Monthly Archives: March 2010

Saving Us From Ourselves: Reforming the Fiduciary Duty of Loyalty

Mar 30, 2010 Julia Belian

In the wake of disaster, we as a species invariably reach out with untold generosity, donating vast amounts of cash and supplies to assist the victims.  And, just as invariably, at least some of the charitable organizations through which most of us funnel our compassion will drop the ball through some form of mismanagement.  In the past twenty years, the relief efforts following almost every major disaster – spring flooding in the Midwest, mudslides and wildfires on the West Coast, hurricanes throughout the Gulf of Mexico, tsunamis in the South Pacific, and, most famously, Katrina – have been plagued by reports of mismanagement ranging from lack of meaningful oversight to outright embezzlement.

Which should mean that right now, as the world struggles to come to the aid of a ravaged and overwhelmed Haiti, would be a prime time to consider meaningful reform of the standards by which such charities conduct their critical business.  For several years, Prof. Melanie B. Leslie of Cardozo School of Law has offered a clarion call for reform of the rules governing fiduciary conflicts of interest, especially within the nonprofit sector.  In the wake of the catastrophic earthquake January 12, the arguments and suggestions in her article The Wisdom of Crowds? Groupthink and Nonprofit Governance deserve serious attention.

Leslie’s article, currently available as a working paper on SSRN, succinctly and clearly lays out the dilemma that lies at the heart of nonprofit management:  With no principal readily available to monitor, and no market to correct, nonprofit boards of directors are uniquely vulnerable to the phenomenon of “groupthink,” a process by which the desired advantages of information exchange are subverted by interpersonal group dynamics.  When a board of directors lacks clear external standards or monitoring, Leslie argues, information asymmetries among the members of the group are more likely to be resolved, not by forthright questioning and discussion, but by confirmation bias and ingroup bias, both of which are further fueled by the desire for group cohesion which is arguably more powerful in the nonprofit sector than in a business setting.  Current law governing fiduciary duties – both state law and the federal law governing tax exempt organizations – not only fails to correct this inherent problem, it actually exacerbates it by setting forth “fuzzy” standards rather than clear rules.  “Fuzzy” standards necessarily require interpretation, and in a setting already prone to cognitive errors, that process of interpretation itself actually increases the board’s tendency to overestimate its own objectivity, to overestimate a proposed deal’s fairness, to under-investigate the true market conditions, and to discourage confrontation among its members.

Leslie proposes two options for correcting the problem of “fuzzy” fiduciary standards, both of them based on her preference for rules.  Rules, she argues, communicate more clearly what the norms of behavior are in a given context and thereby reduce parties’ overestimation of their own compliance, and she offers empirical evidence to support her contention that clearly demarcated rules do more strongly determine parties’ behaviors.  Her first suggestion – and clearly her own personal preference – is to prohibit all self-dealing, period.  She argues that a blanket prohibition on self-dealing would not have to have the dire consequences often predicted, especially for smaller or rural nonprofits, but she also concedes that popular opinion tends to strongly oppose such a bright-line rule.  Her second proposal relies on a set of lower-order rules that, taken together, would not absolutely prohibit self-dealing, but would, I think, get us nearly there anyway, simply by making the process of approving such a transaction more trouble than it would usually be worth to most nonprofit boards.  That is, after all, exactly what Leslie is trying to suggest:  So long as the standards governing self-dealing transactions make engaging in such transactions no more onerous than engaging in non-self-dealing transactions, those standards quietly convey a message to nonprofit managers that such transactions are legally and morally equivalent.  Leslie’s goal is to upend this applecart and, instead, to make clear to nonprofit directors that self-dealing transactions should be presumed impermissible, whether rebuttably or irrebuttably.

It is hard to see how Leslie’s suggestions could be taken amiss.  This “hard” version of the fiduciary duty of loyalty is, at the least, the starting point for learning the concept (or, at least, it is when I teach it), with such ideas as the business judgment rule coming later as particular exceptions to the general duty, exceptions justified in the business world by the availability of shareholder monitoring and self-correcting markets.  Granted, any nonprofit director more accustomed to the rules for business decision-making will likely feel that such strictures hobble their efforts to get things done quickly and thereby provide more benefit to those in need.  But recent history and my own personal experience serving on nonprofit boards tell me that Leslie is right:  Those things we do in the name of beneficence are not always most beneficial for those we serve.  In one of the numbers in the Broadway musical “Avenue Q,” the characters encourage the audience that “When you help others, you can’t help helping yourself,” but that’s precisely the problem.  In the wake of disaster, we as a species do invariably reach out with untold generosity – but we also invariably overestimate our ability to do so in the impartial and objective way required of fiduciaries.  Leslie’s suggested rules would “build a fence” around our benevolence and thereby help us protect our generous impulses from our own short-sighted selves.

