A non-fiduciary who knowingly participated in trustees’ violations of duty was liable for damages in a recent Delaware court ruling
Reproduced with permission of Trusts & Estates magazine (January 2011)
A recent Delaware court decision is making waves in the trusts-and-estates community. In Paradee v. Paradee,1 a trustee was held liable for breach of the fiduciary duty of loyalty for actions he took in reliance on legal counsel. Stranger still, a non-trustee was held jointly and severally liable for this breach. At first glance, Paradee seems to signal that the scope of fiduciary liability is expanding.
A closer look, however, shows that Paradee’s novelty comes not from new law but from its strange facts. The law is clear that getting and following legal advice on how trustees can act won’t protect them from liability for violating how they should act. And, though practitioners are perhaps less familiar with the idea that non-fiduciaries might be on the hook for a fiduciary’s breach, the court’s decision rests on a well established principle of law: One who knowingly participates in a breach of duty assumes liability for resulting damages. Paradee is an important case not because it changes the legal terrain, but because it sheds light on parts of the existing landscape that are rarely navigated. It deserves a look to see what kind of fact pattern led to such an unusual result.
The Wicked Step-Grandmother
In 1978, Charles Paradee, Sr. married Eleanor Clement. His first wife had died the year before. The marriage estranged Charles, Sr. from his son, but he remained close to his grandson, Charles III (Trey). In 1989, when Trey was 20,2 Charles set up an irrevocable trust for him, funded first with cash and then with a second-to-die life insurance policy on himself and Eleanor. The initial trustee was Ronald Sterling, an insurance agent who had a longstanding business relationship with the Paradees.
Though Charles survived until 1998, his mental faculties diminished throughout the 1990s, and Eleanor exercised increasing control over their finances. She used that control to repeatedly direct Ronald to revoke the trust and give her its cash value. Advised that “irrevocable” means just that, Eleanor came up with a different plan: She told Ronald to take out a cash loan against the value of the trust’s life insurance policy (the policy loan) and loan that cash to a corporation founded by Charles, Sr. (the trust loan). Given Eleanor’s involvement with Charles’ financial affairs, the trust loan was presumably within her control. Understandably nervous, Ronald sought legal advice and learned that he was “authorize[d] … to make loans with adequate security and at a reasonable rate of return.”3 Unfortunately, he seemed to have stopped reading after the word “authorized.” He made the trust loan without security and on more favorable terms than he had received for the policy loan.
Even though she effectively transferred the trust’s value to herself, Eleanor kept trying to revoke the trust. She also instructed Ronald to surrender the insurance policy that funded the trust for its cash value. Ronald didn’t comply, but his loyalty to Charles, Sr. and Eleanor kept interfering with his duties. In 1999, Trey turned 30, and by the terms of the trust, had the power to appoint himself trustee. Ronald never told him this — in fact, Ronald never told him about the trust at all! He reported only to Charles, Sr. and Eleanor.
Ronald’s disloyalty and Eleanor’s scheming cost Trey dearly later that year, when the company holding the insurance policy demutualized and issued a stock split. Although eligible policyholders got a number of shares in the new company, those shares were based on policy value, and the trust’s policy was devalued considerably by the policy loan. As a result, the trust got a lot less than it would have if the loan hadn’t been made.
Practicing What She Breaches
The bad news continued for Trey in 2003, when Ronald died. Rather than tell him about the trust, Eleanor appointed herself trustee. By that time, her indifference to Trey’s interests had hardened into outright hostility. Given her prior actions, described by the court as “vindictive” and “vengeful,” the source of her anger is ironic: Trey had tried to protect her from a stockbroker he suspected was a fraud. Though he backed his assertions up with a lot of research, Eleanor concluded he just wanted to seize her assets himself. She even warned folks at a fundraiser they both attended that Trey was a swindler.
Unsurprisingly, Eleanor wasn’t a faithful trustee. She stopped making payments on both the trust loan and the policy loan, causing the policy that funded Trey’s trust to lapse. She then resigned as trustee and appointed her longtime handyman — whom she’d adopted as her son — in her stead. Though she’d long known Trey had the right to be trustee himself, she continued to keep the trust secret.
