Wills, Trusts, and Estates

Fiduciary Duty


While a trustee has basically unlimited power over trust property, his fiduciary duties require him to exercise or not exercise his powers in good faith in the best interests of the beneficiaries. UTC § 815

Trustees' primary fiduciary duties are those of loyalty and prudence.

Loyalty

The fiduciary duty of loyalty requires the fiduciary to act in the best interests of his principal.

Prudence

The fiduciary duty of prudence or care requires the fiduciary to act in in accordance with an objective reasonableness standard informed by industry norms and practices.

No-Further-Inquiry Rule

If a trustee undertakes a transaction that involves a conflict of interest between his fiduciary capacity and personal interests, courts will find that to be a violation of his fiduciary duty and make no further inquiry.

The only defenses are that the settlor authorized the conflict in the terms of the trust, the beneficiaries consented after full disclosure, or that the trustee obtained judicial approval beforehand. R3T § 78.

Exception exist to the no-further-inquiry rule, like investing in a mutual fund managed by the trustee or paying himself reasonable compensation for managing the trust.

The no-further-inquiry rule does not apply to structural conflicts created by the settlor. E.g., a trustee on a company's board is given shares in that company. He can vote for himself still if it is in the best interests of the beneficiaries.

Exculpation

Exculpation clauses excuse trustees from liability for breaches of their fiduciary duties except for "willful neglect or default."

The modern trend is for an exculpation clause to be presumed to be invalid unless the trustee can show that the clause is fair and knowingly consented to by the settlor.

A trustee's fiduciary duty applies to all of the functions of a trustee.

Functions of a Trustee

A trustee has four functions he must carry out:

  1. Distribution Function
  2. Investment Function
  3. Custodial Function
  4. Administrative Function
Distribution Function
Mandatory Trust

In a mandatory trust, the mustee must make specified distributions.

Discretionary Trust

In a discretionary trust, the trustee has discretion over how the property is distributed, but must still exercise this discretion prudently, in good faith, and in accordance with the terms of the trust in light of the needs and circumstances of the beneficiaries.

A discretionary trustee has a duty to inquire into the beneficiaries' finances so he can determine whether a distribution is needed or not.

Investment Function

Trustees have a duty to invest the trust assets prudently.

Prudent Investor Rule
  1. A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.
  2. A trustee's investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.
  3. Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:
    1. general economic conditions;
    2. the possible effect of inflation or deflation;
    3. the expected tax consequences of investment decisions or strategies;
    4. the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;
    5. the expected total return from income and the appreciation of capital;
    6. other resources of the beneficiaries;
    7. needs for liquidity, regularity of income, and preservation or appreciation of capital; and
    8. an asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.
  4. A trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets.
  5. A trustee may invest in any kind of property or type of investment consistent with the standards of this [Act].
  6. A trustee who has special skills or expertise, or is named trustee in reliance upon the trustee's representation that the trustee has special skills or expertise, has a duty to use those special skills or expertise.

One of the most important requirements is to have prudent risk management. If low risk is needed, bonds should be used. If high risk is acceptable, stocks should be used to get better returns. However, there's never a reason to have a single company's stock. That exposes one not only to the risks of the general economy and of that industry, but also of the individual company. A single company is not going to have a high enough rate of return to justify that level of risk.

Principal and Income Problem

It used to be an issue that portfolios had to have the right balance of capital growth and dividend income to maintain impartiality between income beneficiaries and remainder beneficiaries. However now, you can just make an adjustment and distribute the growth as income. (Or alternatively, use a unitrust.)

Adjust

A trustee's power to adjust allows him to distribute the principal as income or to add income to the principal, as needed.

UPIA § 104 allows one to make an adjustment for impartiality problems.

Typically, trustees who are also beneficiaries do not have the power to adjust. However, they may be able to convert the trust into a unitrust with judicial review.

Unitrust

A unitrust is a trust where the settlor just sets a percentage of the trust income to be paid to the income beneficiaries each year. This solves the principal and income problem.

Compensatory Damages for Imprudent Investment

There are two main paradigms as to how to determine compensatory damages:

  1. Capital Lost Plus Interest Measure

    The capital lost plus interest measure of compensatory damages pays the amount of capital lost in the trust plus a set interest rate.

    Common interest rates are the inflation rate, government bond rates, and statutory legal rates.

  2. Total Return Measure

    The total return measure of compensatory damages pays the difference between the value of the trust and the value of the hypothetical prudently-invested trust portfolio.

    (This seems basically the same as the capital lost plus interest measure except it uses the interest rate of a prudently-invested portfolio.)

Just because one is allowed to retain stock (like in his own company), that does not mean that it is prudent to do so. The trustee must still comport with not only the duty of care, but also the duty of prudence.

A trust can authorize a trustee to hold an undiversified portfolio though. A trust can even require a trustee to hold an undiversified portfolio in a certain company.

Custodial Function
Administrative Function
Impartiality

If there are multiple beneficiaries, the trustee has a duty of impartiality. This duty requires him to give due regard to the beneficiaries' respective interests.

This duty does not require a trustee to treat beneficiaries equally. If there is a life-time beneficiary and a remainder beneficiary, the possible investment types will have benefits to one of the beneficiaries to the detriment of the other. The trustee will have to prefer one. Who should be preferred should be set in the terms of the trust.

Principal and Income Problem

It used to be an issue that portfolios had to have the right balance of capital growth and dividend income to maintain impartiality between income beneficiaries and remainder beneficiaries. However now, you can just make an adjustment and distribute the growth as income. (Or alternatively, use a unitrust.)

Adjust

A trustee's power to adjust allows him to distribute the principal as income or to add income to the principal, as needed.

UPIA § 104 allows one to make an adjustment for impartiality problems.

Typically, trustees who are also beneficiaries do not have the power to adjust. However, they may be able to convert the trust into a unitrust with judicial review.

Unitrust

A unitrust is a trust where the settlor just sets a percentage of the trust income to be paid to the income beneficiaries each year. This solves the principal and income problem.

Account

A trustee also has a duty to inform and account. UTC § 813.

This duty requires that a trustee respond promptly to a beneficiary's request for information about the administration of the trust and also to make affirmative disclosures to the beneficiaries of significant developments or intended transactions.

The settlor of a trust can limit the trustee's duty to account to the beneficiaries, but he can not completely eliminate it. A beneficiary always has a right to information reasonably necessary for the protection of his interest in the trust.

UTC § 813 allows trusts to be kept secret from the beneficiaries until they are 25 years old, however many states have rejected these rules.

A trustee is not liable to a beneficiary for a breach if the facts of the breach are fairly disclosed in a formal accounting, filed with the court and served on the beneficiary, to which the beneficiary does not timely object.

A settlor can provide that an informal accounting will have the same effect as a formal accounting.