Course 1 – Lessons 1 to 3: Prudent Trustee Investing

1.         The basics of Trust investing:

These are the beginning ground rules for Trust investing:

  • The Trustee must act as a prudent investor would act;
  • The specifics of the Trust must be considered; and
  • The Trustee must act with reasonable care, skill, and caution.

2.         Hypothetical

Let’s consider a hypothetical situation to demonstrate the problems that can arise and the options you may have to hold your Trustee accountable.  After the hypothetical, we will discuss the rules of Trust investing in more detail.

A.        The Facts

In this factual scenario, imagine that you are the beneficiary of a Trust.  The Trust is held for your benefit until age 35, you are 28 years old.  The Trustee is an old friend of your father’s.  Your father died a year ago and the Trustee began managing your Trust fund at that time.

The Trust owns residential real property that is being rented to a tenant who you do not know.  The tenant has not paid rent in three months, and it appears unlikely that the tenant will start paying rent any time soon.  The Trustee refuses to evict the tenant and refuses to sell the house to turn the asset into cash that could be distributed to you or properly invested.  The house has no mortgage and is worth approximately $500,000.

The Trust had close to $1 million in cash at the time of your parent’s death, but since that time the Trustee has “invested” 20% of the Trust cash in his best friend’s business that he claims is a guaranteed investment.  But in fact, it is a private placement that only allows individuals with a “high net worth” of $1 million or more to invest.  The investment is highly risky and not likely to be recouped in the event of an economic decline.

Additionally, the Trustee has “loaned” his wife’s business $250,000.  The so-called loan is documented with a one-page promissory note that requires monthly repayment at 2% annual interest.  The loan was made a year ago, but to date there have been no payments received by the Trust.  The loan is not secured by any assets of the wife’s business and is not personally guaranteed by anybody.

The rest of the cash is sitting in a non-interest bearing checking account and there are no current plans to invest the assets.

Finally, your father had invested in various risky stocks before his death.  In the year since your father died, these stocks declined in value from a high of $300,000 to their current value of $50,000.  The stocks are publicly traded and could have been sold any time in the last year.  The Trustee has no plans to sell these risky stocks.

B.        The Options for you to hold the Trustee accountable

You believe that the Trustee has violated his duties to properly manage and invest Trust assets under the California Prudent Investor Rule.  Specifically, he seems to have not acted as a prudent investor would under similar circumstances.  He has invested in businesses of his friends and family, and refuses to properly manage the real property.  How are you going to hold your Trustee accountable?  Here are your options:

1.      Letter writing campaign.

Write a letter to the Trustee explaining his violations of the Prudent Investor Rule and ask him to take care of the problems.  If that does not work, then hire a lawyer to write a letter explaining the law and threatening to take action if the Trustee does not fix the investment and management problems.

2.      File for Trustee removal.

File a petition with the probate court asking that the Trustee be removed and either you or a neutral third-party be appointed to act as Trustee.

3.      File a Petition for Instructions.

File a petition with the probate court asking the court to instruct the Trustee to evict the tenant and sell the real property, properly invest the Trust cash, sue for repayment of the loan to his wife’s business, and sell the risky stocks.

4.      File a Petition for Damages Against the Trustee.

File a petition against the Trustee to hold him liable for the harms and losses that your Trust fund has incurred as a result of his mismanagement.

5.      Do nothing.

Do nothing and hope that with time the Trustee will come around to a more prudent investment and management strategy for your Trust fund.

C.         Our Opinion

Listen to the approach that Stewart Albertson would take to hold your Trustee accountable.

D.        Roundhouse

Listen to Stewart Albertson and Keith A. Davidson discuss the options and their recommended approach to this difficult problem.

3.         The UPIA and the PIR…the confusing world of Trust investing

Under the California Prudent Investor act, Trustees must follow the Prudent Investor Rule when investing Trust assets (Probate Code Section 16046).  The rules for investing can be modified by the Trust instrument, so be sure to check your Trust to see if there is any change in how the Trustee can or must invest.  In most Trusts there are not any changes to the Prudent Investor Rule, but occasionally you will find an expansion or restriction of investing duties and powers.

A.        What does the Prudent Investor Rule require of a Trustee?

So what does the Prudent Investor Rule require of a Trustee?  Let’s start with the basics.  Under the rule a Trustee must invest and manage Trust assets as a prudent investor would by considering the purposes, terms, distribution requirements, and other circumstances of the Trust.  And the Trustee must use reasonable care, skill, and caution in making Trust investments (Probate Code Section 16047).

