Clean House

If Ponzi schemer Bernard Madoff serves no other purpose, he's a stark reminder that anyone acting in a fiduciary capacity must maintain high standards of ethical conduct in all dealings with customers and clients. In fact, it could be argued that this year's revelations about the once-revered Madoff plus the near collapse of the U.S. financial market combine to make it so that at no other time in recent memory have wealth advisors, their clients and their attorneys been more sensitive to the need to ensure that fiduciary responsibilities are handled properly. With clients feeling vulnerable, any fiduciary conduct that even seems to create a conflict of interest hits a very raw nerve indeed — and could have far-reaching financial and reputational consequences for all involved.

So, as the year-end approaches, it's wise to reexamine how we can avoid conflicts and ensure appropriate oversight and risk management controls that are not only in place, but also monitored frequently.

Lay of the Land

Fiduciaries are those acting as trustees, executors and guardians. Fiduciary capacity has been interpreted very expansively for bank regulatory purposes to mean not only those acting as a trustee, executor, or guardian, but also an investment manager if the bank receives a fee for its investment advice. Any capacity in which a bank possesses “investment discretion” on behalf of another is considered a fiduciary role.¹ Here, we focus on a fiduciary acting as the trustee of a trust or as the investment manager for a discretionary investment management account.²

A fiduciary conflict of interest exists whenever a fiduciary's ability to act exclusively in the best interest of a trust, trust beneficiaries or account owner is impaired. Any interest or action whereby a fiduciary might personally benefit, financially or otherwise, could be perceived as a violation of the fiduciary duty of undivided loyalty. Any competing interest that influences a fiduciary to act, or creates the perception that a fiduciary has been influenced to act, in a particular way with respect to its duties as a fiduciary that is in contravention to the interest of the trust, the trust beneficiaries or the account owner, compromises the integrity of the fiduciary relationship.

Generally, such conflicts arise in one of three broad categories: investments, discretionary distributions and taxes.

• Investments — Trustees must comply with trust agreements and the prudent investor rule;³ investment managers must comply with contract provisions and agency principles. The Uniform Principal and Income Act defines the standard of prudent investment as an objective one, stating: “The trustee has a duty to the beneficiaries to invest and manage trust assets as a prudent investor would in light of the purposes, terms, distribution requirements and other circumstances of the trust.”⁴ In managing investments, trustees must adhere to fundamental fiduciary standards, including the duty of loyalty, which requires the avoidance of conflicts of interest.⁵
• Discretionary distributions-Making discretionary distributions requires balancing the competing and often conflicting interests between a trust's present income beneficiaries and remaindermen.
• Taxes — Trustees must understand the implications of making various tax elections that may negatively impact one or more beneficiaries of a trust.

Exacerbating the potential for conflicts of interest are the availability of increasingly complex financial services and investments as well as corporate trustees' multifarious affiliations and arrangements with affiliates and service providers.⁶ National financial services regulations provide guidance about how corporate fiduciaries can avoid conflicts of interest through internal policies and procedures to ensure that certain investment, lending or sales practices are monitored or restricted. And certain investment practices that could be self-dealing or constitute other conflicts of interest are generally simply forbidden.

For example, under the Code of Federal Regulations, a national bank (unless authorized by applicable law) may not invest the funds of an account for which it has investment discretion in the stock or obligations of, or assets acquired from, the bank, affiliates of the bank, directors, employees, officers or individuals or organizations with whom there exists “an interest that might affect the exercise of the best judgment of the bank.”⁷

The Affiliate Trap

Corporate fiduciaries must be especially careful when investing trust or account assets in products offered by affiliates. “Affiliate” is generally defined as any corporation or other entity that directly or indirectly is controlled by a financial institution acting in a fiduciary capacity, or that is related to the financial institution by shareholding or other means of common ownership and control.⁸ It's advisable that fiduciaries avoid using investment products provided by affiliates when dealing with irrevocable trust accounts over which the fiduciaries have full investment discretion, or even when they share that discretion with one or more co-trustees. The only exceptions to this caution are when:

1. the investment is authorized pursuant to a court order;
2. specific language in a trust document authorizes the use of investments provided by the fiduciary's affiliate and that language both permits the affiliate to receive compensation and waives any conflict of interest; or
3. the investment in an affiliate's investment offering is permitted under the applicable state law.⁹

Note that an agreement between co-trustees may not be relied upon to waive a conflict of interest of one of the trustees and avoid a beneficiary claim for breach of fiduciary duty.

