The Duty of Loyalty in Trust Law

Contents

1. Where the duty comes from
2. What loyalty asks of a trustee
3. How the duty reached financial advice

Brent O’Mara holds the Certified Fund Specialist and Accredited Investment Fiduciary designations, and the second of those borrows its key word from a far older body of law than anything written for investment advisers. The federal consumer finance agency counts four basic duties for anyone who manages money or property for someone else: act only in that person’s interest, manage the money carefully, keep it separate from one’s own, and keep good records.⁵ Those four are a modern restatement of what trust law has asked of trustees for centuries, and the first of them, loyalty, is the one from which the word fiduciary draws most of its weight.

Where the duty comes from

A fiduciary duty, as Cornell’s online legal encyclopedia defines it, is a legal obligation placed on a person who has been given authority to act on behalf of another; the relationship exists whenever one party places trust and confidence in another and the other accepts responsibility to act on that party’s behalf, and the obligation requires the fiduciary to act in that person’s interest rather than for personal gain.² The same source lists the classic pairs, agents and principals, lawyers and clients, trustees and beneficiaries, and notes that in agency law the duties fall into three categories, obedience, loyalty and care, which also bind the directors of corporations.² A trust is the setting in which these ideas were worked out most fully. A university extension service defines a trust as a legal arrangement in which one party, the trustee, holds and manages assets on behalf of another, the beneficiary, under rules set by the person who created it, the grantor.⁷ The same service lists the common forms: revocable living trusts that can be changed during the grantor’s life, irrevocable trusts that cannot, testamentary trusts created by a will, charitable trusts and special needs trusts, each with the same basic triangle of grantor, trustee and beneficiary.⁷ Trustees, Cornell’s entry on their duties says, owe care, loyalty and good faith, must manage the trust reasonably and avoid self dealing, and where there are two or more beneficiaries owe a further duty of impartiality, taking every beneficiary’s interests into account.¹

Figure

Four basic duties of a fiduciary

1. 01
   InterestAct only in the other person's interest, making decisions that are best for them rather than for the fiduciary.
2. 02
   CareManage the money and property carefully, carrying out financial responsibilities with attention.
3. 03
   SeparationKeep the other person's money and property separate, never mixing it with the fiduciary's own.
4. 04
   RecordsKeep true and complete records of the money and property.

What loyalty asks of a trustee

Two fellows of a college of trust and estate lawyers walked through the role in a recorded conversation. A trustee, one explained, is a person who holds assets for the benefit of another; the trust document is the instruction manual, saying what investments may be made and when distributions may be paid, but beyond the document the trustee owes loyalty, meaning the trustee cannot put his or her own interest or anyone else’s above the beneficiary’s with respect to the trust, together with duties of impartiality, prudence and confidentiality.³ The conversation also made clear that the duty has teeth: trustees are held by courts to the highest legal standard, and a trustee who fails in these duties can be held personally liable, though a reasonable decision that turns out badly, such as hiring a reputable manager whose strategy loses value in a falling market, is usually not a failure of duty.³ A second recording in the same series described the executor of a will and the trustee of a trust as fiduciaries acting on behalf of the estate or the trust and in the best interest of the beneficiaries, and discussed when a corporate trustee or a successor trustee should be named.⁴ The lawyer in that recording said she generally avoided naming two individuals as co trustees, because in nearly every such case she had seen the two fall out over how to handle something, raising costs for the family, and she recommended naming successors, up to about three, with a trust company as the last, since an individual trustee may die or become unable to serve during a trust that can run for decades.⁴

The consumer finance agency’s guide to revocable living trusts shows the duty in an everyday setting. Such a trust has three roles, the grantor who makes it, the trustee who decides about the money or property in it, and the beneficiaries who receive from it; while alive the maker of the trust commonly serves as trustee, a successor steps in when that person can no longer manage, and the trustee, whoever it is, is a fiduciary with authority only over property actually placed in the trust.⁶ The separation duty, never mixing the beneficiary’s property with one’s own, is the practical face of loyalty, and the agency warns that confused records can bring in protective services and the police.⁵ How a trust should be drafted, who should serve, and what the tax consequences are all vary with each family’s circumstances, which is why qualified professionals, not a general description, should settle them.

Figure

The three roles under a revocable living trust

	Role	What the person does
Grantor, also called settlor or trustor	Makes the trust and, while alive, usually serves as its first trustee	Puts money or property into the trust, which has no effect until that happens
Trustee	Makes decisions about the money or property in the trust	Is a fiduciary; may be an individual or a financial institution, with a successor named to take over
Beneficiaries	Receive money or property from the trust	May include the grantor during life and residuary beneficiaries after death

How the duty reached financial advice

The leap from trustee to investment adviser happened by analogy and then by law. During the 2010 debate over financial reform, a Los Angeles newspaper explained the House bill’s provision as requiring all financial advisers to be fiduciaries, which it glossed as trustees for their clients, a phrase that captures how the public and Congress understood the term.⁹ The legal form of that analogy is the SEC’s reading of the Investment Advisers Act: a retirement columnist summarized the agency’s position that an investment adviser’s obligation under the 1940 statute comprises care and loyalty together, the pair Cornell lists for trustees, while cautioning that a credential or an oath, whatever its worth, is not what makes a relationship a legal fiduciary one.⁸ The statute is described under the Investment Advisers Act, the workplace plan version under the retirement plan statute, and the contrast with the broker’s standard under suitability versus fiduciary duty.

Figure

The duties an estate lawyer listed for a prospective trustee

1. 01
   LoyaltyThe trustee cannot put his or her own interest, or anyone else's, above the beneficiary's with respect to the trust.
2. 02
   ImpartialityWhere there are several beneficiaries, the trust may not be administered to prefer the one the trustee is closest to.
3. 03
   PrudenceThe trustee must make sound decisions about management and investment within the trust.
4. 04
   ConfidentialityThe trustee may not discuss the trust or its beneficiaries with outsiders.

The vocabulary of trust law repays learning because it keeps appearing in financial contexts. A fiduciary is anyone who manages money or property for another and must by law act for that person’s benefit.⁵ The grantor, settlor or trustor is the person who creates a trust; the trustee holds and manages what is in it; the beneficiaries receive from it, and residuary beneficiaries are those who take whatever is left once the maker has died.⁶ Loyalty is the duty not to prefer oneself or a third party; impartiality is loyalty applied among several beneficiaries; prudence is the duty of sound decision making; self dealing is the breach loyalty forbids.¹ A corporate trustee is a trust company serving in the role, and a successor trustee is the person or institution named to serve when the first can no longer act.⁴ When a financial professional is described as a fiduciary, these are the words being borrowed.