United States: Estate & Trust Litigation - August 2004

This article first examines the various advantages and disadvantages of the use of a "trust protector" in irrevocable trusts. This is an increasingly popular technique used to add flexibility to the trust administration process, but in some cases, it can add an undesirable additional layer of expense and possibly other problems.

Our recent fiduciary case law round-up begins with a case involving a missing Iraqi general and a fiduciary's duty, or lack thereof, to consider the estate tax consequences of investments.

Next, following the thread of a trustee’s fiduciary duty as it relates to estate planning, Wells Fargo gets embroiled in a case where the court examines a trustee’s duty to review a trust instrument for estate planning effectiveness. This is a somewhat surprising decision that most professional trustees will want to read.

Our third and final case finds J.P. Morgan defending its investment performance in an unusual situation. The Morgan case may signal more judicial willingness to consider the effects of inflation and the time value of money when reviewing a fiduciary's investment record.

The use of trust protectors in trust documents is becoming more and more popular in today’s estate planning environment. The purpose of a trust protector is to provide flexibility to an irrevocable trust. However, before adding a trust protector to any documents, the grantor should carefully weigh the advantages and disadvantages inherent in the role of trust protector.

The trust protector holds a power to direct the trustee in matters relating to the trust. The role of the trust protector and the ability of the trust protector to direct the trustee will vary from trust to trust depending on specific drafting. The greatest advantage of having a trust protector named in a trust document is that it adds flexibility to the trust and allows the grantor to delegate someone to deal with almost every conceivable future circumstance. This is very attractive in today’s changing estate planning environment where the tax law is in flux. Use of a trust protector can allow amendment of the trust document to achieve positive tax results and allow administration consistent with the grantor’s intent when circumstances change.

The greatest disadvantage to the use of the trust protector is that the grantor is vesting significant power in one person. In addition, because the trust protector is often given the power to amend the trust to take into account the changes in the tax laws, beneficial interests may be altered. Finally, a common complaint of naming a trust protector is that it adds another level of administration and administration expense.

Technically, anyone can serve as a trust protector. However, in order to avoid adverse tax consequences (for both the grantor and the trust protector), it is generally advisable to name an independent third party as the trust protector. Trustees, beneficiaries or members of the donor’s immediate family are not independent parties and thus, should generally not be named as trust protectors. Lawyers, accountants, unrelated business-minded friends, brothers, sisters, aunts and uncles of the grantor are often a good choice for the trust protector role. Corporate fiduciaries are not necessarily the best choice due to the conservative view of many corporate fiduciaries which may make it difficult for them to exercise the authority they are granted.

The most important decision after determining who should act as the trust protector is to decide what powers the trust protector should have. This will vary depending on individual circumstances. However, in all cases, the grantor should be very careful in granting powers to the protector and should always have a complete understanding of the consequences of each power given to the trust protector. It is rarely a good idea to give the trust protector very broad powers to deal with every possible change in circumstances that may occur in the future. Instead, the grantor should anticipate the powers that will most likely assist in carrying out the trust purposes which would be better in the hands of someone other than the named trustee.

While there is no set list of powers that should be granted to a trust protector, there are some powers that would be helpful in most situations that the grantor should consider. For example, the trust protector could be given the power to amend the trust to comply with new tax laws or to address any changes in the law or circumstances of a trust or its beneficiaries that would significantly change the tax treatment of the trust or its beneficiaries. In addition, the trust protector could be given the power to terminate the trust or to remove, add or replace the trustee. Other powers could include the ability to change the governing law or to expand or limit the powers of the Trustee. Some powers, however, such as the power to grant, expand, reduce or eliminate a power of appointment, the power to change, eliminate or add provisions regarding the disposition of income and principal or the power to change beneficiaries should be looked at more closely before including them because beneficial interests could be completely altered. Care should be taken to clearly define the purposes of the trust and to give the trust protector ample guidance as to what is expected and allowed and what is not.

It is almost always a good idea to state in the trust document that the trust protector should serve such role in a fiduciary capacity. By specifying that this power must be exercised in a fiduciary capacity, the grantor is imposing a duty of loyalty and impartiality on the trust protector and ensuring that any actions the trust protector takes are for the good of the trust and its beneficiaries, rather that for his or her personal gain. There is an argument that even if the trust document does not clarify the fiduciary nature of the role or even if the trust document says the role of the trust protector is not fiduciary in nature, there will still be an implied duty of loyalty and impartiality because of the nature of the job as the "protector of the trust".

If a grantor does decide to name a trust protector, careful attention should be paid to make the document as clear as possible so the involvement of the trust protector does not unnecessarily complicate the trust administration or cause unwanted tax consequences. Most importantly, the trust protector should not be able to confer any beneficial interest in himself or his family members. Likewise, the trust protector should not be able to confer any beneficial or fiduciary interest upon the grantor. A limitation should be included in the trust document to prevent the trust protector from doing anything that would disqualify a disposition to the grantor’s spouse from the marital deduction or to disqualify a disposition from the charitable deduction. Similarly, the trust protector should be prohibited from doing anything that would cause the trust to fail from being treated as a "designated beneficiary" for the purposes of a qualified plan or IRA.

