CONFLICTS OF INTEREST RED FLAGS

1. CONFLICTS OF INTERESTRED FLAGS Fran M. DeMaris Executive Vice President Cannon Financial Institute

2. “Many forms of conduct permissible in a workaday world for those acting at arm’s length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the “disintegrating erosion” of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd.” Judge Benjamin Cardozo, 1928

3. CASES MORE PREVALENT IN TROUBLED TIMES • Trust estates have had precipitous declines • In 2009 the IMF has predicted $3.4 Trillion loss for Financial Institutions • Beneficiaries feel vulnerable • Litigious by nature • Desperation seems common • Want someone to blame

4. CASES MORE PREVALENT IN TROUBLED TIMES • Volatility increases odds of lawsuits • Hindsight judgment has always been problematic • All related issues in Estate Planning have become uncertain • Taxes • Business/Economy • Investments • Government is viewed as “Broken” by CNN, in a week long program in February 09.

5. CASES MORE PREVALENT IN TROUBLED TIMES • Corporate fiduciaries seen as the “deep pockets”, which is tempting in difficult times • Doing a “good job” does not preclude the possibility of lawsuits • Costs of defense can be exhaustive • Financially and emotionally

6. CASES MORE PREVALENT IN TROUBLED TIMES • Frivolous lawsuits still do reputational damage • Pressure to settle, rather than go to trial, often benefits unreasonable people – the concept of mediation indicates “everyone must give up something” • Facts are often the issue in question: • Testimony, even well done and honest, can seem self-serving without process and written notes to support the position(s) taken

7. CASES MORE PREVALENT IN TROUBLED TIMES • Any “conflict of interest” may be fatal • Hindsight bias, though inappropriate, is: • Insidious and unintentional • Controlling and powerful • Pervasive and unlimited • Fiduciaries and lawyers need to be wary of overestimating the ability of jurors to truly understand the issues involved • “Just because you are paranoid, doesn’t mean people are not after you…”

8. P & I LAW CAN BE CONFUSING • In past times, trust accounting income was a clearly defined concept • With the new 1997 version of UPIA (45 +DC with 28 states unitrust-conversion), in conjunction with the Uniform Prudent Investor; decisions are much more driven by interpretation of what is optimal total return suitable to the trust’s purpose and circumstances, as well as that of the beneficiaries

9. P & I LAW CAN BE CONFUSING • Now the questions revolve around the issues of taxation and DNI • Section 643 defers this issue to State Law • Consistency is the requirement • Logic demands a system which informs beneficiaries of the issues and explains the process to be used

10. P & I LAW CAN BE CONFUSING • In Matter of Orpheus Trust,179 P.ed 562 (Nev.2008), because the trustees were also beneficiaries, a bank was appointed special trustee for the purpose of making an adjustment to income pursuant to the state’s version of UPIA, Sec.104. The District Court denied a petition to make a retroactive adjustment for the preceding year, but the Supreme Court reversed, holding that the corrective nature of the adjustment power suggests, “at a minimum”, that the special trustee could make an adjustment for the year immediately preceding its appointment. • [NJ and MD allow adjustment power only within a set number of days]

11. P & I LAW CAN BE CONFUSING • McKenzie v. Vanderpoel, 61 Cal. Rptr.3d 129,131(Cal. Ct. App.2007) • Despite a trust provision that principal and income matters are to be governed by statutes existing “from time to time”, an income beneficiary’s petition to determine whether the trustee should exercise a statutory income adjustment power would violate a no-contest clause in the governing instrument, according to the Probate Court and Court of Appeals.

12. P & I LAW CAN BE CONFUSING • Estate of Morse, Index No. 83862 (Sur. Ct., Dutchess Cty. Flor. 2006): • The remainder beneficiaries tried unsuccessfully to prevent an adjustment to income that would benefit their stepmother, the income beneficiary. The court applied the “abuse of discretion” standard, as provided by the applicable statute.

13. ASSETS IN DECLINE • Is there a “right way” to decide when to sell in a decline of an asset? • Does it matter if it is unique to the asset or if it is the market as a whole? • As it turns out, it is simply a matter of the individual circumstances of each situation!

14. ASSETS IN DECLINE • Since it often takes years for many of these cases to be brought, and especially for settlement, we must look at several cases still in the courts… • Though the law holds fiduciaries to a high level of care and conduct; it is not so much the results, as the process that affords protection!

