FIDUCIARY RISK MANAGEMENT

TAX MANAGEMENT

Estates, Gifts, and Trusts Advisory Board Meeting

New York City

March 16, 2006

Presented by:

Richard M. Horwood

Horwood Marcus & Berk Chartered

180 North LaSalle Street, Suite 3700

Chicago, Illinois 60601

(312) 606-3200

Prepared by:

Lauren J. Wolven

Jeffrey A. Zaluda

Horwood Marcus & Berk Chartered

180 North LaSalle Street, Suite 3700

Chicago, Illinois 60601

(312) 606-3200

305975/1/5250.012

©2006 Horwood Marcus & Berk Chartered

Fiduciary Risk Management

March 16, 2006

Page 1

FIDUCIARY RISK MANAGEMENT

The phrase “risk management” used to conger up a picture of a corporate technocrat walking through a warehouse with his property and casualty carrier, identifying shaky pallets. But, litigation and regulation have expanded the use of the term to almost all business venues. For a fiduciary the term encompasses several different concepts: (1) accurate and adequate analysis of the potential liability issues involved in accepting a fiduciary position; (2) avoiding action or inaction that could anger or damage a beneficiary or result in a loss to the fiduciary estate; (3) dealing with inflammatory situations; and (4) preparing to defend in a litigation scenario.

The reality is that as long as there are trusts and estates with beneficiaries, there will be lawsuits. Proper risk management, however, should position a fiduciary so litigation rarely, if ever, is unanticipated, and so the fiduciary is always prepared, through proper administration and documentary evidence, to defend. This article explores steps the fiduciary or potential fiduciary can take to defend itself when dealing with less-than-perfectly drafted trusts and wills.

A.Document Review

Before accepting a position as fiduciary, it is crucial to review all governing documents for potential liability issues. If a document has gaps, is ambiguous, or requires the fiduciary to deviate from the standards normally dictated by fiduciary duties, supplemental written agreements or indemnifications may be warranted.

1.Ambiguities

Ambiguities in a document can be patent or latent. A patent ambiguity is one that appears in the language of the document itself.[1] A latent ambiguity does not appear on the face of the document, but results only when reference to outside information is made (e.g., erroneously described real estate).

From the perspective of the courts, an ambiguity does not exist solely because the parties disagree as to the meaning of the document. An ambiguity exists only if the language at issue in the governing document is reasonably susceptible to multiple interpretations.[2] The determination as to whether multiple interpretations are reasonable typically is made after established principles of law are applied in an effort to clarify the uncertainty.[3] Whether or not a true ambiguity exists is a question of law.[4] If a true ambiguity exists, a court order may be necessary to resolve the confusion and protect the fiduciary.

2.Administrative Concerns

Ambiguities are not the only potential liability issue that can be discovered in a careful document review, however. Administrative risk may also become apparent in light of the direction given to the fiduciary in the governing agreement.

If, for example, a trust agreement provides that the trustee must invest entirely in fixed income securities, the trustee is bound to follow the trust agreement but will be violating the duty to diversify. Although it may be argued that the settlor has waived the duty to diversify, thereby relieving the trustee from that obligation, courts have held that a trustee remains obligated to invest reasonably.[5] In this scenario, a written indemnification from the beneficiaries or other risk management actions by the trustee may be warranted.

3.Considerations for Document Review

When reviewing a governing document, the potential fiduciary should have adequate facts before him regarding the elements of the administration that cannot be found in the four corners of the document. At a minimum, the fiduciary should have available a family tree that identifies current beneficiaries and remaindermen, and the family tree also should indicate which beneficiaries are minors or under other legal disability. A general overview of family relationships is helpful, as is a rough sketch of relative family financial resources. It would also be useful to know which beneficiaries had previously had more “strained” relations with prior fiduciaries than others.

In the example above, the reactions of the remaindermen may be very different if the current beneficiary is an older family member with limited resources than they would be if the current beneficiary is the wealthiest member of the family. The family circumstances typically will dictate what type of risk management is warranted and must be considered in the cost-benefit analysis for risk management activities.

The following table sets forth broad principles to keep in mind when reviewing a document in anticipation of accepting a fiduciary position and highlights some of issues to consider.

Legalese is not your friend /
  • Make certain that legal terms such as “per stirpes” have been used properly.
  • “Notwithstanding anything in this agreement to the contrary” and similar phrases invite the reader to look for contradictions in every other part of the document, so make certain contradictions are identified

Boring is best /
  • Check that the language used to describe bequests or give other directions to the fiduciary is clear and consistent
  • Review the document for items requiring interpretation[6]
  • If the document contains a complex formula, try to run the formula in a hypothetical and see if all parties involved agree with the interpretation of the formula

Who’s on first? /
  • Identify the players named or identifiable in the document (including those who may be heirs but not beneficiaries, legatees or devisees) and make a chart of family relationships, if necessary

Timing is everything /
  • Confirm that notice and exercise of rights provisions, indicate a clear cut-off date (e.g. 30
days after the Trustee sends the notice by U.S. mail)
  • Check that the document indicates whether a bequest is made or a subtrust is funded even if
the primary beneficiary of the subtrust does not survive the settlor
  • Consider all reasonable contingencies and determine whether the distribution scheme is clear

4.Possible “Quick Fixes”

Where amendments are possible, the fiduciary should request that the governing document be amended in order to clarify any gaps or resolve any inconsistencies. Even irrevocable documents may be subject to amendment via trust protectors, powers of appointment, or various trustee administrative powers. Also, consider consulting with the drafting attorney, if possible, for an explanation of confusing language. If the attorney is able to provide clarification, request that the explanation be put in writing.

