Hi, this is Keith Davidson at Albertson & Davidson.  In this video, I want to discuss whether the successor trustee of a trust has an obligation to declare the trust settlor incompetent.

Let me explain some of those terms before we get started. The settlor is the person who creates the trust. Typically, when people create these revocable living trusts, they’re the settlor, the creator, and the are also the trustee during their lifetime, so they manage those trust assets.  Somebody is usually named the successor trustee for when the original trustee either loses capacity or dies.

The question is: if you are named as a successor trustee, and you’re seeing the trust settlor is fading and losing capacity, is there an obligation to step in and take action?  This usually happens within families. For example: your father creates a trust, he’s the trustee, and you’re one of three children and named as the successor trustee. You can see that Dad is fading, and starting to lose capacity, and that he is having a hard time managing the finances.  Do you, as a successor trustee, have an obligation to step in and take action?

The interesting thing is that from a legal perspective, you don’t have any legal obligation to step in. A successor trustee doesn’t have any duties, responsibilities, or obligations until they agree to act as trustee.

But, then there’s the moral obligation.  You know that if the trustee can’t manage finances, he going to cause harm to himself because his finances won’t be properly managed, and he’s also going to cause harm to the other trust beneficiaries receiving these assets after he passes away.  And from that perspective, maybe you do have a moral obligation to step in.

The good news: that most trusts usually have a section that tells you what you need to do to have the settlor deemed incompetent. Once you do those things, the settlor is no longer trustee and the successor can step in and start acting.

Many trust documents say you need a letter or declaration from at least one or two treating physicians.  And that’s all you need.  Once you have that letter from the doctor deeming the settlor incompetent, the successor trustee can step into place.  It’s just that simple.  You don’t have to go to court to get an incapacity declaration or a conservatorship. Just follow the steps in the trust.

If your trust doesn’t have instructions on how to have the trustee declared incapacitated, then you do have to go to court.  This is harder and can be a problem.  However, I estimate 90% of trusts have instructions on how to handle the settlor’s incapacity.

So, take a look at your trust. See what it says, and follow those steps. Then, the successor trustee can step in, control and properly manage the assets, and make sure that the trust is stable moving forward.

A Trustee’s duty to manage Trust assets is very different from how you are allowed to manage your own individual assets.  This is America, you can manage your own finances any way you please.  You can be risky and invest big, you can be conservative and invest small, or you can hide your money in your mattress if you like.Losing Money.jpg

But Trustee’s don’t have this freedom of investing.  In California, Trustees are required by law to follow the Prudent Investor Rule, which puts a whole host of rules on investing Trust assets.  For example, Probate Code Section 16047(a) specifically requires a Trustee to invest and manage Trust assets “as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust.”  The Trustee must use reasonable skill, care, and caution in making these decisions.  Skill, care and caution (especially caution) are attributes rarely exhibited by individual Trustees.

Furthermore, the investment decisions must have risk and return objectives reasonably suited to the trust—not the Trustee individually, but the Trust as a whole.  Some of the circumstances that the Trustee must consider include (See Probate Code Section 16047(c)):

  • General economic conditions,
  • The possible effect of inflation and deflation
  • The expected tax consequences of investment decisions or strategies
  • The role that each investment or course of action plays within the overall trust portfolio
  • The expected total return from income and the appreciation of capital
  • Other resources of the beneficiaries known to the Trustee as determined from information provided by the beneficiaries
  • Needs for liquidity, regularity of income, and preservation or appreciation of capital

If you really think about this list of circumstances you will find that most of the criteria is geared towards the needs of the beneficiaries.  Trying to make money is fine, but it cannot outweigh other important factors, such as the need to preserve capital, generate income, and provide liquidity for upcoming Trust requirements—like distributions.  Notice the difference between this list of Trustee investing versus your own personal investments?  As an individual you can focus on just one goal if you like—such as capital appreciation—and you can ignore the other factors.  If you don’t want to focus on income, or capital preservation, you don’t have to.  But Trustee’s don’t have that luxury, they MUST consider all of the factors all of the time.

