The next few decades will see global intergenerational wealth transfers on an unprecedented and almost unimaginable scale. Some estimates range from $15 trillion to more than $40 trillion, but whatever the actual amount turns out to be, it will be mind boggling.
Family offices and high-net-worth individuals are and will be front and center in tackling the challenge of managing this transfer, in most instances using increasingly sophisticated estate-planning strategies and structures. Many of these structures will involve individuals or institutions acting in a fiduciary capacity; for example, as trustee of personal trusts or executor or administrator of personal estates.
Those individuals and institutions will be trusted to make intelligent, appropriate decisions that effectively implement the intended plan and further the interests of both the giving and the receiving generations, while often dealing with facts and circumstances unknown or even unforeseeable at the time of their appointment. In recognition of that trust, they’re often given the extraordinary power, and the concomitantly awesome responsibility, of exercising almost unfettered discretion when making those decisions. With that power comes considerable potential risk, both personally and financially.
Trustee’s Duties
The trustee’s principal duties fall generally within the categories of prudence, loyalty and impartiality.
Prudence. This duty requires that the trustee deal with the trust property as a man or woman of reasonable prudence would deal with their own property, taking into account risk and pursuing the reasonable generation of income and the preservation of capital. In most instances, the trustee must also ensure that the assets are properly diversified. This concept is known as the “prudent person rule” and is codified in the Uniform Prudent Investor Act.
Loyalty. This duty requires the trustee to put the interests of the trust and its beneficiaries above its own and to avoid both actual and perceived conflicts of interest.
Impartiality. This duty prohibits the trustee from treating beneficiaries with similar interests differently; that is, the trustee can’t improperly discriminate among beneficiaries.
It’s not unusual for a single trust to have multiple beneficiaries with significantly different interests and expectations. “Typical Irrevocable Trust Schema,” p. 47, illustrates a typical trust structure under which a grantor has made a gift of certain assets to a trust for the benefit of three beneficiaries. One beneficiary is entitled to the income generated by the trust assets for the trust’s duration, while the other two are entitled only to what remains in the trust on its termination.
From an investment perspective, the interests of these two classes of beneficiaries are diametrically opposed: For example, the income beneficiary would want the trust investments skewed toward income (perhaps entirely in high yielding bonds with little potential for capital appreciation) while the remainder beneficiaries, who would care nothing about current income, would want the portfolio invested for long-term growth (for example, entirely in low or no-dividend stocks). The trustee’s responsibility is to balance these competing needs and seek to provide adequate income for the one beneficiary and adequate capital appreciation for the other two. Given that neither class of beneficiaries is likely to be satisfied with the result, this arrangement is often jokingly referred to as the “duty to disappoint equally,” though most trustees faced with the situation find it nothing to laugh at.
Fiduciary Tasks
The trustee’s tasks fall roughly into four categories: administering; investing; reporting; and discretionary decision making.
Administering. This includes a number of mundane but critically important actions such as: opening and closing bank accounts; calculation and payment of distributions; compiling and maintaining records of correspondence and transactions (for example, income, expenses, assets) not otherwise handled by the external trust custodian, if any; interfacing with external tax and other professionals to ensure timely preparing and filing of trust tax returns and payment of taxes due (the trustee has personal liability for ensuring filing and proper payment); arranging for separate principal and income reporting if applicable; scheduling, minuting and memorializing regular investment and administrative reviews; and authorizing and signing off on subscriptions and redemptions for alternative investments.
Investing. This involves determining the investment allocation best suited to advance the purpose of the trust; if necessary, selecting (and monitoring), hiring and firing investment managers and regularly evaluating their performance against objectives. The test of the trustee’s standard of performance is actually more one of process than result. For example, a trustee isn’t the guarantor of an investment’s performance. If the trustee can show, usually by contemporaneous documentary evidence, that its decision-making process was prudent (for example, it considered all the relevant facts and factors, evaluated all available options in light of the objective(s) sought and made a decision that was reasonable under the circumstances), then the trustee shouldn’t be held to be in breach of its duty of prudent investing even if the investment didn’t perform as anticipated.
However, if the trustee doesn’t have sufficient evidence that it followed a prudent path, or even remembered what it had done so long ago, the absence of a reasonable explanation can be used to create the inference (greatly aided by 20/20 hindsight) that the decision was imprudent, and the trustee can be held liable to make restitution to the trust.
Reporting. For all transactions affecting the trust, the trustee must: (1) identify who’s entitled/required to receive information with respect to the trust; and (2) provide regular reports and accountings.
Discretionary decision making. This is the ultimate fiduciary responsibility—deciding whether, when, to whom and to what extent to: make trust distributions; allocate between income and principal; or terminate, split or change the jurisdictional situs of the trust.