B.        To be, or not to be, reasonable: the Trustee’s standard of action

Let’s break this down a bit.  Managing Trust assets as a prudent investor would means that the Trustee is subject to an objective standard of investing.  It is not good enough for the Trustee to invest in a way that he or she thought was subjectively acceptable.  The investment decisions will be measured against what a prudent investor would do under similar circumstances.  This is a “reasonableness” standard.

There is an upside, and a downside, to reasonableness standards such as this.  One the one hand, it allows a lot of flexibility for the Trustee to invest in a number of different ways; provided that the investments are objectively reasonable.  On the other hand, it can be hard to say definitively that the Trustee breached his investment duties until you go to court and see how the judge rules.  The good news is that the Trustee cannot simply do what he or she wants without regard to what is reasonable.  That’s important—more on that later.

C.         And the purpose is…?

Further, the Trustee must consider the purpose of the Trust, the term of the Trust, the requirement for distributions, and any other relevant circumstances.  In other words, the investments must be tailored to the specific needs of the Trust and the Trust beneficiaries.  If a beneficiary requires a monthly distributions to cover medical expenses, for example, and the Trustee ties up all the Trust assets in long-term investments, that’s a problem.

If the Trust term is short—requiring immediate distribution—then long-term investments are also a violation of the rule.  If, however, the Trust term is long (say twenty years), then retaining substantial amounts of money in a non-interest bearing checking account would be a disaster.

The Trustee has a duty to look at the Trust instrument and consider the specific needs and requirements of the Trust before engaging in a Trust investment strategy.  This is an important first step because any investment strategy that is at odds with the needs of the Trust is likely to fail.  The Trustee must not invest Trust assets in a vacuum—the Trust terms must be considered.

D.        Care, skill, and caution…oh my!

Finally, the Trustee is required to use reasonable care, skill, and caution.  The overall goal of Trust investing is to protect the Trust assets.  That means a risky investment plan that may suit an individual investor is not acceptable in Trust investing.

While the California Probate Code does not specifically spells out the meaning of the terms “care, skill, and caution,” the Law Review Commission comments to Section 16047 references subsection (a) of Section 227 of Restatement (Third) of Trusts: Prudent Investor Rule (1992).  The Restatements defines the terms as follows:

The meaning of “care”

The duty of care requires the trustee to exercise reasonable effort and diligence in making and monitoring investments for the trust, with attention to the trust’s objectives. The trustee has a related duty of care in keeping informed of rights and opportunities associated with those investments.

The meaning of “skill”

The exercise of care alone is not sufficient, however, because a trustee is liable for losses resulting from failure to use the skill of an individual of ordinary intelligence. This is so despite the careful use of all the skill of which the particular trustee is capable.

On the other hand, it follows from the requirement of care as well as from sound policy that, if the trustee possesses a degree of skill greater than that of an individual of ordinary intelligence, the trustee is liable for a loss that results from failure to make reasonably diligent use of that skill.

The meaning of “caution”

In addition to the duty to use care and skill, the trustee must exercise the caution of a prudent investor managing similar funds for similar purposes. In the absence of contrary provisions in the terms of the trust, this requirement of caution requires the trustee to invest with a view both to safety of the capital and to securing a reasonable return.

E.         What does this all mean?

And that brings us back to what a Trustee’s duties really mean.  When a revocable Trust is created and the Trust Settlor (the person who created the Trust) is acting as Trustee and managing the Trust investments, they have the right to invest in anything they like.  There is no objective standard of reasonableness so long as the Settlor is acting as Trustee.

But that all changes (substantially changes) once a successor Trustee takes over.  Then the duties of Trustee investing begin in earnest.  And that is especially true once the Settlor dies and the remainder beneficiaries’ rights become vested.  Now the Trustee is subject to the Prudent Investor Rule and must act under the objective standard of reasonableness.

And yet this does not always happen.  Instead, private Trustees will often think (mistakenly) that they step into the shoes of the Settlor, and therefore, they can do whatever they subjectively want just like the Settlor used to do.  Not so.  In fact, the Trustee has a duty to follow the rules set out in the Uniform Prudent Investor Act—a much different standard than what the Settlor operated under.

