Second, a trustee clearly has added protection when a disinterested party reviews an insurance replacement transaction. In this case, the client’s lawyer had a particular expertise in evaluating life insurance products, undertook an extensive analysis of the proposed replacement and documented his findings in a detailed memorandum.

Third, always ask yourself – is the proposed replacement based on a rational process which serves the best interests of the trust? The trust in this case had substantial non-insurance assets and would not likely ever need the policy cash values for the beneficiaries. Also, the trust beneficiaries had substantial personal assets after the family business was sold.

Finally, always freely disclose any potential conflicts of interest.”

LISI has provided members with significant commentary through the years dealing with the suitability of trust-owned life insurance. Now, Lee Slavutin provides members with his analysis of a fascinating case that contains some very important lessons for insurance processionals, attorneys and trust officers who are asked to opine on “annual policy reviews” where the suitability of a particular life insurance product is on the table.

Lee J. Slavutin, MD, CLU is a principal in Stern Slavutin 2, Inc., an insurance and estate planning firm in New York.  He graduated from Monash University Medical School in Melbourne, Australia in 1974 and became a Fellow of the Royal College of Pathologists of Australia and a Diplomat of the American Board of Pathology in 1981.  Dr. Slavutin left the practice of medicine in 1982 and entered the life insurance business in 1983.  He is a member of the Association of Advanced Life Underwriting and the Million Dollar Round Table and is a Chartered Life Underwriter with the American College.  Dr. Slavutin has published over 160 articles on insurance and estate planning topics for CCH, Warren Gorham and Lamont, Practitioners Publishing Company (PPC), New York Law Journal and others.

He is a member of the CCH Estate and Financial Planning Advisory Board, and the Tax Advisory Panels of PPC and Tax Hotline.  He is the Author of “PPC’s Guide to Life Insurance Strategies”, 13th edition (2011), published by Thomson Reuters. Dr. Slavutin has spoken before the American Law Institute/American Bar Association, the New York County Lawyers’ Association, the American Institute of Certified Public Accountants (CPAs), the New Jersey State Society of CPAs, the Association of Advanced Life Underwriting, the Million Dollar Round Table, and the UJA-Federation Annual Tax and Estate Planning Conference, as well as many New York accounting and law firms.  He was invited to testify before the New York State Senate on the effectiveness of the insurance rating firms and worked with the U.S. General Accounting Office on a similar project.  He is married to Dee and they have two children, Aaron and Lydia.

Here is Lee’s commentary:

EXECUTIVE SUMMARY:

In this case, Wachovia Bank National Association (WBNA) acted as trustee for the James French Trust. French’s children, the beneficiaries of the trust, claimed that WBNA breached its fiduciary duties by exchanging two whole life policies for two no lapse guaranteed universal life (GUL) policies, through its affiliate, Wachovia Insurance Services (WIS).

The beneficiaries sought to obtain lost cash value of the surrendered policies and the commissions earned by WIS. WBNA was vindicated and granted summary judgment. Another fiduciary ILIT case, Cochran v. KeyBank, was reported in LISI Estate Planning Newsletters 1486 (Patrick Lannon & Barry Flagg) and 1499 (Barry D. Flagg and Patti S. Spencer). This case has some very practical take-home lessons for trustees, life insurance advisors and attorneys.

FACTS:

James French founded the J. L. French Company in 1968. JL French is a global manufacturer of high pressure aluminum die casting for the transportation industry.

Jim French created two irrevocable trusts in 1991: Trusts 1 and 2. Trust 1 held life insurance policies and more than $5 million of assets. The beneficiaries of the trusts were Jim’s four children. French gifted stock in the company to his children. The company was sold in 1996 for approximately $200 million. The children received more than $17 million each.

Trust 1 held two life insurance policies with Pacific Life and Prudential. Each policy provided $5 million of coverage. The premium for the Prudential second-to-die whole life policy was scheduled to increase by $40,000 to maintain its death benefit. The policies had a combined cash value of $2.2 million.

In 2004, the French family was looking to replace the Northern Trust Company as trustee and was introduced to WBNA by one of the French children who was active in investment management for the family. French asked WBNA to investigate the insurance policies held in Trust 1. WBNA enlisted the help of an insurance broker with WIS.

