The majority of life insurance policies sold into the secondary market are owned by an irrevocable life insurance trust (“ILIT”). An ILIT is an irrevocable trust specifically designed to hold and own life insurance policies. Once the ILIT has been set up, ownership of the policy or policies is transferred to the trustee of the ILIT. The utility of an ILIT is that it will keep the proceeds of the life insurance out of the trust grantor’s estate upon his or her death.
In the typical life settlement transaction, the trust agreement is reviewed to confirm the trustee possesses the authority to sell the policy out of the trust to a third party. Typically, that is the end of the inquiry, although some purchasers of policies demand the trustee execute a resolution or certificate affirming the trustee’s authority to act under the terms of the trust.
A recent case, Paradee v. Paradee, 2010 WL 3959604, decided by the Delaware Court of Chancery in October 2010, may give participants in the secondary market for life insurance reason to re-think this position and undertake additional diligence when purchasing a policy from an ILIT.
The facts of Paradee could serve as the basis for a day-time soap opera. There is a wealthy but ailing family patriarch, a younger, avaricious stepmother who married the patriarch shortly after his first wife died, an estranged son and a beloved grandson, who, upon the patriarch’s passing, falls out of favor with his step-grandmother.
Prior to passing, the patriarch and the stepmother set up an ILIT for the benefit of the patriarch’s grandson. The trust was funded with approximately $370,000, which was used to purchase a second-to-die life insurance policy on the lives of the grantors. On multiple occasions thereafter, the stepmother attempted to access the policy’s cash value by revoking the trust. When advised that she could not gain access due to the trust’s irrevocability, the stepmother convinced the trustee (a long-time financial advisor to the patriarch and the stepmother) to make a loan on the policy’s cash value in the amount of $150,000. The loan from the trust was unsecured and did not pay a rate of interest equal to the rate charged by the insurance company for the policy loan.
The grandson, the trust’s sole beneficiary, was not told of the existence of the trust, the policy or the loan until after the policy lapsed due to failure to pay interest on the loan. Upon learning of the existence of these previously unknown assets, the grandson sued, alleging among other things a breach of the trustee’s fiduciary duties as trustee of the trust.
The court agreed, holding that the trustee had breached his fiduciary duty of loyalty because his actions in making the loan were undertaken to please the stepmother rather than to act in the best interests of the trust. The court considered and dismissed the defense that the trustee had the legal authority to make the loan, noting that trustees’ actions are reviewed twice under Delaware law, once for legal authority and again for inequitable conduct. Thus, the court concluded that while the trustee undoubtedly had the authority to make the loan, by doing so he nevertheless breached his fiduciary obligation to the trust because the loan was not in the best interest of the trust or its beneficiary.
It is often the case in the sale of life insurance policies from an ILIT into the secondary market that the grantor and insured life under the policy appear to be the motivating force behind the sale of the policy. In fact, providers are occasionally asked to wire the funds from the proceeds of the sale of the policy to a party other than the trustee, and they should deny any request to do so. While the policy purchaser is engaging in no wrongdoing if additional inquiries are not made into the circumstances of the policy sale, the Paradee case is a strong argument for obtaining the written consent of the beneficiaries of the trust itself (rather than just the policy). Failure to do so runs the risk that an unhappy beneficiary could later challenge the sale and unwind the transaction.
James W. Maxson is a Partner in the firm’s Insurance and Reinsurance Practice and co-chairs the firm’s Life Settlement Practice. Mr. Maxson concentrates his practice in corporate and regulatory matters for the life settlement industry, as well as focusing on mergers and acquisitions and securities transactions. Mr. Maxson received his bachelor’s degree from Denison University and law degree from the Ohio State University College of Law.