of deter- as new investment techniques.5 Politics, social develop- mining whether the attorney may assume the fiduciary ments, and financial conditions also spur changes in role. The hesitation on the part of those individuals fiduciary duties. During the past fifty years, the role of arguably most familiar with fiduciary law to serve in a fiduciary has changed as the result of the gradual evolu- fiduciary capacity should serve as a warning. tion of trust administration and of the laws of taxation.6 Wealthy families frequently engage in sophis- 1. Corporate Cases Addressing Fiduciary ticated estate planning techniques, including sales at Duty below-market interest rates. Often, children and Lawsuits in the corporate arena often gar- grandchildren are the beneficiaries of these wealth ner much attention from the press. Recent corporate transfer structures through which assets are funneled fraud lawsuits have involved allegations of breach of to achieve various tax savings. Problems for trustees fiduciary duty. The courts have focused on the duties of typically do not arise until the settlor’s generation has directors and officers, as well as the application (or passed away. Children and grandchildren who are the denial) of director and officer insurance to pay for liabil- beneficiaries of trusts may not have the same positive ities imposed. Some of these decisions ultimately may view of the planning techniques employed or the same carry over to the trusts and estates context, giving rise to relationship with the trustee that the settlor had, which additional evolution of the law in the fiduciary area. * Copyright 2007. Lauren J. Wolven and Jeffrey A. Zaluda. In 2005, the American College of Trust and Estate Counsel 4 All rights reserved. (ACTEC), issued a guide titled “What it Means to Be as Trustee: A Ms. Wolven is the Regional Trust Head with the Chicago Guide for Clients.” American College of Trust and Estate Counsel, 1 Office of Brown Brothers Harriman Trust Company, N.A. Mr. What It Means to Be a Trustee: A Guide for Clients, 31 ACTEC Zaluda practices wealth protection planning with the Chicago law JOURNAL 8-20 (Summer 2005). The guide provides an excellent firm of Horwood Marcus & Berk Chtd. This article is adapted, in summary of trustee duties easily decipherable by the layperson. part, from Horwood and Wolven, Managing Litigation Risks of Loren C. Ipsen, Trends in the Liability of Corporate Fidu- 5 Fiduciaries, BNA TAX MANAGEMENT 857 (2006). ciaries, 24 IDAHO L. REV. 433 (1987/1988). Thrupthi Reddy, How Not to Get Sued, in TRUSTS & ESTATES Edward C. Halbach, Jr., Uniform Acts, Restatements, and 2 6 (2005), available at http://registeredrep.com/mag/finance_not_sued/. Trends in American Trust Law at Century’s End, 88 CAL. L. REV. Id. 1877, 1881 (2000). 3 32 ACTEC Journal 297 (2007)
  • 2. In Re Enron Corporation Securities, administrator of the plan; however, the court rejected Derivative & ERISA Litigation v. Tittle7 and In Re claims that the directed trustee was completely WorldCom, Inc. ERISA Litigation8 indicate that trust absolved from responsibility for the failure of the pen- beneficiaries are more willing to assert their legal sion plan investment in company stock. In reaching its rights and seek remedies for breach of trust than ever decision, the court cited Moench v. Robertson, stand- before. In both of these cases, trust beneficiaries ing for the proposition that a plaintiff may overcome sought to impose broad fiduciary liability under the the presumption that the plan fiduciary investing in federal Employee Retirement Income Security Act of employer stock is presumed to have acted consistently 1974 (ERISA).9 ERISA governs investment of pen- with ERISA only if the fiduciary abused its discre- sion funds by the trustees managing the funds.10 tion.17 Therefore, the directed trustee has potential lia- Only corporate directors and officers who bility if a prudent trustee would have knowledge of the have fiduciary responsibility are liable for breach of imprudent investment. fiduciary duty under ERISA. Liability attaches when 2. Assumed Duty of Review fiduciaries: (1) manage or administer a plan; (2) pro- Corporate fraud cases are not the only vide investment advice; and (3) invest plan assets.11 ones creating new hazards in the world of fiduciary a. Enron duty. Hatleberg v. Norwest Bank Wisconsin demon- In their class action suit, Enron plain- strates the increasing obligations placed on fiduciaries tiffs alleged breach of fiduciary duty under ERISA by the courts.18 In Hatleberg, a trust officer represent- against both corporate and individual defendants.12 ed he had knowledge regarding estate tax planning The plaintiffs claimed the company disclosed false and when he obtained the business of grantor and her hus- misleading information that artificially inflated earn- band. After the death of the grantor’s husband, the ings and income, failed to disclose information regard- trust officer contacted grantor to assist her in complet- ing the company’s financial problems, and failed to ing her estate plan. disclose the true financial condition of the company to As part of this planning, grantor followed the administrative and investing fiduciaries.13 the trust officer’s advice to establish an irrevocable The rulings indicate that a directed trust to receive annual exclusion gifts. Grantor trustee has potential liability if it has notice of an engaged her own attorney, who was not an expert in investment breach. “Notice” in this context means trust law, to implement the trust recommended by the “knows or should know” of the breach.14 The court trust officer. Three years after the trust was estab- concluded that the directed trustee has an affirmative lished, the bank (serving as trustee) became concerned duty to investigate and make a reasonable inquiry in that the trust lacked Crummey19 provisions. The trustee order to determine whether the directing fiduciary is bank contacted the drafting attorney and suggested that violating his duty.15 the issue be remedied. The bank did not copy the b. WorldCom grantor (who was still living) on the letter, and never In WorldCom, the plaintiffs alleged contacted the grantor about its concerns. the company and various fiduciary defendants issued The trust was not amended, and by the false and misleading financial statements. When the time of her death the grantor had contributed $440,000 truth of WorldCom’s finances was made public, the to the trust. The grantor’s estate had to recapture the value of the company stock fell dramatically, resulting gifts, resulting in an additional $173,644 in taxes.20 in financial loss to 401(k) plan participants.16 Although the court held that the trustee The defendants successfully argued had no duty to review the trust for accuracy, it found that the duty of a directed trustee of a plan is to follow the bank liable, in part because it held itself out as an investment instructions from the participants and the expert in managing the trust estate. Because the bank In Re Enron Corp. Sec., Derivative & “ERISA” Litig., 284 132368.html. 7 F. Supp. 2d 511 (S.D. Tex. 2003). In Re Enron, 284 F. Supp. 2d at 530. 