On February 19, 2020, the S&P 500 index closed at a record high of 3386.15. Since that date, markets in the United States, Europe, and Asia have experienced record volatility due to the effects of the COVID-19 crisis and many investment management professionals anticipate that this market volatility will persist throughout the rest of the year. Such volatility creates a challenging environment for fiduciaries charged with investing and managing trust assets. This article offers insights into how a fiduciary should navigate this environment and highlights specific investment liability issues that arise as a result of volatile markets.
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The Standards Trustees Must Satisfy in Investing Trust Assets
The majority of jurisdictions in the United States have enacted a version of the Prudent Investor Rule as the standard that a fiduciary must comply with respect to the investment and management of trust assets. While the duties imposed by the Prudent Investor Rule may be modified by the trust instrument and may differ slightly between jurisdictions, the Prudent Investor Rule provides, generally, that a fiduciary has a duty to invest trust assets as a prudent investor would considering the purposes, terms, distribution requirements, and other circumstances of the trust. The rule requires the fiduciary to exercise reasonable care, skill, and caution in investing the assets of a trust. The rule applies to the investments of the trust in the context of the trust portfolio as a whole.
Importantly, compliance with the Prudent Investor Rule is a test of the trustee’s conduct, not the resulting performance of the trust. The rule imposes a specific duty upon the fiduciary to review trust assets and make decisions concerning the retention and disposition of those assets. It requires the trustee to adopt an investment strategy that considers both income and principal enhancement consistent with the duty of impartiality. In addition, it creates a duty to diversify the assets of the trust.
Navigating Volatile Markets
The most important thing for fiduciaries to remember in navigating volatile markets is that the Prudent Investor Rule remains a processed-based, and not performance-based, standard even though beneficiaries will complain about performance. Therefore, fiduciaries must continue to exercise reasonable, care, and skill in the managing the assets of the trust. In particular, fiduciaries should actively monitor and review a trust’s existing assets to determine whether the trust should retain or dispose of those assets.
The fiduciary should also review the investment managers that the fiduciary has retained or invested trust assets with. In particular, fiduciaries should ensure that trust investment managers are following the investment manager’s respective investment policies, procedures, and guidelines. For example, if the investment manager’s prospectus for a fund states that the fund will invest in a mixed portfolio of 60% equities and 40% bonds, the fiduciary should ensure that the fund’s portfolio mix complies with the prospectus. If it does not, the fiduciary should consider terminating the relationship with the investment manager.
In addition, fiduciaries should maintain regular contact with beneficiaries when markets are volatile to ensure that the trust portfolio is aligned with the best interests of the beneficiaries. Since some beneficiaries may not be overly responsive, the fiduciary should exercise diligence in maintaining contact with the beneficiaries.
Fiduciaries should also make a written record of their rationale for any decisions they make with respect to the retention, disposition, or acquisition of an asset as well as any decisions they make with respect to distributions, investment managers, allocation of principal and income, and investment policies. Documenting communications with beneficiaries regarding the trust portfolio is also important. These written records could serve as valuable evidence in any subsequent litigation that the fiduciary exercised reasonable care, skill, and caution in managing the assets of the trust.
Specific Investment Liability Issues Caused by Volatile Markets
Despite the fact that the Prudent Investor Rule is a process-based standard, there are a number of specific theories of liability that relate to the performance of a trust’s portfolio that disgruntled beneficiaries will assert when there is a substantial decline in the market. While the exercise of prudent trust management should shield a fiduciary from liability based on these theories, fiduciaries should be aware of these investment liability issues.
In response to substantial market declines, beneficiaries have brought cases against fiduciaries alleging that a fiduciary has breached the duty of care by failing to implement a “sell discipline” with respect to the trust portfolio. A “sell discipline” is a process instituted by the trust instrument or the trustee that requires the trustee to sell a liquid trust asset if the value of the asset falls to a predetermined threshold. In theory, a “sell discipline” could prevent the dissipation of the value of a trust asset in a rapidly declining market. In practice, very few trust instruments have a “sell discipline” built into the investment or administration powers of the trust. In addition, very few trustees have implemented “sell disciplines.”
