Rethinking Trust Law Reform: How Prudent is Modern Prudent Investor Doctrine?

Stewart E. Serk - Cardozo Law School

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Over the last two decades, the Restatement (Third) of Trusts1, the Uniform Prudent Investor Act2, and the Uniform Trust Code3—all influenced by modern portfolio theory—have reformulated the traditional approach to trust investing, jettisoning its ban on speculative investing.  Modern portfolio theory’s central tenet is that the prudent investor should seek to diversify risk, not to avoid it altogether.   Modern trust law has implemented modern portfolio theory in a number of ways.  First, recent statutes and Restatement provisions have eliminated the prohibition on speculative investments.  Second, they have imposed on trustees a duty to diversify.  Third, to ensure that persons with an understanding of portfolio theory make investment decisions, statutes and the Restatement have abrogated the traditional prohibition on delegation of investment responsibilities and have sought instead to encourage delegation.

These changes in law have generated a significant shift in trust investment practices.  Equities represent a larger share of trust portfolios—just as modern portfolio theory would suggest they should.  Widespread belief in the investment community that equities always outperform fixed-income investments undoubtedly exacerbated the shift to equities.  This shift has not generated tangible benefits for trust beneficiaries.  The 2008–09 stock market decline has been dramatic.  But, even over a longer time horizon—ten years rather than one—equity investments have performed poorly; both the Dow Jones Industrial Average and the Standard & Poor’s 500 Index stand at lower levels in June 2009 than they did ten years earlier.  In other words, trust law’s implementation of modern portfolio theory has apparently left many trust beneficiaries worse off than if the law had retained more traditional principles of trust investing. That fact suggests that it is time for a re-assessment of the recent “revolution” in trust law doctrine.

The Trust Reform Movement

Trust law traditionally mandated conservative investment strategies for trustees, prohibiting all investment in “speculative” enterprises and focusing on “safe” investments in real estate mortgages, government securities, and high-grade corporate bonds.  A trustee who invested in equities generated no personal gain if the equities increased in value, but the trustee risked liability for imprudence if the trust portfolio declined in value.  Dissatisfaction with the traditional approach became intense during the 1960s and 1970s, when it became painfully apparent to many trust beneficiaries that conservative, “safe” investments bore a significant risk of their own—the risk that high inflation rates would erode the real value of trust principal.

At roughly the same time that inflation risk was eroding the real value of traditional trust investments, academic theory began to challenge the notion that prudent investing required avoidance of all risky investing.  Modern portfolio theory emphasized that diversifying among firms and industries could minimize firm-specific and industry-specific risk.  Moreover, the strongest form of the efficient capital markets hypothesis leads to the conclusion that no investment is a bad investment, because the risk associated with the investment has already been factored into the investment’s price.

Trust law reformers implemented these insights into trust law doctrine.  Although the Second Restatement4, which the American Law Institute promulgated in 1959, had recognized a duty to diversify, that duty plays a far more critical role in the Third Restatement and the Uniform Prudent Investor Act (UPIA).  Under prior law, the duty to diversify was superimposed on a “prudent person rule” that also required a trustee to evaluate the prudence of each individual investment in a diversified portfolio.  By contrast, the Third Restatement and the UPIA permitted trustees to avoid liability for even the riskiest investments—investments that would previously have been deemed imprudent—so long as the trustee adequately diversified those investments.  Moreover, because modern portfolio theory required more sophisticated investment decisions, the likelihood that an individual trustee, or even a corporate trustee, would be able to assemble an ideal portfolio without relying on persons with investment expertise diminished.  As a result, reformers freed trustees from the shackles of the common law rule that prohibited delegation of trustee obligations.

Taken together, these doctrinal changes were designed to afford trust beneficiaries the benefits associated with modern portfolio theory.  But, the changes operated primarily by relieving trustees from liability for actions inconsistent with modern portfolio theory.  They did not impose liability on trustees for failure to take affirmative steps to implement modern portfolio theory.  Of the three major “reforms,” only one imposed liability on trustees, and that one—the duty to diversify—had largely been established before promulgation of the UPIA and the Restatement (Third).  Significantly, neither the Restatement nor the UPIA developed liability rules that would constrain trustees from assuming too much market risk, despite modern portfolio theory’s clear recognition that diversification alone would do nothing to protect investors against market risk.