12 In Re WorldCom, Inc. ERISA Litig., 354 F. Supp. 2d 423 Id. at 555. 8 13 (S.D.N.Y. 2005). Id. at 591. 14 Employee Retirement Income Security Act of 1974 Id. 9 15 (ERISA), 29 U.S.C. §§ 1001-1461 (1998). In Re WorldCom, 354 F. Supp. 2d 423. 16 Id. ERISA applies to all pension funds except state and Moench v. Robertson, 62 F.3d 553, 571 (3d Cir. 1995). 10 17 local pension funds exempt by 29 U.S.C. § 1003(b) (2005). Hatleberg v. Norwest Bank Wisconsin, 700 N.W.2d 15 18 29 U.S.C. § 1002(21)(A) (2005); see also David M. Gische (Wis. 2005). 11 & Jo Ann Abramson, “Corporate Fiduciary Liability Claims in See Crummey v. Comm’r., 297 F.2d 82 (9th Cir. 1968). 19 the Post-Enron Era,” at http://library.findlaw.com/2002/Oct/24/ See Hatleberg, 700 N.W.2d at *P11. 20 32 ACTEC Journal 298 (2007)
  • 3. had gratuitously reviewed the trust document and con- eficiaries and treats the relationship as a partnership tacted the drafting attorney, however, the bank may find it has more defenses upon which it can rely if assumed a fiduciary duty to the grantor.21 litigation ensues. 3. Environmental Liabilities In order to avoid the courtroom, it is important for If real property forming a part of the trust a trustee to understand the acts, emotions and other estate is found to have environmental contamination, triggers that lead to fiduciary litigation. Only some the trustee may face liability under the Comprehensive fiduciary duties are intuitive. Every trustee must Environmental Response, Compensation, and Liabili- become knowledgeable about its legal obligations and ty Act (CERCLA).22 The Asset Conservation, Lender restrictions in order to understand when it is facing Liability, and Deposit Insurance Protection Act23 activity that could put it at risk for personal liability. amended CERCLA and affords some protection to A. Trustees with Special Skills trustees from personal liability unless the trustee The general guiding principles of trust law caused the contamination through its own negligence dictate that a trustee must exercise due care, diligence or otherwise contributed to the contamination. and skill in the administration of a trust. When a In City of Phoenix v. Garbage Services trustee fails to meet the required standard of care Co.,24 the City filed an action to recover response costs through negligence or willfulness, the trustee is per- incurred in cleaning up a landfill forming part of a tes- sonally liable for all losses resulting to the trust estate. tamentary trust of which a bank was trustee. The land- The standard of care and skill generally fill had not been a part of the original trust estate; how- required of a trustee is the standard of a man of ordi- ever, the trustee bank had exercised an option owned nary prudence in dealing with his own property.27 In by the trust to repurchase the landfill. this arena, good intentions do not go very far. Trust Trustee bank argued that it was not the law holds a trustee liable for losses resulting from owner of the property under CERCLA and that, as a the trustee’s failure to use the care and skill of a man matter of law, it was not an owner/operator of the land- of ordinary prudence, even though the trustee may fill because it did not oversee day-to-day operations have exercised all the care and skill of which it was (and therefore was not liable under CERCLA).25 In a capable.28 previous action, the bank had fought to prove its own- If a trustee has a greater degree of skill than ership of the landfill and thus was collaterally estopped that of a man of ordinary prudence and represents this from re-litigating the ownership issue in this action. In higher degree of skill in order to obtain his appoint- any event, however, the court found the bank was an ment, he will be held liable for a loss resulting from owner of the landfill for CERCLA purposes even the failure to use such skill.29 Many jurisdictions have though as trustee it held only bare legal title.26 adopted a heightened standard for trustees with special skills who have so represented their skills.30 II. UNDERSTANDING FIDUCIARY DUTIES Although the duties imposed on trustees may As common sense would indicate, a fiduciary has require greater than ordinary intelligence to navigate a general duty to act reasonably and competently in successfully on one’s own, the particular level of skill administering a fiduciary estate. Fiduciaries tend to required to fulfill the role of trustee does not in and of get themselves in trouble when they view themselves itself prevent a person of ordinary intelligence from as being the party in “control” of the beneficiaries and serving as trustee. An ordinarily intelligent person attempt to exert their “authority” over the beneficia- may assume the role of trustee, however, he may be ries. A fiduciary that communicates well with the ben- required to take reasonable steps to seek competent See id. at 10. See, e.g., RESTATEMENT (SECOND) OF TRUSTS §174 cmt. a.; 21 29 See 42 U.S.C.S. § 9607 (2005). Uniform Trust Code § 806 (2005); Fiduciary Liability of Trustees 22 Pub. L. No. 104-208, 2501-2502, 110 Stat. 3009-462 and Personal Representatives, BNA TAX MANAGEMENT 853. 23 (1996) §107(n)(1). Stevens v. Nat’l City Bank, 544 N.E.2d 612, 616 (Ohio 30 City of Phoenix, Arizona v. Garbage Serv. Co., 816 F. Supp. 1989); Estate of McCredy, 470 A.2d 585, 594 (Pa. Super. Ct. 24 564 (D. Ariz. 1993). 1983); In re Estate of Estes, 654 P.2d 4, 8-9 (Ariz. Ct. App. 1982); Id. at 567. C.B.& T. Co. v. Hefner, 651 P.2d 1029, 1033 (N.M. Ct. App. 1982); 25 Id. at 568. Estate of Beach v. Carter, 542 P.2d 994, 1001 (Cal. 1975); Steiner 26 RESTATEMENT (SECOND) OF TRUSTS § 174; see also Estate of v. Hawaiian Trust Co., 393 P.2d 96, 105 (Haw. 1964); In re 27 Wilde, 708 A.2d 273, 275 (Me. 1998); Estate of Tessier, 468 A.2d Schlemm’s Estate, 78 A.2d 156, 160 (N.J. Super. Ct. Ch. Div. 590 (Me. 1983); In re Estate of West, 948 P.2d 351 (Utah 1997). 1951). But see Liska v. First Nat’l Bank, 322 N.W.2d 892 (Iowa Ct. RESTATEMENT (SECOND) OF TRUSTS § 174 cmt. a; RESTATE- App. 1982); Security Trust Co. v. Appleton, 197 S.W.2d 70 (Ky. Ct. 28 MENT (THIRD) OF TRUSTS § 227 cmt. d. App. 1946). 32 ACTEC Journal 299 (2007)
