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Self-Dealing Ban Eliminates Greatest Fiduciary Conflict-of-Interest

Self-Dealing Ban Eliminates Greatest Fiduciary Conflict-of-Interest
May 01
00:58 2018

Both the DOL and the SEC have focused on the problems inherent in conflicts-of-interest between financial service providers and the clients they serve. Unfortunately, whether intentional or not, there has been a movement to define the term “conflict-of-interest” so broadly that it loses any meaning. Some have gone so far as to even include the very act of offering to serve clients a “conflict-of-interest.”

Perhaps, then, now would be a good time to revisit the evolution of fiduciary duty and the most fundamental of conflicts-of-interest: engaging in self-dealing transactions. To accomplish this, it’s useful to remember these matters began not with the DOL or the SEC, but within that narrow body of banking laws pertaining to trust law. In the sense of trustees, the ban on self-dealing transactions is quite evident. “Trustees are bound by fiduciary duties to protect the interests of trust beneficiaries, and therefore, self-dealing transactions are inherently opposed to those interests,” says Douglas Schneidman, a Trusts & Estates partner at Sullivan & Worcester in New York City.

It’s important to note a “self-dealing” transaction is specifically limited to transactions involving assets of the trust. “A self-dealing transaction, which occurs when a trustee buys or benefits from the sale or purchase of trust property either directly or indirectly, undermines the fundamental duty of the trustee to serve only the interests of the trust’s beneficiaries, by allowing the trustee’s interests to enter into the calculation,” says Jennifer V. Abelaj, CPA and Senior Counsel at Davidoff Hutcher & Citron LLP in New York City. “Only the interests of the trust’s beneficiaries (as well as general public policy) are to be considered.”

Preventing self-dealing speaks to the very nature of the role of the trustee. “The general prohibition against trustees entering into self-dealing transactions stems from what has been called the ‘most fundamental duty of a trustee’ – the duty of loyalty,” says Steven E. Trytten, Esq., Trusts & Estates attorney at Anglin Flewelling Rasmussen Campbell & Trytten LLP, located in Pasadena, California. “This duty protects the beneficiaries of a trust by requiring that the trustee administer the trust solely in the interest of the trust’s beneficiaries. It is a particularly strict duty and does not attempt to balance the interests of the trustee’s personal interests against those of the trustee’s beneficiaries. Rather, it requires that the trustee ‘subordinate his or her interests to those of the beneficiary in every regard.’”

It’s therefore quite simple. If you agree to serve in a trust capacity, you agree to subordinate your needs to the needs of the beneficiary. “A trustee owes the beneficiaries of the trust a fundamental duty of loyalty and must administer the trust solely in the interests of the beneficiaries,” says Martin J. Hagan, Partner at Meyer Unkovic & Scott LLP in Pittsburgh, Pennsylvania. “Acts of self-dealing, where the trustee would pursue their personal advantage, would be a breach of this duty of loyalty, and thus are voidable by the courts.” (Note, you don’t offer this service at no charge. That you will charge a fee is given. The prohibition on self-dealing merely means you cannot augment that fee through the use of trust assets.)

Since the trustee has legal access to all trust property, self-dealing can be seen as a process to place the interests of the trustee ahead of the interests of the beneficiary. “The relationship between the trustee and beneficiary is a fiduciary one and must be exercised with the utmost good faith and integrity,” says Charles Field, Co-chair of Financial Services Practice at Sanford Heisler Sharp, LLP in San Diego, California. “Because the trustee is the legal owner of the trust property with discretionary authority over its acquisition and disposition, the temptation exists for the trustee to abuse its position by selling the trustee’s property to the trust at inflated prices while at the same time buying valuable assets from the trust at below-market prices. The simplest way to prevent trustee self-dealing abuse is simply to prohibit it.”