All of these tasks are important, and they must be undertaken and completed with care lest failure be considered a breach of trust for which the trustee would be personally liable, even to the full extent of their personal assets.
Discretionary Decision Making
The principal reason why wealthy individuals choose the trustees they do is for the trustees to make discretionary decisions with respect to trust assets (for example, who gets them, when, why and how) as the grantors themselves might do if they were still alive and capable. It’s often both the most difficult and the most impactful aspect of the trustee’s role and the one aspect for which a potential trustee’s nature, character and relationship with the trust grantor and their family immediately and sufficiently qualifies them.
However, many trustees come to the role without special qualifications or even the time or interest, to perform the other roles. The most typical task requiring professional assistance is investment management, and while trustees generally are authorized to hire agents to perform that role, in most instances the trustee is still held to the standard of due care in selecting the investment manager and must actively monitor the manager’s performance. Only in certain limited circumstances can the trustee avoid liability for imprudent management of trust assets by others. In all cases, the trustee must provide information, including regular reporting, to certain parties, and must eventually (if not also periodically) provide an accounting of its actions as trustee to the trust beneficiaries and often to the courts as well.
Finally, it’s impossible to ignore or exaggerate the importance of properly handling all of the administrative tasks incumbent on a trustee. Often, it’s the failure to handle these tasks properly that exposes a trustee to criticism by beneficiaries and courts and the risk of personal financial responsibility for resulting damage to the trust.
A Delicate Balance
Let’s assume the following scenario: Rod Paulson was a very successful hedge fund manager. Not surprisingly, he had many close friends in that industry, though none closer than Steve Lamberti. The two men were godfathers to each other’s children, and their families vacationed together regularly. In their respective estate plans, each named the other as trustee of family trusts to be established on death. They trusted each other unquestioningly to do the right thing at the appointed time.
Both men were risk takers, impatient and impetuous, disdaining detail and preferring to focus on “the big picture.” Unfortunately, and unexpectedly, Steve took one risk too many and died in a skydiving accident. Rod was devastated.
At the appropriate time, Rod sat down with his accountant and attorney to discuss the trusts of which he was now sole trustee. He fidgeted with boredom as the accountant chronicled in mind-numbing detail the nuances of process and record keeping required in fiduciary administration. He scowled in irritation when his attorney informed him that fiduciary rules limited his unfettered freedom in investing trust assets, particularly in his own hedge fund. And he stared angrily in disbelief when the attorney explained that fiduciaries are held to the highest standard under law and that his personal wealth—including his hedge fund—could be at risk if he failed to live up to that standard.
Distribution requests. Steve’s two sons, Mario and Paul, were grown and starting families of their own. In due time, they began to make requests for discretionary distributions from their trusts. Paul wanted to buy a large house on the water in another state, and Mario wanted to buy a very expensive Pagani Huayra sports car. Their stepmother Julia, Steve’s widow, strongly objected; though she was entitled to receive income from the trust during her lifetime and thus was also a beneficiary, she had no role in the administration of their trusts. Rod found himself uncomfortably in the middle of intense family disharmony—with pressure and the fiduciary responsibility to make a timely decision on the distribution requests.
Rod was extremely frustrated. The responsibilities of trust administration were distracting him from his business, and his relationship with the trust beneficiaries was beginning to fray, causing him to worry about possible challenges to his performance as trustee. To top it off, he had agreed to serve as trustee for no remuneration, as a favor to his friend Steve. Under normal circumstances, he would simply step out of the role. He had considered the idea of resigning in favor of an institutional trustee, but rejected it because he felt honor-bound to fulfill his late friend’s wishes personally. He also felt he was a better investment manager. And he rejected the idea of serving with an institutional trustee as co-trustee because he was inherently unwilling to share decision making. Basically, he was stuck, feeling out of his depth and none too happy about it. He could use some advice.
How to proceed. If asked, here’s how I would counsel Rod to proceed: First, I would suggest he reach out to Julia to hear her concerns. Most likely, she’s worried about the impact of any principal distributions on the level of income she would receive from the trusts. That’s a legitimate concern and one that Rod must take into account when making his decisions. Julia may also have unique insights into what Steve intended when setting up the trusts, which could help inform Rod’s decision making generally.
There may be other issues and concerns, and possibly some animosity between Julia and the boys; Rod must evaluate those concerns fairly but must avoid allowing Julia’s personal feelings to affect performance of his duty of impartiality among all trust beneficiaries. It’s my experience that Rod’s best course of action would be to listen carefully and empathetically to Julia’s concerns without immediately committing to any particular action. Sometimes, people just need to feel that they’re being heard.
