Fiduciary Consultant Blog

TRUSTEE DUTY TO BE LOYAL TO THE TRUST

It has been observed that, “…two general principals underline much of the  Anglo American law of trusts: the trustee’s duty of loyalty and prudence. As the duty of loyalty is the more ” fundamental” of the two, the trustee is under a duty to act solely in the interest of the beneficiaries as to matters that directly and indirectly involve the trust property”. 3 Scott & Ascher, Sec. 17.2. Also see Uniform Trust Code Sec. 802(a). In fact, a national bank exercising fiduciary powers shall adopt and follow written policies and procedures that address, where appropriate, the bank’s methods for preventing self dealing and conflicts of interest. See Revised Reg. 9 (effective January 29, 1977) in 12 C.F.R. Sec. 9.5(c).

BACKGROUND

In acting in a fiduciary capacity a trustee assumes various general duties. One of the fundamental duties assumed by a trustee in the establishment of a trust relationship is the duty to be loyal to the trust, which includes acting honestly in good faith, and in accordance with the purposes of the trust. The Uniform Trust Code Sec. 105(b)(2) indicates that this duty may not be waived by the grantor/settlor.

The trustee, according to Uniform Trust Code Sec. 802(a) has a duty to act solely in the interest of the beneficiaries concerning matters that directly and indirectly involve trust assets. The duty of undivided loyalty is called the “bedrock” of the trust relationship in Restatement (3rd) of Trusts Sec. 78, comment c(2). The loyalty rule in equity was established because it is usually humanly impossible for the trustee to act fairly in two capacities and on behalf of two interests in the same transaction.

Again, Uniform Trust Code Sec. 802 indicates that a transaction impacted by a conflict between the trustee’s fiduciary and personal interests is voidable by a beneficiary who is affected by the transaction. These transactions could include a corporate fiduciary purchasing or holding it’s own stock for a trust, or depositing funds in it’s own banking department. Indeed, 3 Scott & Ascher Sec. 17.2.14.6 states that “…as long as banks have both trust departments and commercial banking departments, questions of divided loyalty, sometimes quite difficult, will continue to arise.” However, see Rest. (3rd) of Trusts, Sec. 78, comment c(4) and 3 Scott & Ascher Sec. 17.2.

POSSIBLE RESIGNATION AND REMOVAL OF THE TRUSTEE

The fact that a trustee may not allow personal interests to conflict and compete with the interests of beneficiaries could require the trustee to resign from the trust, unless all of the beneficiaries provide their informed consent to the trustee’s retention of the office. See Rest(2nd)Trust Section 170, comment C(1959), 2A Scott on Trusts, Section 170.23 and Rest.(2nd)Trusts, Section 216, Comment g (1959). In fact, the acquisition of a confl;icting interest may be grounds for removal of the trustee. See Rest. (3rd) Trusts, Section 37, Comment e.

EXCEPTION – TRUSTEE FEES AND REASONABLE EXPENSES

A trustee is entitled to take a reasonable fee from the trust for fiduciary services and reasonable expenses, even though this would appear to be a conflict of interest. See Rest. (3rd) Trust, Section 78, Comment c(4), and 3 Scott & Ascher, Section 17.2. It would be unreasonable and unrealistic to expect a trustee to serve without reasonable compensation. See UTC, Section 802 (h)(2), and Rest. (3rd) Trusts, Section 78, Comment c(4). In fact, the trustee has a security interest in the trust assets for reasonable compensation. See Rest. (2nd), Section 242, Comment e(1959).

The reasonableness of the trustee’s compensation can be determined by applying several relevant factors including:

• trustee’s skill, experience and facilities
• time devoted to trust duties
• amount and character of the trust assets
• degree of difficulty, responsibility and risk assumed in administering the trust, including making discretionary distributions

Corporate fiduciaries should be mindful of these relevant factors in their internal annual budgeting process for trust department fees. Occasionally, bank trust departments participating in an income/expense ratio analysis universe with other similar institutions experience pressure from senior management to increase trustee fees resulting in a higher ranking in their performance universe.

DIRECTED TRUSTS

Trustee powers of fiduciaries were traditionally considered personal and, therefore, non-delegable. Currently the trustee may, however, delegate some investment responsibility to an appropriate investment agent with adequate supervision required, and compensate the agent. See Ret. (3rd) Trusts, Section 80, Comment f, and UTC Section 807. A downward revision of trustee fees is often seen if a trustee has delegated significant duties to outside agents including a Registered Investment Advisor (“RIA”) acting as an investment manager. See UTC Section 708.

Thus, some fiduciary authority may be delegated. The trustee, however, must still personally define the trust’s investment objectives, strategies and programs, and must approve of plans developed by the agent advisor. If the trustee exercised prudence in selection the advisor, participates in setting trust investment objectives, and monitors the advisors   performance, the trustee should not be liable for delegation go the advisor. See Uniform Prudent Investors Act, Section 9, versions of which have recently been enacted by several states. See Rest. (3rd) Trusts, Section 80, Comment e, and the Uniform Prudent Management of Institutional Funds Act, Section 5. Delegating some administrative and reporting duties might be prudent under UTC, Section 807 for a family trustee but unnecessary for a corporate trustee according to that Section.

CONCLUSION

Among the fiduciary duties assumed by a trustee loyalty and prudence are paramount, with loyalty generally considered to be the more fundamental. Accordingly, a trustee must act solely in the interest of the beneficiaries. This fact is especially critical with a split interest trust with various classes of beneficiaries. A violation of this duty could result in the resignation or removal of  the trustee, possibly accompanied by a fiduciary surcharge.

