Trust investment disputes


Author: Simon Ekins


In this article we look at some of the issues concerning trustees and beneficiaries where a complaint is made about the performance of trust investments.

In recent years in particular, trustees will be excused for having had many sleepless nights, lying awake asking themselves such questions as:

  • Is my fund exposed to any of the reported $50bn losses in Bernie Madoff’s Ponzi scheme?
  • How much of the decline in global stock markets – $32trn from their 2007 peaks to mid 2009 – are in my fund?
  • Does my fund have exposure to the $50trn market in CDOs that has now blown up with such spectacular effect?

Contemplation of the English authorities that confirm that the trustee is neither insurer nor guarantor of the trust fund could be the only effective sedative.

Victorian beginnings

The legal framework within which complaints about the exercise of trustee investment powers must be considered is very different now to that in place in Victorian England, the era in which investment trusts became commonplace as wealth management vehicles. The role of the trustee then became as concerned with managing financial investments for the new industrial rich as it did the preservation and management of landed estates.

The leading Victorian authority on investment duties, which applied throughout most of the 20th century, is the House of Lords case Learoyd v Whiteley (1886). It contains the classic statement of the trustee’s prudential duty of care in exercising his investment function:

“The duty of a trustee is not to take such care only as prudent man would take if he had only himself to consider, the duty rather is to take such care as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide.”

From this decision the principle emerged that certain investment classes, for example equities, were hazardous per se, and so should be out of bounds for any prudent trustee. As a result Parliament regulated the trustee investment function through lists of permitted investments, generally varieties of annuities, fixed income securities and mortgages. The lists of permitted investments were gradually expanded, including by the Trustee Investment Act 1961, which allowed for an allocation of ‘narrow range’ (secure) investments and ‘wide range’ (riskier) investments, including some equities.

The advent of inflation as a feature of modern economic life increasingly rendered that limited approach to investment not only undesirable but positively dangerous. Investors have now long recognised that in the longer term fixed interest securities may be as risky as, or even more risky than, investment in equities or alternative asset classes. At the same time global markets have become ever more accessible, and the range of financial instruments offering access to equity and debt markets in different ways has increased enormously.

The modern legislative framework

The problem was first addressed by the habitual inclusion in trust deeds of clauses conferring on the trustee much wider investment powers than were contained in the English statutes. A great liberalisation of statutory trustee investment powers then took place in the last years of the 20th century. The Trustee Amendment Act 1988 in New Zealand, the Uniform Prudent Investor Act 1995 (UPIA 1995) in the United States, the Trustee Act 2000 (TA 2000) in England and Wales, as well as similar statutes in Canada, Singapore, the Isle of Man and elsewhere, replaced the Victorian “ordinary prudent businessman” test as the governing principle behind trustee investment duties, with the less restrictive “prudent investor” test.

These statutes were introduced as legislatures worldwide recognised that modern investment conditions were so complex that, in order to manage their funds prudently, most trustees would need to access a wide range of financial markets, would have to rely on specialist advice and might even have to delegate the investment of their funds to professional managers. The statutes establish the necessary procedures that must be followed as the trustee seeks to navigate safely the murky waters of modern investment finance.

A common core of principles emerges from the modern legislation.