Mario’s request to buy a “supercar” is problematic on a number of fronts. While some supercars can appreciate significantly in value over time, they’re known as high risk investments, the success of which depends highly on a buyer’s knowledge and market intuition. They wouldn’t generally be a prudent trust investment, especially absent such expertise. Presumably, Mario’s intent is to drive the car; however, he’s still in his early 20s, and there are too many instances of young men losing control of these high powered machines with tragic consequences for Rod to ignore.
Given the fact that it’s not unreasonable for a young man to want a nice car, my recommendation to Rod would be to say no to the Pagani but yes to a distribution sufficient to purchase a more reasonable performance car, but condition that distribution on Mario’s successful completion of a performance driving course.
Here’s what I would recommend Rod consider:
Agree to make a principal distribution to assist Paul and his wife in buying a new house. In determining the proper amount of that distribution, I would suggest Rod look to local market data, particularly average house prices in the town, city or county where they wish to purchase. Rod could then offer to distribute principal in that amount, with Paul and his wife responsible for selecting a house and financing any excess. To my mind, this would be a reasonable response to the distribution request, consistent with the likely intent of the trust instrument and responsibly responsive to Julia’s concern about impact on her income distributions. To the extent that these principal distributions materially impact Julia’s level of income, Rod could consider exercising his “power to adjust” authority under the trust instrument to invade principal to make up the shortfall.
The suggestions above are just examples of possible solutions to Rod’s dilemma; there may be others equally appropriate to the situation. The key is to have a process for identifying the issues, gathering appropriate information, having a reasonable basis for making the decision and then documenting that decision, its rationale and support for potential use in defending the reasonableness of the decision in the future.
Family Office Manager’s Dilemma
Here’s another scenario to consider: Michael Petersen is CEO of the Miami-based W Family Office, responsible for overseeing more than $650 million in collective assets for 39 family members spread across three generations. The assets are held in multiple structures, including a number of trusts for which Michael serves personally as trustee. One of those trusts holds $10 million in investable assets for the benefit of twin brothers, James and John.
Despite being identical twins, the brothers are quite different. James is very entrepreneurial and has a real talent for business; as a result, he’s already very well off financially. John is more of an academic and is very happy with his life as a boarding school teacher and soccer coach. Both are married but have no children. They each receive about $200,000 in annual income distributions from the trust. The trust terminates on the death of the last of them, and the remainder is distributed to their heirs, per stirpes (the trust had been structured intentionally to benefit the next generation and was fully exempt from generation-skipping transfer (GST) tax).
Request for investment capital. James has come to Michael seeking a $3 million capital investment in a new venture James is starting. While a high risk proposition initially, James is convinced that the investment will quadruple in value in under three years, and he has the track record to support his conviction. While he would prefer a principal distribution in the requested amount, it would also meet his needs if the trust made a direct investment in the venture. James argues that, because the proposed investment of $3 million would consume less than his half “share” of the total trust corpus, there would be no harm to John, and he should be allowed to allocate that amount to this particular investment. He notes that while the investment won’t generate any current income, that’s acceptable because he has other sources of income. James needs an answer very soon or the business opportunity he’s seeking to take advantage of may disappear.
Michael finds himself in a difficult position. As sole trustee, he has the power to make either the distribution or the investment, but must consider the impact on the trust beneficiaries, both present and future. Michael is reluctant to make a principal distribution to James as that would “waste” some of the GST tax exemption allocated to the trust. He knows that John and his wife intend to start a family of their own, and may even adopt, whereas James and his wife don’t plan to have any children. A speculative investment may be appropriate for James as he and his family likely won’t benefit from a remainder interest in the trust, and he doesn’t need the income. John, on the other hand, has a reasonable expectation that his family will benefit from a remainder interest, and he relies heavily on trust income to subsidize his lifestyle. What should Michael do?
Possible solution. There are a number of possible solutions Michael could consider. Here’s one: Michael could turn down the request for a distribution and then exercise his discretion to bifurcate or decant the trust into two separate $5 million trusts, one for James and one for John. The trusts could provide that if either died without heirs, the remainder from that trust would be transferred to the other. Michael could then make the requested investment in James’ trust (with James as beneficiary providing a written approval of the investment, the resulting decrease in income and a waiver of any future claim for breach of duty to diversify). John’s trust would remain invested as is, and he would continue to receive his current level of income. Michael would be wise to obtain a similar approval of the bifurcation arrangement from John.
A Cautionary Tale
With the benefit of sound fiduciary advice, the two scenarios above had positive outcomes. Unfortunately, that’s not always the case, as the following real-life example shows.
Pamela Harriman, Clark Clifford and Paul Warnke were the crème de la crème of Washington politics, luminaries of the D.C. establishment and among the veritable best and brightest of the American political scene. Pamela had used her inheritance and status as the widow of Averell Harriman to enhance her lifestyle and advance her party’s political agenda, ultimately becoming the U.S. ambassador to France. She was “the belle of the ball.” And they were the wisest of “wise men.” All three were trustees of various Harriman family trusts for the benefit of Averell’s children from a previous marriage.