  • 4. “advice, guidance, and assistance” in order to meet the the trust beneficiaries, a duty to diversify the invest- duty of a prudent investor.31 ments in the interest of the trust beneficiaries, and a B. Duty to Invest Prudently: The Prudent duty to pursue an investment strategy that considers Man, the Prudent Investor and the Prudent both reasonable production of income and the safety Trustee of capital.36 A trustee has a basic duty to cause the trust Under New York law, generally, whether a property to produce income.32 The historical rule gov- fiduciary has acted prudently is a factual determina- erning investment of trust property was known as the tion to be made by the trial court.37 No precise formu- “prudent man rule,” and mandated that a trustee pre- la exists for determining whether the prudent person serve the trust property and make it productive. Ulti- standard has been violated in a particular situation; mately, the “prudent man rule” was replaced by the rather, the determination depends on an examination more flexible “prudent investor rule.” This rule has of the facts and circumstances of each case.38 In under- been adopted by legislation in many states, and allows taking this inquiry, New York courts engage in “a bal- a trustee greater flexibility in investments. In essence, anced and perceptive analysis of the fiduciary’s con- the prudent investor rule requires a trustee to preserve sideration and action in light of the history of each the trust property and to make it productive while act- individual investment, viewed at the time of its action ing with reasonable care, skill, caution and undivided or its omission to act.”39 loyalty to the beneficiaries.33 Review of investment decisions necessarily is Jurisdictions that have adopted the prudent made in hindsight. Such a review is purely a subjec- investor rule as articulated by the Restatement afford tive “reasonableness” determination, so it is important trustees the benefit of consideration of the perfor- to document carefully the facts and circumstances sur- mance of the investment portfolio as a whole. The rounding portfolio analysis. For example, a trustee Restatement approach also judges a trustee’s invest- should keep a record of regular meetings and portfolio ment choices at the time the choices are made, and not reviews with investment advisors. Trustees also based purely on the result of an investment portfolio.34 should require the professional investment advisor to Performance, however, likely would be a key factor maintain records of its investment decisions and the persuasive to the decision-maker in a court proceed- research supporting those decisions. Being able to ing. Although the Restatements are not binding unless establish that investments were made after a thought- the rule has been adopted in a particular jurisdiction, ful and careful process can go a long way toward either by statute or case law, they generally are regard- defending a trustee when an investment portfolio fails. ed as highly persuasive authority. 1. Diversification of the Trust Portfolio It is important for a trustee to consider its In most jurisdictions, a trustee has a duty investment duties in light of the trust instrument and to the beneficiaries to diversify the trust portfolio.40 the applicable state law, as the general duty described This duty may be modified by the trust instrument, above is often modified or clarified by these sources. though a trustee generally must keep a close watch on In Illinois, for example, the Illinois Trusts and portfolio performance when asset concentration is per- Trustees Act35 imposes the standards of the prudent mitted or directed. Although the duty is not absolute investor rule on a trustee. The rule requires the exer- and varies among jurisdictions, most courts hold a cise of reasonable care, skill, and caution in the overall trustee to its duty to diversify on the theory that diver- investment strategy for the trust property. Specifically, sification is spreading the risk of investments with the the trustee owes a duty of loyalty and impartiality to ultimate goal of protecting the trust assets.41 RESTATEMENT (THIRD) OF TRUSTS § 227 cmt. d. ABA Course of Study 199, 204-05 (2004). 31 BOGERT & BOGERT, THE LAW OF TRUSTS AND TRUSTEES § See In re Estate of Janes, 681 N.E.2d 332 (N.Y. 1997). 32 37 611 (3d ed. 2000). Id., citing Purdy v. Lynch, 145 N.Y. 462, 475 (N.Y. 1895); 38 See RESTATEMENT (THIRD) OF TRUSTS §§ 176, 181 and 227, see also Matter of Hahn, 466 N.E.2d 144 (N.Y. 1984). 33 cmt. a. In re Rowe, 712 N.Y.S.2d 662 (N.Y. App. Div. 2000); In re 39 RESTATEMENT (THIRD) OF TRUSTS § 227 cmt. b. (“The Estate of Saxton, 712 N.Y.S.2d 225, 230 (N.Y. App. Div. 2000); In 34 trustee is not a guarantor of the trust’s investment performance”). re Estate of Janes, 681 N.E.2d at 337 (citing Matter of Donner, 626 760 ILCS 5/5(a)(2) (1992). N.E.2d 922, 927 (N.Y. 1993)). 35 In Illinois, however, there is a lack of judicial decisions to RESTATEMENT (THIRD) OF TRUSTS § 229 cmt. d. 36 40 aid in the interpretation of the prudent investor rule because the law See, e.g., Steiner v. Hawaiian Trust Co., 393 P.2d 96 (Haw. 41 was revised in 1992 to expand upon the prudent man rule. For a 1964); First Nat’l Bank v. Truesdale Hosp., 192 N.E. 150 (Mass. general discussion on the differences of the prudent investor rule 1934); First Nat’l Bank v. Hyde, 363 S.W.2d 647 (Mo. 1962); see and prudent man rule generally, see Terry L. Turnipseed, Back to also P. G. Guthrie, Annotation, Duty of Trustee to Diversify Invest- the Future: Is Total Return Investing Old Fashioned?, SK004 ALI- ments, and Liability for Failure to Do So, 24 A.L.R.3d 730 (1969). 32 ACTEC Journal 300 (2007)
