W. Scott Simon
Last spring, I attended a financial services conference where the discussion turned to the Uniform Prudent Investor Act. My ears perked up at that point, because I have more than a passing interest, having written The Prudent Investor Act: A Guide to Understanding.
Someone in the audience piped up and said that it was his understanding the act was being displaced by the Uniform Trust Code. How do such vicious rumors get started? So one reason for this month’s column will be to set the record straight and lay to rest this unfair assault on the good name of the Uniform Prudent Investor Act.
Another reason for this month’s column, which will be a respite from my (so far) four-part series on non-fiduciary investment consultants, is to spread the good word about publication in July of the Uniform Prudent Management of Institutional Funds Act. That act, among other things, governs the investment conduct of trustees responsible for non-profit money such as foundations and endowments.
The Bible: Restatement 3rd of Trusts (Prudent Investor Rule)
Think of the Restatement 3rd of Trusts (Prudent Investor Rule)–always a mouthful–as the bible of trust investment law in America. The Restatement is the scholarly and authoritative forebear of the Uniform Prudent Investor Act. In fact, the Restatement can be thought of as a kind of Godfather to the act.
Before getting into what that means, I’d like to answer a basic question that a number of people have asked me: Just what the heck is a restatement? A restatement is a legal treatise that examines the common law and state statutes in a particular field of law and restates them as broad legal principles. These principles (as formulated in a restatement of law) often become a source of authority that is given great respect by courts and legislatures.
There are restatements in many different fields of law, such as criminal law, tort law, remedies law, criminal law, and, of course, of great interest to all modern prudent fiduciaries, trust law. The organization that publishes restatements of the law is the American Law Institute, which was established in 1923. The purpose of the institute, an influential group of attorneys, law school professors, and judges, 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.”
The first volume of the multivolume Restatement 3rd of Trusts, which covers the Prudent Investor Rule, was published in 1992. This was the result of a long effort by the distinguished committee of attorneys and law school professors charged with drafting a new Restatement of Trusts to update the 1959 Restatement 2nd of Trusts. (The first Restatement of Trusts was published in 1935.) Every committee with the responsibility of drafting a new restatement of law has a head honcho drafter, or what is known formally as a Reporter. The Reporter for the Restatement 3rd of Trusts is Edward C. Halbach Jr., the Walter Perry Johnson Professor of Law Emeritus at the University of California Law School.
One of the overarching goals of the committee drafting the Restatement was to revise and supersede the Prudent Man Rule. According to this rule, first set forth in the 1830 Massachusetts case of Harvard College v. Amory, the goal of a fiduciary is to make the assets it manages productive by seeking the highest income possible while safeguarding the value of the principal. The Prudent Man Rule gradually became prevalent in most U.S. jurisdictions through legislation and court opinions and was the rule in the Restatement 2nd of Trusts.
Dissatisfaction with the Prudent Man Rule began to appear in legal and investment circles as the tenets of Modern Portfolio Theory were applied in the 1960s. The Prefatory Note to the Uniform Prudent Investor Act explains: “From the late 1960s the investment practices of fiduciaries experienced significant change. The [Uniform Prudent Investor Act] undertakes to update trust investment law in recognition of the alterations that have occurred in investment practice. These changes have occurred under the influence of a large and broadly accepted body of empirical and theoretical knowledge about the behavior of capital markets, often described as ‘modern portfolio theory.'”
The committee drafting the Restatement, therefore, sought to revise and supersede the Prudent Man Rule by incorporating modern theories of investment and finance into the general language of the Restatement’s Prudent Investor Rule. This underscores the central importance of Modern Portfolio Theory in investing and its tremendous influence in prompting and shaping the reform of U.S. trust investment law. In fact, Modern Portfolio Theory provides the theoretical underpinnings of the Restatement as well as the Uniform Prudent Investor Act.
The black letter and comments of the Restatement represent the official views of the American Law Institute. The Reporter’s Notes to the Restatement, which contain supporting authority, explanation, and other discussion by the Reporter, were not reviewed by the institute and thus are not considered part of its views. Given the prestige of the institute, its pronouncements in the different restatements of law carry great influence and are a ready source of authority for courts and legislatures to follow.
