TRUST PROTECTORS: WHO WILL WATCH THE WATCHMEN?

TRUST PROTECTORS: WHO WILL WATCH THE WATCHMEN? Gregory S. Alexander * The emergence of the trust protector office is one of the major developments in American trust law during the past decade. As Stewart Sterk points out in his excellent and important paper, 1 the trust protector office, though it first developed to enable settlors of offshore asset protection trusts to maximize their control over assets transferred into such trusts while still immunizing them from the reach of creditors, is no longer confined to the asset protection context. Increasingly, estate planners are using it as a device that adds flexibility to long-term trusts and that increases the settlor s ability to control trustee behavior long after the time when the settlor has died or has otherwise become unable to direct the trustee. Professor Sterk s paper does two things. First, it analyzes the trust protector office through the lens of the agency theory of trusts. That theory, developed notably by Robert Sitkoff, 2 has gained considerable attention in recent years as a way to explain trust law s rules regulating the relationships among the settlor, the trustee, and the beneficiaries. Sterk argues that we can best understand the use of trust protectors in the context of ordinary domestic trusts, i.e., beyond offshore assetprotection trusts, as a response to the agency cost problems that are endemic to trusts. He analyzes the various potential functions of a trust protector, which include not only monitoring the trustee but also changing the trust over time in various ways in order to adapt to changing circumstances, as they bear on the trust protector s core purpose of minimizing agency costs. The second contribution of Sterk s paper is to provide us with an instructive preliminary blueprint of the legal regime of default rules that might eventually apply to trust protectors. The aim of these default rules is to resolve the management and distributional issues that the trust protector office s emergence is likely to create. * A. Robert Noll Professor of Law, Cornell Law School. I am grateful to Stew Sterk and Rob Sitkoff for their helpful comments on this paper. 1 Stewart E. Sterk, Trust Protectors, Agency Costs, and Fiduciary Duty, 27 CARDOZO L. REV. 2761 (2006). 2 See Robert H. Sitkoff, An Agency Costs Theory of Trust Law, 89 CORNELL L. REV. 621 (2004). 2807

2808 CARDOZO LAW REVIEW [Vol. 27:6 The trust protector office may turn out to be an effective device in dealing with the agency cost problems that he, Sitkoff, Melanie Leslie and others have identified in trust relationships. 3 At the same time, though, I do worry that trying to ameliorate those problems will create its own set of agency cost problems. If I am right about that, then it is hard to know whether the trust protector position is worth the candle. That is, will the result in most cases be a net reduction in agency costs or will the trust protector office create its own agency costs that offset the reduction in the costs associated with the trustee s position? The introduction of a trust protector in the web of relationships that constitute a trust complicates agency cost analysis in several ways. First, it is not entirely clear who is the trust protector s principal the settlor or the beneficiaries, or perhaps in some situations, both? The configuration of the principal-agent relationships in the garden variety trust (settlor-trustee-beneficiary) is already murky. As Sterk points out, traditional trust law equivocates about who is the principal for the trustee. 4 When a fourth party the trust protector is introduced, matters become murkier still. I read Sterk himself to be somewhat equivocal about the identity of the trust protector s principal. In many situations it will not matter because the settlors and beneficiaries interests will align with each other. This will often, perhaps even usually, be the case, but not always. Suppose, for example, that a trust instrument specifies with great clarity that in no circumstances should the trustee sell a particular inception asset, an asset that constitutes a major portion of the trust portfolio, and suppose further that some time after the trust s creation and the settlor s death, the market value of that asset tanks, threatening the ability of the trust to provide for all of the beneficiaries. (Most of you have probably already recognized this hypothetical as one that tracks the well-known Pulitzer Trust case.) 5 Suppose the trustee decides not to sell the asset. If the trust protector has been granted the power to initiate investment actions or to veto trustee investment decisions, how should the trust protector respond in this situation? Should the trust protector act if he believes that the trustee s decision is unreasonable because it jeopardizes the interests of the beneficiaries? Sterk s analysis 3 See Sitkoff, supra note 2, at 670-71 (analyzing trust protectors from an agency cost perspective); see also Melanie Leslie, Trusting Trustees: Fiduciary Duties and the Limits of Default Rules, 94 GEO. L.J. 67 (2005); Robert H. Sitkoff, Trust Law, Corporate Law, and Capital Market Efficiency, 28 J. CORP. L. 565 (2003); Jonathan R. Macey, Private Trusts for the Provision of Public Goods, 37 EMORY L.J. 295 (1988); A.I. Ogus, The Trust as a Governance Structure, 36 U. TORONTO L.J. 186 (1986). 4 Sterk, supra note 1, at 2761. 5 In re Estate of Pulitzer, 249 N.Y.S. 87 (Surr. Ct. 1931), aff d mem., 260 N.Y.S. 975 (App. Div. 1932).

