Modern Directed Trust Language

In the more than 35 years since the formal recognition of the “directed trust” under Delaware statutory law there have been many lessons learned. As with anything, these lessons have been learned through the process of trial and error, learning what powers and actions are presumed to flow together, and what must be explicitly outlined to ensure a more comprehensive understanding amongst all parties to the trust. This modern language also reflects the need to ensure the regular exchange of information amongst fiduciaries to ensure the accuracy of the trust record and enable all to perform their duties for the maximum benefit of the beneficiaries. Bringing this information together, there are three key areas of concern addressed by modern directed trust, including (1) administrative matters addressing the bifurcated responsibilities, (2) closely held entity management, and (3) the clear application of conflicts of law. 

This article endeavors to provide insights into what additional language should be included in the modern directed trusts to ensure a smooth trust administration and improve the overall directed trust experience.

Administrative Matters

Traditional Bifurcation of Duties

There are several language requirements that have been in directed trusts since the beginning. The first is language which addresses the bifurcation of duties amongst the fiduciaries which typically includes a statement regarding when and how a directed trust may act. The best language will simply state that the directed trustee can act only upon the written direction of the adviser where that adviser has been given sole discretionary decisional authority. This is typically coupled with language indicating that the directed trustee has no duty to seek a direction from the adviser or take any action without that written direction. This language creates a dependency on the adviser’s direction prior to taking any action in the designated area of authority, preventing the trustee from acting independently.

In addition, classic bifurcation language expressly states that a directed trustee shall not have any duty to monitor the adviser’s performance, nor to communicate or warn beneficiaries or third parties regarding a decision of the adviser with which it (the trustee) disagrees with or would have chosen to exercise in a different manner if it had the authority to act alone. Without this language, a trustee would be hesitant to simply follow the adviser’s direction without substituting its own judgment. With the goal of engaging specialists in each key area of trust administration, this language allows each fiduciary to stay in their lane and focus on their specific area of expertise.

Finally, traditional directed trustee language utilizes a modified liability standard for all actions taken at the direction of a third party. In Delaware, as well as under the Uniform Directed Trust Act, that standard is willful misconduct.

Lending and Guarantees

Loans, guarantees and borrowings are an area that has proven to be somewhat complicated in bifurcated trusts. Actions taken to make loans and guarantees can be considered investment decisions, non-investment decisions, or both. By way of example, a trust can engage in lending funds to its underlying entities, third parties, and even to its own beneficiaries. There are differing considerations for each of these types of loans. Adding specific language allocating authority amongst these areas can ease administrative tensions and assist the fiduciaries in determining who has ultimate authority and responsibility as to each. Good language will specifically indicate who has the authority to direct the trustee to:

• Borrow and lend money and to guarantee the repayment of any indebtedness, for such periods of time and upon such terms and conditions as to rates, maturities, renewals and securities it deems appropriate;
• Lend money to beneficiaries on such terms and conditions as Adviser determines to be reasonable; and
• Lend money to beneficiaries for the purpose of starting a business, provided the Adviser reasonably determines that such business has a reasonable probability of success and full repayment of the loan is expected.

Administrative Presumption

A directed trustee will often have the power to approve the additions of property to the trust to ensure that no assets are added to the trust that are in conflict with a corporate trustee’s internal policies. An example of this type of investment is the purchase of a cannabis or cannabis-related business, which, while permissible in many states, remains illegal at the federal level. While a directed trustee does not have the authority to make investment decisions, it may be required to decline the investment. It is important in these instances that the trust include language making it clear that any such review by a corporate trustee is for administrative purposes rather than investment soundness, to ensure that all parties to the trust understand the nature of the review and action to decline the addition of the particular asset. An example of this language might be a statement confirming that “any such reviews shall be deemed administrative in nature and not related to any investment decision.” 

This language can prove useful as it relates more broadly to the trustee’s review of investment documentation. While the adviser may direct the trustee to purchase an asset, it is the directed trustee who reviews the investment documentation to determine if they contain accurate information about the trust and its related parties, contain reasonable standards, and properly allocate responsibility. Utilizing this administrative presumption language helps to ensure that all parties to the trust fully understand what the trustee is doing when reviewing documents and create accurate expectations.

