Beware the Fine Print: Effectively Advising the Individual Trustee in Today's Changing Times 1. January 31, 2012

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1 NORTHERNTRUSTPROFESIONALADVISORFORUM Beware the Fine Print: Effectively Advising the Individual Trustee in Today's Changing Times 1 January 31, 2012 Stacy E. Singer Senior Vice President Midwest Fiduciary Practice Leader (312) ses7@ntrs.com The Northern Trust Company 50 S. La Salle Street Chicago, IL The author wishes to express her deep gratitude to Laura G. Mandel, Senior Trust Administrator, for her assistance in the creation of these materials, which are based in part on materials previously developed by her. 1

2 1. Introduction The vast majority of trusts are handled by individual trustees, named to the position because of the grantor s confidence in their decision making skills. While this may well reflect the best approach for managing the family situation, naming an individual as the fiduciary presents its own unique challenges. Individuals are oftentimes inexperienced and unaware of the proper processes and procedures that should be followed in carrying out their fiduciary duties. As a result, the advisors to such individuals face an additional burden of advising the fiduciary on these issues to ensure that the trust is managed properly. 2. Fiduciary Duties of a Trustee A. One of the most significant challenges for the individual fiduciary is clarifying and understanding the role the individual trustee must play, and how it differs from his or her role as an individual. Many individual trustees believe that they can act as they think appropriate, without any consideration of whether that is the proper fiduciary decision, or whether there are other consideration that are required. B. Key to advising an individual fiduciary is a thorough explanation of the Trustee s fiduciary duties, including: 1. Duty of Loyalty 2. Duty of Impartiality 3. Duty to Furnish Information 4. Duty to Exercise Reasonable Care and Skill 5. Duty to Keep Accounts 6. Duty to Take and Keep Control 7. Duty to Preserve Trust Property C. Trustee s Duty of Loyalty: The trustee is under a duty to the beneficiaries to administer the trust solely in the interests of the beneficiaries. See Restatement of Trusts (Third) 2, Section 78 (2011). This duty is considered 2 In most situations, the terms of the trust document will control. If the document is silent or its provisions are contrary to applicable state law (and state law does not allow the instrument to override it), state law will apply. In general, the Restatement may be used as authority only where both the document and state law are silent. 2

3 to be the most fundamental duty of a trustee. A trustee must not place itself in a position where it would benefit at the expense of the beneficiaries. Even if the transaction is fair to all parties, the transaction may be set aside. See Scott, The Law of Trusts, Section 170 (1987). An example of self-dealing would be a trustee s purchase of assets from a trust.. 1. Actual economic loss to the beneficiary may not be required for a lawsuit. 2. The transaction may be voidable by the beneficiary. The beneficiary also may be entitled to disgorge the trustee s profit on the transaction. 3. The trustee may have a defense if the beneficiary has failed to raise objections in a timely manner ( laches ), or if court approval has been obtained. 4. The document may contain express language which waives the duty of loyalty. D. Trustee s Duty of Impartiality: A trustee has a duty to administer the trust in a manner that is impartial with respect to the various beneficiaries of the trust. See Restatement of Trusts (Third), Section 79 (2011). The duty applies to simultaneous (where several beneficiaries are entitled to share in the income and principal) as well as successive interests. The typical trust provides for successive enjoyment by different beneficiaries. The trustee has a duty of fairness to all of the beneficiaries and of impartiality among them. This duty requires a trustee to balance the competing interests of differently situated beneficiaries in a fair and reasonable manner. Ordinarily, the question of the duty of impartiality of the trustee arises where there are successive beneficiaries, some being entitled to income, others being ultimately entitled to the principal. A trustee s duty to deal impartially with beneficiaries is often challenged when the income beneficiaries want the portfolio skewed towards income producing investments as opposed to growth type investments. Absent contrary provisions in the instrument, a trustee is under a duty to make investment 3

4 decisions which produce income as well as increase the value of the principal (including inflation). The Third Restatement adopts a total portfolio approach to investing. Some commentators are encouraging attorneys to counsel their clients on the unitrust or total return trust alternative; legislation authorizing the conversion of an existing trust to a unitrust or total return trust has now been passed in the majority of states. In short, an income beneficiary receives a fixed percentage of the value of the trust assets rather than the net income. The instrument also may permit the trustee to favor one beneficiary over another. For example: It is my intention that the needs of my spouse shall take priority over the needs of my children. E. Trustee s Duty to Furnish Information: The trustee has a duty promptly to respond to the request of any beneficiary for information concerning the trust and its administration, and to permit beneficiaries on a reasonable basis to inspect trust documents, records and property holdings. See Restatement of Trusts (Third), Section 173 (2011). (State law governs what information beneficiaries are entitled to receive.) Where there are several beneficiaries, each of them is entitled to information. Whether a contingent remainderman is entitled to information varies from state to state (see discussion on page 4, F). This duty is closely related to the duty to keep accounts. Co-trustees are entitled to enough information about the trust to fully participate in the administration of the trust, to carry out the purposes and terms of the trust, and to prevent or redress a breach of trust by a co-trustee. See Bogert, The Law of Trusts and Trustees, Section 961 (1983). This duty may also include providing a beneficiary with a copy of the trust instrument. See e.g. Fletcher v. Fletcher, 480 S.E.2d 488 (Va. Sup. Ct. 1997) (wherein Virginia Supreme Court compelled the trustee to produce the entire trust instrument and not only relevant section.) F. Trustee s Duty to Exercise Reasonable Care and Skill: The trustee is under a duty to the beneficiary in administering the trust to exercise such care and skill as a man of ordinary prudence would exercise in dealing 4

