DB04/831213.0006/4494579.2

How Ethical Rules Govern the Conduct of Estate Planners

19TH ANNUAL SALVATION ARMY

ESTATE AND CHARITABLE GIFT PLANNING INSTITUTE

September 14, 2011

By:

Charles A. Redd of

Stinson Morrison Hecker LLP St. Louis, Missouri

7700 Forsyth Boulevard

Suite 1100 St. Louis, Missouri 63105-1821

(314) 259-4534 (Telephone) (314) 259-3952 (Facsimile)

credd@stinson.com

www.stinson.com

DB04/831213.0006/4494579.2

Table of Contents

Page

A. Joint Representation, Conflicts and Confidentiality .............................................................. 1 1. Introduction ....................................................................................................................1 2. Model Rule 1.7...............................................................................................................1 3. Disclosure of Confidences .............................................................................................2 4. Engagement Letters .......................................................................................................4 5. Representing Families ....................................................................................................7 6. Lawyers’ Conflicts of Interest Give Rise to Fraud Lawsuit In re Aoki, 913

N.Y.S.2d 152 (April 21, 2010) ......................................................................................8

B. Disclosures To Beneficiaries By Trustee’s Lawyer............................................................. 10

C. Obligations Of Lawyer When Maintaining Original Documents ........................................ 11

1. In General.....................................................................................................................11 2. Implied Understanding.................................................................................................12 3. Obligation to Inform Beneficiaries or the Executor ....................................................12

4. Additional Obligations .................................................................................................12

D. Continuing Obligations of Lawyer After Representation Ends ........................................... 13

1. In General.....................................................................................................................13 2. Duty to Monitor Affairs of Client to Ensure That Estate Plan is Not Frustrated by

Subsequent Actions .....................................................................................................13 3. Lawyers Beware...........................................................................................................14 4. Model Rule 1.4 and Dormant Representation..............................................................14

5. Newsletters ...................................................................................................................15 6. Creating a Duty to Provide Services ............................................................................15 7. Effect of Provision That Limited Clients’ Ability To Amend Or Revoke Dunn v.

Patterson, 919 N.E.2d 404 (Ill. App. November 18, 2009) ........................................16

E. Clients Under a Disability .................................................................................................... 17 1. General Ethical Standards ............................................................................................17 2. Recommending Appointment of Guardian ..................................................................19

3. Drafting Estate Planning Documents for a Client With Marginal Capacity ................20

F. Ethical and Fiduciary Liability Consequences That May Arise When Execution of Documents is Delayed ......................................................................................................... 20

G. The Interrelationship Of Professional Ethics Rules With Malpractice Actions .................. 21

DB04/831213.0006/4494579.2

HOW ETHICAL RULES GOVERN THE CONDUCT OF ESTATE PLANNERS

By Charles A. Redd

Stinson Morrison Hecker LLP St. Louis, Missouri

A. Joint Representation, Conflicts and Confidentiality

1. Introduction

Perhaps the most ubiquitous ethical issue confronting estate planning lawyers is the subject of joint representations and the obligations of the lawyer to each of the parties. If the lawyer does not specify the capacity in which he or she will serve a husband and wife, joint representation is presumed to exist. Although the most common joint representation involves a husband and wife, this issue can also arise in multi-generational planning, as discussed below. Examples of conflicts of interests in the joint representation of spouses include the following:

• Blended families often are a source of conflict. A stepparent may not wish to benefit his or her stepchildren, while the other spouse, the biological parent, will feel that the children are entitled to such support. The establishment of a QTIP trust by a spouse with children from a previous relationship generates this same sort of conflict.

• Another common source of conflict is when only one of the spouses has had a prior engagement with the lawyer. The lawyer will then have to make sure that there is no actual or perceived influence by the spouse with whom the lawyer had the prior engagement. A similar problem may exist in which one spouse makes all the decisions for both spouses, while the other spouse is unable to make decisions and simply defers to the decision-making spouse. In this situation, the lawyer may have great difficulty in making sure that both spouses are treated fairly.

• Conflicts can arise when including need-based or other restrictions on property held for the benefit of a surviving spouse. While being viewed by the testator spouse as necessary to protect the surviving spouse, the surviving spouse may view it as unjustifiable or manipulative.

2. Model Rule 1.7

The most relevant American Bar Association (“ABA”) Model Rule of Professional Conduct (the “Model Rule”) regarding this issue is Model Rule 1.7, which prohibits representation where it involves a “concurrent conflict of interest. A concurrent conflict of interest exists if: (1) the representation of one client will be directly adverse to another client; or

- 2 - DB04/831213.0006/4494579.2

(2) there is a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client, a former client or a third person or by a personal interest of the lawyer.”

The lawyer may accept or continue a representation when a concurrent conflict of interest exists if: “(1) the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client; (2) the representation is not prohibited by law; (3) 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 other proceeding before a tribunal; and (4) each affected client gives informed consent, confirmed in writing.” Model Rule 1.7(b). In light of this safe harbor, many lawyers will routinely disclose the advantages and disadvantages of the joint representation and then seek informed consent in writing to the representation, assuming the other requirements of this safe harbor are met. “Informed consent” is defined by Model Rule 1.0(e) as an agreement by an affected person after the lawyer has communicated adequate information and explanation about the material risk of and reasonably available alternatives to the proposed course of action.

3. Disclosure of Confidences

Among the many problems that can arise are confidences that are revealed to the lawyer by one party that are intended by that party to be kept confidential from the other party. The ABA Comment to Rule 1.7 notes the difficulty that arises if a client in a joint representation asks a lawyer not to disclose information to another client in the joint representation, stating that the “lawyer has an equal duty of loyalty to each client, and each client has the right to be informed of anything bearing on the representation that might affect that client’s interests and the right to expect that the lawyer will use that information to that client’s benefit,” as required by Model Rule 1.4, Communication. Presumably withdrawal is required in this circumstance. Under Model Rule 1.16(a)(1), a lawyer must withdraw from the representation of a client if the representation will result in violation of the rules of professional conduct or other law.

This issue was presented in A v. B v. Hill Wallack, 726 A.2d 924 (N.J. 1999). In October 1997, the law firm of Hill Wallack was retained jointly to represent a husband and wife in drafting their Wills. The husband and wife each signed a “Waiver of Conflict of Interest” document and consented to and waived any conflict of interest that may arise. There was no express waiver, however, of the confidentiality of any information that may be disclosed to the lawyers.

In January 1998, before the execution by the husband and wife of their Wills, the mother of a nonmarital child of the husband retained Hill Wallack to commence a paternity suit against the husband. At the time of the representation by the mother, the lawyers at Hill Wallack who represented the husband and wife in connection with their estate planning were not aware of the conflict between the husband and the mother.

After the paternity suit was filed, the husband and wife signed their Wills. Subsequently, Hill Wallack became aware of the conflict between the mother and husband and withdrew as lawyers for the mother. The firm then wrote to the husband and stated its view that it had an

- 3 - DB04/831213.0006/4494579.2

ethical obligation to inform the wife of the existence of the nonmarital child. The husband sued Hill Wallack to prevent it from disclosing any such information to the wife.

The court examined the New Jersey rules of professional conduct and concluded that the firm was entitled, but not required, to disclose the existence (but not the identity) of the child. The court arrived at this conclusion because it held that the husband’s refusal to disclose to his wife the existence of the child was a fraud on his wife. In addition, the court believed that the husband’s child support obligations and other financial responsibilities towards the child could affect distributions to the wife or her estate.

The court rejected imposing an obligation on the firm to make any disclosure to the wife, stating that a disclosure was not mandated by New Jersey’s version of Model Rule 1.6, which deals with disclosure of confidential information. The court stated that the possible inheritance of the wife’s estate by the husband’s nonmarital child was too remote to constitute “substantial injury to the financial interest or property of another,” which would have authorized disclosure under Model Rule 1.6(b). The court went on to suggest that a lawyer commencing the joint representation of co-clients should explicitly agree with the clients regarding the sharing of confidential information.

(a) Lawyer Not Entitled to Disclose. The court in A v. B v. Hill Wallack noted the contrary positions taken by New York and Florida whereby both ethics committees prohibited the disclosure of confidential information obtained during the course of a joint representation. In New York State Bar Ass’n. Comm. on Prof’l Ethics, Op. 555 (1984), A and B employed a lawyer to represent them in connection with the formation and operation of a partnership. B then told the lawyer in confidence that he was actively breaching the partnership agreement. The Committee decided that the lawyer could not disclose the confidential communication to A in the absence of B’s consent. In Florida State Bar Ass’n. Comm. on Prof’l Ethics, Op. No. 95-4 (1997), a lawyer represented both husband and wife in a range of personal matters, including estate planning. Several months after the husband and wife’s Wills were executed, the husband informed the lawyer that he had executed a codicil prepared by another law firm that made substantial provisions for a woman with whom he was having an extramarital relationship. The Committee held that, not only was the lawyer not obligated to inform the wife of the new information, he did not have the discretion to do so. The lawyer was then required to withdraw as lawyer for both parties.

(b) Lawyer Obligated to Disclose. Some states have modified their rules to require a lawyer to reveal confidences in certain joint representation situations. For instance, Hawaii Rule of Professional Conduct 1.6(b) provides, in pertinent part, that “[a]n attorney shall reveal information which clearly establishes a criminal or fraudulent act of the client in the furtherance of which the lawyer’s services had been used, to the extent reasonably necessary to rectify the consequences of such act, where the act has resulted in substantial injury to the financial interests or property of another.” In New Jersey, a lawyer is required to reveal such information, to the extent the lawyer believes necessary, to prevent the client or another person from committing a fraudulent act that the lawyer reasonably believes is likely to result in substantial injury to the financial interest or property of another. NJ Rules of Professional Conduct 1.6(b)(1).

- 4 - DB04/831213.0006/4494579.2

(c) ACTEC Position – Lawyer Entitled to Disclose. The ACTEC Commentaries on the Model Rules of Professional Conduct (4th ed. 2006) (the “ACTEC Commentaries”) on Model Rule 1.6 give the lawyer discretion in determining how to respond. The ACTEC Commentaries then provide the following possible courses of action: “(1) take no action with respect to communications regarding irrelevant (or trivial) matters; (2) encourage the communicating client to provide the information to the other client or to allow the lawyer to do so; or (3) withdraw from the representation if the communication reflects serious adversity between the parties.” The lawyer should not take any action in accordance with one spouse’s request or direction if such action would violate the lawyer’s duty of loyalty to the other client, unless the other client gives informed consent.

The lawyer is also encouraged to advise the client voluntarily to reveal the confidence and to make the client aware of the possible consequences of not revealing the confidence. If the client refuses to reveal the confidence, the lawyer should use his or her discretion to determine if the lawyer should reveal the confidence and whether the lawyer should withdraw from representing one or both clients.

4. Engagement Letters

(a) Conflicts of Interest. Assuming the lawyer, after performing a conflicts of interest analysis, determines that joint representation of two or more clients is appropriate, or presents a conflict that can be waived by informed consent by the clients, the lawyer is strongly encouraged not to commence any representation of multiple clients without first fully disclosing to them the potential conflicts to each client and having the clients sign an engagement letter that carefully details the relationship among and obligations of each of the parties.

Conflicts of interest may arise between spouses, parent and child, a client and entities owned by the client, a fiduciary and beneficiary, or any combination of the above. An engagement letter should discuss the potential for these conflicts to arise and include either the clients’ waiver of the conflicts or specific direction as to how conflicts will be resolved should they arise. Two examples of how these conflicts might be dealt with in an engagement letter are as follows:

• Option 1: If a conflict of interest should arise between you, ethical considerations would prohibit me as the lawyer for both of you from representing either one of you against the other. I would not be able to advocate the position of either of you against the other, and I may then be required to withdraw as the lawyer for both of you.

• Option 2: If a conflict of interest should arise between you, ethical obligations would require me to withdraw as the lawyer for both of you jointly. If otherwise permitted by applicable ethical rules, I may then elect to continue to represent Mary as a client, but John would be required to retain another lawyer to represent him. By signing the enclosed copy of this letter, John agrees under such circumstances to my continued representation of Mary.

- 5 - DB04/831213.0006/4494579.2

The lawyer may have each party execute an engagement letter that states there will be joint representation and that clearly specifies that the lawyer may reveal all confidences to either (or any) party and that no information may be withheld. This type of representation is often referred to as a “show and tell approach.” The engagement letter should seek the waiver of any present or subsequent conflicts and the parties’ consent to this form of representation.

Alternatively, the lawyer may represent the parties jointly (or separately) but be specifically prohibited from revealing any confidences. This approach has been referred to as the “priestly” approach. The priestly approach is fraught with potential conflicts and may result in the lawyer's having to withdraw as counsel for one, both or all clients if a conflict arises (e.g., one spouse informs the lawyer of his intention to withdraw all funds held as joint tenants).

The Commentary to Model Rule 1.7 notes the difficulty that arises if a client in a joint representation asks a lawyer not to disclose information to another client in the joint representation that the attorney’s duty of loyalty and the duty of disclosure under Model Rule 1.4 would normally require the attorney to disclose. Presumably, withdrawal is required in this circumstance. Model Rule 1.16(a)(1).

� Planning Point: Because the engagement letter is seeking the parties’ consent to the relationship therein described, the lawyer must make full disclosure of possible conflicts and his or her procedure for dealing with conflicts should they arise. This procedure may include (depending on the circumstances): (1) withdrawal by the lawyer as counsel to one, some or all of the parties; (2) one, some or all of the parties obtaining new counsel; or (3) the lawyer serving as an intermediary under Model Rule 2.2.

� Planning Point: Even if the lawyer obtains the consent to the joint representation as outlined above, the lawyer cannot assume that joint representation will be appropriate indefinitely. Rather, the lawyer must be vigilant about identifying new conflicts arising in the future or the escalation of existing conflicts that might cause the ongoing joint representation to be inappropriate or require additional disclosures and consents from the individuals involved. Furthermore, in the event a dispute among two or more of the individuals involved arises in connection with the matter, absent the consent of the individuals involved (which is unlikely), the lawyer cannot take sides in the matter and represent one individual against one or more others or the entity. Each would need to retain different legal counsel.

(b) Other Important Issues to Address. Model Rule 1.2 provides with respect to the scope of the representation that a lawyer may limit the objectives of the representation if the client consents after consultation. The most effective way of limiting the objectives of the representation is to define the scope of the representation in an engagement letter.

- 6 - DB04/831213.0006/4494579.2

(c) Discussing Fees and the Scope of Services in the Engagement Letter. Among other advantages, the engagement letter will create a written description of the work that the attorney agreed to undertake in case a dispute arises later concerning the lawyer’s duties to the client. Such a description will also the help client have more accurate and realistic expectations regarding the scope of the representation and the time within which the services will be performed. Otherwise, some clients, or their successors, may expect the lawyer to perform other, additional services. The Model Rules of Professional Conduct, Section 1.5, Comment [2], points out that “a written statement concerning the terms of the engagement reduces the possibility of misunderstanding.” Price, 801 T.M., Conflicts, Confidentiality, and Other Ethical Considerations in Estate Planning.

With regard to attorney’s fees, Model Rule 1.5 further provides, in subsection (b), that “[T]he scope of the representation and the basis or rate of the fee and expenses for which the client will be responsible shall be communicated to the client, preferably in writing, before or within a reasonable time after commencing the representation except when the lawyer will charge a regularly represented client on the same basis or rate. Any changes in the basis or rate of the fee or expenses shall also be communicated to the client.” In addition, Restatement (Third) of the Law Governing Lawyers, § 38(1), similarly requires the lawyer, in most instances, to inform a client of the basis or rate of the fee before, or within a reasonable time after, beginning the representation and states that the information should be given “in writing when applicable rules so provide.”

Some states impose additional requirements. For example, if it is reasonably foreseeable that the attorney’s fee will exceed $1,000.00, California requires a written contract, which specifies the hourly rate, statutory fees or flat fees, and other standard rates, fees and other charges, the nature of the services to be performed and the responsibilities of the attorney and the client. Cal. Bus. & Prof. Code § 6148(a). If these requirements are not met, the agreement is voidable at the option of the client, in which case the attorney is entitled to recover a reasonable fee. Cal. Bus. & Prof. Code § 6148(c).

� Planning Point: As mentioned above, if the attorney’s fee is to be based on hourly rates, the engagement letter should state that the rates will, or are likely to, change periodically. Doing so should provide the lawyer with an adequate basis upon which simply to advise the client of the amount of hourly rate changes as and when they occur. The client should be adequately protected by having advance knowledge that the rates could change in the future and the option of either agreeing to future changes as they became effective or terminating the representation. Price, supra.

(d) Summary. The engagement letter should clearly set forth:

• The individuals that will be represented by the lawyer; • The nature and extent of the obligations of the lawyer. These obligations

should be narrowly described while still being accurate. It is easier subsequently to modify an engagement by adding more obligations than trying to explain why an obligation stated in an engagement letter was not

- 7 - DB04/831213.0006/4494579.2

fulfilled. Gadsen, Kendall, et. al., “How Engaging Can We Be While Playing by the Ethical Rules?” Heckerling Institute on Estate Planning, Special Session (2011);

• The manner of calculating the lawyer’s fees; • The circumstances under which the engagement will terminate; • That each individual involved is consenting to the representation and

waives any potential conflict; and • As discussed above, unless the so-called "priestly" approach is adopted,

that the lawyer may reveal all confidences to the other party or parties.

5. Representing Families

When a lawyer represents members of a family in addition to spouses, the potential bases for conflict are broadened. Even where no conflict exists between spouses, a conflict may arise if the lawyer feels that the spouses’ proposed estate plan would not benefit the family as a whole. For example, the spouses may not wish to take advantage of tax-saving techniques, such as annual exclusion gifts, and instead wish to retain more assets for their own benefit.

(a) Model Rules. In addition to Model Rule 1.7, discussed above, there are many Model Rules directly applicable to this situation. Model Rule 1.9 prohibits a lawyer who has formerly represented a client in a matter from representing another person in the same or substantially related matter in which the person’s interests are materially adverse to the former client unless the former client gives informed consent in writing. If the lawyer did not represent the former client, but the lawyer’s former law firm did, this rule still applies if the lawyer acquired confidential information regarding the former client. This Model Rule also generally prohibits the lawyer from using information obtained during the prior representation to the detriment of the former client. The facts of the Aoki case, summarized below, provide an example of a situation in which this rule may be implicated.

Model Rule 1.4 requires that a lawyer promptly inform the client of any decision or circumstance with respect to which the client’s informed consent is required. The lawyer must also keep a client reasonably informed about the status of a matter.

Model Rule 1.6 prohibits a lawyer, unless an exception is applicable, from disclosing information relating to the representation without the client’s informed consent. This Model Rule applies to all information relating to the representation regardless of its source. See Model Rule 1.6 ABA Comment 3. The duty of confidentiality continues as long as the lawyer has the confidential information, even beyond the death of the client. ABA Informal Opinion 1293 (1974). A lawyer is impliedly authorized to make disclosures about a client when appropriate in carrying out the representation. See Model Rule 1.6 ABA Comment 5; ACTEC Commentaries on Model Rule 1.6. Finally, Model Rule 1.8(b) prohibits a lawyer from using information regarding the representation of a client to the disadvantage of the client without the client’s informed consent unless otherwise permitted or required by the Model Rules.

(b) Case Law. In Haynes v. First National State Bank of New Jersey, 432 A.2d 890 (N.J. 1981), a lawyer prepared a Will for a client when the lawyer had a pre-existing

- 8 - DB04/831213.0006/4494579.2

professional relationship with the principal beneficiary of the Will, who was the client’s daughter. The plaintiffs, the client’s grandchildren, argued that the lawyer’s conflict of interest invalidated the Will under the theory of undue influence. Facts tending to show no conflict of interest and undue influence included the following: (1) the lawyer met with the client alone to review the Will; (2) the lawyer acted in good faith; and (3) the lawyer testified that he believed there was an identity of interests between the client and the beneficiary. Facts tending to show a conflict of interest and undue influence included the following: (1) the client was elderly and lived with the beneficiary; and (2) there was evidence of overreaching by the beneficiary that could have been discovered by the lawyer if he made the appropriate inquiry. The court found that the lawyer did have a conflict of interest and that it was sufficient to raise a presumption of undue influence requiring a “significant burden of proof” to be rebutted. The court characterized the conflict as irreconcilable and doubted whether disclosure and consent could have removed it.

In Will of Man, 490 N.Y.S.2d 213 (1985), a motion was filed to disqualify a lawyer in a will contest case in which the lawyer represented a disinherited child. The lawyer had previously represented the disinherited child’s sibling in other matters involving the decedent. In this case, the sibling was accused of procuring the subject Will by fraud, undue influence and coercion. The court felt that these facts warranted disqualification. But see Chase v. Bowen, 771 So.2d 1181 (Fla.Ct.App. 2000) (no conflict of interest existed when a lawyer revised a Will to disinherit a beneficiary whom the lawyer represented on an unrelated matter).

� Planning Point: When representing families, the lawyer should clearly define whom the lawyer represents and whom the lawyer does not represent. The lawyer should inform the family members that the lawyer does not represent of that fact and recommend that they obtain separate counsel if appropriate. Thomas III, “Ethics - What’s a Lawyer To Do?” Heckerling Institute on Estate Planning, Special Session (2006).

6. Lawyers’ Conflicts of Interest Give Rise to Fraud Lawsuit In re Aoki, 913 N.Y.S.2d 152 (April 21, 2010)

In this case, Rocky Aoki (“Rocky”) was the founder of the Benihana Restaurant chain, comprising approximately 110 restaurants worldwide. The restaurant chain was controlled by Benihana of Toyko, Inc. (“BOT”), which Rocky controlled in its entirety. In 1998, Rocky was convicted of insider trading and resigned from his positions related to the restaurant chain.

Rocky’s long-time personal lawyer was Darwin C. Dornbush. In 1998, on Rocky’s behalf, Mr. Dornbush retained another lawyer named Norman Shaw to draft the governing instrument of an asset protection trust for Rocky called the Benihana Protective Trust (the “Trust”). Rocky transferred his interest in BOT to the Trust. Under the Trust instrument, Rocky and six of his children were discretionary beneficiaries. Rocky also held a testamentary limited power of appointment exercisable in favor of any person other than himself, his estate, his creditors or the creditors of his estate.

In 2002, Rocky married his third wife, Keiko Aoki (“Keiko”). Rocky’s children from his prior marriages became concerned that Keiko may influence Rocky into depriving his children of

- 9 - DB04/831213.0006/4494579.2

part or all of the interests that they expected to obtain under the Trust. In September of 2002, two of the children, Kana and Kevin Aoki (“Kana” and “Kevin”), discussed this issue with Messrs. Dornbush and Shaw.

The next day, Rocky met with Kana, Kevin and Messrs. Dornbush and Shaw and signed a document titled a “Partial Release of a Power of Appointment under New York Estates, Powers & Trusts Law § 10-9.2.” (the “September Release”). The September Release limited the potential donees of Rocky’s power of appointment under the Trust to his descendants. The language of the September Release specified that it was irrevocable. However, no one emphasized the irrevocability of the release to Rocky or explained that he could no longer appoint the trust property to his surviving spouse. Nor was it explained to Rocky that a marital deduction of up to approximately $13 million could no longer be claimed for the property that could otherwise have been appointed to his surviving spouse.

In December of 2002, Rocky signed another document titled “Partial Release of Power of Appointment Under New York Estates, Powers & Trust Law § 10-9.2” (the “December Release”). The December Release further limited Rocky’s power of appointment by eliminating as potential donees those descendants who were non-resident aliens. Mr. Shaw testified that this release was executed solely for tax purposes. The court stated that there was no evidence that anyone explained this document to Rocky or that Rocky understood what he was signing.

In July of 2003, Rocky retained a new lawyer named Joseph Manson. Rocky then executed a codicil to his Will that changed beneficiaries, removed Mr. Dornbush as executor and exercised the power of appointment by appointing over 25% of the Trust principal in favor of Keiko outright. Mr. Manson then requested that Messrs. Dornbush and Shaw render a legal opinion as to the effect the codicil had on Rocky’s original Will. Messrs. Dornbush and Shaw’s legal opinion, completed in September of 2003, concluded that the codicil was invalid because of the releases. Rocky testified that it was not until around the time that Messrs. Dornbush and Shaw completed this legal opinion that Rocky first realized that the releases were irrevocable. Rocky testified that he never would have signed the releases had he understood before he signed them that they were irrevocable.

In September of 2007, Rocky executed a new Will appointing 25% of the Trust principal to Keiko and the remaining 75% to a trust for her lifetime benefit. The Will further provided that, if the releases were found valid (which, Rocky wrote, was “contrary to my desires”), Rocky made an alternative appointment to Keiko to hold the Trust principal in further trust until two of Rocky’s other children, Devon and Steven Aoki (“Devon and Steven”), reached 45, at which time such property would be distributed outright to them.

Rocky died in July of 2008. The Will he executed in 2007 was submitted to probate. Kevin and Kana, as Trustees of the Trust, along with Devon and Steven, objected to the Will, arguing that the releases should be respected. Keiko asserted that the releases were invalid, stating that they were obtained through fraud, and that the Will executed in 2007 should be probated. Devon and Steven then brought a motion for summary judgment.

- 10 - DB04/831213.0006/4494579.2

Keiko relied on Rocky’s statements that he did not intend irrevocably to limit his power of appointment over the Trust property and argued that Messrs. Dornbush and Shaw had a conflict of interest in representing both Rocky and his children and preparing the releases for Rocky’s signature. According to Keiko, the fraud in this case arose from Messrs. Dornbush and Shaw’s failure to inform Rocky of the irrevocable nature of the releases and their adverse tax consequences.

The court found that Messrs. Dornbush and Shaw owed a fiduciary duty to Rocky, who relied on them. The court further found that Messrs. Dornbush and Shaw had entered into an attorney-client relationship with Kevin and Kana in connection with limiting or denying Rocky’s ability to provide for Keiko upon his death. The court stated that Messrs. Dornbush and Shaw had an “impermissible conflict of interest” and they had failed to inform Rocky of that conflict.

The court found that, due to the fiduciary duties owed by Messrs. Dornbush and Shaw to Rocky, it was reasonable for Rocky to have relied on Messrs. Dornbush and Shaw regarding the execution of the releases, even though Rocky failed to read the releases before signing them. According to the court, under New York law, this was a case of constructive fraud, the remedies for which protect a party who, “by virtue of an unequal relationship, places his trust and confidence in another and thereby ‘relax[es] the care and vigilance he would ordinarily exercise in the circumstances’” quoting Brown v. Lockwood, 76 AD2d 721 (NY 1980). The court therefore concluded that there existed triable issues of fact and denied the summary judgment motion.

B. Disclosures To Beneficiaries By Trustee’s Lawyer

The ethical duties of a lawyer who represents a trustee may compel the lawyer to disclose information to the beneficiaries. The ACTEC Commentaries on Model Rule 1.2 (“Scope of Representation and Allocation of Authority Between Client and Lawyer”), addresses this issue. The rule itself states, in pertinent part, that a lawyer must follow the client’s decisions concerning the objectives of the representation and that the lawyer may take such action as is impliedly authorized to carry out the representation. With the client’s informed consent, a lawyer may limit the representation if the limitation is reasonable. The Commentary states that, although the trustee is primarily responsible for communicating with the beneficiaries, the trustee’s lawyer may communicate directly with the beneficiaries regarding the nature of the relationship between the lawyer and the beneficiaries. The Commentary to Model Rule 1.4 (“Communication”) states that the trustee’s lawyer “should make reasonable efforts” to ensure that the beneficiaries are informed of decisions that may substantially affect them.

Specifically, the Commentary to Model Rule 1.2 suggests that the lawyer should explain the role that the lawyer for the trustee usually plays in the administration of a trust, including the possibility that the trustee’s lawyer may owe duties to the beneficiaries. The Commentary goes on to state that the lawyer should provide information to the beneficiaries regarding the trust, but should also warn the beneficiaries that the lawyer does not represent them, and the beneficiaries may wish to retain independent counsel.

- 11 - DB04/831213.0006/4494579.2

This Commentary also explains the duties that the lawyer owes to the beneficiaries. These duties “are largely restrictive in nature,” and “prohibit the lawyer from taking advantage of his or her position to the disadvantage of the fiduciary estate or the beneficiaries. In addition, in some circumstances the lawyer may be obligated to take affirmative action to protect the interests of the beneficiaries.” The nature of these duties depends upon the scope of the representation of the trustee. In addition, a lawyer should not enter into an agreement with the trustee that attempts to limit the lawyer’s duties to the beneficiaries, unless written notice is provided to those beneficiaries. But see Sullivan v. Dorsa, 27 Cal. Rptr. 3d 547 (Ct. App. 2005); Wells Fargo Bank v. Superior Court, 990 P.2d 591 (Cal. 2000) (both holding that the trustee’s lawyer owes no duty to the trust beneficiaries).

The Commentary to Model Rule 1.6 (“Confidentiality of Information”) explains that these duties to the beneficiaries, although limited, may qualify the lawyer’s duty of confidentiality with respect to the trustee. Model Rule 1.6 itself states, in pertinent part, that a lawyer shall not reveal information relating to the representation of a client unless informed consent is given, the disclosure is impliedly authorized or the disclosure is permitted by one of several exceptions listed in 1.6(b), including a disclosure that is required to comply with a law or court order. With regard to situations in which the lawyer believes that his or her services are being used by the trustee to commit a fraud resulting in substantial injury to a beneficiary’s financial interests, the Commentary states that the lawyer usually may disclose confidential information to the extent necessary to protect such beneficiary’s interests.

The potentially expansive nature of the lawyer’s duties to the beneficiaries is further illustrated by the Commentaries to Model Rule 4.1 (“Truthfulness in Statements to Others”), which states that “if a fiduciary is not subject to court supervision and is therefore not required to render an accounting to the court but chooses to render an accounting to the beneficiaries, the lawyer for the fiduciary must exercise the same candor toward the beneficiaries that the lawyer would exercise toward any court having jurisdiction over the fiduciary accounting.”

C. Obligations Of Lawyer When Maintaining Original Documents

1. In General

It is commonplace for lawyers practicing in the trusts and estates field to maintain in a special vault the original wills and certain other estate planning documents of those clients for whom they have drafted the documents. Absent any express agreement to the contrary, does the lawyer have any obligations when he learns that the client has died?