  1. The trustee may be permitted to invest in any kind of asset. UPIA 1995 section 2(e) provides that “a trustee may invest in any type of property or type of investment consistent with the standards of this act.” TA 2000 section 3(1) provides (subject to certain qualifications relating to land) that “a trustee may make any kind of investment that he could make if he were absolutely entitled to the assets of the trust.” Thus any restrictions on the assets available to the modern trustee are swept away.
  2. Each individual investment may be considered not in isolation but in the context of the overall portfolio construction. This is a reflection of Modern Portfolio Theory, which recognises that, in the context of a broad portfolio, the risk associated with an asset should not be judged in isolation, but against the contribution it makes to the overall risk profile of the portfolio. The goal is the proper assessment of ‘systemic risk’ as opposed to ‘individual risk’.
  3. Investments are subject to consideration of suitability and diversification. These, of course, were not new ideas. Modern Portfolio Theory, while seeking to empower the trustee to utilise the full range of modern investment tools, also recognises two fundamental preconditions necessary for successful portfolio construction: (i) the need to select investments suitable for the needs of the trust; and (ii) the need to reduce systemic risk through diversification. Suitability and diversification are standard investment criteria in TA 2000.
  4. Imposition of a duty of care on the trustee in exercising investment powers. TA 2000 section 1 provides that trustees must exercise “such skill and care as is reasonable in the circumstances” in exercising their investment functions. UPIA 1995 requires the exercise of “reasonable care, skill and caution”.
  5. Power to delegate the investment function. The statutes typically address the circumstances in which the trustee should take advice before making investments, and also confer powers on the trustee to delegate investment powers to third parties.

A number of jurisdictions, including the United States, New Zealand and the Bahamas, have codified the issues a trustee should take into account in exercising its investment function. The following list, taken from section 2(c) UPIA 1995, is a good starting point – note that in the United States these are matters that the trustee must consider in making or retaining investments.

  • General economic conditions
  • The possible effect of inflation or deflation
  • The expected tax consequences of investment decisions
  • The role that each investment plays within the trust portfolio
  • The expected total return from income and the appreciation of capital
  • Other resources of the beneficiary
  • Needs for liquidity, regularity of income and preservation or appreciation of capital
  • An asset’s special relationship or special value to the purposes of the trust or to some beneficiaries

This is effectively a more detailed breakdown of the proper considerations necessary to enable a trustee properly to conclude that an investment is suitable for the trust – see principle (3) above. A properly conducted investment selection and management process, allowing for the circumstances referred to above and, as a result, tailoring trust investments to the specific situation faced by the trustee, is a key component of the general duty “to exercise such care and skill as is reasonable under the circumstances” (TA 2000 section 1).

Last on the list of legislative principles came the obligation to take advice and the power to delegate the investment function. Professional trustees are under increasing pressure with regard to investment performance. The reality, of course, is that with access now to global markets in financial products of ever greater breadth and complexity, many trustees will rely on expert advice and seek to delegate some or all of their investment functions. Indeed, TA 2000 section 5 obliges trustees to take advice when making and reviewing investments, unless they reasonably conclude that such advice is not necessary in the circumstances. Such advice may not be necessary if:

  • the fund is sufficiently small that the costs cannot be justified
  • the trustee has the necessary investment expertise
  • the nature of the trust assets, for example property or shares in a family company, may render it unnecessary.

If an English trustee wishes to delegate his investment function to an external investment manager, he must:

  • make an agreement in writing with the manager
  • prepare a written statement that gives guidance as to how the investment function should be exercised (Policy Statement)
  • formulate the Policy Statement to provide guidance to the investment manager with a view to ensuring that the investment functions will be exercised in the best interest of the trust.

Whilst not a legal requirement in all jurisdictions, the preparation of a Policy Statement is widely considered to be industry best practice. It is again all part of the process of taking reasonable steps to ensure that the trust investments are suitable. The trustee will need to have formed a view, if necessary after consultation with the settlor, protector and key beneficiaries, as to the investment objectives for the trust, and set out those objectives in the Policy Statement. The investment manager should be asked to explain its proposals for achieving that objective. The actions of the investment manager should then be regularly monitored to ensure it is doing what it promised to do, and those promises are delivering the expected outcomes. The Policy Statement will be an essential tool in enabling the trustee to establish criteria against which to judge the suitability of investments and the performance of the portfolio as a whole.

Getting it wrong

It is encouraging for trustees, and disheartening for beneficiaries, that modern authorities holding the trustee liable for investment loss are thin on the ground; none has yet emerged from the financial crisis. The leading English authority of (relatively) recent times, Nestle v National Westminster Bank Plc [1994] 1 All ER 118, was decided by the Court of Appeal in favour of the trustee bank. It was held that the bank had misunderstood the scope of its investment powers, and had therefore breached its duty both to undertake regular reviews of the investments and to diversify out of the limited range of equities that constituted the relevant estate.

