Questioning the trust law duty of loyalty: sole interest or best interest?

• Author: Langbein, John H.

INTRODUCTION I. ADDRESSING CONFLICTS OF INTEREST A. The Ubiquity of Conflicts 1. Family and Personal Life 2. Nontrust Service Providers 3. Settlor-Authorized Conflicts in Trusts 4. Trustee Compensation 5. Estate Administration a. Health Care Surrogacy b. Durable Powers B. The Concern About Concealment 1. The Revolution in Equity Fact-Finding 2. Fiduciary Recordkeeping 3. The Fiduciary Duty of Disclosure C. Deterrence (and Overdeterrence) 1. The Auction Rule 2. Boardman v. Phipps 3. In re Kilmer's Will 4. In re Will of Gleeson D. Monitoring E. The Contrast with Corporation Law 1. Mutual Advantage 2. Multiple Fiduciaries 3. Exit II. ESCAPING THE SOLE INTEREST RULE A. The Exclusions 1. Settlor Authorization 2. Beneficiary Consent 3. Advance Judicial Approval B. Attrition: The Burgeoning of Categoric Exceptions 1. Financial Services a. Self-Deposit b. Pooled Investment Vehicles 2. Professional Services 3. Affiliated Persons 4. Intrafamilial Transactions C. Repairing the Rule 1. Best Interest 2. Proof 3. Litigation Effects a. Amateurs b. Incentives c. Clear and Convincing? CONCLUSION INTRODUCTION

The duty of loyalty requires a trustee "to administer the trust solely in the interest of the beneficiary." (1) This "sole interest" rule is widely regarded as "the most fundamental" (2) rule of trust law. In this Article I advance the view that the sole interest rule is unsound, and I indicate how it should be modified.

The sole interest rule prohibits the trustee from "plac[ing] himself in a position where his personal interest ... conflicts or possibly may conflict with" the interests of the beneficiary. (3) The rule applies not only to cases in which a trustee misappropriates trust property, (4) but also to cases in which no such thing has happened--that is, to cases in which the trust "incurred no loss" or in which "actual benefit accrued to the trust" (5) from a transaction with a conflicted trustee.

The conclusive presumption of invalidity (6) under the sole interest rule has acquired a distinctive name: the "no further inquiry" rule. What that label emphasizes, as the official comment to the Uniform Trust Code of 2000 explains, is that "transactions involving trust property entered into by a trustee for the trustee's own personal account [are] voidable without further proof." (7) Courts invalidate a conflicted transaction without regard to its merits--"not because there is fraud, but because there may be fraud." (8) "[E]quity deems it better to ... strike down all disloyal acts, rather than to attempt to separate the harmless and the harmful by permitting the trustee to justify his representation of two interests." (9) Courts have boasted of their "stubbornness and inflexibility," (10) their "[u]ncompromising rigidity," (11) in applying the sole interest rule. Remedies (12) include rescission, (13) disgorgement of gain, (14) and consequential damages. (15)

The underlying purpose of the duty of loyalty, which the sole interest rule is meant to serve, is to advance the best interest of the beneficiaries. This Article takes the view that a transaction prudently undertaken to advance the best interest of the beneficiaries best serves the purpose of the duty of loyalty, even if the trustee also does or might derive some benefit. A transaction in which there has been conflict or overlap of interest should be sustained if the trustee can prove that the transaction was prudently undertaken in the best interest of the beneficiaries. In such a case, inquiry into the merits is better than "no further inquiry."

Part I of this Article probes the rationale for forbidding conflicts of interest under the sole interest rule. I point to the ubiquity of overlaps or conflicts of interest in trust and nontrust settings. A main theme is that the severity of the sole interest rule is premised on assumptions that have become outmoded. Two centuries ago, when trust law settled on the sole interest rule, grievous shortcomings in the fact-finding processes of the equity courts placed a premium on rules that avoided fact-finding. Subsequently, however, the reform of civil procedure and the fusion of law and equity have equipped the courts that enforce trusts with effective fact-finding procedures. I also point to improvements in the standards, practices, and technology of trust recordkeeping, as well as enhanced duties of disclosure, which have largely defused the old concern that a trustee operating under a potential conflict could easily conceal wrongdoing. Discussing the claim that the sole interest rule is needed to deter trustee wrongdoing, I point to cases in which the resulting overdeterrence harms the interests of trust beneficiaries. I compare the trust law duty of loyalty with the law of corporations, which originally shared the trust law sole interest rule but abandoned it in favor of a regime that undertakes to regulate rather than prohibit conflicts.

