New Issues in Trustee Fiduciary Procedural Prudence

roper procedural prudence could well have prevented many of the recent trustee fiduciary litigation cases. Accordingly, it is imperative that trustees pay careful attention to the duties imposed on them in regards to the terms of the controlling trust instruments and in their investment selections. To avoid costly and protracted litigation, trustees should establish procedures to review trust instruments including their requirements and protections, to deal with arbitration provisions, and to comply with the duty to determine the risk tolerance and the needs of beneficiaries.

The conduct of fiduciaries is judged based on whether the fiduciaries have complied with the terms of the will or the trust, and whether they have properly exercised the discretions given to them in a prudent manner. The Restatement, Third, of Trusts §27(2) makes clear that "a private trust, its terms, and its administration must be for the benefit of its beneficiaries . . . ." This provision places an emphasis on the needs of the beneficiaries, even if the trustor has placed restrictions on investments which threaten the purposes of the trust and the well-being of the beneficiaries.

The Uniform Trust Code §801 imposes a duty on a trustee "to administer the trust in good faith, in accordance with its terms and purposes and the interest of the beneficiaries, and in accordance with this Code." In states adopting the Uniform Prudent Investor Act ("UPIA") (currently in 41 states, the District of Columbia and the US Virgin Islands), and in most of the remainder, the trustee must invest the trust assets with a view to the overall portfolio and with regard to the "risk and return" characteristics of the trust and its beneficiaries.

"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 part of an overall investment strategy having risk and return objectives reasonably suited to the trust."

Uniform Prudent Investor Act §2(b). Thus, the current state of the law requires review and monitoring of the status of current investments and their suitability in light of the changing needs and risk tolerances of the beneficiaries.

As long as a trustee takes the steps required under the circumstances to make its discretionary decisions regarding the investments and retention of the assets in a prudent manner, a trustee will not be surcharged because a loss is suffered. Matter of Estate of Janes, 643 N.Y.S.2d 972, 977, aff'd (1997) 90 N.Y. 41, 659 N.Y.S.2d 165. According to the Restatement, Second, of Trusts §204 and the Uniform Trust Code §1003(b), a trustee is not liable for a loss which does not result from a breach of trust.

Recent courts have focused their attention on the procedures undertaken by the trustees in exercising their discretion regarding investments. In the Surrogate Court in Testamentary Trust UW Dumont, the trustee was surcharged over $20 million for failing to diversify a concentration in Eastman Kodak stock (a review in the New York Court of Appeals has been sought). The Pennsylvania Superior Court, In re Scheidmantel, appeal of Trustee Sky Trust, N.A., 868 A.2d 464 (Pa. Super. 205), affirmed a holding of a breach of trust involving the purchase of proprietary mutual funds in diversifying out of a portion of an investment in the trust's own stock. In Meyer v. Berkshire Life Insurance Company, 250 F.Supp.2d 544 (D. Md. 2003), aff'd, 372 F.3d 261 (4th Cir. 2004), the Court assessed damages based on what the trust should have earned, based on an overly conservative investment policy stemming from a failure to assess the risk tolerance of the beneficiaries.

The Janes, Dumont and Scheidmantel courts all found breaches of trust based on the failure of the trustees to establish and implement procedures to comply with their investment duties, as well as to document their decisions. These decisions turned on the question whether the trustees fell below the standard of care of corporate fiduciaries in exercising their discretion. The UPIA provides in §2(a) that "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." Thus, UPIA looks to a standard of care based on following the procedures set forth in the Act, rather than an abuse of discretion standard.

The Appellate Division held in Janes, "a fiduciary will be surcharged for losses resulting from negligent inattentiveness, inaction, or ill-consideration." While erroneous judgment or poor investment performance cannot be the basis of a finding of imprudence, where the facts known at the time of the decision establish its unreasonableness, a finding of imprudence is warranted (see Matter of Wood, 581 N.Y.S.2d 405).

