By Alfred M. Falk
Trustors commonly designate a family member or one of the trustor's advisors or colleagues as trustee. Typically, these individuals are not professional trustees and have only a passing (if any) familiarity with a trustee's duties and how to satisfy them. A common expectation is also that the trustee will receive and retain assets that, collectively, do not satisfy the prevailing investment standard or, by their very nature, will cause the trustee to breach other duties.
Trustors usually do not fully appreciate the burdens that face a trustee. A well advised individual may decline to serve as trustee primarily due to the difficulty of satisfying the duties of a trustee. If properly informed, a trustor may choose to lighten the trustee's burdens to assure that the designated person will serve. The trust instrument may vary a trustee's duties and may reduce the standard to which a trustee is held. After reviewing the general nature of those duties and their impact on nonprofessional trustees, this article explores what a drafting lawyer can do to ease the burden on these trustees and whether a trustor should do so. This article also raises some of the professional responsibility issues that a drafter should consider.
A trustee is generally bound by several duties, including the duty to be prudent, the duty of loyalty and the duty of impartiality. Other duties include the duty to identify and collect property, the duty to protect property, the duty to furnish information and the duty not to delegate unwisely. There is also a duty to carry out the purpose of the trust. The particular ability of a designated individual to carry out the trust purpose drives many trustors' decisions when selecting a trustee.
A trustee must deal prudently with trust assets. This duty includes, and is usually framed in reference to, prudence in the investment of trust assets. In that context, the duty is now codified in some states as the "prudent investor rule" as set forth in sections 227-229 of the Restatement (Third) of Trusts (1992) (Restatement). This standard is different from the "prudent person rule," under which each particular investment made by a trustee could be subjected to scrutiny and possibly held to be imprudent.
Under the prudent investor rule, the investment decisions must be appropriate considering the purposes and assets of the trust and its circumstances as a whole. A trustee should develop an investment strategy that incorporates risk and return objectives reasonably suitable to the trust, taking into consideration such factors as the beneficiaries' ages and needs, how long the trust will exist, the concepts of modern investment portfolio theory and the effects that the loss of purchasing power of money has over time. The appropriateness of each investment is viewed in the context of the whole trust portfolio.
The duty to diversify trust investments is an important aspect of the prudent investor rule. Diversification reduces the risks inherent in having too many eggs in one basket. The duty to diversify exists unless it would not be prudent. For example, it may not be prudent in the case of a relatively small trust fund that will terminate soon or one that would incur a substantial capital gains tax if diversified.
Restatement § 229 imposes on a trustee the duty to review trust assets soon after the creation of the trust, with a view to making and implementing decisions about the retention and disposition of the original investments. That review should trigger actions resulting in a trust portfolio conforming to the prudent investor rule. A trust provision generally authorizing the trustee to retain a type of asset or even a specific asset, such as a family business, will not by itself excuse the trustee from discharging the duty to make changes to the overall portfolio to comply with the general duties, including the duty to diversify. Restatement § 229 cmt. d. Generally, a trust clause that relieves the trustee from the duty to diversify does not by itself relieve the trustee from a duty of care or prudence.
A trustee must display complete loyalty to the interests of the trust beneficiaries. This duty precludes activities in which the trustee has a personal interest as well as those in which third-party interests could influence the trustee. Self-dealing between the trustee, personally, and the trust breaches this duty. Self-dealing can occur in a transaction between the trust and any person related to or affiliated with the trustee, such as the trustee's spouse or a company in which the trustee owns a significant interest.
Self-dealing includes purchase and sale transactions, loans and leases. It also includes other, less obvious transactions. For example, a sale of a trust asset by the trustee to another trust of which he or she is the trustee may breach the duty of loyalty. Even a transaction not involving the trust directly may constitute a breach of this duty. If a trustee owns stock of a corporation, some as a trust investment and some as part of the trustee's personal assets, the trustee may breach the duty by individually acquiring stock of that corporation from a third-party shareholder. An occurrence that is not a transaction may also constitute a breach of this duty. For example, if the trustee controls a corporation in which the trust owns stock, his or her compensation arrangement may constitute a breach of the duty of loyalty.
