ALI-ABA Course of Study Representing Estate and Trust Beneficiaries and Fiduciaries July 17-18, 2008 San Francisco, California

Transcription

1 439 ALI-ABA Course of Study Representing Estate and Trust Beneficiaries and Fiduciaries July 17-18, 2008 San Francisco, California The Prudent Investor in Hindsight By Christopher P. Cline Wells Fargo Bank, N.A. Portland, Oregon These materials are derived from Cline, TM 861, Trustee Investments, published by Tax Management, Inc., a subsidiary of the Bureau of National Affairs, Inc., Washington, D.C. All Rights Reserved.

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3 441 The Prudent Investor in Hindsight 1 Christopher P. Cline Wealth Management Director Wells Fargo Bank, N.A S.W. Fifth Avenue, Suite 1800 Portland, Oregon (503) christopher.p.cline@wellsfargo.com Serving as a fiduciary has always been a tricky business: disgruntled beneficiaries, many of whom have a sense of entitlement or a deep-seated resentment of other beneficiaries, have always made a fiduciary s life complicated. In the past ten years, however, the seeds have been sown to make it just that much more difficult. 2 The Uniform Prudent Investor Act ( Prudent Investor Act ), was designed to make a trustee s life easier, by allowing the trustee to follow more contemporary investment theories. However, it also gives a disgruntled beneficiary more grounds for attacking the actions of a trustee if that trustee does not comply with the Act's provisions. Further, the Prudent Investor Act is based on some underlying assumptions that may be considered counterintuitive (or just plain wrong) by a trustee. Finally, the Prudent Investor Act has been popping up in places that it may not belong. This article addresses the innovations of the Prudent Investor Act, and the developments that have occurred in its wake. I. Background: Modern Portfolio Theory and the Restatement (Third) of Trusts. The Prudent Investor Act is built on two academic developments: modern portfolio theory and the Restatement (Third) of Trusts ( Restatement ). A. Modern Portfolio Theory. To understand the impetus behind the Prudent Investor Act, the estate planning lawyer must be familiar with modern portfolio theory, the economic theory that underlies the Restatement and, by extension, the two acts. Although a discussion of modern portfolio theory is 1 These materials are derived from Cline, TM 861, Trustee Investments, published by Tax Management, Inc., a subsidiary of the Bureau of National Affairs, Inc, Washington, D.C. All Rights Reserved. 2 For more detail on the origins of this change, see, e.g., Hoisington, Modern Trust Design: New Paradigms for the 21st Century, 31st Annual Phillip E. Heckling Institute on Estate Planning, Ch. 6 (1997); Horn, Prudent Investor Rule, Modern Portfolio Theory and Private Trusts: Drafting and Administration Including the Give-Me-Five Unitrust, 33 Real Property, Probate & Trust Journal 1 (Spring 1998); Wolf, Total Return Trusts Can Your Clients Afford Anything Less?, 33 Real Property, Probate & Trust Journal 131 (Spring 1998). 1