The Prudent Investor Rule is meant to safeguard Trust assets by requiring a Trustee to act in a certain way towards Trust investments, and follow a certain process and procedure.  Trustees must take themselves out of their own subjective view of investing (which may be fine for their own assets, but no good for Trusts) and consider a different way of investing Trust assets.

4.         A basic overview of the rules

So these are the beginning ground rules for Trust investing:

  • The Trustee must act as a prudent investor would act;
  • The specifics of the Trust must be considered; and
  • The Trustee must act with reasonable care, skill, and caution.

These are the basic requirements that every Trustee will be measured against to determine if the Prudent Investor Rule was followed.  There are a few more specifics that we will discuss later, but you must keep the basic ground rules in mind for every Trust investing situation.

NOTICE: The rules do not prohibit a loss to Trust assets.  That means that a Trustee could follow all of these basic ground rules perfectly and still incur an investment loss to the Trust.  The fact that Trust investments lost value, by itself, is not enough to prove a breach of investment duty by the Trustee.

The entire Prudent Investor Rule is structured around modern portfolio theory, which does not guarantee against investment losses—losses are a part of investing even in the best of circumstances.  Many people mistake a loss in Trust investments to a breach of duty by the Trustee—not so.

The more important question when a loss incurs is did the Trustee follow the requirements of the Prudent Investor Rule?  If the Trustee followed the rule, then the loss is excusable. If the Trustee failed to follow the rule, then the loss could be personally charged against the Trustee.

The bottom line: Trustees must follow the process created by the Prudent Investor Rule.  Failure to follow the process subjects the Trustee to possible personal liability for the Trust’s investment losses.

If you are a Trustee, you had better set, follow, and document the investment process you took to follow the rules.  If you are a beneficiary, you had better show a lack of setting, following, and documenting the investment process to hold your Trustee personally liable for any losses.

One last word: Trustees are not personally liable if they fail to follow the investment process, but incur no loss.  If your Trustee incurs a gain, then there are no damages you can recoup for a violation of the Prudent Investor Rule.  You may be able to force your Trustee to invest properly in the future, but a lack of losses means a lack of damages; and therefore, no claim against the Trustee.

5.         Modern Portfolio Theory and Trust investing

The California Prudent Investor Act is meant to implement modern portfolio theory in Trust investing.  Basically, that means the law looks at the total portfolio of Trust investments to determine if the Trustee invested properly or not.  A single bad investment will not necessarily be a breach of Trust, if that single investment was reasonable within the overall portfolio of investments.

California Probate Code section 16047(b) states:

A Trustee’s investment and management decisions respecting individual assets and courses of action must be evaluated not in isolation, but in the context of a trust portfolio as a whole and as a part of any overall investment strategy having risk and return objectives reasonably suited to the trust.

Once again, the rule is looking to an overall investment strategy.  That means the procedure for investing is more important than the individual invest results.

A.        And then you must consider a few more circumstances…

Further, the Trustee is expected to consider, where appropriate, the following circumstances when investing:

1.              General economic conditions;

2.              The possible effect of inflation or deflation;

3.               The expected tax consequences of investment decisions;

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 known to the trustee as determined from information provided by the beneficiaries;

7.              Needs for liquidity, regularity of income, and preservation or appreciation of capital;

8.              An asset’s special relationship or special value, if any, to the purposes of the trust or to one of more of the beneficiaries;

Each of these circumstances must be factored into the specifics of the Trust instrument, and the Trust requirements, before developing an objectively reasonable investment strategy.

If a Trustee complies with all the requirements listed above, then that Trustee is free to invest in any type of property or any type of investment.  A single type of investment, by itself, will not necessarily be a breach of trust.  But a Trustee must first ensure that all the considerations listed above have been considered.

But wait, there’s more….

B.        Duty to be informed.

The Trustee’s duty is not done yet, under Section 16047(d), a Trustee has an affirmative duty to make a reasonable effort to ascertain facts relevant to the investment and management of Trust assets.  That means all the circumstances listed above must be investigated by the Trustee before investing to ensure a proper investment strategy has been created and implemented.  The Trustee cannot just assume he or she knows the relevant facts, they have a duty to find out!

