Fiduciary Duty of Loyalty in Affiliated Mutual Funds: Sole Interest vs. Best Interest?
By Stuart A. Ober, CFE, AIFA ®
he American Law Institute-American Bar Association's ("ALI-ABA") "Representing Estate and Trust Beneficiaries and Fiduciaries" seminar, was held on July 19 and 20, 2007 in Boston. The following is largely taken from a portion of the section of the ALI-ABA text submitted by Mary J. Hackett, Sharon L. Rusnak, and Jessica A. Haught, of Reed Smith LLP, Pittsburgh, Pennsylvania. Mary J. Hackett presented the expert views regarding the Trust Law duty of loyalty with respect to investments in affiliated mutual funds, focusing on the issues regarding the "sole interest" vs. the "best interest."
A trustee, under the duty of loyalty, is required to administer the trust solely in the interest of the beneficiaries. Under the "sole interest" position, any transaction in which the trustee has an actual or potential interest would be a violation, no matter how beneficial the transaction may be to the beneficiaries. Under the "best interest," a transaction in which a trustee also benefits should not give rise to liability for the trustee.
John Langbein, Sterling Professor of Law and Legal History at Yale University and Reporter of the Uniform Prudent Investor Act, is an advocate for the "best interest rule" - a "transaction prudently undertaken to advance the best interest of the beneficiaries best serves the purpose of the duty of loyalty, even if the trustee also might derive some benefit."1 Profession Langbein advocates that sometimes beneficiaries are better off in a transaction when a trustee also benefits. He points to corporation law which has abandoned the sole interest rule, favoring a rule that permits a conflicted transaction that satisfies fairness and disclosure standards.
The sole interest rule has been abridged with the rise of professional trusteeships permitting trustee compensation. With the growth of trusteeship in the financial service industry, exceptions to the sole interest rule have been accepted to facilitate financial services provided by trustees. Professor Langbein reasons that the rationale for these exceptions is the integration of functions and economies of scale which benefit beneficiaries.
Professor Langbein contends that the duty of loyalty should be reformulated to prefer the beneficiaries' best interest rather than their sole interest. A conflicted transaction should continue to be presumed to be a violation of the duty of loyalty, but, not conclusively. The defense that the transaction was in the best interest of the beneficiaries should be permitted to the trustee. If the trustee can prove that a conflicted or overlapped transaction was prudently undertaken in the best interest of the beneficiaries, and an inquiry into the merits is better than "no further inquiry," the transaction should be sustained.
According to Professor Langbein, the advantages of mutual funds over common trust funds include:
1. Bank common trust funds are limited to fiduciary accounts. Mutual funds can pool both fiduciary and non-fiduciary accounts into the same fund, thus, allowing mutual funds to be larger that common trust funds. This will allow mutual funds to provide greater economies of scale and diversification.
2. The mutual fund industry's greater size results in a greater variety of fund types, allowing more precise asset allocation for the trust.
3. Open-ended mutual funds promote transparency for beneficiaries and others as they are priced daily and are commonly quoted in the press.
4. When the trustee makes distributions to beneficiaries, the mutual fund has a material tax advantage. Mutual fund shares may be distributed in kind, which does not trigger the recognition and taxation of any gain. In contract, distribution from common trust funds must be liquidated, thereby triggering taxation of any gain.
5. In some states, such as New York, common trust funds are required to go through periodic judicial accountings. According to Professor Langbein, this is a form of make-work that provides opportunity for the court to appoint politically well-connected guardians ad litem to litigate imaginary grievances at the expense of the fund and its trust beneficiaries.2
Accordingly, Professor Langbein notes that during the last twenty-five years, mutual funds have superseded common trust funds as the "pooling vehicle of choice for trust investing."3
Professor Langbein postulates that the fundamental duty of loyalty makes the "sole interest rule" unsound. A court, in some circumstances, will look to the overall "merits of this mode of trust investing" and will weight the "trust beneficiary's best interest over his or her sole interest."4
A trust must remain vigilant in its obligation to act in the "best interest" of the beneficiary when deciding to use affiliated mutual funds.5
When using mutual funds, the trustee may derive fee income from both the mutual fund and the trust, provided that the overarching duty of cost sensitivity still mandate that the expenses be appropriate and reasonable. The duty to monitor requires constant attention of competing funds' costs and comparative performance.6
Professor Langbein concludes that "fiduciary obligation still suffuses the use of affiliated mutual funds."7
On the other side of the debate is Melanie B. Leslie,8
Professor at the Cardozo School of Law, an advocate for the "sole interest rule." The sole interest rule prohibits the trustee from placing himself or herself in a position where personal interests conflict with the interests of the beneficiary. She advocates the traditional "no further inquiry" rule that unequivocally prohibits a trustee from profiting from transactions with the trust without advance approval from a court or trust beneficiaries. This rule also imposes harsh consequences for unauthorized trustee self-dealing.9
Professor Leslie argues that Professor Langbein's position of allowing trustees to profit from purported conflicts of interest as long as the conflicted transactions are in the trust's best interest, is a radical change in trust law. She asserts that the modification of the duty of loyalty in Section 802(f) of the Uniform Trust Code will only make institutional trustees more profitable with negligible comparable benefits for trust beneficiaries.10 The best interest defense would "generate serious harm to future beneficiaries."
