do_not_put_all_your_eggs_in_one_basket

In a fascinating case involving a trust established by President John Adams, a recent opinion of the Massachusetts Supreme Judicial Court follows a long line of cases holding that it is not prudent for a trustee to put all trust assets in one type of investment.

THE TRUSTEE’S DUTY TO PRUDENTLY INVEST TRUST ASSETS

In almost every state and the District of Columbia, the Uniform Prudent Investor Act (“UPIA”) governs the actions of a trustee with respect to investment of trust assets.  Section 2 of the UPIA requires a trustee to “invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.”  Among the “other circumstances” that a trustee must consider in investing and managing trust assets are (1) general economic conditions; (2) the possible effect of inflation or deflation; (3) the expected tax consequences of investment decisions or strategies; (4) the role that each investment or course of action plays within the overall trust portfolio; (5) the expected total return from income and the appreciation of capital; (6) other resources of the beneficiaries; and (7) needs for liquidity, regularity of income, and preservation or appreciation of capital.  [As an aside, it is critical that a trustee DOCUMENT the factors that it considers when investing trust assets.  As one trust scholar and professional has noted, “If an action or decision is not documented, it didn’t happen.”]

But, what about professional trustees, like banks or other corporate trustees?  The general standard stated in Section 2 of the UPIA does apply to professional trustees, but the UPIA makes clear that “A trustee who has special skills or expertise, or is named trustee in reliance upon the trustee’s representation that the trustee has special skills or expertise, has a duty to use those special skills or expertise.”

One of the bedrock principles of the UPIA is the principle of diversification which is based on modern portfolio theory.  Section 3 of the UPIA provides that “A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”  As the Prefatory Notes and Comments to the UPIA instruct, “the long familiar requirement that fiduciaries diversify their investments has been integrated into the very definition of prudent investing” and “case law overwhelmingly supports the duty to diversify.”

Another bedrock principal of investing trust assets is the duty of impartiality.  Where a trust names one individual as the beneficiary of income and another individual as the beneficiary of principle, the interest of the income beneficiary and the principle beneficiary may conflict.  The income beneficiary typically wants more income; the principle beneficiary wants growth.  The duty of impartiality requires a trustee to balance the interests of income beneficiaries to generate income with the interests of principle beneficiaries and remaindermen for growth.  Section 6 of the UPIA states that “If a trust has two or more beneficiaries, the trustee shall act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries.”

CASE STUDY

In 1822, President John Adams established a trust and transferred a portion of his real estate holdings to the trust.  The City of Quincy was named as the trustee. As a result of a cy pres petition, the Woodward School for Girls became the beneficiary of the trust and was entitled to receive all the net income from the trust.

By 1973, all of the real estate President Adams contributed to the trust had been sold, and the assets were invested in a portfolio consisting of 90% fixed income and 10% equity securities.  In April of 1973, the trustee, the City of Quincy, received investment advice about how the assets of the trust should be invested.  The City was advised by South Shore National Bank that the assets should be diversified and invested in a portfolio consisting of 60% equities, 35% fixed income, and 5% cash.  The trustee voted to adopt the bank’s recommendation but the trustee never implemented the recommendation.  By 1990, nearly 100% of the trust assets were invested in fixed income.  As a result, the value of the trust assets in 2008 were exactly the same as the value of the assets in 1973; $321,932.43.  So, in a 35 year period which saw the S & P 500 grow approximately 1,200%, the value of the trust assets did not increase since the assets were invested almost exclusively in fixed income.

In 2005, the school requested an accounting from the trustee.  After a year and a half, the trustee had not produced a complete accounting, so the school petitioned a court for an accounting.  Ultimately, the school filed a complaint against the trustee for breach of fiduciary duty, and the trial court held that the trustee breached its fiduciary duties by failing to keep adequate records, failing to obtain appraisals for real estate and sell it at fair market value, failing to prudently invest the assets of the trust, and failing to diversify the investments of the trust.  [It is interesting to note that during the trial, the judge said “It is inconceivable to me that the value of the portfolio has not doubled, tripled, quadrupled over 60 years.”  The Court hit the trustee with a $3 million judgment, $1.1 million of which was for unrealized gains that should be in the trust had the trustee prudently invested the trust assets.

On appeal, the Massachusetts Supreme Judicial Court applied Massachusetts’ version of the Uniform Prudent Investor Act and held that the trustee failed to prudently invest the trust assets by investing the assets almost exclusively in fixed income.  Specifically, the Court held that the trustee failed to properly diversify the trust assets between fixed income and equity and failed to protect the trust assets from the effects of inflation.

Throughout the 50 page opinion, the Court reflected the central tenets of the Uniform Prudent Investor Act:

On the trustee’s duty to diversify:

Diversification is a central component of prudent investment” and “trustees are discouraged from investing a disproportionately large part of the trust estate in a particular security or type of security.”

On the trustee’s duty of impartiality:

A trustee must necessarily consider both the generation of income and the growth and maintenance of the principal.

On protecting the trust from inflation:

At a minimum, a trustee must consider how best to guard the principal against inflation, if not how to grow the principal while simultaneously generating income to support the beneficiary.

A trustee must accordingly invest with a view both to safety, seeking to avoid or reduce loss of the trust estate’s purchasing power as a result of inflation, and to securing a reasonable return.”

  • Ken Parkinson

    A prudent governance review process focusing on best practices of trust management would have both saved a valuable employer from a major loss, and allowed the beneficiary to have had a potentially greater impact I’ve the years.

    Stewards and Trustees would both benefit from periodic assessments of organizations conformity to best practices in fiduciary governance.

    Unfortunately, this type of case is far too common – and under reported due to arbitration and other settlement structures that encourage non disclosure of facts.

    Robert, Thanks for keeping the public and practitioners informed!