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Today’s class

Today’s class. We begin our discussion of the fiduciary duties of trustees with consideration of the duty of loyalty Trustees must serve the interests of the trust, not of themselves. Trustee powers.

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Today’s class

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  1. Today’s class • We begin our discussion of the fiduciary duties of trustees with consideration of the duty of loyalty • Trustees must serve the interests of the trust, not of themselves

  2. Trustee powers • As the reading indicates, trustees can do their jobs only with broad grants of power. Thus, for example, Indiana grants many powers to trustees. • But if trustees are given broad powers, how do we ensure that they employ them on behalf of the beneficiaries? • If the trust does well, the beneficiaries gain most of the benefit, and if the trust does poorly, the beneficiaries suffer most of the lost. Trust law needs to align the trustee’s incentives with the interests of the beneficiaries. • Trust law also needs to protect against the potential for intentional misconduct • Trust law has created a fiduciary obligation with a number of duties, particularly loyalty and prudence

  3. The fiduciary obligation Settlor Trustee • Rise of Management Trust • Maximum Empowerment • Fiduciary Obligation • Loyalty • Prudence • Subsidiary Rules Beneficiaries

  4. Trustee powers • Question 1, page 674 • Even though UTC § 815 grants sweeping powers in general terms, it still is useful to have the specific enumerations of power in UTC § 816—in a particular case whether the trustee has the power to undertake an action is subject to the vicissitudes of judicial interpretation. • § 816 thus provides certainty for the actions taken. As a corollary, § 816 gives comfort to third parties who deal with the trustee • Question 2, page 674 • Statutes change, trusts sometimes move, or the trustee might find it necessary to conduct business out of state. Third parties are comforted by—and sometimes demand to see—explicit authorization in the trust instrument.

  5. Duty of loyalty • Enforced strictly • When engaged in self-dealing or other transactions that involve the trustee’s personal interests, the trustee is subject to a no-further-inquiry principle • Good faith and fairness to the beneficiaries are not a defense • The beneficiaries can force the trustee to undo the transaction or compensate them in damages • Absent advance judicial approval, the only defenses are settlor authorization or beneficiary consent (plus acting in good faith and in the best interests of the trust) • Some limited exceptions (e.g., corporate trustees can invest in their own mutual funds; conflicts that arise from the structure of the trust), plus acting in good faith and in the best interests of the trust

  6. Hartman v. Hartle, 122 A. 615 (N.J. Ct. Chancery 1923), p.675 Hartman v. Hartle Dorothea What were the facts? Executor Lewis Plaintiff Josephine Dieker Mr. Dieker (Executor) Will directs executors to sell real estate and divide proceeds among children. Josephine sells Farm for $5,500. March 1923 Feb. 1922 1921 April 1922 Executors sell Farm at auction for $3,900 to Lewis, purchased on behalf of Josephine, spouse of an executor. Plaintiff sues executors for self-dealing, seeks one-fifth of profit realized in sale of Farm by Josephine.

  7. Hartman • Was the sale of the Farm to a spouse of one of the trustees acceptable? • Not without advance approval of the court • Did it matter that there was no evidence of fraud? • No. Good faith and fairness are not a defense to self-dealing • What’s the remedy? • Too late to undo the sale and put the farm up for resale, since the current owner is a bona fide purchaser (recall Marsden). Instead, the one child has to give the plaintiff one-fifth of the profits on the resale.

  8. In re Gleeson’s Will124 N.E.2d 624 (Ill. App. 1955), p. 676 In re Gleeson’s Will What were the facts? With expiration of lease imminent, Colbrook renews lease to himself for another year with an increase in rent (from $6/acre to $10/acre) plus a share of the crops. Mary Gleeson leases 160 acres of farmland to Con Colbrook for one year. Feb. 1951 Mar. 1952 Mar. 1950 Mar. 1951 Gleeson dies. Will devises farmland to Colbrook, in trust, for benefit of her three children. Colbrook leases farmland to another tenant. Did Colbrook breach the duty of loyalty by self-dealing when he renewed his lease?

