Directed Trusts Laws and Related Uniformed Acts

Jul 11, 2023 | General Estate Planning, Podcasts, T&E Administration, Uniform Law, Multi-State Issues & Laws

“Directed Trusts Laws and Related Uniform Acts,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Doug Stanley, ACTEC Fellow from St. Louis, Missouri. The Uniform Directed Trust Act is now five years old, with 16 jurisdictions enacting it. What is the latest lay of the land for directed trust from the perspective of a trustee, planner, and litigator? What are the risks of taking direction from the third-party investment and distribution directing trustees? ACTEC Fellows Jocelyn Borowsky of Wilmington, Delaware, Shaheen Imami from Chattanooga, Tennessee, and Laura Mandel of Chicago are with us today to share their practical experiences. Welcome, Jocelyn, Shaheen, and Laura.

Laura Mandel: Thank you, Doug. You know, this presentation could also be called: “Directed Trusts. What could go wrong?”

Directed Trusts – Overview

Shaheen Imami: A lot of stuff, apparently. But, Laura, as a chief fiduciary officer, what are the few things that a trust company will take into account when deciding whether to accept a directed trust?

Laura Mandel: The primary focus is a clear delineation of responsibility, appropriate exoneration language, and clarity as to what actions advisors can direct within the trust instrument. We also must be comfortable that we can work with advisors to fulfill the purposes of the trust and to act in the interest of the beneficiaries. From a corporate trustee perspective, we want statutory protection in executing an advisor’s direction with no responsibility for overseeing the advisor, no duty to warn beneficiaries of potentially adverse consequences from the advisor’s actions, or no responsibility to advise beneficiaries where we might have exercised our fiduciary discretion differently. We prefer to administer directed trusts in states with clear and comprehensive statutes. But also states where there is existing case law interpreting the relevant directed trust statute. And where the courts have expertise in hearing directed trust matters. Jurisdictions where the legislature continually refines their directed trust laws are an important consideration. In addition, practitioners in some states are more familiar with the nuances of drafting directed trusts.

Jocelyn Borowsky: Laura, what is the approach taken by most state laws and the Uniform Acts regarding a trust director’s fiduciary status?

Trust Director Fiduciary Status – Uniform Trust Acts and State Laws

Laura Mandel: The uniform trust code and uniformed directed trust act treat the trust director as a fiduciary. Most states also treat the trust director as a fiduciary but in a handful of states, notably Delaware and Nevada, a trust agreement can provide that a trust director is not a fiduciary. In our trust forms, we make it clear that the investment or distribution advisor exercises their functions in a fiduciary capacity and in a manner that the advisor reasonably believes to be in accordance with the purposes of the trust agreement. Our forms also state that the advisor is deemed to have acted within the scope of its authority to have exercised reasonable care, diligence, and prudence and to have acted impartially as to all persons interested unless the contrary is proved by affirmative, clear, and convincing evidence. So, a comment: in states where a trust director can serve as a non-fiduciary, the question becomes who’s the party from whom a beneficiary can seek redress if the directed trustee is absolved from liability for following the trust director’s instructions, and the trust director is not a fiduciary?

Jocelyn Borowsky:    Yeah. That’s something to think about. But there’s another role that’s come on the scene known as the “trust protector.” In Delaware, a trust protector started to appear in trust agreements in the early 2000’s. We have a 2003 case known as the Friedman case, where the court was grappling with what a trust protector is. And famously remarked, a trust protector, that sounds like a superhero. Shaheen, can you tell us about the McLean case, which deals with the fiduciary status in the part of the trust protector?

Trust Protector – Fiduciary Status

Shaheen Imami:  Sure. To your point about a superhero, I think several of the cases that you’ll find regarding directed trusts demonstrate either a misunderstanding or an ambiguity of how the trust in question operates or the discomfort of the court in reaching a conclusion where a beneficiary might be bereft of a remedy. So, McLean, which was a Missouri Court of Appeals case, the court addressed whether a cause of action existed regarding a trust protector’s liability for failing to remove a trustee who purportedly was damaging the trust. There wasn’t any dispute that the trust agreement vested the trust protector with the authority to remove and replace a trustee or that the defendant’s trust protector accepted his appointment. Rather, the defendant trust protector argued that because neither Missouri law nor the trust agreement created any duty for a trust protector to “monitor or supervise” trustees, he couldn’t be liable for not doing it.

