Trusty trustees: what every trustee should know about California law.

The rules governing a trustee's duties are primarily set forth in the trust instrument, but CPAs who serve as trustees for clients also should be aware that California law plays a major role in the governance of the trustee.

California law provides default rules, which apply if a trust instrument is silent on a matter, and mandatory rules, which apply regardless of the instructions set forth in the trust instrument.

THE MORE OBVIOUS DUTIES

Probate Code Sec. 16040 provides that the trustee must administer the trust with reasonable care, skill and caution under the then-prevailing circumstances that a prudent person acting in a like capacity would use in the conduct of an enterprise of like character and with like aims to accomplish the purposes of the trust as determined from the trust instrument.

This standard is similar to the business judgment rule. A court second-guessing a trustee's reasoned decisions is not common. However, a common error for trustees is believing that they "know" what the settlor wants and proceeding to administer the trust based on this belief rather than the purposes stated in the trust.

If the trustee's understanding of the settlor's intent is inconsistent with the trust instrument, the trustee should seek the court's assistance to resolve the conflict.

Prudent Investor Act. Under this act (Probate Code Secs. 16045-16054), the trustee--unless the trust instrument provides otherwise--must invest in a manner that maximizes the investment return of the entire trust while minimizing the risk to a level reasonably suited to the trust.

The PIA applies to all actions taken by a trustee after the effective date of the act, generally Jan. 1, 1996. The date the trust was created is irrelevant.

The PIA is somewhat of a double-edged sword: It allows a trustee to invest for total return, but it increases a trustee's potential liability for an underperforming trust. To avoid liability, trustees should understand how to invest under the PIA. For an individual trustee, this can be accomplished by delegating the responsibility to a professional under Probate Code Sec. 16052.

Investing under the PIA requires:

* Developing an investment policy statement that includes appropriate objectives, policies and procedures;

* Documenting the reasons for each investment decision; and

* Acquiring the education to become well-informed in investment decisions.

Proper Exercise of Discretionary Powers. Under Probate Code Sec. 16081, the trustee must exercise any discretionary power reasonably, not arbitrarily. Even "absolute," "sole" or "uncontrolled" powers provided in the trust must be applied in accordance with fiduciary duties--that is, trustees must act in good faith and actions must be consistent with the trust's purposes.

Enforce, Defend or Compromise Claims. Under Probate Code Sec. 16249, the trustee has the power to prosecute or defend actions, claims or proceedings for the protection of trust property and the trustee in the performance of the trustee's duties. Related to those powers are the duties in Probate Code Secs. 16010 and 16011: to take reasonable steps to enforce claims and defend actions that may result in a loss to the trust.

Duty to Account. Probate Code Sec. 16062 provides that, unless an exception applies, "... the trustee shall account at least annually, at the termination of the trust, and upon a change of trustee, to each beneficiary to whom income or principal is required or authorized in the trustee's discretion to be currently distributed." Upon demand, a beneficiary is entitled to an account even if the trust waives the account. However, a demand for an account can be a sign of beneficiary dissatisfaction.

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Providing an account is a good idea even when not required because it helps avoid possible disputes by keeping beneficiaries informed. The account also triggers the three-year statute of limitations on trustee liability. Note that the settlor may shorten the three-year statute of limitations to 180 days pursuant to Probate Code Sec. 16461.

THE LESS OBVIOUS DUTIES

Probate Code Sec. 16003 states that the trustee has the duty to deal impartially with the beneficiaries. Even if there is only one current beneficiary, don't forget about the remainder beneficiaries. Examples of trustees failing to act impartially include:

* Failure to invest for both current income and capital appreciation.

* Allowing one beneficiary the use of trust property without providing a similar benefit to other beneficiaries.

* Rewarding one beneficiary for his or her cooperation with the trustee.

The duty of impartiality is especially critical when the trustee is also a beneficiary. While it is permissible for a beneficiary to act as trustee, the trustee/beneficiary has significant risks related to self-dealing and conflicts of interest.

Duty of Loyalty. Under Probate Code Sec. 16002, the trustee must administer the trust solely in the interest of the beneficiaries. When a trustee is involved in a transaction on behalf of more than one trust, the following requirements must be met:

* The sale or exchange is fair and reasonable with respect to the beneficiaries of both trusts; and

* The trustee gives to the beneficiaries of both trusts notice of all material facts.

Duty to Avoid Conflicts of Interest. The existence of a conflict of interest (addressed in Probate Code Sec. 16004) is not necessarily a breach of trust, especially if the settlor created the conflict of interest. However, the trustee has a duty to avoid creating conflicts of interest.

By definition, a transaction in which a trustee has more than one loyalty is a conflict of interest. Conflicts of interest even include transactions between the trustee and a beneficiary if the trustee holds any influence over the beneficiary.

Duty to Avoid Self-Dealing. Self-dealing involves trustees dealing with trust property for their own benefit and violates the duty of loyalty. Unless waived in the trust instrument, acts of self-dealing must be approved by the beneficiaries or the court.

