Though more than a dozen years have passed since the National Conference of Commissioners on Uniform State Laws approved and recommended that states adopt the Uniform Prudent Investor Act (UPIA), there still is relatively little case law interpreting the statute and its various state-by-state adaptations.1 Further, the law that does exist is far from clear. Adding to the confusion is the fact that the so-called Prudent Person Rule, the somewhat less stringent common law standard that guided trustee investments prior to the UPIA, still applies to acts performed by a trustee before a state's enactment of the UPIA. As a result, the investment behavior expected of both corporate and individual fiduciaries is uncertain, and it seems that trustees are unlikely to receive much guidance from the courts anytime soon.

One particularly thorny issue raised by a recent landmark case in New York, Dumont,2 is the scope of a trustee's duty to diversify. We know that a trustee is required to diversify trust assets in the absence of “special circumstances” that demand otherwise.3 But may the trustee limit its attention to the assets within the trust, or is it expected to consider all the assets held by the beneficiary, both in trust and otherwise? Naturally, a fiduciary cannot be responsible for assets over which it has no legal control and even, perhaps, no knowledge. At the same time, it's clearly a bad idea to take a formulaic approach to diversification without regard to the uniqueness of the trust and its beneficiaries. So can a trustee get away with “underdiversifying” a trust because the beneficiary happens to already hold a wide assortment of assets? Or, less commonly, can a trustee get into trouble for “overdiversifying” a trust, for the same reason?

The courts have yet to address these questions directly as they arise under the UPIA, although Section 2(c)(6) directs trustees — in investing and managing trust assets — to consider the “other resources of the beneficiaries.” Further, the commentary to that section notes, “An investment that might be imprudent standing alone can become prudent if undertaken in sensible relation to other trust assets or to other nontrust assets.”

HOLISTIC APPROACH?

Still, in New York, it seems that a fiduciary must actually diversify the trust portfolio; a trustee cannot satisfy its duty (under the Prudent Person Rule) to diversify simply by encouraging a beneficiary to sell her nontrust assets. At least, such was the ruling from the Surrogate's Court in Dumont, before the Appellate Division reversed its decision.4 One of the main problems with the trustee's tactic, the Surrogate's Court pointed out, was that the beneficiary in question was not the sole beneficiary of the trust, so that while achieving diversification in a roundabout way might have worked for her, it could not solve the larger problem with respect to all of the beneficiaries.5

Likewise, a Missouri court applying the Prudent Person Rule held that a trustee is not required, in deciding to what extent to diversify, to consider gifts made outside of the trust by a trust settlor to the trust beneficiaries. In First National Bank of Kansas City v. Hyde,6 the Supreme Court of Missouri rejected an argument that the trustees' duty to diversify was satisfied because the trust settlor had given other property to his family members outright while putting all of his stock in trust for many of the same individuals. The court maintained, “The trustees cannot be charged with keeping abreast of the changing financial condition of the [individuals] … Their care and management of the trust assets are controlled by the expressed purposes of the trust instrument and not by extraneous matters.”7

While a trustee may not be required to keep informed of all of the various beneficiaries' outside assets and investments, the trustee does have a responsibility to be aware of the beneficiaries' circumstances, such as health, age, other sources of income, etc., and to assess diversification prospects accordingly. Failure to diversify may be imprudent in light of a trust's primary purpose, for example, to provide income and support to an aging widow; so held a New York court in Matter of Janes.8 Conversely, a fiduciary's choice to diversify may be deemed imprudent or even “grossly negligent” if that fiduciary neglects to inquire first into the beneficiary's situation and the trust's purpose, as the trustee in the Pennsylvania case of In re Scheidmantel9 failed to do. (In that case, however, the court noted that Pennsylvania does not extend the same duty of diversification to assets owned at the inception of the trust; diversification nevertheless remains the “default” rule in that state for assets added to a trust by the trustee.)10