There are times when I hear people compare Trusts to businesses.  That is a dangerous (and very misapplied) analogy.  Businesses are allowed to risk capital for profit.  If a business risks capital and looses it, then we say “that’s business.”  Businesses operate under the “business judgment rule,” which is a very liberal standard that allows a business to take all sorts of risk without being held liable for those decisions. 

Trusts on the other hand have no such luxury.  Trustees are not allowed to risk capital for profit—in fact that is specifically precluded.  Instead, a Trustee’s investments must be much more calculated and planned out.  Trustee’s must look at the needs of the beneficiaries, the overall purposes of the Trust, and weigh any investment risk against the need to produce income and preserve capital.  In fact, capital preservation is the single biggest differences between Trusts and businesses—businesses can risk capital, Trusts must preserve capital whenever possible. 

If you are an individual Trustee and you think you can invest however you like, or you think you can invest as your parents did when they were alive, you are flat wrong.  This is the biggest single mistake individual Trustees make, and it can be a very costly mistake.  As a Trustee, you have many duties when it comes to investing.  You would be well advised to (1) learn those duties, and (2) follow them as much as possible. 

If you are a beneficiary dealing with an individual Trustee who does not know the Prudent Investor Rule, watch out!  Your Trust fund may be at serious risk of loss.  The Prudent Investor Rule is there to protect you, but it does no good if the Trustee does not know and follow the mandates of the Rule.

It is shocking to me how many Trustees violate their fiduciary duties.  Under California Probate Code Section 16000 et seq. there are voluminous sections on all the duties, responsibilities, and liabilities Trustees must comply with to property administrate a Trust.  There are rules on just about every action a Trustee must take, and on actions the Trustee must NOT take, from proper investing (under the Uniform Prudent Investor Act ), to allocation of items between income and principal, to every other action or inaction required of a Trustee.  Yet, so often these many duties and responsibilities are simply ignored, or worse, not known by the individual trustees. 

And when a Trustee violates his duty, and if that violation is challenged in Court, it is the Trustee’s burden to prove that he met the standards required of him under the California Probate Code.  This is why being a Trustee is a thankless job.

But why do so many Trustees get it wrong?  The biggest problem is lack of knowledge. Many individuals acting as Trustees have no idea that they have a boat-load of requirements to follow under the Probate Code, and likely under the Trust document.  They have never been educated, advised, or inquired about their duties at all.  It seems shocking just how many people willingly assume the many duties as Trustee, but have no idea what those duties are. 

A common misconception is that the person acting as Trustee is in control and can do whatever he likes, even continuing to own and invest the way the Trust creator (called a Settlor) did prior to his death.  Not so.  A Trustee cannot do whatever he likes and he cannot continue to invest or even hold assets that the Settlor acquired during life.  This is because the duties of investing for a Trustee are vastly different from those allowed by individual Settlors who created the Trust in the first place.

As a Settlor, the person is entitled to invest however they like (this assumes we are discussing a typical revocable living trust used in estate planning).  The only duties a Settlor has is to herself.  She does not hold assets for anyone other than herself and the Probate Code says she only is responsible to herself.  But once the Trustee passes and a successor Trustee takes over, the ground rules change substantially. 

For example, an individual Settlor has no duty to diversify assets.  She can hold 100% of the Trust assets in a single asset class (such as real estate), or even in a single stock (i.e. Enron) if she likes.  But when a successor Trustee takes over, a duty to diversify the Trust assets comes into effect.  That means the new Trustee must take immediate action to sell a portion of the Trust assets and diversify those investments as required by the Probate Code—there is no leeway here.  Assets MUST be diversified by Trustees!

If I had to guess how many private, individual Trustees are in breach of trust (this does not include professional fiduciaries or corporate fiduciaries), I would say from 80% to 90% of them.  Sounds extreme?  Maybe, but my experience with individual Trustees would suggest that 100% of them are in breach of trust as to at least some aspect of their duties. 

So when you are asked to act as Trustee of a California Trust, the first thing you should do is find out what duties and responsibilities you have.  You’ll be glad you did because it will be up to you alone to prove you complied with those duties.  And it’s much easier to comply with duties you know about than duties you don’t.