“You Sold My Deceased Father’s Insurance Policy for How Much!?!”: Fiduciary & Professional Responsibility in Life Settlements and Life Insurance Portfolio Management David S. Neufeld, J.D., LL.M. (Taxation)1 609.919.0919 David@DavidNeufeldLaw.com I. New World of Life Insurance A. No longer only “buy and die” B. At least four options for every policy owner everyday they own a policy 1. Hold until death with out-of-pocket or cash value payments (a) do nothing (b) policy conversion (c) paid up reduced face (d) 1035 exchange 2. Lapse or surrender 3. Borrow cash to pay premiums (a) from family members (b) from beneficiaries (i) split dollar (c) from a bank or other commercial lender with outside collateral (d) from a specialized lender collateralized with death benefit (i) Legacy Loan; New York Life (ii) Analogous to a reverse mortgage 4. Sell to a third party (a) Active insurance portfolio management should be an ongoing process but often comes into focus only when a policy sale is contemplated (b) STOLI is not part of this equation (c) Brief description of STOLI (“stranger owned life insurance;” also called SOLI, SPINLIFE, IOLI) (i) There are many variations and some participants may take issue with one or more elements in any one definition. Stated most neutrally STOLI has the following characteristics (from J. Alan Jensen & Stephan R. Leimberg, Stranger-Owned Life Insurance: A Point/Counterpoint Discussion, 33 ACTEC J. 110 (2007)). o “An insured would purchase a disposable policy with the clear intent to sell it after the two-year contestability period expired. . . . The [insured] will be told that he will not expend any of his own funds because the agent has procured nonrecourse financing for the purchase of the insurance. The insured nominally will act as grantor of a life insurance trust that will apply for and own the policy. The loan and accrued interest © 2009 by David S. Neufeld. All Rights Reserved 1 Admitted to practice law in New Jersey and New York will be due in two years. At that time, the agent will tell the insured that, in all probability, the policy will be sold to investors for a price that will pay the loan and accrued interest, leaving a profit to split between the agent and the insured. . . . If the insured survives for two years, the owner (the life insurance trustee) typically has two options, in addition to sale of the policies to investors: (1) have the insured pay the outstanding debt with accrued interest and retain the policy; or (2) transfer the policy to the lender in lieu of foreclosure.” (d) How STOLI differs from: (i) “Traditional” premium financing: commercial or private lenders will finance the cost of insurance premiums and take a security interest in the policy by way of a collateral assignment; the policy cash value or death benefit will be used to re-pay the loan and accrued interest, but the remaining death benefits remain the property of the policy owner or beneficiaries, as the case may be. STOLI may involve financing but also typically involves the transfer of the policy to the lender or other party to the transaction, such that the investor/lender realizes all or most of the death benefit, even if that significantly exceeds the outstanding debt. Even if the STOLI loan putatively can be re-paid often the economics are such that repayment is a practical impossibility. Not so with true premium financing, universally recognized as legal and legitimate. (ii) “Traditional” life settlements: whether a life insurance policy is no longer needed (e.g. life circumstances have changed, policies funding corporate buy-sell arrangements are no longer relevant) or it is just more costly than the client is comfortable with, policy owners often decide that disposal of the policy is the prudent choice. In some cases (often where the insured is over 72 years old) an investor (often a bank or hedge fund) might consider it a wise investment to purchase the policy and incur the future premiums, and the seller will realize more than the cash value of the policy. In contrast to STOLI, this involves policies that were not acquired with the intent to sell them to third parties. State law and the courts all support the validity of this type of transaction. II. Our Story A. The Cast 1. Jerry, the widower family patriarch 2. Elaine, the ILIT Trustee (not a family member) 3. Jackie Chiles, the financial/accounting/legal advisor 4. Newman, the insurance professional 5. Kramer and George, the adult children B. The Storyline 1. Some years back, with the intent to keep the policy for its duration, Jerry arranged with Elaine, the ILIT Trustee, for Elaine to acquire a $5 million life insurance policy on Jerry, naming the Trust as owner and beneficiary of the policy and Kramer and George the trust beneficiaries. 2. Still in good health Jerry felt he had better things to do with his money than to continue to make gifts to the trust to pay for life insurance benefiting his “selfish, spoiled children.” Jerry heard about “life settlements” at the club and from Newman. 3. Jerry comes in to see Jackie Chiles to discuss this concept (starting the conversation with “I want to sell my policy”) and Jackie, Elaine and Newman end up helping negotiate a sale to sell the policy for $1 million. 4. Three months later Jerry gets hit by the proverbial bus. 5. The next day Kramer and George come to Jackie to find out what they need to do to collect the $5 million on the policy. To their shock they find out that the policy had been sold for $1 million. 