Generally, the obligations of a lawyer who maintains original documents are determined by the agreement between the lawyer and client. As discussed below, these obligations may arise if there are express or implied agreements or understandings between the client and the lawyer regarding the lawyer’s duties and responsibilities relating to the estate plan. The lawyer and client may agree that the lawyer will undertake the responsibility to learn of the client’s death (e.g., by reading death notices) or that the lawyer, upon learning of the client’s death, will file the Will with the appropriate court.

- 12 - DB04/831213.0006/4494579.2

2. Implied Understanding

An implied understanding may exist if the lawyer has in the past undertaken a greater role in the handling of the client’s estate planning matters. This is more likely to occur where the lawyer has regular contact with the client and performs ongoing services, as is often the case with high net-worth clients.

3. Obligation to Inform Beneficiaries or the Executor

In New York Eth. Op. 724, N.Y. St. Bar Assn. Comm. Prof. Eth. (November 30, 1999), the Committee concluded that, in the absence of an agreement, if the lawyer has maintained the client’s original Will, after the client’s death, the lawyer must assure that the executor and/or beneficiaries are aware of its existence, unless the lawyer knows of a later valid Will. The lawyer, however, does not have an obligation to take steps to learn of the client’s death or to file the original Will with an appropriate court.

4. Additional Obligations

At least one jurisdiction has imposed a greater obligation on the lawyer who drafts a Will and retains the original where the named executor refuses to file the Will. In Pennsylvania Ethics Opinion 97-66 (1997), the husband, the named executor, refused to probate the Will. The husband, however, provided the lawyer with some information for the inheritance tax return and therefore entered into an attorney-client relationship with the lawyer.

The Committee held that an “attorney who has drafted a will and is still in possession of it after death has an absolute obligation to take steps to see that the will is given effect.” Such an obligation was deemed to fall within the scope of Model Rule 8.4(d) which forbids an attorney from “[engaging] in conduct that is prejudicial to the administration of justice.”

The lawyer was directed to inform all the beneficiaries of the Will of their interests thereunder. In addition, the lawyer was encouraged to warn the husband of the lawyer’s actions and to ask the husband to seriously reconsider. If the husband demands that the lawyer give him the Will, the lawyer must decline and either retain it or file the Will with the court. Finally, unless the executor is completely cooperative, it was suggested that the lawyer resign as the lawyer settling the estate.

� Planning Point: It is advisable for a lawyer who drafts Wills and other estate planning documents and who intends to maintain the originals of such documents for safekeeping to agree with his clients in advance what obligations the lawyer is assuming, such as whether, after the client’s death the lawyer must assure that the executor and/or beneficiaries are aware of its existence and, for that matter, whether the lawyer has a duty to inquire as to the health of the client.

- 13 - DB04/831213.0006/4494579.2

D. Continuing Obligations of Lawyer After Representation Ends

1. In General

A lawyer’s obligation to a client once the initial tasks of the representation are completed raises two issues. First, does the lawyer have a duty to monitor the affairs of the client to ensure that the estate plan originally prepared and executed is not frustrated by subsequent actions of the client? Second, does the lawyer have a continuing obligation to advise a client of changes in the law occurring after the initial representation has ended?

2. Duty to Monitor Affairs of Client to Ensure That Estate Plan is Not Frustrated by Subsequent Actions

The first issue was addressed in Stangland v. Brock, 747 P.2d 464 (Wash. 1987).

In 1979, a lawyer named Norman Brock prepared a Will for Ralph Schalack that left all of his real property to Alvin Stangland and Bruce Kintschi. At the time the Will was signed, Mr. Schalack’s farm was the substantial asset of his estate. The residue of the estate was bequeathed to different individuals.

In February 1982, Kenneth Carpenter, a real estate lawyer practicing in the same law firm as Mr. Brock, prepared a sales contract for the Mr. Schalack’s farm. Mr. Brock was not aware that the property was being sold. Mr. Carpenter stated that he had no knowledge of the terms of Mr. Schalack’s Will.

Mr. Schalack died on May 7, 1982. Messrs. Stangland and Kintschi brought an action against Messrs. Brock and Carpenter and their law firm seeking damages for professional negligence. Specifically, the complaint alleged that Mr. Brock was negligent in not drafting the Will to provide that the farm (or sales proceeds thereof) would ultimately pass to the Messrs. Stangland and Kintschi, as was the intent of the decedent. In addition, the lawyers were alleged to be negligent by not advising Mr. Schalack that entering into the sale of the property would frustrate the intent under his Will.

The court found that, notwithstanding that Mr. Brock was a member of the same law firm as Mr. Carpenter, Mr. Brock had no duty to advise the decedent of the contract’s possible effect on his estate plan. The court stated:

If we held that Brock had such a duty, we would be expanding the obligation of a lawyer who drafts a will beyond reasonable limits. While an individual retains an attorney to draft his will the attorney’s obligation is to use the care, skill, diligence and knowledge that a reasonable, prudent lawyer would exercise in order to draft the will according to the testator’s wishes. Once that duty is accomplished, the attorney has no continuing obligation to monitor the testator’s management of his property to ensure that the scheme established in the will is maintained. The time and expense that would be required for the attorney to follow all of the testator’s activities with respect to his property would prevent the attorney from being able

- 14 - DB04/831213.0006/4494579.2

to provide reliable and economical services to that client, and would constitute an overwhelming burden on the attorney’s practice as a whole.

The court further found that Mr. Carpenter had no reason to know of the contents of the Mr. Schalack’s Will and could not have foreseen that the sale of the property may harm the respondents.

3. Lawyers Beware

It should be noted that the court’s holding in Stangland v. Brock should not be read to imply that a lawyer does not have any obligation to monitor a testator’s activities with respect to his or her assets where the lawyer has actual knowledge of a subsequent transaction. Further, courts may be more inclined to impose a greater level of implied knowledge in situations where the firm represents the client on an ongoing basis (e.g., high net-worth clients who require legal representation on a regular basis). In addition, courts in other jurisdictions could reach a result that is less favorable to estate planning lawyers.

4. Model Rule 1.4 and Dormant Representation

Model Rule 1.4 provides that a lawyer must keep his or her clients reasonably informed about the status of a matter and promptly comply with reasonable requests for information and shall explain a matter to the extent reasonably necessary to permit the client to make informed decisions.

The ACTEC Commentaries to Model Rule 1.4 introduced the concept of “dormant representation” as follows:

The execution of estate planning documents and the completion of related matters, such as changes in beneficiary designations and the transfer of assets to the trustee of a trust, normally ends the period during which the estate planning lawyer actively represents an estate planning client. At that time, unless the representation is terminated by the lawyer or client, the representation becomes dormant, awaiting activation by the client. . . . Although the lawyer remains bound to the client by some obligations, including the duty of confidentiality, the lawyer’s responsibilities are diminished by the completion of the active phase of the representation. As a service the lawyer may communicate periodically with the client regarding the desirability of reviewing his or her estate planning documents. Similarly, the lawyer may send the client an individual letter or a form letter, pamphlet, or brochure regarding changes in the law that might affect the client. In the absence of an agreement to the contrary, a lawyer is not obligated to send a reminder to a client whose representation is dormant or to advise a client of the effect that changes in the law or the client’s circumstances might have on the client’s legal affairs. (emphasis added).

- 15 - DB04/831213.0006/4494579.2

The ACTEC Commentaries provide the following examples:

Example 1.4-1: Lawyer (L) prepared and completed an estate plan for Client (C). L performed no other legal work for C in the following two years but has no reason to believe that C has engaged other estate planning counsel. L’s representation of C is dormant. L may, but is not obligated to, communicate with C regarding changes in the law. If L communicates with C about changes in the law, but is not asked by C to perform any legal services, L’s representation remains dormant. C is properly characterized as a client and not a former client for purposes of [Rules] 1.7 and 1.9.

Example 1.4-2: Assume the same facts as in Example 1.4-1 except that L’s partner (P) in the two years following the preparation of the estate plan renders legal services to C in matters completely unrelated to estate planning, such as a criminal representation. L’s representation of C with respect to estate planning matters remains dormant, subject to activation by C.

� Planning Point: For new clients, the issue should be resolved at the beginning of the representation. A lawyer should carefully set out his or her responsibilities in an engagement letter with respect to the actions to be taken by the lawyer and should also include what will not be required of the lawyer (e.g., the obligation to see that a trust is funded, assets properly transferred or designated beneficiary forms properly completed). The engagement letter should clarify whether the lawyer has a continuing duty to advise the client or to take other actions regarding subsequent changes in the law or other circumstances that may affect the client’s estate plan. In addition, the lawyer might consider sending an “exit” letter to the client specifying that the engagement has been completed and that the lawyer assumes no obligation to inform the client of any changes in the law or otherwise that might require a reconsideration of the estate plan.

5. Newsletters

Lawyers should be careful when sending out newsletters to clients advising them of changes in the law not to make any implication that the lawyer has assumed the obligation continually to update the client as to future changes in the law or that the lawyer has assumed any obligation to review any client’s particular estate plan without first being contacted by the client. If the client has a reasonable belief that the representation has not ended, the lawyer may have a continuing duty to that client.

6. Creating a Duty to Provide Services

The above discussion raises the issue of whether, through maintaining contact with a former estate planning client, e.g., by sending newsletters regarding recent developments in trusts and estates law, the lawyer may be suggesting to the client that the lawyer is undertaking a duty to inform the client of changes in the law that may affect the carrying out of the client’s

- 16 - DB04/831213.0006/4494579.2

intent. Obviously, with fundamental changes in the transfer tax law occurring in 2011 and 2013, if such a duty exists, lawyers would be carrying a heavy burden in consulting all their clients with estate plans that are affected by these changes.

Under the ACTEC Commentaries, at least, no such duty arises. In the discussion of Model Rule 1.8, the Commentaries state that “sending a client periodic letters encouraging the client to review the sufficiency of the client’s estate plan or calling the client’s attention to subsequent legal developments does not increase the lawyer’s obligations to the client.”

7. Effect of Provision That Limited Clients’ Ability T o Amend Or Revoke Dunn v. Patterson, 919 N.E.2d 404 (Ill. App. November 18, 2009)

Charles and Charlotte Dunn engaged an attorney named Lawrence F. Patterson to prepare an estate plan for them. Mr. Patterson prepared a joint trust as well as durable powers of attorney and living wills for each of them. The Dunns signed these documents on June 12, 2006.

Each of these documents contained a qualified amendment and revocation provision, which provided that any amendment or revocation of the documents may only be executed with the written consent of Mr. Patterson or by order of the court. Mr. Patterson would later testify that he routinely inserts a qualified amendment and revocation provision in his clients’ estate planning documents to prevent his elderly clients from amending or revoking their estate planning documents while under undue influence or when lacking the ability to make reasonable decisions regarding estate planning matters.

In November of 2006, the Dunns engaged a lawyer named Timothy J. McJoynt and requested, among other changes, to remove the requirement that Mr. Patterson must approve any revocation of or amendment to the estate planning documents. Mr. McJoynt then called Mr. Patterson to inform him of the Dunns’ wishes and to request his consent to these amendments. Mr. Patterson then requested a meeting with the Dunns to discuss this issue. The Dunns refused to meet with Mr. Patterson. On February 6, 2007, Mr. Patterson sent a letter to the Dunns requesting that they execute a formal notice of termination regarding his role in any amendment to or revocation of the Dunns’ estate planning documents. Mr. Patterson never received a response to this request.

The Dunns then filed suit seeking a declaratory judgment against Patterson. Specifically, the Dunns sought a court order finding that the Dunns had the absolute authority to amend their estate planning documents and that Rule 1.2(a) of the Illinois Rules of Professional Conduct required Mr. Patterson to follow their directions. In another attempt to determine whether he should consent to the amendments, as part of this suit Mr. Patterson served a notice of discovery on the Dunns. Mr. Patterson never received a response from the Dunns regarding this notice either.

The trial court found for the Dunns, holding that the qualified amendment and revocation provision was contrary to public policy and void because the provisions were contrary to Rule 1.2(a). Mr. Patterson appealed to the Illinois Appellate Court.

- 17 - DB04/831213.0006/4494579.2

Rule 1.2(a) states, in pertinent part, that “a lawyer shall abide by a client’s decisions concerning the objectives of representation and, as required by Rule 1.4, shall consult with the client as to the means by which they are to be pursued.” The Dunns argued that, pursuant to this Rule, an attorney must follow his or her client’s directions as long as the directions given by the client are not contrary to law, unethical, unwise or in violation of an ethical or legal obligation.

Mr. Patterson argued on appeal that the amendment and revocation provisions are a proper means for a grantor to limit his or her own future ability to amend or revoke the trust instrument. Mr. Patterson argued that the amendment and revocation provisions are merely third-party consent provisions, which are legal in Illinois. See RESTATEMENT (THIRD) OF

TRUSTS, § 63(1), cmt j. The Dunns responded by arguing that, relying on Rule 1.2(a), the limitations in the document are not permissible when the consent required is that of the drafting lawyer. The court, however, agreeing with Mr. Patterson, stated that giving a lawyer the authority to grant consent such as in this case is actually consistent with the fiduciary duty that a lawyer owes to a client.

The Dunns relied on Sherman v. Klopfer, 336 N.E.2d 219 (1975), in which the court found that a lawyer who ran a business with his aunt and drafted various documents for her breached his fiduciary duty by failing to give the aunt sufficient control of the business so as to permit her to sell its assets and by refusing to consent to the sale of the business. The court in this case, however, distinguished Sherman by pointing out that the Sherman court came to its decision because the lawyer misled the aunt and the lawyer stood to gain from the provisions of the documents he drafted. Neither of these facts were present in this case.

The court explained that “[w]here, as here, the lawyer is given no financial stake in an estate by virtue of his capacity as a fiduciary, we see no reason why the family lawyer cannot act in such capacity simply because he is drafting a trust document.” The court also believed that the amendment and revocation provisions “are not inconsistent with the duty of a lawyer to follow his clients’ instructions under Rule 1.2,” and that the Dunns executed the estate planning documents containing the amendment and revocation provisions with an understanding of these provisions. The court also believed that Mr. Patterson’s refusal to consent to the Dunns’ changes to the estate planning documents was appropriate, stating that “a meeting with the plaintiffs, at a minimum, was necessary so that Patterson could assess competency and any possible undue influence.”

E. Clients Under a Disability

1. General Ethical Standards

(a) Model Rule 1.14. Model Rule 1.14(a) makes it clear that the lawyer’s duty to the client does not end simply because the client may be disabled. Specifically, the Model Rule provides that the lawyer should “as far as reasonably possible, maintain a normal client-lawyer relationship with the client.” This includes maintaining adequate communication with the client to determine the client’s objectives and goals and the ways in which to achieve them. If the lawyer determines that a normal attorney-client relationship cannot be maintained, Model Rule 1.14(b) permits the lawyer to take steps to protect the client’s interests. This may,

- 18 - DB04/831213.0006/4494579.2

depending on the circumstances, include seeking guidance from medical diagnosticians or others to ascertain the client’s mental state or petitioning a court for the appointment of a guardian. Model Rule 1.14, ABA Comments 5 & 6.

(b) Revealing Confidences of a Disabled Client. Most state ethics opinions have espoused relaxing the confidentiality requirements of the lawyer if the lawyer determines it to be in the client’s best interests. Various jurisdictions, however, have expressed different opinions as to the point at which the lawyer may reveal the confidence and to whom the confidence may be revealed. See Illinois State Bar Ass’n, Op. 00-02 (2000) (lawyer may not reveal confidences to parent unless lawyer is of the opinion that the adult client is disabled to the extent a guardian should be appointed; however, lawyer may consult with physician); Oregon Op. 1991-41 (1991) (lawyer authorized to disclose confidential communications to family members to avoid more extreme protective actions); Pa. Bar Ass’n Comm. on Legal Ethics and Prof’l Responsibility, Informal Op. 90-89 (1990) (confidentiality should be protected at least until the lawyer determines that it is necessary to seek appointment of a guardian).

In 2002, the ABA added an additional paragraph to Model Rule 1.14 stating that “[i]nformation relating to the representation of a client with diminished capacity is protected by Rule 1.6. When taking protective action pursuant to paragraph (b), the lawyer is impliedly authorized under Rule 1.6(a) to reveal information about the client, but only to the extent reasonably necessary to protect the client’s interests.” Model Rule 1.6 provides that:

(a) A lawyer shall not reveal information relating to the representation of a client unless the client gives informed consent, the disclosure is impliedly authorized in order to carry out the representation or the disclosure is permitted by paragraph (b).

(b) A lawyer may reveal information relating to the representation of a client to the extent the lawyer reasonably believes necessary:

(1) to prevent reasonably certain death or substantial bodily harm; (2) to prevent the client from committing a crime or fraud that is

reasonably certain to result in substantial injury to the financial interest or property of another and in furtherance of which the client has used or is using the lawyer’s services;

(3) to prevent, mitigate or rectify substantial injury to the financial interests or property of another that is reasonably certain to result or has resulted from the client’s commission of a crime or fraud in furtherance of which the client has used the lawyer’s services;

(4) to secure legal advice about the lawyer’s compliance with these Rules;

(5) to establish a claim or defense on behalf of the lawyer in a controversy between the lawyer and the client, to establish a defense to a criminal charge or civil claim against the lawyer based upon conduct in which the client was involved, or to

- 19 - DB04/831213.0006/4494579.2

respond to allegations in any proceeding concerning the lawyer’s representation of the client; or

(6) to comply with other law or a court order.

The ABA Comment to the Model Rule 1.14 provides that the ability to disclose confidences is not open-ended and should generally be limited to situations where the client is at risk of substantial physical, financial or other harm unless action is taken and the lawyer cannot adequately act in his or her own interest. “At the very least, the lawyer should determine whether it is likely that the person or entity consulted with will act adversely to the client’s interests before discussing matters related to the client.”

2. Recommending Appointment of Guardian

The appointment of a guardian for an individual is an extreme measure and should not be undertaken lightly.

(a) Model Rule 1.14(b). This Model Rule gives the lawyer discretion to seek the appointment of a guardian only when the lawyer reasonably believes that the client: (1) has diminished capacity; (2) is at risk of substantial physical, financial or other harm unless action is taken; and (3) cannot adequately act in the client’s own interest. The intent is for the lawyer to consider all of the options to determine what is in the client’s best interests. Several states, including New York and Oregon, have taken similar stances in their ethics opinions. See New York State Bar Ass’n Comm. on Prof'l Ethics, Op. Number 746 (July 18, 2001) (concluding that a lawyer who serves as the client’s attorney-in-fact may petition for the appointment of a guardian without the client’s consent only if the lawyer determines that the client is incapacitated and that there is no practical alternative, through the use of the power of attorney or otherwise, to protect the client’s best interests); Oregon State Bar Ass’n Bd. of Governors, Formal Opinion 1991-41 (the lawyer “must reasonably be satisfied that that there is a need for protective action and must then take the least restrictive form of action sufficient to address the situation”). The ABA, in ABA Formal Opinion 96-404 (August 2, 1996), provided that the protective action, such as obtaining the appointment of a guardian, should be “the least restrictive under the circumstances.” ACTEC Commentaries, Model Rule 1.14.

(b) Minority View . In California State Bar Standing Committee on Professional Responsibility and Conduct, Formal Op. No. 1989-112 (1989), the Committee ruled that a lawyer could not ethically institute a conservatorship proceeding for a client he or she believed to be incompetent if it was against the client’s express wishes and doing so would require the lawyer to violate his or her client’s confidences and represent potentially conflicting interests, notwithstanding the lawyer’s view that it would be in client’s best interests. The Committee stated that the lawyer may withdraw under such circumstances.

(c) Lawyer’s Role. Generally, if a guardian is appointed, the lawyer should assist the guardian to benefit the client. However, if the lawyer reasonably believes that the guardian is not acting in the client’s best interests, the lawyer may be obligated to act contrary to the guardian to protect the client’s interests. See In re Makarewicz, 516 N.W.2d 90 (Mich.App.

- 20 - DB04/831213.0006/4494579.2

1984); see also, Alaska Ethics Op. 87-2 (1987). The ACTEC Commentaries to Model Rule 1.14 provide that the lawyer may have such an obligation even if the lawyer represents the guardian.

(d) Other Measures. In addition to appointing a guardian, the ABA Comment to Model Rule 1.14 provides that the protective measures a lawyer may take include: (1) consulting with family members; (2) using a reconsideration period to permit clarification or improvement of circumstances; (3) using voluntary surrogate decision-making tools such as durable powers of attorney or revocable trusts; or (4) consulting with support groups, professional services, adult-protective agencies, social services or other governmental agencies or other individuals or entities that have the ability to protect the client. In taking any protective action, the Comment further explains that the lawyer should consider the wishes and values of the client, the client’s best interests and the goals of limiting intrusion into the client’s decision-making autonomy, maximizing client capacities and respecting the client’s family and social connections. The ACTEC Commentaries to Model Rule 1.14 add that the lawyer should consider the impact the lawyer’s actions may have on the potential challenges to the client’s estate plan.

3. Drafting Estate Planning Documents for a Client With Marginal Capacity

A lawyer drafting estate planning documents for a client must ascertain that the client has the requisite mental capacity to execute the specific document in question. The lawyer must keep in mind that the mental capacity required for executing various documents may not be identical. For example, the capacity needed for executing a Will differs from the capacity for executing a contract. Additionally, the state of mind of the client at the time the document is executed must be ascertained. This is of critical importance for the client who may go in and out of various stages of dementia.

If the lawyer believes a client is incapable of acting rationally, the lawyer should not present to the client a document for signature. If the client is experiencing a lucid moment, however, the lawyer is advised to document the occurrence and, if possible, to have witnesses to the execution. In the case of a Will, it is helpful for the lawyer to read parts of the Will out loud and to ask if the client understands what the lawyer is reading. See Kirtland, “Dealing With Mental Capacity Issues in Estate Planning,” 30 EST. PLAN . 192 (2003).

F. Ethical and Fiduciary Liability Consequences That May Arise When Execution of Documents is Delayed

Model Rule 1.3 directs that a lawyer shall represent a client with “reasonable diligence and promptness.” This Rule is implicated when an estate planning lawyer drafts an estate plan for a client, a significant period of time elapses after the drafts are completed but not signed and the client dies before signing the document. The ABA Comment to this Rule sets a high standard by stating that a lawyer should “take whatever lawful and ethical measures are required to vindicate the client’s cause or endeavor” and that “a lawyer should carry through conclusion all matters undertaken for a client.”

- 21 - DB04/831213.0006/4494579.2

Although there appear to be very few, if any, ethics opinions or cases that mention this Model Rule in the estate planning context, there is a line of cases dealing with the fiduciary liability exposure of a lawyer whose client has died before executing his or her new estate planning documents. Notwithstanding that many jurisdictions have expressed a willingness to allow non-client beneficiaries under a Will to sue the drafting lawyer where the Will was negligently prepared, see, e.g., Blair v. Ing, 21 P.3d 452 (Haw. 2001), the cases that have addressed whether a non-client beneficiary can sue an estate planner for failure to complete the execution of an estate planning document before the client died have found that the estate planner was not liable in tort to the disappointed beneficiaries. In Radovich v. Locke-Paddon, 35 Cal.App.4th 946 (1995), the court noted that, without an executed Will, it could not find an express intent to help the beneficiary (“the only person who can say what he or she intended – has died”) and, further, that harm to the beneficiary was not sufficiently foreseeable. See also Krawczyk v. Stingle, 543 A.2d 733 (Conn. 1988) (stating that “the imposition of liability to third parties for negligent delay in the execution of estate planning documents would not comport with a lawyer’s duty of undivided loyalty to the client”); Gregg v. Lindsay, 649 A.2d 935 (Pa. Super. Ct. 1994) (finding that a lawyer who drafted estate planning documents for a client that were not signed before the client died was not liable to a beneficiary under the draft estate plan because there was no contract between the client and the lawyer to grant a benefit to the beneficiary).

The California Court of Appeals has recently dealt with this issue again. In Hall v. Kalfayan, 190 Cal.App.4th 927 (December 8, 2010), a prospective beneficiary under a Will brought a malpractice action against the lawyer who drafted the Will but failed to have it executed before the testator’s death. A conservator for the testator had dealt on the testator’s behalf with the lawyer regarding the drafting of the Will. Relying on Radovich and another recent California case that came to similar result, Chang v. Lederman, 172 Cal.App. 4th 67 (2009), the court found that the lawyer did not have a duty to the potential beneficiary to have the Will executed before the testator’s death. The court stated that the lawyer owed a duty only to the conservator on behalf of the testator. The court added that the testator herself had not expressed a desire to have a new Will prepared and had only a limited conversation with the lawyer about the disposition of her estate.

G. The Interrelationship Of Professional Ethics Rules With Malpractice Actions

In any malpractice action, the plaintiff generally must prove a duty on the part of the attorney, the failure of the attorney to exercise the ordinary skill and knowledge required of an attorney and that such failure caused damage to the plaintiff. For the plaintiff to prove the failure of an attorney to exercise the ordinary skill and knowledge required of an attorney, it will often be helpful to show a violation of the applicable ethical standards. The plaintiff would argue that a reasonable attorney would have followed such ethical standards, that failure to follow these standards is a failure to follow the standard of care expected of a reasonable attorney and that this failure caused harm to the plaintiff. See generally, Richmond, Why Legal Ethics Rules Are Relevant To Lawyer Liability, 38 ST. MARY’S L.J. 929 (2007).

As explained by the Model Rules Scope Comment 20, and the Preliminary Statement of the Model Code of Professional Conduct, a violation of the ethics rules is not tantamount to malpractice. The Model Rules go on to state, however, that “since the Rules do establish

- 22 - DB04/831213.0006/4494579.2

standards of conduct by attorneys, an attorney’s violation of a Rule may be evidence of a breach of the applicable standard of conduct.” While most courts agree that a violation of the ethics rules does not by itself establish a malpractice claim, see, e.g., Mainor v. Nault, 101 P.3d 308 (Nev. 2004); Davis v. Findley, 422 S.E.2d 859 (Ga. 1992), courts have taken different stances on the admissibility and reliability of ethics violations.

Most states permit admission into evidence of an attorney’s violation of the ethics rules and/or specific references by the expert witnesses to such rules. See, e.g., Mayol v. Summers, Watson & Kimpel, 585 N.E.2d 1176 (Ill.App. 1992) (approving a jury instruction specifically quoting Illinois’ version of Rule 1.1 (Competence)); Pressley v. Farley, 579 So.2d 160 (Fla.App. 1991); Fishman v. Brooks, 487 N.E.2d 1377 (Mass. 1986) (holding that, “if a plaintiff can demonstrate that a disciplinary rule was intended to protect one in his position, a violation of that rule may be some evidence of the attorney’s negligence” but also holding that, “expert testimony concerning the fact of an ethical violation is not appropriate.”).

A Michigan court has ruled that, if a plaintiff establishes a violation of the ethics rules by a defendant attorney, there is a rebuttable presumption of malpractice. In Lipton v. Boesky, 313 N.W.2d 163 (Mich.App. 1981), the attorney represented the plaintiffs in connection with litigation over the construction of an office building. When the plaintiffs later sued their attorney for malpractice, they alleged numerous violations of Michigan’s Code of Professional Responsibility. The court, reasoning that the ethics rules establish a standard of conduct and that the clients should be able to assume that such standard will be met during the course of the representation, held that a violation of the Model Rules is rebuttable evidence of malpractice. A later Michigan case held, while adhering to the general principles of Lipton, that the plaintiff usually must present expert testimony as to the defendant’s violation of the conflicts of interest rules before the rebuttable presumption of malpractice arises. Beattie v. Firnschild, 394 N.W.2d 107 (Mich.App. 1986); see, also, Hart v. Comerica Bank, 957 F.Supp. 958 (E.D. Mich. 1997).

Courts in California and Pennsylvania have gone even further, holding that, depending on the facts, expert testimony is not necessary to establish a violation of the ethics rules. David Welch Co. v. Erskine & Tulley, 203 Cal.App.3d 884 (1992) (“The standards governing an attorney’s ethical duties are conclusively established by the Rules of Professional Conduct. They cannot be changed by expert testimony”); Rizzo v. Haines, 555 A.2d 58 (Pa. 1989).

In contrast, the Supreme Court of Washington in Hizey v. Carpenter, 830 P.2d 646 (Wash. 1992), appeared to be much less receptive to a plaintiff’s use of the rules of professional conduct or responsibility in malpractice actions against attorneys. The court explained that the ethics rules, which were designed to regulate the relationships among the attorney, the client and the court, were not meant to be applied in malpractice cases, which only concern the relationship between the attorney and the client. Applying the ethics rules in malpractice cases would cause attorneys to elevate those ethics rules that primarily regulate the relationship between the attorney and client over those ethics rules that primarily regulate the relationship between the attorney and the court. While holding that no reference may be made to the ethics rules, it nevertheless permitted an expert to testify in reliance on the ethics rules, effectively diluting its position on this issue. Other Washington cases illustrate the narrow applicability of the Hizey

- 23 - DB04/831213.0006/4494579.2

decision. Cotton v. Kronenberg, 44 P.3d 878 (Wash.App. 2003) (ethics rules can be considered in breach of fiduciary duty cases, but not malpractice cases).

Other decisions, however, are consistent with Hizey in holding that professional rules are inadmissible in a legal malpractice claim. See Orsini v. Larry Moyer Trucking, Inc., 833 S.W.2d 366 (Ark. 1992) (holding that the lower court did not err by refusing to admit into evidence the Model Rules of Professional Conduct because such rules were meant as guidelines only, not to establish a civil cause of action for malpractice); Webster v. Powell, 391 S.E.2d 204 (N.C.App. 1990) (holding that the trial court properly excluded evidence of a breach of a rule of professional conduct because such breach is not a basis for civil liability and, therefore, was irrelevant to the malpractice claim).

Alabama has effectively eliminated any reliance upon ethics rules as proof of negligence. Under Ala. Code § 6-5-578, a violation of an ethics rule does not give rise to an independent cause of action, and evidence of a violation of an ethics rule or of any action taken in response to a charge of an ethics rule violation is inadmissible in a malpractice action.

The 19th Annual Estate & Charitable Gift Planning Institute

More Uncertainty than Ever:Estate Planning with a Foggy Crystal Ball

Looking through the Crystal Ball – What’s New and Noteworthy?