THE SETTLOR'S CHOICE

The total-asset/trust-asset question is also potentially tied to one of the leading issues being litigated today with respect to trust diversification, that is, the validity of “retention clauses” authorizing trustees to keep trusts concentrated with a certain type of asset, usually a particular stock. After all, in many of these cases the trust settlors' likely rationale for permitting stock concentrations is that the beneficiaries already own enough other assets outside of the trust to make the risk-spreading benefits of diversification unnecessary. But the courts have made it clear that while a settlor may choose to abrogate the trustee's duty to diversify, it is the settlor — not the trustee, not the beneficiary and not the court — that has this discretion.

The court in Wood v. U.S. Bank, N.A.11 held that a trustee may not avoid the duty of diversification unless the trust document indicates the settlor's “clear intent” to allow such a result (or unless “special circumstances” exist, usually in the form of some asset with sentimental value such as farmland or a controlling interest in a family business). In that case, the court found that the settlor's language authorizing retention of stock was intended to circumvent only the Rule of Undivided Loyalty and not the diversification requirement, as the trust happened to be invested in the stock of the trustee corporation. A year later, the same Ohio court in Fifth Third Bank v. Firstar Bank, N.A.12 was even less forgiving of a trustee's failure to diversify a trust, holding, somewhat bafflingly, that a clause in the trust document allowing the trustee to retain undiversified stock “although it may represent a disproportionate part of the trust” did not demonstrate the settlor's clear intent to abrogate the duty of diversification.

In New York, courts are equally cautious about recognizing a settlor's intent to relieve a trustee of the obligation to diversify, although both courts that heard the Dumont case did acknowledge such an intent. (Considering that the settlor in the case went so far as to prohibit the sale of Eastman Kodak stock unless a compelling reason other than diversification existed, it would have been difficult to find otherwise; it was the existence of such a compelling reason, not the intent to abrogate the duty to diversify, that was ultimately at issue in Dumont.)

What these cases demonstrate, beyond the courts' apparent reluctance to let trustees off the hook for declining to diversify, is that the choice to opt out of diversification — whether in consideration of the beneficiaries' other assets, a family history of stock ownership in a particular company, or any other factor — must come from the settlor and no one else.

THE TAKEAWAY

What is the bigger lesson that comes out of these diversification cases? Ultimately, the common thread seems to be that trustees have run into trouble not because they neglected to consider every one of the beneficiaries' assets outside of trust, specifically. Rather, it was their failure to communicate with the beneficiaries, keeping informed generally of their circumstances, financial and otherwise, as well as to remain faithful to the purposes of the trusts as expressed in the trust instruments, that created problems for these fiduciaries. The UPIA, like the Prudent Person Rule, is a study in subjectivity, and as a result, courts have quite a bit of leeway in judging trustees' actions. When there is the appearance of trustee misconduct or neglect, it seems the courts will not hesitate to make their displeasure known, even if the real issue is not so clear-cut as a simple failure to diversify.

Understanding this tendency may help to explain how a seemingly failsafe nondiversification clause came to be struck down in Fifth Third Bank. As the court reasoned, “Even if we determined that the [trust document] had relieved [the trustee] from the duty to diversify,” there was evidence that the trustee “failed to verify facts relevant to the investment and management” of the trust and “did not take into consideration the economic conditions, the tax consequences, and the need for liquidity.”13 The takeaway: while the law pertaining to fiduciaries is unsettled, a trustee will go a long way in protecting itself from a potential judgment by keeping the lines of communication with the beneficiaries open at all times, making a good-faith effort to carry out the trust for its expressed purposes — and using common sense.

THE NEXT LEVEL

Of course, avoiding lawsuits is well and good — but what about a trustee's ultimate concern: How to best serve its client? Yes, a trustee owes a duty to administer the trust in accordance with the settlor's directions, but a key part of performing this task is to further the beneficiaries' financial condition. If diversification does not serve the beneficiaries' best interests, but the trust document contains no evidence of the settlor's “clear intent” to abrogate the duty to diversify and no “special circumstances” exist, how can a trustee protect the beneficiaries' well-being without breaching its duty to the settlor?