  • 5. The Restatement (Third) of Trusts42 2. The Impossible Game: Investment addresses distribution of risk of loss and has been cited Direction In A Trust Instrument by many courts in assessing whether a trustee has a As noted above, a settlor generally may duty to diversify. Specifically, Section 227 of the alter the basic rules of fiduciary governance by express Restatement describes the investment authority that is direction in the governing instrument. Several cases normally to be implied for the trustee, which includes decided in recent history, however, indicate that the diversification.43 A trustee may avoid diversifying directions of a settlor regarding investments may not assets, however, if, under the circumstances, it “is pru- be blindly followed and are to be considered in light of dent not to do so.”44 reasonable investment policy. Two highly publicized Although many states have adopted a cases regarding single stock positions, In re Estate of mandatory diversification provision, some states do Dumont 48 and In re Estate of Kettle,49 resulted in liabil- not mandate this duty. In the last fifty years, fiduciary ity for both trustees, who had taken opposite actions investment practices have evolved considerably. regarding the stock position and the directions within Investments once thought risky are now commonly their governing trust instruments. found in fiduciary portfolios. Options, futures and for- 3. In re Estate of Dumont eign investments have become an accepted part of a In Dumont, language in the Will permitted diversified investment portfolio. the corporate fiduciary to retain the estate’s single Because the law regarding duty to diversi- stock position in Kodak.50 The trustee did not diversi- fy has undergone changes with the evolution of the fy the trust’s portfolio between the time it assumed the investment markets, it may not be unusual to find trusteeship in 1958 until 2002, when it hurriedly sold older cases in a given state that reject the duty to diver- off the Kodak stock over a nine-month period. This sify and more recent cases that adopt this generally failure to diversify occurred despite negotiations with accepted duty of a trustee. For example, until 1995, the beneficiaries in 1997 and court action by the bene- the great weight of authority in the state of New York ficiaries in 1998 objecting to the trustee’s accounts on was that trustees did not have a mandatory duty to the basis of losses incurred due to “improper retention diversify assets.45 Despite early uncertainty concern- of a near 100% concentration in Kodak stock and ing the Illinois position,46 in Illinois the trustee has a overall mismanagement of the trust estate.”51 duty to diversify the investments of the trust unless, In December 2001, the trustee officially under the circumstances, the trustee reasonably determined that a compelling reason existed to sell believes it is in the interests of the beneficiaries and some of the stock. The trustee decided to sell 95% of furthers the purposes of the trust not to diversify.47 the stock over a thirteen-month period in order to See also RESTATEMENT (THIRD) OF TRUSTS § 228. ter…sell, transfer and dispose” of the stock. Additionally, 42 Id. § 228 cmt. d. buried within this paragraph is an interesting notation that the 43 Id. § 227(b). testator’s estate would be primarily comprised of a single 44 See, e.g., In re Sheldon’s Will, 289 N.Y.S. 887 (Sur. Ct. security: the stock of Eastman Kodak Company (“Kodak”). 45 1936); In re Mendleson’s Will, 261 N.Y.S.2d 525, 535 (Sur. Ct. Further along in this final paragraph, Charles Dumont includ- 1965). New York enacted the Prudent Investor Act, effective January ed the following language: 1, 1995, which requires trustees to diversify assets unless the trustee reasonably determines that it is in the interests of the beneficiaries It is my desire and hope that said stock will be held by my said not to diversify. N.Y. EST. POWERS & TRUSTS §11-2.3 (2004). Executors and by my said trustee to be distributed to the ulti- See Cent. Nat’l Bank v. United States Dep’t of Treasury, mate beneficiaries under this Will, and neither my Executors 46 912 F.2d 897 (7th Cir. 1990). The Seventh Circuit noted that after nor my said trustee shall dispose of such stock for the purpose McCormick v. McCormick, 536 N.E.2d 419 (Ill. App. Ct. 1989) of diversification of investment and neither they or it shall be (asserting that Illinois law “does not impose a duty on a trustee to held liable for any diminution in the value of such stock. diversify the trust assets”) and Hamilton v. Neilson, 46 N.E.2d 94 (Ill. App. Ct. 1942) (involving the duty of an Illinois executor to Finally, and most importantly, he concluded his retention lan- diversify), the status of the duty to diversify in Illinois law was “in guage with the following language (the “exception phrase”), a fog.” Id. at 902-3. which remains the crux of this litigation: 760 ILCS 5/5(a)(3) (2005). 47 2004 NY Slip Op 50647U (Sur. Ct. 2004). The foregoing provisions shall not prevent my said Executors 48 73 A.D.2d 786 (N.Y. App. Div. 1979). or my said Trustee from disposing of all or part of the stock of 49 See Dumont, 2004 NY Slip Op 50647U at *2. The court Eastman Kodak Company in case there shall be some com- 50 outlined the relevant provisions of the testator’s will as follows: pelling reason other than diversification of investment for After the dispositional provisions, the testator added an exten- doing so. sive paragraph “LASTLY”, wherein he set forth the powers of the nominated fiduciaries, notably the power to “adminis- See id. at *3. 51 32 ACTEC Journal 301 (2007)
  • 6. spread the capital gains tax over three tax years. The the estate will demand a delicate bal- stock was actually sold within nine months.52 ancing act.56 Because the period in question spanned more than thirty years, the court was faced with applying 4. In re Estate of Kettle two different standards to the trustee’s investment deci- In Kettle, the testator’s Will provided that sions.53 During the first part of the trust administration, the executor and trustee should retain a single stock the prudent person rule applied, which did not require position unless there was a compelling reason to dis- diversification. After January 1, 1995, the prudent pose of the stock.57 Two months after receiving the investor rule became applicable due to a change in New stock, the trustee then decided to sell the stock in the York law, and diversification was required by statute. interest of diversification. The testator’s widow, Ultimately, the court held that the fiduciary claiming breach of trust, filed suit to compel the breached its duty by failing to diversify. One of the trustee to repurchase the stock and also sought mistakes that the court noted the trustee had made was removal of the trustee. in its interpretation of “compelling reason,” as used in The court held that the “trustee acted in the governing instrument.54 The court also found that breach of its trust when it sold the stock,” as the stock the trustee’s complete lack of documentation regarding was a good investment at the time it was sold and the the investment performance of the trust’s assets was a trustee failed to show a compelling reason for sale breach of trust in itself.55 The court awarded the benefi- (diversification apparently not being a compelling rea- ciaries more than $20 million. Although this case was son) as required by the express request of the