November 6, 2012
Brad Pettit, Senior Attorney, National Legal Research Group
The volatility of stock, bond, and real estate markets, as evidenced by the technology stock and real estate "bubbles" during the last two decades, makes it incumbent upon trust professionals to make sure that they comply with current legal standards for managing and investing trust assets. The Uniform Trust Code provides generally that a trustee must act "prudently" when administering a trust:
§ 804. Prudent Administration.
A trustee shall administer the trust as a prudent person would, by considering the purposes, terms, distributional requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.
Unif. Trust Code § 804 (U.L.A. 2000 & Westlaw current through 2011 annual meetings of the Nat'l Conference of Comm'rs on Uniform State Laws and A.L.I.).
The Uniform Prudent Investor Act expressly states 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." Unif. Prudent Investor Act § 3 (U.L.A. 1994 & Westlaw current through 2011 annual meetings of the Nat'l Conference of Comm'rs on Uniform State Laws and A.L.I.) (emphasis added); see also P.G. Guthrie, Annotation, Duty of Trustee to Diversify Investments, and Liability for Failure to Do So, 24 A.L.R.3d 730 (1969 & Westlaw databases updated weekly). The Restatement of Trusts similarly provides that "[i]n making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so." Restatement (Third) of Trusts ["Restatement"] § 90(b) (2007 & Westlaw current through Apr. 2012).
The Comment to § 3 of the Uniform Prudent Investor Act provides two examples of situations in which a trustee's general duty to diversify investments may be less than absolute:
Circumstances can, however, overcome the duty to diversify. For example, if a tax‑sensitive trust owns an underdiversified block of low‑basis securities, the tax costs of recognizing the gain may outweigh the advantages of diversifying the holding. The wish to retain a family business is another situation in which the purposes of the trust sometimes override the conventional duty to diversify.
Unif. Prudent Investor Act § 3 cmt.
It should also be noted that under the prudent investor rule, a trustee's duty to diversify may be enlarged or restricted by the express terms of the trust regarding investments:
The prudent investor rule, a default rule, may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust. A trustee is not liable to a beneficiary to the extent that the trustee acted in reasonable reliance on the provisions of the trust.
Id. § 1(b).
The Prudent Investor Act also makes it clear that a trustee does not have to make investment decisions, such as diversification, in a vacuum and can take into account matters such as the economy as a whole and the purposes of the trust:
§ 2. Standard of Care; Portfolio Strategy; Risk and Return Objectives.
. . . .
(b) A trustee's investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.
(c) Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:
(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, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;
(5) the expected total return from income and the appreciation of capital;
(6) other resources of the beneficiaries;
(7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and
(8) an asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.
Id. § 2(b)B(c).
The Comment to § 90 of the Restatement discusses the role of proper asset allocation when diversifying the investment portfolio of a trust:
Asset allocation decisions are a fundamental aspect of an investment strategy, and are a starting point in formulating a plan of diversification (as well as an expression of judgments concerning suitable risk‑return objectives). These decisions deal with the categories of investments to be included in a trust portfolio and the portions of the trust estate to be allocated to each. These decisions are subject to adjustment from time to time as changes occur in the portfolio, in economic conditions or expectations, or in the needs or investment objectives of the trust. Basic asset classifications might begin with cash equivalents, bonds, asset‑backed securities, real estate, and corporate stocks, with both debt and equity categories further divided by their general risk‑reward or income/growth characteristics, by the domestic, foreign, tax‑exempt, or other characteristics of the issuers, and the like.
There is no defined set of asset categories to be considered by fiduciary investors. Nor does a trustee's general duty to diversify investments assume that all basic categories are to be represented in a trust's portfolio. In fact, given the variety of defensible investment strategies and the wide variations in trust purposes, terms, obligations, and other circumstances, diversification concerns do not necessarily preclude an asset‑allocation plan that emphasizes a single category of investments as long as the requirements of both caution and impartiality are accommodated in a manner suitable to the objectives of the particular trust.
Restatement § 90(b) cmt. g.