By Ann B. Burns

i

TABLE OF CONTENTS

I. Planning Opportunities in 2011 and 2012 ...........................................................................1

A. Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010.....................................................................................................................1

1. Overview of estate and gift tax provisions of PRA 2010............................1

2. Calculating remaining gift tax exemption ...................................................1

B. Why Make Gifts Now?............................................................................................2

1. Caution – don’t get over-zealous.................................................................2

2. Advantages of gifting now ..........................................................................2

3. Disadvantages of gifting now......................................................................3

4. Gift splitting.................................................................................................3

C. Planning Options .....................................................................................................4

1. Forgive loans ...............................................................................................4

2. Life insurance ..............................................................................................4

3. Lifetime family trusts ..................................................................................5

II. Qualifying as a Grantor Trust..............................................................................................6

A. Advantages of a Grantor Trust ................................................................................6

B. Grantor Trust Provisions .........................................................................................7

1. Power to pay premiums ...............................................................................7

2. Power to distribute income..........................................................................7

3. Power to add beneficiaries...........................................................................7

4. Trust income payable to grantor’s spouse ...................................................8

5. Power to substitute assets ............................................................................8

C. Tax Reimbursement Clauses ...................................................................................9

D. Caveats ....................................................................................................................9

ii

III. Reciprocal Trusts...............................................................................................................10

A. The Two-pronged Grace Test ...............................................................................10

B. The Interrelatedness Prong of Grace.....................................................................11

IV. Step Transactions...............................................................................................................11

A. Substance Over Form ............................................................................................11

B. Economic Risk of Change in Value ......................................................................12

V. Use of Disclaimers ............................................................................................................14

A. Basic Requirements ...............................................................................................14

B. Nine Month Requirement ......................................................................................15

C. Severable Interests.................................................................................................15

D. Formula Disclaimers .............................................................................................18

E. Passage of Disclaimed Property ............................................................................20

F. Creditor Protection ................................................................................................21

1. History of relation-back rule......................................................................21

2. Federal tax liens.........................................................................................21

3. Disclaimers in bankruptcy .........................................................................23

4. Disclaimers avoidable by creditors............................................................23

G. Use of Disclaimers to Provide Flexibility .............................................................24

1. All to spouse ..............................................................................................24

2. Disclaimer plan..........................................................................................24

3. Marital deduction plan...............................................................................25

4. Closely held business assets ......................................................................25

VI. 2010 Estate Administration ...............................................................................................25

A. Default Rule...........................................................................................................25

B. Alternate Regime...................................................................................................26

iii

C. Impact of Prior Gifts on Estate Tax Calculation ...................................................26

D. Portability ..............................................................................................................26

E. Basis Adjustments .................................................................................................27

VII. 2013 AND BEYOND........................................................................................................27

A. Missing from TRA 2010 .......................................................................................27

1. Ten-year minimum GRAT term................................................................27

2. Consistency of basis ..................................................................................28

3. Valuation discounts ...................................................................................28

4. Special use valuation .................................................................................28

B. The Green Book ....................................................................................................28

1. Consistency in valuation............................................................................28

2. Valuation discounts ...................................................................................28

3. Minimum GRAT terms .............................................................................29

C. Treasury Priority Guidance Plan ...........................................................................29

D. Bundled Fiduciary Fees .........................................................................................29

EXHIBIT A – Form 8939 Allocation of Basis

1

The 19th Annual Estate & Charitable Gift Planning InstituteMore Uncertainty than Ever: Estate Planning with a Foggy Crystal Ball

Looking through the Crystal Ball – What’s New and Noteworthy?©1

I. PLANNING OPPORTUNITIES IN 2011 AND 2012

A. Tax Relief, Unemployment Insurance Authorization, and Job Creation Act of 2010

1. Overview of estate and gift tax provisions of PRA 2010

The Tax Relief Act of 2010 (“TRA 2010”) provides for gift, estate, and generation-skipping tax (“GST”) exemptions at $5,000,000 indexed from 2010 beginning in 2012. The maximum rate for estate, gift, and generation-skipping tax is 35%. The estate and generation-skipping exemptions of $5,000,000 began in 2010. The gift tax exemption of $1,000,000 was extended through 2010 and increased to $5,000,000 beginning in 2011.

The exemptions and tax rates expire at the end of 2012. At that time the gift and estate tax exemptions will return to $1,000,000. The GST exemption is indexed for inflation and is expected to be approximately $1,400,000 after 2012.

2. Calculating remaining gift tax exemption.

With the gift tax exemption amount increased to $5,000,000, it can be complicated to calculate the amount of remaining gift tax exemption available, especially in circumstances where the taxpayer has made prior taxable gifts. The remaining unified credit is subtracted from the gift tax calculation to determine gift tax owed. The amount of the unified credit available is determined by subtracting the amount of unified credit applicable to prior gifts. The calculation of the amount of unified credit applicable to prior gifts is made using the gift tax rate in effect in the current year and is applied to the gift tax value of the gift made in the prior year. The effect is to treat all gifts as if they are taxable at the new 35% rate rather than the higher rates in effect in prior years.

This method of calculating the remaining gift tax exemption available makes it possible for a donor who has made taxable gifts in prior years to make gifts in 2011 and 2012 of the difference between the current $5,000,000 gift tax exemption and the prior $1,000,000 gift tax exemption without paying gift tax.

1 Copyright Ann B. Burns (May 2011)

2

B. Why Make Gifts Now?

1. Caution – Don’t get over-zealous.

Regardless of the gift and estate tax advantages of giving away property during lifetime, the most important first step is to determine the life style needs of the donor and the property available to satisfy those needs. Planners should prepare a cash flow and retirement analysis for the donor to assure that sufficient assets are retained to meet all future needs. Financial advisors play an important role in assisting the client in determining cash flow needs including, for example, estimated future costs of education, health care, and assisted care in later life. All of these projections should be made as conservatively as possible to assure that clients retain sufficient assets for their own needs.

Assets available for gifting strategies are the “excess assets” not needed by the client to support the client’s lifestyle.

2. Advantages of gifting now.

Assuming that assets appreciate in value over the lifetime of the donor,one important advantage of transferring assets now is to remove the appreciation in value of the asset from the donor’s estate. Although the value of the gift (as of the date of the gift) is included in the estate tax calculation, any appreciation in value of that asset is not. In some cases, such as a public offering or a sale of a company, the appreciation in value of the asset can increase markedly in a short period of time. More frequently, assets appreciate gradually over a long period of time. Either way, substantial tax benefits can be achieved by making gifts of appreciating assets. Additionally, the income produced by the assets, such as interest, dividends, and rents will be removed from the estate for estate tax purposes.

In situations in which fractional interest discounts are allowed the estate tax advantages of making gifts today can be even more substantial. For example, gifts of fractional interests in real estate or minority interests in closely-held businesses, family partnerships, or limited liability companies can be very efficient ways of using the increased gift tax exemption amount.

The ability of a donor to pay the income taxes on income from a grantor trust can further leverage the gift and estate tax benefits of a current gift. The ability to create generation-skipping trusts and allocate the new, larger, GST exemption can provide even greater benefits.

3

3. Disadvantages of gifting now.

A fundamental underlying assumption about gifting is that assets will appreciate. In the not too distant past, we have experienced substantial decline in values of assets, including real estate. One substantial disadvantage of current gifting arises if the assets decline in value after the date of the gift. Because gifts by their nature are irrevocable, any unforeseen change in circumstances can be difficult to address.

Additionally, if the estate tax applicable exclusion amount is reduced below the current $5,000,000 amount in the future, a 2011 or 2012 gift may incur some estate tax at the death of the donor (or of the spouse in the case of gift splitting) because the date of death exemption amounts and estate tax rates may apply to the gift. If, for example, the estate tax rate were to increase to 50% and the exemption amount returned to $3,500,000, an estate tax of $750,000 could be due attributable to a gift of $5,000,000. Additionally, this estate tax might be due on the death of the first spouse even if the decedent had a fully maritalized estate plan.

It is important to note, that if the current gift does incur a future estate tax, the current gift does not result in more transfer tax than would have been incurred without making the gift. A lifetime gift may change the timing of the tax payment, but all other gift tax advantages discussed above would still be realized. As it currently stands, the law is unclear on this issue and further guidance from the Internal Revenue Service or further congressional technical corrections are needed.

Under most state laws, it would be difficult for the executor to apportion the additional estate tax against the recipients of the prior gifts unless state law and the document specifically allowed recoupment of the estate tax. The donee could agree at the time the gift was made to pay any additional estate tax in an agreement akin to a net gift arrangement, but barring such agreement, the additional estate taxes usually would be borne by the estate. Careful consideration of the tax apportionment language of the estate planning documents is critical.

4. Gift splitting.

When gift splitting is employed, a gift by one spouse is treated as if made one-half by each spouse. The advantage of gift-splitting is that a married couple can make gifts worth up to $10,000,000 rather than $5,000,000. At the death of either spouse, however, one-half of the value of the gift is added to the estate as adjusted taxable gifts, thus increasing the estate tax due. Careful planning is needed to assure that the recipients of the estate of a consenting spouse are not penalized for gifts made to other individuals.

4

For gifts included in the donor spouse’s gross estate under I.R.C. § 2035, the consenting spouse is not required to include one-half of the gift in his or her estate as an adjusted taxable gift. If assets are fully includable in the estate of the donor spouse under a section other than I.R.C. § 2035 (because the donor is treated as the transferor of both halves of the assets for estate tax purposes), the consenting spouse’s unified credit is not restored and additional estate tax may be paid. Caution should be used in gift splitting, especially in circumstances where the recipients of the gift are different from the recipients of the spouses’ estates.

C. Planning Options.

1. Forgive loans.

For many years, clients who have fully used their gift tax exemption and annual exclusions have made loans to their children instead of outright gifts. Some of these loans have been made for specific purchases such as houses and automobiles, and others have been more generally made for investment purposes. Parents have been able to make loans to children and grandchildren at historically low interest rates. In situations in which the interest is paid annually, the loans do not increase in principal amount, but may, over long periods of time, raise concerns that the IRS may argue that the loan is in actuality a gift. Where loan payments are not made and interest is forgiven each year, the IRS’s argument may be stronger.

With the $5,000,000 gift tax exemption, parents may be interested in forgiving these outstanding loans. Fortunately, the forgiveness of debt will not result in discharge of indebtedness income to the children or grandchildren. Rev. Rul. 2004-37, 2004-1 C.B. 583 provided that the discharge of debt in the form of a gift is treated as a gift rather than under the “debt discharge rules.” Forgiveness of debt can provide an effective use of the gift tax exemption because the interest obligation from the children back to the parents is extinguished. All income and appreciation on the assets originally loaned is excluded from the donor’s estate from the date of the original loan.

2. Life insurance.

Many clients have irrevocable life insurance trusts that have been in existence for many years. Often, annual premiums increase over time. Ideally, the donor can make contributions to the irrevocable life insurance trust by utilizing annual exclusion amounts. In situations in which the annual exclusion amounts are insufficient to cover the entire premium amounts, gift tax exemption is used. Over long periods of time and with large life insurance death benefits, the $1,000,000 gift tax exemption maybe fully utilized.

5

The new $5,000,000 gift tax exemption can provide the ability to continue funding existing life insurance or to purchase additional death benefit coverage passing significant wealth to younger generations. The irrevocable life insurance trust can be funded with some or all of the current gift tax exemption and in the case of dynasty trusts, the generation-skipping tax exemption.

Split dollar agreements at low interest rates can be advantageous to assist with the payment of large life insurance premiums. Where the annual exclusions or the available exemption amount were insufficient to cover the cost of large life insurance premiums, loans are used to supply the trust sufficient cash funds to pay the premiums. The new exemption equivalent may be useful to cover substantial gifts to existing life insurance trusts to pay off the split dollar loans and to fund future premium payments as they come due.

Estate planners should encourage some clients to avoid the temptation to cancel life insurance in light of the new $5,000,000 exemptions for several reasons. First, the $5,000,000 may be rolled back in the future, so tax payers cannot count on having it available to apply to their estates. Secondly, the leverage supplied by life insurance can be a hugely beneficial means of providing funds to future generations on an estate tax-free basis. Even if the insurance trust is not needed to provide liquidity for estate taxes, the insurance trust provides assets for the children and grandchildren and the flexibility to leave other estate assets to charities or other individuals.

3. Lifetime family trusts.

One of the most effective ways to use the new gift tax exemption is to create a long-term generation-skipping trust funded with appreciating assets. Assuming the trust is irrevocable and the donor retains no interests in the trust that would cause the trust assets to be included in the donor’s estate at the time of the donor’s death, all appreciation in value of the assets will be excluded from the donor’s estate. The income and growth on the assets will inure to the benefit of younger generations without being subject to further transfer taxes. In states that allow trusts to continue indefinitely, the future accumulation can be substantial. Even in states that have retained the rule against perpetuities, the accumulation of income and appreciation over the course of a generation can be large.

Some such dynasty trusts are created to include the donor’s spouse as a permissible beneficiary of the trust. Although one view of this type of design is that it “wastes” exemption equivalent, it can provide flexibility in the event that the spouse should have financial needs in the future.

6

A lifetime family trust that includes the donor’s spouse can be designed with substantial flexibility and may allow the spouse to be a trustee, to be a discretionary beneficiary, and to hold a limited power of appointment. If spouses create trusts for one another, they should take care to avoid the reciprocal trust doctrine, discussed in greater detail in Section III below. Because this trust would not need to qualify for the marital deduction, the spouse’s interest could terminate upon remarriage or the trust could define the spouse to be the person to whom the grantor is married from time to time to retain maximum flexibility.

The ability to allocate generation-skipping tax exemption to the trust allows the trust assets to be excluded from the estates of the children as well as the grantor as long as the children do not hold any estate tax includable powers over the trust assets. By making the trust a grantor trust for income tax purposes, the trust assets can grow without the drag of income taxes. If a grantor retains sufficient powers to cause the trust to be a grantor trust for income tax purposes but not the powers that cause inclusion in the grantor’s estate for estate tax purposes, the grantor can pay the income taxes of the trust without being deemed to make additional contributions to the trust. The qualification of a trust as a grantor trust for income tax purposes is more fully discussed at Section II below.

The lifetime family trust can be used even more efficiently if the assets contributed to it are valued for gift tax purposes at a discount. Assets such as interests in closely-held businesses, family limited partnerships, limited liability companies, and fractional interests in real estate, all have the potential to provide a highly leveraged use of the gift tax exemption. Notable in the Tax Relief Act of 2010 is the absence of a provision disallowing fractional interest discounts for closely-held assets transferred within a family. Discounts for lack of marketability and minority interest are still available for closely-held assets, and may be used when making transfers outright to or in trust for family members.

II. QUALIFYING AS A GRANTOR TRUST.

A. Advantages of a Grantor Trust.

The advantages of a trust that is deemed to be a grantor trust for income tax purposes is that the grantor may pay all or part of the income tax for the trust without the payment being deemed to be an additional gift to the trust. Assets of the grantor are diminished by the amount of the tax liability while the assets of the trust are not. Thus, trust assets can grow in a tax-favored environment for future generations while reducing the estate of the grantor for estate tax purposes. A trust that is a grantor trust may purchase assets from, or sell assets to, the grantor without either party recognizing gain or loss. Additionally, the transfer of life insurance by sale or gift between a grantor and the grantor trust can avoid the transfer for value rules which would otherwise cause income tax recognition.

7

The grantor trust, however, is not for the faint of heart. In years in which the trust has significant income tax liabilities, the grantor may be surprised to discover that the grantor may be required to pay substantial income taxes without a supply of cash to make the payment. Often, grantor trusts are designed so that the grantor may relinquish the powers that otherwise render the trust a grantor trust and thus terminate the grantor’s income tax liability for the trust.

B. Grantor Trust Provisions.

1. Power to pay premiums.

I.R.C. § 677(a)(3) provides that the grantor is treated as the owner of any portion of the trust as to which the grantor (or a non-adverse person) may use trust income to pay premiums on life insurance policies on the life of the grantor or the grantor’s spouse. This power does not automatically cause the inclusion of the proceeds of the life insurance in the grantor’s gross estate but may cause a portion of the trust to be treated as a grantor trust for income tax purposes.

PLR 8126047 provided that the trust was a wholly-grantor trust, both as to income and principal, because the trustee was authorized to pay life insurance premiums, first from income, and then from principal. The trust further provided that if these amounts were insufficient to pay the insurance premiums the trustee could request additional contributions to the trust from the grantor. Additionally, the trustee was authorized to borrow against the life insurance policies and apply loan proceeds to the premium amounts due. This strategy can be used to cause an irrevocable life insurance trust to be a wholly-owned grantor trust. It is doubtful, however, that the power to pay insurance premiums would cause the trust to be a grantor trust if the trust did not, in fact, own life insurance.

2. Power to distribute income.

I.R.C. § 674 provides that the grantor is deemed to be the owner of any portion of a trust of which the grantor or a non-adverse party (without the approval or consent of any adverse party) may affect the beneficial enjoyment of the income or principal. This type of “sprinkling power” can be used to cause the grantor to be taxed on the income or principal of the trust but is difficult to utilize without also causing inclusion of the trust under I.R.C. §§ 2036 or 2038. If the power is granted solely over income, the trust could be deemed to be a grantor trust as to income only, requiring that capital gains taxes be paid by the trust.

3. Power to add beneficiaries.

I.R.C. §§ 674(b)(5) and (6) provide that the grantor is treated as the owner of a trust for income tax purposes if a non-adverse trustee has the power to add after-born or after-adopted children as trust beneficiaries, and holds

8

the power to distribute trust income and principal. These powers would cause the trust to be a wholly-grantor trust for income and capital gains purposes. As long as the grantor has no control over or pre-existing agreement with the non-adverse trustee regarding the exercise of the power, this power should not cause estate tax inclusion.

4. Trust income payable to grantor’s spouse.

I.R.C. § 677(a)(1) will treat a trust as a grantor trust if a non-adverse trustee has the power to pay trust income to or for the benefit of the grantor’s spouse. Importantly, this power should not be exercisable in a fashion that would discharge the obligation of the grantor to support the spouse. The grantor trust status under this code section would apply to the income of the trust but not to capital gains. Additionally, the power would terminate upon the death of the spouse and presumably, the grantor trust status of the trust likewise would terminate.

I.R.C. § 677(a)(1) also provides for grantor trust treatment if a non-adverse trustee may pay all of the trust income to the grantor. Although this power in and of itself might not require estate tax inclusion of the trust under I.R.C. §§ 2036 or 2038, a risk exists that this power coupled with other powers, such as the power to change trustees could cause such estate tax inclusion.

5. Power to substitute assets.

I.R.C. § 675(4) provides that a trust is a wholly-grantor trust if the grantor retains the power, exercisable in a non-fiduciary capacity, to substitute trust assets for assets of equal value. The power to substitute assets does not cause estate tax inclusion under any of the estate tax statutes and thus is one of the most popular means of creating a grantor trust, especially with respect to trusts that do not own life insurance. Often coupled with the power of a non-adverse trustee to add trust beneficiaries, this power causes the trust to be treated as a wholly-owned grantor trust and is not includable in the grantor’s estate for estate tax purposes.

It should be noted, however, that if the trust does hold life insurance, the power to substitute other assets for the life insurance policy may be deemed to be an incident of ownership and thus, cause the policy to be included in the grantor’s estate for estate tax purposes. The trust document should contain a limitation on the grantor’s power to reacquire life insurance policies.

In circumstances where the grantor is a trustee, the power to substitute assets may be deemed under state law to be held in a fiduciary capacity which does not meet the grantor trust requirements. Accordingly, the

9

document should clearly state that the power is held in a non-fiduciary capacity or the grantor should not also act as trustee.

Rev. Rul. 2008-22, 2008-16 IRB 796 provided guidance indicating that where a grantor retained the power, exercisable in a non-fiduciary capacity, to acquire property held in trust by substituting other property of equal value, the substitution power, by itself, did not cause the value of the trust property to be includable in the grantor’s gross estate provided that the trustee had a fiduciary obligation to ensure that the grantor’s compliance with the terms of the power by satisfying itself that properties acquired and substituted by the grantor were of equivalent value, and the power was not exercised in a manner that would shift benefits among trust beneficiaries.

C. Tax Reimbursement Clauses.

The question has often arisen as to whether the grantor’s payment of a trust’s income tax liabilities was treated as an additional gift to the trust. Rev. Rul. 2004-64, 2004-2 CB 7 addressed the gift tax consequences of a grantor’s payment of income taxes attributable to the inclusion of the trust’s income in the grantor’s taxable income. The IRS held that when the grantor of a trust, who is treated as the owner of the trust for income tax purposes, pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, the grantor is not treated as making a gift to the trust or the trust beneficiaries of the amount of the tax paid. If, however, pursuant to the trust agreement or applicable local law, the grantor must be reimbursed by the trust for the income tax payable, the full amount of the trust assets is includable in the grantor’s gross estate under I.R.C. § 2036(a)(1). If the trust agreement or applicable local law merely gives the trustee the discretion to reimburse the grantor for the income tax liability the existence of that discretion, by itself, whether or not exercised, will not cause the value of the trust assets to be includable in the grantor’s gross estate.

Therefore, it is crucial that a trust document not require reimbursement to the grantor of the income taxes paid, but rather provide the trustee with discretion to determine whether to reimburse the grantor or not.

D. Caveats.

Care should be taken to assure that a grantor is not given powers over life insurance, including the power to substitute assets, that might otherwise cause inclusion of the life insurance in the grantor’s estate under I.R.C. § 2035. Additionally, the grantor, if given the power to substitute assets for voting stock in a closely-held company, may be deemed to hold rights over voting stock that would cause inclusion of the assets in the grantor’s estate under I.R.C. § 2036.

The power to substitute assets places on the trustee the fiduciary obligation to assure that the fair-market value of the assets substituted is equal. Accordingly,

10

when substituting hard-to-value assets, estate planners may wish to consider a refunding or adjustment clause in the agreement to require the parties to “true up” the asset swap to adjust to the values as finally determined for estate or gift tax purposes. The IRS has refused to rule on the question of what powers will cause a trust to be a grantor trust for income tax purposes.

III. RECIPROCAL TRUSTS.

A. The Two-pronged Grace Test.

Reciprocal trusts are defined as trusts that have interrelated, reciprocal, and substantially identical economic property interests, created by two people for the benefit of one another under a common plan. See Lehman v. Comm’r, 109 F.2d 99 (2d Cir. 1939). Typically, this is an issue when the husband is the beneficiary of his wife’s trust, and the wife is the beneficiary of the husband’s trust. Reciprocal trusts are dangerous in estate planning because they can cause estate tax inclusion under I.R.C. § 2036 as retained economic interests.

The U.S. Supreme Court adopted the reciprocal trust doctrine in 1969 in United States v. Estate of Grace, 395 U.S. 316 (1969). The decedent, Joseph Grace, was very wealthy when he married his wife Janet. Janet had no wealth of her own. Mr. Grace signed a trust agreement on December 15, 1931, in which he named his wife as the income beneficiary of his trust for her life. He funded the trust with his own assets. Mrs. Grace signed an identical trust agreement fifteen days later, naming her husband as the income beneficiary of her trust for his life. It was also funded with Mr. Grace’s assets. Mrs. Grace died in 1937 and Mr. Grace died in 1950. The IRS argued that the trusts were reciprocal and that the value of Mrs. Grace’s trust that benefited Mr. Grace for his lifetime was a part of his taxable estate. The Supreme Court agreed.

The Court held that “application of the reciprocal trust doctrine is not dependent upon a finding that each trust was created as a quid pro quo for the other. Such a ‘consideration’ requirement necessarily involves a difficult inquiry into the subjective intent of the settlors.” Writing for the majority, Justice Marshall stated the test for application of the reciprocal trust doctrine: there is no requirement to show a tax-avoidance motive in order to reverse the transfers, only that the trusts are interrelated and that the arrangement leaves the settlors in approximately the same economic position as if they had created trusts naming themselves as lifetime beneficiaries.

In Grace, the trusts were substantially identical in terms, they were created at approximately the same time, and they were part of a single transaction designed and carried out by Mr. Grace. The transfers to the trusts left each party (to the extent of mutual value) in the same objective economic position as before the transfers. Id. The decedent’s estate was “undiminished” to the extent of the value of Mrs. Grace’s trust, so the Court stated the trust must be added to the value of his estate.

11

A common estate planning practice is to create mirror estate plans for a husband and wife. This common practice is problematic when a husband and wife create mirror irrevocable life insurance trusts (“ILITs”) naming each other as beneficiaries. Separate ILITs for a husband and wife are often used because they avoid the pitfalls of spousal gift splitting to a single ILIT. The practitioner must ensure that the trusts are not “interrelated” under the reciprocal trust doctrine. The ILIT provisions cannot be identical, and the ILITs should be created at different times - preferably months apart. See Estate of Levy, 46 T.C.M. 910 (1983) (trusts were not interrelated because a special power of appointment was contained in one trust but not the other).

B. The Interrelatedness Prong of Grace

In PLR 200426008, a husband and wife each created an ILIT to benefit their son. The husband contributed assets to his trust and the wife contributed assets to her trust. The husband was the trustee of the wife’s trust, and the wife was trustee of the husband’s trust. They were also beneficiaries of each other’s trusts. The trusts appeared to be identical but each contained differences that were sufficient to avoid being interrelated according to the IRS.

The Service pointed out that the husband’s trust gave his wife a right to withdraw specified amounts of trust principal after the son died. His trust also gave her an inter vivos special power upon the son’s death to appoint trust principal among any of the husband’s issue and their spouses or trust for such persons. If she did not exercise this power, the trust granted her a different special power upon the son’s death to appoint trust principal among any of the husband’s issue and any charities or trust for such persons. The trust also gave the wife a testamentary special power over any marital trust assets. The wife’s trust contained a limitation that the husband could not be a beneficiary of any trust other than a marital trust until three years after the wife’s death, and at that time, his distributions were further limited. These differences were sufficient for the Service to conclude that the husband’s and wife’s ILITs were not interrelated.

The Service’s position is interesting because the trusts’ differences do not seem to be material. Three out of the four differences in the husband’s trust depended on the son predeceasing the mother, an event that was not likely to occur.

IV. STEP TRANSACTIONS.

A. Substance Over Form.

The step transaction doctrine can be another way for the Internal Revenue Service to argue that an otherwise valid tax-free transfer is a gift for tax purposes. The doctrine can arise in a multitude of circumstances, but most frequently, is raised with gifts of partnership interests, closely-held company stock, and limited liability company units. The argument is that the two-step process of transferring assets to the entity in exchange for ownership interests followed by a subsequent

12

gift of the ownership interests is in fact a single transaction. Where the step transaction is successfully argued no discounts may be available for gift tax purposes on the transfers of the entity interests.

In Gross v. Commissioner, T.C. Memo 2008-221 (9/29/08), the Tax Court addressed a question involving the step transaction doctrine and found in favor ofthe taxpayer, although the court had concluded that the taxpayer had not validly formed the limited partnership prior to the gift transaction. In that case, the taxpayer argued that the partnership was formed on July 15, 1998 when Mrs. Gross and her daughters agreed to create the partnership and filed the Certificate of Limited Partnership with the State of New York. Mrs. Gross’s daughters each contributed $10.00 to the partnership on July 31, 1998 and Mrs. Gross contributed $100 on November 16, 1998. From October through early December, Mrs. Gross transferred certain marketable securities to the partnership and on December 15, 1998, the parties executed a partnership agreement and Mrs. Gross executed a deed of gift transferring to each of her daughters a 22.25% interest in the limited partnership.

The service argued that the partnership was formed on December 15, 1998, when the parties signed the partnership agreement and that Mrs. Gross’s contribution of the securities to the partnership and the gift of the partnership interest to the daughters occurred all on the same date. The court held that pursuant to New York law, the parties’ intent to form a partnership manifested on July 15, 1998, when the mother and daughters agreed to create a partnership. Under New York law, the form of the partnership was a general partnership until the date that the limited partnership agreement was signed. Accordingly, the court held that the partnership was created on July 15, 1998. The court further determined that the partnership had been formed and funded by December 4, 1998, some 11 days before the date of the gifts of partnership interests.

The court refused to apply the step transaction document because it held that 11 days had passed between the formation and funding of the partnership and the gifts of the partnership interests. Although the partnership agreement was not signed until the date of the gift, the court allowed a 35% valuation discount on the transaction.

B. Economic Risk of Change in Value.

In Linton v. United States, 630 F.3rd 1211 (9th Cir. 2011), the Ninth Circuit applied the step transaction document to the creation, funding, and gift of a family limited liability company but found no step transaction to have occurred. In that case, William and Stacy Linton met with their attorney, Richard Hack, on January 22, 2003, and signed the following documents:

Quit claim deed conveying real estate to the LLC

Assignment of assets to the LLC

13

Letters authorizing transfer of securities and cash to the LLC

Trust agreements created for the children of William and Stacy

Gift documents conveying to each child’s trust 11.25% interest in the LLC

The trust agreements and gift documents were signed but left undated. All other documents were both signed and dated.

The Ninth Circuit remanded to the district court the question of when the taxpayer’s intention to donate became manifest and irrevocable. The question focused on whether Lintons’ delivery to their attorney of signed but undated trust agreements and gift documents were intended to effect irrevocable gift transfers at that time or at some future date. The question of when the gift was effective was not resolved by the Ninth Circuit’s reading of the lower court’s record.

The Ninth Circuit was reluctant to address the step transaction issue because of the possibility that the lower court’s determination of the timing of the transactions might render the issue moot, but addressed the “traditional three tests” in any event. The court held that the step transaction doctrine would treat multiple transactions such as the funding of a family limited liability company, followed by a gift of the LLC units, as a single integrated transaction for tax purposes if all of the elements of at least one of the following three tests were satisfied: (1) the end result test, (2) the interdependence test, or (3) the binding commitment test.

The court addressed the end result test finding that the taxpayer’s subjective intent is “especially relevant” and that in this case, the results sought by the Lintons is consistent with the tax treatment they sought. The Lintons wanted to convey LLC interests to their children without giving them management control or ownership of the underlying assets. The court found that even if the transactions could somehow be merged, the Lintons would still prevail because the end result would be that their gift of LLC interests would be taxed as the taxpayers contended.

The court reasoned under the interdependence test that the separate and distinct steps of the Lintons’ transaction were steps usually expected in an otherwise bona fide business setting, and accordingly, were not so interdependent of one another as to be treated as one transaction. The court further found that the binding commitment test was inapplicable because the Lintons’ transactions took place over the course of over no more than a few months, possibly weeks, and that the binding commitment was intended only to be applied to transactions spanning over several years.