5 with his own property; and if the trustee has or procures his appointment as trustee by representing that he has greater skill than that of a man of ordinary prudence, he is under a duty to exercise such skill. See Restatement of Trusts (Second), Section 184 (1959) and Restatement of Trusts (Third), Section 227. The standard is objective. Some states impose a higher standard on corporate trustees (e.g. California). The trust instrument can, of course, alter this standard. For example: The trustee shall not be liable for any action taken in good faith, provided he has not acted with gross negligence or willful default. G. Trustee s Duty to Keep Accounts: The trustee is under a duty to the beneficiary to keep and render clear and accurate accounts with respect to the administration of the trust. See Restatement of Trusts (Second), Section 172. Again, review applicable state statutes on who is entitled to receive accountings. Some states require notice of the existence of a trust to current beneficiaries and presumptive remaindermen (e.g. under Florida Statutes , the trustee has a duty to inform all beneficiaries, defined as current income or principal beneficiaries and all reasonably ascertainable remainder beneficiaries, of the existence of the trust and the address of the trustee and upon request provide a copy of the trust instrument and annual accountings). 1. All co-fiduciaries and beneficiaries who are entitled to income or principal may be entitled to accountings. 2. A trustee s accounting should reflect all receipts, including all gains and losses on investments, and disbursements. If costs are incurred due to a trustee s failure to keep clear accounts, such costs are chargeable against the trustee and not the account. Not only must a trustee keep accounts, but he must render an accounting when called on to do so at reasonable times by the beneficiaries. See Scott on Trusts, Section 172 (1970). A trustee s refusal to produce an accounting is grounds for his removal. The Comptroller of the Currency requires a corporate 5

6 trustee to keep its fiduciary records separate from other records of the bank. 3. A trustee may require approval of accounts before distribution of the assets. Typically, a trust instrument will provide that the beneficiaries can approve the trustee s accounts. For example, Upon written request, the trustee shall send a written account of all trust receipts, disbursements, and transactions and the property comprising the trust to each income beneficiary and, at the option of the trustee, to the future beneficiaries of the trust. A future beneficiary of a trust is a person to whom the assets of the trust would be distributed or distributable if the trust then terminated. Unless court proceedings on the account are commenced within three months after the account is sent, the account shall bind and be deemed approved by all of the following beneficiaries who have not filed written objections to the account with the trustee within three months after the account is sent, and the trustee shall be deemed released by all such beneficiaries from liability for all matters covered by the account as though such account were approved by a court of competent jurisdiction: (a) each beneficiary to whom the account was sent and (b) if the account was sent to all income and future beneficiaries of the trust, then all beneficiaries of the trust who have any past, present, or future interest in the matters covered by the account. H. Trustee s Duty to Take and Keep Control: The trustee is under a duty to the beneficiary to take reasonable steps to take and keep control of the trust property. See Restatement of Trusts (Second), Section 175 (1959). It is the duty of the trustee not only to take physical possession of the trust property, but in appropriate cases to see that it is designated as trust property. See Scott on Trusts, Section 175 (1987). Typically, if a corporate trustee is acting, it has custody of the assets. In some situations it is proper for the trustee to put the beneficiary in possession of 6

7 the property; for example, a beneficiary may occupy a residence titled in the name of the trust or have possession of tangible personal property. I. Trustee s Duty to Preserve Trust Property: It is the duty of the trustee to use care and skill to preserve the trust property, See Scott on Trusts, Section 176 (1987). The standard of care and skill is that of a person of ordinary prudence. If the property is lost or destroyed or diminished in value, the trustee is not subject to a surcharge unless the trustee failed to exercise the required skill or care. Where, however, the loss to the trust estate is the result of a trustee s failure to use proper care or skill or where the loss is due to negligence, a trustee is liable to the beneficiaries for loss (depending on state law or the provisions of the trust instrument). 1. A trustee must not allow rights to subscribe to shares of stock or subscription warrants to expire. 2. A trustee must pay taxes on real property held in the trust. 3. A trustee must keep property in good repair. If a trustee neglects to make repairs and damage occurs, the trustee may be liable to the trust estate for the loss. The duty to make repairs does not require a trustee to make improvements. See Bogert, The Laws of Trusts and Trustees, Section 600 (1981). ( Improvements are changes, extensions or additions to land or personal property, which alter or increase its value and productivity.) 4. A trustee must protect the property from theft, i.e. obtain insurance. 3. Understanding the Terms of the Trust A. Estate planning documents are filled with terms of art that make perfect sense to advisers and no sense to individuals. In advising the individual trustee, ensuring that the trustee thoroughly understands the terms of the document is, in many ways, the most fundamental responsibility of the advisers. B. Among the many terms and concepts that need to be explained are the following: 1. Fiduciary duty in general 7