With revocable trusts or discretionary investment management accounts, grantors or principals can waive the conflict associated with trustees using products provided by their affiliates. When such a waiver is in place, fiduciaries may exercise their discretion to use investments offered by their affiliate — but, of course, still must ensure these investments are otherwise prudent. A grantor who reserves the power to modify or revoke a trust instrument is usually considered the absolute owner of a trust's property.

Thus, the grantor of a revocable trust can direct the fiduciary to conduct otherwise impermissible transactions. If the grantor requests a transaction that would normally violate the duty of undivided loyalty, the trustee should require that the trust agreement be amended to authorize the transaction or require the grantor to authorize each transaction in writing.¹⁰

Similarly, the use of products provided by an affiliate may be authorized by the terms of the agreement governing a discretionary investment management account. In all circumstances, full disclosure should be given, which includes the terms of the transaction and all associated fees and compensation to be paid to the affiliate. A fiduciary that adheres to these guidelines presumably has taken the necessary measures to ensure that its duty of undivided loyalty has not been breached.

A distinction may be drawn when the fiduciary invests trust assets in its own proprietary mutual funds registered under the Investment Company Act of 1940. In the past 15 years, the vast majority of states have enacted statutes providing that a trustee's investment in proprietary mutual funds is not prohibited by the duty of loyalty, even though the fiduciary's related or parent company collects commissions and fees in its capacity as an investment advisor.

Still, the investment must in all other respects be considered a prudent investment. In addition, state law may require specific disclosure and/or fee adjustments. As a best practice for risk management, certain corporate fiduciaries elect to rebate to their trusts and investment management accounts overlapping trustee or investment management account fees and fund-level fees paid to an affiliate.

Competing Beneficiaries

The duty of impartiality imposes upon a trustee the responsibility of generating income for the present income beneficiary class while also growing the principal for the future beneficiary class. Absent express language in the trust instrument, a trustee is prohibited from investing a trust's assets in a manner that unfairly favors the current beneficiaries to the detriment of the remainder beneficiaries and vice versa.

To satisfy this duty of impartiality, trustees historically have invested trust assets with a certain balance between equities and fixed income securities. New distribution alternatives made available under state law allow trustees to satisfy the duty of impartiality by investing trust assets pursuant to the prudent investor standard, which generally provides that the trust assets be invested to achieve a favorable total return. Some states now grant trustees the discretion to make an equitable adjustment between income and principal through the use of a “power to adjust.” Other states grant trustees the right to convert an income interest into a unitrust interest and pay out a fixed percentage of the value of the trust. A number of states have enacted both a power to adjust statute and a unitrust statute.

Favoring one beneficiary over another in any aspect when administering a trust can have severe consequences for even well-intentioned fiduciaries. Particular caution should be exercised during court proceedings when asking for instructions and for construction of trust agreements. Although trustees may be entitled to seek instructions or construction in a court proceeding, arguing that a trust should be interpreted in a manner favorable to one beneficiary and detrimental to another constitutes a breach of the trustee's duty of impartiality. In at least one reported decision, the court determined that such action on the part of the trustee constituted blatant favoritism in breach of the trustee's duty of impartiality, and the trustee was precluded from receiving an award of trustee's attorney fees and costs from the trust.¹¹

Professional Standards

An attorney representing a fiduciary is the fiduciary's fiduciary. The potential for conflicts of interest is endless and the management of conflicts of interest requires constant vigilance. Attorneys representing fiduciaries whose practice includes the representation of individuals in estate planning are commonly faced with conflicts and potential conflicts between fiduciary clients and their individual trust settlor and beneficiary clients. In addition, attorneys practicing in firms with commercial litigation and transactional practices face conflicts and potential conflicts in the representation of corporate fiduciaries.

