Trust Modification: When Flexibility Conflicts With Settlor Intent

“Trust Modification: When Flexibility Conflicts With Settlor Intent,” that is the subject of today’s ACTEC Trust and Estate Talk.

This is ACTEC Fellow Julia Meister from Cincinnati, Ohio.

Irrevocable trusts are designed to provide certainty, but changing circumstances, sometimes where appropriate, lead trustees and beneficiaries to seek modifications. How much flexibility does the law allow before a proposed change undermines the settlor’s original intent?

ACTEC Fellow Amanda D’Arcy of Wilmington, Delaware joins us to examine the concept of a trust material purpose, the role of the Uniform Trust Code in trust modifications, and the legal boundaries practitioners should understand before altering an irrevocable trust.

As a note, any statements or opinions expressed are those of the presenter individually and are not the opinions or positions of their respective employer or anyone else. Welcome, Amanda.

Why Trust Modifications Can Lead to Litigation

Amanda D’Arcy:  Thank you, Julia, appreciate you having me. In the evolving landscape of trust administration, the process of modification can provide convenience and the power to reshape a rigid instrument to meet changing circumstances. But the power can be problematic if it’s left unchecked. When a modification crosses the line and compromises a material purpose of the governing instrument, the process can transform an effort to preserve and to a trigger for costly litigation and judicial reversal.

So how does material purpose play a role in trust modification?

The Claflin Doctrine and the Origins of Material Purpose

Well, American trust law has historically prioritized settlor intent in the context of material purpose. American courts have focused on identifying a trust material purpose, a concept rooted in Claflin v. Claflin from 1889, which established what is now commonly referred to as the Claflin Doctrine. And in Claflin, the Massachusetts Supreme Judicial Court refused to terminate a trust early where the settlor intentionally structured distributions to be paid in three installment periods which had not yet all occurred, holding that the distribution scheme reflected a material purpose that could not be overridden by a beneficiary’s preference to receive the funds any sooner.

Modern trust law incorporates the Claflin Doctrine through both the restatement third of trust and the uniform trust code. So, if you look at the Restatement (Third) section 65, it’s specifically that the identification of a material purpose requires more than a general inference. It typically demands evidence of a specific concern or objective motivating the settlor, such as doubts about a beneficiary’s judgment, maturity, or financial management skills. Comment (d) to section 65 emphasizes that courts should look for circumstances indicating the trust structure was intended to serve more than the mere convenience in allocating benefits while recognizing that the nature or design of a trust may itself suggest a protective or otherwise material purpose.

Judicial vs. Non-Judicial Trust Modifications

So, we know that there are essentially two ways to modify a trust; the first way is through judicial permission, and the second way would be in a non-judicial manner. We’ll be focusing on the Uniform Trust Code (UTC) for purposes of discussing both processes.

The UTC adopts Claflin’s principles while providing structured mechanisms for modifying or terminating irrevocable non-charitable trusts. And we see that first with respect to judicial approval in the Uniform Trust Code section 411. 411 has two means by which to judicially modify or terminate a trust; 411(a), which allows a court to approve a modification or termination. If the settlor and all beneficiaries consent, even if the change violates a material purpose of the trust, I think that’s important to point out here, because it goes to show that as long as the settlor is consenting that the material purposes issue is not a concern to the court. 411(b), however, only allows for modification with court approval, if the court determines that the proposed action is not inconsistent with the material purpose when the settlor cannot or does not consent. An distinction to note here as to settlor intent being of preeminence to the court.

There’s little in the UTC text itself defining material purpose. The comments to section 411 cite and adopt the third restatement section 65 comment D, which I previously read.

When Non-Judicial Settlement Agreements Are Appropriate

Now, we talked about judicial modification, let’s talk about non-judicial modification. In addition to judicial modification, the UTC provides a non-judicial alternative through NJSAs (nonjudicial settlement agreement) under section 111 of the Uniform Trust Code, permitting interested persons to resolve disputes or address administrative matters without court approval. Under UTC Section 411, a non-judicial settlement agreement is valid only to the extent it does not violate a material purpose of the trust, and it must include terms and conditions that could be properly approved by the court.

Uniform Trust Code Section 111(d) provides a non-exclusive list of matters that can be resolved by a non-judicial settlement agreement, which include some of the following. The interpretation or construction of the terms of the trust, the approval of a trustee’s report or accounting, direction to a trustee to refrain from performing a particular act, or the grant to a trustee of a necessary or desirable power, among others.

So, this NJSA mechanism promotes efficiency and collaborative trust administration while preserving settlor intent, but caution is warranted here because a violation of material purpose renders an NJSA and a modification done under an NJSA void at the outset. And it’s important to note that all necessary and interested parties have to be included with respect to the NJSA, either directly or through adequate representation, virtual representation, and I’m going to talk about that a little bit soon. So even when proceeding by an NJSA, it is technically the gold standard to obtain court approval of an NJSA to confirm compliance with the requirements I stated above. And this is expressly contemplated in Uniform Trust Code section 111(e), which states as follows, “Any interested person may request the court to approve a non-judicial settlement agreement to determine whether the representation as provided was adequate and to determine whether the agreement contains terms and conditions the court could have properly approved.” I will add an additional point that is not infrequently requested of a court when it issues an order approving an NJSA, which is to ask the court to confirm that the agreement itself does not violate a material purpose of the trust.