8 2. Current v. remainder beneficiary 3. Vested v. contingent beneficiary 4. Power of appointment 5. Income and principal 6. Generation skipping tax exempt v. non exempt 7. Mandatory v. discretionary 8. Discretionary distributions (see below) 9. Accounting 10. Estate tax and estate tax reimbursement C. In addition, the actual terms of the document need to explained both verbally and in writing, using language a lay person can understand (and remember). 1. Who is entitled to income or principal? 2. Under what circumstances? 3. Who decides? 4. Are there any conditions? 5. Can anyone change the terms? 6. Are there timing issues? 7. Who decides on investments? 8. Are there any restrictions? 9. Are any responsibilities waived? 10. Is there a removal power? If so, under what conditions or circumstances can it be excised and by whom? D. Discretionary Distribution Terms 1. Usually, the instrument sets forth a standard of distribution, which can range from very narrow to very broad. Sometimes the terms of the trust express no standards or other clear guidance concerning the purpose of a discretionary power, or about the relative priority intended among the various beneficiaries. In effect, the specific distribution standard set forth in the instrument limits the trustee s discretion. The case law of the state which governs the trust largely defines the standard. As noted in the Restatement (Third) 8

9 presumed meanings yield to findings of actual contrary intention [on the part of the grantor] and also may be affected by context and the more general purposes of the trust and the estate plan of which the trust is a part. The following is a brief outline of the most commonly encountered standards: 2. Support and maintenance. This is probably the most common standard found in trust instruments. Support and maintenance encompass distributions to beneficiaries for normal living expenses such as housing, clothing, medical care, food, payment of taxes, premiums on life and property insurance and interest on debt. This standard may be construed to include routine vacations and support of a beneficiary s dependents. (See K, below). This standard does allow for inflation adjustments and may for increased distributions to meet increases in the beneficiaries needs. Courts have tended to view these terms as synonymous even when this results in the terms being treated as redundant. These terms are usually accompanied by a reference to a beneficiary s standard of living. (See G, below.) These terms do not authorize distributions to enlarge the beneficiary s personal estate or to enable the making of extraordinary gifts. See comment d (2) of Section 50 of the Restatement (Third). 3. Health. This term includes routine items, such as annual physicals and medications as well as unusual items such as surgery, nursing care, hospitalization, psychoanalysis and rehabilitation. Arguably, plastic surgery for cosmetic purposes or travel to spas and health resorts would not be covered. See Butler, Franzen and Heisler, Illinois Institute for Continuing Legal Education, Trust Administration, Discretionary Distributions, Chapter 5 (2005). Health is generally construed more broadly than medical needs. If the intention is to assure the beneficiary special health care such as in home care, additional language is advisable. 9

10 4. Education. This would include not only tuition, room and board, books and travel to school, but also other expenses such as tutors. Bogert, The Law of Trusts and Trustees, Section 181 (2d ed. rev. 1981). The Restatement (Third) provides: The term education without elaboration is ordinarily construed as extending to payment of living expenses as well as fees and costs of attending an institution of higher education or a beneficiary s pursuit of a program of trade or technical training, and the like, as may be reasonably suitable to the individual and to the trust funds available for that purpose. Courts have construed education to include education through college, but unless there is explicit language in the instrument it probably does not include professional or graduate study. See Bogert, The Law of Trusts and Trustees, Section 182 (2d ed. rev. 1981). In general, courts have reasoned that if a settlor intended to provide for a professional course of training beyond an undergraduate degree, the settlor would have included an express provision relating to distributions for graduate/ professional education. Definition of Education. The term education as used herein may include, but shall not be limited to, (a) education at public or private nursery, elementary or high schools, including boarding schools, (b) undergraduate or graduate study in any and all fields whatsoever of a professional character or otherwise, at public or private universities, colleges or other institutions of higher learning and (c) any other activity, including travel, which shall tend to develop fully the talents and potentialities of the beneficiary of a trust. The expenses of education shall be deemed to include, but shall not be limited to, (a) tuition, books and incidental charges made by the school attended by the beneficiary for whom payment is made, (b) any travel costs to and from the institution attended by the 10

