W. Scott Simon
In last month’s column, I discussed how the father of Modern Portfolio Theory, Nobel laureate Harry Markowitz, unknowingly set out on a course one day in 1950 that would change the nature of investing forever. That day also marked the beginning of a long process in which an understanding of the nature of financial markets and investing increased exponentially, aided especially by the rapid acceleration in computing power.
An important outcome of this process was the great reformation in the law of trusts in the 1980s, 1990s, and 2000s. Modern Portfolio Theory quite literally caused an evolution in the law of trusts.
The Prefatory Note to the Uniform Prudent Investor Act (UPIA) underscores the significant influence that Modern Portfolio Theory has had on investing and its tremendous effect in encouraging and guiding the reform of the law of trusts in America:
“[F]rom the late 1960s the investment practices of fiduciaries experienced significant change. [UPIA] 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 UPIA, as noted in last month’s column, codifies the essential principles of trust law laid down by the Restatement (Third) of Trusts. The Restatement identifies five “principles of prudence.” Among these are those which “instruct trustees [that is, fiduciaries] and courts that: (1) sound diversification is fundamental to risk management and is therefore ordinarily required of trustees; (2) risk and return are so directly related that trustees have a duty to analyze and make conscious decisions concerning the levels of risk appropriate to … the trusts [including those for the benefit of trust fund babies, participants in private 401(k) plans and in public employee pension plans, and others] they administer; (3) trustees have a duty to avoid fees, transaction costs, and other expenses that are not justified by needs and realistic objectives of the trust’s investment program.”
The Restatement–which supersedes the 1935 Restatement of Trusts and the 1959 Restatement (Second) of Trusts–was issued by the American Law Institute (ALI) in 1992 (with periodic updates in 2003, 2007, and 2012). Established in 1923, the ALI is an eminent group of attorneys, law school professors, and judges that formulates principles of law often cited by courts and legislatures as sources of legal authority. (Examples of other Restatements–which are legal treatises well known to generations of law students–include the Restatement (Second) of Conflict of Laws and the Restatement (Second) of Contracts.)
The Restatement (as is true of any other Restatement of Law) encompasses text that sets forth black- letter law (such as its section 90–otherwise known as the Prudent Investor Rule) along with explanatory Comments, instructive Illustrations and detailed Reporter’s Notes. Every Restatement of the Law has a Reporter who is a widely respected professor of law in his or her relevant field. The Reporter, with the assistance of other distinguished law professors, jurists, and attorneys, drafts and coordinates the black- letter law of a Restatement as well as its Comments and Illustrations. Although these are formally approved by the ALI, the Reporter’s Notes are authored solely by the Reporter.
The Reporter for the Restatement is the late Edward C. Halbach Jr., who was the Walter Perry Johnson professor of law emeritus at Boalt Hall, the University of California, Berkeley law school where he also served as the former dean. (Professor Halbach was of immense aid to me and most gracious in offering many helpful suggestions to help strengthen the manuscript of my 2002 book, The Prudent Investor Act: A Guide to Understanding. He endured a nearly six-hour, uninterrupted phone conversation with me in going over a final review of the manuscript. As I noted in the acknowledgments section of my book, Ed Halbach was the very epitome of what it means to be a scholar and a gentleman.)
Two years after issuance of the Restatement, the National Conference of Commissioners on Uniform State Laws (NCCUSL) issued the UPIA in 1994. The NCCUSL, founded in 1892, is a confederation of state commissioners on uniform laws. Its membership comprises 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.
Among the more than 250 uniform and model laws issued by the NCCUSL are those that flow directly from promulgation of the UPIA. These include the 1997 Uniform Management of Public Employee Retirement Systems Act (UMPERSA), 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 through rules related to principal and income allocation for private family trusts (now revised as the 2018 Fiduciary Principal and Income Act with enactment in one state); the 2000 Uniform Trust Code, which not only draws upon the Restatement but also incorporates the entire text of the UPIA (enacted in 34 states plus the District of Columbia); and the 2006 Uniform Prudent Management of Institutional Funds Act (UPMIFA), which governs the investment conduct of the fiduciaries (directors and trustees) serving as stewards of the portfolios (institutional funds) of charitable organizations such as foundations and endowments (enacted in 49 states plus the District of Columbia and the U.S. Virgin Islands).
In May 2015, the U.S. Supreme Court reminded all in Tibble v. Edison International that the underlying foundation of the Employee Retirement Income Security Act of 1974, as amended (ERISA), is the 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 its opinion, the court relied heavily on the Restatement and the UPIA, treating them as authoritative clarifications of the principles applicable under ERISA to fiduciary investment matters.
The legislative history of ERISA makes clear that the law governing qualified retirement plans is tied closely to these principles of the law of trusts. (See the Preamble to ERISA Regulations section 2550.404a-1 and the accompanying discussion.) In addition, ERISA is derived from the common law of trusts, the Restatement restates that the common law of trusts and the UPIA is a codification of the Restatement, so it’s not difficult to understand that the standards of the UPIA have a direct bearing on the conduct of investment fiduciaries of qualified retirement plans such as 401(k) plans. John Langbein, the Reporter for the UPIA and Sterling Professor Emeritus of Law and Legal History at Yale Law School, observes: “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.”
As is apparent, virtually every investment fiduciary in America charged with investing and managing other people’s money is governed by the principles of the law of trusts, whether those principles are expressed in ERISA, the Restatement, or the UPIA and its numerous progeny such as UPMIFA which governs non-profits such as foundations and endowments. Even in the 48 states where public employee retirement plans are not governed by UMPERSA, there are state fiduciary laws which typically track the fiduciary language of the law of trusts found in ERISA and they apply to such plans.
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.