C.         A word on investor policy statements (IPS’s).

You should notice by now that investing Trust assets takes a lot of work.  There are numerous factors that must be considered starting with what a prudent investor would do under like circumstances, considering the specifics of the Trust (how long will the trust estate be held, requirements for distributions, etc.), and then the portfolio considerations such a general market conditions, inflations/deflation, tax consequences, etc.

How does a Trustee keep all of this straight?  That’s where an IPS comes in handy.  An IPS is a written document that describes the investment strategy in great detail.  The IPS will describe the investment objectives of the Trust, where all the Trust considerations can be written down.  And then it describes the types of investments that are likely to meet the investment objectives.  Finally, there is a section describing the individual investments that have been chosen, and the allocation of assets to each investment to ensure they are properly diversified.

The California Probate Code does not require a Trustee to create or maintain an IPS, but using a written IPS allows the Trustee to prove that all the necessary investment considerations where made and implemented.  Better yet, the Trustee can check on the investments on a regular basis and adjust the IPS to current circumstances.

D.        A final word on investing: diversification.

Under Section 16048, a Trustee has a duty to diversify the Trust investments unless, under the circumstances, it is prudent not to do so.  The Trustee also does NOT have to diversify if the Trust instrument either removes this duty or provides specific language that a certain type of property is to be retained by the Trustee.

For example, if the Settlor owned rental real estate, he or she may instruct the Trustee to continue owning such property and relieve the Trustee from a duty to diversify trust assets.  In that case, the Trustee does not have to diversity investments.  Absent specific language, however, the Trustee must diversify Trust assets.

Diversification is meant to protect the Trust estate.  By diversifying the Trust investments, the Trust estate is protected from a single investment class crashing due to economic factors.  While diversifying is a common defense to investment losses, many Trustee’s fail to account for this important requirement.

6.         How does all this play out in court?

If you are a Trustee, you can see that you have your work cut out for you.  The Prudent Investor Rule sets out a seemingly impossible list of criteria that you must consider before investing.  And whatever investments you choose must be monitored and adjusted on a regular basis to remain reasonable.

Yet, proving that a Trustee breached his or her duty to properly invest can be a difficult job for a beneficiary.  This is primarily because you need to bring in financial experts to opine on whether the investment strategy was prudent under the circumstances.  And you can bet that the Trustee will do the same to support his investment plan.  Due to the “reasonableness” standard under which Trustee’s operate, there is no single rule that will establish a breach of trust.  Instead, the facts and circumstances of each case must be weighed and decided by the judge, which means every case is different.  Many times there is no way to know how the court will rule until the court rules.

Further complicating a beneficiary’s case, investment losses, by themselves, do not establish a breach of trust.  A Trustee may incur an investment loss and still be found to have properly followed the Prudent Investor Rule.  Or the court may excuse an investment loss even if it were incurred in violation of the Prudent Investor Rule.

7.         So how should you proceed if you are a beneficiary facing an investment loss to your Trust?

How do you hold your Trustee liable for investment losses?  You need to attack the Trustee’s process—or lack of process, as the case may be.  Whether a Trustee acted appropriately or not in investing depends on the steps the Trustee took to follow the Prudent Investor Rule.  Oftentimes, an individual Trustee will fail to document the process used to follow the rules.  Therefore, the Trustee may have a hard time proving that the process required by the Prudent Investor Rule was followed at all.

It is this lack of process that will most likely result in the Trustee being in breach of duty.  If the Trustee has a documented process that evidenced his compliance with the Prudent Investor Rule, then you are far less likely to hold that Trustee liable for investment losses.  The Prudent Investor Rule values an investment process over everything else.  It is not whether the Trust suffered investment losses that matters, it’s whether the Trustee followed an appropriate process of investing.

Arguably, if the Trustee followed an appropriate process for investing then there should be no losses—or the losses should be less than would otherwise be incurred.  But that may be speculation.  The law cannot force a Trustee to be a guarantor of Trust investments.  Instead, the law requires a certain procedure to be followed in considering and selecting Trust investments.  If that procedure is followed, then loses are excusable because all appropriate care, skill, and caution was exercised—what more can a Trustee do?

Where a Trustee fails to follow the necessary procedure for Trust investing, however, then the Trustee may be held personally liable for any losses.  In other words, where the Trustee refuses to follow the procedure set by law, then he may voluntarily make himself a guarantor of Trust investments.

In the end, it is up to the court to decide whether a Trustee must pay for investment losses or not.