11 beneficiary, (c) his or her room and board and (d) a reasonable amount of spending money. 5. Best interests and welfare. This is a much broader and less definite standard than maintenance and support. This standard permits payments for luxuries or enjoyment. This standard does not, however, permit a complete distribution of and termination of a trust. See Scott on Trusts, Section (4 th ed. 1987). The standard best interests and welfare is frequently used in larger trusts to authorize the trustee to accumulate or to distribute income among beneficiaries to achieve certain tax savings. The question often arises whether a best interests and welfare standard is broad enough to permit distributions to the beneficiary for the purpose of making gifts for estate planning purposes. The answer is unclear (See E, below). One Illinois Supreme Court case, Rock Island Bank & Trust Co. v. Rhoads, 353 Ill. 131, 187 N.E. 139 (1933), held that distributions to a life tenant under a comfort and satisfaction in life standard which enabled the beneficiary to make charitable gifts were permissible. In the Rock Island case, the Court focused on the settlor s pattern of gift giving and the beneficiary s desire to continue the gift program. But see Kemp v. Paterson, 4 A.D.2d 153, 163 N.Y.S.2d 245 (1967) (wherein the court held that distributions to the income beneficiary under a best interests standard for gifts to the natural objects of her bounty to avoid estate taxes were unauthorized under the terms of the trust). See also Dunkley v. Peoples Bank & Trust Co. 728 F. Supp. 547 (W.D. Ark. 1989) (surcharging trustee and requiring return of assets that had been distributed to allow indirect gifts to be made by discretionary beneficiary under support, reasonable comfort and best interests standard). 6. Authority of Trustees to Make Gifts from Marital Trusts. Trustees may be approached to make discretionary distributions from marital 11

12 trusts to enable a spouse to make gifts. This, of course, results in the marital trust being diminished and a lower estate tax at the surviving spouse s death. The rationale is that facilitation of the spouse s estate planning objectives is in the spouse s best interest or for the spouse s welfare. There is limited law on this issue. In Matter of Mandel, 46 Misc.2d 850, 261 N.Y.2d 110 (1995), the court refused to permit an invasion in a marital trust where the will authorized invasions for the spouse or for her use. Similarly, in another case the court denied an invasion to enable the wife to make gifts to her children pursuant to a clause which authorized invasions of principal in the absolute discretion of my Trustee as shall be appropriate and to the best interest of my wife In re Estate of Howard, 236 S.E.2d 423 (1977). In Estate of Hartzell v. Commissioner, T. C. Memo (1994), the IRS argued that the exercise of an invasion power over property held in a general power of appointment marital trust was invalid and the surviving spouse s gifts of property should not be recognized. The will authorized invasions of principal for the comfort, maintenance, support and general well being of the spouse, or to continue the standard of living to which she is accustomed, or to aid her in living at a standard to which she is accustomed, or to aid her in the event of any accident, injury, illness or other emergency affecting her. The Tax Court ruled that the property removed from the marital trust was not improperly distributed to a third party and therefore not includable in the surviving spouse s gross estate. In Technical Advice Memorandum , the IRS determined that annual exclusion gifts made from a marital trust were improper 12

13 because the marital trust was held for the spouse s exclusive benefit and distributions to facilitate estate planning objectives were not for the spouse s comfort (the applicable standard) and exclusive benefit. Distributions for tax planning reasons may be permissible if the trustee is given absolute discretion to make discretionary payments, rather than having discretion to make invasions for the benefit of or in the best interest of the spouse. 7. Comfort. The term comfort standing alone can encompass a beneficiary s enjoyment, happiness, pleasure or satisfaction in life. The term authorizes distributions to a beneficiary beyond strict support or maintenance, and could include travel and certain luxuries. Frequently, however, the word comfort often accompanies a support standard. Here the language adds nothing to the usual meaning of support for a beneficiary whose lifestyle is already at least reasonably comfortable. Such terms tend to elevate the standard for a beneficiary whose accustomed lifestyle has been more modest. See comment (d) (3) of Section 50 of Restatement (Third). 8. Standard of living. Occasionally, standards will be expressed in terms of the beneficiary s standard of living or manner in which the beneficiary is accustomed to living. This standard is ambiguous unless the point in time to which the living standard relates is clearly stated. The Restatement (Third) takes the position that the term accustomed manner of living is ordinarily that enjoyed by the beneficiary at the time of the settlor s death or when the irrevocable trust is created. In addition, the Restatement notes that if a beneficiary becomes accustomed over time to a higher standard of living, that standard may become the appropriate standard of support if consistent with the trust s level of productivity and not inconsistent with an apparent priority among beneficiaries or other purpose of the settlor. In the case of a surviving spouse, the appropriate standard is likely to be that to which the beneficiary was 13