In footnote 9 of the opinion, the court discussed at length an underlying principle of the step transaction doctrine to ensure that “the two transactions are adequately distinct that the second transaction merits independent, and more favorable, tax

14

treatment.” In addressing the question of how far apart the two transactions must occur, the court noted that the parties must assume a “real economic risk” of a change in valuation of the assets during the time period. The government in this case had not challenged that the nine days between January 22 and January 31 was a sufficiently long period to make the transactions distinct. The parties had been subject to some economic risk of change in value during the time period between the first and second steps of the transaction.

V. USE OF DISCLAIMERS.2

A. Basic Requirements.

I.R.C. § 2518 provides the following requirements for a qualified disclaimer:

I.R.C. § 2518, although contained in the gift tax section of the tax code, provides the requirements of a qualified disclaimer for purposes of federal gift, estate, and generation-skipping transfer taxes. I.R.C. §§ 2046 and 2654(c), with respect to estate taxes and generation-skipping transfer taxes, respectively, succinctly state that “[f]or provisions relating to the effect of a qualified disclaimer for purposes of this chapter, see section 2518.”

Section 2518 spells out the requirements that must be met for a disclaimer to be a qualified disclaimer for tax purposes:

The disclaimer must be in writing,

The writing must be received by the transferor of the interest or the holder of legal title to the property within nine months after the later of: (a) the date on which the transfer creating the interest was made; or (b) the date on which the disclaiming person attains age 21,

The disclaiming person must not have accepted the interest or any of its benefits,

As a result of the disclaimer, the interest must pass without any direction on the part of the disclaiming person, and

The interest passing as a result of the disclaimer must pass either: (a) to a person other than the

2

© 2011 University of Miami School of Law. Portions of this material were initially prepared for the 45th Annual Heckerling Institute on Estate Planning, published by LexisNexis Matthew Bender. They were reprinted with the permission of the Heckerling Institute and the University of Miami.All rights reserved.

15

disclaiming person; or (b) to the spouse of the decedent.

B. Nine Month Requirement.

In Breakiron v. Gudonis, 106 AFTR. 2d 2010-5999, the District Court of Massachusetts addressed the question of the effectiveness of a disclaimer that was made more than nine months after the date of the transfer. Mr. and Mrs. Breakiron each created 10-year qualified personal residence trusts in 1995. They each transferred an undivided one-half interest in real estate to their trust. In 2005, the trusts expired and the real estate was to be distributed to the children. Within nine months of the date of the expiration of the trusts, one son disclaimed his interest in the trusts with the intention that his share of the trust property would be distributable to his sister pursuant to the terms of the trusts.

The nine-month disclaimer period, however, in fact, began to run on the date of the creation of the trusts and expired on September 27, 1995. The son had consulted with an attorney who had incorrectly advised him that he could disclaim the property within nine months after the trusts’ termination.

The IRS assessed a gift tax in the amount of $2,300,000. The son filed suit in district court for reformation of his disclaimers and included the United States as a party to the suit. The U.S. removed the case to federal district court.

The son requested that the court allow him to rescind his disclaimer for mistake of law. The court found that Massachusetts law did, in fact, allow rescission of the document on the grounds of mistake when there is “full, clear, and decisive proof” of a mistake. The question then was the effect of the reformation on the son’s federal gift tax liability. The court discussed at length the competing circuit court views of the matter and determined that in the Breakiron case, where the IRS was a party to the action, the power to rescind for mistake of law was binding on the IRS and granted summary judgment in favor of the taxpayer.

Although the Internal Revenue Service has extended the due date for qualified disclaimers of property received from a decedent who died in 2010 until September 19, 2011, many states have not modified their nine-month rules for filing a valid disclaimer under state law. A federal disclaimer would not be a qualified disclaimer for gift or estate tax purposes if it is invalid under state law.

C. Severable Interests.

The Tax Court wrestled with the definition of a severable interest in Estate of Christiansen v. Comm’r, 130 T.C. 1 (2008). Helen Christiansen died leaving her entire estate to her only child, Christine Hamilton. Christiansen’s will also provided that if Hamilton disclaimed any portion of the estate, 75% of the disclaimed portion would pass to a charitable lead trust and 25% would pass to

16

Christiansen’s private foundation. The court addressed the question of whether the disclaimer was valid as to the assets passing to the charitable lead trust.

The charitable lead trust had been designed to provide for payments to charity for 20 years beginning after Christensen’s death and at the end of the 20 year term to pay the remaining assets to Hamilton. If Hamilton were not living at the termination of the trust, the property would pass to the foundation. The Service argued the fact that Hamilton did not disclaim her contingent remainder interest in the charitable lead trust failed the tests of Section 2518 because the disclaimed property did not pass solely to a person other than Hamilton. See I.R.C. § 2518(b)(4) and Treas. Reg. § 25.2518-2(e)(3).

The estate did not take a charitable deduction for the value of the remainder interest that would pass to Hamilton, but did claim a charitable deduction for the portion of the disclaimed property that would pass to the charitable beneficiary during the 20 year lead term of the trust. The Service argued that the interests were not severable and accordingly no charitable deduction should be allowed.

The Tax Court agreed with the Service’s argument relying on Treas. Reg. § 25.2518-2(e)(3) which provides:

If the portion of the disclaimed interest in property which the disclaimant has a right to receive is not severable property or an undivided portion of the property, then the disclaimer is not a qualified disclaimer with respect to any portion of the property. Thus, for example, if a disclaimant who is not a surviving spouse receives a specific bequest of a fee simple interest in property and as a result of the disclaimer of the entire interest, the property passes to a Trust in which the disclaimant has a remainder interest, then the disclaimer will not be a qualified disclaimer unless the remainder interest in the property is also disclaimed.

(Emphasis supplied by court). The court discussed at length Hamilton’s argument that her remainder interest in the charitable lead trust was severable property and need not be disclaimed.

The court likened the definition of severable property to the definition of a molecule – “the smallest particle of a substance that retains the properties of that substance.” Id. at 11. Likewise, the court examined the term “an undivided portion of the property” from Treas. Reg. § 25.2518-3(b) which specifically provides an example of a disclaimer of a remainder interest in Blackacre with a retained life estate. The court undertook a discussion of Walshire repeating that court’s argument that: “[d]isclaiming a vertical slice – from meringue to crust –qualifies; disclaiming a horizontal slice – taking all the meringue, but leaving the crust – does not.” Id. at 12. The court reasoned that the only difference between Christiansen and Walshire is that in Walshire, the taxpayer disclaimed the

17

remainder interest and kept the income and in this case, Hamilton tried to do the reverse. The court determined that her disclaimer was not a qualified disclaimer.

In lengthy concurring and dissenting opinions, the judges discussed the meaning of “severable property.” Judge Kroupa, who had been the trial judge in the case, indicated that she found the charitable intent of Christiansen and Hamilton to be compelling, and she would have allowed a charitable deduction for the portion of the disclaimed property attributable to the charitable interest in the charitable lead trust. Judge Kroupa found persuasive the fact that the annuity interest and contingent remainder interests in the charitable lead trust were created by Christiansen, the transferor, and not as a result of the disclaimer as in Walshire. Accordingly, Hamilton “did not create or carve out a particular interest for herself and disclaim the rest.” Id. at 29. Judge Kroupa also distinguished the holding in Walshire because there the interests at issue were an income interest and a remainder interest rather than an annuity interest and a remainder interest.

The dissent argued that the holder of an annuity interest could do nothing to affect the contingent remainder and vice versa, reasoning that the “two separate parts are in no way dependent on one another.” Id. at 32. The dissenting rationale rested in part on the fact that the separate interests were created by the transferor and not by operation of the disclaimer.

A separate concurring opinion elaborated on why Hamilton’s remainder interest in the charitable lead trust and the charity’s 20-year annuity were not severable by discussing two examples. In the first, T devised the income from a farm to A for life, then to B for life, with the remainder passing to A’s estate. The concurring opinion stated that A’s life estate and remainder interest in the property were “separate transferor-created interests” and that A could make a qualified disclaimer of any portion of either the income interest or the remainder. SeeTreas. Reg. § 25.2518-3(a)(1)(i). The concurring opinion reasoned that although the life estate and the remainder were separate interests they were not severable property, and accordingly, A could not make a qualified disclaimer of the income from the property for a term of years.

By contrast, in the other example, the concurring judges assumed that T devised a fee simple in the farm to A. Neither a life estate or a remainder interest in the farm was a separate transferor-created interest nor were they severable property interests. Accordingly, A could make a qualified disclaimer of all or any portion of the farm but could not retain a life estate under the rational of Walshire. By way of these examples, the concurring opinion determined that although an interest may be severable as the term is used in Section 2055, a remainder following a life estate or a term of years, or an annuity is not severable as that term is used for purposes of Section 2518. The concurring opinion concluded that the remainder interest is entirely dependent on the annuity because it is “affected by the amounts distributed to the annuitant, and by the source of those distributions, either from income or corpus.” Id. at 24.

18

D. Formula Disclaimers.

The Eighth Circuit squarely addressed the validity of a formula disclaimer in Estate of Christianson v. Comm’r, No. 08-3844, 2009 WL 3789908 (8th Cir. Nov. 13, 2009). In that case, the decedent’s daughter, Hamilton, disclaimed a portion of the contingent remainder interest in her mother’s estate. The result of the disclaimer was that 75% of the disclaimed property would pass to a charitable lead annuity trust and 25% would pass to her mother’s private foundation. The formula disclaimer stated in pertinent part as follows:

A. Partial Disclaimer of the Gift: Intending to disclaim a fractional portion of the Gift, Christine Christiansen Hamilton hereby disclaims that portion of the Gift determined by reference to a fraction, the numerator of which is the fair market value of the Gift (before payment of debts, expenses and taxes) on April 17, 2001, less Six Million Three Hundred Fifty Thousand and No/100 Dollars ($6,350,000.00) and the denominator of which is the fair market value of the Gift (before payment of debts, expenses and taxes) on April 17, 2001 (“the Disclaimed Portion”). For purposes of this paragraph, the fair market value of the Gift (before payment of debts, expenses and taxes) on April 17, 2001, shall be the price at which the Gift (before payment of debts, expenses and taxes) would have changed hands on April 17, 2001, between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts for purposes of chapter 11 of the [Internal Revenue] Code, as such value is finally determined for federal estate tax purposes.

Additionally, the disclaimer contained a “savings clause” that:

to the extent that the disclaimer set forth above in this instrument is not effective to make it a qualified disclaimer, Christine Christiansen Hamilton hereby takes such actions to the extent necessary to make the disclaimer set forth above a qualified disclaimer within the meaning of section 2518 of the Code.

Estate of Christiansen v. Comm’r, 130 T.C. 1, 5 (2008). The tax court held that the formula disclaimer was valid as to the amount that passed to the foundation. The Commissioner appealed from the tax court’s determination that the formula disclaimer was valid as it related to the property passing to the foundation.

The Commissioner challenged the validity of the disclaimer and the amount reported as the estate’s overall value. The parties settled the issue of valuation

19

with the result that the corresponding increase in the valuation of the estate assets increased the charitable deduction for assets passing to the charitable foundation. The Commissioner denied the estate an increased charitable deduction as a result of this valuation adjustment arguing that the act of challenging the estate’s return and the resulting adjustment in valuation served as a post-death, post-disclaimer contingency that disqualified the disclaimer under Section 2513.

The Commissioner presented two arguments. First, that the transfer of assets to the foundation was “dependent upon the performance of some act or the happening of a precedent event” because it could not be determined until after the Commissioner’s challenge to the estate tax return. Estate of Christianson v. Comm’r, No. 08-3844, 2009 WL 3789908, at *1 (8th Cir. Nov. 13, 2009). Second, that fractional formula disclaimers should be disallowed for policy reasons because such disclaimers fail to preserve a financial incentive for the Commissioner to audit an estate’s return.

The Court of Appeals rejected both arguments. As to the first argument, the court stated that “all that remained uncertain following the disclaimer was the valuation of the estate, and therefore, the value of the charitable donation. The foundation’s right to receive 25-percent of those amounts in excess of $6.35 million was certain.” Id. at *2. The court distinguished between events that occur after the date of death that change the value of an asset and events that occur post-death that are “merely part of the legal or accounting process of determining value at the time of death.” Id. The court distinguished contingent events from a post-death resolution of the actual value of property. The Court of Appeals quoted the tax court:

That the estate and the IRS bickered about the value of the property being transferred doesn’t mean the transfer itself was contingent in the sense of dependent for its existence on a future event. Resolution of a dispute about the fair market value of assets on the date Christianson died depends only on a settlement or final adjudication of a dispute about the past, not the happening of some event in the future.

Id. at *3. The court recognized that the phrase “as finally determined for federal estate tax purposes” is used in other code sections and is not dependent upon post-death contingencies.

With respect to the public policy arguments, the court took issue with the Commissioner’s argument that formula disclaimers reduced the incentive of the Commissioner to enforce the tax laws. The court noted that the Commissioner’s role is not dependent upon maximizing tax receipts and that Congress did not appear to intend the tax law to maximize incentives for the Commissioner to audit returns. The court also found that “countless other mechanisms” are in place to promote and police the accurate reporting of estate values without the threat of

20

audit by the Commissioner. The court affirmed the validity of the formula disclaimer and the ruling of the tax court.

E. Passage of Disclaimed Property.

A rather alarming case out of the district court in Mississippi dealt with how property passed as a result of a disclaimer. Tatum v. U.S., 106 AFTR. 2d 2010-6556 (2010). In Tatum, a son disclaimed his interest in stock passing pursuant to his father’s will. The father’s will provided as follows:

Should my son, Franklin M. Tatum Jr., or either of my grandsons, John Merl Tatum Jr. or Robert O’Neal Tatum, predecease me, their descendants shall take per stirpes the share of their deceased ancestor.

Id. at 4. The probate court issued an order stating that the disclaimed stock would pass to the children of the son as if the son had predeceased the father. The probate court also entered an order distributing the disclaimed property to the grandchildren.

The IRS issued a notice of deficiency for over $700,000 in gift tax under the theory that the property had passed to the grandchildren, not as the result of a qualified disclaimer, but instead, at the direction of the son.

The father’s will expressly provided for an alternate disposition of the residue of the estate if a beneficiary predeceased him but was silent on the question of how the property passed in the event of disclaimer. The district court attempted to review and apply Mississippi law in determining what effect to give the disclaimer and how the disclaimed property should pass. Although some evidence existed that Mississippi law followed the general rule that disclaimed property passes as if the disclaimant predeceased the testator, the court declined to apply that law and instead, relied on a technical advice memorandum that had notbeen cited by either of the parties. The court held that the will’s alternate disposition provision did not apply to disclaimers and that the disclaimed property should have passed by intestate succession to the son and daughter. Thus, the transfer of the stock to the grandchildren was a gift by the son and not as a result of a qualified disclaimer. The taxpayer has appealed the decision to the Fifth Circuit.

Although I.R.C. § 2513 controls a determination of whether a disclaimer is a qualified disclaimer, state law applies in determining the effect of the disclaimer on the property law rights of the parties. Estate planning documents should be carefully drafted to make clear to whom disclaimed property must pass.

21

F. Creditor Protection.

1. History of relation-back rule.

Courts have long wrestled with the question of whether a disclaimer can effectively avoid the disclaimant’s creditors. Absent statutes to the contrary, an effective disclaimer can prevent creditors of the disclaimant from attaching the disclaimed property. Most cases finding that the disclaimant’s creditors cannot reach the disclaimed property rely on the “relation back” doctrine that holds that the disclaimer relates back to the original transfer. The disclaimer acts as a refusal to accept the benefits of the property and, accordingly, is not a transfer from the disclaimant. The fact that the disclaimant has not made a transfer prevents the disclaimer from being a fraudulent transfer under creditor and bankruptcy statutes. UDOPIA takes this same approach and provides in Section 5(f) that a disclaimer is not a transfer, assignment, or release. For a more complete discussion of the “relation back” doctrine and its impact on creditors’ claims, see LaPiana, Some Property Issues in the Law of Disclaimers, 38 REAL PROP. PROB. & TR. J. 207 (2003-2004).

The Uniform Disclaimer of Property Interests Act (“UDOPIA”) does not directly address the effect of disclaimers on state law creditors. Some states allow disclaimers to avoid the claims of creditors. Numerous states have statutes that allow a disclaimer to avoid the claims of creditors. Eg., CAL. PROB. CODE § 281 (West 1991). Other states prohibit the use of disclaimers to avoid creditors or if the disclaimant was insolvent at the time of the disclaimer. Eg., MINN. STAT. § 525.532 and § 501B.86 (1945).

2. Federal tax liens.

Until the Supreme Court’s decision in Drye v. United States, 528 U.S. 49 (1999), the circuit courts were split on the question of whether a taxpayer’s disclaimer of an inheritance could defeat a federal tax lien. The court in Drye settled the matter by holding that a disclaimer does not avoid a federal tax lien under I.R.C. § 6321.

In that case, the decedent’s son was the sole heir of decedent’s estate under the in testate laws of Arkansas. On the date of decedent’s death the son, Drye, was insolvent and owed tax deficiencies of approximately $325,000. The total estate was worth approximately $233,000. Drye filed a disclaimer of his entire interest in the estate that met all of the requirements of state law and I.R.C. § 2518. Under state law the disclaimer operated as if Drye had predeceased his mother and the entire estate instead passed to Drye’s daughter. Drye’s daughter subsequently created a trust with the estate proceeds for the benefit of herself and her parents. The Internal Revenue Service filed a Notice of Levy on the accounts held in the trust’s name. The trustee filed a wrongful levy action

22

and the service counterclaimed against the trust, its trustee, and the beneficiaries. On cross-motions for summary judgment the district court ruled in the government’s favor and the matter was appealed to the Eighth Circuit Court of Appeals.

The Eighth Circuit affirmed the district court’s ruling that the federal tax liens attached to Drye’s interest in the estate on the date of decedent’s death and that the disclaimer was ineffective to invalidate the federal tax liens. The Eighth Circuit determined that Drye’s right to inherit had pecuniary value that was transferable under Arkansas law and was considered a property right under I.R.C. § 6321. The result was that the Service’s pre-existing federal tax liens attached to Drye’s right to inherit at the time of his mother’s death.

The United States Supreme Court granted certiorari in Drye in order to resolve a conflict among the circuits on the question of the impact of a disclaimer on a federal tax lien. For a deeper discussion of the previous rulings in the Eighth, Ninth, Fifth and Second Circuits, see Bluestein, Disclaimers and Federal Tax Liens’ Effect on Inheritances, 36 REAL PROP. PROB. & TR. J. 391 (2001-2002).

The Supreme Court interpreted the language of I.R.C. §§ 6321 and 6331(a) to indicate that Congress meant “to reach every interest in property that a taxpayer might have” and noted that inheritances and devises were not included in Section 6334(a)’s list of property that is exempt from tax levy. The court determined that the question of whether a state-law right constitutes “rights to property” under the Section 6321 tax levy statute is a matter of federal law. Although state law determines the rights the taxpayer possesses, federal law determines whether those rights are taxable. The court concluded that although state law might protect a disclaimant’s right vis-à-vis ordinary creditors, only federal law could determine whether a federal tax lien could attach. Although a valid disclaimer under state law might have the effect of circumventing ordinary creditors, the state law could not protect the disclaimed property from a federal tax lien.

The Supreme Court affirmed the Eighth Circuit’s ruling that state law inheritance rights have a pecuniary value and are transferrable or assignable and, accordingly, may be attached for federal tax lien purposes. The court indicated that Drye’s expectancy interest arose as of the date of his mother’s death and at that time could be attached by the Service. Although the Supreme Court’s ruling appears to rely more on the ability of the IRS to reach all manner of assets and interests for tax collection purposes, the court also appeared to be swayed by its belief that the disclaimant could, in effect, assign his interest to another by disclaiming the property knowing that it would pass to his daughter. This ability to

23

take action and have the property pass to Drye’s daughter was determined by the court to be a valuable property right.

3. Disclaimers in bankruptcy.

Recently, the Ninth Circuit has declined to extend the holding in Drye to the bankruptcy context. In Re Costas, 555 F.3d 790 (9th Cir. 2009). The court in Costas held that a disclaimer was not a transfer of property within the meaning of the bankruptcy statutes and that the disclaimed property thus was not a part of the bankruptcy estate.

Rachelle Costas executed a valid disclaimer under state law of her share of her father’s estate. Shortly after filing her disclaimer, Rachelle filed for bankruptcy under Chapter Seven. The trustee in bankruptcy sought to invalidate the disclaimer under 11 U.S.C. § 548 as a transfer prior to the date of the filing of a bankruptcy petition. The trustee argued that the Supreme Court’s decision in Drye applied equally to the Federal Bankruptcy Code. The bankruptcy appellate panel determined that the disclaimer was effective and that the disclaimed property was not a part of the bankruptcy estate. The Ninth Circuit affirmed. The court in Costasdetermined that whether a disclaimer constituted a “transfer” under the bankruptcy code was a matter of federal law, although the determination of whether the disclaimant held “an interest in property” was to be determined under state law.

The bankruptcy trustee in Costas argued that the court’s rationale in Dryeshould be applied because the disclaimant’s power to “in effect” guide the disposition of the property should be recognized as an interest in property for bankruptcy purposes. The court in Costas, however, distinguished Drye because there the tax lien had been in place prior to the execution of the disclaimer. In Costas, the disclaimer was executed prior to the disclaimant’s filing the petition for bankruptcy. Accordingly, the “retroactive divestment of property interests occurred prior to the bankruptcy.” Id. at 796. The court also pointed out that Drye was limited to tax lien cases only. The court reasoned that the collection of taxes was the primary focus in Drye and justified the “extraordinary priority accorded federal tax liens.” The Costas court did not extend Drye to bankruptcy actions.

4. Disclaimers avoidable by creditors.

The question of whether a disclaimant’s creditor may reach the disclaimed property is governed by local law. The fact that a disclaimer is voidable by the disclaimant’s creditors does not affect the determination of whether the disclaimer is a qualified disclaimer under I.R.C. § 2518. However, a disclaimer that is wholly void or that is voided by the disclaimant’s creditors is not a qualified disclaimer. Treas. Reg. § 25.2518-1(c)(2).

24

Examples provided in the regulations outline the situation in which the state law disclaimer statute requires that a disclaimer must be made within six months of the death of the testator. A disclaimer made after the six months period has expired is treated under state law as an assignment of the interest disclaimed and thus could be reached by creditors. The regulations indicate that if a disclaimer was made within the period allowed under Section 2518 it would be a qualified disclaimer for tax purposes notwithstanding the fact that the creditors could attach the disclaimed property. Treas. Reg. § 25.2518-1(c)(3) E.g. (1).

G. Use of Disclaimers to Provide Flexibility.

1. All to spouse.

An estate plan may be prepared that provides that all assets will pass outright to the surviving spouse or to a Qtip trust for the spouse. In the event that the spouse disclaims some or all of the assets, the disclaimed property would pass by reason of the estate planning documents to the children. The advantage of this type of plan is that it is fairly easy to administer, it provides an opportunity for the surviving spouse to determine what portion of the decedent’s estate tax exemption should be utilized and leaves the spouse free to determine what, if any, assets the surviving spouse might need. The downsides to this type of plan are that the disclaimed property is no longer available for the spouse’s use, that the children may be too young to receive the assets at the death of the first spouse, and that the spouse’s options of retaining the assets or disclaiming them are fairly limited.

2. Disclaimer plan.

A disclaimer plan can provide that assets pass outright or in trust to the surviving spouse and that any portion of the estate that is disclaimed will pass to a family trust for the benefit of the spouse and children. The advantages of this plan are that it allows the surviving spouse to make partial or full use of the decedent’s estate tax exemption, and whether to fund the family trust to the full federal or state funding level. Additionally, the surviving spouse can be a beneficiary and a trustee of the family trust providing more flexibility for the family. The surviving spouse may not hold a power of appointment over any portion of the disclaimed property (other than a five and five power). If the family trust does provide for a power of appointment in the spouse, the spouse must also disclaim the power of appointment. The surviving spouse may act as a trustee of the family trust as long as distribution powers are limited to an ascertainable standard.

25

3. Marital deduction plan.

In states that still maintain an estate tax and have exemption equivalents below the federal estate tax exemption, a marital deduction plan may be drafted to fund the family trust to the lesser of the federal and state exemption level. The surviving spouse may disclaim additional assets to more fully fund the family trust up to the federal exemption, thus, incurring a state estate tax on the death of the first spouse. This plan can provide great flexibility for the surviving spouse to determine whether the payment of state death tax on the first death is advisable.

4. Closely-held business assets.

If closely-held business assets or other hard-to-value assets are disclaimed the planner should consider using a formula disclaimer like that described in Christianson, and in Example 20 in the regulations to I.R.C. § 2518. Reg. § 25.2518-3(d) Eg20. A formula disclaimer of closely-held business interests will assure that unintended estate taxes are not incurred by the disclaimer of too large or too small a value.

Caution should be exercised in using disclaimers of closely-held assets to avoid unintentionally creating valuation discounts. For example, if a decedent owned 100% of a limited liability company, and left the entire company to his spouse, a disclaimer by the spouse of half of the LLC interests could create a serious estate tax problem. The full fair-market value of 100% of the LLC would be includable in the decedent’s estate under I.R.C. § 2032. However, the marital deduction available under I.R.C. § 2056 for the 50% LLC interest passing to the surviving spouse would be a discounted value for a minority interest. If the disclaimed portion were to pass to a family trust or to charity, the intention would have been to avoid estate tax completely. However, the fact that the marital deduction would be less than 50% of the total value of the LLC would cause estate tax to be incurred.

VI. 2010 ESTATE ADMINISTRATION.

A. Default Rule.

The default estate tax rule for estates of decedents dying in 2010 is that the estate tax law applies at the rate of 35% and an estate tax exemption of $5,000,000 is available. TRA 2010 § 301(a). For estates to which the estate tax applies, the basis for assets for income tax purposes is stepped up to the fair-market value of the assets on the date of death as finally determined for federal estate tax purposes. The estate tax return and payment date of the estate tax is extended to no earlier than nine months after the date of enactment of TRA 2010 or September 19, 2011 for decedents who died from January 1, 2010 through

26

December 16, 2010. An additional six-month extension should be available under I.R.C. § 6018 but the issue is uncertain.

B. Alternate Regime.

Executors may elect to have the modified basis rules of I.R.C.§ 1022 apply instead of the estate tax regime discussed above. TRA 2010 § 301(c). The statute does not specify when or how the election is made although certain guidance by the IRS is in process. The Treasury Department and IRS have announced that Form 8939 will be the appropriate form for making the allocation of basis adjustment. A copy of Form 8939 is attached as Exhibit A.

Originally, the election was to have been made by April 18, 2011, but the due date has now been extended until special rules have been developed with respect to the allocation of basis adjustment. The special rules will be published in Publication 4895, Tax Treatment of Property Acquired From a Decedent Dying in 2010. Because the publication had not been issued prior to the due date of a 2010 decedent’s individual income tax return, as of April 18, 2011, the Treasury Department issued a notification indicating that a taxpayer may need to file an extension to the income tax return on which will be reflected the gain or loss from sale of any assets received from a decedent who died in 2010. The Service stated that if “you owe additional tax because the estimate turns out to be incorrect, penalty relief will be available if the estimate was based on a reasonable interpretation of the law. Interest, however, will accrue.”

C. Impact of Prior Gifts on Estate Tax Calculation.

Section 2001(b) provides that the estate tax is computed on the sum of the amount of the taxable estate plus the amount of adjusted taxable gifts. The second part of the calculation requires a subtraction of the amount of gift tax that would have been payable with respect to prior gifts if the gift tax rate in effect at the decedent’s death had been applicable at the time of the gifts. This second calculation is intended to assure that the estate will be taxable at the highest marginal tax rate.

The reduction of the estate tax rate to 35% created the need to add a new Section 2001(g). Section 2001(g) provides that the second part of the calculation is made using the tax rates in effect at the date of death to compute the gift tax imposed and the gift tax unified credit allowed in each year in which gifts were made. In essence, this means that the taxpayer will receive a credit, not for the actual gift tax exemption used at the higher rates from prior years, but of a calculated amount based on the lower rates currently in effect.

D. Portability

TRA 2010 allows an estate the benefit of any unused estate tax exemption available from the estate of a predeceased spouse. I.R.C. § 2010(c) has been amended to provide that the estate tax applicable exclusion amount is the

27

$5,000,000 base exclusion amount (indexed beginning in 2012 from 2010) plus the “deceased spousal unused exclusion amount.” The amount available from a predeceased spouse is limited to the last deceased spouse’s remaining unused exemption. This would prohibit the use of either picking and choosing the predeceased spouse who left the largest amount of exemption remaining or the doubling up of multiple exclusions from multiple predeceased spouses.

Perhaps the most onerous requirement is that the executor of the predeceased spouse’s estate must timely file an estate tax return and make an election to permit the surviving spouse’s use of the remaining exclusion amount. In circumstances in which an estate tax return is not otherwise required the executor of the estate of a married decedent may wish to file an estate tax return to make the election. This requirement could greatly add to the cost and complexity of even small estates.

The surviving spouse may also use the deceased spouse’s unused exclusion amount for gift tax purposes during lifetime. This in effect allows gift splitting with a deceased spouse.

E. Basis Adjustments.

If the executor elects to have the modified carryover basis system apply to the estate, the estate may make a $1,300,000 basis adjustment by adding to the income tax basis of the estate assets up to $1,300,000 in order to adjust the basis of the estate assets up to but not in excess of their fair-market value. Additionally, the executor can allocate up to $3,000,000 to increase the basis of assets received by a surviving spouse outright or in a Qtip trust. The basis of an asset may not be adjusted above its fair-market value on the date of death, and must be reported by the executor on Form 8939 in order to obtain the benefits of the basis adjustment. The questions of the holding period, nature of the gain, and impact of net operating losses are not fully resolved by the statute and await further guidance by the IRS.

The final Form 8939 will be released by the I.R.S. at least 90 days before it is required to be filed. The form will be available on the I.R.S. website at www.irs.gov/pub/irs-pdf/f8939.

VII. 2013 AND BEYOND.

A. Missing from TRA 2010.

Several senate proposals in 2010 included tax provisions that did not make their way into TRA 2010. Some of those provisions include the following:

1. Ten-year minimum GRAT term.

The Baucus Bill, introduced in late 2010, included a proposal to require that a grantor-retained annuity trust have a minimum ten-year term and

28

that the annuity amount must not decrease in any year from the prior year and the remainder interest must have a value greater than zero as of the date of the transfer to the trust. The purpose of this proposal was to curtail the use of short-term laddered GRATs to remove appreciation in excess of the applicable federal rate from taxpayers’ estates.