testator.58 overturned on appeal February 3, 2006, the reasons for The trustee was required to repurchase the stock at its the successful appeal continue to make the admonish- own expense and to pay the widow’s attorneys fees ments of the surrogate court a warning to trustees. and expenses. The court also remanded for a determi- Trustees often assume that their job is nation as to whether the trustee should be required to made easier when the governing instrument provides reimburse the three trusts involved for the capital gains specific instruction regarding trust investments. This taxes incurred by reason of the sale. faith in a protected position can be misguided and lead A trustee faced with express instruction to substantial liability. The following words of the regarding trust investments must monitor that invest- Dumont court may be better guidance for trustees ment portfolio even more carefully than a trustee using faced with narrow investment direction: a standard investment mix. If the trustee determines that the investment strategy outlined in the trust instru- Where a fiduciary is administering an ment is not the best course of action in light of the con- estate under directives of a retention siderations that a trustee must make in determining an clause, it is incumbent upon that fidu- investment portfolio, the trustee should approach ciary to develop a uniform under- investment of trust funds as a matter that must be nego- standing of the testator’s words, bas- tiated. First, the trustee should consider its options ing such a definition on the input of an with respect to possible releases or indemnifications experienced team of industry profes- from the beneficiaries. If these options are not ade- sionals, preferably under the guidance quate to protect the trustee, the trustee should consider of in-house legal advice. It is also crit- seeking the guidance of the courts as to whether it must ical that the fiduciary’s actions reflect follow the direction of the trust instrument or whether an understanding that a retention it should invest according to some other standard. clause does not exculpate itself from C. Duty of Impartiality: The Income Benefi- poor judgment and laziness, but ciaries, the Remaindermen and the Trustee instead that a retention clause almost Proper observance of fiduciary duties requires requires a greater level of diligence a delicate balancing act to manage the relationships and work, as prudent management of with and between beneficiaries. A trustee is required Making matters worse for the trustee, the last of the indi- is well settled that a fiduciary’s prudence is a test of conduct, not 52 vidual remainder beneficiaries passed away while the litigation performance.” See id. at *10. was pending, leaving three charities as the presumptive remainder- See id. at *18. 56 men. The charities joined the individual beneficiary in her suit See Kettle, 73 A.D.2d at 786. The decedent’s will stated “I 57 against the trustee, as did the New York Attorney General. See id. note that I am particularly desirous that my TRW, Inc., securities be See id. at *4-*5. retained by my Executrix and by my Trustee unless compelling 53 See id. at *9. reasons arise for the disposal thereof.” 54 In reviewing the trustee’s performance, the court stated “It Id. 55 58 32 ACTEC Journal 302 (2007)
  • 7. to deal impartially with all beneficiaries of a trust and ative structures within the confines of the trustee’s to protect each of their interests.59 This rule applies defined duties that balance the different positions of whether the beneficiaries’ interests are simultaneous all beneficiaries. or successive.60 The tough part is that it also applies For example, a trustee may consider the whether the interests of the beneficiaries are aligned or fact that trust income will exceed the life beneficiary’s are in direct conflict. needs, but may not ignore altogether the income bene- Despite the general rule that a trustee may not ficiary’s interests in productivity, unless that beneficia- favor one beneficiary over another, the trust instru- ry provides informed consent or makes a specific ment may grant the trustee authority to differentiate. request that the trustee do so.65 At least one court even For example, the terms of the trust may modify the has held that a trustee should not consider the assets of duty by granting the trustee discretionary power to the beneficiary in setting an investment portfolio determine the beneficiaries who will receive income absent an express direction in the trust instrument to from the trust.61 Where the trust instrument modifies adjust the portfolio on that basis.66 the trustee’s duties, a court will not interfere with the In Stevens v. Nat’l City Bank,67 a trust was exercise of the trustee’s discretion, except to prevent created and split into four shares for the benefit of the the trustee from abusing it.62 testator’s three children and grandson. One of the ben- 1. Balancing the Investment Portfolio eficiaries, a daughter of the testator, was to receive all The trustee’s duty of impartiality encom- of the income from her share of the trust, plus discre- passes the requirement that the trustee balance the tionary payments of principal as the trustee saw fit for investment portfolio to achieve fairness in growth and support and maintenance. Upon this beneficiary’s income.63 In other words, the trustee has a duty to the death, the remaining principal was to be divided and income beneficiary to invest in assets that will produce distributed to the issue of the beneficiary, per stirpes. reasonable income not substantially lower than that The trust instrument gave the trustee the earned by trust investments generally, while at the authority to manage and sell all of the property in the same time maintaining the safety of the trust principal. trust and to reinvest the funds as he saw advisable.68 In many trust situations, the duty of impartiality neces- After nine years of the trustee’s selling and reinvest- sarily pits the interests of the income beneficiary ing of stock for diversification, the beneficiaries filed against the interests of the remaindermen by creating a a complaint against the trustee for breach of trust conflict of investing for growth versus income. because the stock that the trustee sold had increased A proper balancing of interests will vary in value. depending on the circumstances of any particular trust The Ohio Supreme Court found the trust situation. To determine how the interests should be instrument expressly granted the trustee the power and balanced, the trustee must consider, at a minimum, the