The 101 Biggest Estate Planning Mistakes

Mar 25, 2010 Gerry W. Beyer

What fun!  That was my first reaction to this new book by Herbert Nass, the famous New York attorney who has worked on the estate plans of countless celebrities.  By using the wills of the rich, famous, and infamous as examples, Nass guides readers though the most common and significant mistakes individuals and their attorneys make during the estate planning process.

In the span of eleven chapters, Nass sets out his top 101 missteps which individuals and their attorneys are prone to take when planning an estate.  A good way to get a flavor of the scope of his coverage is to peruse the titles of his chapters:

• The Single Biggest Mistake is Not Planning for the One Certainty in Life … Death
• Mistakes Involving Tangible Personal Property
• Mistakes Involving Real Estate
• Mistakes Involving Executors and/or Trustees
• Mistakes Involving Guardians, Minors, or Step-Children
• Mistakes Involving Prior Marriages, Prenuptial Agreements, and Significant Others
• Estate Planning Mistakes Involving Tax and Copyright Issues
• Estate Planning Mistakes Involving Disgruntled Friends and Family
• Mistakes Involving Funerals, Burials, or Cremation
• One-of-a-Kind Mistakes by Celebrities and Icons
• Rookie or Boneheaded Mistakes

Perhaps the best feature of this book is the inclusion of real-life examples for most of the mistakes which often include reproductions of the actual wills or other documents which contain the errors.  Significant to note is that most of these are not from the wills typically reproduced such as those of Elvis, President Kennedy, and Anna Nicole Smith.  See Wills of Famous and Influential People. Here are some examples showing the novelty and diversity of the samples reproduced: Jackie Gleason, Phil Silvers, W.C. Fields, Mae West, Rock Hudson, Gloria Swanson, James Morrison, and John Cassavetes,

Not only is Biggest Mistakes an entertaining read for its intended lay audience, it also serves as a useful resource for practitioners and a learning tool for law students.

Although most practitioners will not learn anything earthshaking, the examples serve as reminders of what happens if they do not exercise proper care in each step of planning an estate.  I predict, however, that almost every estate planner will come away with something previously unconsidered.  Here is one of the insights I gained.  I consistently warn my students not to unstaple a will once it is stapled together because contestants use multiple staple holes as evidence of fraudulent page substitution.  I had not thought of what to do once removal is done – how does one “unring the bell.”  Nass provides a wonderful suggestion – obtain an affidavit from the person who removed the staples which explains the circumstances behind that removal.  He even includes a sample affidavit.

For law students, this book brings to life many of the key pitfalls typically discussed by their professors such as executing documents improperly, naming an even number of co-fiduciaries, and failing to plan for out-of-state real property.  One important warning, however, is in order.  In Nass’s attempt to make the book accessible to a wide audience, he often generalizes legal rules.  These overstatements may be confusing at times such as the admonition that serving as a witness to a will in which the witness is a beneficiary would void the gift.  Although still true in many states, students who study primarily the Uniform Probate Code which provides in § 2-505(b) that this fact is irrelevant may be left wondering “what’s going on here?”

Learning from your own mistakes is good, learning from the mistakes of others is better, and not making mistakes in the first place is best.  Biggest Mistakes helps readers avoid making the mistakes themselves by learning from the errors of others in both an informative and engaging manner.  Definitely, a good deal!