Re-Examining Modern Portfolio Theory as a Basis for Trust Investing

Market reverses over the past decade have left intact some of the basic premises of modern portfolio theory.  First, the premise that diversification of investments can reduce risk without compromising expected return has emerged largely unscathed.  The jury may still be out on whether a select number of savvy investors can reduce risk and increase return more effectively by careful study of the “fundamentals” associated with a small number of investments.  The empirical evidence, however, suggests that it will be a rare investor who can consistently “beat the market,” and it certainly appears unlikely that trust beneficiaries as a whole would be better off if trust law doctrine relieved trustees of the duty to diversify.

Second, market reverses have not undermined modern portfolio theory’s conclusion that an investment portfolio, including a trust portfolio, can optimally deal with non-diversifiable market risk by adjusting the portfolio’s percentage of high-risk, high-return investments.  Recent market reverses cast doubt on the proposition that, over the long term, equities will always outperform bonds and treasury bills.  But,  ignoring the historical returns of equities would be imprudent, just as it would be imprudent to ignore more recent events.  What recent events have emphasized is the standard caveat that past performance is no guarantee of future results.  In the face of uncertainty, hedging one’s bets remains a sensible strategy.

Other premises of portfolio theory seem less inevitable than they once did.  Consider first the premise that to compensate for the risk an investor takes the expected return on common stocks and other more volatile investments must be higher than the expected return on more stable investments .  That premise assumes that investors are risk averse rather than risk neutral or even risk preferring—a premise that appears not to be universally true.  Moreover, even if investors were risk averse, the investments that would command a risk premium would be those that present the greatest perceived risk to investors.  Over the last several decades, however, modern portfolio theory has conditioned many investors to believe that the risk associated with equity investments is low (because stocks always outperform fixed-income investments in the long run), and that fixed-income investments generate significant inflation risk.  If the investing public internalizes these messages, there is little reason to expect that equity investments must pay a “risk premium” to entice investors; instead, in periods of steady rise in stock prices, investors are more likely to underestimate the risks associated with market decline.

Second, insights from behavioral economics challenge the premise that every investment is, in appropriate proportion, a suitable trust investment.  That premise derives from the strong form of the efficient capital markets hypothesis, which holds that because the market price reflects all available information about a security’s risk and return, every investment is a suitable investment at its current price.  Behavioral economics suggests, however, that the pricing of individual securities reflects investor psychology as much as it reflects economic fundamentals.  A “herd” mentality causes many investors to bid up the price of securities (or to sell them off) without any economic foundation for the investment decisions.  The problem is especially serious with new issues, where the investor has no significant basis for determining expected return or covariance.  But, if an investor has no sound basis for determining expected return, the investor has no basis for assuming that adding the stock to a portfolio will preserve expected return or reduce risk—the objectives of diversification.

Putting Theory Into Practice:  Re-examining Doctrinal Implementation of New Learning About Investment Practice

Even if one were to accept all of the modern portfolio theory principles endorsed in the UPIA and the Restatement, the doctrinal structure those enactments established provides an inadequate framework for assuring that trustees apply those insights.  And, to the extent that modern portfolio theory underestimates particular investment risks, the doctrinal structure magnifies the risk to trust beneficiaries.

Unlike individual investors, trustees do not reap the benefits or suffer the losses that result from their investment decisions.  As a result, the trust relationship generates agency costs, raising questions about the role legal doctrine can and should play in addressing any mismatch between the interests of the beneficiaries and those of the agent (the trustee).

So long as preservation of trust principal is treated as the trust’s primary objective, aligning the trustee’s interests with those of the trust beneficiaries is not difficult.  Imposing liability on a trustee who makes investments that place trust principal at risk creates the right incentives; because the trustee receives no personal benefit from the higher returns the trust will generate from investments that do place trust principal at risk, but does bear the downside loss associated with such investments, the trustee who is at all sensitive to financial incentives will avoid risking trust principal—the hypothesized goal of the trust settlor.

Rejection of traditional theory complicated the agency-cost problem.  The “prudent” trustee could no longer look to any single talisman in making investment decisions; an investment strategy that balanced risk and return would best serve beneficiaries.  How, then, should the legal system encourage trustees to take the appropriate risks?  Traditional doctrine discouraged all investment in equities, particularly equities in companies not regarded as “blue chips.”  As a result, the drafters of the Third Restatement and the UPIA focused their efforts on eliminating any inference that a trustee could be held liable for imprudence merely because the trustee had invested part of a trust portfolio in high-risk, high-expected-return securities.

