In a celebrated 1830 Massachusetts decision, Harvard v. Amory, Judge Samuel Putnam pronounced a legal principal that became the universal standard for fiduciary conduct, the “Prudent Man Rule.” His opinion stated:
All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is 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.
That rule, as modified and narrowed by state legislatures and courts, has guided trustees for over 150 years. But the certainty and protection it provides trustees increasingly has come at the expense of investment performance. For example, the rule evolved to prohibit entire categories of investments and to protect trustees who ignore the impact of inflation or deliver mediocre investment results so long as they invest in “prudent” securities.
As the weaknesses of the Prudent Man Rule became increasingly apparent to the trust community, efforts were made to update it, culminating with the publication of the Uniform Prudent Investor Act in 1994. This act, which should soon apply in all 50 states, drastically changes the way trusts must operate.
With Investing and Managing Trusts under the New Prudent Investor Rule, John Train and Thomas A. Melfe show trustees how to manage trusts according to the New Rule. The authors’ experience makes them particularly suited to write such a guide. Train founded his own money management firm 40 years ago and is the author of several books on investing, as well as numerous columns in financial publications. Melfe practices trust and estate law in New York City and has written and lectured extensively on trusts, wills, taxes, and estate planning.
While the New Rule is directed at trustees of private trusts (including charitable trusts), the authors argue that it may well influence the investment duties of foundation trustees, since the laws governing investment by charitable corporations and trusts are converging and should eventually settle on a single standard. “If there is doubt, board members would seem well advised to use the New Rule as a guide to investing a charitable corporation’s funds, rather than to ignore it and hope they are acting prudently.” This warning should be taken seriously given that “by imposing a very high standard of care the New Rule makes it easier to establish trustee liability.”
The New Rule contains five basic principles:
- Diversification is fundamental to risk minimization and is therefore ordinarily required of trustees.
- 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 purpose of the trust.
- Trustees have a duty to avoid fees, transaction costs, and other expenses that are not justified by the objectives of the investment program.
- The fiduciary’s duty of impartiality requires a conscious balancing of current income and growth.
- Trustees may have a duty, as well as the authority, to delegate as prudent investors would.
In the first chapter the authors review the history of trusts, summarize the different types of trusts, and explain the key duties of trustees. The second chapter addresses prudence, the central concept of trust management, reviewing the evolution of the legal standard of prudence from Judge Putnam’s Prudent Man Rule to the new Model Act. The authors describe prudence as “ a process, not a result,” a “flexible and unspecified standard of care” lacking the “safe harbor” features found in other regulatory areas such as federal securities and tax law. A key feature of the Model Act permits a trustee to delegate investment and management functions that he previously had to perform personally. This change will allow trustees to invest in private equity, venture capital hedge funds, and other asset classes long favored by institutional investors but considered “imprudent” under the old rule.
In the third chapter the authors offer a framework for a trust management system that trustees can adopt to help show they discharged their investment responsibilities prudently. “An organized and disciplined approach lends the appearance and, one hopes, the substance of prudence. A seat-of-the-pants approach smacks of imprudence.” They suggest documenting the trustee’s decision-making process and developing an orderly procedure for delegating duties to outside agents, such as investment managers. In selecting outside investment managers, the authors suggest using screening processes similar to those employed by institutional investors. An example of a questionnaire for a manager search is included as one of many useful appendixes.
The fourth chapter addresses the nuts and bolts of investing under the New Rule. The authors suggest an approach to diversification, explaining that if the purpose is to spread risk so as to avoid large losses, less is needed than one might think (academic studies have shown that beyond twenty companies in several industries, little is gained by further diversification).
The authors have strong views on the subject of risk, and are especially scornful of the common practice of equating risk with market price volatility. Volatility, after all, is what allows one to buy low, and Train and Melfe are quick to point out that some of the most successful portfolios are among the most volatile. In their view, the more significant real risk elements trustees should focus on are business risk, country risk, market risk (overpaying for a stock), and inflation. But while the New Rule requires trustees to take note of the likelihood of inflation (or deflation) the authors warn of the difficulties of usefully integrating views of inflation into investment action.
And finally, the authors include a brief discussion of sources of investment information. They caution trustees to avoid a short-term perspective since trusts intrinsically have long-term objectives, and suggest a bias toward “letting profits run” in highly successful investments rather than mechanically selling down winners to stay within an allocation formula.
Investing and Managing Trusts is clearly written and packed with useful information. It is a timely handbook for trustees of personal and charitable trusts seeking to understand their responsibilities under the New Rule. It is also a useful guide for trustees of foundations and other nonprofits wishing to apply a more rigorous framework to investing the funds with which they have been entrusted.
Russell P. Pennoyer is a partner of the investment bank Benedetto, Gartland & Company, Inc., where he raises capital for private equity partnerships. He is also a trustee of the Achelis and Bodman Foundations and of several private trusts.