Craig Hersch, Florida Bar Board Certified Wills, Trusts & Estates Attorney and CPA at the Sheppard Law Firm in Fort Myers/Naples Florida, offers the following example, “When a trustee commits an act of self-dealing, it is usually by entering into a transaction with the trust that the trustee is empowered to serve. Suppose Tom the Trustee is trying to sell his house. He listed it for $400,000. Tom is also the trustee for a trust in which Susan and Jennifer are beneficiaries. If Tom were to sell the house to the trust for $400,000, it may not appear proper since no one usually gets their asking price. Here, the presumption of either selling something to the trust at a price higher than fair market value or buying something from the trust at a price below fair market value is great. Therefore, it is best not to self-deal and to work with third parties in ‘arms-length’ transactions. Trustees must act in a fiduciary capacity meaning that they should always act in the best interests of the beneficiaries of a trust.”

Much of the law which proscribes self-dealing by trustees comes from individual states, but there is much commonality among the states and what is called the “Uniform Trust Code.” Trytten says, “Across the country and particularly in California, the duty of loyalty dictates that the trustee must be motivated solely by acting in the best interests of the beneficiaries. This jurisprudence has evolved in contemplation of the fact that trustees generally have a greater level of sophistication and access to trust-related information than the beneficiaries. While this duty of loyalty requires the trustee to act in the beneficiaries’ best interests across a wide range of actions, the particular vulnerability of beneficiaries to self-dealing transactions led to a specific codification of the prohibition against self-dealing. The California version of the prohibition against self-dealing, for example, appears in Section 16004 of the California Probate Code as a duty to avoid conflict of interest.”

Is the Prohibition Against Fiduciary Self-Dealing New?

The shift from the broad brush of loosely defined “conflicts-of-interest” to the sharply defined self-dealing transaction may appear of recent vintage, but that’s only because many are only now becoming familiar with the concept of “conflict-of-interest.” It’s know natural that, as the focus narrows itself to more material conflicts-of-interest that they now discover the significance of a “self-dealing transaction.” It may surprise many that this specific issue is not new had has long been considered the most important area of concern. “We can trace the roots of the self-dealing prohibition through several centuries of the old English common law of equity,” says Field.

Trytten says, “Carl Sagan wisely stated that ‘if you wish to make an apple pie from scratch, you must first invent the universe.’ Similarly, if you want to explore when the prohibition against trustees entering into self-dealing transactions made its first appearance in case law, you have to turn to the root of our modern law – the legal system of the late medieval period in England. During this period, the general concept of fiduciary duties as they pertained to trusts arose and was slowly broken into core components and codified.”

Indeed, we can trace the modern beginnings of trust law – and the associated ban on self-dealing transactions – back to King John and the Magna Carta, with relevant case law following shortly thereafter. “Case law dating back to beginnings of trusts in the 16th century out of England discuss self-dealing problems,” says Hersch. “Trusts were originally established even before that time for Crusaders. Women weren’t allowed to own real estate, so a king or other noble who owned land would put his land in trust for another man to care for while the king/noble was fighting in the Crusades. Early case law established that when the king/noble returned, the trustee must return the land, even if he tried to say that the land was now his for some reason, either through his efforts caring for the land, from squatter’s rights or so forth. These cases established the first trust law.”

“But to skip ahead a great deal to more modern law,” says Trytten, “cases that are still good law and cited today appeared in California as early as the 1920s (although germane but now archaic cases began appearing much earlier across the country). In 1934, one still-cited case succinctly set out a prohibition against trustee self-dealing that would evolve to become California’s modern Section 16004 prohibition – “a trustee is also expressly forbidden to deal with trust property for his own profit and is inhibited from taking part in any transaction concerning the trust in which he has an interest, present or contingent, adverse to that of his beneficiary.” In other words, the prohibition against self-dealing is not a new concept nor is it revolutionary. Where the concept of a trustee-beneficiary relationship enters into a jurisdiction’s jurisprudence, the duty of loyalty inspired prohibition against self-dealing takes root soon after.

Today, we have the Uniform Trust Code, the culmination of centuries of case law pertaining to trusts. “The common law has required trustees to act in the interests of beneficiary since time immemorial,” says Abelaj, “and the principle has been restated through the years in court decisions and in such texts as the Restatement (Second) of Trusts and the Uniform Trust Code.”