authority to invest and reinvest the trust property; there- purposes of the trust, the terms of the trust instrument, fore the trustee was entitled to exercise that power and distribution requirements outlined in the trust. without the consent of the court or of the beneficia- Frequently, analysis of the relative needs and requests ries.69 The court also emphasized the trustee’s duty to of the beneficiaries also is warranted. invest as a prudent person would in this situation where Market risks and tax treatments are com- he is seeking a reasonable income for the income bene- mon concerns that a trustee must address when creat- ficiaries and preserving the capital for the remainder ing an investment strategy that fits the needs of both beneficiaries.70 Where there are successive beneficia- the life beneficiary and remaindermen.64 In addition, a ries, the court stated the trustee is under a duty to act trustee must consider other circumstances in determin- impartially with regard to their respective interests.71 ing how the interests of the beneficiaries should be The court concluded that the trustee ful- balanced. A trustee should consider the unique inter- filled his duty of impartiality in attempting to create as ests and situations of all beneficiaries when making much income for the life beneficiary as possible, while investment decisions, and should look to develop cre- at the same time keeping in mind the interests of the See SCOTT & FRATCHER, THE LAW OF TRUSTS § 183, at 557 See RESTATEMENT (THIRD) OF TRUSTS § 227 cmt. i. 59 64 (4th ed. 1987); RESTATEMENT (THIRD) OF TRUSTS §183. See id. 65 See RESTATEMENT (SECOND) OF TRUSTS § 183 cmt. a. Godfrey v. Chandler, 811 P.2d 1248 (Kan. 1991). 60 66 See Eric P. Hayes, Understanding and Using Trusts, UUTR 544 N.E.2d 612 (Ohio 1989). 61 67 MA-CLE 4-4, §4.12.1 (2001). See id. at 616. 68 See RESTATEMENT (SECOND) OF TRUSTS § 183 cmt. a.; see See id. at 616-17. 62 69 also id. § 187. See id. at 617. 70 See RESTATEMENT (THIRD) OF TRUSTS § 232. See id., citing RESTATEMENT (SECOND) OF TRUSTS § 232. 63 71 32 ACTEC Journal 303 (2007)
  • 8. remainder (principal) beneficiaries.72 It was clear from The court noted that the trustee deliberate- the trustee’s act of diversification and attempts to dis- ly excluded the plaintiff from a letter which discussed tribute the risk of loss that he was acting to satisfy his how the family trusts operated, an exclusion that was duties as both a prudent investor and impartial fiducia- not trivial as it explained important aspects of the trust ry by protecting the interests of both the income and instruments. The court also considered evidence that remainder beneficiaries. the trustees regularly met with the plaintiff’s mother The Restatement provides that the trustee and siblings outside the presence of the plaintiff and must consider two aspects of “productivity” in meet- discussed issues affecting the trusts. ing the standards of a prudent investor, while still On several occasions, the trustees express- observing the duty of impartiality.73 First, the trustee ly informed the plaintiff’s attorney that the plaintiff had must determine the appropriate level or range of no current interest in the mother’s trust, when in reality, income productivity for the particular trust. This the plaintiff was a beneficiary and was eligible to determination is a matter for interpretation and fidu- receive distributions from the mother’s trust. As a ciary judgment once all relevant factors are consid- result, for several decades the plaintiff believed himself ered. Second, the trustee must incorporate the produc- to be merely a remainderman of his mother’s trust. The tivity objective into an overall portfolio strategy while court also noted that once the plaintiff discovered his remaining impartial to the remainder beneficiaries. status as a current beneficiary of his mother’s trust, he The trustee owes a duty to the remainder- promptly sought distributions from the trust that were men to preserve the trust corpus and this duty normally repeatedly put off by the trustees. includes a general goal of protecting the purchasing In reviewing the trustees’ actions, the court power of the trust principal.74 It is significant to remem- first concluded that the trustees had a duty to notify all of ber that while a trustee must observe both the prudent the beneficiaries, including the plaintiff, of their status as investor rule and the duty of impartiality when making beneficiaries of their mother’s trust and breached their investment decisions, the trustee’s conduct typically will fiduciary by failing to do so. The court found the be reviewed in the context of the portfolio as a whole, trustees further breached their fiduciary duties by failing rather than investment by investment.75 Thus, it may be to give impartial consideration to the plaintiff’s interests. permissible for a particular investment to be underpro- D. Duty of Loyalty: The Beneficiaries and the ductive where the trust estate as a whole is productive. Trustee 2. Neutrality in Communications With The duty of loyalty requires a fiduciary to the Beneficiaries administer the trust solely in the interest of the bene- In addition to the trustee’s duty to make ficiaries, specifically to the exclusion of the fiducia- investment decisions that do not favor one beneficiary ry’s own interests.77 A “common sense” duty, it is over another, the trustee must remain impartial in pro- non-delegable, is inherent in every action of the fidu- viding information to the various beneficiaries of a ciary, and at times requires the fiduciary to make dif- trust. It is well established that the trustee bears the ficult decisions. burden of providing material information to the bene- A court generally will not interfere with a ficiary of a trust. With respect to information requests, trustee’s exercise of discretion or undertake to substi- the trustee generally is obligated to provide complete tute its discretion for that of the trustee as long as the and accurate information material to the beneficiary’s trustee acts in good faith and within the limits of sound status with regard to the trust upon request. discretion. Although a beneficiary may seek relief In McNeil v. Benett,76 the plaintiff, the eldest from the court for a breach of the duty of loyalty, a income beneficiary of a trust created by his father for him court generally cannot interfere with a trustee’s and his siblings, argued that the trustees failed to inform actions consistent with the plain terms of a trust agree- him and affirmatively misinformed him of his status ment unless the actions are arbitrary, in bad faith, or under the trust. The plaintiff also claimed the trustees outside of the trustee’s authority.78 failed to give impartial consideration to his interests by 1. Self-Dealing providing his three siblings with materially greater As a result of the duty of loyalty, a trustee access to information and influence over trust decisions. is prohibited from selling trust property to himself See id. at 617. BOGERT & BOGERT, THE LAW TRUSTS TRUSTEES § 72 77 OF AND RESTATEMENT (THIRD) OF TRUSTS § 227 cmt. i. 543. 73 Id. § 181 cmt. a. Kloha v. Duda, 246 F. Supp. 2d 1237, 1241 (D. Fla. 2003) 74 78 Id. § 227 cmt. i. (citing In re Moir Hotel, 186 F.2d 377, 382 (7th Cir. 1950)); Scott v. 75 792 A.2d 190 (Del. Ch. 2001), aff’d in part, rev’d in part, Arden Farms Co., 28 A.2d 81 (Del. Ch. 1942); Warehime v. Ware- 76 McNeil v. McNeil, 798 A.2d 503 (Del. 2002). hime, 761 A.2d 1138 (Pa. 2000). 32 ACTEC Journal 304 (2007)