The court noted that it was an issue of first impression in Missouri but pointed to first the existing law regarding “a voluntary assumption of duties and related liability.” And two, “the inference of specific duties that might reasonably follow from a fiduciary relationship.” In that case, because the trust agreement was created for the purpose of investing settlement proceeds in a prudent manner, the court found it possible that a trust protector owed duties to the trust itself and might include a duty to protect the trust itself from foreseeable injury. So, the court also found by extension that the power to remove and replace trustees, which was held in a fiduciary capacity in that case, meant that a grantor expected the trust protector to exercise his power of trustee removal if that trustee was acting against the purpose of the trust. So, ultimately, the court found that such an inference allowed for the breach of duty claim to go forward.

Jocelyn Borowsky:  So, Shaheen, what lesson do you draw from McLean in terms of drafting? One of the lessons I always took away from that case was to be very clear about the extent to which a trust protector acts in a fiduciary capacity. And to rule it out if it’s not intended for the trust protector to act in a fiduciary capacity, especially when there is an absence of case law or statute on the subject.

Shaheen Imami:  At a minimum, I’d say you’re right. But I think that each of these cases stresses the importance of being very specific with your drafting language rather than allowing for flexibility through vagueness, which is, I think, what a lot of drafters initially think. We want to make our documents flexible so they can change with the times or change with the circumstances. But in circumstances involving directed trustees and directed trust provisions, I think it’s really important to be narrow. To keep things skinny, to be very, very specific, and not be overbroad in what you’re trying to accomplish. I think Laura has more on this point.

Laura Mandel: So, another thing to be aware of when preparing a directed trust agreement is the scope of the trust director’s powers. The Uniform Directed Trust Act does not specify expressed trust director’s powers but instead leaves it to the drafting attorney to supply the terms. Many states have expressed provisions regarding the scope of the trust director’s authority. But the definitions are not all-inclusive. Care should be taken, especially in the realm of lending, borrowing, and pledging trust assets, to define each party’s role and scope of authority. Jocelyn, do you want to talk about the Mennen case?

Other Cases: Trust Protector Fiduciary Status

Jocelyn Borowsky:  Sure. The Mennen case was a Delaware case that came out in and around 2014. There were two different opinions. This involved a trust that was set up as a directed trust back in 1970 but the trust agreement provided that only four of the trustee powers – buying, selling, participating in mergers, and voting stock – were to be directed by the trust director. Unfortunately, the trust director directed investments in failing companies and further directed the trustee to lend funds to the failing companies. These particular powers were not very clearly subject to the direction of the trust director. The trustee ended up settling out of the case. And there’s no written opinion with respect to that but the takeaway is when drafting a trust agreement with directed powers, it’s important to consider all of the trustee’s financial powers, and to the extent, it is intended to be directed to clearly define the scope of the investment director’s authority.

Laura Mandel:  Shaheen, are there other cases related to a trust director’s scope of authority?

Shaheen Imami: There are a few that involve trust interpretation issues, which again emphasize the need for careful drafting. In Shelton v. Tamposi, which is a New Hampshire case, the trustee and the beneficiary sought to remove the investment directors. They effectively wanted to decouple the administration of certain sub-trusts from other sub-trusts. And they also sought, in this case, which was important, “a declaratory ruling that the trustee could compel the investment directors to make distributions to the sub-trusts to then allow the trustee to make distributions to the beneficiaries of those sub-trusts.” So, as the court interpreted it and parsed the language of the trust instrument, it found that because the investment directors were given exclusive authority over the investment and management, including sale of the trust assets, the trustee was a “excluded fiduciary” in that regard and, therefore, was prohibited from compelling the investment directors to sell assets and making distributions to the sub-trusts.

Further, the court found that the trust provisions on which the trustee relied did not specifically address distributions to the sub-trusts only from the sub-trusts. So, they could not be read as granting the trustee the authority requested. In Schwartz v. Wellin, which was a U.S. District Court in South Carolina interpreting South Dakota law, the court dismissed a complaint for breach of fiduciary duty filed by the plaintiff trust protector against defendant trustees based on the real party and interest requirement. The trust protector, in that case, argued that the trust agreement, which he purportedly amended in his capacity as trust protector, expressly authorized his complaint because that amendment granted him the power to engage in litigation involving the trustee or the protection of trust assets. But even with that language in place, the court held that the real party and interest test is one for the courts to decide, not one for private parties to decide.