Yet somehow, the glittering doyenne and the titans of probity managed to lose over $40 million of the Harriman trust assets, principally by relying too heavily on the advice of scoundrels and investing in a disastrous real estate project that had once been a Playboy Hotel. In addition, Pamela had borrowed funds from a trust of which she was trustee (a clear breach of her fiduciary duty of loyalty); when the trust terminated, almost all of the trust assets consisted of IOUs from Pamela.
Their excuses weren’t exactly compelling: Pamela claimed not to have been actively involved with the trusts (except to the extent of her self-conflicted borrowing); Clark said that he had trusted the investment manager to make the investment decisions; and Paul claimed to have been kept in the dark regarding all trust transactions. None of these arguments shielded them from fiduciary liability.
While we don’t know exactly how much the three trustees had to pay to the trusts in restitution, we do know that Pamela was forced to sell key items from her treasured art collection, and at one point Clark was expected to contribute $3 million of his personal funds. Everyone associated with the estate was sued, including Averell’s former firm and the law firm that had prepared the original estate documents. The case made headlines across the globe.
And the moral of this story? Even the best and brightest can do some of the worst and stupidest things when acting as trustee. And they do so at their peril.
Enter the Lawyers
Recent years have seen an increase in litigation against trustees, and many law firms now list “fiduciary litigation” as a specialty. Institutional trustees are a favorite target, as they have deep pockets and large numbers of clients who can bring class action claims. Jury awards can be staggering—I served as an expert witness on trust matters in the successful appeal of a $350 million jury award against a large U.S. bank—and the scope of the intergenerational wealth transfer referenced above will only encourage more litigation. Individual trustees and family office personnel will also be likely targets in this wave of litigation and must be aware that claims may be brought well into the future by beneficiaries not even born today.
A Good Safety Net
The term “high wire act” is often used figuratively to refer to something that’s difficult or dangerous or a situation in which it would be easy to do the wrong thing. Based on the examples above, it seems an apt metaphor for some of the challenges trustees may face when attempting to fulfill their fiduciary obligations. Fortunately, there are a number of sources that a trustee may look to for support and assistance in meeting those challenges—a “safety net” of sorts to help prevent the trustee from getting “injured.” Here are some potential sources of assistance:
Corporate trustee as co-trustee. Benefits include: expertise; continuity; complete set of administrative, reporting and risk management capabilities; dedicated fiduciary professional(s); tax reporting services. Considerations include: usually insist on handling investment management; corporate reorganizations and staff turnover can adversely impact relationship; some institutions can appear to be bureaucratic and distant; need to have a mechanism to address resolution of potential disagreements among co-trustees; standardized fees may seem expensive.
Corporate trustee as agent for trustee. Similar benefits and concerns as above; usually requires investment management; firms vary in the degree to which they’ll provide fiduciary-related guidance (for example, discretionary decision-making advice); may be (though not necessarily are) less expensive than when serving as trustee.
Corporate trustee as administrative trustee or agent. Administrative and reporting support only; doesn’t include investment management and typically provides no fiduciary-related guidance; fees are generally discounted below normal trust fees to reflect reduced responsibilities and attendant liability.
Corporate trustee or custodian as recordkeeper. Basically a custodial offering with fiduciary-specific features such as principal and income accounting and consolidated reporting (that is, including “held-away” assets); fees are generally slightly above custody fees.
Outsourced support for fiduciary and administrative functions. Contractual arrangements with boutique providers of fiduciary-specific administrative support and fiduciary guidance, customized to the individual trustee’s needs and potentially supportive of enhanced fiduciary liability insurance at reasonable rates.
Risky Business
In many ways, individual trustees are the most at risk. Like Rod Paulson, the hedge fund manager in the first scenario, most individuals aren’t prepared to undertake all of the tasks required of a fiduciary. They may not have the time to devote to the job or the interest or patience to attend to the minutiae involved. They may not have the support for or the discipline to maintain the records necessary to evidence the prudence of their actions should that be questioned in the future. And they likely don’t have the type or scope of insurance coverage to protect their personal wealth from dissipation via litigation.
The trustees in all three of the fiduciary situations described above would have benefited greatly from the advice of an experienced fiduciary professional. Rod would also have benefited from the assistance and support of an individual or firm experienced in fiduciary administration, process management and record keeping, and both Rod and Michael would have benefited from fiduciary liability insurance (it’s doubtful that Pamela, Clark and Paul would have qualified). Fortunately, there are providers of all three services that can be offered individually or in concert. Together, they can provide the sort of customized safety net that can help individuals say “yes” to the fiduciary request.
— This article was adapted from one that originally appeared in the December 2019 issue of The International Family Offices Journal.