4 442 beyond the scope of this article, an excellent introduction to the topic was prepared by Professor Jonathan R. Macey. 3 Two concepts arise from modern portfolio theory that are crucial for estate planning lawyers to understand. The first is the concept of the two types of risk: Market risk, which deals with market volatility (e.g., the stock market); and firm-specific (or non-market) risk, which deals with the volatility of a particular asset (e.g., a company that may go bankrupt). 4 An investor should obtain higher returns by accepting greater market risk (i.e, investments in stocks are riskier than in bonds, so as market risk increases so should the return on investment). On the other hand, firm specific (or non-market risk) generates no additional return because an investor can avoid it by diversifying her investments. An investor should take at least two steps to deal with these risks. First, she should determine the level of volatility she is willing to accept in exchange for the return she hopes to receive. This will determine the level of market risk she assumes. Second, she should diversify her portfolio in accordance with her chosen level of market risk to avoid non-market risk. 5 The second concept, more controversial than that of risk, is that of market efficiency, which assumes that information about assets is disseminated efficiently and all assets are priced more or less correctly. 6 If this is true, no investor should be able to consistently outperform the market. An investor s best strategy, in that case, is to invest passively, primarily through index funds, which should perform as the market does as a whole. Under the theory of market efficiency, active management (picking particular stocks, for example) is problematic because it generates additional management expense without a consistently higher return. 7 B. The Restatement. Although the prudent investing concept has been with us for over 150 years, 8 the Restatement changed it significantly It provides that a trustee is under a duty... to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust. This duty applies to investments not in isolation but in the context of the trust portfolio and as part of an overall investment strategy, which should incorporate risk and return objectives reasonably suitable to the trust. 9 A trustee must diversify the investments of the trust unless, under the 3 Macey, An Introduction to Modern Financial Theory (2d ed. 1998), published by the American College of Trust and Estate Counsel Foundation. Another important discussion can be found in Malkiel, A Random Walk Down Wall Street (6th Ed. 1996). 4 Macey, id. at Id. at There actually are three different types of market efficiency: weak form, semi-strong form and strong form. For a discussion of each of these theories, see Macey, id. at Id. at Harvard College v. Amory, 26 Mass. (9 Pick.) 446, 461 (1830), that held that trustees should invest in the same manner that men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as probable safety of the capital to be invested. 9 Restatement of the Law (Third) of Trusts, 227(a)(1992). 2

5 443 circumstances, it is prudent not to do so. 10 granted by the terms of the trust. 11 A trustee also has the powers expressly or impliedly Trustees have the further duty, within a reasonable time after the creation of the trust, to review the contents of the trust estate and to implement decisions concerning the retention and disposition of original investments in order to conform to the requirements of 227 and In other words, the trustee must review the original investments [with the trust investment objectives in mind], and, as necessary, formulate a plan for restructuring the portfolio to achieve a suitable level of risk and expected return with appropriate degrees of diversification and income productivity. 13 The analysis will change, of course, if those original assets are impermissible investments under local law or if the agreement directs that they be retained or disposed of. The decision to retain or sell original assets may be influenced by transaction costs and the tax consequences of sale, and also may properly be influenced, even without trust terms expressly bearing on the decision, by the property s special relationship to some objective of the settlor that may be inferred from the circumstances, or by some special interest or value the property may have as part of the trust estate. Such special assets might include land used in a family farming operation, the assets or shares of a family business, or stock holdings that represent or influence control of a closely or publicly-held corporation. 14 Investment directions spelled out in the trust agreement are legally permissible and are ordinarily binding on the trustee in managing the trust assets, thus often displacing the normal duty of prudence. However, the trustee may not be under a duty to comply with a term of the trust if a court order directs or authorizes non-compliance when, as a result of circumstances not known or anticipated by the settlor, compliance would defeat or substantially impair the accomplishment of the purposes of the trust. In such situations the trustee may have a duty to apply to the court for permission to deviate from those directions. 15 More importantly, trust language that merely authorizes a particular investment is permissive only, and the trustee is not required to retain permitted investments. Although it is not clear the degree to which the trustee may have to give special consideration to specifically authorized investments, as against simply omitting them from serious consideration, it is very clear that a permissive provision does not remove the trustee of the fundamental duty to act with prudence. 16 Additionally, mere authorization with regard to an investment does not constitute an exculpatory clause. Taken together, these provisions indicate that trust provisions are strictly construed against dispensing with [the] requirement [of diversification] altogether. 17 This last idea is potentially very troubling: a great many trust agreements are drafted in a way that authorizes a trustee not to diversify. It is likely that, in such cases, the lawyer drafting the provision intended it to not only avoid the duty to diversify, but also to exculpate the 10 Id. at 227(b). 11 Id. at Id. at Id. at 229, Comments Id. at Id. at 228, Comment, Page Id. at Id. at