It is generally not a defense to an action for breach of the duty of loyalty that the trustee acted in good faith. Nor is it a defense that the trust received fair market value in the transaction, or that the trustee did not profit by the transaction.
A trustee must act impartially as between the various classes of beneficiaries (e.g., as between the income and remainder beneficiaries) as well as among concurrent beneficiaries. This duty applies to the trustee's decisions on both investments and distributions.
This duty is a potential source of trouble for a trustee who must try to generate income for distribution to one set of beneficiaries while growing principal to offset loss of purchasing power for another set of beneficiaries. The situation is aggravated if the trustee is also an income beneficiary, as is common when a surviving spouse serves as trustee. See In Re Estate of Cooper v. Cooper, 913 P.2d 393 (Wash. Ct. App. 1996) (surviving spouse/trustee held liable to the remainder beneficiaries for investing too large a portion of the trust estate in income generating bonds, notwithstanding that a small equity position performed exceptionally well for the trust).
Ameliorating the Trustee's Situation
A trustor may do many things in the trust instrument itself to facilitate an individual's service as trustee. In undertaking such an effort, a drafter must exercise care to avoid creating tax problems, such as jeopardizing the marital deduction or unintentionally creating general powers of appointment. The following is not a comprehensive list of the issues to consider when facilitating service by an individual as trustee. Corporate fiduciaries share many of these same concerns, and some of the suggested cures may also be appropriate for them.
Statutory provisions may resolve some of these problems. For example, some states provide leeway for a trustee as to the assets initially received in trust. A drafter should use caution when relying on such statutory provisions, because laws or the trust situs may change. It is possible that less forgiving statutory provisions will some day govern the trust. Also, some statutory provisions are not as comprehensive as a trustee might desire, relieving him or her from one duty but leaving in place other duties that cause a dilemma.
Some jurisdictions have not yet adopted the prudent investor rule. Because it is a significant improvement over the prior rules that governed fiduciary investing, the prudent investor rule can be of great assistance to any trustee, particularly a non-professional trustee, as it facilitates delegation of investment decisions. So long as the trustee exercises prudence in the delegation and supervision of an investment professional, he or she will not be liable for that person's performance. Thus, the trustor should consider incorporating the prudent investor rule into the trust document.
The initial assets of a trust may include illiquid assets such as a business entity that has been in the family for one or more generations or interests in a family entity such as a limited partnership or an LLC. Some or all of the assets held by that entity may or may not be liquid. A trustor might establish an inter vivos trust for the express purpose of making a single, speculative business or investment opportunity available to younger generation family members.
At some point, the prudence of those holdings as trust assets or the lack of diversification may come into question. Accordingly, the trustor should consider relieving the trustee of the duty to invest prudently or to diversify the trust investments by specific trust language, tailored to fit the particular circumstances. The trustor may prefer that the trustee comply with the general duty of prudence once the initial assets have been liquidated. Also, the drafting lawyer should be cautious about using language that could be interpreted to relieve a trustee from the duty to make assets income producing, if the trust is to qualify for the marital deduction.
A prospective trustee may be a family member who also owns an interest in the business or family entities, either personally or as trustee of other trusts. The resulting conflict of interests may make it difficult for that trustee to comply with the duty of loyalty. A specific clause may relieve the trustee from the duty of loyalty in those circumstances. Such a provision could address the ownership of interests in the same entities by the trustee, as well as any possible transactions and other circumstances that the trustor might reasonably expect. For example, these provisions can contemplate sales or purchases under buy-sell agreements, owner loans to the entity and employment arrangements. Again, the trustor may intend to limit the application of such a clause to the assets initially received in trust.