Intrafamily Loans and Tangible Property

Mar 25, 2010 Wendy Gerzog

The article Revisiting Dickman: Are Loans of Tangible Property Gifts? by Joseph M. Dodge, recently posted on SSRN, exhaustively covers this central question left unanswered by the Supreme Court in its 1984 Dickman decision. Dodge describes a common scenario in wealthy families: informally, parents allow their adult child to use their vacation home rent-free for an unspecified time. The piece then delves into the query about whether or not that familiar occurrence is a taxable gift. To answer that question, the article takes the reader into a wide-ranging discussion that includes property interests, imputed income, psychic benefits, Internal Revenue Code section 7872 (dealing with gift tax and income tax consequences of below-market interest loans of money), revocable transfers, and the estate tax consequences of the retained enjoyment of property.

Dodge argues against subjecting tangible personal use property to the gift tax. After all, he suggests, when you swim in a neighbor’s pool, that neighbor has not transferred a property interest to you. The permission to use property does not create a property interest in the user because it implicitly includes the power to revoke that permission.  Dodge analyzes Dickman, criticizing the court’s minimizing the real problem of cost-free loans of personal-use tangible property when it stated that the IRS was not interested in taxing such neighborly or familial gifts. The court too easily dismisses the issue by saying that, in any event, the annual exclusion and credit exemptions would shelter those transactions from any transfer tax. He critiques the court’s overgeneralizations and explains that the gift tax is not a tax on foregone economic opportunities but a tax on wealth transfers. Moreover, he states that the annual exclusion would not be available if a transaction was characterized as forming a tenancy at will plus a reversion, because there would be no ascertainable present value of the child’s interest.   After examining the case under different transfer tax principles, Dodge concludes that Dickman was doctrinally confused and wrongly decided.

Indeed, Dodge wishes that the court had not chosen to decide Dickman, because Congress was already working on Internal Revenue Code section 7872, which provides a statutory imputed cross payment approach. Dodge considers that provision to be the best unified solution to both the gift and income tax issues in the case; in addition, he contends that it correctly does not apply to the rent-free use of tangible personal-use property. Dodge does not believe that Dickman should be extended to his hypothetical scenario because in allowing such cost-free personal use of the parents’ vacation home, there is no property transfer (generally such event would not constitute even a tenancy at will); alternatively, if there is a property transfer, the transfer is incomplete because of the retained power to revoke. Further, it lacks value and has no tax avoidance potential.

When Dodge focuses on the policy issue of whether or not such loaned use of personal use property can have the effect of transfer tax avoidance, he asks whether or not by making their vacation home available to their adult child, the parents are diminishing their estate and he concludes that they are not. It is axiomatic that a gift of services is not subject to transfer tax because there is no diminution of the transferor’s estate. According to Dodge, a loan of tangible personal use property likewise does not result in a transfer of wealth. While the recipient receives something of value, the property owner has not thereby reduced his assets.

Moreover, although the gift tax is sometimes described as a backup to the income tax, according to Dodge, there is no danger of income tax abuse by shifting income to the property owner’s child. In this factual setting, the child would lack the right to rent the property to another so that any rental income derived by illegally renting the property would belong to the owner. Dodge acknowledges that it is reasonable for the income tax, an annual tax incorporating the concept of realization, to tax interest-free loans of money. However, he considers it unsound for the gift tax to tax a child’s rent-free use of a vacation home because the gift tax is imposed once, only at the time of a completed gift of a property interest.

Dodge concludes by distinguishing between a gift term loan of tangible property and gift demand loan of similar property in a non-commercial context. He explains that a gift term loan is a taxable gift that should be taxed and valued under the applicable Code section depending on whether the gift is made to a family member, to a non-related individual, or to a charity. A gift demand loan to an individual, by contrast, should not be subject to gift tax because there is no property transfer, there is an incomplete gift, Dickman does not provide a basis to extend its holding to this activity, or it represents only a consumption or quasi-support benefit given to third parties.

Dodge’s article is imaginative, insightful, and very well written. It is a must read. How often you find an article that teaches you an incredible amount about transfer taxes, and at the same time provides a piercing review of one of the most revolutionary and recent Supreme Court pronouncements in the gift tax and income tax areas?

Whose Trust is It?

Mar 13, 2010 Thomas Gallanis

There is a central tension in the law of trusts between the rights of the settlor and of the beneficiaries.  On the one hand, the organizing principle of the law of donative transfers, as stated in Section 10.1 of the Restatement 3d of Property (Wills and Other Donative Transfers), is that the “donor’s intention is given effect to the maximum extent allowed by law.”  On the other hand, the Restatement 3d of Trusts emphasizes in Section 27(2) that “a private trust, its terms, and its administration must be for the benefit of its beneficiaries.”  A similar benefit-the-beneficiaries rule is codified in Section 404 of the Uniform Trust Code (UTC) and made mandatory in UTC Section 105.

