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Today’s class

Today we continue our discussion of the fiduciary obligation of trustees with consideration of the trustee’s “duty of prudence.”

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Today’s class

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  1. Today we continue our discussion of the fiduciary obligation of trustees with consideration of the trustee’s “duty of prudence.” As with other fiduciary duties, the concern is that trustees may not exercise their powers to manage the trust wisely, with the beneficiaries suffering harm as a result. The duty of prudence, then, is designed to ensure that trustees serve the settlor’s objectives and the beneficiaries’ interests as they engage in the administrative activities of the trust. Today’s class

  2. The duty of prudence includes a number of duties, including The duty to review and make initial decisions about trust assets in a reasonable time, The duty to act impartially when there are multiple beneficiaries, The duty to incur only appropriate and reasonable costs, The duty of inquiry into the needs of beneficiaries (recall Marsden) The duty to invest trust assets prudently (prudent investor rule)—our main focus today The duty of prudence

  3. Trust investment law:The early years, p. 688 1719 Trustees authorized to invest in South Sea Company 1720 South Sea Bubble Bursts 90% drop in stock price Post-1720 “Court list” of proper and improper investments Stock investment forbidden or greatly restricted

  4. Trust investment law:The middle years, p. 688 1800s “Court lists” are codified; such “legal lists” proliferate in U.S. 1830 Amory: “Prudent Man Rule” Standard: “prudence,” but not “speculation” Mid-1900s Most states abolish their lists in favor of Amory’s “Prudent Man Rule”

  5. Trust investment law:The prudent man rule 1959-1990s: Part II Hindsight bias (e.g., it was “common know- ledge” that in August 1929 “a crash was al- most sure to occur”) Opt-outs hard (e.g., Authorization to buy stock A “does not mean that” buying stock A is prudent) 1959-1990s: Part I PMR replaced “legal lists,” but focused on “speculation,” per se rules and safe harbors Focus on default risk, ignored inflation risk Investments reviewed in isolation, not as part of portfolio

  6. Trust investment law:Toward the prudent investor rule 1976-1988 Critics draw on MPT, argue for scrutiny of portfolio-as-a-whole, risk/return as test of prudence ERISA, Delaware, California, and a few other states adopt portfolio-as-a-whole statement of prudence Early 1990s Restatement (Third) & Unif. Prudent Investor Act Prudent Investor Rule: trust investments are “evaluated not in isolation, but in the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust” (§2.b)

  7. Uniform Prudent Investor Act, p. 694 • The trustee is supposed to consider not only liquidity and regularity of income, but also risks of inflation (or deflation) and appreciation of principal (§ 2.c) • Any kinds of investments are permissible (§ 2.e) • The Act specifically mentions non-traditional investments, like interests in closely held enterprises, tangible personal property and real property (§ 2.c.4) • The trustee “shall diversify the investments of the trust” unless special circumstances indicate that the trust purposes are better served without diversification (§ 3)

  8. Stocks v. bonds: National trend (FDIC 1986 - 2006), p. 701

  9. In re Estate of Janes 681 N.E.2d 332 (N.Y. 1997), p. 702 In re Estate of Janes (1) What were the facts in this case? Aug. 1973 1980 May 1973 1982 Sept. 1973 to Feb. 1980

  10. In re Estate of Janes (2) In re Estate of Janes

  11. In re Estate of Janes (3) In re Estate of Janes Source: Yahoo! Finance

  12. Janes • The trustee argued that concentrated investment in a stock was permissible as long as there were no “elements of hazard” that would make the investment worrisome (p. 704) • Elements of hazard include undercapitalized company, weak management, lack of profitability or history of paying dividends, not an industry leader modification • Even though NY operated under the old prudent man rule that allowed for investments that were standard for investment managers, the court effectively applied the prudent investor standard

  13. Janes and the prudent investor rule • The court cited to some of the factors in § 2.c of the prudent investor rule, as well as the principle in § 2.b that investments must be evaluated in the context of the entire portfolio rather than in isolation (page 705) • The court also invoked the § 2.f duty of a trustee with “special skills or expertise” to use those special skills or expertise when administering the trust (page 706)