2006] WATCHING THE WATCHMEN 2809 of such situations is not entirely clear. He suggests that even if the trust protector believes that the trustee s decision is unreasonable, the trust protector perhaps should defer to it, but the reason for suggesting a deferential role in such cases is not clear. At one point, Sterk says that the settlor might prefer that the trust protector defer, 6 but then he says that the trust protector may have reasons to defer, reasons that are rooted in the beneficiaries best interests. 7 If the trust protector is convinced that the settlor would not want the asset to be sold but is equally convinced that retention jeopardizes the beneficiaries best interests, whose interests should guide the trust protector? 8 The problem is a fundamental one because until we are clear about who is the trust protector s principal, we cannot assess what course of action by the trust protector and what standard to judicial review is appropriate from the agency cost perspective. If the settlor is always the principal and the sole principal, then Sterk s surmise that a deferential standard of trust protector behavior and a concomitant standard of review the trust protector should be liable only if the protector has made no reasonable inquiry into the trustee s behavior or if no reasonable person would fail to act on the facts available to the protector 9 seems well founded. If, on the other hand, an agency relationship exists with the beneficiaries as well, then a highly deferential standard may not be appropriate, as it would lead to a sacrifice of the beneficiaries best interests. In this respect, the deferential standards of behavior and review would not reduce overall agency costs. One possible response to this point, one that I suspect Professor Sterk would make, is that the beneficiaries are not ordinarily the trust protector s principals, nor should they be. From a cost perspective, we are better off avoiding a more interventionist standard of review that exposes trust protectors to liability whenever a court concludes that a different course of action by the trust protector would have been in the beneficiaries best interests. Such an interventionist standard would increase monitoring costs without reducing agency costs. But do we want to leave the beneficiaries entirely and always without any recourse against a trust protector who fails to act? A question very much worth asking is whether there are circumstances in which we want to enable the beneficiaries to act directly against the trust protector. Suppose, for example, that a group of beneficiaries 6 Sterk, supra note 1, at 2782. 7 Id. 8 John Langbein offers a strong version of the benefit-the-beneficiaries argument in relation to the Pulitzer case in John H. Langbein, Mandatory Rules in the Law of Trusts, 98 NW. U. L. REV. 1105, 1111-17 (2004). 9 Sterk, supra note 1, at 2790.