2. Consistency of basis.

The Baucus Bill also included a proposal that the basis of property in the hands of heirs must be equal to its value as finally determined for federal estate tax purposes, and the basis of property in the hands of donees would be limited by the fair-market value as finally determined for gift tax purposes for purposes of determining loss. This provision was intended to defeat the transfer of depreciated assets for the purpose of shifting loss deductions.

3. Valuation discounts.

Several proposals made adjustments to I.R.C. § 2704 to eliminate minority interest and marketability valuation discounts for intra-family transfers.

4. Special use valuation.

At least one proposal would have increased the special use valuation adjustment amount from $750,000 indexed to $1,000,000 in 2010 under the current law to $3,500,000 indexed from 2009, beginning in 2011. The intention was to provide further benefit for the family farm.

B. The Green Book.

On February 14, 2011, the Treasury released its General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals, commonly referred to as The Green Book, which provided the details of President Obama’s budget proposals. Three items related to transfer tax issues:

1. Consistency in valuation.

This rule would require that the basis of an asset for income tax purposes be the same as determined for federal estate or gift tax purposes, thus in the event of an audit of an estate or gift tax return, the adjustment in valuation for transfer tax purposes would also be made for income tax basis purposes.

2. Valuation discounts.

Section 2704 would be revised to add additional disregarded restrictions that would be ignored for transfer tax purposes in valuing an intra-family transfer of an interest in a family-controlled entity. Certain restrictions in

29

the entity documents including limitations on the interest holder’s right to liquidate or be admitted as a full partner would be disregarded for valuation purposes. For the most part, this would restrict the ability of families to take marketability discounts on intra-family transactions, although minority interest discounts might still be available.

3. Minimum GRAT terms.

The Green Book proposal would require that grantor-retained annuity trusts have a minimum ten-year term, a remainder interest greater than zero and annuity interests that do not decrease in any year.

C. Treasury Priority Guidance Plan.

Treasury officials have indicated that their top priority is providing guidance for 2010 decedents’ estates, giving guidance regarding portability of a spouse’s estate tax exemption and allocation of basis issues.

D. Bundled Fiduciary Fees.

The IRS has issued a notice with respect to the treatment of investment advisory and other costs subject to the 2% floor under I.R.C. § 67(a). The IRS previously had issued its notice that non-grantor trusts and estates were not required to “unbundle” a fiduciary fee into parts consisting of costs that were fully deductible and costs that were subject to the 2% floor.

The IRS had initially provided this relief for tax years beginning before January 1, 2008. In late 2008, the IRS extended the relief to apply to tax years beginning before January 1, 2009. In 2010, the IRS again extended the relief for an additional year. Now, in Notice 2011-37, 2011-20 I.R.B., the IRS has extended the relief until the issuance of final regulations. Possibly, this puts the issue to bed for the foreseeable future.

EXHIBIT A

A-1

A-2

A-3

A-4

GP:2981135 v1

ADMIN01/900999.02479_0015/11599035.2

Identifying and Avoiding Breaches of Fiduciary Duty

19TH ANNUAL SALVATION ARMY

ESTATE AND CHARITABLE GIFT PLANNING INSTITUTE

September 14, 2011

By:

Charles A. Redd of

Stinson Morrison Hecker LLP St. Louis, Missouri

7700 Forsyth Boulevard

Suite 1100 St. Louis, Missouri 63105-1821

(314) 259-4534 (Telephone) (314) 259-3952 (Facsimile)

credd@stinson.com

www.stinson.com

ADMIN01/900999.02479_0015/11599035.2

Table of Contents Page

A. Administration of Estates of 2010 Decedents Under the Tax Relief Act of 2010..................................................................................................................................... 1

1. Introduction ..............................................................................................................1 2. Modifications to EGTRRA ......................................................................................1 3. Election Regarding 2010 Decedents ........................................................................2

4. GST Effect of Election Available to 2010 Decedents .............................................4

5. Extension of Certain Deadlines ...............................................................................4

B. Trustee’s Discretion and Standards Regarding Distributions ............................................. 5

1. Ascertainable Standards ...........................................................................................5 a. Health, Support, Education and Maintenance ...............................5 b. Other Standards .............................................................................6

c. “Accustomed Manner of Living.” .................................................7 2. Consideration of Other Resources ...........................................................................8

C. Current Issues Regarding a Trustee’s Duties in the Administration of Trust-Owned Life Insurance ............................................................................................. 10 1. Cochran ..................................................................................................................10 2. Florida Statutes § 736.0902 ...................................................................................11

a. Duties Relating to Prudent Investor Rule ....................................11 b. Insurable Interest .........................................................................12

c. General Protection from Liability ...............................................12

d. No Compensation ........................................................................12

e. Qualified Person ..........................................................................12

3. Paradee ...................................................................................................................13 a. Paradee Family, Trust and Life Insurance Policy .......................13 b. Attempts to Revoke Trust; Trust’s Loan .....................................13 c. Successor Trustees .......................................................................14

d. Court’s Analysis ..........................................................................15

e. Remedies .....................................................................................16

D. Current Issues Regarding a Trustee’s Duties in Administering Trust Investments ....................................................................................................................... 16

1. Chase Manhattan Bank ..........................................................................................16 2. Karo........................................................................................................................18 3. Wood ......................................................................................................................19 4. Schumacher ............................................................................................................20

E. Exculpatory Clauses.......................................................................................................... 22 1. Generally ................................................................................................................22 2. Retention of Investments .......................................................................................23 3. Fifth Third Bank ....................................................................................................23

Table of Contents (continued)

Page

ii

ADMIN01/900999.02479_0015/11599035.2

F. Required Disclosures to Beneficiaries .............................................................................. 24 1. Introduction ............................................................................................................24 2. Information Required to be Disclosed -- Nature and Timing ................................24

a. The Restatement and Case Law ..................................................24

b. State Statutory Law .....................................................................27

3. Duty to Keep Beneficiaries Informed Under the Uniform Trust Code .................27

a. The Uniform Rules. .....................................................................27

b. Modifications in Enacting Jurisdictions ......................................29 c. Statute of Limitations ..................................................................29

d. Modifying UTC Notification Requirements by Governing Instrument Language .................................................30

4. Janowiak ................................................................................................................31 a. Facts .............................................................................................31

b. Appellate Court Analysis ............................................................32

5. Quick ......................................................................................................................33

G. More Recent Developments Regarding Fiduciary Liability ............................................. 34

1. Children’s Wish Foundation International, Inc. v. Mayer Hoffman McCann, P.C., No. SC 90944, 2011 WL 681093 (Mo. banc, February 8, 2011) ..........................34

2. Schmitz v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 939 N.E.2d 40 (Ill.App. 2010) ......................................................................................................................36

3. Herlehy v. Marie V. Bistersky Trust Dated May 5, 1989, No. 1-10-0071, 2010 WL 5487547 (Ill.App. December 23, 2010) .................................................................37

a. Facts .............................................................................................37

b. Arguments and Disposition in the Trial Court ............................38 c. Review by Appellate Court .........................................................39

ADMIN01/900999.02479_0015/11599035.2

IDENTIFYING AND AVOIDING BREACHES OF FIDUCIARY DUTY

By: Charles A. Redd

Stinson Morrison Hecker LLP St. Louis, Missouri

A. Administration of Estates of 2010 Decedents Under the Tax Relief Act of 2010

1. Introduction

On December 17, 2010, the President signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312 (the “TRA”). The TRA included new federal estate, gift and generation-skipping transfer (“GST”) legislation that is applicable to those who died in 2010, to those who die in 2011 or 2012 and to gifts made in 2011 and 2012 but not gifts made in 2010. The TRA then sunsets on December 31, 2012, and the law put in place for 2011 and future years by the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107-16 (June 7, 2001) (“EGTRRA”), will be applicable for all transfer tax purposes beginning on January 1, 2013. Given recent history, it is impossible to predict whether the provisions of the TRA will be extended beyond December 31, 2012. The following is a summary and analysis of the provisions of the TRA that are of most interest to estate planning practitioners.

2. Modifications to EGTRRA

Before the TRA was enacted, Section 901 of EGTRRA provided that “[a]ll provisions of, and amendments made by, this Act shall not apply . . . to estates of decedents dying, gifts made, or generation skipping transfers, after December 31, 2010.” Thus, if Congress and the President had taken no action and allowed EGTRRA to sunset on December 31, 2010, the provisions that applied before EGTRRA was signed into law would have become effective again. Among many other changes (such as the repeal of beneficial GST tax provisions such as those dealing with qualified severances, retroactive allocations and substantial compliance), the sunset of EGTRRA would have meant that the applicable exclusion amount would have reverted to $1 million for estate, gift and generation-skipping transfer (“GST”) tax purposes, and the top tax rate for all three transfer taxes would have returned to 55%. The TRA modifies Section 901 of EGTRRA to delay the sunset until December 31, 2012. TRA §§ 101(a), 304. Thus, the provisions of the TRA may be available for only two years, depending on what action, if any, Congress and the President take to modify the TRA before the sunset. TRA § 301(a) modifies the provisions of EGTRRA so that the estate and GST taxes are reinstated as of January 1, 2010, and the carryover basis rules under Internal Revenue Code (“IRC”) § 1022 are repealed as of January 1, 2010. Thus, for any decedent dying in 2011 or 2012, the assets included in the value of the decedent’s gross estate will receive a step-up in

- 2 -

ADMIN01/900999.02479_0015/11599035.2

basis, eliminating the need to pay capital gains taxes on pre-death unrealized gains. This is of particular benefit to persons with greatly appreciated assets and to real estate investors with negative basis property. The gift tax provisions under EGTRRA are also modified such that the applicable exclusion amount under IRC § 2505(a)(1) is re-unified with the estate tax applicable exclusion amount under IRC § 2010(c). TRA §§ 301(b), 302(b).

3. Election Regarding 2010 Decedents

The TRA also allows an executor of the estate of a decedent who died in 2010 to choose which estate tax regime will apply to such estate. This provision, however, is applicable only to Chapter 11 of the IRC (the estate tax) and the basis rules of IRC §§ 1022 and 1014. The executor has two options: (a) follow the new estate tax and basis rules established under the TRA; or (b) follow the estate tax and basis rules that existed during 2010 under EGTRRA. Under the first option, the estate tax will be applicable to the decedent’s estate but the estate will have a $5 million applicable exclusion amount and be able to use the step-up in basis provisions of IRC § 1014. Under the second option, the estate will not be subject to estate tax and the estate must use the carryover basis provisions under IRC § 1022. If the executor wants to follow the second option, the executor must affirmatively elect that treatment on a timely-filed estate tax return (including extensions granted). Once such an election is made, the election is revocable only with the consent of the Treasury. For an in-depth discussion of the requirements of IRC § 1022, see Cantrell, “The Power of Post-Mortem Planning (Selected Issues for 2010 and 2011),” 45 Heckerling Institute on Estate Planning, Ch. 8 (2011).

An executor of an estate with a value that is less than the decedent’s applicable exclusion amount will likely decline to opt-out of the estate tax. In this situation, the step-up in basis rules will apply, there will be no need to file an estate tax return and the executor can avoid allocating basis under IRC § 1022 and submitting such allocation to the IRS on a Form 8939.

One situation in which carryover basis may be preferable even when the value of a decedent’s estate is less than the decedent’s applicable exclusion amount is if the primary reason why the executor was able to conclude that the value of the gross estate is less than the applicable exclusion amount was through the application of aggressive valuation discounts. If the IRS challenged the discounts and the discounts are reduced, estate tax may be due, which would have been avoided by electing out of the estate tax. Belcher, Donaldson & Kaufman, “Recent Developments,” 45 Heckerling Institute on Estate Planning, Ch. 1 (2011).

An executor of an estate with a value that exceeds the decedent’s applicable exclusion amount will likely make the election to avoid application of the estate tax. The executor would have to consider, however, if the appreciation in the property passing from the decedent exceeds the additional basis available under IRC § 1022, the future income tax consequences of losing the step-up in basis and subjecting the estate beneficiaries to capital gain tax if and when they dispose of the property received from the estate. Akers, “Estate, Gift and Generation-Skipping Transfer Tax Provisions of ‘Tax Relief . . . Act of 2010,’ Enacted December 17, 2010,” (12/21/2010) (hereinafter, “Akers”). If it is assumed that the beneficiaries only will be subject to a 15% capital gains tax rate if and when they sell property received from the estate, electing out

- 3 -

ADMIN01/900999.02479_0015/11599035.2

of the estate tax and avoiding the current application of a 35% tax rate on the gross estate often will be justified. Belcher, Donaldson & Kaufman, supra. One situation in which the executor of a decedent’s estate the value of which is greater than the decedent’s applicable exclusion amount may want to subject to estate to estate tax is if a substantial amount of the property held in the estate is encumbered with debt in excess of the basis of the property. When such property is sold, the difference between the amount of the debt and the basis of the property will be considered taxable gain, often called “phantom gain.” See Hesch, “Why Electing Out of the Estate Tax for Individuals Who Died in 2010 May be the Wrong Choice,” 36 Estates, Gifts and Trusts Journal 139 (2011). If the executor elects out of the estate tax, then, upon the surviving spouse’s death, no property will be included in the gross estate under IRC § 2044 because no QTIP election would have been made for the estate of predeceasing spouse.

� Planning Point: If a donor made a large gift to his or her spouse and the donee spouse died less than one year later, in 2010, with an estate plan that allocates the assets received from the donor to a QTIP trust, the donee spouse’s estate should consider electing out of the estate tax so as to avoid the possible application of IRC § 1014(e), which could eliminate the step-up in basis for the assets that were transferred by gift to the donee spouse shortly before the donee spouse’s death.

EXAMPLE : Suppose a decedent died in 2010, survived by a spouse, with a gross estate having a value of $12 million. The estate plan allocates to the decedent’s children the maximum amount that can pass to the children without generating federal estate tax and allocates the balance of the estate to the spouse. If no election out of estate tax applicability were made, $5 million would pass to the children, and $7 million would pass to the spouse. If the executor instead elected out of the estate tax, all $12 million would pass to the children, and the spouse would receive nothing. This example assumes that there is no applicable state statute that would reallocate disposition amounts between the children and the spouse in a manner presumed to be more aligned with the decedent’s intent. Cf, Md. Code Ann., Estates & Trusts, § 11-110.

EXAMPLE : Suppose a decedent died in 2010, survived by a spouse, with a gross estate having a value of $5 million. The estate plan allocates the entire estate to the spouse but with a contingent disposition, to the extent the spouse disclaims, to a credit shelter trust for the spouse’s remaining lifetime for the concurrent benefit of the spouse and the decedent’s descendants. If no election out of estate tax applicability were made and the spouse did not disclaim, $5 million would pass to the spouse, resulting in no federal estate tax, and a full step-up in basis for all assets would be achieved, but, at the later death of the spouse, the entire estate of the predeceased spouse, except to the extent given away or

- 4 -

ADMIN01/900999.02479_0015/11599035.2

consumed, would be included in the spouse’s estate for estate tax purposes. If the executor instead elected out of the estate tax and the spouse made a qualified disclaimer, again, no federal estate tax would be imposed, but basis step-up would be limited to a maximum $1.3 million adjustment under IRC § 1022. However, at the subsequent death of the spouse, all of the property held in the credit shelter trust, regardless of how large it had grown and how small the surviving spouse’s applicable exclusion amount was, would escape estate taxation.

Note that, in the second Example, if the executor elected out the estate tax and the surviving spouse disclaimed, the extra $3 million of basis adjustment for qualified spousal property under IRC § 1022(c) would be lost because the surviving spouse did not receive any property from the decedent. This basis adjustment also would be lost in the first Example if the executor elected out of the estate tax.

4. GST Effect of Election Available to 2010 Decedents

TRA § 301(c) adds that “[f]or purposes of section 2652(a)(1) . . . the determination of whether any property is subject to the tax imposed by such chapter 11 shall be made without regard to any election made under this subsection.” IRC § 2652(a)(1) contains the definition of a “transferor” for GST tax purposes, which term is defined, essentially, as the last person who was subject to estate or gift tax with respect to the subject property. This provision of the TRA is important because, if a 2010 decedent’s executor makes an affirmative election not to be subject to estate tax, the provision ensures that the decedent will nevertheless meet the definition of a “transferor” under IRC § 2652(a). See Joint Committee on Taxation, “Technical Explanation of the Revenue Provisions Contained in the ‘Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010,’ Scheduled for Consideration by the United States Senate,” (JCX-55-10) n. 53, December 10, 2010. The decedent’s being regarded in this situation as a transferor is not a problem in connection with a direct skip that flows from the decedent’s estate because the GST tax rate for generation-skipping transfers in 2010 is zero. However, this provision unfortunately locks in the result that, if the estate plan of such a decedent provides for any indirect skips into so-called “GST trusts,” the executor will have to allocate GST exemption to such indirect skips in order to avoid GST tax on taxable distributions or taxable terminations with respect to such GST trusts at some point in the future.

5. Extension of Certain Deadlines

The TRA provides that, for decedents dying and for GSTs after December 31, 2009 and before December 17, 2010 (i.e., the date of enactment), the filing of any estate or GST tax return (i.e., returns for taxable terminations and taxable distributions) and any payment of estate tax shall not be due any earlier than September 19, 2011 (i.e., the first business day that is nine months after the date of enactment). The deadline for the filing a gift tax return for gifts made in 2010 was not extended. Thus, even if a decedent died in January of 2010, without the application of any extensions, penalties or interests, the due date for the filing of the decedent’s estate tax return and

- 5 -

ADMIN01/900999.02479_0015/11599035.2

the payment of any estate tax is September 19, 2011. This extension gives an executor more time to choose whether to make an election under TRA § 301(c), discussed above. In addition, the deadline for making a disclaimer under IRC § 2518 of property passing from such a decedent has been extended to September 19, 2011, giving additional planning flexibility in light of the changes enacted by the TRA. However, this extension also gives more time for one or more of the requirements for a qualified disclaimer to be violated, such as the disclaimant’s acceptance of benefits. Furthermore, compliance with the disclaimer rules under applicable state law is a requirement of a qualified disclaimer under IRC § 2518, and the time under state law within which to make a valid disclaimer obviously is unaffected by the TRA. Akers, supra; see, e.g., Conn. Gen. Stat. Ann. § 45a-579 (imposing a nine-month time limit for making a valid disclaimer). In addition, IRC § 2518(c)(3), which treats certain disclaimers as qualified even if certain requirements are not met, does not apply in this situation. B. Trustee’s Discretion and Standards Regarding Distributions

1. Ascertainable Standards

Reasonably definite or objective standards serve to assure a beneficiary some minimum level of benefits, even when other standards are included to grant broad latitude with respect to additional benefits. See Restatement (Third) of the Law - Trusts (“Restatement 3rd”) § 50, cmt. d. The settlor can give the Trustee the power to make distributions, for example, “for the beneficiary’s support, maintenance and education,” “in the event of sickness, accident, misfortune or other emergency,” etc. Restatement 3d § 50, cmt. b provides that “[a]bsent language of extended (e.g., ‘absolute’ or ‘uncontrolled’) discretion, a court will also intervene if it finds the payments made, or not made, to be unreasonable as a means of carrying out the trust provisions.”

a. Health, Support, Education and Maintenance. “Support” and “maintenance,” unless otherwise defined in the trust instrument, usually allows for distributions for the beneficiary’s normal living expenses, such as housing and medical care, and may be influenced by the standard of living enjoyed by the beneficiary during the settlor’s life. See, e.g., In re Levinson’s Will, 162 N.Y.S.2d 287 (Surr.Ct. 1957). A power to distribute principal for a beneficiary’s “support” may include the power to distribute principal for the support of the beneficiary’s spouse and children. See, e.g., In re Sullivan, 12 N.W.2d 148 (Neb. 1943); Seattle-First National Bank v. Crosby, 254 P.2d 732 (Wash. 1953).

Under Restatement 3d § 50, cmt. d(2), the terms “support” and “maintenance” are synonymous and allow for distributions for purposes beyond necessities. The Restatement comment also provides that distributions for the following purposes are generally encompassed in a support and maintenance standard: “regular mortgage payments, property taxes, suitable health insurance or care, existing programs of life and property insurance, and continuation of accustomed patterns of vacation and of charitable and family gifting.” Distributions for “reasonable, additional comforts or ‘luxuries’ that are within the means of many individuals of like station in life, such as a special vacation of a type the beneficiary had never before taken,” may also be permissible. Restatement 3d § 50 does not allow distributions for the following purposes under a support and maintenance standard: “payments that are unrelated to support but

- 6 -

ADMIN01/900999.02479_0015/11599035.2

merely contribute in other ways to a beneficiary's contentment or happiness,” such as “distributions to enlarge the beneficiary’s personal estate or to enable the making of extraordinary gifts.”

Restatement 3d § 50, cmt. d(2), also provides that the term “support” is not as broad as “welfare” and “happiness” standards, but it does allow distributions to maintain the beneficiary’s accustomed manner of living, further discussed below. The term “education,” unless otherwise defined in the trust instrument, generally includes college education but not graduate level or professional education. See, e.g., Southern Bank & Trust Company v. Brown, 246 S.E.2d 598 (S.C. 1978); Epstein v. Kuvin, 95 A.2d 753 (N.J. Super. 1953). It seems clear that the term “health” includes emergency medical treatment, but there appears to be little consensus as to whether this term covers other forms of health care. See, e.g., Kiziah, Four Chosen Words, TRUSTS & ESTATES, Aug. 2006, at 26.

b. Other Standards. Distributions may be limited to an ascertainable standard and at the same time subject to the Trustee’s “sole discretion” in making the payments. One court held that a Trustee making distributions in such circumstances must pay the minimum amount that in the opinion of a reasonable person would be necessary for maintenance and support and that the Trustee may exercise discretion with regard to additional payments. Schofield v. Commerce Trust Co., 319 S.W.2d 275 (Mo.App. 1958). Another court held that such a standard does not allow a Trustee to make distributions for other than health, support, maintenance and education of the beneficiary. In re Estate of Mayer, 672 N.Y.S.2d 998 (Surr.Ct. 1998).

The term “comfort” is generally limited to the beneficiary’s health and support. Estate of Vissering, 990 F.2d 578 (10th Cir. 1993) (allowing distributions “required for the continued comfort” of the beneficiary). Some courts have defined the term to include the beneficiary’s enjoyment, pleasure, happiness, satisfaction or peace of mind. See, e.g., In re Mirfield’s Estate, 126 N.Y.S.2d 465 (Surr.Ct. 1953) (allowing distributions to purchase an automobile to enable the beneficiary’s daughter to visit the beneficiary because her visits “did much to ease the mind” of the beneficiary). At least one court has concluded that the term “comfort” should be defined as related to the settlor’s, rather than the beneficiary’s, accustomed standard of living. Gulf National Bank v. Sturtevant, 511 So.2d 936 (Miss. 1987).

The term “best interests” is often interpreted to allow for distributions for broad purposes, including expenses for luxury items. “Best interests” include peace of mind, as well as financial gain. Wiedenmanyer v. Johnson, 254 A.2d 534, aff’d, 259 A.2d 465 (1969). Some courts have even determined that a Trustee operating under a “best interests” standard has the authority to distribute the entire trust principal to the beneficiary in a lump sum, provided that such a distribution is not an abuse of the Trustee’s discretion. See, e.g., Lees v. Howarth, 131 A.2d 229 (R.I. 1957); but see Kemp v. Paterson, 159 N.E.2d 661 (N.Y. 1959) (holding that the termination of a trust by the payment of the entire principal to the income beneficiary in the income beneficiary’s “best interest” was not authorized).

� Planning Point: Because the best interests standard is a rather amorphous concept, without any further language in the trust instrument explaining the settlor’s intent, use of this standard may lead to disagreements between

- 7 -

ADMIN01/900999.02479_0015/11599035.2

the Trustee and the beneficiary as to which distributions are in the beneficiary’s best interests. Charles D. Fox IV, “Best Practices for Trust Administration,” Estate Planning Council of St. Louis, March 5, 2007. Thus, additional explanation in the trust instrument concerning the settlor’s intent would be appropriate.

On the other end of the spectrum, the term “emergency” is often interpreted very narrowly; usually authorizing distributions for the beneficiary’s unusual and unforeseen expenses but not for routine or ordinary support and maintenance. See, e.g., Budd v. Comm’r, 49 T.C. 468 (1968).

c. “Accustomed Manner of Living.” When language such as “accustomed standard of living” or “accustomed manner of living” is included in a discretionary distribution clause, courts have held that the Trustee does not have the power to dictate the beneficiary’s standard of living. Rather, such language sets the standard by which the support and maintenance of the beneficiary is to be measured. See, e.g., In re Estate of McCart, 847 P.2d 184 (Colo.App. 1992). In Emmert v. Old National Bank of Martinsburg, 246 S.E.2d 236 (W.Va. 1978), the court held that, in the absence of specific language, the level of support that was mandated under the document was to be judged by that to which the son was accustomed at the settlor’s death, “which [the settlor’s] upbringing of [his sons] led them to expect.” See also, Barnett Banks Trust Co. v. Herr, 546 So.2d 755 (Fla.App. 1989).

The Restatement 3d § 50, cmt. d(2), states that a beneficiary’s accustomed manner of living “is ordinarily that enjoyed by the beneficiary at the time of the settlor’s death or at the time an irrevocable trust is created.” See, e.g., In re Golodetz’ Will, 118 N.Y.S.2d 707 (Surr.Ct. 1952) (the Trustee’s authority to invade principal to maintain the beneficiary’s standard of living referred to the beneficiary’s standard of living at the death of the testator). Thus, the issue of exactly what was the beneficiary’s accustomed manner of living at the referenced time may arise. The Trustee will often be unable to obtain detailed records of the relevant parties’ expenditures at that time. See Kiziah, “Four Chosen Words,” Trusts & Estates, Aug. 2006, at 26.

The comment goes on to say that the amount of distributions under an “accustomed manner of living” standard can be adjusted for inflation, the beneficiary’s deteriorating health or increased financial burden due to the beneficiary’s dependents.

� Planning Point: Issues involving trust distributions are very fact sensitive because both the extent of a beneficiary’s right to income or principal distributions and the existence and extent of a Trustee’s discretion to make such distributions depend on the intent of the settlor of the trust, which can go beyond the trust language. See, e.g., In re Will of Flyer, 245 N.E.2d 718 (N.Y. 1969). Due to the fact sensitive nature of this area and the significant negative consequences that can result if the Trustee makes repeated distributions based on an incorrect interpretation of the trust instrument, the Trustee should consider availing himself, herself or itself of the right to request court instructions when the Trustee has an honest doubt as to the meaning and extent of discretion granted in the trust instrument. See, e.g., Sections 456.2-201.3 and 456.2-202.3, RSMo.; Ohio

- 8 -

ADMIN01/900999.02479_0015/11599035.2

Rev. Code § 2107.46; see, also, 3 Austin Wakeman Scott & William Franklin Fratcher, THE LAW OF TRUSTS § 187 (4th ed. 1988).

� Planning Point: Whether the Trustee’s discretion regarding distributions is absolute or limited, the Trustee should establish formal procedures for carrying out distributions, including the type and amount of information to be obtained from the beneficiaries and other sources before making a given distribution. Weinsheimer & Brooks, “Risk Management for Trustees,” 39 Heckerling Institute on Estate Planning ¶ 1505 (2005). Procedures should also be established regarding the timing and nature of distributions to each beneficiary.

2. Consideration of Other Resources

A Trustee with discretionary distribution powers will often need to determine whether the Trustee should consider the beneficiary’s other resources in deciding whether or to what extent to make distributions to that beneficiary. In New York, determination of the question is based on whether the settlor created the trust to provide for the beneficiary’s support (in which case outside resources would not be a factor) or whether the trust instrument authorizes the Trustee to invade principal for the beneficiary’s support if the income is insufficient for the beneficiary’s needs (in which case outside resources would be a factor). In re Martin’s Will, 199 N.E. 491 (N.Y. 1936).

In Hart v. Connors, 228 N.E.2d 273 (Ill.App. 1967), the trust instrument stated that “my said wife may use all or any part of the corpus of the trust if required for her support or maintenance in accordance with her present standard of living.” Although the court held that the wife’s other income had to be considered in making principal distributions, the court proceeded to state “[n]othing is said by the testator that she must first exhaust her own resources and we are not persuaded that she must do so.” See also, Sibson v. First National Bank & Trust Co. of Paulsboro, 165 A.2d 800 (N.J.Super. 1961).

In Matter of Estate of McNab, 558 N.Y.S.2d 751 (App.Div. 1990), the Trustees were authorized to distribute as much of the trust income to the beneficiary as they in their sole discretion deemed advisable to supplement an annuity that the settlor transferred to the beneficiary. The court determined that the Trustees could not require the beneficiary to use his personal assets for support before receiving a distribution from the trust. See also, Godfrey v. Chandley, 811 P.2d 1248 (Kan. 1991) (Trustee directed to pay to beneficiary so much as is necessary for the beneficiary’s health and maintenance; court held that an inference arose that the beneficiary should receive support from the trust property, regardless of income); Hamilton National Bank v. Childers, 211 S.E.2d 723 (Ga. 1975).

Restatement 3d § 50, cmt. e., states that, if the trust instrument does not address whether the Trustee should consider a beneficiary’s other resources, the “general rule of construction” presumes that the Trustee is to consider other resources but has some discretion in the matter. This comment also provides that the Trustee should normally only take into consideration the beneficiary’s income and “other periodic receipts.” In In re McNeel’s Trust, 282 N.Y.S.2d 103 (Sup.Ct. 1967), the Trustees were authorized to make discretionary principal payments to the

- 9 -

ADMIN01/900999.02479_0015/11599035.2

settlor’s daughter “if said trustees shall deem it necessary or desirable for any reason to do so.” In deciding whether a principal invasion was “desirable,” the court held that the Trustees could, but need not, consider the daughter’s other resources. See also, NationsBank of Virginia v. Estate of Grandy, 450 S.E.2d 140 (Va. 1994) (a Trustee may consider the beneficiary’s other resources, absent an expression of intent to the contrary).