14 accustomed while living with the settlor. See e.g. Barnett Banks Trust Company v. Herr, 546 So. 2d 755 (Fla. App. 1989). One Illinois case has held that the point in time at which the standard of living is determined is the date of execution of the instrument and not the settlor s subsequent death or the standard of living at the time of the request. See Hart v. Connors, 85 Ill. App.2d 50, 228 N.E.2d 273 (1 st Dist.1967). If there has been a change in the standard of living from the date of execution of the instrument until the settlor s date of death, the beneficiary could be locked into an unintended standard in some states. See also In re Estate of McCart, 847 P 2d 184 (Colo. App. 1992) (Colorado court of appeals found the accustomed standard of living distribution standard to be non-variable, yet the court focused only on the last three years of the settlor s life in determining the applicable standard of living ). 9. Distributions to purchase a residence. Ordinarily, explicit language should be in the trust instrument before distribution is made for such a large expenditure. Such distributions are frequently treated as advancements. (See V, below). 10. Comfortable maintenance, health, education and welfare. The inclusion of the words comfortable and welfare authorizes distributions that go beyond the mere maintenance and support of the beneficiary. As discussed above, the use of the terms comfort or comfortable imply distributions not solely for the necessities of life, but may include things that bring ease, contentment or enjoyment. Several courts have interpreted the term comfort (which is different than comfortable support and maintenance) as the equivalent to station in life. 11. Distributions in the trustee s sole discretion. Many trust instruments attempt to grant unlimited discretion to the trustee either by omitting a standard of distribution or by granting the trustee sole, absolute 14

15 and uncontrolled discretion. Both case law and commentary state that where there is no standard, courts will not interfere with a trustee s discretion if the exercise is made in good faith and consistent with the purposes of the trust. See Restatement of Trusts (Third), Section 50, comment c states: Once it is determined that the authority over trust distributions is held in the role of trustee, words such as absolute or unlimited or sole and uncontrolled are not interpreted literally. Even under the broadest grant of fiduciary discretion, a trustee must act honestly and in a state of mind contemplated by the settlor. Where a trustee is given sole and absolute discretion, the court will intervene only if the trustee acts arbitrarily or dishonestly. See Scott on Trusts, Section 187 (4 th ed. 1987). Similarly, under the Uniform Trust Code the use of terms such as absolute, sole, or uncontrolled require a trustee to act in good faith and in accordance with the terms and purposes of the trust and the interests of the beneficiaries. In Matter of Stillman, 107 Misc.2d 102, 433 N.Y.2d 701 (1980), the trustees refused to invade principal to support the grandsons of the grantor. The grandsons sued for abuse of discretion, and the court ordered the trustees to make discretionary distributions for support despite the instrument s grant of absolute and uncontrolled discretion to the trustees. See also PLR (distinguishing discretion from sole discretion ). 12. Discretion for support of dependents. If the discretionary trust is for the benefit of, for instance, the grantor s daughter, there is a split of authority as to whether that discretion also extends to the support of anybody who is legally dependent upon the beneficiary, such as a spouse or minor child. Section 50 of the Restatement (Third) provides that a support standard generally includes support of a spouse and minor children including suitable education of a beneficiary s children. Again the terms of the trust instrument and state law would be determinative. See Edward C. Halbach, 15

16 Problems of Discretion in Discretionary Trusts, 51 Columbia Law Review 1425, 1436 (1961). The term dependents should be defined in the instrument. If distribution may be made to a beneficiary and those dependent upon him and if no definition is given, it is unclear whether payments be made (a) to those persons to whom the beneficiary has a legal obligation of support; (b) to those persons considered the dependents of the beneficiary for income tax purposes; or (c) to those persons who are, in fact, dependent upon the beneficiary. 13. Distributions upon Fulfillment of Specified Conditions. Often the instrument will provide that a beneficiary is entitled to a distribution if he/she maintains sobriety or remains drug free. Such conditions are permissible provided they do not violate public policy. An example of a condition that violates public policy is to condition distributions upon a beneficiary s divorcing a particular individual. See Restatement of Trusts (Third), Section 76 (2003) ( a trust or a provision in the terms of a trust is invalid if enforcement of the trust or provisions would be against public policy, even though its performance does not involve the commission of a criminal or tortious act by the trustees ). 4. Fees (aka The Elephant in the Room) A. Many individual trustees are uncertain whether or how much to charge for serving as trustee. If the individual as agreed to act out of loyalty or a sense of duty to the grantor, she may be uncomfortable with the idea of charging a fee; however, the amount of time and energy involved in meeting her obligations may cause a change of heart. 1. Restatement (Third) of Trusts, Section 38, states: A trustee is entitled to reasonable compensation out of the trust estate for services as trustee, unless the terms of the trust provide otherwise or the trustee agrees to forgo compensation. 16

17 2. Of course, this definition begs the real question what is reasonable? The Restatement (Third) states The trustee's experience, skill, and facilities, however, are factors in determining the reasonableness of compensation. Local custom is a factor to be considered in determining compensation. Other relevant factors are: the trustee's skill, experience and facilities, and the time devoted to trust duties; the amount and character of the trust property; the degree of difficulty, responsibility, and risk assumed in administering the trust, including in making discretionary distributions; the nature and costs of services rendered by others; and the quality of the trustee's performance. 3. In some states, state law provides for a percentage fee, subject to a reasonableness standard. In all states, the amount of compensation can be reviewed by a court to ensure it is reasonable. 4. If the trustee has special skills or experience, a higher fee may be appropriate. For example, an attorney, accountant or investment professional likely will be entitled to a higher fee than an individual who has no experience in these areas. However, the appropriate fee may still be lower than the hourly fee such individual charges third party clients. B. As in most cases, the terms of the trust may provide for specific compensation terms either more or less than would otherwise be permitted. If the terms in the document are not unreasonable, they will be honored by the courts. (State law may also provide for compensation.) 5. Potential Conflicts of Interest A. In general, the most likely conflict of interest for an individual trustee arises where the individual is also a beneficiary. The Restatement (Third) illustrates the issue clearly: It is virtually inherent in the nature of trusts and trustees' responsibilities that, in many matters of trust administration, personal interests of a beneficiary-trustee will come into conflict with the interests of other beneficiaries, to whom the trustee owes fiduciary duties. 17