15. ASSETS IN DECLINE • Growney vs. Central Pacific Bank, Cir. Ct. No. 1CC09-1-s 001374 (2009): An heir to the $2 billion Campbell Estate has sued CPB for being “asleep at the switch” while his stocks were falling in value. CPD managed an investment account when stock like AIG, Citibank, and B of A began to tumble. For example, CPB paid $69.26/share for AIG in March 2008 and sold it for $2.17/share sixth months later. AIG later bottomed at about $0.35/share in March 2009. The complaint alleges CPB “neglected to take any action to end the hemorrhaging”, and that “it appeared they were buying and selling stocks with no apparent strategy”. • The focus will likely be on the record of the documented thought process when the stocks were bought and while they were declining

16. ASSETS IN DECLINE • McGinley v. B of A, 279 Kan. 426 (2005): An RLT instrument required the bank as trustee to consult the settlor before buying or selling any stock, and to then follow her instructions. Because there was a high concentration of Enron, the trustee had the settlor sign a letter directing its retention and relieving the trustee of any responsibility to analyze or monitor that stock. After Enron collapsed, the settlor sued the trustee for failure to comply with the Uniform Prudent Investor Rule. The Court rejected the claim, but noted the trustee should have explained the consequences of the agreement and alerted the settlor when the stock declined significantly. • One may question if this result would be consistently followed in all jurisdictions without the follow through with the settlor…

17. ASSETS IN DECLINE • Hartman v. Walker, 73 Va.Cir 245 (Va.Cir.Ct 2007) An income beneficiary thought his income too low and sought an $800,000 surcharge and trustee removal. The lower court granted the motion of the trustee for summary judgment, but the appeals court reversed. Trust language that authorized retention of undiversified investments did not relieve the trustee of their fiduciary responsibility. The beneficiary was entitled to whatever information he needed to protect his interest in the trust. When the trustee failed to inform the income beneficiary of offers received by the trustee from third parties to buy non-income producing trust properties, they may have breached their duty to communicate information necessary to allow the income beneficiary the right to protect his interests.

18. RETAINED ASSETS • There exists in this arena some difficulty in finding consistent patterns of court action with respect to the direction to retain specific assets or exculpate the trustee from liability with respect to retained or other conflicted assets • Judging these issues within the new framework of the Uniform Prudent Investor Rule is even more challenging

19. RETAINED ASSETS • Fifth Third Bank v. Firststar Bank, 2006 Ohio 4506, appeal denied, 860 NE2d 768 (Ohio 2007): A CRUT funded with P&G stock contained a clause permitting the trustee to ”retain, without liability for loss or depreciation resulting from such retention, original property, real or personal, received from Grantor or any other source although it may represent a disproportionate part of the trust.” The trustee gradually reduced the concentration of P&G stock, but not fast enough to avoid to consequences of a sharp drop in its value--by the end of the first year the trust estate lost half of its value. The trial court awarded damages in excess of $1 million. The Court of Appeals affirmed stressing that a mere authorization to hold a high concentration of stock does not eliminate the duty to diversify.

20. RETAINED ASSETS • Ervin Estate, 2008, Mich.App. LEXIS 426: The Court of Appeals reversed and remanded because the trustee was exempt from the Prudent Investor Rule under the unique language of the governing instrument, which authorized the trustee “to invest and reinvest…in income producing assets in accordance with its judgment, not being limited by any present or future investment laws…” There was also a very specific clause authorizing retention of the stock in question, unless it ever became “unproductive of income” with exculpatory language to protect the trustee as well. The bank was reimbursed for costs incurred in defending itself in this action.

21. RETAINED ASSETS • Wege Trust v. Fifth Third Bank, 2008 Mich.App. LEXIS 1259: • General retention language plus good communications created a safe harbor for a bank that consciously decided not to diversify a large concentration of stock

22. RETAINED ASSETS • Nelson v. First National Bank, 543 F.3d 432 (8th Cir.2008): The Court upheld a summary judgment in favor of a corporate trustee that did not liquidate a heavy concentration of one stock within two weeks of the settlor’s death. The facts heavily favored the trustee. For example, (1) the settlor had directed the trustee to retain the stock notwithstanding any consequent risk and lack of diversification, (2) the settlor had repeatedly expressed his firm belief that the stock was the best investment for the trust, and (3) within the two week period, the trustee had looked closely at the issue of diversification and discussed it with the settlor’s attorney and accountant, and scheduled a meeting with the trust beneficiaries. Even so, they were sued…