  9. Gleeson • Could Colbrook defend his lease on the grounds that • He increased his rent payments by 2/3 and added a share of the crops • There wasn’t time to find another tenant before the term of the lease would begin • That he had already sown part of the next year’s crop • That he was open and honest and that his lease was in the best interests of the trust • None of that mattered. The duty of loyalty required him to pay all of his profits to the trust

  10. Settlor authorization • Trustees can engage in conflicted transactions with settlor authorization • Must the authorization be specific to the transaction, or can settlors also authorize conflicted transactions implicitly by appointing a trustee who comes to the role with an existing conflict of interest? • In other words, can the settlor provide authorization by accepting a structural conflict of interest? • Let’s look at Rothko to find out

  11. In re Rothko372 N.E.2d 291 (N.Y. 1977), p. 679 In re Rothko What were the facts? Mark Rothko dies, leaving 798 paintings of “tremendous value.” Names Reis, Stamos, and Levine as executors. Rothko’s children (plus state AG) sue to remove executors and rescind contracts. Executors appeal. Appellate court affirms factual and legal findings but with adjustment to damages. May 1970 1972 Feb. 1970 1971 Nov. 1977 Executors dispose of paintings, within three weeks, through contracts with MAG and MNY, two related corps. Surrogate Court makes the following findings: • Reis, as an officer of MNY, was conflicted. • Stamos, as struggling artist, was conflicted by need to curry favor with MAG and MNY. • Levine, though not conflicted, acted imprudently, given Reis’ and Stamos’ conflicts of interest.

  12. Structural conflicts • The court muddied the waters with its discussion on page 682, when it drew a distinction between self-dealing and other conflicts of interest • The Restatement does not draw such a distinction • But there are the exceptions for structural conflicts of interest (e.g., corporate trustee that invests trust assets in the corporation’s own mutual funds) • Did Rothko expect his trustees to continue dealing with MNY?

  13. Structural conflicts • Did Rothko expect his trustees to continue dealing with MNY? • The year before he died, he sold a number of paintings to the gallery at prices comparable to those of the executors’ 1970 sale, and he signed a long-term exclusive consignment contract with the gallery • Maybe he picked the trustees because he was afraid other trustees would deal with other galleries • Even if he did, the trustees still had to meet standards of good faith and best interests, and the court found that they did not do so (hasty sales without independent appraisal; high commission for the gallery)

  14. Rothko and damages • Had the trustees been guilty only of selling the paintings for too low a price, they would not have been liable for appreciation damages. • But because they also acted on a conflict of interest (or in Levine’s case failed to police his co-trustees), they were assessed appreciation damages. • But Levine sought advice of counsel • That was evidence of prudence, but not an automatic defense—trustees might shop around for a favorable opinion

  15. We continue our discussion of the fiduciary obligation of trustees with consideration of the trustee’s “duty of prudence.” As with other fiduciary duties, the concern is that trustees may not exercise their powers to manage the trust wisely, with the beneficiaries suffering harm as a result. The duty of prudence, then, is designed to ensure that trustees serve the settlor’s objectives and the beneficiaries’ interests as they engage in the administrative activities of the trust. Duty of prudence

  16. The duty of prudence includes a number of duties, including The duty to review and make initial decisions about trust assets in a reasonable time, The duty to act impartially when there are multiple beneficiaries, The duty to incur only appropriate and reasonable costs, The duty of inquiry into the needs of beneficiaries (recall Marsden) The duty to invest trust assets prudently (prudent investor rule)—our main focus today The duty of prudence

  17. Trust investment law:The early years, p. 688 1719 Trustees authorized to invest in South Sea Company 1720 South Sea Bubble Bursts 90% drop in stock price Post-1720 “Court list” of proper and improper investments Stock investment forbidden or greatly restricted

  18. Trust investment law:The middle years, p. 688 1800s “Court lists” are codified; such “legal lists” proliferate in U.S. 1830 Amory: “Prudent Man Rule” Standard: “prudence,” but not “speculation” Mid-1900s Most states abolish their lists in favor of Amory’s “Prudent Man Rule”

  19. Trust investment law:The prudent man rule 1959-1990s: Part II Hindsight bias (e.g., it was “common know- ledge” that in August 1929 “a crash was al- most sure to occur”) Opt-outs hard (e.g., Authorization to buy stock A “does not mean that” buying stock A is prudent) 1959-1990s: Part I PMR replaced “legal lists,” but focused on “speculation,” per se rules and safe harbors Focus on default risk, ignored inflation risk Investments reviewed in isolation, not as part of portfolio