Other breaches of duty, where discretion is involved, may be judged on an abuse of discretion standard. Even where breach of discretion is the test, a failure to make realistic, good faith efforts to exercise discretion can be held to be an abuse of discretion, Copley v. Copley, 126 Cal. App. 3d 248, 284-285 (Cal. App. 1981). "Giving trustees discretionary or broad powers does not mean that there are no limits to those powers. Trustees' actions will be reviewed for abuse of that discretion." In re Green Charitable Trust, 431 N.W. 2d 492, 498 (Mich. App. 1988). "Furthermore, a court will intervene where the exercise of a power is left to the judgment of a trustee who improperly fails to exercise that judgment. Thus, even where a trustee has discretion whether or not to make any payments to a particular beneficiary, the court will interpose if the trustee, arbitrarily or without knowledge of or inquiry into relevant circumstances, fails to exercise the discretion."

The proper steps which a prudent trustee should be expected to take in managing a trust to ensure compliance with fiduciary duties include the following:

1. Initial Analysis

Upon acceptance of the trust, the trustee must examine its terms and assets to establish the duties imposed upon it. The trustee must conduct an "[i]nitial formal analysis and investment plan consistent with testator's primary objective." Janes, 659 N.Y.S.2d 165, at 172. Similarly, the Dumont Court found that the trustee had breached its duties where during the first three years' of the trust's management, "there are no copies of correspondence, no copies of review forms, no internal memos regarding the trust's terms, no documents whatsoever as to the investment strategy of the trust or the performance of Eastern Kodak."

2. Determination of Trust Terms

Where the trust instruments contain restrictions on investment discretion, procedures must be established to obtain a proper construction of such terms. The Court in Dumont found that a direction not to diversify was merely a recommendation and that a provision empowering the trustee to sell Eastman Kodak for "compelling" reasons dictated the sale under the initial circumstances of the trust and later changes in the performance of the Kodak stock and the needs of the beneficiaries. "In fact, the empowerment language is written using mandatory terms whereas the retention language which relies upon the phrase 'it is my desire and hope' is clearly precatory." Dumont, supra at 6.

The court relied upon the testimony of an expert:

"The proper way to address unique terms of a trust would be first to utilize a 'team resolve' approach wherein a group of the bank's own employees would meet to determine a uniform resolution to a trust's phraseology . . . . If no consensus was reached, the matter should then be forwarded to counsel for preparation of a legal opinion. Finally, if necessary, a request for a judicial construction would be in order." Dumont, supra at 12.

The Dumont Court noted that if a court had been asked to review the matter, liability could have been resolved before interest made the lapses so expensive.

3. Review of Trust for Easily Identifiable Impediments

In Hatleberg v. Norwest Bank Wisconsin, 700 N.W. 2d 15 (Wis. 2005), the Wisconsin Supreme Court found that ordinarily the trustee would not have a duty to review the trust for tax flaws unless it had contractually agreed to do so. However, the trustee must "warn [the grantor] regarding easily identifiable impediments or pitfalls' that would thwart the grant's intent." 700 N.W. 2d at 22.

The Court concluded: "We are reluctant to impose liability on a trustee for not discovering and correcting a defect in a trust resulting from negligence by an unaffiliated drafter, unless the responsibility was assumed by contract." 700 N.W. 2d at 23.

Care must be taken to assure that the services promised by the trustee (such as in a sales brochure) do not involve review of the documents for tax defects.

4. Need for Defined Procedures to Determine and Review Construction of Ambiguous Terms

The Court in Dumont held that "The second problem with the bank's approach is that within its own internal structure, it did not clearly specify whose job it was to handle questions of document interpretation on management directives."

Without procedures to review the initial decisions, the court can conclude that the trustee is failing to supervise its agents in the management of the trust, leading to a finding of procedural imprudent and subsequent surcharge for the resulting losses.

5. Investigation of the Risk Tolerance and Financial Needs of Beneficiaries

Investigation at Initiation of Trust

Several courts have focused on the duty of the trustee to contact the beneficiaries to determine their financial needs and risk tolerances. In Meyer v. Berkshire Life Insurance Company, 250 F.Supp.2d 544 (D. Md. 2003), aff'd, 372 F.3d 261 (4th Cir. 2004), the Court found liability based on failure to assess the risk tolerance of the beneficiaries. Interestingly, in this case the investment manager chose too conservative an approach for the dentists in the plan, leading to underperformance.