18 Illustrative are matters ranging from the exercise of discretion regarding distributions to the trustee's selection of investments. B. Explaining this conflict to the individual trustee is often the most challenging job of the attorney or other adviser. The individual trustee may not understand the risks involved, or see that the actions taken may not meet the fiduciary standards required especially the duties of loyalty and impartiality. C. In some cases, the individual trustee may even need separate counsel for each role one for her role as trustee, another for her role as beneficiary. In fact, it may be beneficial (and is common in many documents) to allow the individual trustee to appoint an independent trustee to make certain tax and other decisions. This will avoid the conflict, as well as the potential adverse tax consequences. 6. The Importance of Process and Documentation A. The courts have repeatedly advised that the Trustee does not have an obligation to always be correct in making decisions; however, the fiduciary does have a duty to follow a process for evaluating issues and to document that process. See, for example, In re Will of Dumont, 791 N.Y.S.2d 869 (2004), reversed on other grounds, 809 N.Y.S.2d 360 (2006). B. Corporate fiduciaries create and maintain various investment, oversight, compliance and discretionary committees that reflect a clear process, together with documentation standards associated with each committee. If the process is reasonable based on the available knowledge and if the process if followed, the fiduciary may escape liability for otherwise faulty decisions, especially of the problems are only clear in retrospect. C. Documenting discretionary decisions 1. Written Request a. Generally, a request for a discretionary distribution must be made in writing (or confirmed in writing) by the beneficiary if he or she is capable of doing so. This would include electronic mail or facsimile. If the beneficiary is a minor, the 18

19 parent or guardian should make the request. The request should state the reason for the request and should be as detailed as possible. Any oral request for a discretionary distribution should be confirmed in writing by the beneficiary or the trustee. The trustee should receive as much information as is possible as to the reason for the request, together with adequate information about the beneficiary s own financial resources where the governing instrument requires that they be considered (See IX, below). For instance, if the request relates to education, it should be itemized in terms of tuition, room and board, books, and incidental expenses. If the beneficiary has already incurred an expense, a copy of the receipt should be attached. In addition to the above information, the trustee should consider the scope of the power provided in the governing instrument and the size of the trust. b. As a rule, prior to making discretionary distributions, the Trustee should make appropriate inquiries into the circumstances and needs of the particular beneficiaries or classes of beneficiaries. In addition, the Trustee should review the past history of requests and payments. The trustee has a duty to inquire into the needs of beneficiaries and to respond to those needs independent of a beneficiary s request. It is then the duty of the trustee to take the initiative; and, on a regular basis, obtain adequate information as to the resources and needs of beneficiaries so that appropriate recommendations can be made or updated and the trustee s discretion can be exercised properly. A trustee is under a duty to the beneficiary to give him such information as is reasonably necessary to enable him to enforce his rights under the trust. See Restatement of Trusts (Third), Section 82 (2003). 19

20 2. Nonexercise of power. Abuse of trustee discretion can occur through nonexercise of a discretionary power. See Marsman v. Nasca, 573 N.E.2d 1025 (Mass. App. Ct. 1991) (court found that trustee had a fiduciary duty to inquire into a beneficiary s resources to recognize his needs where trustee had power to invade principal for beneficiary s comfortable support and maintenance ); Kolodney v. Kolodney, 6 Conn. App. 118, 503 A.2d 625 (1986) (trustee s failure to inquire into beneficiary s needs was an abuse of discretion). See also, Feibelman v. Worthern National Bank, 20 F.3d 835 ( Ala. App. Ct. 1994) (trustee abused its discretion in failing to evaluate beneficiary s lifestyle before making discretionary distributions of principal where trust permitted distributions as necessary to maintain beneficiary s standard of living at date of grantor s death). 3. It is advisable to review the asset allocation for the trust in conjunction with the discussion of potential distributions to the beneficiary. Charts that illustrate the impact of various levels of distributions (3-4% per year) on the trust over the long term are advisable. See attachment titled How Much Can I Spend In some cases, the distinction between income and principal is no longer relevant in determining whether discretionary distributions should be made. Other factors such as investment concentrations may impact the asset allocation and ultimately the ability of the trustee to make discretionary distributions. 4. Trustee Recordkeeping/Discretionary File a. It is the trustee s obligation to keep full and accurate records of trust administration, including its reasons for making discretionary distributions. See Restatement of Trusts (Third), Section 83 (2003). b. In addition, records of distributions are necessary for income tax and accounting purposes and to enable the trustee to provide the beneficiaries with accurate information. The 20