Luckily, as with most rules, there is a narrow exception to the rule that avoidance of the diversification requirement must be approved explicitly by the settlor. In New York, and possibly in other states as well, a trustee may enter into an agreement with the beneficiaries authorizing an alternative investment plan that does not include diversification. Such a plan, however, will be scrutinized closely in court: It must still conform to the settlor's overall purpose for the trust; all the beneficiaries must give their informed consent; and the agreement's validity may be governed by principles of equity rather than contract law.

In the New York case of In re Saxton14 (decided under the Prudent Person Rule), the court was faced with an “Investment Direction Agreement” (IDA) among the trustee and beneficiaries of a trust that authorized the trustee to retain an undiversified stock concentration. In that case, the trustee initiated the IDA, and the beneficiaries apparently received little communication from the trustee (either before or after the IDA was executed) as to their financial conditions or the consequences of signing the agreement. Furthermore, the beneficiaries requested more thorough communication from the trustee, to no avail, and the two remainder beneficiaries, who concededly had signed the agreement, later urged the trustee to prepare a diversification plan. The court found that because the trustee failed to obtain the beneficiaries' informed consent, the IDA was not enforceable as a contract and that, in any event, the beneficiaries repudiated the agreement when they demanded that the trustee diversify the trust.

Still, agreements such as the one in Saxton between trustees and beneficiaries are a potentially valuable tool for trustees wishing to retain stock concentrations or otherwise undiversified trust portfolios in their beneficiaries' interests. Such a course of action, while not anticipated by the settlor, may nonetheless be the one most favorable to the beneficiaries. Moreover, an agreement may authorize the trustee to retain a particular stock only under certain circumstances or for a limited time; the possibilities are limitless. As long as a trustee actively involves the beneficiaries in a discussion of their overall holdings (which the trustee should always be doing anyway) and explains the ramifications of non-diversification, such an agreement should be upheld. And, most importantly, the beneficiaries will be better served.

Endnotes

  1. In re Chase Manhattan Bank, 26 A.D.3d 824, 809 N.Y.S.2d 360 (App. Div. 4th Dept. 2006).
  2. See Wood v. U.S. Bank, N.A., 160 Ohio App.3d 831, 828 N.E.2d 1072, 1078-79 (Ohio App. 1 Dist. 2005) (noting that the Uniform Prudent Investor Act (UPIA) “has received little judicial attention in Ohio — or elsewhere”).
  3. 4 Misc.3d 1003(A), 791 N.Y.S.2d 868 (N.Y. Sur. Ct. Monroe Co. 2004), rev'd, In re Chase Manhattan Bank, 26 A.D.3d 824, 809 N.Y.S.2d 360 (App. Div. 4th Dept. 2006).
  4. UPIA, Section 3.
  5. In re Will of Dumont, 4 Misc.3d 1003(A) (N.Y. Sur. Ct. Monroe Co. 2004).
  6. First National Bank of Kansas City v. Hyde, 363 S.W.2d 647 (Mo. Sup. Ct. Div. No. 2, 1963).
  7. Ibid., at 655.
  8. Matter of Janes, 90 N.Y.2d 41, 681 N.E.2d 332, 659 N.Y.S.2d 165 (1997).
  9. In re Scheidmantel, 868 A.2d 464, 2005 PA Super 6 (2005).
  10. Ibid., at 480.
  11. See supra note 2.
  12. Slip Copy, 2006 WL 2520329 (Ohio App. 1 Dist.), 2006-Ohio-4506.
  13. Ibid., at *5 (internal quotations omitted).
  14. InreSaxton, 274 A.D.2d 110, 712 N.Y.S.2d 225 (App. Div. 3d Dept. 2000).