What has made the harshness of the trust law sole interest rule tolerable across the last two centuries is that its bark has been worse than its bite. A group of excusing doctrines and a further group of categoric transactional exceptions, both reviewed in Part II of the Article, have drastically reduced the scope of the sole interest rule. Those devices allow the well-counseled trustee to escape much of the mischief that would otherwise result from the overbreadth of the rule. Of these excusing doctrines, the rule allowing a trustee to petition for advance judicial approval of a conflicted transaction is particularly revealing. When deciding whether to authorize the transaction, the court inquires whether it is in the best interest of the beneficiary. Thus, practice under the advance-approval doctrine supports the theme of this Article, that conflicted transactions that are beneficial to trust beneficiaries ought to be allowed.

Section II.B of the Article reviews exceptions to the sole interest rule that have developed to legitimate particular classes of conflicted transactions. These categoric exceptions are mostly rooted in statute. Many reflect the business practices of bank trust departments and other institutional trustees--for example, allowing the deposit of trust funds in the trustee's commercial banking division or investing trust funds in trustee-sponsored investment pools such as mortgage participations, common trust funds, and mutual funds. Institutional trustees did not exist in the early nineteenth century, when the English and American courts settled the sole interest rule. Modern trusteeship is increasingly embedded in commerce, from which the patterns of mutual advantage that are characteristic of bilateral exchange are being absorbed into fiduciary administration. The common thread that runs through the categoric exceptions is that they facilitate the best interest of the beneficiary, even though the trustee also benefits or may benefit.

I recommend (in Section II.C) reformulating the trust law duty of loyalty in light of these developments. I would generalize the principle now embodied in the exclusions and exceptions, which is that the trustee must act in the beneficiary's best interest, but not necessarily in the beneficiary's sole interest. Overlaps of interest that are consistent with the best interest of the beneficiary should be allowed. What is needed to cure the overbreadth of the sole interest rule is actually quite a modest fix: reducing from conclusive to rebuttable the force of the presumption of invalidity that now attaches to a conflicted transaction. Under a rule thus modified, the trustee would be allowed to defend a breach-of-loyalty case by proving that a conflicted transaction was prudently undertaken in the best interest of the beneficiary.

1. ADDRESSING CONFLICTS OF INTEREST

   There can be no quibble with the core policy that motivates the duty of loyalty. Any conflict of interest in trust administration, that is, any opportunity for the trustee to benefit personally from the trust, is potentially harmful to the beneficiary. The danger, according to the treatise writer Bogert, is that a trustee "placed under temptation" will allow "selfishness" to prevail over the duty to benefit the beneficiaries. (16) "Between two conflicting interests," said the Illinois Supreme Court in an oft-quoted opinion dating from 1844, "it is easy to foresee, and all experience has shown, whose interests will be neglected and sacrificed." (17) In the law and economics literature this phenomenon of divergence between the interest of the manager and that of the beneficial owner has been much discussed in recent years, especially in corporate law, under the rubric of agency costs. (18)

   1. The Ubiquity of Conflicts

      What is troubling about the sole interest rule is not its sensitivity to the dangers of conflicting or overlapping interests, but its one-sidedness in failing to understand that some conflicts are not harmful, and indeed, that some may be positively beneficial. Bogert, for example, asserts that "[i]t is not possible for any person to act fairly in the same transaction on behalf of himself and in the interest of the trust beneficiary." (19) The sole interest rule is premised on this notion that a conflict of interest inevitably imperils the interest of the beneficiary. On that premise rests the "no further inquiry" rule, which prevents a court even from inquiring "whether the trustee did in fact take any advantage of his situation." (20) For the beneficiary to invalidate the transaction, it suffices to show merely that the defendant "held the office of trustee and might possibly have had the means of taking advantage of his situation." (21)

      The stringent view of conflicts of interest that motivates the sole interest rule misunderstands a central truth: Conflicts of interest are endemic in human affairs, and they are not inevitably harmful. Accordingly, indiscriminate efforts to prohibit conflicts can work more harm than good.

      1. Family and Personal...