  20. Trust investment law:Toward the prudent investor rule 1976-1988 Critics draw on MPT, argue for scrutiny of portfolio-as-a-whole, risk/return as test of prudence ERISA, Delaware, California, and a few other states adopt portfolio-as-a-whole statement of prudence Early 1990s Restatement (Third) & Unif. Prudent Investor Act Prudent Investor Rule: trust investments are “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” (§2.b)

  21. Uniform Prudent Investor Act, p. 694 • The trustee is supposed to consider not only liquidity and regularity of income, but also risks of inflation (or deflation) and appreciation of principal (§ 2.c) • Any kinds of investments are permissible (§ 2.e) • The Act specifically mentions non-traditional investments, like interests in closely held enterprises, tangible personal property and real property (§ 2.c.4) • The trustee “shall diversify the investments of the trust” unless special circumstances indicate that the trust purposes are better served without diversification (§ 3)

  22. Stocks v. bonds: National trend (FDIC 1986 - 2006), p. 701

  23. In re Estate of Janes 681 N.E.2d 332 (N.Y. 1997), p. 702 In re Estate of Janes (1) What were the facts in this case? Janes dies. $3.5 million of estate put in trust, with $2.5 million in stock, $1.8 million of which is in Kodak common stock. Surrogate finds that trustee acted imprudently, imposes surcharge. Appellate court affirms but modifies damages. Trustee appeals. Price of Kodak stock falls from $139/share to $47/share. Aug. 1973 1980 May 1973 1982 Sept. 1973 to Feb. 1980 Trustee sells 2,000 Kodak shares. Keeps 11,000 shares, worth $1.8 million. Trustee files accounting. Mrs. Janes objects, seeks surcharge for losses incurred by “imprudent retention of high concentration of Kodak stock.”

  24. In re Estate of Janes (2) In re Estate of Janes

  25. In re Estate of Janes (3) In re Estate of Janes Source: Yahoo! Finance

  26. Janes • The trustee argued that concentrated investment in a stock was permissible as long as there were no “elements of hazard” that would make the investment worrisome (p. 704) • Elements of hazard include undercapitalized company, weak management, lack of profitability or history of paying dividends, not an industry leader • Even though NY operated under the old prudent man rule that allowed for investments that were standard for investment managers, the court effectively applied the prudent investor standard

  27. Janes and the prudent investor rule • The court cited to some of the factors in § 2.c of the prudent investor rule, as well as the principle in § 2.b that investments must be evaluated in the context of the entire portfolio rather than in isolation (page 705) • The court also invoked the § 3 principle of diversification and the § 2.f duty of a trustee with “special skills or expertise” to use those special skills or expertise when administering the trust (page 706)

  28. Janes and damages • There are two tests for measuring damages • Value of stock when it should have been sold plus interest from date of sale to date of court decision • Value of stock when it should have been sold plus gains if it had been invested prudently (total return damages, p. 710) • The Rothko court had used the second measure, but in that case, the trustees violated their duty of loyalty • Here the court used the first measure, but the Restatement follows the second measure

  29. Note questions • Note 1, pages 707-708 • The trustees could have avoided the risk of evolving judicial standards by making regular accountings. If an accounting is approved, the trustee is protected for the matters fairly disclosed in that accounting. Second, it would have put the issue of the portfolio allocation in front of a roughly contemporaneous court, less likely to be affected by hindsight or later developments in investment theory.

  30. Opting out of the prudent investor rule • As we’ve seen with many statutory rules, they are default rules that can be waived • “The prudent investor rule, a default rule, may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust. A trustee is not liable to a beneficiary to the extent that the trustee acted in reasonable reliance on the provisions of the trust.” • UPIA §1, page 711 • But courts are reluctant to recognize waivers, so careful drafting is important • Janes, as a former state senator, might have wanted his trust to favor Kodak, an important local company

  31. Trustee Powers • Except as provided in the terms of the trust and subject to [prudent investor provisions in Ind. Code § 30-4-3.5], a trustee has the power to perform without court authorization [subject to provisions about conflicts of interest or multiple trustees], every act necessary or appropriate for the purposes of the trust including, by way of illustration and not of limitation, the following powers: • Ind. Code § 30-4-3-3

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