No case has ever expressly held that a trustee must implement an objective “sell discipline” in order to satisfy his or her duties under the Prudent Investor Rule. Indeed, some courts have criticized the theory because a sell discipline could effectively lock in losses for the trust that may be difficult to recover. See In re Mark Anthony Fowler Special Needs Trust, 160 Wash. App. 1001) (Ct. App. 2011). However, at least one court has held that a trustee violated the Prudent Investor Rule by failing to take any measures to protect against a decline in the value of a trust’s stock where the trustee recognized that it was highly probable that the stock would continue to decline in value. See Uzyel v. Kadisha, 188 Cal.App.4th 866 (2010). Therefore, while fiduciaries should not be liable for failing to implement a sell discipline, they must be diligent in monitoring performance and have a reasonable basis for continuing to hold an asset during a decline in performance.
Overweight Equity Accounts
While both equity markets and bond markets have experienced substantial volatility during the COVID-19 crisis, equity markets have historically experienced greater declines in bear markets than other forms of investment. Beneficiaries have brought claims against fiduciaries for allegedly breaching the duty of diversification in situations where a trust has held substantial equity positions with respect to the overall value of the trust.
Generally, fiduciaries can defeat such claims because a trust’s investment mix does not implicate the duty to diversify. Rather, the duty to diversify generally requires the fiduciary to convert a single asset trust or a trust in which there is an over-concentration in a single asset (usually more than between 10 and 15% of the portfolio value) into more than a single investment, so that there is no over-concentration in any particular asset. Therefore, investing heavily or entirely in equities or in bonds does not violate the duty to diversify. See, e.g., Central National Bank of Mattoon v. United States Department of Treasury, 912 F.2d 897 (7th Cir. 1990); Goddard III v. Continental Illinois National Bank and Trust Co., 177 Ill. App. 3d. 504 (1st Dist. 1988).
However, at least one case has held that an over-concentration in a particular type of investment class could constitute a failure to diversify. See Estate of Scharlach, 809 A. 2d 376 (Pa. Super. 2002). Therefore, trustees should be mindful of the asset allocation in prudently managing trust portfolios. If a trustee decides it is prudent to concentrate the assets of a trust in a single asset class, the trustee should be prepared to defend the process in reaching that decision.
Performance Versus Benchmarks
When trustees and other investment managers sell their investment services, they will typically compare their performance to various benchmarks and indices. As a result, beneficiaries have brought claims against trustees for failing to either outperform or meet the performance of a specific index or benchmark, such as the S&P 500. Courts have generally rejected these claims. These courts have held that trustee liability is measured by whether the trustee acted imprudently in managing the assets of the trust, it is not based on any performance driven standard. See Matter of Jakobson Trust, 662 N.Y.S.2d 360 (N.Y. Surr. 1997); In re Trusts of Kuoching, 717 N.Y.S. 2d 512 (App. Div. 2000). Therefore, if a trustee employs a prudent process in investing trust assets, the trustee should have limited exposure for performance that does not meet or exceed benchmarks.
Unconventional Investment Vehicles
As markets have gotten more complex, a number of fiduciaries have found unconventional investment vehicles, such as investing on margin, short sales, or engaging in venture capital practices, to be attractive investments. However, when such investments have resulted in a loss, courts have found that these investments are imprudent due to their inherent risk. See, e.g., Merrill Lynch v. Bockock, 247 F. Supp. 373 (S.D. Tex. 1965); Mennen v. Wilmington Trust Co., 2015 WL 1897828 (Del. Ct. Ch. 2015). As a result, fiduciaries face substantial liability exposure in a volatile market environment if they have invested trust assets in unconventional investment vehicles because volatile markets increase the risk of a complete loss with respect to such investments. Therefore, fiduciaries should avoid investing trust assets in unconventional investment vehicles unless directed by the trust instrument and generally approved by the beneficiary.