Courts have weighed in on the general duty of a trustee to diversify the investment portfolio of a trust. For example, a New Jersey court said:
The exercise of such "care, skill, prudence and diligence" under the [New Jersey Prudent Investor] Act requires a fiduciary to diversify investments "so as to minimize the risk of large losses." Therefore a prudent fiduciary "should not invest a disproportionately large part of [a] trust estate in a particular security or type of security."
In re Will of Maxwell, 704 A.2d 49, 61 (N.J. Super. Ct. App. Div. 1997) (quoting Comm'l Trust Co. v. Barnard, 142 A.2d 865, 871 (1958)), cert. denied, 708 A.2d 65 (N.J. 1998).
But, as a New York court pointed out, in order to determine whether the prudent person standard has been violated,
[(1)] the court should engage in a balanced and perceptive analysis of the trustee's consideration and action in the light of the history of each individual investment, viewed at the time of its action or its omission to act[; and (2) a]ll of the facts and circumstances of the case must be examined to determine whether a concentration of a particular stock in an estate's portfolio violates the prudent person standard.
In re Rowe, 712 N.Y.S.2d 662, 665 (App. Div. 2000) (citations omitted) (internal quotation marks omitted), leave to appeal denied, 749 N.E.2d 206 (N.Y. 2001). More recently, a New York appellate court pointed out that decisions like the one in Rowe must be viewed in light of the current version of that state's prudent investor statute, which provides that "[a] trustee shall exercise reasonable care, skill and caution to make and implement investment and management decisions as a prudent investor would for the entire portfolio, taking into account the purposes and terms and provisions of the governing instrument." In re HSBC Bank USA, N.A., 947 N.Y.S.2d 292, 300 (App. Div. 2012) (quoting N.Y. Est. Powers & Trusts Law ' 1-2.3(b)(2). The HSBC Bank court went on to say that "the prudent investor rule puts diversification at the forefront of the fiduciary's obligations, but allows leeway for the fiduciary to opt out if the beneficiaries require otherwise or if the testator/settlor directed a different course of action[.]" Id. at 301. Thus, "[a]t times, holding an overweight concentration of a security may be in the best interests of the beneficiaries." Id. at 305.
A recent decision by an Illinois court provides another excellent example of the tension between the general rule that a trustee must diversify the trust's portfolio of investments and the rule that a trustee also may take into consideration other matters when deciding or seeking to diversify the investments of a trust. Carter v. Carter, 2012 IL App (1st) 110855, 965 N.E.2d 1146, appeal denied, 968 N.E.2d 1064 (Ill. 2012). In Carter, the remainder beneficiary of a marital trust brought suit against the trustee/life income beneficiary, alleging, inter alia, that the trustee/income beneficiary had breached her fiduciary duty to diversify the investments of the trust when she invested the portfolio solely in income-producing tax-free municipal bonds. It should be noted that in Carter, the marital trust in question contained language that excused the trustee from diversifying the trust's assets.
In Carter, the trust remainderman argued that the trustee/income beneficiary's investment elections, which eschewed diversification and favored income over appreciation, constituted a breach of her duty to act as a prudent investor and that the permissive nondiversification clause in the trust did not insulate the trustee from liability where she knew that a failure to diversify would harm the remainder beneficiary. The Carter court rejected the remainderman's argument and, in a very trustee-favorable decision, held that the plaintiff had failed to establish a cause of action under the prudent investor rule because there was no evidence that the trustee/income beneficiary's decision to invest in municipal bonds was "wholly" arbitrary or unreasonable. In reaching its decision, the Carter court also relied heavily on the trust language that excused the trustee from diversifying the trust's investments and ruled that such a trust provision "altered the requirements of the prudent investor rule." Id. ¶ 36.As the discussion above illustrates, trustees have the general duty to diversify the investment portfolio of a trust. However, the general rule of diversification is subject to further analysis as to whether full or partial diversification of the trust is required by the objectives of the trust or would be prudent under the circumstances. As the Carter decision suggests, courts still seem to be reluctant to interfere with a trustee's decisions regarding diversification of trust investments, especially if the trust instrument expressly states that the trustee is not required to diversify the investment portfolio.