Under the American Bar Association Model Rules of Profession Conduct,¹² an attorney may not represent concurrent clients if:

• the representation of one client will be directly adverse to another client; or
• there is a significant risk that the representation of a current client will be materially limited by the lawyer's responsibilities to another current client, a former client or a third person or by a personal interest of the lawyer.

But a lawyer may undertake such representation if:

• the lawyer reasonably believes that she will be able to provide both competent and diligent representation to each current client;
• the representation is not prohibited by law;
• the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or proceeding before a tribunal; and (not or)
• each client gives informed consent, confirmed in writing.

Additional rules provide stringent safeguards with respect to an attorney's business relationships with clients and govern duties to former clients.¹³

It's imperative at the outset of any fiduciary representation to screen carefully for conflicts and potential conflicts. When conflicts are identified, lawyers should obtain all necessary consents. Some corporate fiduciaries as a matter of practice do not grant waivers or grant only limited waivers that do not extend to litigation. Some are more flexible, responding to each situation's circumstances.

When consents are not forthcoming, lawyers should decline the fiduciary representation. In addition, when representation is limited to the fiduciary but does not extend to the trust's beneficiaries, lawyers should consider informing the beneficiaries in writing.

Vigilance

Knowing the rules is the first step; initially checking relationships and screening investments is the next. But neither the applicable law nor fiduciary relationships and investments are static.

The rub comes in constantly revisiting the conflicts issue to ensure compliance with applicable laws, accepted industry and professional standards and established policies and procedures in light of current relationships and investments.

Assess each client relationship regularly to ensure that changes in beneficiaries of trusts are identified, any changes in the investment objectives of trusts and investment accounts are determined, and written documentation is in place. Those documents should confirm that investments are consistent with the current investment objective, that the investments are appropriate for the client's needs, and that all actions taken by the fiduciary continue to be in accordance with its established risk management guidelines.

Attorneys representing fiduciaries should continually review their representation. If a conflict arises, they should determine whether additional waivers or withdrawal are warranted.

Deviation from sound principles may spark financial liability and hurt the fiduciary's or the attorney's reputation. Indeed, we've all seen the devastating impact that actual or even perceived conflicts of interest can have on the reputation and financial well-being of those entrusted with looking after the best interests of others. Negative public opinion, once established, is extremely difficult to erase. Fiduciaries and their counsel have a responsibility to exercise an abundance of caution in their dealings with clients, for their clients' sake first and secondarily, for their own.

Thayer J. Herte, far left, is a managing director at J.P. Morgan Chase & Co. in Chicago, and Suzanne L. Shier is a partner in the Chicago office of Chapman and Cutler LLP

Endnotes

1. 12 Code of Federal Regulations (CFR) Sections 9.2(d), (e), (i).
2. The discussion of discretionary investment management accounts in this article is limited to accounts managed by banks and does not include the discussion of accounts managed by registered investment advisors subject to the requirements of the Investment Advisors Act of 1940. This article does not address the issue of conflicts of interest in accounts subject to the Employee Retirement Income Security Act of 1974.
3. Restatement (Third) of Trusts, Section 90 (Prudent Investor Rule).
4. Uniform Prudent Investor Act, <www.law.upenn.edu/bll/archives/ulc/fnact99/1990s/upia94>.
5. Ibid.
6. Office of the Comptroller of the Currency, Handbook on Conflicts of Interest (June 2000), at p. 2.
7. 12 CFR Section 9.12(a)(1).
8. 12 U.S. Code Section 221a(b).
9. 12 CFR Section 9.2(b).
10. Handbook on Conflicts of Interest, supra note 6 at p. 6.
11. The Northern Trust Company v. Heuer, 202 Ill. App. 3d 1066 (1990).
12. The American Bar Association Model Rules of Professional Conduct (Model Rules) have been adopted, with varying degrees of modification, in 46 states, the District of Columbia and the Virgin Islands.
13. Model Rules 1.8 and 1.9.