One More Into the Breach
The new handyman-cum-trustee, William Smith, Sr., was “straightforward and honest,”4 but not financially sophisticated. For a long time, he thought the trust was just one of Eleanor’s accounts and treated it as she directed. It took him two years to understand Trey’s beneficiary status, prompting him to ask Eleanor’s lawyer what to do. Her “tortoise-like” response took another two years, delayed for reasons “no one could explain.” Trey was finally told about the trust in 2009, 20 years after it was formed and 10 years after he had the right to become trustee himself. He immediately appointed himself trustee and demanded payment on the trust loan. By this time, Ronald, Eleanor and William, Sr. had cost the trust dearly through their mismanagement. The court ruled that all three had breached their duty of loyalty to Trey — and Eleanor was found jointly and severally liable for the damages wrought by Ronald and William, Sr.’s misdeeds.
Though Eleanor’s liability has raised eyebrows, there’s nothing novel in the holding. As the court noted, “‘[I]t is bedrock law that the conduct of one who knowingly joins with a fiduciary ... in breaching a fiduciary obligation, is equally culpable [for resulting damages].’”5 Nor is liability for knowing participation in a breach some quirk of Delaware law: it’s been dealt with extensively in treatises and law reviews,6 and is found in common law jurisdictions the world over.7 Eleanor’s repeated attempts to revoke the trust, and her successful campaign to access the cash on terms that favored her over Trey, conclusively established her knowing participation in the other trustees’ breaches. Though it may be rare to hold non-fiduciaries liable for breach of loyalty, on these facts it was inevitable.
Ronald’s liability is also worthy of comment, only because it reaffirms a point that practitioners would do well to keep in mind. Some trustees will believe, as Ronald apparently did, that seeking legal advice is a dispositive defense to a fiduciary breach. It’s not.8 Practitioners should remind trustees that their acts or omissions have to be more than legally permissible — they have to be motivated solely by a desire to act in the beneficiary’s best interests. The trust and policy loans were transparently made to please Charles, Sr. and Eleanor. By acting for them rather than for Trey, Ronald breached the duty of loyalty — and, the court suggested, could well have been liable for any damages even if he had structured the policy loan the way his lawyer told him to.9
"99 Problems (But Breach Ain't One)"
Trusts can be tricky to administer at the best of times. Steering clients away from breaching their duties of loyalty and care will save them a heap of trouble in an already difficult task. To that end, Paradee highlights an important point that’s easy to forget: Although the trust concept is perfectly natural to practitioners, it’s not an intuitive arrangement to the layman. Both Ronald and William, Sr. thought that their obligation was to the party who handed them the assets; Eleanor thought she could exercise control because the assets were hers (and Charles, Sr.’s) to begin with. Practitioners need to explain clearly, even repeatedly, to grantors and trustees alike that trust assets are for the sole benefit of the beneficiaries, and “legally permissible” actions will still create liability if they’re taken with anyone else’s interests in mind. This is especially important with clients who aren’t used to acting as trustees, and have strong ties to the grantor. The oft-forgotten tort of knowing participation creates another hazard. Eleanor’s behavior was extreme, but plenty more common scenarios could throw liability on third parties for knowing participation. For example, a bank permitting a deposit or withdrawal by a fiduciary — whether he is a trustee, a corporate officer or an agent — may be liable if it knows the transaction facilitates a breach of duty. While there’s no affirmative duty to seek out knowledge of a breach, clients dealing with fiduciaries should flag any signs of wrongdoing before finishing up their transactions, to avoid imputation of constructive knowledge. Paradee reminds us that the issues swirling around fiduciary duties, and the liabilities they entail, can be more complicated and expansive than we think.
1 Paradee v. Paradee, C.A. 4988-VCL (Del. Ch. Oct. 5, 2010) (Mem. Op.).
2 Though the opinion said that Trey was nine when the trust was formed, it also said the trust was formed in December 1989, Trey was born July 1969, and he turned 30 in 1999. See ibid.
If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:
Samatha E. Weissbluth
Simon N. Johnson