21 Restatement (Third) specifically notes that the trustee may contribute to the common expenses of the guardian of a minor child without itemization of the expenses or direct application of trust funds. It is advisable, however, to request a budget from the guardian of the minor child. 5. Routine Payments. If routine payments are being made the trustee should monitor the payments and obtain supporting documentation to justify continued payments. For example, if payments are being made for education, the trustee should obtain certification confirming the beneficiary s enrollment at the educational institution. In National Academy of Sciences v. Cambridge Trust Co., 370 Mass. 303, 346 N.E.2d 879 (1976), a testator left money in trust for his wife with the proviso that if she remarried, her income interest was to cease and the principal was to be paid to the National Academy of Sciences. The wife remarried, did not inform the trustee of her remarriage, and endorsed all the checks using her first husband s surname. The court surcharged the bank for the amount of those payments because, although there was a limitation on payment of income, the bank made absolutely no effort to determine whether or not the beneficiary had remarried. A factor in determining whether it is equitable to allow the trustee to recoup overpayment to a beneficiary is the nature of the mistake by the trustee whether he is negligent or not. Even where a trustee has made an overpayment in good faith, a change in the position of the beneficiary may be sufficient to prevent the trustee from recovering the overpayment. See Restatement of Trusts (Second), Section 254, comment d (1959). a. In addition, the governing instrument may require further investigation of the beneficiaries financial status, behavior, employment, family situations or other matters. It may, for example, be advisable to secure a budget, financial statements or income tax returns from a beneficiary or a 21

22 written statement from the beneficiary as to his needs or wishes. Depending on the standard and considerations imposed, it may also be wise to analyze the comparative financial standing of a class of beneficiaries, including the beneficiaries income tax situations and projected estate tax situations. Many trust instruments now require that a beneficiary be gainfully employed or a productive citizen (so called incentive trusts ). See, Butler, Franzen and Heisler, Illinois Institute for Continuing Legal Education, Trust Administration, Discretionary Distributions, Chapter 5 (2005). 6. Co-trustees a. If there are one or more co-trustees, written approval from the co-trustees is necessary before a distribution can be made. See Restatement of Trusts (Second), Section 194 (1959). At common law, trustees of a private trust must act unanimously. If there are three or more trustees, a majority vote of the trustees may be controlling depending upon the trust instrument and state law. See e.g. Illinois Trusts and Trustees Act, 760 ILCS, 5/10 (2010). The Illinois statute, however, does not say how issues are to be resolved if the trustees are evenly divided on an issue. In some cases, the instrument will state that, in the event of a disagreement, either the decision of the individual or corporate trustee will control. 7. Controlling Decisions. Any action or inaction of the majority of the trustees having joint powers shall be as effective as if taken by all trustees. If the trustees are evenly divided, the individual trustee shall decide. A nonconcurring trustee shall not be liable for any action or inaction of any other trustee. 7. Investment Decisions -- Prudent Investment Rules A. Background 22

23 1. The historical rule governing investment of trust property was known as the Prudent Man Rule. a. The Rule mandated that a trustee preserve the trust property and make it productive. b. Ultimately, the Prudent Man Rule was replaced by the more flexible Prudent Investor Rule, which allows a trustee greater flexibility in investments. 2. In essence, the Prudent Investor Rule requires a trustee to preserve the trust property and to make it productive while acting with reasonable care, skill, caution and undivided loyalty to the beneficiaries. B. Legislatures in many states have formally adopted the Prudent Investor Rule, while courts in other jurisdictions have referred to the Rule as articulated in the Restatement of Trusts in their decisions. 1. Those trustees in jurisdictions that have adopted the Restatement s version of the Prudent Investor Rule are given the benefit of consideration of the performance of the investment portfolio as a whole. 2. The Restatement approach also judges a trustee s investment choices at the time the choices are made, not later in time based purely on the result of an investment portfolio 3 3. Section 227 of the Restatement (Third) of Trusts suggests a list of characteristics a trustee should consider in examining a contemplated investment, and a trustee may wish to consider incorporating the suggested elements into an investment review checklist as part of the trustee s risk management plan. 3 RESTATEMENT (THIRD) OF TRUSTS 227 cmt. b. ( The trustee is not a guarantor of the trust s investment performance. ). However, inevitably, performance may be a key factor persuasive to the decision-maker in a court proceeding. 23