The court found that South Dakota law didn’t address a trust protector’s authority to bring a lawsuit on a trust’s behalf. There were only references to trustees and not trust protectors. So, because the plaintiff’s trust protector didn’t demonstrate that he personally suffered an actual or threatened injury, he wasn’t a real party in interest.

Notably, although it’s unclear if the language in the referenced trust amendment would have changed the court’s mind in that regard, the court found that the trust protector lacked the authority to amend the trust agreement to expand his own power to include that litigation power.

The last case that I’ll mention is Accident Insurance v. U.S. Bank, which is a fourth circuit case. The gist there is to understand the entirety of the documents in play, which goes back to what both you and Jocelyn were talking about in the drafting context. The thrust of the plaintiff’s complaint there was that the defendant trustee improperly accepted certain assets to then distribute out to the beneficiary, ultimately under the trust. The defendant claimed that the trust agreement absolved it of any duty or responsibility involving the qualification character or valuation of trust assets. The defendant was also appointed to direct a trust provision allowing it to follow and rely upon all instructions from the plaintiff and grantor unless a trust agreement provided otherwise. Unfortunately, for the defendant, a separate trust provision, which wasn’t in the same place as some of the directed trust provisions, required the defendant, before accepting any asset for deposit, to determine that such asset is in a form that the plaintiff or the defendant could negotiate and distribute without consent or signature from any other entity or third party. In that case, that wasn’t what happened here.

So, although the defendant wouldn’t incur any liability for actions it took in good faith, reliance on the instructions from the grantor or the plaintiff for any loss arising out of the performance of its contractual duties, the court found that under the trust agreement, there were situations where the defendant would not be a directed trustee, which in this case, included accepting qualifying assets.

So, in the end, the court found that the provisions that the defendant relied on to explain its directed trustee role were subordinate to the contract terms that provided otherwise. So, the trust agreement obliged the defendant to reject any proposed asset that it determined after due diligence was non-negotiable without third-party consent.

Jocelyn Borowsky: So, that sounds like a failure to understand the scope of authority in Accident Insurance, and Shelton v. Tamposi, this is sort of the intersection of directing distributions by a party who’s not in charge of directing investments. And since that case, we’ve updated our forms to coordinate those powers together so they work together.

Laura, what were some other issues that routinely come up with directed trusts that might benefit from being addressed in a trust agreement?

Laura Mandel: Certain directed investment decisions may place the trustee in a conflicted position. For example, if an investment trust director directs the trustee to make loans and pledge trust assets as collateral, what if the loan is being made by the corporate trustee’s banking department and the bank is therefore acting in two capacities, lender and trustee? The lender has a right to collect assets if the loan is non-performing but a fiduciary has a duty to preserve trust property. We include language in our forms defining the scope of a trust director’s investment authority along with related exoneration and waiver of conflict provisions where the trustee is acting as both trustee and lender.

Also, consider who’s responsible for the valuation of assets. It’s usually the investment trust director, but make it clear in the terms of the instrument. In practice, many corporate trustees will send an annual request to trust directors to provide a current valuation for all assets. Consider the respective roles of the trust director and the directed trustee if litigation occurs, especially if that litigation is related to directed investments. From a drafting perspective, it may be advisable for the terms of the trust to confer on a trust director a power to participate or even direct litigation in some cases.

Joycelyn, let’s talk about exoneration. Most states’ statutes exonerate a directed trustee from loss, but can you drill down on some of the differences between the state statutes and the uniform acts?

Directed Trustee Protections – Exoneration

Jocelyn Borowsky: Sure. There are about four different types of these statutes. And at one end of the spectrum is the uniform trust code, which does not expressly exonerate a directed trustee. At the other end of the spectrum, you have states like Nevada and a handful of other states that follow the Nevada model, which provides that a directed trustee is not liable for loss in complying with a directed act.

