Flexibility’s Role in Modern Prudent Fiduciary Investing

Since all investments place capital at risk, it's impossible to provide absolute safety from the capriciousness of financial markets.

W. Scott Simon

 

In last month’s column, I cited Tibble v. Edison International, the 2015 U.S. Supreme Court case decided unanimously, in which the court reminded all that the fundamental, underlying foundation of the Employee Retirement Income Security Act of 1974, as amended (ERISA), is the common law of trusts. The court observed: “We have often noted that an ERISA fiduciary’s duty is ‘derived from the common law of trusts…'” In effect, then, ERISA “federalized” the common law of trusts.

Twenty years later, the National Conference of Commissioners on Uniform State Laws (NCCUSL) promulgated the Uniform Prudent Investor Act (UPIA). The NCCUSL, founded in 1892, is a confederation of state commissioners on uniform laws. Its membership is comprised of hundreds of attorneys, judges, and law professors who are appointed by each of the 50 states, the District of Columbia, Puerto Rico, and the U.S. Virgin Islands, to draft uniform and model laws and work toward their enactment.

The NCCUSL has promulgated more than 200 uniform and model laws during its existence, including the Uniform Commercial Code, a well-known example of a uniform law. Other examples of such uniform laws are those in the investment field, all of which sprang from the UPIA which, in turn, was birthed by the Restatement (Third) of Trusts (Restatement). These include the 1997 Uniform Management of Public Employee Retirement Systems Act, which governs the investment conduct of fiduciaries responsible for municipal, county, and state public employee pension plans; the 1997 Uniform Principal and Income Act, which helps to coordinate the implementation of Modern Portfolio Theory and prudent investing with rules pertaining to principal and income allocation for private family trusts; the 2000 Uniform Trust Code; and the 2006 Uniform Prudent Management of Institutional Funds Act, which governs the investment conduct of the fiduciaries (e.g., directors and trustees) serving as stewards of the portfolios (e.g., institutional funds) of charitable organizations.

The UPIA governs the investment conduct of fiduciaries of private family trusts. The 23-page UPIA, as noted, is derived from the 300-plus page 1992 Restatement–successor to the 1932 Restatement of Trusts and the 1959 Restatement (Second) of Trusts–all promulgated by the American Law Institute (ALI). In existence since 1923, the ALI is an influential group of attorneys, law school professors, and judges that formulates statements of legal principles which often become sources of authority followed by courts and legislatures.

The purpose of the ALI, as stated in its charter, is to “promote the clarification and simplification of the law and its better adaptation to social needs, to secure the better administration of justice, and to encourage and carry on scholarly and scientific legal work.” (Examples of Restatements–which are legal treatises–include the Restatement of Remedies and the Restatement of Criminal Law.)

Every Restatement has a Reporter who is typically a distinguished professor of law in his or her relevant field. The Reporter, aided by input from other distinguished law professors, jurists, and attorneys, coordinates and drafts the respective Restatement and commentary. The Reporter for the Restatement was Edward C. Halbach Jr., the Walter Perry Johnson professor of law emeritus at Boalt Hall, the University of California, Berkeley law school.

Halbach, appointed dean at Boalt Hall at age 33, completed his monumental four-volume work–first promulgated in 1992 (which incorporated previous drafts going back to the late 1980s)–only in 2007. The Restatement revises and supersedes the 1959 Second Restatement by incorporating modern principles and theories of investment and finance into the basic text of the Prudent Investor Rule and its supporting commentary.

The Need for Flexibility

A primary purpose in promulgating the Restatement was to restore the flexibility and generality of the Prudent Man Rule which had been set forth by the Massachusetts Supreme Judicial Court in the 1830 case of Harvard College v. Amory. Dictum in that case–which forms the foundation of trust investment law in America–admonishes trustees to “observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”

Harvard College recognized implicitly that there are no “safe” investments per se: “Do what you will, the capital is at hazard. If the public funds [i.e., ‘safe’ government securities] are resorted to, what becomes of the capital when the credit of the government should be so much impaired as it was at the close of the last war [the War of 1812]?”

While investing in American enterprises had always been speculative by nature, the Harvard College court recognized that even government bonds could be risky at times. Since all investments placed capital at risk (more or less), it was therefore impossible to provide absolute safety from the capriciousness of financial markets.

The Prudent Man Rule crafted by the Harvard College court represented a significant advance in American trust law. The court set forth a flexible and very general rule of investment prudence to be followed by trustees, thereby rejecting the attempt to specify approved types of investments such as government bonds (and, say, utilities stocks a century later). Halbach summarizes concisely the case for flexibility: “Flexibility is needed not just for the widely varied objectives and circumstances of different trusteeships but also to adapt over time to changes in the operation of financial markets, in the investment products available and in the practices of fund managers, as well as in the theories and knowledge underlying these practices.”

Over the next century, however, courts altered the Prudent Man Rule established by Harvard College. The flexible and broad principles established in that case changed into narrow rules. As these rules were adopted in an effort to offer guidelines to trustees, the Prudent Man Rule lost much of its flexibility and generality. Judging and classifying investments on a stand-alone basis (now verboten given the importance of the portfolio as the relevant unit of analysis under modern prudent fiduciary investing) tended to stamp broad classes of assets or courses of action as “speculative, “or imprudent, as a matter of law (i.e., “bonds good, stocks bad”). Itemized lists of legislative- and court-approved trust investments–known as “Legal List Rules”–appeared in many jurisdictions.

Ironically, the commitment of those drafting the Restatement who favored restoring flexible and broad fiduciary investment principles first established in a legal case nearly 200 years ago was actually tested during the Restatement’s drafting process. Some involved in that process felt that indexing investment strategies should be the only prudent ones allowed when managing trust assets under modern prudent fiduciary investing (i.e., the Restatement as well as the UPIA and, as noted, its myriad progeny).

Cooler heads prevailed, however. They reminded their peers that one of the fundamental, underlying goals of the great reformation of trust investment law that began in the 1980s was to restore flexibility and generality to the Prudent Man Rule by creating the Prudent Investor Rule. Mandating indexing investment strategies–or active investment strategies, for that matter–would be the very antithesis of that massive undertaking.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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