When a problematic document is not amendable, look first to the fundamental rules of construction to try to determine what a court might find if the question were brought to the court for a decision. Even if the case law is clear, consider requesting a letter from the drafting attorney or obtaining an attorney opinion letter from trust counsel as to the legal reasoning supporting the interpretation of the document. Clarification in this manner is advisable even in a situation where all parties are friendly to the fiduciary.

If a clarification is possible by reference to statutory or case law, the fiduciary should be certain to document in writing that research was done and why a particular conclusion was reached.

5.Rules of Construction

a.Application

Rules of construction are to be used only where a document contains no express answer to a particular question.[7] When a document is clear, but the terms are undesirable, it generally is improper to attempt to apply the rules of construction to the document in an effort to deviate from the express intent of the settlor.

b.Governing Principles

Whenever any uncertainty arises regarding language in a governing document, reference should be made to the applicable state law to determine whether statutes or case law can provide a resolution to the question at hand. Generally, the rules of construction for trusts are the same as the rules of construction for wills.[8] Intent of the testator is the governing principle, and the main purpose of applying legal authority to construe a document is to determine the settlor’s intent.[9]

The settlor’s intent should be determined by looking at the entire document[10], and by reviewing the plain language of the document, giving the words used their ordinary meaning.[11] Words and clauses should not be ignored merely because they produce an undesirable result. Meaning and effect should be given to every clause of the document, if possible.[12] Once it has been determined, the intent of the settlor is to be carried out unless it is contrary to public policy.[13] When the governing document provides clear instruction to the fiduciary, but the fiduciary or beneficiaries have strong evidence indicating contrary settlor’s intent, an action for reformation may be appropriate.

At times, however, the rules of construction, as applied, may conflict with basic principles of equity or with other rules of law. Though the rules are fairly well-established, the courts can be fickle. For example, two opinions from Illinois highlight the uncertainty surrounding these supposedly well-established rules. In Altemeier v. Harris, 86 N.E.2d 229, 233 (Ill. 1949), the court stated,

“It frequently happens that a certain equitable principle may be well established as applied to a given state of facts but will not control when additional facts would produce a situation which would make its application contravene other settled rules of law. Yet, when a case arises in which there are facts present that require the application of different principles, it is the duty of the court to be cautious, and to be careful not to render a decision which may be favorable to the parties at the expense of disturbing settled principles.”

Compare that with Harris Trust and Sav. Bank v. Beach, 513 N.E.2d 833, 834 (Ill. 1987), where the court held,

“Rules of construction, which are applied in the same manner to both wills and trusts, are court created presumptions of what the ordinary settlor or testator would have intended the ambiguous terms to mean; they are merely the court’s own assessments of what the person probably meant when the provision was drafted. Such rules should not be allowed to defeat what the ordinary settlor would have intended. When a rule of construction tends to subvert intentions, the rule is no longer legitimate and must be discarded.” [Citations omitted.]

Thus, if strict reference to the rules of construction produces what the fiduciary considers an odd or unjust result, court action may be recommended to ensure the fiduciary of liability protection.

c.Presumptions

Certain courts apply presumptions that favor family of the testator and those the testator chooses to benefit in the governing document. For example, in resolving an ambiguity, some courts apply a presumption that a testator intends that the property pass in a manner that avoids intestacy.[14] As one court stated,

“It has been observed on multiple occasions that the only reason anyone can have for making a will is to change the devolution of his property from that prescribed by the statutes of descent and distributions. Hence there is a strong presumption that the testator intended to dispose of his entire estate, and courts are decidedly averse to adopting any construction of a will which leaves a testator intestate as to any portion of his estate, unless compelled to do so.”[15]

One issue that arises frequently in the context of construction of governing documents involves distribution of a share provided for a beneficiary who dies prior to the moment his share is funded when the document is silent as to an alternate distribution scheme. As a general rule, a testator must clearly indicate an intention to disinherit heirs.[16] Also, in the absence of a contrary intention, case law may provide that a per stirpes distribution is favored.[17]

Some states also have anti-lapse statutes that apply to fill in the gaps when an alternative distribution scheme has not been set forth in the document. In other words, the statute applies unless the testator has specified that it will not apply. In general, the primary purpose of these statutes is to avoid intestacy resulting from the prior death of a legatee. Generally, in the construction of anti-lapse statutes, state legislatures craft the statutes in order to allow close biological family members to become substitute takers when a testator’s bequest fails.[18]

The Uniform Probate Code (“UPC”) provides an illustration of a typical anti-lapse statute. Many states have adopted either the 1991 UPC version of the anti-lapse statute or the predecessor version of the UPC.