Her analysis criticizes Professor's Langbein's contention that the sole interest analysis "overdeters" fiduciaries and prevents trustees from engaging in transactions that will mutually benefit both the beneficiary and the trustee. Professor Leslie argues that this deterrence theory only promotes trustee "opportunism" to engage in conflicted transactions.11
Professor Leslie cites the banking industry's effectiveness at lobbying state legislatures to discount the fact that state laws have authorized certain "conflicted transactions," such as the investment of trust assets in affiliated mutual funds. She sees the "best interest" analysis as an opportunity only for corporate fiduciaries to profit at the trust's expense.12
In an April 2006 paper,13
Professor Leslie maintains that state statutes permitting investments in affiliated mutual funds "dramatically increase beneficiaries' monitoring costs" and "remove incentives for disclosure to the beneficiaries." A "trustee need no longer subordinate its interests to those of the trust."14
Professor Leslie asserts that recent statutes would be much improved if they differentiated between professional and non-professional trustees. She suggests, in analyzing the duties of the professional trustee, that a rule permitting delegation of the investment function should reflect the following objectives:15
a. The trustee should provide full information to settlors during the trust creation process and craft any modifications of fiduciary rules narrowly and specifically;
b. The trustee should provide full and fair disclosure to beneficiaries prior to deviating from the settlor's reasonable expectations; and
c. The trustee should perform to the highest level of professional standards consistent with the settlor's intent.
Tamar Frankel, Professor of Law at Boston University, another advocate for the "sole interest rule," served as plaintiffs' expert in Kutten 1. Professor Frankel opined that the conversion of common trust funds benefits the trustee at the expense of the beneficiaries. However, her expert report also discussed various "exceptions" to the rule including a purported "Chinese Wall" separating the various departments of a bank as corporate trustee. Professor Frankel acknowledged that an additional exception to the rule exists where a trustee may obtain the approval and consent of the beneficiaries to engage in a transaction that purportedly involves a conflict.
Another advocate for the "sole interest rule" is Robert Flannigan, Professor of Law at the University of Saskatchewan. Professor Flannigan, in his article, The Strict Character of Fiduciary Liability, 2006 NZ Law Review 209 (2006), challenges Professor Langbein's position of permitting a trustee to demonstrate that actions were taken in the best interest of the beneficiary. Professor Flannigan instead advocates for a strict interpretation of fiduciary liability with a limited exception for consent. He concludes his article: "The fiduciary standard has been strict for centuries, yet there are continuing daily reports of ever more troubling fiduciary malfeasance. Directors divert incomprehensible amounts of corporate wealth to themselves and their associates. Insider trading is believed to be rampart. Remote quid pro quo benefits are common place. Agents and employees exploit the confidential information of their employers. Solicitors take from trust accounts. Caregivers molest our children. In short, opportunism remains undeterred and underdetected. …Can it be right for us to now essentially invite fiduciaries to arrange for their own best interest while ostensibly arranging for the best interest of their beneficiaries?16
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Stuart A. Ober, CFE, AIFA ® serves as a consultant and expert in fiduciary and securities litigation. He may be contacted at 845-679-2300 or ober@stuartober.com.
The complete course of study materials for "Representing Estate and Trust Beneficiaries and Fiduciaries" is available from ALI-ABA at 800-253-6397 or at www.ali-aba.org.
Notes:
1
Questioning the Trust Law Duty of Loyalty: Sole Interest or Best Interest? 114 Yale L.J. 929, 932 (March 2005).
2
Id. at n. 231.
3
Id. at 973-974.
4
Id. at 972.
5
Id.
6
Id. at 974 (citing the Restatement (Third) of Trusts: Prudent Investor Rule Section 227 cmt. M (1992) and U.P.I.A. Section 9 cmt).
7
Id.
8
Author of In Defense of the No Further Inquire Rule: A Response to Profession John Langbein, 47 Wm. & Mary L. Rev. 541 (November 2005) and Trust Law in the 21st Century: Common Law, Common Sense; Fiduciary Standards and Trust Identity, 27 Cardozo Law Review 2713 (April 2006).
9
In Defense of the No Further Inquire Rule: A Response to Profession John Langbein, 47 Wm. & Mary L. Rev. 541 (November 2005), 3.
10
Id. at 544.
11
Id. at 550.
12
Id.
13
Trust Law in the 21st Century: Common Law, Common Sense: Fiduciary Standards and Trustee Identity, 27 Cardozo Law Rev. 2713, 2733 (April 2006).
14
Id. at 2734.
15
Id. at 2735-2736.
16
The Strict Character of Fiduciary Liability, 2006 NZ Law Review 209 (2006), at 242.
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