In Matter of Estate of Saxton (2000) 274 A.D.2d 110, 712 N.Y.S.2d 225, the trial court in its surcharge opinion discussed the duty of the trustee to educate the beneficiary, whose naïve view of risk or affection for a family company had led them to approve concentrations which are objectively too risky for the circumstances.

If the beneficiaries' subjective views are objectively unreasonable, the trustee may wish to consider seeking instruction from the court and disclose the consequences to all beneficiaries.

Periodic Investigation of Risk Tolerance

In Dumont the Court held that: "It was imperative that the bank engage in regular discussions with those beneficiaries to ensure that the trust was fulfilling its purpose and to verify that compelling reasons [to diversify] did not exist. The bank could not prudently manage this trust without acquiring such information . . . ." In this case the need to balance the needs of the two beneficiaries was required in order to comply with a duty of impartiality.

The trial Court in Dumont found as a breach the fact that "its procedure for monitoring this trust contained no mechanism whereby it could elicit input as to what the needs [of the beneficiary] were. The court previously discussed and held that this management style was a breach of the bank's fiduciary duty."

Thus, the Court found breaches in the fact that no investigation of the risk tolerance was undertaken, but also in the fact that the bank's supervision plan contained no requirement to assume that such initial investigation and periodic reviews were undertaken.

The Court in In re Scheidmantel, 868 A.2d 464 (Sup.Ct. 2005) found liability where the trustee did not investigate the circumstances of the income beneficiary at a time when he was in critical condition in a hospital. The failure to determine the short time horizon of the trust was held to be a breach. "Nor can [the Court] agree that Trustee had no duty to keep abreast of changes in those factual circumstances by making inquiry with reasonable frequency and at reasonable intervals concerning the need for the Life Tenant." 868 A. 2d at 487.

Even if the trust contains language allowing retention of a concentrated asset, the duty of the trustee to periodically review the investment concentration is not excused. A direction must be reviewed on a regular basis to determine whether the investment risk has changed because of the changes in the investment or its relationship to a changed financial market or because of the changes in the needs of the beneficiaries. Matter of Estate of Saxton (2000) 274 A.D.2d 110, 712 N.Y.S.2nd 225, Restatement, Second, of Trusts §167.

Duty to Investigate at Change in Income Beneficiary

The Court in Dumont dealt with a sprinkle trust which then provided all income to the remainder beneficiary at the death of her mother. The Court held that the failure to examine the income needs of the former beneficiary constituted a breach of trust. Given the low dividend provided by the Eastman Kodak shares held in great concentration in the trust, an evaluation of the income beneficiary's needs would have provided a compelling reason, under the terms of the trust, to liquidate the concentration to obtain higher income.

"The death of Blanche Hunter [the mother] should have turned the bank's attention to Margaret Hunter as income beneficiary of the trust, and should have immediately initiated discussions between the trust officer and Margaret Hunter as to the trust's terms, the performance of Eastman Kodak and the general market, and the needs and desires of Margaret Hunter for her own income stream." Dumont, supra, at 14.

Duty to Investigate at Changes in the Market Value of Principal Asset

The Dumont Court held that substantial decreases in the market value and future prospects of the Kodak stock (the principal asset of the trust) should have triggered a review. "A significant drop in stock value such that this duty to preserve is compromised, would dictate that a prudent action by the trustee would be to sell the falling stock and attempt to regain the losses sustained by the corpus. Where prudence dictates sale, a retention clause [in the controlling instrument] is superseded. In re Hubbell, 302 N.Y. 246, 97 N.E. 2d 888 (1951)." Ibid. at 19. The Court in Dumont held that a prompt sale should have been triggered by a substantial drop in price of Kodak . . . ." Ibid. at 20.