If the court finds that a grant of support is conditioned on the need of the beneficiary, the Trustee usually must take into account other assets of the beneficiary when making discretionary distributions. See e.g., In Re Estate of Tashjian, 544 A.2d 67 (Pa. Super. 1988); Boston Safe Deposit & Trust Company v. Boynton, 443 N.E.2d 1344 (Mass.App. 1983); but see Hamilton National Bank v. Childers, 211 S.E.2d 723 (Ga. 1975); Peoples Bank & Trust Co. v. Shearin, 219 S.E.2d 299 (N.C.App. 1975) (where testamentary trust was to provide for the needs, protection and support of the decedent’s husband, but Trustee was directed to be “guided by practical considerations such as whether my husband is still working, his health and other factors,” the court held that husband’s income was to be considered in accomplishing the trust purposes, but there was no implication that consideration should extend to his separate estate).

A beneficiary’s other resources could include other actual income or any available sources of income, even those not generating income at the present time, such as undeveloped realty. A trust provision stating that “other income” is to be considered should require the Trustee to take into account only other active sources of income. On the other hand, governing instrument language stating that the Trustee must consider “other sources of income” of the beneficiary implies that unproductive income sources should be made productive. The use of words such as “other assets or funds” implies that the beneficiary must liquidate all assets and consume the liquidation proceeds as a prerequisite to receiving distributions from the trust.

The consideration of the beneficiaries’ other resources should be contemplated by the grantor and clearly addressed in the trust instrument. The trust instrument should specify: (a) whether other resources should be considered; (b) what affect that consideration will have on distributions; (c) what resources should be considered; and (d) what evidence of such resources will be acceptable. This issue is often a source of conflict between the Trustees and beneficiaries, who may resent the fact that they have to provide information concerning their other resources to the Trustee to “prove” that they should receive a distribution. Often, in the absence of specific direction regarding the consideration of other resources, the Trustee will be guided by other trust provisions. For example, if the grantor expressed the intent to preserve the trust principal for future generations, the Trustee may conclude that the other resources of the current beneficiaries should be considered. Pruett, “Tales From the Dark Side: Drafting Issues From the Fiduciary’s Perspective,” 35 ACTEC J. 331 (Spring 2010).

� Planning Point: If a beneficiary has a power of withdrawal and may receive discretionary distributions of income and principal, the Trustee should consider any pending opportunities to withdraw as well as the amounts of any actual withdrawals taken in determining the amount of any discretionary distributions potentially to be made to such beneficiary and in determining whether the Trustee is acting impartially toward all beneficiaries. Weinsheimer & Brooks, supra.

- 10 -

ADMIN01/900999.02479_0015/11599035.2

� Planning Point: The interpretation of a standard of distribution is governed by state law. Thus, this is yet another aspect of trust administration where the consideration of state law and a trust’s situs must be analyzed, with a possible consideration of changing the trust situs to achieve the settlor’s objectives.

C. Current Issues Regarding a Trustee’s Duties in the Administration of Trust-Owned Life Insurance

1. Cochran

In In re Stuart Cochran Irrevocable Trust, 901 N.E.2d 1128 (Ind.Ct.App. 2009), on December 28, 1987, Stuart Cochran established an irrevocable trust (the “Trust”) and named his two daughters as the beneficiaries (the “Beneficiaries”). With assistance from his insurance advisor, Art Roberson, Mr. Cochran funded the Trust with life insurance policies. Mary Kay Vance, to whom Stuart was married when the Trust was established but from whom he was later divorced, held a power under the Trust instrument to appoint new Trustees. On February 3, 1999, Ms. Vance appointed KeyBank, N.A. (“KeyBank”) as the new Trustee. At that time, the Trust’s assets consisted of three life insurance policies and one annuity with an overall net death benefit of $4,753,539.

In 1999, the Trust property was exchanged for two variable universal life insurance policies (the “VUL policies”). The total death benefit of the VUL policies was $8 million. In 2001 and 2002, the investments held in the VUL policies drastically declined in value such that the expenses of maintaining them exceeded the income they generated. In the Spring of 2003, KeyBank retained Oswald & Company (“Oswald”), an independent insurance consultant, to audit the VUL policies. Oswald concluded that the financial strength ratings of the carriers were either good or excellent. However, the audit indicated that it was likely that the VUL policies would lapse before Mr. Cochran reached his life expectancy of 88 years, that additional premiums could be required to support the VUL policies and that Mr. Cochran lacked the financial resources to fund the Trust further.

Mr. Roberson then recommended to KeyBank that the Trust exchange the VUL policies for a John Hancock policy that offered a lump sum death benefit of $2,787,624 and was guaranteed to age 100. KeyBank requested Oswald to review this John Hancock policy and compare it to the VUL policies. Oswald concluded that John Hancock’s financial strength was excellent and recommended purchasing the policy if Mr. Cochran was comfortable in doing so. Both Oswald and KeyBank believed that the guaranteed benefit would appeal to Mr. Cochran. Accordingly, in June of 2003, KeyBank retired the VUL policies and purchased the John Hancock policy (the “Exchange”). The death benefit at the time of purchase was $2,536,000.

Mr. Cochran died unexpectedly in January of 2004 at the age of 53. On April 2, 2004, the Beneficiaries filed a petition to seek an accounting and a claim for surcharge arising from an alleged breach of fiduciary duties by KeyBank, as Trustee, under the Indiana Uniform Prudent Investor Act. Ind. Code § 30-4-3.5-1 et. seq.

- 11 -

ADMIN01/900999.02479_0015/11599035.2

After the trial court ruled in favor of KeyBank, the Beneficiaries appealed to the Court of Appeals of Indiana. Regarding the Exchange, the Beneficiaries argued that KeyBank imprudently delegated certain decision-making functions to Messrs. Roberson and Cochran. The court found that KeyBank actually did not delegate any investment duties to Mr. Roberson. Instead, KeyBank relied on its independent insurance consultant, Oswald, to analyze the Trust policies rather than rely on Mr. Roberson’s reviews and recommendations.

The Beneficiaries also argued that KeyBank disregarded Oswald’s recommendations concerning whether to maintain the VUL policies or to obtain the John Hancock policy. To the contrary, the court stated that “it is evident that Oswald found both options - the existing VUL policies and the John Hancock policy - to be palatable,” and that “[u]nder these circumstances, we cannot say that KeyBank . . . parted ways from Oswald’s advice and recommendations. KeyBank merely chose between two relatively acceptable options.” The court also stated “[o]f course it could have done more, but nothing in the record leads us to second-guess the trial court’s conclusion that, while KeyBank’s ‘process was certainly less than perfect,’ it was adequate.” The court added that Keybank’s decision could not be judged in hindsight and found that the Exchange was “eminently prudent.”

2. Florida Statutes § 736.0902

On July 1, 2010, Florida became the latest state to provide that, in certain circumstances, a Trustee of a trust that holds life insurance is: (1) excluded from the application of the prudent investor rule; and (2) not subject to liability arising from a lack of insurable interest in the life insurance policy.

a. Duties Relating to Prudent Investor Rule. The protections offered by the Florida statute are applicable if: (1) the trust owns insurance on the life of a qualified person; (2) the trust instrument does not contain a provision opting out of the application of the statute; (3) the insurance was not purchased from an affiliate of the Trustee and neither the Trustee nor an affiliate of the Trustee received any commission unless duties have been delegated to another person under FSA § 518.112 (dealing with the delegation of investment functions); and (4) either the trust instrument contains a provision opting into the application of the statute or the Trustee gives notice to qualified beneficiaries and there is no objection within 30 days of receipt or the objection is withdrawn. If the trust instrument and the Trustee meet these requirements, then the Trustee has no duty to: (1) determine whether the life insurance is or remains a proper investment; (2) investigate the financial strength of the life insurance company; (3) determine whether to exercise any policy option available; (4) diversify with respect to the life insurance; or (5) inquire about or investigate the health or financial condition of the insured.

Under the Florida Trust Code, a “qualified beneficiary” is defined as a beneficiary who, on the date the beneficiary’s qualification is determined: (1) is a distributee or a permissible distributee; (2) would be a distributee or permissible distributee if the interests of the distributees and permissible distributees terminated on that date without causing the trust to terminate; or (3) would be a distributee or permissible distributee if the trust terminated in accordance with its terms on that date. FSA § 736.0103(14).

- 12 -

ADMIN01/900999.02479_0015/11599035.2

b. Insurable Interest. This portion of the Florida statute is applicable if: (1) a trust owns insurance on the life of a qualified person; (2) the life insurance was not purchased from an affiliate of the Trustee and neither the Trustee nor an affiliate of the Trustee received any commission unless duties have been delegated to another person under FSA § 518.112; (3) the Trustee did not have knowledge that the beneficiaries lacked an insurable interest when the policy was issued; and (4) the Trustee did not have knowledge, upon the issuance of the policy, that (a) the purchaser of the policy did not have an insurable interest and (b) there was an agreement with a third party to transfer the policy or policy benefits in a manner that would violate Florida law (e.g., a “stranger-owned life insurance” arrangement). For a Trustee that meets these requirements, the Trustee has no duty to determine whether there is or was a sufficient insurable interest in the policy. FSA § 736.0902(1)(a). In addition, this protection only applies if the trust instrument does not contain a provision opting out of the application of the statute. FSA § 736.0902(4).

c. General Protection from Liability . With respect to any life insurance policy to which this section applies, the Trustee will incur no liability to the beneficiaries or any other person for any loss sustained with respect to the life insurance. FSA § 736.0902(3). This part of the statute does not make any specific reference to the duties removed. Lannon & Hasty, “Florida’s ILIT Trustee Protection Statute: § 736.0902,” LISI Estate Planning Newsletter #1681 (July 29, 2010) at http://www.leimbergservices.com/. Thus, this statute may be interpreted as exculpating a Trustee from any loss sustained with respect a life insurance policy regardless of whether the loss is sustained due to a lack of an insurable interest or imprudent investments.

d. No Compensation. The Florida statute also provides that a Trustee who performs fiduciary or advisory services relating to the insurance policy will not be compensated for performing the services listed above regarding the prudent investor rule or the determination of an insurable interest. FSA § 736.0902(8).

e. Qualified Person. A “qualified person” is defined as a person who is an insured or a proposed insured, or the spouse of that person, who has provided the Trustee with the funds used to acquire or pay premiums with respect to a policy of insurance on the life of that person or the spouse of that person, or on the lives of that person and the spouse of that person. FSA § 736.0902(2).

� Planning Point: Note that the Florida statute limits its application through: (1) the “qualified person” requirement; (2) allowing a grantor to opt out of the application of the statute in the trust instrument; and (3) unless the trust instrument contains a provision opting into the statute, beneficiaries can object to the application of the statute upon receipt of notice. Lannon & Hasty, supra.

� Planning Point: Other states that have similar statutes include Delaware (12 Del. Code § 3302(d)), West Virginia (W.VA Code § 44-6-2A), North Dakota (26 N.D. Code § 1-33-44), Wyoming (Wy. Stat. Ann. § 4-10-902), South Carolina (S.C. Code Ann. § 62-7-933(J)), Alabama (Ala. Code § 19-3B-818) and Pennsylvania (20 Pa. C.S.A. § 7208).

- 13 -

ADMIN01/900999.02479_0015/11599035.2

3. Paradee

a. Paradee Family, Trust and Life Insurance Policy. In Paradee v. Paradee, C.A. No. 4988-VCL, 2010 WL 3959604 (Del. Ch., October 5, 2010), William Charles Paradee, Sr. (“Charles, Sr.”) had two children from his first marriage: W. Charles Paradee, Jr. (“Charles, Jr.”) and Eleanor Lee Cain. In 1978, the year following his first wife’s death, Charles, Sr. married Eleanor Clement Paradee (“Eleanor”). Charles, Sr. was 71 at this time, while Eleanor was 54. The marriage strained relationships in the family. In particular, Charles, Jr. and Eleanor developed a strong dislike for one another. The conflict carried over to the family business, the Paradee Oil Company, established by Charles, Sr. Due to a conflict between Charles, Jr. and Charles, Sr., in 1985, a small portion of the Company was split off for Charles, Jr. to operate as a separate company.

Despite Charles, Sr.’s estranged relationship with Charles, Jr., Charles, Sr. had a very close relationship with Charles, Jr.’s son, W. Charles Paradee, III (“Trey”). In December of 1989, Charles, Sr. created the W. Charles Paradee, Sr. Irrevocable Trust (the “Trust”) for Trey’s benefit. Charles, Sr. made a contribution of $183,019 to the Trust and Eleanor made a contribution of $183,000. The Trustee of the Trust, Eugene N. Sterling, who was the Paradees’ life insurance agent, then used the funds to purchase a second-to-die insurance policy on the lives of Charles, Sr. and Eleanor from Manufacturers Life Insurance Company (the “Policy”). The projected death benefit was $1,150,700.

The total initial premium for the Policy was $366,018.47. If the Policy performed as expected, no other premiums would be required. The Policy consisted of $191,784 in whole life and $593,666 in paid-up additional insurance. Dividends were to be used to purchase paid-up additions.

Trey was nine years old when the Trust was formed. As explained below, Trey did not know of the existence of the Trust until many years later.

b. Attempts to Revoke Trust; Trust’s Loan. The court inferred from the facts that, through the 1980s and 1990s, Eleanor increased her control over both the administration of the Trust and the Paradee Oil Company as Charles, Sr.’s mental and physical abilities declined. In July of 1993, Eleanor was the driving force behind a letter sent from Eleanor and Charles, Sr. to Mr. Sterling instructing Mr. Sterling to terminate the Policy and revoke the Trust. Eleanor’s reason for terminating the Policy was to obtain cash to pay an unexpected tax liability related to the Paradee Oil Company. Even though the Paradees had substantial liquid assets and very little, if any, debt, Eleanor did not want to pay the tax liability from their personal funds because it would “ruin their ‘balance’ in terms of income and principal.” The court, however, citing to Eleanor’s wealth and repeated attempts to terminate the Policy (as described below), did not credit this justification, stating that “Eleanor simply preferred for selfish reasons to shift the cost of their tax bill to someone else . . . She despised Charles Jr., and I suspect she had no particular love for his son . . . Revoking Trey’s Trust to pay the [] tax would force Charles Jr.’s family to foot the bill.”

The Paradees’ lawyer, Joanna Reiver, was able to convince Eleanor that revoking the Trust by terminating the Policy was not possible because of the irrevocable nature of the Trust.

- 14 -

ADMIN01/900999.02479_0015/11599035.2

Around September of 1993, Ms. Reiver, Eleanor and Mr. Sterling discussed the alternative of having the Trust loan money to the Paradees’ business, which by that time was named the Silver Corporation. Mr. Sterling then obtained the advise of another attorney, Mark Olson, who recommended that the loan should be made “upon terms comparable to those which a commercial bank would offer,” which would mean the use of prevailing interest rates, monthly amortization, adequate security and the borrower obtaining a loan commitment from a commercial bank. Mr. Olson added that “[i]n no case should the trustee make a loan unless the loan payments will be adequate to cover debt service on the policy loan plus the amount required to keep premiums current.”

Mr. Sterling, as Trustee, then obtained a $150,000 loan on the Policy from Manufacturers Life Insurance Company (the “Policy Loan”) to fund the Trust’s loan to the Paradees (the “Trust Loan”). The Policy Loan charged compound interest at a floating rate set in the first year at 8.75%. Despite Mr. Olson’s advice, the Trust loan was unsecured. The terms of the Trust Loan were substantially different from the Policy Loan. The Trust Loan’s interest rate was fixed and accrued simple interest rather than compounding. While the Policy Loan charged 8.75% in interest in the first year, the Trust Loan charged 8%. In addition, even though the loan terms required monthly interest payments, at Mr. Sterling’s request, the Paradees paid interest annually.

In 1994 and 1997, Eleanor again made unsuccessful attempts to collapse the Policy and terminate the Trust. After Eleanor requested that the Policy be surrendered for its cash value of $155,000, Mr. Sterling sought the advice of Mr. Olson, who strongly advised Mr. Sterling not to surrender the Policy. Mr. Olson stated that “[t]he trust own[s] a paid-up policy with a $1.1 million death benefit. If the proceeds of any smaller policy plus the loan to the Paradees (assuming it to be collectible) do not aggregate $1.1 million, the trust beneficiary (W. Charles Paradee, III) could bring an action seeking to hold you personally responsible for the difference.”

Charles, Sr. died in July of 1998. Although, under the terms of the Trust Loan, the Trust had the right to collect the principal and interest at this time, Mr. Sterling made no effort to do so. In July of 1999, Trey turned 30 years of age, which, under the Trust terms, gave him the power to remove the Trustee and designate himself as Trustee. However, Trey still had no knowledge of the Trust or the Policy and Mr. Sterling did not notify him.

In September of 1999, Manufacturers Life Insurance Company demutualized and became Manulife Financial Corporation (“Manulife”). The Trust then received Manulife shares, which were reduced by the amount of the Policy Loan.

The relationship between Eleanor and Trey then became very hostile. The court explained in detail an incident that occurred from 2000-2003 in which Trey believed that one of Eleanor’s investment brokers was making fraudulent statements to her about investment returns and trying to take advantage of her. Trey went to great lengths to warn Eleanor, but Eleanor instead rejected Trey’s advice and became very troubled that Trey was trying to gain access to Eleanor’s money.

c. Successor Trustees. Mr. Sterling died in April of 2003. Eleanor appointed herself as Successor Trustee. At 33 years old, Trey had the power to appoint himself

- 15 -

ADMIN01/900999.02479_0015/11599035.2

as Trustee at this time, but Eleanor did not inform him of this. Instead, Eleanor continued to discuss with Ms. Reiver ways in which to collapse the Policy and access its cash value. As the court described, “Eleanor consciously, intentionally, and vengefully refused to take any action to protect or preserve the Policy because she did not want Trey to benefit.”

In early 2003, before Mr. Sterling died, Eleanor contacted Ms. Reiver to gain information about the current status of the Policy, again attempting to ultimately revoke the Trust. When Ms. Reiver contacted Mr. Sterling about this, Mr. Sterling told Ms. Reiver that one way the Policy could lapse is if the borrower, Silver Corporation, stopped paying the interest on the Trust Loan. Starting in 2003, Silver Corporation (which was owned by a Trust controlled by Eleanor) stopped making interest payments. Interest was capitalized and added to the Policy Loan balance until March of 2005, when the policy lapsed with an outstanding loan balance of $185,203.94. The value of the Manulife stock held in the Trust at this time had a value of $300,172.12.

In July of 2005, Eleanor appointed William J. Smith, Sr. as Trustee of the Trust. Mr. Smith had been a general handyman for the Paradees since the 1960s. In June of 2004, for estate planning reasons, Eleanor adopted Mr. Smith. Initially, Mr. Smith followed Eleanor’s directions and did not inform Trey of any aspect of the Trust or distribute any Trust income to Trey. The court believed, however, that, unlike Eleanor, who intentionally tried to harm Trey, Mr. Smith simply did not know of any obligations he owed to Trey as Trustee. Mr. Smith eventually learned of Trey’s interest in the Trust, and, at his request, Ms. Reiver informed Trey of his interest in a letter that she sent to Trey in August of 2009. Trey promptly appointed himself as Trustee. In September of 2009, Silver Corporation paid the Trust $340,389.04, comprising of $150,000 in loan principal and $190,398.04 in interest.

d. Court’s Analysis. Trey then sued Eleanor and Mr. Smith as the former Trustees of the Trust. The court first considered Trey’s claim that Eleanor aided and abetted Mr. Sterling in breaching his fiduciary duties by making the Trust loan. See Jackson Nat’l Life Ins. Co. v. Kennedy, 741 A.2d 377 (Del.Ch. 1999). The court found that, when Mr. Sterling decided to have the Trust loan money to the Paradees, Mr. Sterling breached his duty of loyalty. The court stated that Mr. Sterling was more interested in pleasing his clients, the Paradees, then determining what would be in the best interests of the Trust. Furthermore, the court explained that “[t]here was no upside to the Trust in loaning funds to an entity controlled by the Paradees, and much less so on an unsecured basis and at a fixed rate approximating (but initially less than) the floating interest rate on the Policy Loan.” Eleanor and Mr. Smith argued that Mr. Sterling was exculpated from liability under Delaware law due to his reliance on Mr. Olson’s advice. However, the court found that Mr. Sterling was not exculpated because he did not act in good faith. The court then stated that Eleanor knowingly participated in Mr. Sterling’s breach of fiduciary duty. The court therefore concluded that Eleanor, under Delaware law, “is liable to the same extent as Sterling would have been, had he not passed away in 2003.”

In addition, the court found that Eleanor also breached her fiduciary duty by refusing to disclose information to Trey concerning the Trust and to pay to him the Trust income to which he was entitled. The court found that Mr. Smith also breached his fiduciary duty of loyalty in this respect. However, the court stated that Mr. Smith’s liability is limited in this case because (1) he did not knowingly withhold information and income from Trey, (2) under the Trust

- 16 -

ADMIN01/900999.02479_0015/11599035.2

instrument, he could not be liable for the actions of Eleanor as the predecessor Trustee and (3) he was only responsible for the assets that were delivered to him upon assuming the office of Trustee, which did not include the Policy.

e. Remedies. The court first found Eleanor liable for $1,150,700, which was the estimated death benefit of the Policy when it was purchased in 1990. Eleanor was also found liable for the lost value of Manulife stock that the Trust would have received as a result of the 1999 demutualization if not for the Policy loan. The court also found Eleanor and Mr. Smith liable for lost dividends on the Manulife stock. Finally, due to her egregious conduct in repeatedly attempting to harm Trey’s interest in the Trust to serve her own interest, Eleanor was ordered pay Trey’s attorneys fees.

D. Current Issues Regarding a Trustee’s Duties in Administering Trust Investments

1. Chase Manhattan Bank

In In re Chase Manhattan Bank, 809 N.Y.S.2d 360 (App.Div. 2006), reversing In re Will of Dumont, 791 N.Y.S.2d 868 (2004), Charles Dumont created a trust under his Will primarily to provide income to his daughter, Blanche Hunter, during her lifetime. The Will provided that, upon Blanche’s death, which happened in 1972, the income that had been distributed to Blanche would be distributed to Blanche’s daughter, Margaret Hunter, for her life. The trust was to terminate at Margaret’s death.

The trust was funded with stock in Eastman Kodak, Inc. Mr. Dumont’s Will provided that: “[i]t is my desire and hope that said [Kodak] stock will be held by my said Executors and by my said Trustee to be distributed to the ultimate beneficiaries under this Will, and neither my Executors nor my said Trustee shall dispose of such stock for the purpose of diversification of investment and neither they [n]or it shall be held liable for any diminution in the value of such stock.” The Will went on to provide that “[t]he foregoing . . . shall not prevent my said Executors or my said Trustee from disposing of all or part of the stock in case there shall be some compelling reason other than diversification of investment for doing so” (emphasis added). In 1973, Ms. Hunter asked that the Kodak stock be sold after the value of the stock dropped considerably. The Trustee, however, took no action.

In 1998, Ms. Hunter and one of her daughters (the “Beneficiaries”) sought an accounting of trust activities between December 1972 and August 1998. After the accounts were filed, they objected on the grounds that the Trustee had failed to invest prudently, “failed to exercise reasonable diligence and care and failed to afford adequate consideration to the interests of the income beneficiaries of the trust.” The Beneficiaries later sought a refund of legal fees and commissions paid to the Trustee.

The Beneficiaries argued that the high concentration of Kodak stock combined with its “miniscule” income yield was the compelling reason other than diversification to sell the stock on January 31, 1973, and, therefore, the Trustee breached its fiduciary duty by holding the same concentration of Kodak stock after that date. The Trustee argued that no compelling reason other than diversification existed until December 2001, which is when the Trustee actually began selling the stock.

- 17 -

ADMIN01/900999.02479_0015/11599035.2

After trial, the Surrogate’s Court determined that a compelling reason other than diversification to sell the stock was any factor that would indicate that an interest of any beneficiary was not being properly maintained. The Surrogate’s Court also concluded that the Trustee breached its fiduciary duties by failing to: (a) interpret the language in the decedent’s Will; (b) communicate properly with the beneficiaries; and (c) be impartial between the life income beneficiary and the remainder beneficiaries. In addition, the Surrogate’s Court found that a compelling reason to sell the stock existed by January 31, 1974 (and not by January 31, 1973, as the Beneficiaries argued) because of the stock’s substantial losses, its dismal prospects for future gains and its low income yield. The Surrogate’s Court calculated damages in excess of $24,000,000.

The court applied the New York prudent person rule, which was the law in effect during 1973 and 1974. New York, along with many other states, has replaced the prudent person rule with the Prudent Investor Act. NY EPTL § 11-2.3. However, the result in this case would have been the same under either set of rules.

On appeal, the Appellate Division of New York’s Supreme Court concluded that the Surrogate’s Court properly rejected the Beneficiaries’ argument that a compelling reason to sell the stock existed as of January 31, 1973. However, the Appellate Division found that the Surrogate’s Court erred in looking beyond the Beneficiaries’ objections to determine that compelling reasons other than diversification to sell the stock existed on January 31, 1974 and then calculating damages based on this determination.

The Appellate Division explained that “‘[a] surcharge may not be predicated on a ground neither alleged nor proved,’” quoting Matter of Doelger, 4 N.Y.S.2d 334 (App.Div. 1938), aff’d, 18 N.E.2d 42 (1938). The Appellate Division stated that “the Surrogate sua sponte determined that the Trustee acted imprudently on an unpleaded date based on a composite, unpleaded theory of imprudence. Objectants neither alleged nor offered proof that a compelling reason for the sale of the Kodak stock other than diversification existed on January 31, 1974.”

The Appellate Division took this matter further, however, and stated that, even assuming that the Surrogate’s Court properly considered the reasons cited for determining that compelling reasons other than diversification existed for selling the stock, “there was no evidence that the Trustee acted imprudently in failing to sell 95% of the stock by January 31, 1974.” Relying on In re Bank of New York, 364 N.Y.S.2d 164 (1974), and Matter of Janes, 659 N.Y.S.2d 165 (1997), the Appellate Division explained that a finding of liability cannot be based upon mere hindsight or an error of investment judgment and that the Surrogate’s Court conclusion that the Trustee should have sold the stock before January 31, 1974 was “impermissibly based on nothing more than hindsight.” The Appellate Division discussed evidence showing that the stock’s fundamentals and performance were still strong at this time and that the Trustee would have actually acted imprudently if it sold the stock before January 31, 1974. The Appellate Division explained that the Surrogate’s Court’s discussion of the stock’s fundamentals on January 31, 1974 was insufficient to establish a compelling reason other than diversification to sell the stock. With regard to the stock’s low income yield, the court added that the Surrogate’s Court failed to analyze whether “the income was reasonable in view of the ‘needs and interests’ of the income beneficiary.” The Surrogate’s Court instead focused on a comparison of the income yields between 1973 and 1974.

- 18 -

ADMIN01/900999.02479_0015/11599035.2

In light of this decision, the Appellate Division never addressed the appeal of the calculation of damages.

� Planning Point: Unfortunately, the reversal does not provide much guidance to Trustees because the decision is narrowly based on procedural problems with the Surrogate’s Court decision. See Rikoon, “Dumont Reversed,” Trusts & Estates, at 56 (March 2006).

2. Karo

In Karo v. Wachovia Bank, N.A., 712 F.Supp.2d 476 (E.D. Va. 2010), on October 18, 1966, Rosalie S. Karo established the Karo Inter Vivos Residual Trust (the “Trust”). The primary beneficiaries were her husband, Toney Karo (“Toney”), her son, Drew Karo (“Drew”) and her minor grandson, W.A.K. Toney and Central National Bank were designated as the Co-Trustees. Central National Bank eventually merged with Wachovia, and the Trust became the holder of a number of shares of Wachovia stock. In October of 2007, the Wachovia stock constituted approximately 65% of the Trust’s assets. On several occasions between 2003 and 2007, Wachovia recommended to Toney and Drew that the Trust diversify its assets, but Toney and Drew withheld consent and instead signed several “Letters of Retention” (“LORs”). The LORs acknowledged Wachovia’s advice (as well as Wachovia’s conflict of interest arising from the Trust’s ownership of Wachovia stock) but indicated Toney and Drew’s desire to preserve the Trust’s ownership of Wachovia stock. Wachovia’s share price declined substantially during this time period. The Trust beneficiaries brought claims alleging that Wachovia failed to diversify the Trust portfolio, breached the duty of loyalty for investing in its own stock, as well as other claims. Before the United States District Court for the Eastern District of Virginia, Wachovia argued that the Trust instrument waived the requirements of the Virginia Prudent Investor Rule. Under Va. Code § 26-45.3, for such a waiver to be effective, the trust instrument must “expressly manifest [] an intention that [the Rule] be waived.” This is accomplished in one of the following ways: (a) by a specific waiver of the “prudent man” or “prudent investor” rule; (b) by inclusion of a Trustee power to make “speculative” investments; (c) by an express authorization for the Trustee to acquire or retain a specific asset or type of asset such as a closely held business; or (d) by other language synonymous with (a), (b) or (c). The Trust instrument empowered the Co-Trustees to take actions “as they in their uncontrolled discretion may deem advisable,” subject to certain conditions. In addition, the Trust instrument authorized the Co-Trustees “[t]o retain as permanent any now existing investments (including stock of the corporate Trustee or in any of its affiliates and holding companies) of the trust property and any investments hereafter transferred to the Trustees . . . .” Finally, the Trust instrument authorized the Trustees “to invest the trust property and from time to time alter, change, or vary such investments and reinvestments thereof without being confined to investments lawful through statute or otherwise for fiduciaries in the State of Virginia . . . .” The court agreed with Wachovia, finding that, although the waiver was not unlimited, the Trust instrument did waive the requirements of the Prudent Investor Rule as it related to the

- 19 -

ADMIN01/900999.02479_0015/11599035.2

Trust property at the Trust’s creation (including Wachovia stock and related companies) and any investments later transferred to the Trust. The court also upheld the effectiveness of the LORs signed by Toney as Co-Trustee and Drew as a Trust beneficiary, stating that “[t]here is no evidence that any of these retention documents were returned unsigned or that Toney ever attempted to rescind these retention authorizations.” The court stated that the LORs gave Toney and Drew “the ultimate authority to direct the Trustees’ actions” and that “Wachovia fulfilled all duties required under Virginia law and the terms of the trust instrument.”