A trustee may not have adequate powers to manage a business absent specific language in the trust documents. Although statutes in some jurisdictions include comprehensive business management powers, a drafting lawyer should consider adding powers specifically concerning a particular business, contemplating the needs of the type of business involved.
Some trust beneficiaries may work for the business or own interests in it while others do not. Under those circumstances, a trustee's decisions about the business may breach the duty of impartiality. For example, the decision to keep a business interest or to loan further trust funds to the business may be seen as favoring the beneficiary who works for or owns other interests in the business. If the business continually reinvests all of its earnings with the prospect of future growth, that course of conduct may be seen as favoring remainder beneficiaries over current income beneficiaries. Consequently, it may be appropriate to add a clause that relaxes the duty of impartiality to the extent of decisions made about the business.
Relax Standard of Care
Trustees are held to a very high standard of care in the fulfillment of their duties. In most jurisdictions, the trustor may relax the standard of care by specific language in the trust instrument. A clause reducing the trustee's standard might place the burden of proof on the party asserting a failure to meet the reduced standard. It might also require proof by a standard in excess of a mere preponderance of the evidence (such as clear, cogent and convincing evidence). A trustee, however, may not be relieved of the duty to act in good faith.
Drafters should judiciously use exoneration or exculpatory clauses for a trustee's benefit. When combined with particular trustee powers or distribution clauses, such powers may create unintended grantor trust treatment for income tax purposes. Conversely, a drafter should not rely on such combinations of clauses to create grantor trust status, given the uncertainty over which exoneration and exculpation clauses are broad enough (and valid and enforceable under local law) to create a grantor trust.
A relaxed standard of care may not apply to a drafter who also serves as a fiduciary. To take advantage of such a provision in an instrument, the drafting lawyer may need to have the trustor seek independent counsel on that clause.
The form in which some of the investments are held may present problems for the trustee. For example, holding real property or a general partnership interest may excessively expose other trust assets to the risks of real estate ownership and partnership operations. If that is possible, a clause may be inserted that protects the trustee from liabilities incurred by reason of ownership of that real estate or partnership interest. Alternatively, the form of ownership could be converted to a limited liability entity during the settlor's lifetime.
Even if a trustee prevails in a lawsuit with beneficiaries or other interested parties, a court may nevertheless require the trustee to pay the expenses of his or her own defense. Paying the trustee's defense costs from trust assets may itself constitute a breach of the duty of loyalty unless done with the benefit of a court order. The trust agreement could prevent that result by requiring that such expenses be advanced or reimbursed to the trustee if he or she prevails in such an action.
Reduce Beneficiary Conflicts
A common trust plan requires the distribution of all income to the current (usually senior generation) beneficiary of the trust. On that person's death, the remainder is distributed to the next generation. This situation creates a conflict of interest between the two classes of beneficiaries. The income beneficiary would like to see the trust invested to yield the highest income return possible, while the remainder persons are keenly interested in preserving the purchasing power of the trust corpus that they will receive one day.
Thoughtful clients often choose to provide some form of total return or discretionary distribution schemes. These plans reduce the significance of allocations to principal and income, simplify trust administration and blur the distinction between income and principal, thereby making it possible to reduce tensions between successive generations of beneficiaries. Even marital deduction trusts, which must entitle a surviving spouse to receive all of the trust's income each year, can include an element of such an approach so long as the income rights are protected.
The total return approach provides annual distributions calculated by reference to the value of the trust's assets (at inception or over time), with further distributions not allowed at all or allowed only in dire circumstances. The trust terms guarantee cash flow for current beneficiaries while protecting the purchasing power of the interests held for future beneficiaries.
