Trust and the Prudent Investor
Goodness is the only investment that never fails ~ Henry David Thoreau.
A trustee, which can be an individual or a bank, upon appointment becomes a “fiduciary” which is a legal status that confers rights upon the trustee, but also many serious obligations.
In Michigan, a trustee is bound by the laws governing fiduciary relationships as defined under Michigan’s Estates and Protected Individuals Code (EPIC). EPIC defines this “fiduciary relationship”:
A fiduciary stands in a position of confidence and trust with respect to each heir, devisee, beneficiary, protected individual, or ward for whom the person is a fiduciary. A fiduciary shall observe the standards of care described in section 7302 and shall discharge all of the duties and obligations of a confidential and fiduciary relationship, including the duties of undivided loyalty; impartiality between heirs, devisees and beneficiaries; care and prudence in actions; and segregation of assets held in the fiduciary capacity. With respect to investments, a fiduciary shall conform to the Michigan Prudent Investor Rule. M.C.L.A. §700.1212.
Although EPIC recites several, significant duties, the concepts embodied in the words in the statute are undefined. For example, while the term “undivided loyalty” may sound obvious, in practice it may not be so obvious in every circumstance. The importance of the fiduciary’s exercise of the fiduciary’s duties to each of a trust’s heirs, devisees, beneficiaries, protected individuals or wards becomes heightened during the trustee’s investment of trust assets. An investment in violation of the duties imposed upon the trustee could subject the trustee to personal liability for any losses incurred by the trust.
The standards applicable to the trustee’s investment of trust assets have evolved over hundreds of years. The flexibility of the trustee to make investments has often been based upon economic circumstances of the times and has swung like a pendulum based upon the conservatism and societal circumstances of the times. The evolution of the “Prudent Investor Rule” that is most common today dates back to eighteenth century England.
As a reflexive reaction to the wide-ranging collapse of private investments at the time and the resulting impact upon fiduciary accounts, English courts in the 1800s mandated that fiduciaries were required to invest only in securities backed by the government. Initially, United States courts declined to impose such a harsh rule and instead following the “Prudent Man Rule” based upon the 1830 decision in Harvard College v Armory.
However, in around 1869, the tide turned in America and a majority of the states adopted even stricter rules than in force in England, including in some states a list of legal investments and a blanket prohibition on private securities investments.
In the 1930s, the evolution continued with the introduction of the “Prudent Person Rule.” Under such rule, the fiduciary was expected to invest the trust asset portfolio as a “prudent person” would invest his/her own property while emphasizing the importance of capital preservation, beneficiaries’ needs, and regular income streams. Each investment was judged on its own merits, speculation was to be avoided and delegation of the investment function to third parties by the trustee was prohibited.
During the 1990s, the standard evolved again with the adoption of the Uniform Prudent Investor Act (UPIA) which has now been adopted in some form by 41 states. The UPIA was developed by the National Conference of Commissioners of Uniform State Laws in 1994 and sets out the guidelines for financial planning as a fiduciary. Under the UPIA, the fiduciary investment standard incorporated a related concept known as the “Modern Portfolio Theory” (MPT). MPT shifts the focus away from a review of individual investments to a modern approach of reviewing the portfolio as a whole. Diversification is expressly required, and no type of investment is deemed inherently per se imprudent. Trustees are also allowed to delegate investment management to third parties who are qualified.
Michigan adopted the “Prudent Investor Rule” as part of EPIC. Since Michigan courts will now look to the performance of the trust portfolio as a whole, it is important for the trustee (or the third party such as a bank investment officer) to have a plan. This plan is commonly prepared through an Investment Policy Statement (IPS) that is developed between the fiduciaries (ie, trustee, investment advisor, portfolio manager) and the trust beneficiary that outlines the general rules and duties for all involved in the investment process. The IPS is a written investment plan and serves as a guide for evaluating the overall portfolio performance. The IPS states the client’s goals, objectives, risk tolerance, portfolio review milestones, asset allocations, and any other material investment facts or assumptions. An IPS also helps all involved parties to remain focused upon developed investment goals, particularly when economic times are turbulent.
When preparing an IPS, the following key elements should be included at a minimum:
- Background Facts: client information; location of client’s assets; amount to be managed; trustee information; interested parties pursuant to the trust; tax status of assets; special needs of the client; anticipated life of the trust
- Objectives: investment objectives; deadlines and time benchmarks; risk tolerance; restrictions on assets; need for liquidity or cash reserves; anticipated withdrawals and deposits
- Prohibited Transactions: security type and class
- Monitoring and Control: responsibilities for each member of the process; timeframes for review meetings