The Uniform Trust Code must be adopted by individual states and establishes the basic fiduciary responsibility of trustees. “The duty of loyalty has been recognized Anglo-American courts for centuries,” says Hagan. “More recently, it has been restated in the Uniform Trust Code, which most states, including Pennsylvania, have enacted. The duty of loyalty is now a statutory mandate.”

The body of law that makes up the Uniform Trust Code represents the recent proliferation of the use and popularity of a variety of trust vehicles. “[While] The prohibition against self-dealing is it common law principle dating back centuries,” says Laurie Giles, a practicing attorney from Trumbull Connecticut, “case law is relatively new (last 30 years) as the use of trust becomes more commonplace. For example, when I begin practicing trust law 25 years ago I probably drafted 2- 4 per year, now I draft 3-5 per month. And, not only are they more complex, but the fiduciary trustee is generally not a trained Institutional trustee, but rather a family member or friend who is unfamiliar with fiduciary responsibilities and liability.”

How Common are Exceptions to the Ban on Fiduciary Self-Dealing?

In the case of self-dealing, an allowed exception doesn’t necessarily shield the trustee from being accused of a fiduciary breach. Trytten explains why when he says, “Other than the exceptions to a trustee’s self-dealing generally coming from either the settlor’s intent or with the express and informed consent of a trust’s beneficiaries, there are typically no exceptions to the ban on self-dealing transactions for trustees, because a breach of the duty of loyalty generally cannot be negated. Indeed, the ‘no further inquiry’ rule common in most jurisdictions provides that even where the trustee acted in good faith, the terms of the self-dealing transaction were fair, and the trust suffered no loss or the trustee received no profit, the trustee still has no defense to his self-dealing. To put it another way, a leading California case describes the inability to negate a breach of the prohibition against self-dealing thusly:

When a fiduciary enters into a transaction with a beneficiary whereby the fiduciary’s position is improved, or he obtains a favorable opportunity, or where he otherwise gains benefits, or profits, it may fairly be said that an advantage has been obtained. To declare that the advantage obtained must be shown to be unfair, unjust, or inequitable before the presumptions arise would result in the imposition of a condition which is not required by section 2235.”

The Uniform Trust Code does now identify certain very precisely defined exceptions. Hagan says, “Certain exceptions to the ban on self-dealing have been recognized by the courts and are now included in the Uniform Trust Code, including the following: 1) the transaction was authorized by the trust instrument; 2) the transaction was approved by the court; 3) the beneficiaries consented to the trustee’s conduct, ratified the transaction, or gave a release to the trustee; and, 4) the beneficiary did not commence a judicial proceeding challenging the transaction within the time limits allowed by law.”

Even when the trust document specifically permits self-dealing activity, it sometimes requires a court ruling to determine the validity of that exception. “Some exceptions are allowed if either the trust documents or the beneficiaries choose to permit some forms of self-dealing, although the case law in both instances allows a court to determine whether the transaction was reasonable,” says Abelaj. “In O’Hayer v. de St. Aubin (30 A.D.2d 419), for example, the court held that the trustor, in appointing his son a trustee and indicating that his son should ‘profit’ from the trusteeship, clearly wanted his son to retain the fullest control over the operation and continuation of the family corporations. The court held that, to the extent that the son, as trustor, acted in good faith, the rule prohibiting self-dealing and individual profit by the trustee should not apply.”

It’s important to note a trustee’s fiduciary duty does not vanish with the exception. It may, in fact, become more tenuous. “One exception could be if the trust instrument included a clear, unmistakable and explicit self-dealing clause that permits the trustee to sell property to or buy property from the trust,” says Field. “However, such a clause does not give a trustee free rein to abuse their authority or exonerate a trustee from acting in his or her self-interest to the detriment of the beneficiary. The authority must be exercised in good faith and terms must be fair. It would also be prudent for the beneficiary to review and approve the terms of any self-dealing transaction. However, the exception can become a bit murky in states that that have express statutory prohibitions against trustee self-dealing.”