3. Wood

In Wood v. U.S. Bank, 828 N.E.2d 1072 (Ohio App. 2005), appeal denied, 835 N.E.2d 727 (2005), John Wood II created a trust that held assets worth approximately $8 million. Mr. Wood’s wife, Dana Wood, was one of the beneficiaries. Mr. Wood served as Trustee during his lifetime and then named Star Bank (now known as U.S. Bank, National Association) as successor Trustee. Throughout Mr. Wood’s life, nearly 82% of the trust’s assets consisted of Star Bank stock and the remaining 18% consisted of stock in another company, Cincinnati Financial. The Trustees were permitted under the trust agreement to retain, manage and invest the stock held in the trust “as they deemed advisable or proper.” Shortly after Mr. Wood’s death, Star Bank’s trust officers and the beneficiaries (including Ms. Wood) met and agreed that some of the trust assets should be sold to cover the debts, taxes and expenses of the estate. As a result of this sale, Star Bank stock comprised an even higher percentage of the trust assets than before the sale. Meanwhile, Star Bank’s stock increased in value from $21 per share in October 1998 to almost $35 per share in early 1999. In April 1999, Ms. Wood and her financial advisor made an oral request for Star Bank to sell some of the Star Bank stock. Star Bank did not sell any stock as a result of the request. By mid-2000, when Star Bank stock was worth only $16 per share, Star Bank made the final distribution to the beneficiaries. Based on expert testimony using an average mutual fund as the basis for estimating value, Star Bank’s failure to diversify cost Ms. Wood more than $775,000. The case was considered by a jury that found in favor of Star Bank.

Ohio enacted the Uniform Prudent Investor Act 1999. The Act codified the concept of “modern portfolio theory” and provides that a Trustee’s investment and management decisions respecting individual trust assets will not be evaluated in isolation, but rather, in the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust. Ohio R.C. § 1339.53(D) (now, Ohio R.C. § 5809.02). Ohio R.C. § 1339.54(B) (now, Ohio R.C. § 5809.03) provided that “[a] Trustee shall diversify the investments of a trust unless the Trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”

Ms. Wood’s main contention on appeal arose from the trial court’s jury instructions. The trial court had instructed the jury to apply an “abuse of discretion” standard in determining whether Star Bank was liable. Ms. Wood argued that the second of the above-cited Ohio statutes should have been used as the standard and that the jury instructions should have instead referenced this statute. With regard to this issue, the appellate court first had to decide whether Star Bank had an initial duty to diversify under these circumstances.

- 20 -

ADMIN01/900999.02479_0015/11599035.2

According to the appellate court, the language of Mr. Wood’s trust instrument was unambiguous and authorized Star Bank, as Trustee, to retain its own stock even though Star Bank would ordinarily not have been permitted to do so under the “rule of undivided loyalty.” Ms. Wood argued, however, that the retention language in the trust instrument did not override Star Bank’s statutory duty to diversify. The court agreed with this distinction and found that the retention language did not alter the duty to diversify. The court noted that, if Mr. Wood had intended the duty to diversify not to apply, he should have “clearly indicated” such an intention in the trust agreement. As the court explained:

The retention clause merely served to circumvent the rule of undivided loyalty. The trust did not say anything about diversification. And the retention language smacked of the standard boilerplate that was intended merely to circumvent the rule of undivided loyalty - no more, no less.

The court found Mr. Wood’s trust instrument was silent as to diversification, and, therefore, the duty to diversify set forth in Ohio R.C. § 1339.54(B) applied. The only exception to this rule occurs when the Trustee “reasonably” determines that there are “special circumstances.” Star Bank argued that the Act can be expanded, restricted, eliminated or otherwise altered in the trust instrument, without express reference to the Act. Relying on the Restatement 3d § 227(b), the court denied these arguments and found the retention language was a broad generalization and not specific enough to relieve a Trustee of its statutory duty to diversify. The court stated that, to eliminate the duty to diversify, the trust instrument must specifically authorize the Trustee “to retain in a specific investment a larger percentage of the trust assets than would normally be prudent.” The authorization to retain in this case, the court found, was insufficient to meet this standard. The case, therefore, was reversed and remanded.

4. Schumacher

In Schumacher v. Schumacher, 303 S.W.3d 170 (Mo.App. W.D. 2010), Louis E. Schumacher, Sr. established an irrevocable trust (the “Trust”) in 1976 for the benefit of two of his children, James Price Schumacher and Cindy Sue Davis (the “Beneficiaries”). During the relevant time period, the Trustees of the Trust were Louis Edward Schumacher Austin and Mr. Schumacher’s spouse, Sara Schumacher (the “Trustees”). Sara Schumacher was referred to by the court and the parties as “Topper.”

The Trust instrument stated that income was to be paid to the Beneficiaries during Mr. Schumacher’s life and for five years after his death. At the end of this period, the Trust property was to be equally distributed among Mr. Schumacher’s descendants.

In 1984, the Trustees formed a limited corporation called The Schumacher Group, Ltd (the “Corporation”). Topper was the President of the Corporation. In 1986, Mr. Schumacher and Topper created a revocable trust and named themselves as Trustees.

Mr. Schmacher died in 1998. At that time, the revocable trust split into three separate trusts: a QTIP trust, a marital trust and a family trust (the “Subtrusts”). Topper was the sole Trustee of the Subtrusts. The Beneficiaries were also beneficiaries of the Subtrusts.

- 21 -

ADMIN01/900999.02479_0015/11599035.2

Upon Mr. Schmacher’s death, the Trust held land, cash and cash equivalents and stock in the Corporation. In January of 2001, the Trustees formed the Topper Schumacher Family Limited Partnership (the “Partnership”) and the Lou Schumacher, Sr., LLC (the “LLC”). The LLC was the general partner of the Partnership. The Trustees then funded both the Partnership and the LLC with all the remaining Trust assets.

In addition, Topper, as Trustee of the Subtrusts, transferred assets of those trusts to the Partnership in exchange for Partnership interests. After these transactions and subsequent transactions: (a) the LLC, Partnership and the Corporation held all the assets held by the Trust at Mr. Schumacher’s death and a substantial portion of the Subtrusts’ assets; (b) the Trust and Subtrusts held interests in these entities; and (c) Topper was in control of the LLC, the Partnership, the Corporation and the Subtrusts. In accordance with the Trust instrument, the Trust terminated in May of 2003 and the Trust property was distributed to Mr. Schumacher’s children.

In November of 2005, the Beneficiaries filed an action for declaratory judgment, asserting that the Trustees had no power under the Trust to convert Trust assets into assets of the Partnership. The Beneficiaries further alleged that the distribution of the Corporation’s stock to the Beneficiaries was an improper distribution. In addition, the Beneficiaries alleged that Topper, as Trustee of the Subtrusts, did not have the authority to convert the assets held in these trusts to Partnership interests.

The trial court initially stated that the Trust instrument and the governing document of the revocable trust authorized the above transactions. However, these actions still had to comply with the Missouri Uniform Trust Code.

The trial court concluded that the funding of the Corporation, LLC and the Partnership with trust assets in exchange for interests in these entities had the effect of keeping the Beneficiaries from receiving distributions of Trust property. Absent an agreement of all the partners, the Beneficiaries had no ability to gain access to Partnership assets. The trial court also found that the transfer of the Subtrusts’ assets in exchange for interests in the Partnership, the LLC and the Corporation similarly deprived the Beneficiaries of those assets as well. Therefore, the trial court found that the Trustees had violated their duty to adhere to the purposes of the Trusts, their duty of loyalty and their duty to prudently administer the Trust. The trial court concluded that the transfers were voidable by the Beneficiaries.

On appeal, the Trustees asserted that the trial court erred in entering a judgment finding that the Trustees had breached their fiduciary duties because it exceeded the scope of the parties’ pleadings and the issue was not tried by consent. The court rejected this argument because it found that the parties had impliedly consented to the trying of that issue.

The Trustees also asserted that the court failed to consider evidence that would have supported the Trustee’s investment decisions. The appellate court agreed with this argument, stating that the trial court did not consider disputed facts and therefore prevented the Trustees from proving any affirmative defenses. The court reversed and remanded the case to the trial court to allow it to hear evidence regarding the Trustees’ affirmative defenses.

- 22 -

ADMIN01/900999.02479_0015/11599035.2

E. Exculpatory Clauses

1. Generally

A trust instrument often will contain an exculpatory clause that provides limited relief to a Trustee from liability for the exercise of fiduciary discretion. Exculpatory clauses are strictly construed by the courts, and will not apply to a breach of trust that does not fall within the scope of the exculpatory provision. Pieterse and Coates III, Exculpatory Clauses May Give Trustees Extra Protection From Liability, 37 Estate Planning 26 (March 2010).

The Restatement 3d § 96(1) (tentative draft, no. 5, 2009) states that “[a] provision in the terms of a trust that relieves a trustee of liability for breach of trust, and that was not included in the instrument as a result of the trustee’s abuse of a fiduciary or confidential relationship, is enforceable except to the extent that it purports to relieve the trustee: (a) of liability for a breach of trust committed in bad faith or with indifference to the fiduciary duties of the trustee, the terms or purposes of the trust, or the interests of the beneficiaries; or (b) of accountability for profits derived from a breach of trust.”

The Uniform Trust Code (“UTC”) § 1008 provides that an exculpatory clause is unenforceable to the extent that it “relieves the trustee of liability for breach of trust committed in bad faith or with reckless indifference to the purposes of the trust or the interests of the beneficiaries; or was inserted as the result of an abuse by the trustee of a fiduciary or confidential relationship to the settlor.”

A majority of jurisdictions have adopted a similar approach, ruling that exculpatory clauses may relieve the Trustee from liability for errors of judgment, failure to diversify trust investments or the acts of Co-Trustees. Generally, however, most jurisdictions do not permit exculpatory clauses to relieve fiduciaries for liability beyond ordinary negligence. See, e.g., New England Trust Co. v. Paine, 59 N.E.2d 263 (Mass. 1946) (“exculpatory provisions inserted . . . without any overreaching or abuse by the trustee of any fiduciary or confidential relationship to the settlor are generally held effective except as to breaches of trust committed in bad faith or intentionally or with reckless indifference to the interest of the beneficiary and as to any profit which the trustee has derived from a breach of trust.”); Ascher and Scott, ASCHER AND SCOTT ON

TRUSTS, § 24.27.3 (5th ed. 2007) (explaining that the vast majority of courts have concluded that, despite the presence of an exculpatory clause, a Trustee cannot escape liability for breaches of trust committed in bad faith or with intentional or reckless disregard for the interests of the beneficiaries or the purposes of the trust).

Some states have codified this policy regarding exculpatory clauses. A New York statute provides that any provision in a will that attempts to exonerate a fiduciary from liability for failure to exercise reasonable care and prudence is void as against public policy. NY EPTL § 11-1.7. New York courts have expanded the applicability of this statute to cover inter vivos trusts and powers of attorney. See, e.g., In re Kassover, 476 N.Y.S.2d 763 (Surr.Ct. 1984). Delaware, on the other hand, has adopted a less restrictive approach and allows the settlor of a trust to relieve the Trustee of liability for following the terms of a trust as long as there is no willful misconduct. 12 Del. C. § 3313(a).

- 23 -

ADMIN01/900999.02479_0015/11599035.2

2. Retention of Investments

Most courts have held that a general clause allowing the Trustee to retain a high concentration of a type of trust property as an investment will not be upheld. See Wood v. U.S. Bank, N.A., 828 N.E.2d 1072 (Ohio Ct.App. 2005) (discussed above in these materials; clause permitting Trustee to hold its own stock did not lessen the duty to diversify); Donato v. BankBoston, N.A., 110 F.Supp.2d 42 (D.C.R.I. 2000); Restatement 3d § 92, cmt d(2) (“a general authorization in an applicable statute or in the terms of the trust to retain investments received as part of the trust estate does not ordinarily abrogate the trustee’s duty with respect to diversification . . ..”). Among the factors that may be important in determining whether an authorization in the trust instrument to retain property received as a part of the trust estate dispenses with or modifies the Trustee’s normal duty with respect to diversification are: (a) whether, in effect, the settlor has intended to encourage or merely to authorize retention of the investments; (b) whether an authorization to retain applies to specific investments, to particular types of investments or to all property received as a part of the trust estate; (c) the character of the original trust property in question; and (d) the purpose of the trust generally and, especially, any identifiable purposes underlying the particular grant of authority. Restatement 3d § 92, cmt d(2).

In Americans for the Arts v. Ruth Lilly Charitable Remainder Annuity Trust #1 U/A January 18, 2002, 855 N.E.2d 592 (Ind.App. 2006), a general retention clause, which authorized the Trustee to retain investments, combined with a clause explicitly lessening the Trustee’s duty to diversify, was sufficient to exculpate the Trustee from the default duty to diversify trust assets. The court observed that the Restatement left open a window enabling a settlor to reduce a Trustee’s duty to diversify by including a clause to that effect in the trust instrument.

� Planning Point: The conduct of the Trustee likely is a major factor in determining whether an exculpatory clause will be upheld. See, e.g., Nelson v. First National Bank and Trust Co. of Williston, 543 F.3d 432 (8th Cir. 2008); In re Wege Trust v. Fifth Third Bank, 2008 WL 2439904 (Mich.App. 2008). Additional steps that should be considered by a Trustee trying to maximize the validity of an exculpatory clause include: (1) before execution, obtain documentation regarding the settlor’s intent behind the exculpatory clause; (2) maintain communication with the beneficiaries during trust administration; and (3) attempt to minimize the increased risk of holding a concentrated position (e.g., through hedges or collars). Pieterse & Coates III, supra.

3. Fifth Third Bank

In Fifth Third Bank v. Firstar Bank, No. C-050518, 2006 WL 2520329 (Ohio App., 1st Dist. 2006), Elizabeth Reagan established a charitable remainder unitrust (“CRUT”) in 2000, naming Firstar Bank, N.A. (“Firstar”), now known as U.S. Bank, National Association, as Trustee. When established, the trust’s sole asset was $2 million worth of stock in Procter & Gamble Co. (“P&G”). Under the CRUT instrument, Ms. Reagan would receive 8% of the CRUT’s principal value as redetermined each year. Upon her death, the CRUT remainder would be distributed to three charities. Ms. Reagan testified that Firstar knew that one of the purposes

- 24 -

ADMIN01/900999.02479_0015/11599035.2

of the trust was to diversify out of P&G stock. The CRUT instrument provided that “[t]he trustee shall have expressly the following powers . . . to retain, without liability for loss or depreciation resulting from such retention, original property, real or personal, received from Grantor or from any other source, although it may represent a disproportionate part of the trust.”

The Firstar trust officer began to reduce the concentration of P&G stock by selling portions of the stock on a monthly basis, except for a time period during which the stock value decreased. By the end of the first year, however, the value of the stock held in the CRUT had decreased by 50%. Ms. Reagan replaced Firstar with Fifth Third Bank as Trustee. Ms. Reagan then sued Firstar claiming that Firstar had breached its fiduciary duty. After a jury trial, the CRUT was awarded over $1 million in damages.

On appeal to the Ohio Court of Appeals, Firstar asserted that the CRUT instrument exculpated the bank from liability for any losses in the value of the trust assets, as allowed under Ohio R.C. § 1339.52(C), part of Ohio’s version of the Uniform Prudent Investor Act. In Wood v. U.S. Bank, N.A., 828 N.E.2d 1072 (Ohio App. 2005), this same court held that “even if the trust document allows the trustee to ‘retain’ assets that would not normally be suitable, the trustee’s duty to diversify remains, unless there are special circumstances” and that, under the above statute, the duty to diversify could be altered only if “the instrument creating the trust clearly indicates an intention to abrogate the common-law, now statutory, duty to diversify.” The court concluded that the above-quoted language from the trust instrument allowing the Trustee to retain assets did not clearly indicate an intention to abrogate the duty to diversify. Therefore, the court affirmed the judgment of the trial court.

F. Required Disclosures to Beneficiaries

1. Introduction

A Trustee’s successful administration of a trust is often facilitated by clear and frequent communication with the beneficiaries. Keeping the beneficiaries informed can help avoid the Trustee’s involuntary removal and/or being sued for breach of fiduciary duty. Furthermore, to be able to enforce the Trustee’s duties, the beneficiaries must know of the trust’s existence and the details of its administration.

Settlors may wish to restrict or even eliminate information concerning a trust that is disclosed to the beneficiaries, however, primarily because having such information may reduce the beneficiaries’ motivation to become productive individuals. However, a settlor who conceals information concerning a trust may cause the beneficiary to distrust the Trustee and may actually increase the likelihood of a beneficiary filing a claim against the Trustee. The rules and cases discussed below illustrate an attempt by legislatures and courts to balance the settlor’s desire to limit information provided to the beneficiaries and the beneficiaries’ need to obtain the information necessary to enforce their interests.

2. Information Required to be Disclosed -- Nature and Timing

a. The Restatement and Case Law. Usually, when the settlor is competent and can revoke the trust, the settlor can easily keep information regarding the trust from the

- 25 -

ADMIN01/900999.02479_0015/11599035.2

beneficiaries. Restatement 3d § 74. Once the settlor becomes incapacitated or dies and can no longer revoke the trust, however, the Trustee’s duties that are owed directly to the beneficiaries and the beneficiaries’ rights regarding the trust are implicated. Restatement 3d § 82 states that:

(1) Except as provided in § 74 or as permissibly modified by the terms of the trust, a trustee has a duty: (a) promptly to inform fairly representative beneficiaries of the existence of the trust, of their status as beneficiaries and their right to obtain further information, and of basic information concerning the trusteeship; (b) to inform beneficiaries of significant changes in their beneficiary status; and (c) to keep fairly representative beneficiaries reasonably informed of changes involving the trusteeship and about other significant developments concerning the trust and its administration, particularly material information needed by beneficiaries for the protection of their interests. (2) A trustee also ordinarily has a duty promptly to respond to the request of any beneficiary for information concerning the trust and its administration, and to permit beneficiaries on a reasonable basis to inspect trust documents, records, and property holdings.

See also, Restatement (Second) of Trusts (“Restatement 2d”), § 173 (Trustee must provide accurate information to the beneficiary upon request and allow the beneficiary to inspect trust records).

Restatement 3d § 82, cmt. a(1), discussing the term “fairly representative” beneficiaries, states that “the trustee’s duty under this requirement is to make a good-faith effort to select and inform a limited number of beneficiaries whose interests and concerns are fairly representative of - i.e., likely to coincide with - those of the trust’s beneficiaries generally, thereby affording a reasonable opportunity for monitoring the trustee’s duty of impartiality as well as faithful, prudent administration of the trust.” The Comment also provides that, usually, the Trustee’s duty can be met by providing the required information to current beneficiaries and to those who would become current beneficiaries if the interests of one of the current beneficiaries were to terminate. Comment e points out that the requirement under Subsection (2) is not limited to representative beneficiaries but applies to any beneficiary’s request for information, subject to reasonable restrictions in the trust instrument.

In McNeil v. McNeil, 798 A.2d 503 (Del. 2002), the settlor established five trusts, four of which were for the benefit of his four children, while the other trust was for the benefit of his wife. The Trustees were to provide the children with the income necessary to maintain the children’s accustomed standard of living. The wife’s trust was to provide income not only to the wife but also to all of the settlor’s descendants and their spouses. One of the children, Hank, who became estranged from the family, believed that he was only a remainder beneficiary of the wife’s trust. The Trustees never informed Hank about the actual terms of the trust instrument, even though all the Trustees knew that all of the children were current income beneficiaries of the wife’s trust. Consequently, Hank never received any distributions from the wife’s trust, but all the other children did. When Hank found out that he was a current beneficiary, he filed suit against the Trustees, seeking, among other remedies, make-up distributions from the trust and removal and surcharge of the Trustees.

- 26 -

ADMIN01/900999.02479_0015/11599035.2

The Trustees argued that the provisions of the trust instrument gave them nearly unfettered discretion in handling trust assets. As to any distribution, the trust agreement gave the Trustees the discretion to decide the amount of the distribution, the recipient of the distribution and whether the distribution would be from income or principal. The trust also relieved the Trustees from personal liability except for acts constituting gross negligence.

The court found, however, that these provisions were not relevant to the Trustees’ fiduciary duty to inform beneficiaries of the basic terms of the trust. Relying on the Restatement 2d, the court believed that the Trustees should have informed Hank that he was a current income beneficiary, especially when Hank repeatedly attempted to obtain information from the Trustees regarding the wife’s trust. The court came to this conclusion despite the facts that the successor Trustees reasonably assumed that notification had already been given and the Trustees had distributed millions of dollars to Hank from his own trust. Furthermore, the court refused to uphold a provision in the trust agreement that stated that a Trustee’s decision was not reviewable by a court. The court consequently affirmed the Chancery Court’s surcharge of the Trustees, along with make-up distributions, removal of the Trustees and other remedies.

In Boyce Family Trust v. Snyder, 128 S.W.3d 630 (Mo.App. 2004), the Trustee entered into an agreement to buy a supermarket that the Trustee owned individually. The beneficiaries agreed to the transaction. The Trustee, however, failed to disclose to the beneficiaries detrimental information relevant to the sale and downplayed potential problems with the store’s performance. The court held that the Trustee was liable for breach of fiduciary duty. The court emphasized that the Trustee had a duty to inform the beneficiaries of all facts known to him so that the beneficiaries, when considering whether to consent to the Trustee’s purchase of the supermarket, could have made an informed decision.

� Planning Point: Restatement 3d § 82, cmt. d, points out that, while the required disclosures primarily help the beneficiaries protect their interests, the requirements can also benefit the Trustees as well by providing the Trustee with a defense based on laches (including estoppel or ratification) or the statute of limitations in a future dispute between the Trustee and one or more beneficiaries. Restatement 3d § 83, cmt. c, provides that “a court order approving all or part of a trustee’s accounts discharges the trustee from liability (or further liability) for matters appropriately disclosed.”

The terms of the trust instrument can modify a beneficiary’s ability to obtain information concerning a trust. Use of such provisions in the trust instrument, however, is limited. Comment a(2) to Restatement 3d § 82 states that:

[A]lthough subject to modification by the trust provision, the duty to provide information to certain beneficiaries . . . may not be dispensed with entirely or to a degree or for a time that would unduly interfere with the underlying purposes or effectiveness of the information requirements.”

Provisions stating that the Trustee shall have no liability for failure to disclose information to beneficiaries will not be interpreted as broadly as its language indicates. Restatement 3d § 83, Cmt. d, states that such provisions do not eliminate the Trustee’s duty “to

- 27 -

ADMIN01/900999.02479_0015/11599035.2

furnish information in accordance with the rules (and qualifications) stated in § 82; nor does it dispense with the duty to maintain records in some reasonable form….”

b. State Statutory Law. Several states (in addition to those states that have enacted the UTC, discussed below) have enacted statutes regarding a Trustee’s required disclosures to beneficiaries. California, for example, provides that the Trustee has a duty to: (1) keep the beneficiaries of the trust reasonably informed of the trust and its administration; (2) provide, upon reasonable request by a beneficiary, a report of the trust’s transactions; (3) provide prompt notice to the beneficiaries when the trust becomes irrevocable and whenever there is a change of Trustee; (4) provide, upon the request of any beneficiary or an heir of the settlor, a copy of the trust instrument when the trust becomes irrevocable; and (5) provide annual accountings to the current beneficiaries. Many of these requirements cannot effectively be waived by the settlor in the trust instrument. Cal. Prob. Code §§ 16061.7; 16062; 16061.5; 16060; 16061.

See also, 12 Del. Code § 3303(a) (giving a settlor the ability to limit or eliminate the Trustee’s duty to disclose trust information to beneficiaries); Rev. Code WA § 11.100.140 (the Trustee must provide written notice to income beneficiaries for “significant nonroutine transactions” unless there is a “compelling circumstance” for not disclosing the transaction); Conran v. Seafirst Bank, No. 40075-4-I, 1998 WL 40659 (Wash.App. 1998); Flohr v. Flohr, No. 47734-0-I, 2002 WL 528778 (Wash.App. 2002).

3. Duty to Keep Beneficiaries Informed Under the Uniform Trust Code

The UTC, now enacted in 23 states and the District of Columbia, contains provisions concerning how much trust information must be disclosed to beneficiaries and a settlor’s right to control such disclosure. The provisions of the UTC that codify the Trustee’s duty to inform and report are among the most controversial portions of the UTC and, as a result, have become the least uniform among jurisdictions that have enacted the UTC.

a. The Uniform Rules. The Comment to UTC § 706, provides that “a particularly appropriate circumstance justifying removal of the trustee is a serious breach of the trustee’s duty to keep the beneficiaries reasonably informed of the administration of the trust or to comply with a beneficiary’s request for information. . . .”

The UTC limits the persons to whom the duty to inform and report is owed in the case of most revocable trusts and a trust over which a beneficiary holds a power of withdrawal. With regard to a revocable trust, the Trustee owes duties exclusively to the settlor when the settlor has capacity to revoke the trust. In addition, a Trustee owes a duty to inform and report to any beneficiary who holds a power of withdrawal, as if such beneficiary is the settlor, to the extent of the property subject to the power. When these rules apply, the Trustee’s duties under UTC § 813, discussed below, are owed to the settlor or the power holder, as the case may be. UTC § 603 and Comment. Thus, for example, in the case of a testamentary marital deduction trust over which the beneficiary/surviving spouse has an unlimited inter vivos power of withdrawal, the Trustee’s duty to inform and report will run only to such beneficiary.

- 28 -

ADMIN01/900999.02479_0015/11599035.2

UTC § 813 codifies and expands the Trustee’s common law duty to keep beneficiaries informed when UTC § 603 does not apply. It imposes an affirmative obligation to keep “qualified beneficiaries” reasonably informed about the administration of the trust and of the material facts necessary for them to protect their interests. The Trustee must also meet several specific notice requirements and submit annual reports. “Nonqualified beneficiaries,” an undefined term, are entitled to information from the Trustee only upon their specific request.

UTC § 813 makes distinctions based upon the defined terms “beneficiary” and “qualified beneficiary” as well as the undefined terms “distributee” and “permissible distributee.” “Beneficiary” under the UTC includes one holding a present or future interest, whether such interest is vested or contingent, including a person who holds a power of appointment over trust property in a capacity other than that of a Trustee. Some states have added a definition of “permissible distributee” that generally defines such person as a beneficiary that is currently eligible to receive any distribution from a trust. See, e.g., Section 456.1-103(14), RSMo.; D.C. Code § 19-1301.03. A “qualified beneficiary” includes current beneficiaries, presumptive remainder beneficiaries and those beneficiaries who would be current beneficiaries if the interests of the current beneficiaries, but not the trust, terminated.

Within sixty days after accepting a Trusteeship, the Trustee must notify the qualified beneficiaries of the acceptance and of the Trustee’s contact information. In addition, within sixty days after the date the Trustee acquires knowledge of the creation of an irrevocable trust, or that a formerly revocable trust has become irrevocable, the Trustee must notify the qualified beneficiaries of the trust’s existence, of the identity of the settlor, of the right to request a copy of the trust instrument and of the right to a Trustee’s report. UTC § 813.

� Planning Point: Unlike most of the UTC, which applies to all trusts whether created before or after the effective date of the UTC, UTC § 1106, these specific duties to inform are prospective only. UTC § 813(e).

In addition to annual reporting requirements, the Trustee must promptly respond to any beneficiary’s (not just a qualified beneficiary’s) request for information, unless such request is unreasonable under the circumstances. UTC § 813. A Trustee is required to notify the qualified beneficiaries of any change in the method or rate for computing the Trustee’s compensation. The Trustee must also promptly provide a beneficiary with a copy of the trust instrument upon such beneficiary’s request. Whenever the UTC requires notice to the qualified beneficiaries, the Trustee must also give notice to any other beneficiary who has sent the Trustee a request for notice. UTC § 110.

� Planning Point: The Comment to UTC § 813 states that providing a beneficiary with a copy of the annual report ordinarily satisfies a Trustee’s affirmative duty to keep the beneficiaries reasonably informed, and that a Trustee is not ordinarily obligated to furnish information to a beneficiary in the absence of a specific request. However, the Comment also states that a Trustee may be required to give the beneficiaries advance notice of a non-routine transaction that significantly affects the trust estate and the beneficiaries’ interests.

- 29 -

ADMIN01/900999.02479_0015/11599035.2

A beneficiary may waive the right to reports or other information that the Trustee would otherwise be required to give the beneficiary and may withdraw a previous waiver as to future reports and other information. A waiver by a beneficiary does not relieve the Trustee from liability for matters that the report or other information would have disclosed. UTC § 813(d). Moreover, if the report would have disclosed a potential claim against the Trustee, the statute of limitations will not begin to run against a beneficiary who does not receive the report because it was waived. UTC § 1005 Comment.

b. Modifications in Enacting Jurisdictions. Jurisdictions that have enacted the UTC have done so with numerous varying modifications, especially with regard to UTC § 813 and the definition of terms used in that Section. For example, Kansas modified the definition of qualified beneficiary to mean only a beneficiary who either is eligible to receive mandatory or discretionary distributions of trust income or principal or would be so eligible if the trust terminated on the date qualified beneficiary status is determined. KSA § 58a-103. The Utah definition includes the current mandatory and permissible distributees, and the presumptive remainder beneficiaries, but excludes the UTC’s intermediate class of successor beneficiaries who would become distributees or permissible distributees if the interests of the current beneficiaries, but not the trust, terminated. Utah Code Ann. § 75-7-103; see also 18-B Maine Rev. Stat. Ann. § 103.12; Wyo. Stat. Ann. § 4-10-103.

With regard to which beneficiaries are entitled to information, the Kansas statute provides that the duty to inform and report is owed only to the surviving spouse so long as the surviving spouse is a qualified beneficiary or holds any power of appointment over the entire trust estate and where all other qualified beneficiaries are issue of the surviving spouse. KSA § 58a-813. The statute, for example, will apply to a trust created for the benefit of a surviving spouse, with the remainder to the descendants of the settlor and the settlor’s spouse. Thus, this statute will benefit a settlor who does not want his or her children or other descendants to know about the trust until after the deaths of both spouses. Ohio law may have the same effect in many instances because the Trustee’s affirmative duties under its version of UTC § 813 are limited to only current beneficiaries. Ohio R.C. § 5808.13.