In recent years, the adoption by various states of new fiduciary legislation cited above has allowed trustees to depart from many of their common law requirements including fees and the ability to retain and compensate outside investment counsel. Accompanying the new flexibility, however, is the increased potential for liability and fiduciary surcharge actions. The prudent trustee will promulgate and adopt internal policies and procedures to address the question of “reasonableness” in setting trustee fees and the level  of compensation for outside investment advisors along with the establishment of internal oversight rules. Thus, increased flexibility presents new challenges to the trustee.

BACKGROUND

In modern estate planning trusts are often used as a dispositive vehicle to accomplish a variety  of purposes. In addition to state and federal tax savings, trusts can create and customize a unique plan to hold and/or distribute assets to different groups of people over a prolonged time period. This situation is typically seen in a trust designed to qualify its assets for the Federal Estate Tax Marital Deduction with the surviving spouse receiving an income interest, with possible invasion of principal, during his/her lifetime. At the death of the surviving spouse another group of individuals, typically the children of the marriage, may then receive an income interest, with possible distributions of trust principal at a date in the future.

This distributive pattern, also seen in a Credit Shelter Trust, provides two distinct groups of individuals, or trust beneficiaries, commonly referred to as current income beneficiaries, and remainder beneficiaries or principal beneficiaries. Thus a trust established in this fashion can have beneficiaries with different and distinct interests, and is referred to as a split interest trust.

Whether the split interest trust is established at the death of the testator – a testamentary trust – or during the life time of the grantor or settlor – a living trust or trust under agreement – the designated trustee(s) have several specific duties and responsibilities in effectively administering the trust. One is the Duty of Impartiality.

DUTY OF IMPARTIALITY

The Uniform Trust Code Section 803 states that the duty of a trustee to act impartially does not mean that the trustee is required to treat the various beneficiaries equally. Rather, the trustee must treat the beneficiaries equally in light of the purposes and terms of the trust. Similarly, 4 Scott & Ascher, Section 201 states that the trustee is under a duty to act with “due regard” to the beneficiaries respective interests.

Restatement (Third) of Trusts, Section 79(2) indicates that the trustee duty of loyalty is the specific duty  to treat all trust beneficiaries impartially, that is, not favor one beneficiary over another unless authorized to do so by the governing instrument. Even when so authorized the trustee’s discretionary acts favoring one beneficiary over another must be in furtherance of the intentions of the settlor/grantor and not in furtherance of the trustee’s own biases and predilections.

Again, 4 Scott & Ascher, Section 20.1 indicates that a trustee runs a major risk of breaching the duty of impartiality in the context of the competing interests of income beneficiaries and remaindermen. This Section further states that the general duty of loyalty also requires that the trustee balance the interests of the income beneficiaries and the remaindermen – the trustee must be impartial when dealing with those with conflicting equitable interests.

IMPARTIALITY INVESTMENT PROBLEMS FOR THE TRUSTEE

Recently several states have adopted revisions of the Uniform Prudent Investors Act, the Uniform Principal and Income Act and the Uniform Trust Code that may impact the traditional and common law responsibilities of handling and managing trust investments under the Duty of Impartiality when administering a split interest trust. Reallocation authority, however,  is provided for under Restatement (Third) of Trusts under Section 79 allowing the trustee to make appropriate accounting adjustments to comply with the duty of impartiality even absent permissive legislation.

Consider a trustee of a split interest trust investing a significant percentage of trust assets in “junk bonds” producing an extremely high yield. Over time an erosion of the purchasing power  of the trust accounting income may result in an inflationary period. Statutory reallocation authority might allow the trustee to transfer  a portion of the income to the principal account without advantaging the current income beneficiaries at the expense of the remaindermen.

Conversely, reallocation authority could also be helpful where a trust investment (a concentration of trust assets in an aggressive “high growth” common stock that does not pay a dividend) advantages a remainderman at the expense of the current income beneficiary.

Unique investment problems occur concerning impartiality with a trust requiring periodic distributions of all net trust accounting income with no provisions for the invasion of principal – an “income only trust”. The potential conflict between current income beneficiaries and remaindermen may result from the traditional distinction between income and principal, a trust accounting concept that takes no account of the investment concept of total return. See Restatement (Third) of Trusts, Section 90 and 4 Scott & Ascher, Section 20.1. Some jurisdictions allow the trustee to petition the appropriate court for a judicial reformation of the trust to a Non Charitable Unitrust to address these problems.

TRUSTEE DISCLOSURE OF INFORMATION

Trustee problems concerning impartiality can arise with a trustee’s duty to disclose versus the trustee’s general duty of loyalty including the specific duty of confidentiality in communications between current income beneficiaries and remaindermen. A possible answer to this dilemma may lie in another specific trustee duty: the duty to balance the interests of the current income beneficiary and the remainderman.

Impartiality applies not only to successive equitable interests, but also to concurrent ones – simultaneous beneficiaries. Current beneficiaries – income or discretionary – may have differing needs and tax positions versus the remaindermen different objectives and risk tolerance.

CONCLUSION

A trustee of a split interest trust must be mindful of the various fiduciary duties and responsibilities, both statutory and traditional/common law, in administering the trust. A breach of any of these fiduciary duties and responsibilities could cause a significant surcharge against the trustee. This fact is especially true concerning the different interests of current income/discretionary beneficiaries and remaindermen in  a split interest trust.

The use of bank sponsored proprietary mutual funds as investments in trust accounts where the bank is trustee is quite controversial.