Addressing the Absence of an Adviser to Direct

Key to the bifurcation of traditional trustee duties is the on-going existence of the various advisers. Over time, the need for this has become more clear as directed trustees are not always a part of a larger bank with investment capabilities.  While not intended, many trusts can leave a gap period where no adviser is serving. To prevent these, it is important to include language in the trust which gives the responsibility and authority of each adviser specifically to another fiduciary (other than the directed trustee) in the event of a gap period. An example of this language is included below:

However, should there ever be a time when no Investment Adviser has been appointed to direct the Trustee, the Trust Protector shall exercise all investment authority under the trust until such time as a successor Investment Advisor can be appointed.

Communication

Communication is perhaps the most important aspect of the directed trust. Utilizing multiple professionals from varying fields of specialty to do what a single trustee has done historically requires organization and a clear understanding amongst those advisers. One key area of concern specific to a directed trust is ensuring clear expectations as to the method by which information will be exchanged. From the format of the original direction letter, to the provision of on-going information regarding activity occurring between trust holdings and the trust, it is important that all parties understand (1) the method or format in which information must be communicated, (2) the specific information that is needed by all parties, and (3) the timing in which this information should be communicated. 

Section 3317 of Title 12 of the Delaware Code provides some guidance in this regard, emphasizing the duty to keep co-fiduciaries informed about the administration of the trust with respect to that fiduciary’s duty or function, to the extent that providing such information is reasonably necessary to perform their duties. For the directed trustee, all information affecting the trust and its assets are necessary to the performance of its duties, since one of its primary functions is that of recordkeeping. An example of language which sets expectations as to the form of communications is included below. It is important to note that it includes flexibility as to any “form as is acceptable to the Trustee” to allow for changes in technology and practice. 

Any direction to the Trustee shall be in writing, delivered by mail, courier, facsimile transmission, electronic mail, or otherwise in such form as is acceptable to the Trustee and to such address as the Trustee may specify from time to time by written instruction to the Adviser.

Entity Management

Directed trusts often utilize the creation of entities to hold varying types of assets in the trust while allowing managers to exercise direct management of the asset by serving as the manager or general partner of the entity. Over time, directed trustees have discovered that while this format works well for management of the investments, it can result in a lack of information at the trust level and unintended decision making remaining with the trustee. Language developments in this area can be broken down into three parts, (1) exercising of ownership rights, (2) financial reporting, and (3) valuation.

Exercising Ownership Rights

Without specific language in the trust instrument, it can be difficult to determine who retains the power to exercise the trust’s rights as owner of an underlying entity. For this reason, it is important to be clear that the adviser will be responsible for directing any current and future actions taken by the trust with regard to exercising ownership rights such as voting, electing officers and managers, and even dissolving the entity. A sample of this type of language is included below:

The directed trustee shall not take any action, render any advice or oversee or review any activities with respect to any partnership, LLC or other entity owned by the trust. The Investment Direction Adviser shall have the obligation to direct the trustee to as to all activities associated with the Trust owning an interest in the applicable entity.

As the owner of the asset, it may also be necessary to execute documents related to transactions involving the closely held entity and tax reporting for the entity. It is the responsibility of the adviser to be familiar with the activities of the entity, and aware of the accuracy of any representations, warranties, or covenants that the trust makes when executing documents related to the entity. Language which may be helpful includes:

The Investment Direction Adviser shall direct the Trustee with respect to making any representation, warranty or covenant required to be made in order to maintain any investment and to direct and instruct the Trustee on the future actions, if any, to be taken with respect to such representations, warranties and covenants. 

Financial Reporting

Directed trustees who serve in trusts holding closely held entities face several limitations with regard to entity information. The value and activity of the entity is needed for accounting purposes to ensure that transactions involving the trust are properly recorded in the trust’s accounting, tax purposes to ensure that the trust’s income tax filings are accurate, and beneficiary disclosure purposes to ensure that beneficiaries of the trust, or their designated representatives, are able to properly understand the current state of trust assets. Since the directed trustee does not have decision making authority over the trust assets, it can be difficult to obtain complete information absent the assistance of the adviser. 