It’s therefore safer, despite possessing the imprimatur of an exception, to obtain some reliable third-party assessment before entering into a self-dealing transaction. “If it can be established that self-dealing is at ‘arm’s length’ then it might be permissible,” says Hersch. “If a trustee had a verified appraisal, for example, justifying a purchase price outside of the self-dealing transaction, then it might survive scrutiny. A trustee who self-deals is playing with fire, however. A lawsuit filed by a beneficiary could remove the trustee from his post, and then he would have to defend the claim with his own resources.”

One notable exception to the lack of exception is (primarily) the DOL’s liberal permissiveness regarding self-dealing transactions on the part of financial service providers vis-à-vis their clients. To a lesser extent, the SEC allows this, but primarily among institutional entities. “Regulatory agencies, such as the Department of Labor or the Securities and Exchange Commission, have enacted rules that allow exceptions where the fiduciary puts safeguards in place to protect against abuse,” says Field. “The safeguards typically relate to fairness of the transaction and disclosure of the terms of the transaction.  For example, the Department of Labor permits investment advisers of mutual funds to offer their mutual funds as options to their employees who participate in the investment advisers 401(k) plan if the arrangement meets the standards set forth in the DOL’s PTE 77-3.  The SEC promulgated a number of rules under Section 17 of the Investment Company Act of 1940 to permit a wide variety of transactions between an investment company and affiliated parties that occupy a fiduciary position to the investment company.  As an illustration, an investment adviser to a mutual fund that complies with the rules may direct the mutual funds brokerage trades to a broker-dealer owned by the investment adviser.   In each exemption, the reasonableness of the fee is of paramount importance.”

Fiduciary Beware: Self-Dealing Transactions Represent a Land Mine Too Easily Stepped Upon

There are simply too many potential problems that can arise when engaging in self-dealing transactions. “Self-dealing by trustee is akin to walking in a minefield; you never know where the bombs are,” says Giles. “While there are some exceptions, i.e., the trustee purchases trust property at fair market value. I invariably advise trustee clients to be sure they can show clearly that their fiduciary responsibilities are upheld. They must not take any actions that are or have the appearance of conflict of interest, or breach of fiduciary duty.”

John Palley, a California Probate Attorney with Meissner, Joseph & Palley, Inc. in Sacramento, California wonders of it’s better that trustees avoid self-dealing transactions altogether. He believes it safer, at least in cases where probate is an option, to rely solely on the courts to determine the adequacy of what would normally be deemed a self-dealing transaction. “The problems with self-dealing by trustees can be at least partially alleviated by having the probate court supervising a probate case,” he says. “That is, trusts are great for most people but going through probate, after death, can be better than trusts in some situations due to the stricter court supervision. Of course, using a licensed professional fiduciary can reduce the risk of problems in both trust administrations and probate cases.”

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

4 Comments

  1. Dennis Myhre
    Dennis Myhre May 02, 10:17

    Chris, “Self Dealing” engages a third party into the scenario, often a disqualified person that creates the self-dealing issue in the first place.

    The problem with your theory is that if the OED staff under the EBSA issues an Exemption letter, which is often the case, the self-dealing continues unabated.

    Whenever exemptions are put in place, the investor loses. Over the years, Principal Life has applied for, and received, exemptions from ERISA prohibited transaction rules. A couple examples include holding revenue sharing income in their general account, and selling proprietary products to their own plan sponsors. Ironically, they are prohibited from selling such funds to their own employees (as a Fiduciary), but can do so to millions of other 401(k) investors.

    In my opinion, the most effective way to control self-dealing is to eliminate the exemption procedures under the Federal Pension law. Prohibited transactions were included in ERISA for a good reason, and to permit exemptions from ERISA is detrimental for investors.

  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author May 02, 11:02

    Dennis, thanks for the comment, and, yes, you seem to be on to something.

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