A trustee may achieve the same effect with provisions that allow discretionary distributions of income and principal. When drafting discretionary distribution powers, a lawyer should be thorough in creating the distribution standards, define terms used in distribution standards and clarify whether the trustee is to consider other resources available to a beneficiary and how the trustee is to obtain information about those resources. Of course, discretionary income distribution clauses may not be used in most marital deduction trusts. For discussions of alternatives to the traditional and discretionary distribution schemes, see William L. Hoisington, Modern Trust Design: New Paradigms for the 21st Century, University of Miami Institute on Estate Planning (1997); and Jerold I. Horn, Prudent Investor Rule, Modern Portfolio Theory, and Private Trusts: Drafting and Administration Including the "Give-Me-Five" Unitrust, 33 Real Prop. Prob. Tr. J. 1 (1998).
Trustees are generally entitled to reasonable compensation. If the trust document is not more specific, the individual trustee may not know how much compensation will be considered reasonable. Whenever beneficiaries become unhappy about other aspects of trust administration, the trustee's fees become an added focus of discontent. A trustor can help by including a standard or a specific measure for compensating the trustee, such as a reference to the time and effort expended or to a percentage of the assets under administration (perhaps using a sliding scale, as do most corporate fiduciaries). If co-trustees will serve, the trustor should specify whether the co-trustees are entitled to aggregate compensation exceeding that which a sole trustee would be entitled to receive.
Clarify Reporting Requirements
Most jurisdictions require a trustee to report periodically to certain classes of beneficiaries. Many statutes classify the beneficiaries to whom reports are required as "income" beneficiaries. In other words, the statutes may create some ambiguity about who is entitled to reports, especially if the traditional income beneficiary distributive plan is not used. Accordingly, a trustor may wish to define the trustee's reporting duties. In that case, the document should prescribe the scope of the reports to be given, who is to receive them and how often and by when the trustee is to render them. The trustor can even provide for finality after some period of time, so that the trustee need not rely on laches as a defense to an action on an old accounting.
An individual accepting a fiduciary position would always like to see the road out. It should be relatively easy for one to terminate service as a trustee and for a new person to take over administration of the trust. The trust document should provide a clear line of succession or a mechanism to determine succession, preferably without court intervention. The provision should make it easy for a trustee to determine what steps to follow and whom to notify of the change.
A new trustee will ordinarily have a duty to verify the accounts of his or her predecessor, investigate the prior administration and pursue the prior trustee for any breaches of fiduciary duties. A successor trustee may be more likely to accept the appointment if he or she can avoid this duty, especially if assuming the position from a friend or relative. A successor trustee can be relieved of any duty to investigate the prior administration or to challenge prior accountings. A trustor could completely relieve a successor trustee from any duty to pursue the prior trustee, even for known breaches of duties, possibly conditioned on the new trustee's (1) giving reasonably prompt notice of breaches or suspicious circumstances to some class of beneficiaries and (2) informing the recipients that they bear the burden of pursuing the prior trustee for any breaches of duties.
Some state statutes provide a form of relief from a new trustee's obligations to pursue a former trustee. If so, a successor trustee should comply with the provisions of that statute, notwithstanding any provision in the trust document itself. It may even be desirable to obtain an agreement among all of the affected parties or a court order protecting the new trustee against the actions of his or her predecessor.
Selecting a Nonprofessional or Professional Trustee
If a client wants an individual to serve as trustee, it may be necessary to include provisions that address some or all of the concerns raised in this article. Otherwise, it is possible that the individual will not actually serve when the occasion arises. There is good reason for the protections that have been built into the law for trust beneficiaries, however, and the drafting lawyer can assist the client in exercising the judgment necessary to determine how far to go.
A client should appreciate the perils of nondiversification, even when it is the result of holding a cherished family business. The client also needs to understand that such provisions can hinder the ability of trust beneficiaries to obtain appropriate relief if a trustee goes astray. A trustor using some of these provisions is exhibiting a level of trust that simply may not be reasonable in many cases.
In some situations, it is not reasonable to expect a nonprofessional trustee to assume the duties of trusteeship or for the trustor to allow the evisceration of beneficiary protections. If providing relief from a trustee's duties is not appropriate, then the client should consider whether to designate a professional trustee. Frequently, a client's concerns about using a professional trustee are ill-founded.