Likewise, where there is specific information needed by the trustee for tax or other reporting purposes, it is the responsibility of the adviser to ensure that the trustee receives any and all needed documents and information from the entity. This is particularly important with wholly owned entities for which the trust retains filing and reporting responsibilities relative to income or foreign transactions.

Investment Adviser annually shall provide any corporate trustee with copies of financial statements for any entities that are held, directly or indirectly, by the trust and shall provide written advice to any corporate trustee of the fair market values, cost basis and acquisition dates for income tax purposes that should be assigned to any trust assets for which valuation information is not publicly available. The Investment Adviser shall also provide transactional information for any such entities that are needed by the corporate trustee for tax or other reporting purposes. 

Valuation

In addition to providing information regarding the transactions of various entities owned by the trust, Section 3313(d) of Title 12 of the Delaware Code establishes a basis for the adviser’s role in valuing non publicly traded investments. For this reason, it is prudent to include language within your trust instrument that fully reflects the responsibilities of the adviser in providing information to the directed trustee. Some sample language is included below:

Investment Direction Adviser shall have the duty to confirm to the Trustee, in writing, the value of trust assets at least annually and upon the request by the Trustee.

Conflicts of Law Concerns

The very nature of directed trusts requires that there be multiple fiduciaries acting in multiple locations. To ensure that any matters relating the administration of the trust are measured in reference to Delaware law and adjudicated in the Delaware Chancery Court, it is important to include specific language within the trust instrument addressing the settlor’s intent for the trust’s administration to apply Delaware law.

Governing Law

There are three aspects of governing law that are intentionally selected at the time the trust is created: validity, construction and administration. While validity and construction do not typically change, the law governing administration generally moves with the trustee. Directed trustees are typically located in an advantageous jurisdiction to specifically take advantage of its laws and court system. For this reason, the trust instrument should be specific as to what state’s laws will govern the administration of the trust. In addition, language should also address the settlor’s choice of situs for judicial purposes, such as: “any proceeding involving the Trust must be brought in the State of Delaware, in the Delaware Court of Chancery, for so long as the situs of the Trust shall be that State.”

Place of Administration

Many states have differing means of measuring where a trust’s place of administration will be found. This is particularly significant in the context of a directed trust, where multiple fiduciaries are taking actions which are part of the trust’s administration in multiple locations. To avoid a most significant contacts analysis or the application of a specific state’s laws, it is important to specifically indicate the settlor’s intent with regard to the law that will govern administration of the trust and the state that will be deemed the principal place of administration of the trust. 

Most typically, it is best to indicate that it is the state in which the corporate trustee is administering the trust to allow the shifting of the law upon any potential change of corporate trustee which is most often selected based upon its geographic location and the laws of that specific state.

Duty to Monitor Laws of Other States

In considering the mobility of the trust and the ever-changing landscape of trust law, most trust instruments include a provision to change the situs of the trust. The directed trustee is typically a professional trustee, it has often chosen to be located in an advantageous jurisdiction for a specific reason. It has intentionally tied itself to that jurisdiction and established expertise with regard to its laws and will not be an expert in the laws of other states. It is important to ensure that someone with a more global perspective has the responsibility of determining when it would be prudent to move a trust to a new situs. To that end, it is important also to incorporate language confirming that the directed trustee is not responsible for monitoring the laws of other states and determining if another state’s laws might be more advantageous with regard to a discreet benefit to the trust. 

The Trustee shall have no duty to monitor the laws of other jurisdictions in order to determine whether or not the powers to change the situs or the jurisdiction whose laws shall govern the administration of any trust hereunder should be exercised, and no Trustee shall have a duty to exercise such power nor, absent willful misconduct, any liability to any person for failure to exercise such power or failure to consider whether to exercise such power.

Conclusion

As directed trust law continues to evolve, so will the modern language. It is important to understand the intricacies of the directed trust relationship, see its strengths and weaknesses, and draft documents that both clearly define the bifurcated roles and encourage open communication amongst fiduciaries. It is then that the directed trust can be most successful.

Commonwealth Trust Company is pleased to provide this article as a guide. Commonwealth Trust Company is not engaged in the practice of law and is not providing legal advice by the provision of these materials. Commonwealth Trust Company recommends that clients seek the opinion of their attorney regarding the specific legal and tax issues addressed in this article.