24 Characteristics A Trustee Should Consider In Examining A Contemplated Investment 4 1. Expectations concerning the investment s total return, and also the amount and regularity of the income element of that return whenever the beneficial interests or purposes supported by the trust are affected by distinctions between trust accounting income and principal. 2. The degree and nature of risks associated with the investment and the relationship of its volatility and characteristics to the diversification need of the portfolio as a whole. 3. The marketability of the investment, and the relation between its liquidity and volatility characteristics and the amount, timing, and certainty of the trust s cash flow or distribution requirements. 4. Transaction costs (including tax costs) and special skills associated with the acquisition, holding, management, and later disposition of the particular investment. 5. Any special characteristics of the investment that affect its risk-reward tradeoffs and effective return, such as exposure to unlimited tort liability, the presence and utility of tax advantages, and the maturity dates and possible redemption provisions of debt instruments. C. In the absence of binding authority, some courts have looked to the rules set forth in the Uniform Prudent Investor Act (UPIA) as persuasive authority to offer guidance in a case involving allegations of breach of the duty to invest prudently. 1. Like the Restatement, the UPIA establishes that fiduciaries be evaluated on the basis of the portfolio as a whole, rather than on their individual investments. 2. The UPIA also varies the investment standard depending on the particular skill level of the trustee with respect to investments, which is a concept often expressed in case law. 4 The list of considerations is taken verbatim from the RESTATEMENT (THIRD) OF TRUSTS

25 3. The UPIA, like the Restatement, sets forth a checklist of considerations that a trustee must take into account when determining a proper investment portfolio for the trust. Circumstances A Trustee Should Consider In Investing and Managing Trust Assets 5 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 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 D. Diversification of the Trust Portfolio 1. Subject to modification by specific directions provided in the trust instrument, the trustee generally has a duty to the beneficiaries to diversify the trust portfolio. 2. This duty is not absolute and varies among jurisdictions. E. Balancing the Investment Portfolio 1. The trustee must be aware of the duty of impartiality and properly balance growth and income where the trust creates these distinctions. 2. Consider the ability to adjust income and principal or to convert to a unitrust. 5 The list of considerations is taken verbatim from the UNIFORM PRUDENT INVESTOR ACT 2(c) (1995). 25

26 8. Communication Dos and Don ts A. Outline the trust administration process, including anticipated frequency of communication 1. Consider whether to communicate the rules of administration in person, with a letter, or both a. Provide the beneficiaries with the fiduciary s preferred contact information b. Give alternates to accommodate different communication styles c. Phone, , letter d. Set expectations regarding response times for phone calls, s and letters 2. Remember that the duty of impartiality requires a fiduciary to be fair in communicating with beneficiaries 3. Even the difficult beneficiaries are entitled to information 4. Before denying a request just because he or she can, the fiduciary should consider what is achieved by saying no 5. Beware of the spokesperson beneficiary, as well as the squeaky wheel beneficiary B. Consent or Ratification 1. Generally, a beneficiary must be competent and of legal age in order to provide valid consent or ratification. 2. The fiduciary also must fully disclose the material aspects of the transaction for which it seeks consent or ratification. a. To obtain the full benefits of this protection, a trustee should insist that the beneficiaries obtain independent counsel to advise regarding any transactions at issue. b. If a beneficiary does not wish to retain independent counsel, the fiduciary should be certain that the relevant facts and circumstances surrounding the transaction are set forth in a 26

27 written document through which the beneficiary gives its consent or ratifies the actions of the fiduciary. c. Documenting that a transaction is fair and reasonable also is a recommended practice. C. Handling the Flow of Information, Making Decisions and Implementing Decisions 1. Communication with the beneficiaries on a regular basis can prevent many disagreements between beneficiaries and trustees. 2. Keep personal feelings for a particular beneficiary out of the trust administration, as emotional decision-making may lead to lawsuits for breach of duty. 3. Use of Advisors and Agents a. Individual Trustees are unlikely to understand when to look to their advisors for guidance. Part of what an adviser needs to do is explain to the trustee when an adviser is needed, as well as when a specialized adviser may be necessary. b. Consider the case of Vento v. Colorado National Bank, 907 P.2d 642 (1995). There, Colorado National Bank served as Trustee of four separate trusts that owned coal mining property. Seven years after an initial lease of the mine, the Trustee was approached by the lessee, requesting changes to the lease and approval to assign the lease to another coal company that planned to purchase the lessee s assets. The plaintiff objected to the changes and assignment; the trustee ultimately agreed. Plaintiff then sued alleging, among other things, a breach of fiduciary duty because the trustee failed to consult independent mining experts and attorneys with experience in mining leases prior to agreeing to the changes and assignment. On that issue, the Appellate Court affirmed the trial court finding in favor of the plaintiff, ruling that the trustee failed to exercise judgment and care when it failed to seek the advice of independent mining experts and also 27

28 should have hired outside legal counsel to assist Id at 646. c. A trustee can and will be held liable for failing to hire the appropriate advisers with the needed expertise to advise in the administration of the trust. 9. Conclusion: Working with an individual trustee can be both rewarding and challenging. Understanding what information needs to be provided, how to explain and advise someone without any technical background or framework, and ensuring that proper processes and procedures are implemented and followed is never easy. However, when successful, it is one of the most important ways an adviser can ensure that his client s wishes are carried out. LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see by Stacy E. Singer All rights reserved 28