Some clients base their concerns on the untested belief that a corporate fiduciary will charge substantially more for the service. An individual who properly fulfills his or her fiduciary duties will expend considerable time and effort, however. It is unfair to expect such a person to do so for less than fair compensation. Taking less than fair compensation may be a signal to beneficiaries and others (like a court) that the trustee did not provide the requisite service in fulfillment of his or her duties. A well compensated individual trustee will often receive as much or more than a similarly serving corporate trustee.
Sometimes concerns arise from a perception that a corporate fiduciary can never understand the family the way that a family member can. Thus, the client does not believe that trust officers can carry out the fiduciary purpose. Frequently, however, corporate fiduciaries are actually better situated to assist when family problems or needs arise. They have seen many similar situations to draw on for solutions, and they are not burdened with charges of favoritism arising from family history.
Ordinarily, it will be easy for a drafting lawyer to determine the identity of his or her client. These issues typically arise in connection with drafting a will or trust for an estate planning client. Even if the drafting lawyer does not represent any other person connected with the instrument, the law in many jurisdictions imposes on the lawyer a duty of care to the intended beneficiaries. In those jurisdictions, the lawyer should consider the extent to which a waiver of a trustee's breach of a duty might be held to breach a lawyer's duty of care to the beneficiaries.
Representing more than one member of a family always presents ethical concerns for the lawyer who may, for example, be drafting a trust for a member of a marital community and naming the client's sibling as a trustee for trusts that will benefit the client's spouse. The issues raised by representing spouses are beyond the scope of this article, but this is one situation where properly dealing with the conflicts up front can save much grief later.
If the client is selecting his or her sibling to serve as trustee and the lawyer also represents that sibling, the lawyer should be concerned about a possible duty to that sibling to provide protections in the trust document. ABA Model Rule of Professional Conduct 1.7(b) requires a lawyer to obtain a client's consent before representing him or her in a situation where the representation may be materially limited by the lawyer's responsibilities to another client.
If the lawyer represents successive generations of the same family and is drafting a trust for a senior generation family member that benefits younger generation members, could the lawyer's responsibilities to those younger generation members materially limit the lawyer's work on the trust? Could the lawyer have a duty to disclose to them the provisions that relieve the trustee from the normal trustee duties and standards?
What if the candidate for trustee meets with the lawyer and the client, and they discuss the terms of the trust? Does that person, although not otherwise represented by the drafting lawyer, have a right to believe that he or she is a client for matters related to the trust? In many jurisdictions, the question is whether he or she could have a reasonable expectation tha t the lawyer is looking after his or her interests as trustee of the trust. Clarifying the relationship in writing is probably not overkill.
If the lawyer is one of the trustees designated in the trust, an attempt to reduce the standard of care or to modify fiduciary duties applicable to the lawyer's conduct as trustee may fail unless the client obtains independent counsel on that issue. The client's designation of the lawyer raises other ethical concerns as well.
Generally, with regard to the ethical issues in the estate planning practice, a lawyer should refer to Commentaries on the Model Rules of Professional Conduct and Engagement Letters: A Guide for Practitioners, both issued by and available from the American College of Trust and Estate Counsel.
When a client wants to designate a nonprofessional trustee, the lawyer should anticipate the issues that will concern the prospective trustee and then discuss with the client the various ways to increase the likelihood that the designated person will actually be willing to serve as trustee. The lawyer should also explore the possibility of using a professional trustee if the provisions favoring the trustee do not seem appropriate for the trust under consideration. The lawyer must also be mindful of the ethical concerns as well. In other words, "pity the poor trustee, but do not set yourself up to be pitied."
Alfred M. Falk is a member of Gordon, Thomas, Honeywell, Malanca, Peterson & Daheim, P.L.L.C. in Tacoma, Washington.
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