Probably the most significant development in trust investment standards in this country in the last decade has been the introduction of the "Prudent Investor Rule" -- the new rule governing how trustees invest trust funds.
This rule is found in the Uniform Prudent Investor Act, a state statute introduced in 1994 that has been adopted by 34 states and the District of Columbia over the last several years. Several states, including Maryland, have not adopted the act but have laws that are substantially similar.
Nonprofits that rely on trust income and institutions that serve as trustees should become very familiar with the act, which is still being considered by a number of states. The significance of the rule change is easily expressed by the change from a focus on the "prudent man" or "prudent person" to a focus on the more experienced "prudent investor."
This and other changes could be very significant in financial terms to nonprofits that benefit from the assets of a trust after a life-time beneficiary passes away.
The change to the act displaced one of the oldest rules in American Trust Law: the "Prudent Man" rule governing trust investments. The old rule was defined in the United States in the celebrated case of Harvard College v. Amory in 1830 by the Massachusetts Supreme Judicial Court.
The origins of the old rule date back even a century earlier to the chambers of the House of Commons in England in 1719. It was political posturing at its best that resulted in Parliamentary approval for English trustees to purchase shares of the South Sea Company, and a large number of trustees seized the opportunity.
Unfortunately, the new trust investors lost nearly 90 percent of the value of their trust investments in the company when it folded a year later. The reflexive response by the government of the day resulted in a list of trust investments that they presumed to be safe, largely government bonds. The lesson had been learned well -- it was 140 years before an equity stock was added to the list.
Through conservative judicial interpretation in the United States, the old rule created a rigid focus on an asset-by-asset analysis rather than on the trust assets as a whole. This resulted in an outright prohibition on certain assets and asset classes, and a lack of understanding for the corrosive effect of inflation on the purchasing power of the trust.
The "Prudent Investor Rule" in the act now offers "something old, something new, something borrowed, something blue" to benefit a trust portfolio.
The Prudent Investor Rule includes the duty to diversify the trust assets which comes from a long line of legal cases, and treats diversification as a fundamental element that is required for prudent investments. Often it will be difficult for smaller trusts to be diversified properly. As a result, pooled investment vehicles, such as mutual funds, are often used to achieve diversification.
The act also outlines old law that requires a new trustee of an old trust to review the trust assets and implement investment decisions to bring the trust into compliance with the terms and distribution requirements of the trust. Finally, the act includes the old law that the trustee has a duty to minimize investment costs. The official comment introducing the act cautions trustees from "double-dipping" by hiring and compensating external professionals under the new delegation rules (below) while also compensating themselves at their prior rates when they performed the delegated function themselves.
The core of the Uniform Prudent Investor Act is the new definition of the standards of prudence for a trust investor -- the so-called "Prudent Investor Rule." The act specifically instructs investors to make investment decisions regarding assets 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."
The trustee must now consider general economic decisions, the effects of inflation, expected tax consequences of investment decisions, the expected total return from income and the appreciation of capital, and the other resources of the trust beneficiaries.
The act has borrowed the emphasis on delegating trustee responsibilities from a number of other laws, including the Employee Retirement Income Security Act (ERISA). This was a complete reversal of the prior position in trust law, which highly limited a trustee's ability to delegate investment and management functions.
Recognizing the need to delegate a number of investment management decisions to a professional, the act now openly permits that delegation but requires the trustee to periodically review the work of an assigned investment manager.
Under the new emphasis for diversification, the rigid focus on individual assets and the avoidance of prohibited assets has passed. Blue chips to small capitalization stocks will all merit potential consideration. As a practical matter, the act's requirement to craft the investment design to the trust's tolerance of market and industry risk is likely to result in greater use of equities.
In fact, the act now makes it possible to consider relatively novel assets, such as foreign securities, when such assets are likely to enhance the diversification of the trust's assets.
As a result, the implications for investing under the act should be reviewed by trustees and specialized legal counsel. By the terms of the act, a trustee should now ensure that each trust has an investment strategy considering the economic conditions, the effect of inflation, and the resources of the beneficiaries, among other circumstances.
The written strategy should consist of the investment objective and the plan for implementation. Diversification is essential. For small trusts, the only practical way to achieve diversification may be through mutual funds. Equally, it may be impractical for older trust to diversify where there are substantial built-in gains. For larger trust, the emphasis on diversification may force trustees to delegate investment decision-making for an entire class of assets to a specialized money manager.
Passive investment strategies should be considered for the cost-sayings hey offer when the investments are linked to index fund management. Here, the investments mirror the main market indices, e.g. the S & P 500 index.
Thankfully, the days of legal lists of prohibited investments are gone, but the expectations for trustees have markedly increased.
Kevin E. Coventon, CPA, Esq. and Blair R.Allan, Esq., are partner and of counsel, respectively, of Loeb & Loeb LLP in New York City and are members of the firm's Non-Profit Practice Group.
States That Have Adopted The Uniform Prudent Investor Act
District of Columbia
(**.) Substantially similar
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|Author:||Allan, Blair R.|
|Publication:||The Non-profit Times|
|Date:||Feb 15, 2001|
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