Business people often innocently fall into a potentially dangerous trap. If you are a director of your company and also have stock and real estate interests, your estate planner may already have created a living or charitable trust for you. Most owners of closely held businesses are unaware of the conflict of interest which can arise when corporate stock is placed into a trust which the owner controls as trustee. This conflict arises more often than most business owners recognize. When the owner of an interest in a corporation puts that stock into a trust, he has accepted the potentially conflicting fiduciary duties of corporate director and trustee. More problematically, he may be imposing those conflicts on his successors.
One Typical Scenario
In a typical scenario, a business owner and spouse pass away leaving portions of their corporate stock to multiple beneficiaries. Often the owners leave the oldest child in control of both the business as CEO and director as well as successor trustee of the founders’ living trust. However, the trust, which served to minimize estate tax liability for the family, now serves to impose fiduciary duties on the eldest child to manage the trust assets for the benefit of all. The child of the founder, who may have been running the business with little accountability for years, now must take the interest of his or her younger siblings to heart. The beneficiaries have an interest in minimizing officer compensation while the trustee CEO has an interest in maximizing it. Expenses which were customary now come under scrutiny. Capital investment, financing and tax decisions become arenas for potential conflict between the trustee insider and the now interested sibling beneficiaries. “The way it has always been done” and “the way mom and dad did it” must now be evaluated by the fiduciary standard: What is in the best interests of the trust and the beneficiaries? The business can no longer be run for the benefit of the favorite son or daughter. Tempers flare and accusations follow.
The standard estate planning devices come with a trap for unwary business owners in in form of the conflicting fiduciary duties which can arise when corporate stock is put into a trust. If the beneficiaries include anyone other than the business owner-trustee, the trap is set. If a director becomes a trustee over stock in the corporation they become subject to conflicting fiduciary duties: Is their loyalty primarily to the corporation and its shareholders or to the trust and its beneficiaries?
Duties of Corporate Directors and Trustees
Directors owe fiduciary duties to the corporation they serve. A director’s fiduciary duty is characterized by the director’s defined role within the corporate governance structure. Trustees are held to a higher standard. Trustees “must exclude all selfish interest” by devoting himself or herself completely to the beneficiaries’ interests. The California Probate Code binds trustees to more than the duty of loyalty, duty of impartiality and the duty to avoid conflicts, but also to the duty to take control of trust property and make it productive, enforce trust claims, respond to beneficiary requests, report and account to beneficiaries, invest prudently and dispose of improper investments.
Director Protections: The Business Judgment Rule and Other Steps
There is a way out of the trap. If a director finds himself or herself in the trap and a beneficiary suggests that the trustee has breached their fiduciary responsibilities as a director, there may be protection if the directors’ decisions were made in good faith and the director exercised reasonable business judgment. The director may also rely on the reports and information provided by management and the decisions of committees.
To further limit the risk of conflicts and self-dealing, the corporate officer or director may engage professional trustees to join in the management or invite special trustees to help manage problem assets. Outside trustees provide accountability and disclosure, which is one reason beneficiaries sometimes specifically request these protections. But professional trustees also come with significant downsides. Professional trustees can be expensive, and the potential loss of control threatens to undermine or eliminate the management’s crucial ability to control the corporate business.
Some Additional Protection for the Trustee-Director
The corporate officer and director who suddenly becomes a trustee of the stock is not without some protection. Case law has recognized that where the trustor knew of the potential conflict of interest in creating the trust then courts will remove the trustee only for specific disloyalty and self-dealing. However, this recognition of the intention of the trustee is limited. In order to protect the stock interest as trust asset, the trustor must have been aware of the conflict, and the trustee must still act in good faith to avoid self-dealing.
Trustee-directors should beware the trap. By exercising reasonable business judgment and looking to the interests of both shareholders and beneficiaries, the director who becomes a trustee can limit the risk which follows from accepting those potentially conflicting duties.
Beware Conflicting Fiduciary Duties (Be slow to enter the Trap)
There are still many reasons, tax and otherwise, for business owners to place corporate stock into trusts. However, estate planning lawyers should take care to counsel their clients on the implications for current or future discrepancies arising from the conflicting role of trustee and director. Business owners and managers who become trustees must recognize that the new responsibility of trustee may come with conflicting fiduciary obligations. For trustee-directors, business as usual can mean a rude awakening to liability and removal as trustee.
Invitation to discuss this Issue
As always, I would be delighted to discuss this matter with you should you want to discuss a more specific scenario. I can be reached at (949) 852-1800.