2810 CARDOZO LAW REVIEW [Vol. 27:6 believes that the trustee has acted in ways that disfavor them and favor another group, perhaps in investment decisions. If they request the trust protector to investigate whether there has been a possible breach by the trustee of the duty of impartiality, and the trust protector, relying on the deferential model that Professor Sterk generally favors (and I concur with him on that), should the beneficiaries be able to force the trust protector s hand? The beneficiaries might prefer to handle their complaint through the trust protector rather than in some more direct fashion because they want to avoid alienating the trustee with whom they will (or may) have an ongoing relationship in the future. If we think that there are circumstances in which the beneficiaries ought to be able to force the trust protector s hand, then should we rethink the abuse of discretion standard that Sterk generally favors? I think more discussion about the beneficiaries role in such situations or others like it would clarify and strengthen Professor Sterk s otherwise excellent paper. Second, the introduction of a trust protector into the picture complicates the principal and agent relationships in another respect as well. As Sterk points out, the trustee s de facto principal might now become the trust protector rather than either the settlor or the beneficiaries. This change is especially likely where the trust protector has the power to remove the trustee, a power that the settlor might well wish to confer on the trust protector for the reasons that Sterk gives. The more power you give to the trust protector over the trustee, the more you risk making the trustee look like a mere agent, a development that the settlor probably neither contemplated nor would have wanted. This observation leads to a third, and broader, point regarding the difficulty of analyzing the agency cost problems under a trust protector regime. There s a Catch-22 involved here. The more power you give the trust protector, the more you simply swap one set of agency cost problems for another. (This is point made by Kenneth Arrow in the excerpt that Sterk quotes.) 10 On the other hand, if you give the trust protector fewer powers in order to avoid the kinds of problems I ve just identified, then you don t fully address the agency costs that initially led you to introduce the trust protector into the picture. Of course, this is not an either-or situation. The choice is not a simple binary one because, as Sterk lucidly lays out, there is a wide range of powers that might be conferred on a trust protector. The trust instrument can tailor the trust protector s powers to be as broad or narrow as the settlor wants. Still, there is inevitably some degree of tradeoff here, one that complicates the agency cost calculus. 11 10 Sterk, supra note 1, at 2777 n.74. 11 See Sitkoff, supra note 2, at 671 (suggesting that this trade-off will usually favor using a

2006] WATCHING THE WATCHMEN 2811 Beyond these general concerns with trust protectors, I have some specific comments about Professor Sterk s program of default rules. Sterk is surely correct in arguing that a routine transplantation to trust protectors of the same fiduciary standards applied to trustees would be a mistake. Trust protectors are not simply co-trustees; indeed, there may even be some question, depending upon the degree to which the trust protector is empowered, about whether the trust protector is a fiduciary at all. Sterk s deferential standard of behavior and the concomitant standard of review make good sense in most situations. One can imagine situations, though, in which a more activist, or interventionist, standard of behavior (and high standard of review) might be appropriate. If a trust protector is given not simply veto powers or powers to withhold consent from a trustee but more extensive powers, especially directive powers over both investments and distributions, and a power to replace the trustee, the trust protector s role approaches that of a co-trustee sufficiently perhaps to warrant a higher standard of behavior and a more searching standard of review than something like the business judgment rule or the no rational basis test that Sterk proposes. This would seem appropriate, for example, where the protector was given extensive directive powers over trust investments because the protector possesses special expertise in that area. The general point is that one size won t fit all, which is one of the reasons why it will be so difficult for courts to figure out just what the fiduciary rules should be with respect to trust protectors. 12 Somewhat along the same lines, are there ever situations in which the trust protector s consent to a trustee decision should immunize the trustee from liability? That is, should the protector ever be a safe harbor? It seems to me it would be a mistake ever to let the trustee completely off the hook because the protector consented to the trustee s action. Approval of a trust protector, even one with great expertise in the area in which the action was taken, say an investment decision, is not like judicial approval, and making the protector s consent a safe harbor would seriously risk creating perverse incentives for trustees where a protector is in the picture. It seems to me very important that we not allow the trust protector office to dilute the fiduciary standing, with all of its obligations, of the trustee s office. Moreover, the trustee should not only remain subject to fiduciary duties but should retain its historical position as the core fiduciary in the complex web of trust relationships. My basic reaction, then, is that Professor Sterk has it just right in protector). 12 Moreover, the settlor can, and probably should, specify the standards which should govern the protector s conduct.

2812 CARDOZO LAW REVIEW [Vol. 27:6 his basic approach of keeping the trust protector office secondary to that of the trustee and in adopting a flexible approach to the position.