6. It’s not too long before Kramer and George file a suit against Jackie, Elaine and Newman for $4 million and emotional distress. III. Fiduciary and Professional Obligations Once the Question Is Asked A. Ignoring the client is not acceptable advice 1. Knee jerk reactions such as “I don’t like these new fangled gadgets” or “they’re a bunch of crooks” is not advice 2. Hoping the client forgets the request is not advice 3. In this day and age these are acceptable and mainstream transactions and you need to be able to deal with them as with any other question from a client. B. What is your ethical duty? 1. Who is the client? (a) Is it Jerry, the insured and the person paying your bills? (i) The problem starts with the phrase “I want to sell my policy.” (b) Is it Elaine, the ILIT Trustee? (c) Is it Kramer and George, the trust beneficiaries? 2. What is your role? (a) Are you Elaine, the ILIT Trustee? (i) What are your fiduciary duties? o Duty of undivided loyalty: “A trustee shall administer the trust solely in the interests of the beneficiaries.” Uniform Trust Code (“UTC”) §802(a); Rest. 2d Trusts §170(1) • No loyalty owed to the settler; but a duty to follow the trust’s terms as established by the settlor. • “A trustee is under a duty to the beneficiary of the trust to administer the trust solely in the interest of the beneficiary. The trustee must exclude all self-interest, as well as the interest of a third party, in his administration of the trust solely for the benefit of the beneficiary.” Bogert on Trusts & Trustees, §543 • “Duty of loyalty issues often arise in connection with the settlor’s designation of the trustee. For example, . . . the settlor will name a friend or family member who is an officer of a company in which the settlor owns stock. In such cases, settlors should be advised to consider addressing in the terms of the trust how such conflicts are to be handled. Section 105 authorizes a settlor to override an otherwise applicable duty of loyalty in the terms of the trust.” Drafting Note to UTC §802(a) • “No breach of the duty of loyalty occurs if the transaction was authorized by the terms of the trust …” Note to UTC §802(b) • California: Cal. Prob. Code §16002; • Florida: Fla. Stat. Ann. §736.0802; • New Jersey: introduced SB 2221/A3496 (2008-2009 session) o Duties to make property productive and to diversify: “A trustee almost always has a duty to cause the trust property to produce income. The duty may be either express or implied. . . . Obviously the purpose of a trust may be such as not to require the trustee to obtain income from the trust property. . . . Thus it cannot be said that every trustee owes the beneficiary a duty to make the trust property productive. All trustees owe to the trust beneficiaries a duty to bring to the beneficiaries the benefits of the trust in the way prescribed by the settlor.” Bogert on Trusts & Trustees §611 citing the Uniform Prudent Investor Rule (“UPIA”). • California: Cal. Prob. Code §16045 et seq; • Florida: Fla. Stat. Ann. §518.11 et seq; • New Jersey: N.J.S.A. 3B:20-11.1 et seq. (ii) Does/should the Uniform Prudent Investor Act apply? Is life insurance just another asset class? o Normally UPIA would not apply to a typical ILIT where the stated purpose is to hold a policy until death and sale of the policy is not permitted or addressed in the trust instrument. • Continuing scrutiny of the policies, however, is mandated to be certain that the policies and premium structure continue to be appropriate to changing facts year to year, even in the absence of UPIA application. • But when the trust instrument authorizes a sale (authorization to sell is a necessary predicate; if a sale is not authorized, the trustee would likely be prohibited from entertaining one) then it would seem that it is implied within the instrument that the trustee has the ongoing duty not only to manage the insurance portfolio with respect to alternative insurance policies but also to weigh the relative value of a sale compared to keeping the policy. This duty is continuous and does not arise only when the settler suggests it. . If portfolio management is imperative and insurance can be parceled into the various asset classes (i.e. a whole life policy equals fixed income securities) would a version of modern portfolio theory be the guide? See Weber & Hause, “Life Insurance as an Asset Class: A Value-added Component of an Asset Allocation,” a white paper published by Ethical Edge Insurance Solutions, LLC. • Care must be taken in drafting the trust (See Klein, “Duty to Diversify,” New York Law J., September 22, 2008.) . Precatory language (“I wish that the trustee will retain the policy even if a sale may be appropriate”) might not be sufficient to shelter all trustee decisions if in fact the decision to not sell is deemed unreasonable. See, e.g. In Re Charles G. Dumont, 791 NYS2d 868 (2004), rev’d in part, 809 NYS2d 360 (App. Div. 4th Dept. 2006), appeal denied, 813 NYS2d 689 (App. Div. 4th Dept. 2006), appeal denied, appeal dismissed, 855 N.E.2d 1167 (2006). . Nor might exculpatory language protect the trustee. See, e.g., Estate of Allister, 545 NYS2d 483 (1989). (iii) Bottom line: o For a sale of a policy to be contemplated the trust instrument must permit it. o The trust instrument should delimit the scope of what is meant by the duty of loyalty to make it clear that selling a policy rather than holding it is within the exercise of the trustee’s duty even if that means that it reduces the beneficiary’s actual amount realized. Otherwise, it may be unclear that a policy sale can ever be beneficial to a beneficiary notwithstanding the settlor’s subsequently developed convictions. o The trust instrument should delimit the scope of the prudent investor rule to permit a trustee to retain a policy even when a sale is within his powers and a sale may be the prudent investment action. Invoking Delaware trust law and delegating investment decisions may be recommended as well. o The trustee should have copious documentation based on objective analysis supporting his conclusion to sell or not to sell. (b) Are you Jackie Chiles, the