Residual liability in the trust context of excluded fiduciaries

Charles E. Rounds, Jr.
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Some states by statute have introduced into their trust jurisprudence the concept of the excluded fiduciary: In the case of a trust the terms of which allocate fiduciary functions between the trustee and, say, a trust protector, the trustee is an excluded fiduciary as to those functions that have been allocated elsewhere. South Dakota is just such a state. See SDLC Chap.55-1B. Section 1B-2 of the South Dakota statute is essentially a hold harmless provision on steroids that is clearly intended to all but eliminate any co-fiduciary liability that the excluded fiduciary might otherwise have incident to the protector’s carrying out of his allocated functions. Here is a link to the section: http://sdlegislature.gov/Statutes/Codified_Laws/DisplayStatute.aspx?Type=Statute&Statute=55-1B-2. One wonders how safe this harbor actually is, the trust being a creature of equity, not legislation. There are three principles of equity that may not have been effectively negated, namely that (1) One may not knowingly participate in a breach of trust, such as by facilitating the transfer of the trust property in derogation of the trust’s terms; (2) A trustee on actual notice of a breach must take reasonable steps to remedy it; and (3) the beneficiary is entitled to all the information in the trustee’s possession that would further the beneficiary’s ability to protect the equitable interest. To the extent the trustee fails to fully disclose that information on the trust accountings (or in the trustee’s reports), then constructive fraud doctrine may be implicated as well.

Assume a purpose of a trust is to retain and operate a closely held corporation. The trust’s terms allocate to a trust protector the power to direct how the company is managed and to the corporate trustee the duty to manage a separate portfolio of publicly-traded securities that is also held in the trust. The protector in breach of the trust’s terms and in violation of the duty of loyalty directs the sale of the company to himself for less than what the company is clearly worth. The trustee acquiesces. The trustee knows or should know about the protector’s breaches of trust if only because it prepares the trust accountings (reports). It would seem that the trustee risks co-fiduciary liability should it fail to attempt non-judicially to get the protector to remedy the situation, and if the protector is uncooperative then fail to put the matter before the court. To make matters worse, a failure to disclose the breaches on the accountings (or in the trustee’s reports) might well constitute constructive fraud. Constructive fraud in the trust context is taken up generally in §8.15.60 of Loring and Rounds: A Trustee’s Handbook [pages 1268-1270 of the 2017 Edition]. The section is reproduced in its entirety below:

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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