Nonetheless, the institute is not a governmental body and no restatement of law has the sanction of any statute.
The Octopus: Uniform Prudent Investor Act
To help rectify this, the Uniform Prudent Investor Act was published in 1994 by the National Conference of Commissioners on Uniform State Laws. This Chicago-based group, founded in 1892, is a confederation of state commissioners on uniform laws. Commissioners of each of the 50 states, the District of Columbia, Puerto Rico, and the U.S. Virgin Islands have access to more than 300 prominent attorneys, judges, and law professors who are available to draft uniform and model laws and work toward their enactment. (To date, the commissioners have promulgated approximately 250 uniform and model laws, including such hits as the Uniform Commercial Code.)
The Uniform Prudent Investor Act sets forth prudent fiduciary standards governing the investment conduct of trustees of private family trusts. The terms of the act, however, make clear that its standards also have a bearing on the investment conduct of fiduciaries in other fields of investing. These fiduciaries, as will be shown, include those responsible for investing and managing the assets of ERISA retirement plans, public employee retirement plans, and charitable nonprofits, including foundations and endowments.
The 23-page act draws upon and codifies the 300 plus-page Restatement. A commentator explains the close relationship between the Restatement and the Uniform Prudent Investor Act: “[The act’s] tie to the Restatement is significant, because it is the Restatement that provides numerous examples of prudent and imprudent investing, as well as providing the underlying rationale of the rules that are now part of the [act].”
As a result, the act and its commentary embody the wording and principles of prudence laid down by the Restatement and its commentary. The Restatement and the act stand together at the very center of modern prudent fiduciary investing; indeed, they define its very standards.
The act has served as a model for states that have adopted their own versions of it. To date, 44 states (get busy Delaware, Florida, Georgia, Kentucky, Louisiana, and New York), the District of Columbia, and (lest we forget) the U.S. Virgin Islands have enacted the act into law. The American Bar Association endorsed the act in 1995, as has the American Bankers Association.
The tentacles of it have spread far and wide into virtually all fields of U.S. trust investment law. These fields are covered by uniform acts published by the National Conference of Commissioners:
• The Uniform Management of Public Employee Retirement Systems Act, published in 1997.
• The Uniform Principal and Income Act, 1997.
• The Uniform Trust Code, 2000.
• The Uniform Prudent Management of Institutional Funds Act, 2006.
It’s not a stretch, then, to say that the fiduciary investment standards of the Uniform Prudent Investor Act govern, directly and indirectly, the conduct of a wide variety of trustees in the investment and management of hundreds of billions of dollars.
Uniform Management of Public Employee Retirement Systems Act
Public pension plans are regulated by state laws, which vary considerably, and in many cases have not kept up with modern investment practices. The Uniform Management of Public Employee Retirement Systems Act sets forth uniform standards governing the investment conduct of fiduciaries responsible for investing and managing the assets of public employee pension plans.
These uniform standards are based on trust law. Fiduciaries are required to live up to the trust law standard, which is the highest known in law. The National Conference of Commissioners’ summary of the act describes the special responsibilities of fiduciaries when they hold assets in trust: “By declaring that all retirement system assets are held in trust, public employees are guaranteed the highest standard of conduct in the management and investment of assets for retirement that the law can establish. A trustee carries the greatest burdens of care, loyalty and utmost good faith for the beneficiaries to whom he or she is responsible.”
The act incorporates modern investment practices with relevant text and commentary from the Uniform Prudent Investor Act. Chapter 15 of my book is an analysis of how closely the text of the act tracks that of the Uniform Prudent Investor Act. Wyoming and Maryland enacted the Uniform Management of Public Employee Retirement Systems Act into state law in 2005, and the fiduciary sections of the act became law in South Carolina in 1998.
Uniform Principal and Income Act
The Uniform Principal and Income Act helps to coordinate the implementation of Modern Portfolio Theory and prudent investing with new rules pertaining to principal and income allocation in trusts. The prefatory note to the act states that one of the two purposes in publishing it was “to provide a means for implementing the transition to an investment regime based on principles embodied in the Uniform Prudent Investor Act.”
The Uniform Principal and Income Act is meant to accommodate both the duty of impartiality and facilitate fiduciary implementation of principles of Modern Portfolio Theory and prudent investing set forth in the Uniform Prudent Investor Act and the Restatement.