attorney/accountant? (i) What are your ethical duties as a lawyer? o A lawyer must represent a client with reasonable diligence and with competence. ABA Model Rule of Professional Conduct, Rules 1.2 and 1.3 o Conflicts of interest (ABA Model Rules 1.7 and 1.8(f)) • A lawyer may not represent two clients with a conflict of interest; that is where the representation of one client is directly adverse to the interest of another client. • A lawyer shall not generally accept compensation for representing a client from one other than the client • Some conflicts may be waivable by the client • “In estate administration, the identity of the client may be unclear under the law of a particular jurisdiction. Under one view, the client is the fiduciary; under another view the client is the estate or trust, including the beneficiairies.” Note 27. (ii) What are your ethical duties as an accountant (CPA or EA)? o Conflicts of interest • “Members often serve multiple interests in many different capacities and must demonstrate their objectivity in varying circumstances. . . Regardless of service or capacity, members should protect the integrity of their work, maintain objectivity, and avoid and subordination of their judgment.” AICPA ET Section 55, Article IV.02 • “Members and Associates will demonstrate honesty, integrity and objectivity in all of their professional actions and relationships.” NAEA Code of Ethics #2 • “Members will not represent conflicting interests without express written consent . . . .: NAEA Rules of Professional Conduct #5 (iii) What if the policy owner, the insured and the policy beneficiaries are all one? (iv) What if the policy owner hired you and the owner, the insured and policy beneficiaries are all different? (v) What if the settlor (Jerry) hired you but the policy owner is an ILIT Trustee (Elaine) and the beneficiaries are the adult settlor’s children (Kramer and George)? o If you are asked to represent the trustee in the sale do you need separate engagement letters? o Is this an inherent conflict of interest? o Is it waivable? (vi) Bottom line: o If the settlor retains your services and pays you, you represent his interests. o You do not represent the trustee. o If you take on the trustee as a client then you must help him meet his obligations to the beneficiaries within the terms of the trust. o When it comes to selling or keeping a policy these obligation may be in conflict with the wishes of the settlor (even acknowledging that it is not “his” policy and the sale proceeds remain in the trust for the beneficiaries). o While it may be waivable, it might be wiser to have trust language that more closely align the interests of the settlor with that of the beneficiaries when it comes to deciding whether to sell or not. (c) Are you Newman, the insurance producer? (i) “Inherent in [the role of liaison between the purchasers and suppliers of insurance] is the combination of professional duty to the client and to the company as well. Ethical balance is required . . . .” (NAIFA Code of Ethics) (ii) Society of Financial Service Professional and MDRT, among others, also have rules governing professional conduct and ethics (iii) I have found no major organization representing insurance producers that has rules specific to life settlements and representing differing interests. (iv) What if Newman is a captive agent? o Insurance company or insured or owner? 2 For an excellent explanation of this process and its rationale see Leimberg, et al, “Life Settlements: Know When to Hold and Know When to Fold,” 62 J. Fin. Serv. Prof. 61 (Sept. 2008). o Where does this leave insurance agents prohibited from discussing settlements with clients? (v) What if Newman is an independent broker? IV. The Overarching Standard A. Once you determine your role, your client and your duty to that client you must provide—and you need to be able to demonstrate that you provided—the best advice based on objective analysis B. This protects your clients so that they know that whatever decision they make based on the options available to them is grounded in the best information they can get. AND C. This protects you if and when Kramer’s and George’s case reaches the judge and jury. 1. Proof that you used the best analytical tools available 2. Well documented file V. The Analysis2 A. Step 1: Conceptual Analysis 1. Will the client benefit from a settlement? (a) Who is the client? (b) What was the client’s original need? (c) Does the client still need insurance? (d) Is the client unable to continue paying premiums? (e) Might the client need insurance in the future? 2. Does the client fully understand the transaction? (a) The client will receive immediate funds that may be taxable (b) A stranger (typically an investment fund) will own the policy (c) Someone will need to check on him/her regularly (d) Reduced insurance capacity B. Step 2: Financial Analysis 1. Will the client realize more from the sale than the beneficiaries will receive from policy maturity? 2. Compare (a) Value of the policy held to projected life expectancy (“LE”), with (b) The net sale proceeds 3. The greater of these component at LE is a defensible choice assuming the analysis is done correctly and the variables are chosen correctly C. Example 1. Thanks to Leimberg & LeClair for the use of LifeSettlement NumberCruncher™ to perform this demonstration; LSNC is one of the tools commercially available that provide one of the components of the comprehensive analysis provided by programs such as Life Settlement Analytics™. 2. The value of keeping the policy to projected LE (a) NPV(DB)-[CSV+NPV(P) + NPV(IT) + NPV(GT) + ET] (i) where DB=death benefit; CSV=cash surrender value; P=future premiums; IT=income tax; GT=gift tax. 3. The value of selling the policy today (a) Gross offer – (commissions + IT + ET) 4. Demonstration VI. Summary