The insurance review process started in May 2004 and continued off and on until May 2005 when the 1035 exchange for the new policies was completed. Here are the salient features of the insurance review:

• The WIS insurance broker reviewed the two existing policies and WBNA introduced the notion that Jim French could lower premiums and receive guaranteed death benefits, “pointing out, however, the condition that the Trust is not dependent on the cash surrender value.”
• WIS examined a number of different options for the existing policies and proposed replacing the two policies with two GUL policies from John Hancock that had the same death benefit, but lower guaranteed premiums.
• The French family was represented by the law firm of Quarles & Brady. John Bannen, a partner in the firm, reviewed the WIS insurance proposal. Bannen was also a Chartered Life Underwriter and had written and presented on the subject of GUL policies more than eight times in 2004 and 2005. Bannen highlighted for French the two main disadvantages of GUL policies, namely, the low cash values and lack of flexibility. Bannen described a GUL policy as a “trade off” of flexibility for certainty. He made it clear that it would be a mistake to buy GUL if the client was interested in cash value accumulation.
• Bannen compared the Prudential and Pacific Life policies with the potential replacement policies from John Hancock, “showing the replacement policies’ superior rates of return calculations and their diminishing impact on cash value over time.”
• After reviewing Bannen’s memorandum, French agreed to take the John Hancock policy applications.
• WBNA advised French that a conflict waiver would be necessary because its affiliate, WIS, would earn commissions if the new policies were purchased by the trust. French was upset by this request and WBNA withdrew it.
• French’s lawyers asked for a rebate of insurance commissions to the trust and a reduction in trustee fees. Both requests were denied by WBNA.
• On May 27, 2005, the 1035 exchange of the policies was completed. French was “very dissatisfied with the last minute difficulties, specifically the request for the waiver…”
• In November 2005, the Frenchs challenged the 1035 exchange. It was too late to reverse the transaction. It is not clear from the published opinion what prompted this challenge, especially after the thorough analysis of the insurance transaction by the family’s lawyers.
• The Frenchs claimed that the 1035 exchange caused the trust to lose $846,000 in cash value.

The Court looked at three issues: duty of loyalty and self dealing, good faith and the prudent investor rule.

The Frenchs claimed that the 1035 exchange was a self-dealing transaction because it resulted in a $512,000 commission for WBNA’s affiliate, WIS. The Court pointed out that when the fiduciary is a trustee, the tasks that the trustee agrees to undertake are set out in a trust agreement. The French trust provided “without limiting powers incidental to the purposes of the trust or otherwise existing by law, the trustees and all successors shall have, without approval of any court, the power…to continue as trustee and to deal with any trust hereunder without regard to conflicts of interest…”  The Court concluded that the specific authority to self deal controls over the general obligation to act as a fiduciary.

Having found that WBNA was authorized to act in a self-interested transaction, the Court then had to analyze whether the transaction was executed in good faith. A self interested transaction does not preclude the possibility that it was undertaken in the best interests of the trust. The Court pointed out that:

• WBNA engaged in a lengthy analysis of the transaction before executing the exchange.
• The conflict was freely disclosed to French. French knew WIS would earn a commission and his lawyers requested a rebate of commission and a reduction in fees.
• The entire premise of the exchange was the immediate loss of cash value in favor of lower premiums and a guaranteed death benefit.
• “The undisputed facts reflect that WBNA acted in the best interests of the trust, not that it pursued the exchange just for the commission.”

The Court then turned to the Prudent Investor Rule:

• The Frenchs claimed they preferred the flexibility of accumulated cash value afforded by the original policies.
• The trust had over $5 million of other assets and so cash value did not appear to be a major concern at the time of the exchange.
• The Frenchs’ own attorney recognized that GUL policies have a place in the diversified portfolio of a trust.
• The beneficiaries of the trust had significant other assets and it was unlikely that economic circumstances would force surrender of the Hancock policies before the death of the insured. The policies were designed to provide a superior rate of return at death, not at surrender.
• The Court concluded that the 1035 exchange was a prudent investment of the trust.

COMMENT:

ILIT trustees and life insurance advisors can take home a few key lessons from this case:

• Disclose and document the disadvantages or downsides of any insurance recommendation.

o     Bannen’s memorandum describing the low cash values and inflexibility of GUL made it almost impossible for French to claim that he did not understand exactly what he was buying.

• A trustee clearly has added protection when a disinterested party reviews an insurance replacement transaction.

o     In the Cochran case, KeyBank retained an independent insurance consultant to review the proposed replacement before moving forward.

o     In the French case, the client’s lawyer had a particular expertise in evaluating life insurance products, undertook an extensive analysis of the proposed replacement and documented his findings in a detailed memorandum.

• Always ask yourself – is the proposed replacement based on a rational process which serves the best interests of the trust?

o    The French trust had substantial non-insurance assets and would not likely ever need the policy cash values for the beneficiaries.

o    The trust beneficiaries had substantial personal assets after the family business was sold.

o    The GUL policies had superior rates of return at death and became an attractive investment in the trust’s portfolio.

• Always freely disclose any potential conflicts of interest.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

 Lee Slavutin

CITE AS:

LISI Estate Planning Newsletter #1960, (May 15, 2012) at http://www.leimbergservices.com/ Copyright 2012 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission

CITES:

French v. Wachovia Bank, N.A., 2011 U.S. Dist. LEXIS 72808 (E.D. Wisconsin 2011); In re Stuart Cochran Irrevocable Trust, 901 N.E.2d 1128 (Indiana Court of Appeals, March 2, 2009).