New Year and New Risk Analysis: A Word of Warning to Every Trustee of a Trust that Holds Ownership of a Closely Held Business
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In family-run businesses, it is common for a single individual to wear multiple hats. For example, a trustee may also serve as a director or manager of a closely held family business whose ownership interests are held in the trust for which he/she is responsible. Both trustees and directors/managers owe fiduciary duties of care and loyalty to their respective entities. The performance of those duties, however, is typically evaluated under different standards based upon whether an individual is acting as a director or as a trustee. In the case of a director/manager who is also a trustee, it is important to clarify these fiduciary duties and the standards that govern them upon review.
The Business Judgment Rule Protects Directors and Managers
Decisions made by directors and managers generally fall under the protection of the business judgment rule. This rule presumes that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the company’s best interests. Unless the party challenging a director’s decision can establish facts rebutting that presumption, courts will respect the director’s judgment.The business judgment rule focuses a court’s inquiry not on the wisdom of director’s decision but rather on the process by which the decision was reached, asking whether the director deliberated on the decision, was reasonably informed by due diligence, and acted in good faith. Courts have generally said that the rule reflects the principle that the management of corporate affairs is committed by law to directors’ discretion, as well as the reality that directors must take some risks to make profits. The rule also reflects the recognition that business people generally are more competent than judges to make business judgments.
More Stringent Rules Apply to Trustees
Trustees, like corporate directors, owe fiduciary duties to a trust’s beneficiaries. But those duties are not identical to those owed by directors. Actions taken by trustees are generally evaluated under a more stringent standard when courts question whether fiduciary duties were breached, and unlike corporate law, under trust law, trustees are virtually prohibited from self-dealing. Trustees must act with complete and undivided loyalty to the trust. Unlike directors evaluated under the business judgment rule, trustees are not entitled to a presumption of good faith. Instead, under the prudent investor rule, trustees generally must exercise the care and skill that a person of ordinary prudence would exercise in dealing with their own property. Under section 804 of the Uniform Trust Code and applicable state law, trustees must exercise reasonable care, skill, and caution in satisfying this standard.
When a trust owns an interest in a closely held business, determining the standard for evaluating a trustee-director’s breach of fiduciary duty is not an easily answered question. The Massachusetts Appeals Court has warned that a fiduciary wearing multiple hats must “be very nimble as well as most prudent.” Unfortunately, there is no universal bright-line rule declaring which standard should apply in this context. While a trustee-director may purport to only act in one capacity when taking certain actions, some courts, such as the Massachusetts Appeals Court, have cautioned that “in truth, all hats are worn together at all times.” These jurisdictions have concluded that the stricter trust fiduciary standard generally defeats the less stringent business judgment rule when both are potentially applicable. For example, the Supreme Court of Alabama in a case involving a trustee-director concluded that the trustee-director most certainly violated his duties as a trustee, even if did not commit self-dealing under the corporate director standard.
The Missouri Court of Appeals and Appellate Division of the Supreme Court of New York have also determined that the trust standard should govern the propriety of a trustee’s actions—even when that trustee is also a corporate director. Courts in other states, including Rhode Island, however, have held that trustee-directors are still entitled to the protection of the business judgment rule when they are vested with discretion to act. As a result, the door could be propped open for an unhappy trust beneficiary to argue that decisions made that benefit the trustee constitute improper self-dealing, among other potential violations.
A recent legal saga from Georgia highlights the importance of clarifying which competing fiduciary duties apply to the conduct of a trustee who also controls a closely held entity that the trust holds an interest in. In Rollins v. Rollins, two brothers acted as trustees of family trusts and partners of the family business partnership in which the trusts were also partners. After the trusts’ settlor died, the brothers amended the partnership agreement to alter how distributions were made and to vest themselves with the exclusive authority to manage the partnership. The trust beneficiaries alleged that the brothers breached their fiduciary duties, and the Georgia appellate courts set about determining what standard should govern the brothers’ conduct. The Georgia Supreme Court ultimately concluded that the trustee-level fiduciary duties applied to the defendants when they voted as trustees on behalf of the trusts, but the duties owed to partners applied to any actions the brothers took as individual partners.
The Rollins decisions make clear that, in this murky legal area, it is important to clarify which fiduciary duties apply and to monitor compliance. Before any actions are taken, the parties should contemplate what standard of review would apply to a trustee-director-manager’s challenged conduct, and act and document accordingly. In addition, some other measures can be considered to address the risk:
- As much as possible, the trust instrument, corporate by-laws and/or operating agreement should clarify what duties a fiduciary owes from the outset;
- A settlor can include a provision in the trust instrument expressly permitting a trustee to undertake certain otherwise interested transactions in connection with the closely held corporation;
- A settlor may also, in the trust instrument, shield a trustee-director from liability for trustee-level fiduciary duties if the trust owns only a minority portion of the corporate entity’s stock;
- The business entity’s by-laws or operating agreement should clearly specify that directors/managers are entitled to the protection of the business judgment rule; and/or
- A settlor can also consider separating the trustee and director/manager roles by bringing on a qualified and trusted third-party trustee.
The two-hat conundrum is quite common in family-run businesses. Parties that may find themselves facing competing fiduciary duties should proceed with caution and consider the measures above. We recommend consulting with a law firm that is experienced in working with closely held and family-run businesses to help with your risk analysis and compliance.
Greg Neibarger is co-chair of Dentons’ Fiduciary Litigation practice group and leader of the Unfair Competitive Business Practices Team. Vienna Bottomley is a member of Dentons’ Commercial Litigation practice group, where she focuses her practice on general commercial litigation and government investigations. Greg and Vienna regularly assist trustees and members of closely held companies with duty-compliance and other fiduciary issues and disputes.