Once the drafters of the Restatement and the UPIA rejected categorical restrictions on types of investment, they were largely content to make marginal changes to the traditional standard-based prudent-person rule.  The standard-based approach provides little protection to beneficiaries against a trustee’s assumption of excess market risk.  The drafters, however, provided no black-letter substitute for the old regime’s protection against market risk.  Instead, they exhorted trustees to consider the risk tolerance of the trust in assessing how much market risk to take.  But neither the Restatement nor the UPIA indicates what standard of review to apply to the decisions trustees make in response to that exhortation.

The Restatement and the UPIA admit two possible interpretations.  First, courts might construe the Restatement and UPIA to confer broad discretion on trustees, with limited judicial review of a trustee’s investment judgment, so long as the trustee adequately diversifies firm-specific risk.  That interpretation imposes little discipline on trustees.  Second, courts might construe the Restatement and UPIA as imposing on courts a responsibility to provide more substantive oversight of the prudence of a trustee’s decisions.  That interpretation imposes on the trustee a liability risk that the trustee cannot reasonably avoid, which is likely to raise trustee fees and price some settlors out of the trust market.  Neither alternative is attractive.

How can trust law induce trustees to be more responsive to the investment objectives of the trust settlor and to the financial needs of the trust beneficiaries?  One answer is to develop a set of rule-like safe harbors that provide trustees with significantly more guidance than current law while simultaneously providing incentives for the settlor and the trustee to discuss and agree upon trust investment strategy at the time the settlor creates the trust.

Suppose, however, that the UPIA and the Restatement were amended to include, either in black letter or in a comment, something like the following language: “No trustee shall be liable for exposing the trust or its beneficiaries to excessive market risk if the trustee limits the trust’s investment in equities to 60% of the aggregate trust portfolio.” The addition of this language would not expose trustees to additional liability, but would instead create a “safe harbor” for them.

The safe harbor would provide a blueprint for trustees seeking to avoid liability.  A trustee who takes advantage of the safe harbor avoids both the expense of legal advice and the threat of liability of a de novo review regime, under which a court would substantively examine the prudence of the trustee’s investment decisions.  Because these costs would otherwise be passed on to the trust settlor and/or beneficiaries, the safe harbor approach would make trusts more affordable than would a regime that imposed more risk on the trustee.

At the same time, superimposing a safe-harbor provision on a regime that otherwise carefully scrutinizes investment decisions mitigates agency costs far better than a regime in which courts defer to trustee decisions.  If the primary concern in a regime regulated only by the market is that trustees will be inclined to pursue high expected return even when the risk associated with that return is not in the interest of trust beneficiaries, a safe-harbor regime addresses that concern by providing an incentive to limit equity investments to the amounts encompassed by the safe harbor.

Consider now the principal objections to such a safe-harbor regime (or one like it).   One potential objection is that rulemakers—legislators, with the aid of experts and lobbyists—do not have enough information about optimal investment strategy to craft sensible rules.  Were it not for the inadequacy of market discipline, the absence of reliable information about investment strategy might be a plausible argument for deference to the decisions of trustees.  This, however, is not an argument that a standard-based regime would be preferable to the safe-harbor approach.  In a standard-based regime, legal decision-makers will ultimately have to evaluate the prudence of particular investment strategies, but they will do so ex post, generating the potential for hindsight bias—a problem mitigated by a legal regime that provides trustees with ex ante safe harbors.

A second objection focuses on the inadequacy of one-size-fits-all safe harbors to account for the disparate needs and risk tolerances of trusts established for a multitude of different purposes.  A trustee, however, can protect itself against liability for departing from the safe harbor regime by ensuring that language in the trust instrument authorizes trust investment practices that differ from those that qualify for safe harbors. Alternatively, the trustee can protect itself by obtaining consent from the trust beneficiaries.

None of this is to suggest that a rule-based safe-harbor approach would have avoided all losses to beneficiaries during recent bear markets or to suggest that it will prevent future losses.  A safe harbor approach, however, does have greater potential for reducing agency costs than does the current version of the prudent-investor rule.

Acknowledgments:

Stewart E. Sterk is the Mack Professor of Law at Benjamin N. Cardozo Law School.

This Legal Workshop Editorial is based on Mr. Sterk’s Article: Stewart E. Sterk, Rethinking Trust Law Reform: How Prudent is Modern Prudent Investor Doctrine?, 95 CORNELL L. REV. 851 (2010), available at http://www.lawschool.cornell.edu/research/cornell-law-review/upload/Sterk-final.pdf

  1. RESTATEMENT (THIRD) OF TRUSTS (2007)
  2. UNIF. PRUDENT INVESTOR ACT (1994)
  3. UNIF. TRUST CODE (amended 2000)
  4. RESTATEMENT (SECOND) OF TRUSTS (1959).

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