Trusts Flashcards
(5 cards)
Summary
Friend breached the duty of loyalty, the duty to invest prudently, the duty to diversify the trust investments, and the duty of care when he invested 90% of the trust’s assets in the preferred stock of two closely held corporations. Friend breached the duty of loyalty because he had a substantial financial interest in one of the closely held corporations. He breached the duty to invest prudently and the duty to diversify because the investments significantly diminished the liquidity of the trust principal and because A Corp. and B Corp. were involved in similar high-risk businesses. He breached the duty of care by investing in a manner that precluded carrying out the trust’s obligations to James with respect to the payment of income and James’s annual 5% withdrawal power.
Friend breached the duty of loyalty by investing the trust assets in a corporation in which Friend, in his individual capacity, had a substantial investment.
A trustee owes trust beneficiaries a duty of loyalty and must administer the trust exclusively in the beneficiaries’ interests. Because the trustee must act on behalf of the beneficiaries, and not on behalf of himself, the duty of loyalty is breached when a trustee enters into transactions, on behalf of the trust, that involve a conflict of interest or self-dealing. Friend entered into a transaction involving a conflict of interest.
Uniform Trust Code § 802(c) provides that an investment in “a corporation . . . in which the trustee . . . has an interest that might affect the trustee’s best judgment” is presumptively a breach of the duty of loyalty. Here, Friend invested in A Corp., in which he held 70% of the common stock. Although the comments to § 802 note that the presumption of a breach can be rebutted by showing that the terms of the transaction were fair or that the transaction would have been made by an independent party, there is no evidence to support such a showing in this case. It is also hard to imagine that an independent trustee would have made such a risky and illiquid investment.
Friend breached the duty to invest prudently by investing the trust assets in the illiquid stocks of cash-poor, closely held corporations without proven, marketable products.
Almost all states have adopted, in one form or another, the Uniform Prudent Investor Act. Under this act, a trustee owes trust beneficiaries a duty to invest trust assets prudently. UNIF. PRUDENT INV. ACT § 1. In assessing whether a trustee has breached this duty, the Act requires consideration of a number of factors, including (1) the distribution requirements of the trust (id. § 2(a)), (2) general economic conditions (id. § 2(c)(1)), (3) the role the investment plays in relationship to the trust’s overall investment portfolio (id. § 2(c)(4)), and (4) the trust’s need for liquidity, regularity of income, and preservation or appreciation of capital (id. § 2(c)(7)). All of these factors support a finding that Friend’s investment was imprudent.
The investments in A Corp. and B Corp. represented a very large share (90%) of the trust assets and dominated the portfolio. The investments drastically reduced the liquidity of the trust, making it impossible to meet the trust’s distribution requirements. The investments also reduced the trust’s annual income, resulting in a reduction in mandatory income distributions. The effects of the investments on the trust income and liquidity were not unexpected, but were known at the outset. Moreover, the technologies that both companies planned to develop were unproven; working prototypes had not been developed, and there was no evidence that such inventions would succeed in the highly competitive cell-phone market.(See Point Four.) Lastly, since the companies were developing competing technologies, there is a good chance that ultimately one of them would fail (e.g., Blu-ray vs. HD DVD).
Friend breached the duty to diversify by investing 90% of the trust’s assets in two corporations that were involved in the same type of business and subject to the same market risks.
A trustee owes a duty to diversify trust investments unless he “reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”UNIF. PRUDENT INV.ACT§3.
The diversification duty rests on the assumption that it is risky to place all or substantially all of one’s assets in the same investment basket. Although there is “no automatic rule for identifying how much diversification is enough,” (id. § 3 cmt.), it seems highly unlikely that any fact finder would find the investment of 90% of trust assets in one narrow and unproven market sector sufficiently diverse.
Additionally, there are no facts in this case to support a finding that a lack of diversification was warranted because of special circumstances. Settlor funded the trust with publicly traded securities. The terms of the trust contemplated investments that would produce income and distributable principal.
Friend breached the duty of care by investing the trust assets in a manner that precluded administration of the trust in accordance with its terms and purposes.
Under the common law, a trustee owes beneficiaries the duty to act with care, skill, and prudence. See generally GEORGE T.BOGERT, TRUSTS § 93 (6th ed. 1987). Although the Uniform Trust Code does not impose on trustees a duty of care, it does impose a duty to “administer the trust in good faith, in accordance with its terms and purposes and the interests of the beneficiaries . . . .” UNIF. TRUST CODE§801.
Whichever formulation is used, Friend breached his duty by making investments that made it impossible to carry out the terms of the trust. The facts clearly evidence Settlor’s intention to provide James with an annual income and imply that this income may have been intended to supplant the support Settlor provided James before creating the trust. The facts also clearly show that Settlor gave James the power to annually withdraw up to 5% of trust principal over the first 10 years of the trust. The investments in A Corp. and B Corp. effectively prevented James from exercising his withdrawal power and dramatically curtailed his income from the trust.