Delaware has a low liability statute which provides that the directed trustee is not liable as long as it does not act with its own willful misconduct. And then, there’s the Uniform Directed Trust Act, which uses the willful misconduct type language but is not quite the same thing as Delaware. The UDTA provides that the directed trustee will not be liable for reasonably complying with the directed act but must not carry out the directed act if doing so would be an act of willful misconduct. The preamble to UDTA states that a directed trustee is not liable except for its own willful misconduct, like Delaware. But leading practitioners critique the UDTA for the uncertainty that is injected into determining whether complying with the act is itself willful misconduct. The criticism is that by making the directed trustee responsible for determining whether the trust director’s directed direction is an act of willful misconduct.

The trustee must monitor the trust director or evaluate the merits of the directed act.

Laura Mandel: Jocelyn, are there any other differences between the Uniformed Directed Trust Act and leading trust law states?

Jocelyn Borowsky: Yes. Well, the Uniform Directed Trust Act imposes a requirement of reasonable compliance with the directed act. If the directed trustee reasonably tries to comply but fails to do so, it’s not liable. This injects uncertainty into compliance if the trustee cannot carry out the act.

In contrast, the Nevada-directed trust statute and similar statutes have a different approach. If the directed act to subject to a condition precedent which is not fulfilled then the trustee is not liable for failure to comply. There is no reasonable compliance standard. Delaware does not have a reasonable compliance standard either. In the Fischberg case, the directed trustee- that’s a Delaware case- refused to comply with the direction to transfer funds to an offshore trust for the beneficiaries who were facing criminal indictment. The trustee was not liable for failure to comply with the direction in that context.

Laura Mendel: Jocelyn, is there a duty to share information among the parties?

Uniform Directed Trusts Act – Duty to Share

Jocelyn Borowsky: The Uniform Directed Trust Act imposes an affirmative duty to share information with other interested parties. The Delaware statute imposes a duty to share information with interested parties but only upon request. And then Nevada and similar statutes do not have any duty to share information.

Laura Mendel: So, Jocelyn, what do courts make of these statutes?

Jocelyn Borowsky:    Well, in Delaware, we have the Duemler case, which came out in 2004. And in that case, the court upheld Delaware’s directed trust statute. There the trustee got a prospectus about a share tender offer, it sent it on to the investment adviser and the trust director. The trust director took no action and did not direct the trustee in any matter. And then, there was a loss. Then, the trust director turned around and sued the directed trustee. The court held in favor of the directed trustee. Why? Because the statute is really clear.

As long as the directed trustee did not act with its own willful misconduct, then it’s not liable for the loss. And the court clearly understood that this fell on the shoulders of the trust director; it was the trust director’s responsibility to protect the trust and invest its assets and failing to do so was not the fault of the trustee.

Shaheen, what do other courts make of directed trusts?

Shaheen Imami: Well, it depends on the state. Most aren’t Delaware, let’s be clear about that. And even in states that have a directed trust statute, you should be looking at even states that don’t have a directed trust statute. For instance, mens rea Remus, which is a New York case, the court held that despite clear language in a trust agreement that absolved the trustee from liability for carrying out the written duties of the investment committee, accountability is an essential element of all fiduciary relationships that can’t be waived. And so, that’s something I think that you probably ought to look at across the board when you’re considering any situation where your trustee, your directed trustee, might be exposed.

So, the court there actually found that if a trustee’s concern that following the directions of an advisory committee or director may result in a breach of fiduciary duty, the trustee is required to come to the court for instruction. In a similar manner to when two fiduciaries don’t agree on how to administer an estate.

So, under the facts at hand, the court found it was proper for the trustee to have come to it asking if it was okay to follow the direction of the advisory committee and that the trustee would have been liable for a breach of fiduciary duty had it not done so. Similarly, in Hurtado v. Rainbow Disposal, which was a district court case, a U.S. District Case that is, out of California, and it’s an ERISA case, so it’s not exactly the same, but it’s important for what it holds.

The court there stressed that under the duty of prudence, a directed trustee can disobey the named fiduciary or director’s directions when it’s plain that the directions are imprudent. And so, the plaintiffs there plausibly allege that the trustee violated its fiduciary by failing to act in the face of a self-dealing transaction.

So, it’s kind of one of those situations where you might go to a military order in saying that you’re not obliged to follow an immoral order. It’s kind of one of those circumstances where the trustee probably ought to think about, well, what does it really believe is being done here? And should it follow it and, if it thinks that there’s a question, maybe it does go to court to find out.

Doug Stanley: Shaheen, Jocelyn and Laura thank you for this thoughtful discussion on directed trusts and the relative state laws.

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