Some jurisdictions further limit the duty to respond to a request for information. For example, in Kansas, unless the rules discussed in the previous paragraph apply, the duty to respond is limited to a request from only a qualified beneficiary. KSA § 58a-813; see also Ala. Code § 19-3B-813.

c. Statute of Limitations. The UTC protects Trustees by providing that an action for breach of trust may not be commenced more than one year after the Trustee provided a report that adequately disclosed the existence of a potential claim for breach of trust and informed the beneficiary of the one-year time limitation. Adequate disclosure means that the report provides sufficient information so that the beneficiary either knows of the potential claim or should inquire about it. In the absence of a report that adequately discloses a claim, a five-year statute of limitations applies, which does not begin to run until the Trustee is removed, resigns or dies, the beneficiary’s interest in the trust terminates or the trust itself terminates. UTC § 1005 & Comment. Many of the jurisdictions that have enacted the UTC have modified the length of the above statue of limitations. See, e.g., Neb. Rev. Stat. § 30-3894(c); N.H. Rev. Stat. Ann. § 564-B:10-1005(c).

- 30 -

ADMIN01/900999.02479_0015/11599035.2

� Planning Point: Therefore, a possible disadvantage to statutes that modify the UTC and further limit the types of beneficiaries who must receive information concerning trust transactions is the running of the statute of limitations; these statutes effectively increase the length of time during which certain beneficiaries may discover and pursue claims against a Trustee. Furthermore, in addition to the items discussed above that are required to be disclosed in the report to the beneficiaries, the Trustee or the Trustee’s advisor should add to that list the statute of limitations for the bringing of a claim by the beneficiaries, as described in UTC § 1005 and modified by applicable law.

d. Modifying UTC Notification Requirements by Governing Instrument Language. Notification requirements can protect a beneficiary against a dishonest Trustee, and reporting requirements can provide a Trustee with some protection by starting the clock on the statute of limitations. However, settlors often have legitimate reasons for limiting the disclosure of trust information. Settlors may want to limit disclosure when establishing a trust to provide for a spouse in a situation where there are children from a previous marriage. Settlors with mentally unstable, drug-addicted or unmotivated beneficiaries may wish to limit the amount of information such beneficiary has regarding the trust. Settlors who wish to provide for children in unequal amounts also may wish to limit disclosures to the beneficiaries.

Like most provisions of the UTC, those setting forth the Trustee’s duty to inform and report may be restricted, or in some instances eliminated, in their effect by appropriate provisions in the trust instrument. For example, a trust provision can validly waive the requirement that a beneficiary be furnished with a copy of the entire trust instrument.

Among the provisions that cannot be waived under the UTC is the Trustee’s obligation, under UTC § 813, to notify the qualified beneficiaries who are age twenty-five or older of the existence of an irrevocable trust, of the identity of the Trustee and the right to request Trustee reports. Also, regardless of the beneficiary’s age, the trust instrument may not waive the Trustee’s obligation to respond to a request of a beneficiary of an irrevocable trust for a Trustee’s report and other information reasonably related to the trust’s administration. UTC § 105. Thus, the settlor may, by the terms of the trust, modify or waive the duty to provide annual reports to the qualified beneficiaries. The settlor may also waive the duty to advise a beneficiary under the age of twenty-five of the existence of the trust, the identity of the Trustee and the beneficiary’s right to request the Trustee’s reports.

Some jurisdictions essentially follow the UTC in making the two specific duties above nonwaivable. See, e.g., D.C. Code 19-1301.05; N.M. Stat. Ann. § 46A-1-105.B. However, several jurisdictions have modified UTC § 105 as well in their enactment of the UTC. Jurisdictions such as Kansas, Tennessee, North Carolina, Utah and Wyoming have deleted one or both of the UTC provisions that made these duties nonwaivable. KSA § 58a-105; Tenn. Code Ann. § 35-15-105; Utah Code Ann. § 75-7-105; Wyo. Stat. Ann. § 4-10-105; NCGSA § 36C-1-105. Thus, apparently, a settlor who creates a trust governed by the law of one of these states is free to modify or entirely waive the duty to inform and report. In contrast, Pennsylvania provides that the entire section dealing with a Trustee’s duty to inform and report (20 Pa. C.S.A. § 7780.3) is nonwaivable. 20 Pa. C.S.A. § 7705.

- 31 -

ADMIN01/900999.02479_0015/11599035.2

� Planning Point: UTC § 1006 provides that a Trustee who acts in “reasonable reliance” on the terms of a trust instrument is not liable for a breach of trust to the extent the breach resulted from the reliance. This release from liability should protect a Trustee from liability when the trust instrument waives or restricts, within the parameters allowed under the UTC, the duty to inform or report.

4. Janowiak

a. Facts. In Janowiak v. Tiesi, 932 N.E.2d 569 (Ill.App. 2010), Michael H. Janowiak was an employee and principal shareholder of a family business called Professional Education International, Inc. (“PEI”). Angelo Tiesi served as the attorney for Michael’s father, Ronald Janowiak, who was also a shareholder in PEI. Angelo was also the Trustee of an irrevocable trust (the “Trust”) established by Ronald. The Trust held PEI stock for Michael’s benefit.

In 2004, Michael was informed of poor financial prospects for PEI. Michael contacted Angelo to obtain the value of the shares held in the Trust for Michael’s benefit. Angelo refused to provide such information, informing Michael that Angelo would need to obtain Ronald’s permission. Angelo then resigned as Trustee, explaining to Michael that he has a conflict of interest as Trustee and as the attorney for Ronald. As part of Angelo’s resignation, Angelo requested that Michael sign a document under which Michael would become the successor Trustee and under which Angelo would be released from any liability. The release stated: “I do hereby release, hold harmless and indemnify Angelo F. Tiesi, his heirs and assigns from any and all liability relating to his acts or failure to act as trustee of the Michael H. Janowiak Trust.” Michael later signed this document. Michael then brought a claim against Angelo for breach of fiduciary duty and fraud. Michael claimed that the other shareholders in PEI, Ronald and Michael’s brother, conspired to mislead Michael to sell his shares at a price below fair market value. Michael also claimed that Angelo knew about this scheme and assisted them in withholding from Michael relevant information about PEI’s financial prospects. In June of 2005, Michael sold his shares for $1.01 million to Ronald, which was the value stated in a valuation report obtained by Ronald. Michael claimed that these misrepresentations and concealment caused Michael to sell his interest at a price significantly below fair market value. Michael claimed that the valuation report on which he based the value of his shares contained false information about PEI’s future performance. Ronald then amended his will to ensure Michael would not receive PEI shares back upon Ronald’s death. In July of 2006, Michael obtained another valuation report of the PEI shares. Such report found serious flaws in the first report and valued the PEI shares at $2.924 million. The court stated that Michael also sued his brother and Ronald, but the disposition of such cases were irrelevant to its decision in this case. The circuit court dismissed Michael’s complaint on summary judgment, finding that the release barred Michael’s claims because Angelo had effectively resigned as Trustee before the

- 32 -

ADMIN01/900999.02479_0015/11599035.2

execution of the release and therefore Angelo did not owe Michael a fiduciary duty. The circuit court also found that Angelo did not commit fraud.

b. Appellate Court Analysis. On appeal of the summary judgment order, Michael argued that Angelo breached his fiduciary duty as Trustee by failing to disclose material information concerning the true value of PEI to Michael and in securing Michael’s release of his fiduciary duties. Angelo contended that Michael’s claims were barred by the release, which fully encompassed Michael’s claims. Angelo also asserted that, regardless of the effectiveness of the release, Angelo did not fraudulently induce Michael to sign the release. Michael asserted that the release was ineffective because Angelo’s failure to disclose, giving rise to claims of fraudulent concealment and fraud in the inducement.

The court stated that the “concerns in this case are fraught with genuine issues of material fact.” The court first explained that there were disputed facts concerning who entered the date on the release document. Thus, it was not settled whether the date on the document was actually the effective date of the release. Consequently, it was unsettled whether the release was effective before or after Angelo’s resignation as Trustee. The court stated that “[i]f the effective date of the release was prior to defendant’s actual resignation, or if it was established that defendant drafted and/or negotiated the release prior to his resignation, defendant’s alleged actions presumably would be subject to scrutiny as a fiduciary with the attendant presumption of fraud.” The court concluded that the circuit court’s finding that the effective date of the release was after Angelo’s resignation was made in error. Furthermore, if it is established that Angelo resigned before the effective of the release, that does not necessarily mean that Angelo did not owe fiduciary duties to Michael when he signed the release. The court discussed cases such as Comedy Cottage, Inc. v. Berk, 495 N.E.2d 1006 (Ill.App. 1986), for the proposition that fiduciaries may breach their fiduciary duties even after resigning as a fiduciary if the activities engaged in after resignation began when the fiduciary was still acting or if the former fiduciary used information obtained during the fiduciary relationship. In this case, Michael had alleged that Angelo assisted in the scheme to defraud Michael and did not disclose material information to Michael. These allegations, according to the court, may serve to vitiate the release. In addition, the court stated that there still existed genuine issues of material fact concerning whether there was fraud in the inducement of the release, which, the court stated, would invalidate the release in its entirety. Under Illinois law, fraud in the inducement arises if the defendant makes a false representation of a material fact knowing or believing it to be false and doing it for the purpose of inducing the plaintiff to act. If the defendant is a fiduciary of the plaintiff, fraud in the inducement may arise through concealment of facts. Thornwood, Inc. v. Jenner & Block, 799 N.E.2d 756 (Ill.App. 2003). Michael had alleged that Angelo concealed the scheme to defraud Michael and that such concealment induced Michael to sign the release. Angelo also argued that Michael had the right to inspect the corporate records, due to his position as a shareholder, and that his failure to do so was the actual cause of the Michael’s damages. Rejecting this argument, the court found the Michael relied on the Angelo’s fraudulent misrepresentation and concealment. Furthermore, the court stated that “we find that defendant

- 33 -

ADMIN01/900999.02479_0015/11599035.2

could have reasonably anticipated that plaintiff would not have sought the corporate records or attempted to discover the fraud on his own, due to defendant’s concealment of the fraud and breach of his fiduciary duty.” See Soules v. General Motors Corp., 402 N.E.2d 599 (Ill. 1980). Consequently, the court found that Michael has clearly alleged proximate cause sufficient to state a claim for both fraud and breach of fiduciary duty. As another reason for why Michael’s claims should not be rejected due to the signing of the release, the court stated that the language of the release could be ineffective to bar such claims. The court explained that the intention of the parties controls the scope and effect of the release. Fuller Family Holdings, LLC v. Northern Trust Co., 863 N.E.2d 743 (Ill.App. 2007). Where the releasing party was unaware of other claims, general releases are restricted to the specific claims contained in the release agreement. Thus, a release will not be construed to defeat a valid claim that was not within the contemplation of the parties. Farm Credit Bank of St. Louis v. Whitlock, 581 N.E.2d 664 (Ill. 1991). The court found that the release in this case was general and did not encompass the claims alleged by Michael. The court reversed and remanded the case to the circuit court.

5. Quick

In Quick v. Pearson, 112 Cal.Rptr.3d 62 (Cal.Ct.App. 2010), Samuel D. Blowitz established a trust (the “Trust”) that took effect upon his death in 1971. Samuel’s two children, Adrianne Pearson and J. Michael Blowitz, served as Co-Trustees. The Trust instrument provided that the remainder interest would be distributed to Mr. Blowitz’s grandchildren in separate trusts. When a grandchild became 25 years of age, his or her interest would be distributed outright to such grandchild. One of the grandchildren was Robert Quick, Jr. His father was Michael Blowitz, the Co-Trustee, and Marilyn Bennets was his mother. However, Marilyn was married to, and Robert, Jr. was raised by, Robert Quick, Sr. Robert, Sr. and Marilyn divorced in 1978. Robert, Jr. did not know that Michael was his father until 1989, at which time Michael and Robert, Jr. began to establish a relationship with each other. The evidence showed that Samuel and the Co-Trustee of the Trust, Adrianne, also knew that Robert, Jr. was Michael’s son. Robert, Jr. knew very little about his grandfather, Samuel Blowitz, and Robert, Jr. did not know yet that he held a remainder interest in the Trust. Robert, Jr. was apparently a financially-stable adult when he established a relationship with Michael and Robert, Jr. never inquired about the financial matters of Michael or any property held for the benefit of Samuel’s descendants. Robert, Jr. did not learn of his interest in the Trust until 2007, when one of the other grandchildren informed him of his possible interest. The Trust, however, had distributed all its assets by then. Robert, Jr. was also informed that the Co-Trustee, Adrianne, actively concealed Robert, Jr.’s interest from him by directing the grandchildren to not tell Robert, Jr. about the Trust. By January of 2008, Robert, Jr. had obtained a copy of the Trust instrument and filed suit against Adrianne for breach of trust, asserting that Adrianne “willfully and unlawfully refused to

- 34 -

ADMIN01/900999.02479_0015/11599035.2

give Quick notice that he was a beneficiary of the trust and willfully failed to distribute Quick’s share of the trust remainder to Quick.” Adrianne asserted that Robert, Jr.’s claim was barred by the statute of limitations and the equitable doctrine of laches, essentially asserting that Robert, Jr. had a duty to inquire when he learned the identity of his natural father in 1989 and Adrianne’s attempts to conceal the Trust from Robert, Jr. would not have prevented Robert, Jr. from finding out about his interest if he had inquired in a timely manner. The trial court granted summary judgment for Adrianne. Under California law, Robert, Jr.’s claim is subject to a 3-year statute of limitations that begins to run “after the beneficiary discovered, or reasonably should have discovered, the subject of the claim.” Cal. Prob. Code § 16460. The court explained that, “when the plaintiff has notice or information of circumstances to put a reasonable person on inquiry, or has the opportunity to obtain knowledge from sources open to his investigation (such as public records or corporation books), the statue commences to run.” 2 Witkin, Cal. Procedure (2d ed. 1970) Actions. Adrianne argued that Quick, Jr. could have easily found out about his interest in the Trust long before he did by simply asking Michael, who was a Co-Trustee and with whom he had a good relationship. Adrianne also argued that the doctrine of laches applied because Robert, Jr.’s unreasonable delay was detrimental to Adrianne, who made the final distribution of trust property in 1991. The court disagreed with Adrianne, stating that Robert’s Jr.’s relationship with Michael did not put Robert, Jr. on notice that he may have an interest in the Trust. In fact, according to the court, no such notice arose until he was actually informed of his Trust interest in 2007. In contrast, the court pointed out that Adrianne had full knowledge that Robert, Jr. was a beneficiary but made no distributions to him. Thus, the court concluded that Robert, Jr. stated a claim for breach of trust and that his claim was not barred by the statute of limitations. Regarding Adrianne’s assertion of the equitable doctrine of laches, the court stated that Adrianne was prevented from asserting this because she had “unclean hands,” meaning, in this case, that her statements to the other grandchildren to not inform Robert, Jr. of the Trust contributed to the delay in bringing the claim. G. More Recent Developments Regarding Fiduciary Liability

1. Children’s Wish Foundation International, Inc. v. Mayer Hoffman McCann, P.C., No. SC 90944, 2011 WL 681093 (Mo. banc, February 8, 2011)

Children’s Wish Foundation, International, Inc. (“CWF”) is a charitable organization that provides gifts to terminally ill children. At least during the time period relevant to this case, one of CWF’s fundraising methods was to receive gifts in kind, which would be distributed to hospitals and Ronald McDonald houses. CWF employees handled and documented its inventory of gifts in kind on a spreadsheet. CWF engaged the accounting firm of Mayer Hoffman McCann, P.C. (“Mayer Hoffman”) to audit CWF’s financial statements, including an assessment of the accuracy of its inventory of gifts in kind.

- 35 -

ADMIN01/900999.02479_0015/11599035.2

In its engagement letter, Mayer Hoffman required CWF to provide complete and accurate financial records and other information to Mayer Hoffman. Regarding the gifts in kind, CWF provided Mayer Hoffman with the spreadsheet. Mayer Hoffman conducted the audit in 1999. It discovered that in 1998, CWF experienced a tenfold increase in gifts in kind and that many of the gifts received by CWF already had been distributed. Ultimately, Mayer Hoffman concluded that CWF’s financial statements fairly represented CWF’s financial position. Mayer Hoffman forwarded the financial statements to CBIZ Accounting, Tax & Advisory of Kansas City, Inc. (“CBIZ”), which prepared CWF’s 1999 tax return. CWF’s spreadsheet of gifts in kind actually contained serious errors and overstated the value of gift in kind contributions on CWF’s financial statement by approximately $1.31 million. In addition to the inaccuracy of the spreadsheet, there was testimony that CWF employees also did not provide Mayer Hoffman with additional documentation that may have allowed its auditors to discover the inaccuracy earlier. In October of 2000, a Pennsylvania court filed an order to show cause against CWF. The order related, in part, to the overstated value of the gift in kind contributions shown on CWF’s 1999 tax return. CWF then conducted an internal investigation and discovered the erroneous records. The opinion does not explain the consequences to CWF for overstating its gifts in kind contributions on its 1999 tax return. CWF then brought a professional negligence action Mayer Hoffman and CBIZ. Mayer Hoffman and CBIZ asserted that CWF failed to provide accurate records in support of the audit. At trial, Mayer Hoffman and CBIZ then offered a contributory negligence instruction to the jury. The contributory negligence instruction was submitted to the jury over CWF’s objection. The jury found for Mayer Hoffman and CBIZ. Under the contributory negligence rule, a plaintiff cannot recover damages if the plaintiff’s own negligence directly contributed in any way to the injuries sustained. Gramex Corp. v. Green Supply, Inc., 89 S.W.3d 432 (Mo. banc 2002). Therefore, even if the defendant’s conduct was the primary cause of the plaintiff’s injury, the defendant could escape all liability under the contributory negligence rule. Alternatively, under the comparative fault rule in Missouri, whether relief is sought for personal damages or property damages, any contributory fault on the part of the plaintiff reduces proportionately the amount awarded as damages for an injury attributable to the plaintiff’s contributory fault, but does not bar recovery. Although contributory negligence has been abrogated in Missouri in favor of comparative fault for cases involving personal injury, Gustafson v. Benda, 661 S.W.2d 11 (Mo. banc 1983), whether comparative fault applies in a professional negligence action alleging only economic damages was an unresolved issue. On appeal, CWF contended that the trial court erred in submitting a contributory negligence instruction to the jury because contributory negligence should not apply in a negligence action that involves only economic damages and no personal injury. The court first pointed out that Missouri’s comparative fault rule is based on the Uniform Comparative Fault

- 36 -

ADMIN01/900999.02479_0015/11599035.2

Act (“UCFA”). In a comment to the UCFA, it is stated that comparative fault is not recommended to apply to matters involving economic loss, but recognizes that a court may determine that comparative fault is applicable in these situations. The court stated that the adoption of comparative fault rules is not necessarily inconsistent with the UCFA. The court further stated that the “central premise of the comparative fault rules is that the law should allocate fault according to the parties’ conduct. This premise holds true in professional negligence cases independent of the nature of the plaintiff’s injury.” The court concluded that the comparative fault rule established in Gustafson applies to claims of economic loss caused by professional negligence, citing cases from six states that came to a similar conclusion. The court therefore reversed and remanded the case.

2. Schmitz v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 939 N.E.2d 40 (Ill.App. 2010)

The Plaintiffs, comprised of seven individuals, were all beneficiaries under the Marvin F. Huth Revocable Trust, dated November 21, 1997 (the “Trust”). The grantor, Marvin Huth, and his wife, Shirley Huth, served as Co-Trustees. The Trust instrument provided for payments of income and principal to Mr. Huth during his life and, upon his death, such payments were to be made to his surviving spouse. If his spouse did not survive him, such payments were to be made to Mr. Huth’s descendants. In 1998, Mr. & Mrs. Huth became clients of a financial advisor at Edward Jones named James Maher. As Co-Trustees of the Trust, Mr. & Mrs. Huth then established and funded Trust accounts at Edward Jones. Mrs. Huth then died in January of 1999. In 2001, Mr. Maher moved to Merrill Lynch, Pierce, Fenner & Smith, Inc. (“Merrill Lynch”), and Mr. Huth, as Trustee, transferred the Edward Jones Trust accounts to Merrill Lynch. The aggregate balance of the Trust accounts at this time was in excess of $2.364 million. As part of the transfers, Mr. Huth, in both his individual capacity and as Trustee, signed two Client Relationship Agreements (“CRAs”). Both CRAs contained the following arbitration clause:

I agree that all controversies that may arise between us shall be determined by arbitration. Such controversies include, but are not limited to, those involving any transaction in any of my accounts with you[] or the construction, performance or breach of any agreement between us, whether entered into or occurring prior [to], on or subsequent to the date hereof

After Mrs. Huth’s death, Mr. Huth married Patricia Bartsokas-Huth and executed two amendments to the Trust instrument that named Ms. Bartsokas-Huth as a Co-Trustee and as a beneficiary. Mr. Huth then died in April of 2004 and Ms. Bartsokas-Huth became sole Trustee. Ms. Bartsokas-Huth, as Trustee, also signed a CRA in June of 2004. It contained the following arbitration clause:

You agree that all controversies that may arise between us shall be determined by arbitration. Such controversies include, but are not limited to, those involving any transaction in any of your accounts with Merrill Lynch[] or the construction,

- 37 -

ADMIN01/900999.02479_0015/11599035.2

performance or breach of any agreement between us, whether entered into or occurring prior [to], on or subsequent to the date hereof. This agreement to arbitrate all controversies does not constitute an agreement to arbitrate the arbitrability of any controversy between us, unless otherwise clearly and unequivocally required by the arbitration forum elected . . .

In October of 2009, the Plaintiffs filed a claim against Merrill Lynch and Mr. Maher (the “Defendants”). The claim alleged that Merrill Lynch and Mr. Maher breached their fiduciary duty and committed professional negligence by permitting Ms. Bartsokas-Huth to make a series of substantial, improper withdrawals following Mr. Huth’s death, totaling approximately $1 million. In November of 2009, the Defendants filed a motion to dismiss and to compel arbitration based on the CRAs. The lower court denied the motion and the defendants appealed to the Appellate Court of Illinois. The court first stated that it must determine whether the CRAs and other evidence submitted by the Defendants are sufficient to bind the Plaintiffs, as beneficiaries of the Trust, to the arbitration provisions in the three CRAs. The court found that the Plaintiffs have no contractual relationship with Merrill Lynch and thus cannot be compelled to arbitrate this claim. Under Illinois law, if a Trustee is given control over the management of the trust property, the beneficiaries have no personal liability. If the beneficiaries retain control over the Trustee and trust property, the Trustee is regarded as the agent of the beneficiaries and the beneficiaries will be liable upon the Trustee’s contracts. Kessler, Merci, & Lochner, Inc. v. Pioneer Bank & Trust Co., 428 N.E.2d 608 (Ill.App. 1981). Because the Plaintiffs did not have any control over the Trustees or the Trust property, neither Mr. Huth nor Ms. Bartsokas-Huth acted as an agent of the Plaintiffs when they signed the CRAs. In addition, according to the court, the same result can be reached by reviewing the language of the CRAs, which stated that these provisions applied only to those who signed the CRA and did not contain any language binding the heirs, beneficiaries, assigns, etc. of the parties. Furthermore, the Plaintiffs could not be considered third-party beneficiaries of the CRAs because there was no provision in the contract specifically designating the Plaintiffs as third-party beneficiaries. Wheeling Trust & Savings Bank v. Tremco Inc., 505 N.E.2d 1045 (Ill.App. 1987). The court therefore affirmed the order of the lower court denying the motion to dismiss and compel arbitration.

3. Herlehy v. Marie V. Bistersky Trust Dated May 5, 1989, No. 1-10-0071, 2010 WL 5487547 (Ill.App. December 23, 2010)

a. Facts. On May 5, 1989, Marie V. Bistersky established a revocable trust (the “Trust”) and designated First Illinois Bank of LaGrange as Trustee. The Trust instrument provided that it may be amended by Ms. Bistersky at any time, in whole or in part, by an “instrument in writing (other than a will) that is delivered to the Trustee.” Over the following 10 years, Ms. Bistersky amended the Trust instrument six times to change beneficiaries and the size of their interests. The sixth amendment was executed on December 9, 1999. By this time, Bank

- 38 -

ADMIN01/900999.02479_0015/11599035.2

One Trust Company, N.A. (“Bank One”) had assumed the role of Trustee. The sixth amendment provided for several pre-residuary, pecuniary bequests, including a gift of $200,000 to each of Timothy J. Herlehy (“Timothy”) and Michael Herlehy (“Michael”), Ms. Bistersky’s grandnephews. The residue of the Trust property was to be distributed among five charities (the “Charities”).

In August of 2001, Timothy and Michael each received a gift of $100,000 from Ms. Bistersky. At the same time, Ms. Bistersky executed another amendment to the Trust instrument. Among other changes, the amendment reduced the gift to each of Michael and Timothy from $200,000 to $100,000. Ms. Bistersky then engaged an attorney named William Boylan to review the Trust instrument. Mr. Boylan told Ms. Bistersky and Timothy that the majority of the Trust assets would be distributed to the Charities. Ms. Bistersky stated that she would like the stock investments to be distributed to Timothy and only a “leftover” portion to pass to the Charities. In January of 2002, Timothy and Ms. Bistersky then met with Christopher Joyce, an executive vice president and trust officer at LaGrange Bank (“LaGrange”), to discuss Ms. Bistersky’s estate plan and the prospect of LaGrange becoming the Trustee of the Trust. At this time, Mr. Boylan was drafting another amendment to the Trust instrument that would appoint LaGrange as the new Trustee. Ms. Bistersky then executed the new Trust amendment prepared by Mr. Boylan in February of 2002. While the amendment did appoint LaGrange as Trustee, it gave Timothy the power to remove the Trustee after Ms. Bistersky’s death. The Trust assets were then transferred to LaGrange. The amendment did not contain any changes to the Trust instrument regarding the disposition of Trust property after Ms. Bistersky’s death. After this amendment was signed, Mr. Boylan was not approached by anybody about creating another amendment to the Trust instrument. Mr. Joyce then engaged Feldman Securities Group (“Feldman”), an investment advisory firm, to analyze and make recommendations regarding the reallocation of Trust assets. Feldman then prepared its recommendations for Ms. Bistersky’s review (referred to by the court as the “Feldman investment form”). As part of the Feldman investment form, Feldman included the following statement: “[w]e understand this trust is for the benefit of [Ms. Bistersky]. These assets will eventually go to her nephews.” Mr. Joyce gave Ms. Bistersky the Feldman investment form and she reviewed and approved Feldman’s recommendations by signing the Feldman investment form. Ms. Bistersky then died in August of 2002. The value of the investments at this time was approximately $1,250,000. Approximately $300,000 of Trust property was distributed pursuant to the specific bequests. The value of the residue was approximately $950,000. In October of 2002, Timothy replaced LaGrange Bank with ATG Trust Company.

b. Arguments and Disposition in the Trial Court. In September of 2005, Timothy and Michael brought a lawsuit against LaGrange for breach of fiduciary duty, alleging

- 39 -

ADMIN01/900999.02479_0015/11599035.2

that the Feldman investment form constituted an amendment to the Trust instrument, thereby giving a relatively small portion of the Trust property to the Charities and a much larger portion to Timothy and Michael. Alternatively, if the Feldman investment form did not constitute an amendment to the Trust instrument, then LaGrange breached its fiduciary duty by not acting upon the recommendations in the Feldman investment form, which constituted written instructions from Ms. Bistersky regarding the disposition of her Trust assets. Timothy and Michael argued that LaGrange had a duty to ensure that a valid amendment to the Trust instrument was effectuated by contacting an attorney to draft the amendment. Timothy and Michael argued that Mr. Joyce assured Ms. Bistersky that he would arrange for the preparation of this amendment and bring the amendment to Ms. Bistersky for her signature. LaGrange filed a motion to dismiss in the trial court, which was granted. Timothy and Michael appealed.

c. Review by Appellate Court. The trial court found that the Feldman investment form was not a valid amendment to the Trust instrument because it was drafted by a nonlawyer, which violates Section 2BB of Illinois’ Consumer Fraud Act. 815 ILCS 505/2BB. On appeal, the court agreed with the trial court and rejected Timothy and Michael’s argument that LaGrange, which is exempt from that section of the Consumer Fraud Act, should be considered the preparer of the Feldman investment form because Mr. Joyce presented the Feldman investment form to Ms. Bistersky. In addition, Mr. Joyce testified that LaGrange did not draft trust documents nor retains an attorney to do so. See also Landheer v. Landheer, 891 N.E.2d 975 (Ill.App. 2008) (construing section 2BB). Furthermore, the court thought that it was important that Feldman was hired to advise Ms. Bistersky on changing her trust investments and not to change the Trust instrument. In fact, like LaGrange, Feldman does not draft Trust amendments.

The court then turned to the issue of whether the Feldman investment form complies with the trust’s requirement that Ms. Bistersky could amend the trust by an “instrument in writing (other than a will).” Black’s Law Dictionary defines an “instrument” as a “written legal document that defines rights, duties, entitlements, or liabilities, such as a contract, will, promissory note, or share certificate.” The court found that the Feldman investment form did not meet this definition. According to the court, there was no indication that the Feldman investment form defined “rights, duties, entitlements, or liabilities” or that it even constituted a “legal document.” Thus, the court concluded that the purpose of the Feldman investment form was only to advise Ms. Bistersky as to reallocating her Trust investments and not to amend the Trust instrument. In addition, the court believed that the statement in the Feldman investment form that the Trust’s stock “will eventually go to her nephews” was not specific enough to constitute a trust amendment under Illinois law. See Eychaner v. Gross, 779 N.E.2d 1115 (Ill. 2002). This statement in the Feldman investment form also contradicted statements from Ms. Bistersky that the Trust stock was to be distributed to Timothy only. The court then turned its attention to the issue of whether LaGrange breached its fiduciary duty by failing to have an attorney draft an amendment to the Trust instrument. The court found that LaGrange had no duty to amend the Trust instrument. The court stated that Timothy and Michael did not point to any evidence showing that LaGrange had such a duty. In addition, LaGrange, as a corporation, is prohibited from practicing law, 705 ILCS 220/0.01 et seq., and the evidence showed that LaGrange never drafts trust amendments for its clients nor employs an attorney to do so.

- 40 -

ADMIN01/900999.02479_0015/11599035.2

Timothy and Michael argued that LaGrange voluntarily assumed a duty because Mr. Joyce assured Ms. Bistersky that he would coordinate with an attorney as needed to prepare the Trust amendment. Assuming a duty even existed, the court rejected the argument, stating that LaGrange’s failure to contact or retain an attorney was not the cause of Timothy and Michael’s damages in this case. Instead, the failure execute a valid Trust instrument was the cause of Timothy and Michael’s damages.