In the right circumstances, the use of a trust protector can be invaluable in giving the grantor the peace of mind that his intent will be carried out even if the laws or circumstances of named beneficiaries change. On the other hand, granting broad powers to a trust protector can cause unintended results and change beneficial interests that the grantor never intended. Before including a trust protector in any trust document, the grantor should have the opportunity to carefully consider the possible consequences of giving someone the powers he or she is contemplating. Most importantly, if a grantor does decide to add a trust protector to a trust document, the drafting attorney should carefully define and specify the powers of the trust protector, the limitations placed on the trust protector and the intent of the grantor in naming the protector.

General Ali, an Iraqi citizen and a nonresident alien, traveled to Atlanta from Iraq in March of 1989 for a visit with his son, Issam Namik. While in Atlanta, Ali arranged for a wire transfer from a Swiss bank account to Wachovia Bank. Ali and Namik then visited a branch of Wachovia, and purchased a $350,000 one-year CD with the money that had been transferred. Ali transferred additional funds to the Bank, at which time he purchased a $350,000 eighteen-month CD, as well as a $2,650,000 six-month CD (the "Jumbo CD") on March 15, 1989.

The next day, Ali returned to the Bank and met with Tom Slaughter, a trust officer. Slaughter met with Ali and Namik for approximately two hours, and Slaughter reviewed a Revocable Living Trust Agreement with Ali. After their discussion, Ali executed the Trust Agreement. No one at the Bank had any contact with Ali after this meeting.

When the Jumbo CD matured on September 11, 1989, Slaughter prepared a memorandum to his supervisor recounting the origin of Ali’s trust account. The Slaughter memorandum explained how the Trust was to be funded and indicated that Ali wanted "no market risks" and had requested that his funds be invested "only in U.S. Government issues." David Addison, a Bank trust officer assigned to the account, attempted to contact Ali in Atlanta and Iraq to no avail.

According to the Bank, the Slaughter memorandum did not provide sufficient information to determine Ali’s investment goals and create a permanent investment program. Because Ali could not be reached, the Bank invested the Trust funds in a taxfree Fidelity money market fund to maintain liquidity and protect the principal until the Bank could ascertain Ali’s long-term objectives. Over a year later, the Bank learned that Ali had been imprisoned upon his return to Iraq and had died in prison in May of 1990. Ali had no will, and the Bank was appointed administrator of Ali’s estate.

Ali’s estate was subject to United States estate tax, and the estate paid $933,248.49 in estate taxes to the Internal Revenue Service and the Georgia Department of Revenue. Because of the lapse of time between the date the return was due and the date of actual filing, the estate also had to pay $542,018.01 in interest. The remaining assets passed to Ali’s heirs.

The heart of the case is Namik’s claim that the Bank breached its fiduciary duties as trustee by failing to consider the estate tax consequences of its investment decisions and by disregarding Ali’s specific instructions regarding investments. Namik relied on provisions of the Internal Revenue Code which provide an exemption from estate taxes for assets of a nonresident alien which are invested in certain investments, including U.S. government issues.

The Georgia appellate court held that the trust in question was primarily an investment vehicle which contained no testamentary provisions. Moreover, the Slaughter memo was not a valid trust amendment and therefore, the trial court erred in holding that the Bank, as the trustee of a simple revocable living trust, had a duty not disclosed in the instrument to provide estate tax planning advice to Ali and to consider the tax consequences of its investments.

The appellate court noted that the trial court’s order effectively requires any bank making any investment on a customer’s behalf to consider the estate tax consequences of that investment, and Georgia law imposes no such requirement. The applicable statute merely indicated that "a trustee may consider . . . the anticipated tax consequences of the investments." In addition, the court noted that the Supreme Court of Georgia has declined to impose a duty on a fiduciary to inform itself and advise the beneficiary of obscure tax laws.

A senior trust officer at Wells Fargo Bank (n/k/a Norwest Bank) contacted Mr. Erickson to offer investment and estate planning assistance. The trust officer represented that he had knowledge on avoiding estate taxes and recommended an estate plan to that effect. Before Mr. Erickson could finalize his plan, he died. The trust officer then contacted Mrs. Erickson to express his condolences and offer to finish the estate planning work her husband had started; specifically, an irrevocable trust to take advantage of the annual exclusion amount. Mrs. Erickson had her neighbor, an attorney, draft the document, and the trust officer was aware that this attorney had no specific estate planning experience. The attorney failed to include Crummey powers necessary to provide the beneficiaries with a present interest under Section 2503 of the Internal Revenue Code. From 1985 through 1998, Mrs. Erickson contributed $440,000 to the trust. In 1988, however, the bank became concerned over the trust’s lack of Crummey powers and contacted the attorney requesting that he modify the trust, but this was never accomplished. The trust officer continued managing Mrs. Erickson’s finances and advising her to make continuing contributions to the trust. Upon Mrs. Erickson’s death, her estate had to recapture the $440,000 in gifts thus incurring over $173,000 in taxes. The Plaintiff (Mrs. Erickson’s daughter) sued the bank and trust officer, and the court found both defendants liable.