CPAs should request that the settlor include in the trust instrument provisions allowing the accountant to engage their firm. Otherwise, providing accounting services would be self-dealing unless such services were provided as part of the trustee's duties.

Delegation of Duties. Probate Code Sec. 16052 authorizes the trustee to delegate various duties, such as investment decisions and management functions. If the delegation is reasonable, trustees may be able to limit their responsibility and liability.

Care must be used in selecting the agent, determining the scope of the delegation and reviewing the agent's performance. For example, when engaging an investment adviser, be clear as to whether the investment adviser is taking overall responsibility or is just advising the trustee regarding portfolio design, strategy and procedures.

Duty to Report. The duty to report is broader than the duty to account. Even if remainder beneficiaries are not entitled to an account, they may be entitled to a report.

Probate Code Sec. 16060 requires the trustee to keep the beneficiaries reasonably informed and Probate Code Sec. 16061 states "... on reasonable request by a beneficiary, the trustee shall provide the beneficiary with a report of information about the assets, liabilities, receipts, and disbursements of the trust, the acts of the trustee, and the particulars relating to the administration of the trust relevant to the beneficiary's interest, including the terms of the trust."

LIABILITY ISSUES

Trustees generally are not personally liable to creditors and claimants of trusts. This is similar to a corporation's officer not being liable for the debts of the corporation (assuming the officer did not personally guarantee the obligation). However, if a trustee personally harmed someone, the trust provides no protection against the trustee's liability.

Liability for Breach of Fiduciary Duty. Probate Code Sec. 16400 defines a breach of trust as a violation of any fiduciary duty and can be separated into three types: ordinary negligence, gross negligence (recklessness) and intentional (willful) breach of trust. Any amount that a trustee is ordered to pay to a trust is commonly referred to as a surcharge.

Defenses to Liability for Breach of Fiduciary Duty. Even when trustees breach a fiduciary duty, they may not be liable. Exculpatory clauses may limit the trustee's liability for certain failures.

But under Probate Code Sec. 16461, exculpatory clauses can't limit liability for gross negligence or intentional acts. Further, courts routinely impose higher standards on professional trustees. Query how a court would view accountants who are serving as trustees and are paying themselves their full professional rate.

Although exculpatory clauses may help certain trustees avoid liability for a breach of trust, it's unlikely that an exculpatory clause will avoid the removal of a negligent trustee.

Beneficiaries also may limit a trustee's liability by consenting to the act or the failure to act; releasing the trustee; or affirming the acts of the trustee (Probate Code Secs. 16463-16465). But such defenses require that beneficiaries had capacity, knew their rights, were not pressured and were treated fairly.

Trustee Liability for Attorney Fees. A judge could order the trustee to pay back attorney's fees paid from the trust. During litigation, the trustee must be careful in paying attorney fees. If the litigation is with a third party, the trustee may want to request the consent of the beneficiaries or the court before pursuing the litigation.

It is too easy for a party to second-guess a trustee's decision to pursue litigation after the fact. If a court were to determine that the litigation was not likely to provide a benefit to the trust, the court might surcharge the trustee for all attorney fees.

If the litigation is between the trustee and beneficiaries, the ability to pay the trustee fees from the trust may depend on the nature and outcome of the dispute.

COMPENSATION

Most trusts provide that a trustee shall be paid "reasonable" compensation, but there is no clear answer as to what amount of compensation is reasonable.

Many judges prefer determining a trustee's fee by applying an hourly rate, determined by the trustee's expertise, to the trustee's work. Rarely will that hourly rate be the same for CPAs as the rate they charge for accounting services. This is an issue a CPA may want to discuss with the client before agreeing to serve as trustee.

A common mistake is setting compensation based upon a fee schedule. If this is done, the following should be considered:

* Would a professional trustee have incurred similar costs for attorneys, accountants and investment advisers?

* Did the trustee provide a level of benefit similar to a professional trustee?

* Is the trust paying expenses that would be a cost of doing business of a professional trustee (such as liability insurance authorized by Probate Code Sec. 16240)?

FINAL CONSIDERATIONS

While the laws governing trustees can be long and complex, CPAs acting as trustees should keep the following in mind:

* Follow the trust instrument and California law;

* Keep a paper trail for all transactions and discretionary acts;

* Communicate with beneficiaries;

* Request authorizations from the court and beneficiaries as needed;

* Invest properly under the Prudent Investor Act;

* Delegate responsibilities when appropriate;

* Obtain liability insurance for property and actions; and

* Determine reasonable compensation.

BY NELSON J. HANDY, ESQ. & JOHN T. ROGERS JR., ESQ.

Nelson J. Handy, Esq. is a Los Angeles-based senior counsel of private wealth services at Holland & Knight LLP and a member of the CalCPA Estate Planning Committee. You can reach him at [e-mail]. John T. Rogers Jr., Esq. is a partner in the private wealth services section of Holland & Knight LLP and a fellow of the American College of Trust and Estate Counsel. You can reach him at [e-mail].