Duty to Investigate at Termination of the Trust

The Court in Scheidmantal held that the trustee had breached its duty when it failed to investigate the needs of the remainder beneficiary at the death of the income beneficiary when it sold additional shares and purchased institutional shares of its proprietary mutual fund with the proceeds. The trust required the distribution of the corpus on the death of the income beneficiary. The trustee never consulted the remainder beneficiaries to ascertain their desires and imposed possible restrictions on their ability to take the newly purchased institution class of its proprietary mutual fund.

If the trustee or executor has discretion to distribute in cash or kind, the fiduciary should check with the heirs or beneficiaries to determine their desires before selling assets which otherwise would pass to them in kind.

6. The Two-Minute Annual Review

The Court in Dumont held that the annual reviews of the investments and the needs of the trust could not be adequately investigated in the short time allowed during such review. "No meaningful discussion could be had on the nuances of Dumont's language or the existence of external circumstances possibly warranting sale, in the mere two minutes of average attention the Dumont trust received from the IRC [Investment Review Committee] once per year.... The IRC was little more than a reason for the trust officers to pick up the file, and possibly to communicate to each other in order to generate paperwork for an amalgamation of superiors to almost blindly sign their approval." Dumont, supra, at 12.

In Janes, the courts similarly derided the annual reviews where the concentration of stock was routinely approved without discussion during a period of declining prices and dividends, without considering alternative investments. 659 N.Y.S.2d at 172.

If an institution is going to devote little time to the Office of the Comptroller of the Currency's Reg 9 (which requires, inter alia, a fiduciary to review all trust-owned policies at least once during every calendar year), it is essential to have preliminary materials prepared by investment officers detailing the status of investments and the reasons for retention or sale, appending them or referencing them in the minutes so that the detailed basis for the committee's review is evident from the record.

7. Consideration of Internal Concentration Guidelines

In Janes, the trial and review courts found fault with the fact that the trust officers failed to document considerations of internal review criteria for concentrated positions. Janes, supra 659 N.Y.S.2d at 172. The trustee's own internal guidelines provide a measurement of investment risk as well as a factor which should be referenced and considered in annual reviews.

8. Failure to Document Decisions

The Dumont Court held that "The complete lack of documentation alone is itself a breach of trust. Matter of John d. Rockefeller, Jr. NYLJ, March 1, 2004, at 31.

9. Exculpatory Clause/Release

According to the Restatement (Second) of Trusts §217, "[a] release or contract is not effective to discharge the trustee's liability for a breach of trust, if ... the release or contract of the beneficiary was induced by improper conduct of the trustee." 324 F. Supp.2d at 196.

In Estate of Saxton, (App. Div. 2000) 712 N.Y.S.2d 225, the court upheld a surcharge of a corporate trustee for investment breaches, despite the claim that a written Investment Directive Agreement signed by all beneficiaries expressly approved holding all of the trust assets in a single stock. On appeal, the Appellate Division rejected the argument that the investment directive constituted an enforceable contract, pointing out the duty of the trustee to inform the beneficiaries of the consequences of such an agreement.

Estate of Stralem (Surr. 1999) 659 N.Y.S.2d 274, involved an in terrorem or no contest clause, requiring the beneficiaries to accept the trustee's account. Citing legislative comments, the Court had no problem holding that such restrictions violated public policy and were void.

Accordingly, exculpatory provisions are often illusory. In evaluating the terms of the trust, the auditor or risk manager must understand that such clauses are only as good as the proof supporting the disclosure of all facts to the settler/testator and her knowledge that she was changing the standard of care. Particularly where the clause was placed in the instrument by the proposed fiduciary, it may be subject to great scrutiny.¹

Notes

____________________________________________________________________________________
Stuart A. Ober, CFE, AIFA ®, is the president of Securities Investigations, Inc., a firm providing due diligence and consulting services in securities and fiduciary litigation (845)679-2300 or ober@stuartober.com).

The text of "Representing Estate and Trust Beneficiaries and Fiduciaries" is available from American Law Institute-American Bar Association, at http://www.ali-aba.org or call (800) CLE-NEWS or 800-253-6397. Stuart A. Ober, CFE, AIFA ®, is the president of Securities Investigations, Inc., a firm providing due diligence and consulting services in securities and fiduciary litigation (845 679 - 2300 or ober@stuartober.com).