The act is now law in 41 states and the District of Columbia. The American Bar Association endorsed it in 1998.
Uniform Trust Code
The Uniform Trust Code is a national codification of the law of trusts as well as an effort to reform that body of law by incorporating modern notions of fiduciary investment conduct.
The Uniform Prudent Investor Act pertains to a series of duties required of a trustee concerning the investment and management of trust assets. The Uniform Trust Code pertains to a series of duties required of a trustee concerning the investment, administration, and distribution of trust assets. The two, therefore, overlap in a number of areas.
To handle this overlap, the National Conference of Commissioners drafted the Uniform Trust Code so that article 9 of the code had no content. This allows state legislators to insert certain sections of the Uniform Prudent Investor Act into article 9 of the code that are not already addressed in article 8.
The following sections of the Uniform Prudent Investor Act are already incorporated virtually verbatim into article 8 of the code: “special skills” of Uniform Prudent Investor Act section 2(f), “duty of loyalty” of section 5, “impartiality” of section 6, “investment costs” of section 7 and “delegation” of section 9.
That leaves the following sections of the Uniform Prudent Investor Act to be incorporated by state legislators into article 9 of their respective versions of the Uniform Trust Code: “prudent investor rule” of section 1, “standard of care, portfolio strategy, and risk and return” of section 2(a)-(e), “diversification” of section 3, “duties at inception of trusteeship” of section 4, “reviewing compliance of section 8 and “language invoking standard of the [Uniform Prudent Investor Act ]” of section 10. The code is now law in 16 states and the District of Columbia.
Uniform Prudent Management of Institutional Funds Act
The Uniform Prudent Management of Institutional Funds Act governs the investment conduct of trustees responsible for non-profit money, such as foundations and endowment funds at, say, hospitals, colleges, and universities.
The act revises the 1972 Uniform Management of Institutional Funds Act, which is currently law in 48 states and the District of Columbia. The act requires trustees to conduct themselves according to the prudence standard of investment decision-making by using, for example, a portfolio approach in making investments and considering the risk and return objectives of their funds. The act, by incorporating provisions of Modern Portfolio Theory from the Uniform Prudent Investor Act, brings the law governing charitable institutions into line with modern investment practices, thereby permitting more efficient management of charitable funds.
The new act (unlike the 1972 act) makes clear that standards for investing and managing institutional charitable funds will be the same regardless of whether a charity is organized as a trust or a non-profit corporation, or in some other way. Another organization, the Independent Sector (convener of the Panel on the Non-Profit Sector), has seconded this notion by recommending that modern investment
practices should apply uniformly to charitable organizations, whether they’re based in trust law or non-profit corporation law. The Panel on the Non-Profit Sector released nine Draft Supplemental Recommendations that were submitted to the Finance Committee of the U.S. Senate in October (the original report was submitted in June 2005). One such Draft Supplemental Recommendation concerns prudent investor standards.
The second of three recommendations made by the Panel in this Supplemental Recommendation states: “Charitable organizations should work with their state legislatures to amend state laws to ensure that the prudent investor standard of care for investment decisions, as set forth in the Restatement of Trusts (Third) and the Uniform Prudent Investor Act, is made applicable to all charitable organizations, whether formed as trusts or corporations.”
Back to the Future: Employee Retirement Income Security Act
The Uniform Prudent Investor Act is also an important source of authority for regulating the investment conduct of trustees of private sector pension plans governed by the federal Employee Retirement Income Security Act (1974). ERISA, as federal law, preempts all state laws “insofar as they may now or hereafter relate to any employee benefit plan.”
Nonetheless, ERISA absorbs much of the common law of trusts developed by the states. John Langbein, the Reporter for the Uniform Prudent Investor Act, who is Chancellor Kent Professor of Law and Legal History at Yale University law school explains: “ERISA has always been interpreted with a strong eye on the common law, and it is therefore quite clear that the Uniform Prudent Investor Act will powerfully affect the federal courts in their interpretation of ERISA.”
When you’re swimming in the ocean, you have to watch out for sharks, but if you’re a fiduciary investing and managing other people’s money, you’d better keep your eye on the octopus.
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™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.