  • 9. individually or from having a personal interest in the other trust parties in determining reasonableness of purchase “of such a substantial nature that it might compensation. Under the Restatement (Third) of Trusts, affect his judgment in making the sale.”79 In addition, a trustee need not receive approval from a court with the trustee may not sell property to a third person with respect to the amount of fees it may charge; however, a the understanding that the third person will reconvey trustee who takes excessive compensation may be the property to the trustee or hold it for him.80 The ordered to refund it.85 Broad acceptance of this rule has transactions noted above are not an exclusive list of been demonstrated by case law in several jurisdictions. prohibited activities. The restrictions imposed by the duty of loyalty may be summarized by saying that the III. PRACTICAL GUIDANCE FOR TRUST trustee may not enter into any transaction or assume or ADMINISTRATION continue in a position in which his personal interest or A. Reviewing the Document for Specific the interest of a third party is or will become adverse Terms and Ambiguous Provisions to the interest of the beneficiary.81 Before accepting a position as fiduciary, it is The most common violation of the duty of crucial to review all governing documents for potential loyalty, self-dealing, is considered particularly egre- liability issues. If a document has gaps, is ambiguous, or gious behavior because it necessarily prohibits the requires the fiduciary to deviate from the standards nor- trustee from maintaining its disinterested and indepen- mally dictated by fiduciary duties, supplemental written dent judgment in administering the trust. The self- agreements or indemnifications may be warranted. dealing restrictions prohibit a trustee from lending 1. Initial Review trust funds to itself, acquiring from a third party, for A true “ambiguity” for legal purposes the trustee personally, any interest in the trust property, exists in a trust instrument only if the language at issue and selling or leasing the trustee’s own property to in the governing document is reasonably susceptible to itself as trustee.82 The prohibition on self-dealing multiple interpretations.86 The determination as to includes not only transactions in which a trustee whether multiple interpretations are reasonable typical- directly buys from or sells to the trust estate, but also ly is made after established principles of legal interpre- extends to transactions with a firm or corporation of tation are applied in an effort to clarify the uncertainty. which the trustee is a member, or the trustee’s spouse, Ambiguities are not the only potential lia- agents, employees and other individuals whose inter- bility issue that can be discovered in a careful docu- ests are closely identified with those of the trustee.83 ment review, however. Pitfalls of administration may Lack of benefit to the trustee will not nec- also become apparent in light of the direction given to essarily prevent a successful claim for breach of the the fiduciary in the governing agreement. If, for duty of loyalty. As long as the transaction poses a con- example, a trust agreement provides that the trustee flict of interest to the trustee, the transaction may be must invest entirely in fixed income securities, the voidable at the option of the beneficiary, regardless of trustee is bound to follow the trust agreement but will the trustee’s gain or loss. be violating the duty to diversify. Although it may be 2. Excessive Fees argued that the settlor has waived the duty to diversify, Another common violation of the duty of thereby relieving the trustee from that obligation, as loyalty involves trustees taking excessive fees for ser- noted above, some courts have held that a trustee vices rendered. A trustee generally is entitled to rea- remains obligated to invest reasonably. sonable compensation for services performed in When reviewing a governing document, administration of a trust (based on the nature and the potential fiduciary should have adequate facts amount of work performed), unless the terms of the before him regarding the “soft side” of the administra- trust provide otherwise or the trustee consents to tion. At a minimum, the fiduciary must identify current waive compensation.84 A trustee violates his duty of beneficiaries and remaindermen. The information col- loyalty, however, when the trustee takes excessive lected should also include birth dates and health con- compensation for trustee services. cerns to enable the fiduciary to recognize, and review Courts generally will consider factors such the documents in light of, legal disabilities. A general as the trustee’s experience, skill and relationship with overview of family relationships is helpful to determine RESTATEMENT (THIRD) OF TRUSTS § 170 cmts. b-d, § 206, BOGERT & BOGERT, THE LAW TRUSTS TRUSTEES § 79 83 OF AND cmt. b, and § 78. 543. RESTATEMENT (THIRD) OF TRUSTS § 170 cmt. e. RESTATEMENT (THIRD) OF TRUSTS § 38. 80 84 BOGERT & BOGERT, THE LAW OF TRUSTS AND TRUSTEES § RESTATEMENT (THIRD) OF TRUSTS § 38 cmt. c. 81 85 543. See RESTATEMENT (THIRD) PROPERTY § 11.1. 86 RESTATEMENT (THIRD) OF TRUSTS § 206. 82 32 ACTEC Journal 305 (2007)