  14. Janes and damages • There are two tests for measuring damages • Value of stock when it should have been sold plus interest from date of sale to date of court decision • Value of stock when it should have been sold plus gains if it had been invested prudently (total return damages, p. 710) • The Rothko court had used the second measure, but in that case, the trustees violated their duty of loyalty • Here the court used the first measure, but the Restatement follows the second measure

  15. Note questions • Note 1, pages 707-708 • The trustees could have avoided the risk of evolving judicial standards by making regular accountings. If an accounting is approved by the court, the trustee is protected for the matters fairly disclosed in that accounting. Second, it would have put the issue of the portfolio allocation in front of a roughly contemporaneous court, less likely to be affected by hindsight or later developments in investment theory.

  16. Opting out of the prudent investor rule • As we’ve seen with many statutory rules, they are default rules that can be waived • “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.” • UPIA §1, page 711 • But courts are reluctant to recognize waivers, so careful drafting is important • Janes, as a former state senator, might have wanted his trust to favor Kodak, an important local company

  17. Wood v. U.S. Bank Wood v. U.S. Bank, N.A. 828 N.E.2d 1072 (Ohio App. 2005), p. 712 What were the facts in this case? 1999 mid-2000 1998 Apr. 1999

  18. Wood and opting out of the prudent investor rule • Ohio had adopted the UPIA, so the court applied the UPIA’s opt out provision • Did John Wood waive the duty to diversify when he authorized the retention of the Firstar stock?

  19. Modifying the duty to diversify • No modification • The trustee may “retain any securities in the same form as when received” (page 712) • Modification may be found • The trustee is directed or authorized to “retain all of the securities bequeathed to the trustee” (page 715) • The trustee may “retain any or all of the securities, as the trustee deems proper, without regard to the ordinary requirement of diversification” (page 715)

  20. Modifying the duty to diversify:Third Restatement, § 229 • “It is a question of interpretation whether . . . an authorization to retain property . . . modifies the trustee's normal duty with respect to diversification. • “Among the factors that may be of importance in this matter are: • whether, in effect, the settlor has intended to encourage or merely to authorize retention of the investments; • whether an authorization to retain applies to specific investments, to particular types of investments, or to all property received as a part of the trust estate; • the character of the original trust property in question; and the purpose of the trust generally, and • especially any identifiable purposes underlying the particular grant of authority.

  21. Another area for clear drafting • Inadequate language: • The trustee may make investment decisions “as to it may seem suitable, and to change investments and to make new investments from time to time as it may seem necessary or desirable, regardless of any lack of diversification, risk, or nonproductivity.“ • Spragins, page 717

  22. Limits to the ability to eliminate the duty to diversify • UPIA § 1 allows the settlor to expand, restrict or eliminate the duty to diversify, BUT • Trustees are subject to a duty to seek judicial modification of an administrative provision of a trust when adhering to the provision could “cause substantial harm to the trust or its beneficiaries” (Restatement (Third) of Trusts § 66, page 645) • Courts in Pulitzer and Mayo ordered modification, but court in Toledo Hospital did not

  23. Beneficiary waiver of duty to diversify • A trustee is not liable to a beneficiary for breach of trust if the beneficiary • consented to the conduct constituting the breach, • released the trustee from liability for the breach, • or ratified the transaction constituting the breach, unless . . . • at the time of the consent, release, or ratification, the beneficiary did not know of the beneficiary’s rights or of the material facts relating to the breach. • Uniform Trust Code § 1009

  24. UPIA §9: Delegation (a) A trustee may delegate investment and management functions….The trustee shall exercise reasonable care, skill, and caution in: (1) selecting an agent; (2) establishing the scope and terms of the delegation…; and (3) periodically reviewing the agent’s actions…. (b) In performing a delegated function, an agent owes a duty to the trust to exercise reasonable care to comply with the terms of the delegation. (c) A trustee who complies with the requirements of subsection (a) is not liable to the beneficiaries or to the trust for the decisions or actions of the agent ….

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