Total Return Trust Conversion
Many states have adopted statutory provisions that allow for the conversion of a trust that defines the current beneficiaries’ rights in terms of accounting income, to “total-return” trusts, otherwise referred to as unitrusts. If the beneficiaries do not agree on a conversion, or the appropriate rate of total return to be applied, the trustee can initiate a court proceeding to decide the issue. However, volatile markets can make conversion proceedings more complex and expensive as expert financial testimony will be necessary to demonstrate that a conversion will not cause a substantial erosion in the principal value of the trust.
England and Offshore
Much of what is said above about the situation in the United States holds true in England and the offshore jurisdictions albeit often expressed in slightly different language. We would like to highlight certain facets of claims in those jurisdictions. Claims for investment losses against a trustee fit into three categories: (1) unauthorized investments, (2) disloyal investments and (3) failure to invest with due care and attention or “negligent” investments.
Claims for unauthorized investment are now comparatively rare owing to statutory expansion of the categories of authorized investment; however, owing to the right of beneficiaries to investment by investment falsification of unauthorized investments such claims are devastating if successful. Under s 3 of the Trustee Act 2000, a trustee in England and Wales has a ‘general power of investment’, which allows him to invest the assets of the trust in any kind of investment he could make as if he were absolutely entitled to those assets. This statutory power does not extend to investments in non-UK land, save for loans secured on land (s 3(3) and 8, Trustee Act 2000). The statutory power may be widened by the trust instrument, which usually contains very wide powers of investments, but such clauses will be interpreted strictly against the trustee (Re Maryon-Wilson’s Estate  Ch 55). Likewise, the power can be limited by the provisions of a trust deed, if the trust was drafted after 3 August 1961. If the trustee has made unauthorized investments the beneficiaries may require that any unprofitable ones were made with the trustee’s own funds rather than with the trust assets.
Disloyal investment is more commonly seen and still problematic for trustees. As a fiduciary, the trustee owes undivided loyalty to his beneficiaries, and must not place himself in a position where his duties to third parties or his own interests conflict with his duty to the beneficiaries. Investments made in breach of this duty are disloyal investments. The trustee may be required to re-constitute the trust for any disloyal investments on an investment-by-investment basis without regard to whether they were competent investments; however, the trustee can argue that the disloyalty did not cause the losses, albeit the burden of establishing causation as a defence is on the trustee.
Finally, the trustee has an obligation to invest with due care and attention (for its jurisprudential and statutory expression see Re Whiteley (1886) 33 ChD 347 and s 1 of the Trustee Act 2000). In connection with such claims all of the common law protections and requirements of a claim sounding in negligence have been incorporated into this equitable claim. Significantly, losses suffered during the global financial crisis were held to be not foreseeable and therefore not actionable (Rubenstein v HSBC Bank plc  EWHC 2304 (QB),  2 CLC 459; though the decision was overturned on appeal  EWCA Civ 1184,  1 All ER (Comm) 915 on fact specific grounds that the investor in question had made it clear they did not want any exposure to the market). One wonders if such an argument would be successful to defeat claims arising from the current pandemic.
There are a number of arguments founding liability which might be (and likely will be) made for current investment losses including the failure to take advice. Whilst it is possible for the trustee to neither take advice nor to appoint a discretionary asset manager over the trust assets, this is limited to where the trustee believes it “unnecessary or inappropriate” to do so (section 5, Trustee Act 2000). The difficulty of course is that in retrospect given substantial losses in the trust this decision may appear questionable or indeed actionable. Additionally, whether the trustee has in fact taken advice is likely to be an issue in light of the rise of the doctrine of contractual estoppel (which estopps claims against investment advisors for negligent advice where their boilerplate language asserts that no advice has been given even where advice is in fact given) in JP Morgan Chase Bank v Springwell Navigation Corp.  EWCA Civ 1221,  All ER (D) 08 (Nov).
Volatile markets present a challenging environment for fiduciaries to navigate. While market declines increase the likelihood that beneficiaries will bring claims against fiduciaries for financial mismanagement, fiduciaries should be able to defeat such claims if they have exercised care in making decisions with respect to the retention, disposition, or acquisition of trust assets. As long as fiduciaries employ a prudent process in managing the investment of trust assets, it is unlikely that they will be liable for claims of breach of fiduciary duty resulting from the performance of the trust’s portfolio.