  • 10. sensitive interactions. A rough sketch of relative family “there has been a special confidence reposed in one financial resources is useful as well to highlight possi- who in equity and good conscience is bound to act in ble investment allocation concerns. The family circum- good faith and with due regard to the interests of the stances typically will dictate what type of risk manage- one reposing confidence.”87 Establishment of a fidu- ment is warranted and must be considered in the cost- ciary relationship often shifts the burden of proof to benefit analysis for risk management activities. the trustee in any litigation matter where a breach of 2. Possible Methods for Resolving Docu- duty is alleged by a beneficiary. Trustees, therefore, ment Issues must take care to document their communications Intent of the testator is the governing prin- with beneficiaries in order to create a proper record of ciple in interpreting a trust instrument. That intent is trust administration. determined according to the words of the trust instru- 1. Communicating With Beneficiaries ment, and not with regard to extrinsic knowledge of When a trustee assumes the fiduciary role, the parties involved. The settlor’s intent should be he may want to write a letter to the beneficiaries out- determined by looking at the entire document, by lining his plan of action for the trust administration. reviewing the plain language of the document, and by This letter could include a summary of the trust terms, giving the words used their ordinary meaning. Words guidelines for contacting the trustee or making distrib- and clauses should not be ignored merely because they ution requests, and information regarding the pro- produce an undesirable result. posed investment of trust funds. One of the most fre- When the governing document provides quent complaints made by beneficiaries is lack of clear instruction to the fiduciary, but the fiduciary or communication. Starting off on the right foot can beneficiaries have strong evidence indicating that the build good will for the future. settlor’s intent was for a result other than that pro- Quarterly, or at least annually, update let- scribed by the document, an action for reformation ters also are useful. Keeping the beneficiaries may be appropriate. Where reference to the rules of informed may not only make them happy, but may construction produces what the trustee considers an estop them from suing later. odd or unjust result, a court action may be recommend- 2. Managing Risks and Documenting ed to ensure that the trustee is acting appropriately. Beneficiary Agreement With Trustee Where amendments are possible, the fidu- Actions ciary should request that the governing document be It is rare that a trust will be administered amended in order to clarify any gaps or resolve any without resulting in at least one disagreement between inconsistencies. Also, consider consulting with the the trustees and the beneficiaries. If resolving a con- drafting attorney, if possible, for an explanation of con- flict requires acting in a manner that is not clearly fusing language. If the attorney is able to provide clar- within the boundaries of the trust instrument or that is ification, request that the explanation be put in writing. against the objection of a beneficiary, the trustee needs When a problematic document is not to keep risk management in mind. amendable, look first to the fundamental rules of con- First, the trustee should look to the lan- struction to try to determine what a court might find if guage of the trust instrument. Trust agreements often the question were brought to the court for a decision. contain “exculpatory provisions” seeking to hold a If a clarification is possible by reference to statutory or trustee harmless for acts in good faith that may result case law, the trustee should document in writing that in loss to the trust. Exculpatory provisions should be research was performed and should outline why a par- distinguished from provisions specifically authorizing ticular conclusion was reached. a trustee to engage in a transaction that would ordinar- Even if the case law is clear, a letter from ily be prohibited. legal counsel may be advisable to keep with the trust A trust instrument may not relieve the records. Clarification in this manner is advisable even in trustee of liability when a breach of trust occurs a situation where all parties are friendly to the fiduciary. involving bad faith of the trustee, intentional or reck- B. Managing Beneficiary Expectations less indifference of beneficiary interests, or profit to If a trustee wants to avoid being sued, it is the trustee.88 Such clauses are a violation of public imperative that the trustee understand the relationships policy, and so are deemed invalid.89 that beneficiaries have with one another. A fiduciary Second, consent to or ratification of the relationship generally is defined as one in which trustee’s actions may bar a beneficiary from pursuing a Estate of Smith By & Through Smith v. Underwood, 127 1971). 87 N.C. App. 1, 9 (N.C. Ct. App. 1997), citing Curl v. Key, 316 S.E.2d See RESTATEMENT (SECOND) OF TRUSTS § 222(2). 88 272, 275 (N.C. 1984) (quoting Link v. Link, 179 S.E.2d 697 (N.C. See id. at cmt. (2). 89 32 ACTEC Journal 306 (2007)
  • 11. claim for breach of fiduciary duty. Consent typically IV. CONCLUSION occurs before the transaction takes place, and ratifica- Acquiring knowledge of trustee duties is only half tion will be after-the-fact in a formal manner or implied the battle in managing fiduciary risk. Communication when a beneficiary accepts benefits of the transaction with the beneficiaries on a regular basis can prevent with full knowledge of the breach.90 Generally, a bene- many disagreements between beneficiaries and ficiary must be competent and of legal age in order to trustees. It is important to keep personal feelings for a provide valid consent or ratification. The fiduciary also particular beneficiary out of the trust administration, must fully disclose the material aspects of the transac- as emotional decision-making can lead to lawsuits for tion for which it seeks consent or ratification. breach of duty. A fiduciary looking to protect itself from Start the administration process with a technical liability for breach through consent or ratification by review and review of governing law, but do not ignore the beneficiaries should insist that the beneficiaries the natural human curiosity that the beneficiaries will obtain independent counsel to advise regarding the have in their trust. Provide information, lay the breach transaction. If a beneficiary does not wish to ground rules, and then stick to those rules. Taking the retain independent counsel, the fiduciary should time to properly plan a trust administration may well obtain a written acknowledgment of full disclosure. pay for itself by helping you to avoid lawsuits. See Dominic J. Campisi, New Horizons in Fiduciary Risk, Beneficiaries and Fiduciaries (2004). 90 SK004 ALI-ABA Course of Study—Representing Estate and Trust 32 ACTEC Journal 307 (2007)