23. RETAINED ASSETS • Matter of Hyde, 845 N.Y.S.2d 833 (App.Div. 2007), appeal denied 881 N.E.2d 1197 (N.Y.Ct.App. 2008): The trust instrument granted the trustee absolute discretion in managing the trust estate, which included a high concentration of closely held stock with an unusual capital structure. Class A shareholders controlled the decision to liquidate, but virtually all liquidation proceeds would go to class B shareholders. Beneficiaries alleged failure to diversify, but the Court found that the corporate trustee had “made a reasonable determination that it was in the best interests of the beneficiaries not to diversify”. The record indicated that the trustee had made a concerted effort to understand its options and to make informed decisions that would be in the best interest of the trust beneficiaries.

24. EXCULPATORY CLAUSES • Can relieve a trustee of liability for breach of trust, but not to the extent that relief is available to relieve the trustee of liability for a breach of trust committed in bad faith or with indifference to the fiduciary duties of said trustee, the terms or purposes of the trust, or the interests of the beneficiaries. § 96 RESTATEMENT THIRD OF TRUSTS • UTC § 1008 (b) “An exculpatory term drafted or caused to be drafted by the trustee is invalid as an abuse of a fiduciary or confidential relationship, unless the trustee proves the term is fair under the circumstances and that its existence and contents were adequately communicated to the settlor”.

25. EXCULPATORY CLAUSES • Scott and Asher on Trusts, supra, 24.27.4 ”The scrivener/fiduciary has the burden of establishing that the client realized the implications of the clause.”

26. DIVERSIFICATION • Is usually required. But there are times when the trustee need not diversify, and other times when diversifying can even induce litigation. • Section 2 of the Uniform Prudent Investor Rule reminds us to “diversify unless the trustee reasonably believes it is in the best interest of the trust and/or beneficiaries not to diversify.”

27. DIVERSIFICATION • Decisions to buy or sell cannot be made without reference to the purposes and circumstances of the trust and its beneficiaries • Hyde, Nelson v. First National Bank, and Fifth Third v. Firststar Bank are all on point from the previous discussions

28. DIVERSIFICATION • In re, Appeal of Trustee Sky Trust, 868 A.2d 464 (Pa.Super. 2005): The corporate trustee held a large block of its own stock in a RLT that divided into marital and non-marital trusts for the surviving spouse. The trustee’s policy was to perform a portfolio review within 60 days of funding, though it took nearly 7 months in this case. The portfolio manager decided to diversify partly because his reading of the governing document led him to believe that the settlor’s goal was to “take advantage of estate tax planning, not necessarily income production”.

29. DIVERSIFICATION • This was evidently done without first inquiring about the health or financial situation of the surviving spouse, who was quite ill and survived less than two years. The bank’s investment plan lengthened the investment time horizon, which the Trial Court ruled grossly negligent under these circumstances. The Superior Court affirmed: “Diversification cannot become a goal in and of itself…[it’s] a tool to provide the means to effectuate a settlor’s goals…if used properly and prudently with due regard to the specific facts and circumstances that exist in a particular case.”

30. DIVERSIFICATION • The bank did not have a duty to seek the beneficiary’s approval, but it did have a duty to investigate the life tenant’s health and financial circumstances. “Simply put, there were no reasonable prospects that the trust could continue in existence long enough to experience capital growth from the chosen diversification strategy and it was gross negligence to sell safe and high performing assets in the implausible hope that a long-term capital gain could be realized.” Marketing brochures had touted “continual supervision…by capable specialists.” In short, the trustee had a duty to gather relevant information and then to tailor a plan that fit the actual circumstances of the trust.

31. DIVERSIFICATION • In re Rowe, 712 N.Y.S.2d 662 (App.Div. 2000), Appeal denied, 749 N.E.2d 206 (N.Y. 2001): Several months following the funding of a CLT entirely with IBM stock, a corporate trustee’s investment committee considered diversifying the trust estate, but decided to hold off selling until the price recovered from a recent decline. Rather than bounce back, however, the price continued downward and was worth only about half its original value by the time the trustee rendered an accounting to the beneficiaries. The Surrogate Court found the trustee negligent for not diversifying relatively soon after opening. The Appellate Division agreed and noted that the trustee had “failed to follow its own internal protocol…[and] failed to conduct more than routine reviews of the IBM stock…[with] no particular consideration to the unique needs of the particular trust.”