Common Examples of a Trust’s Material Purpose

As one might expect, American case law is varied on material purpose and modification throughout the country. Examples of possible material purpose that have been considered and contemplated by courts in the context of modification cases include some of the following:

• The choice and identity of the trustee and the change of trustee,
• the consideration and rationale of the settlor in creating and maintaining the trust, and
• the selection of particular assets to be held in trust,
• the level of discretion afforded to the trustee,
• the level of power participation and access afforded to the beneficiaries, the particular family dynamics, if any,
• and tax and asset protection considerations, if any.

I now want to turn to a couple of case studies so that we can sort of see how courts look at these cases in real time. One is a judicial modification and the other is a non-judicial modification.

Case Study: The Flint Decision on Judicial Trust Modification

So, the first case, which is an example of a judicial modification case, comes from the Flint case, it’s a 2015 Delaware Court of Chancery decision, which involved the testamentary trust in which the court noted that the settlor provided the settlor’s wife and daughter income interests while vesting investment authorities solely in independent trustees and limiting the beneficiaries access to principal. Decades later, the interested parties petitioned the court to restructure the trust as a directed trust and wish to vest investment discretion in a family selected investment advisor. The court rejected the petition to modify, finding that every proposed change in its opinion conflicted with the settlor’s clearly expressed intent to keep investment decisions squarely within the control of the independent trustee.

Case Study: The Johnson Trust and Non-Judicial Modification

The next case that I’m going to talk about is a non-judicial modification, as I mentioned, and that’s the Johnson Irrevocable Trust from 2012, Pennsylvania Orphan’s Court case. This involved a trust in which a settlor established an irrevocable trust for the benefit of his wife, children, and grandchildren. The trust gave the trustees discretion to distribute principal and income to the wife only when her other income sources were insufficient for her reasonable support, while separately authorizing discretionary distributions to the settlor’s descendants for their maintenance support and education.

After the settlor died, all necessary and interested parties entered into a family settlement agreement, but they didn’t seek court approval of the agreement. The agreement replaced the wife’s need-based distribution standard with a fixed 4% uni-trust payout, regardless of need, and the children and grandchildren surrendered their rights to discretionary distributions during the wife’s lifetime. Four years later, one then serving trustee and two other signing parties to the agreement petitioned the Orphan’s Court to terminate the agreement at its outset. They argued that the agreement required court approval, and because court approval was not obtained, it was void at the outset, and they also argued that the agreement violated a material purpose of the trust and was therefore void at the outset.

The court concluded the court approval was not required under Pennsylvania’s NJSA statute, but did confirm, in its opinion, that the agreement violated a material purpose of the trust, because in the court’s view, the settlor intended distributions to the wife only in circumstances of genuine need and intended to preserve assets for the remainder beneficiaries, while still allowing discretionary distributions to them during the wife’s lifetime. Because all parties were competent adults who had knowingly entered into and agreed to the arrangement, the court chose to invalidate the agreement only prospectively from the date of the termination petition was filed and not to void it from inception.

Best Practices for Avoiding Invalid Trust Modifications

These principles and cases demonstrate that the risks involved in trust modification are not merely academic. Even consensual agreements can be declared invalid years later, creating risk and exposure for all the parties involved. Whether proceeding through court approval or a non-judicial settlement agreement with respect to modification, trustees and practitioners, and all parties, must begin with a disciplined analysis of settlor intent and identify any material purposes embedded in the trust structure, including distribution standards and fiduciary design. And it’s important, I think, for you to consider the list of case examples that I previously read across the country where courts are looking at what exactly is settlor intent in their view.

Modifications are particularly vulnerable when they reallocate decision-making authority, they alter dispositive protections or they weaken safeguards deliberately chosen by the settlor. It’s important not to rely exclusively on beneficiary unanimity as a substitute for a material purpose analysis, and I think the Johnston case and also the Flint case demonstrate that.

With respect to non-judicial settlement agreements, consider using them conservatively and do a thorough material purpose analysis and ensure that all necessary parties are included in the agreement. As to NJSAs where there’s any doubt that exists as some material purpose or to the adequacy of virtual representation so that all necessary parties are included, you may want to consider seeking judicial approval because, as I mentioned previously, it is the gold standard because it remains the most effective protection against to later to a challenge.

Why Judicial Approval Remains the Gold Standard

As to virtual representation with respect to NJSAs, consider issues of potential conflict. Across multiple provisions, the Uniform Trust Code makes clear that representation is valid only to the extent there’s no conflict of interest between the representative and the person represented with respect to the particular question or dispute, and all beneficiaries are necessary parties. The consequences of inadequate representation with respect to a non-judicial modification are significant, including invalidating and voiding the NJSA and the modification itself at the outset.

So careful documentation of purpose, conservative use of non-judicial mechanisms, and judicial approval where doubt exists are the most effective tools for ensuring that efforts to modernize trust administration do not ultimately defeat the very objectives the trust was created to achieve.

Julia Meister: Thank you, Amanda, for that overview.

 

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