This essay, Burn the Rembrandt?  Trust Law’s Limits on the Settlor’s Power to Direct Investments, by one of America’s leading scholars of trust law, Professor John Langbein of the Yale Law School, explores the limits that trust law places on the power of the settlor, as the author of the trust’s terms, to direct the trustee’s investment decisions.  The essay is a response to an earlier article in the Boston University Law Review by Professor Jeffrey Cooper, in which Professor Cooper criticized the benefit-the-beneficiaries rule, instead proposing greater deference to the intentions of the settlor, for example where the settlor “intentionally and thoughtfully impaired beneficiaries’ economic rights.” See Jeffrey A. Cooper, Empty Promises: Settlor’s Intent, the Uniform Trust Code, and the Future of Trust Investment Law, 88 B.U. L. Rev. 1165, 1166 (2008).

Professor Langbein’s response begins with an “arresting example” (p. 378) provided several years earlier by Professor Gareth Jones of Cambridge University: “A settlor may destroy his own Rembrandt. But he cannot establish a trust and order his trustees to destroy it.”  See Gareth H. Jones, The Dead Hand and the law of Trusts, in Death, Taxes and Family Property 119, 126 (Edward C. Halbach, Jr., ed, 1977).  Using this example, Professor Langbein explores the reasons why trust law limits the “unilateral dominion” (p. 379) of the settlor.  He points to the need for dead hand control and also for the recognition and enforcement of the equitable property rights of the beneficiaries (and the corresponding fiduciary duties of the trustee).  As he explains, “A transferor who chooses to use the trust form . . . must accept that minimum regime of fiduciary obligation that defines a trust” (p. 380).

One of the many innovations of the UTC, promulgated in 2000 and amended in subsequent years, was to organize in one place—Section 105—the rules of trust law that are mandatory.  These rules apply irrespective of the settlor’s contrary intent.  As Professor Langbein rightly emphasizes, however, the content of the mandatory rule that the trust must be for the benefit of the beneficiaries is not much of an innovation.  Trust law has long insisted that the settlor cannot “countermand the trustee’s duty to act in good faith” (p. 383).  There is an “irreducible core,” as Professor David Hayton has written, to the trustee’s fiduciary duty.  See David Hayton, The Irreducible Core Content of Trusteeship, in Trends in Contemporary Trust Law 47, 48-49 (A.J. Oakley ed. 1996).  I have explored this irreducible core with respect to the trustee’s duty to keep beneficiaries informed of the trust and its administration.  See Thomas Gallanis, The Trustee’s Duty to Inform, 85 N.C. L Rev. 1595 (2007).  In this Essay, Professor Langbein explores the irreducible core of prudent investment.

The Restatement 3d of Trusts has much to say about the duty of prudent investing, as does the Uniform Prudent Investor Act, incorporated into the UTC as Article 9.  Relying on the economic insights of modern portfolio theory, the duty of prudent investment is, for the most part, default law.  The settlor is given great latitude to use the terms of the trust to direct the trustee’s investment decisions.  There is an outer limit to the settlor’s power, however.  As with other core duties of the trustee, the duty of prudent investment cannot be eliminated entirely.   This idea, in a related context, is expressed well in the Comment to UTC Section 412(b), on the modification of the trust’s administrative terms where “continuation of the trusts on its existing terms would be impractical or wasteful or impair the trust’s administration.”  The Comment states in pertinent part: “Although the settlor is granted considerable latitude in defining the purposes of a trust, the principle that a trust have a purpose which is for the benefit of its beneficiaries precludes unreasonable restrictions on the use of trust property. An owner’s freedom to be capricious about the use of the owner’s property ends when the property is impressed with a trust for the benefit of others.” (Emphasis added.)

In this Essay, Professor Langbein explains why the benefit-the-beneficiaries rule appropriately places an outer limit on the settlor’s authority to direct investments, and he responds to Professor Cooper’s concerns that this limit will adversely affect settlor or trustee behavior or increase litigation.

The Essay is well worth reading, and I commend it highly.