In upholding the lower court’s judgment against the bank and trust officer, the appellate court held, as an initial matter, that the bank had a duty to review the trust document for accuracy notwithstanding that the trust did not specifically impose a duty to review. The court stated that liability may be imposed upon one who, having no duty to act, nonetheless gratuitously undertakes to act and does so negligently. Accordingly, the bank created an assumed duty of review when it decided to notify the attorney about the missing Crummey provision. The court rejected the bank’s defense that opining on the trust’s validity would have been tantamount to the unauthorized practice of law stating that because the bank claimed to have trust expertise, advising about the necessity for Crummey provisions would not constitute the unauthorized practice of law. The court also rejected the bank’s defense that its notification of the drafting attorney should have been sufficient to fulfill its duty to Mrs. Erickson because of the trial court’s finding that, at the time the bank notified the attorney, that attorney no longer had a professional relationship with Mrs. Erickson. Finally, as further rationale for liability, the court noted that the bank had solicited Mrs. Erickson’s business and repeatedly informed her that the trust was an effective mechanism to reduce her estate taxes even after it became aware of the trust’s deficiency.

Plaintiff, Luiz Eduardo Fontes Williams ("Williams") and his brother, Anthony, are the remaindermen of the "Gem Trust," an intervivos trust created by their father in 1958.

Their mother, Maria Williams, a Brazilian citizen and resident, was the trust’s sole income beneficiary. J.P. Morgan was appointed trustee of the Trust at its creation.

In the late 1960s, the United States and Brazil began negotiating a bilateral tax treaty which, if approved, might have had adverse tax consequences on Maria Williams’s interest in the Trust. To avoid these consequences, Morgan liquidated the Trust assets in late 1970 and 1971 and invested the proceeds in tax-exempt bonds.

The treaty was never ratified. Morgan continued to invest the assets of the trust in tax-exempt bonds and cash rather than in potentially more lucrative alternatives until June 1, 2001, when Morgan reinvested the Trust assets in a diversified portfolio.

Williams filed suit against Morgan for breach of fiduciary duty as trustee. He alleged that Morgan mismanaged the Trust assets, wrongfully retained assets it should have sold, and failed to diversify the Trust assets. Williams further alleged that by January 1, 1975, Morgan knew or should have known that the treaty was not going to be ratified, and should not have continued to design the Trust’s investment strategy around the treaty’s possible ratification. On January 1, 1975, the Trust was valued at $767,123. When Morgan diversified the Trust assets on June 1, 2001, the Trust’s value was $787,221, an increase of about $20,000 over a 26 year period.

Morgan moved for summary judgment on the ground that even if it did breach its fiduciary duties as trustee, Williams suffered no damages. Morgan argued that the Trust did not lose any capital and that as a remainderman, Williams could sue only for lost capital.

Williams argued, even though the Trust’s actual paper value might have risen slightly between 1975 and 2001, the Trust lost as much as 70 percent of its real-world value. Morgan argued that the Court cannot consider the Trust’s real-world value but must instead limit its inquiry to the absolute numbers, and under this criteria, Williams "suffered no cognizable economic injury."

In applying New York law, the U.S. District Court stated that Morgan’s argument would require a court to dismiss any claim for breach of fiduciary duty when the trustee’s asset management yielded some net gain, no matter how slight, and no matter how many real missed opportunities may have existed at various intervening points at which the trustee reasonably could have pursued a more profitable investment plan. Furthermore, accepting Morgan’s argument would mean that a trustee could always escape potential liability for a breach of its fiduciary duties simply by maintaining the entire trust principal at all times in cash or cash-equivalent fixed income securities. Such a narrow, if highly protective, investment strategy is bound in the long term to produce no loss of capital on paper. Thus, under Morgan’s reasoning, as long as the trust suffered no diminution of principal, merely breaking even would always immunize the trustee from claims for breach of fiduciary duty. Consequently, simply by insulating the principal from any prospect of loss, the trustee would be under no obligation to exert any effort to improve the trust’s value and would risk no liability exposure for absence of long term performance of the account.

The crux of the court’s ruling is that banks hold themselves out to the public as possessing professional investment judgment and special skills honed and devoted to protecting and augmenting the value of funds entrusted to them. Morgan’s contention would convert a trustee or investment bank into nothing more than a self-service warehouse for money.

The ruling in this case was for denial of Morgan’s motion for summary judgment on liability. Hopefully, there will be a further ruling on the calculation of damages that will shed some light on the court’s willingness to consider the time value of money as well as lost investment opportunities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.