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Trust Rules: Show, Tell and Sell-Part 2

Our state legislatures have been hard at work considering and adopting versions of two uniform trust laws proposed over the past dozen years. Last month, I discussed a controversial Uniform Trust Code provision that requires disclosure of financial information and activities to trust beneficiaries. This months column concerns a development that can greatly affect trusts’ ability to own interests in family owned businesses. Storm clouds may be gathering over your estate plans.

The Uniform Prudent Investor Act (UPIA), initially developed in 1994, removes “common law” investment restrictions. The common law is essentially a potpourri of legislation and court cases that requires the trustee to exercise prudence on an investment-by-investment basis. Trustees can be held accountable for each bad investment even though the overall portfolio performs well.

Modern Portfolio Theory

Under the UPIA, trustees use modern portfolio theory to guide investment decisions. Modern portfolio theory asserts that risk can best be reduced through diversification. A combination of diversified, more risky investments in a variety of asset classes (e.g., domestic and international stocks, bonds, hedge funds, private equity, real estate, etc.) actually can be less risky than a less diversified portfolio, with just a few asset classes.

To enable this approach, each investment will now be evaluated not in isolation, but in the context of the portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust.

Mandated Diversification

The UPIA mandates diversification unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are best served without it. When writing the governing instrument, the trustor can enunciate special circumstances and override the requirement. So, the ability to override the diversification requirement appears to be the saving grace for trusts heavily invested in family business interests.

But, of course, it’s not that simple. First, the UPIA is retroactive. Whether the trust instrument sufficiently expresses the trustor’s intent—t o retain the family business—is problematic at best for trusts created before the statute was enacted.

Intent Might Not Be Enough

Second, the trustor’s express intent might not be enough. Consider the following trust instrument language from a recent case involving a large concentration of Kodak stock contributed to a trust:

“It is my desire and hope that said stock will be held by my trustee to be distributed to the ultimate beneficiaries under this instrument, and my trustee shall not dispose of such stock for the purpose of diversification of investment, and my trustee shall not be held liable for any diminution in the value of such stock. The foregoing provisions shall not prevent my trustee from disposing of all or part of the stock of Eastman Kodak Company in case there shall be some compelling reason other than diversification of investment for doing so.”

That would seem to do the trick. But a New York court recently held a trustee liable for more than $20 million in damages for not dumping the Kodak stock when it began declining in value. According to the court, the problem was not a failure to diversify; rather, it was failing to dispose of the stock for the compelling reason that it was declining in value. Apparently, the trustee failed to employ a full-time clairvoyant to anticipate the decline!

If you absolutely, positively want the trust to hold the family business stock, you might state something like “I absolutely, positively want the trustee to retain the stock of my family business and under no circumstances whatsoever may he, she or it ever dispose of such stock. I mean never! Ever!”

Overriding Duty

Ignoring whether that constraint makes any sense (since your clairvoyant might just be wrong in predicting that it makes sense to hold the stock forever under all possible circumstances), will that work? Some people are skeptical. The reason is that trustees have a duty of loyalty to their beneficiaries that arguably trumps everything else. So, if selling is in the beneficiaries’ best interests, the trustee might be obligated to go to court to get permission to sell the stock despite strong language to the contrary.

So, what can you do if one of your greatest desires is to perpetuate family ownership of your business? Forgoing the use of trusts is not a very satisfactory answer for numerous tax and family reasons. Picking trustees who either do not understand their fiduciary obligations or are willing to ignore them certainly is an option. But I question whether a trustee who is ignorant or willing to flagrantly disregard his or her responsibilities is best for the family in the long run.

Stop by my column next month for some thoughts on how to best position your family and trusts as these state law rules continue to unfold.




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