32. COMMUNICATION • The duty to communicate with beneficiaries requires a fiduciary to provide all the information necessary to allow beneficiaries to protect their interests in the trust. • Communication has been a guiding principle of the fiduciary world, further enhanced by case law as in the previous examples; and shaping a core foundation in the development of the Uniform Trust Code.

33. COMMUNICATION • Ford vs. Fisher Investments, Civil Action No. 4:09-cv-1349 (May 4, 2009): When the settlor of a self-settled trust gave Fisher Investments discretionary control over the trust’s portfolio, the asset allocation was 27% cash, 32% fixed income, and 41% equities. Fisher allegedly changed it to 100% equities. The shift coincided with the dramatic loss in stock values in September, October, and November 2008. The settlor/trustee had acquiesced in the reallocation, but later claimed not to have understood the degree to which the change would increase the risk of substantial losses. From the complaint: “Fisher Investments had a duty to manage the…account in a manner directly comporting with the needs and objectives of [the settlor/trustee]…to keep informed regarding the changes in the market…and act responsively to protect [her] interests; to keep [her] informed as to each completed transaction; and to explain forthrightly the practical impact and potential risks of the course of dealing in which Fisher Investments was engaged.”

34. COMMUNICATION • Welch v. Weiner, 2007 Mich.App. LEXIS 2704: The trustee sent a check to someone he described as a contingent beneficiary, but declined to provide information about the trust. The Court of Appeals found that the beneficiary was entitled to a copy of the instrument and an accounting, and it instructed the Probate Court to remove the trustee for failing to provide information to which the beneficiary was entitled.

35. CONFLICTS OF INTEREST • Conflicts are generally consentable, but require a comprehensive explanation of all relevant considerations in a documented process • Conflicts are often referred to as the “cardinal sin of a fiduciary relationship” • UTC § 1009 is specific in this position and requires fiduciaries to be able to prove/document their compliance with beneficiaries

36. CONFLICTS OF INTEREST • In re Saxton, 712 N.Y.S.2d 225 (App.Div. 2000): The trust estate consisted entirely of IBM stock. The beneficiaries agreed in writing with a decision not to diversify, but later changed their minds. The court put the burden on the trustee to show that the beneficiaries “had the intent to form a contract and so formed it with actual and full knowledge of all legal rights.” Because the trustee did not warn them “of the effects that their execution of the [waiver] would have on their legal rights or how their direction to hold IBM exclusively would fall far short of what would have been required of a prudent corporate trustee,” they were not bound by their waiver. More than a $6Million surcharge to the trustee.

37. TRUST PROTECTORS • The concept of committees named by grantors in trusts to make recommendations on family decision-making, or established to direct voting of stock in specific circumstances (Family Owned Closely Held or Own Bank Stock of the trustee) has been a long-standing tradition in fiduciary accounts

38. TRUST PROTECTORS • This historic perspective has led to more recent interest and legal inclusion of the concept of the “Trust Protector” • Through the official comment in UTC § 808, the use of Trust Protectors was introduced to American estate planning in the world of offshore trusts, where the protector’s job was to change the situs of the trust and remove and replace trustees in an attempt to stay a step ahead of creditors • This has created a rather unsavory feel to the term

39. TRUST PROTECTORS • More recently, the term has become part of the discussion in the use of Special Needs Trusts, both first and third party; particularly with respect to discretionary decisions • The term has begun to have wings under the Uniform Trust Code…

40. TRUST PROTECTORS • Today, trust protectors are often authorized: • To remove and replace trustees, and name successors to fill vacancies in any position • To make administrative changes, including investment management • To make substantive changes to trust terms to address changes in tax laws or other legal or factual changes that may impact the trust, as in situs

41. TRUST PROTECTORS • To add or remove beneficiaries • To direct discretionary distributions • To alter an existing beneficiary’s interest in a trust • Can also be limited to very specific issues: • Major changes in transfer tax systems • Elimination of all transfer taxes beyond a certain point

42. TRUST PROTECTOR SELECTION • Selection of a trust protector requires careful consideration: • Individual, advisor, committee? • Permit beneficiaries, trustees, third parties to appoint if/as needed in the future • Exoneration/indemnification provisions to shield the protector and allow them to serve as a watchdog • Grantors/Beneficiaries should not serve: • Tax liabilities • Conflicts of Interest • Perceived inappropriateness