Code / Code Reference / Terms
Unif. Prob. Code / § 2-603 (1990) /
  • If the devisee is a grandparent, lineal descendant of a grandparent, or stepchild of the testator or the donor of the power of appointment exercised by the testator’s will, and this devisee predeceases the testator, various scenarios may occur:
  • If the gift is not a class gift, a substitute gift is created in the devisee’s surviving descendants.
  • If the gift is a class gift, with exception for a gift to “issue,” “descendants,” heirs of the body,” “heirs,” “next of kin,” “relatives,” or “family”, a substitute gift is created in the deceased devisee’s surviving descendants. The class members who survive the testator take shares proportionally as if the devisee survived the testator, and the devisee’s surviving descendants receive the share of the devisee.
  • If the will provides for an alternative gift when a substitute gift would otherwise be created under either of the above scenarios, the alternative gift prevails only if the designated devisee of the alternative gift is entitled to take under the will.

The following chart summarizes several typical anti-lapse statutes.

State / Statutory Reference / Terms
California / Cal. Prob. Code § 21110 and §240 /
  • If a transferee, specifically, kindred of the transferor/testator or kindred of a surviving, deceased, or former spouse of transferor, dies or is treated as having predeceased the testator, or the gift otherwise fails, the issue of the transferee take by representation.
  • The statute does not apply if the instrument expresses contrary intention or provides for a substitute gift.

Georgia / Ga. Code Ann. § 53-4-64 /
  • If a beneficiary predeceases the testator or the execution of the will, the beneficiary’s surviving descendants inherit intestate shares as if inheriting from the beneficiary.
  • Statute applies to class gifts unless contrary intent exists.

Illinois / 755 ILCS 5/4-11 /
  • If a descendant of the testator has died, the share goes per stirpes to the descendants of the deceased descendant.
  • If the gift is to a class and a member of the class dies, the other members of the class split the deceased member’s share (unless deceased member was a descendant of the testator, in which case rule #1 applies)
  • All other lapsed legacies go to the residue

Texas / Tex. Prob. Code Ann. § 68 (1997) /
  • Generally, if a devisee who is a descendant of the testator or descendant of the testator’s parent predeceases the testator or the execution of the will, or is otherwise treated as having predeceased the testator, the shares are divided per stirpes among descendants of the devisee who survived the testator by 120 hours.
  • With exception to the above scenario, if a gift fails for any reason, it goes to the residue.
  • If there are multiple devisees to a residuary estate and one of the devises fails, that share passes to the other residuary devisees in proportion to their interest in the residuary estate.
  • If all devisees to a residuary estate predecease the testator or the execution of the will, or are otherwise treated as having predeceased the testator, the residuary estate is distributed as if the testator died intestate.
  • Manifestations of contrary intent regarding application of the statute will be upheld.

In drafting a will or trust, practitioners should ensure that the client’s intent regarding what happens to a gift if an intended devisee fails to survive the testator.[19] Often, a document will make reference to heirs-at-law or a charitable entity as the ultimate taker.

While almost all states apply the anti-lapse statutes to class gifts, practitioners should refer to the anti-lapse statute in the applicable jurisdiction to determine whether the gift will be shared among fellow class members where a class member predeceases the testator. Also, where applicable, practitioners should determine whether the relevant statute specifically excludes application of the statute to class members who have died before execution of the will.[20] Where an anti-lapse statute does exist, it should be determined whether the statute applies in the trust context.

B.Managing Uncertainty in Governing Documents

1.Revising Unamendable Documents to Clarify Uncertainty

In determining the appropriate method for managing uncertainty created by a governing document, a risk-benefit analysis is appropriate. In many cases, the cost of a court proceeding is a deterrent to both fiduciaries and beneficiaries. The parties may look to resolve the issue by agreement rather than deplete the managed funds on attorney fees and court costs.

The first step is a careful scrutiny of the governing documents. Administrative clauses often provide the fiduciary with a hidden exit strategy. A trustee, for example, may have the authority to merge an existing trust into a new trust or to distribute the trust estate to create a new trust for any individual beneficiary. Powers of appointment may also be available to escape provisions of a governing document that do not contemplate the current family circumstances or financial climate.

Even when the document affords flexibility, a fiduciary should consider carefully the potential risks associated with departing from the original terms of the governing document. Particularly in a situation where beneficial interests are being altered, a fiduciary should consider requesting that the beneficiaries consent to the action and/or indemnify the fiduciary.

For a proposed alteration that will affect beneficial interests, the fiduciary must take particular care to adhere to its duty of impartiality. For example, it is not uncommon that a beneficiary approaches the fiduciary and requests a modification that favors the beneficiary over other beneficiaries. Simple examples of this might be an alteration in the investment provisions that favors growth over income, or the establishment of subtrusts for grandchildren when one child has more children than another. If the fiduciary determines it is appropriate to communicate the request to the other beneficiaries, the fiduciary should clearly identify in the written correspondence that it has been approached with a request and is merely conveying that request to determine the positions of the other beneficiaries on the proposal. In today’s litigious climate, fiduciaries must choose their words carefully in all instances.