However, the appellant was unable to establish causation. It was for her to prove on the balance of probabilities: (i) that if the bank had regularly reviewed the investments and had understood its investment powers, it would, as a prudent trustee, have diversified the portfolio; and (ii) that the notional diversified portfolio would have been worth more than the actual portfolio. This was a matter of expert evidence. The relevant period under investigation was 1922 to 1959, and the appellant was unable to discharge the burden of proof.

We must look further afield for cases where the trustee has been fixed with liability. In the United States, the trustee of The Estate of Rodney B Janes had maintained the trust fund 71% invested in a single blue chip stock (Eastman Kodak) with a miserly dividend yield of approximately 1.06%. Through the 1970s, Kodak stock declined by two thirds from its value at the testator’s death. The bank made no effort to diversify, apparently satisfied by informal representations by the widow that she and her deceased husband both “loved Kodak”.

Litigation eventually followed. In 1997 the New York Court of Appeals, in finding for Mrs Janes (or by that time, her estate), held that the bank had:

“failed to consider the investment in Kodak stock in relation to the entire portfolio of the estate…ie whether the Kodak concentration itself created or added to investment risk.

Second…in maintaining an investment portfolio in which Kodak represented 71% of the estate’s stock holdings, and the balance was largely in other growth stocks, [the bank] paid insufficient attention to the needs and interests of the testator’s 72 year-old widow, the life beneficiary of three quarters of the estate, for whose comfort, support and anticipated increased medical expenses the testamentary trusts were evidently created.

Lastly, in managing the estate’s investments, [the bank] failed to exercise due care and the skill it held itself out as possessing as a corporate fiduciary… Notably, there was proof that [the bank]:

  • failed initially to undertake a formal analysis of the estate and establish an investment plan consistent with the testator’s primary objectives;
  • failed to follow [the bank’s] own internal trustee review protocol during the administration of the estate, which advised special caution and attention in cases of portfolio concentration of as little as 20%; and
  • failed to conduct more than routine reviews of the Kodak holdings in the Estate, without considering alternative investment choices, over a seven year period of steady decline in the value of the stock.”

If the trustee had been obliged to consider the list of factors now in place with UPIA 1995, it may well have saved itself several million dollars in compensation.

The need to balance the competing interests of life tenants (income) with residuary beneficiaries (capital) is a key concern for trustees. It was central in Nestle, and also central in the New Zealand case of Re Mulligan [1998] 1 NZLR 481. In that case, a testator died in 1949 leaving his widow a substantial legacy and a life interest in a farm, with nephews and nieces as residuary beneficiaries. The farm was sold in 1965 and the estate invested $108,000 in fixed interest securities. It held those securities, allowing the widow to live happily off the income, until she died in 1990. Both the trustees and the widow recognised the damaging effect of inflation on the value of the capital – in 1965 $108,000 could buy 14 residential properties in Christchurch; in 1990 it couldn’t buy one. But the widow seems to have been a forceful character and the trustees suppressed their instincts to diversify in order to keep her happy. The residuary beneficiaries then succeeded in a claim for breach of duty in failing to treat the income and capital beneficiaries equally by diversifying into a mixed portfolio of fixed interest securities and equities. The court accepted expert evidence in that case that a prudent trustee would have diversified as to 40% equities and 60% fixed interest.

Conclusions

As noted above, no authorities on trust investment loss claims have emerged from the financial crisis. That may, in part, be because significant falls in the prices of mainstream investments, such as equities, have been recovered to a great extent since the credit crunch. The FTSE 100 declined in value by over 40% from November 2007 to April 2009. However, by May 2011 that index was only down 12% from its 2007 peak. A common characteristic of Rodney B Janes, Nestle and Re Mulligan is that they all concern misguided investment policies followed over several decades, leading to plainly irreversible losses. In those cases, also, the trustees were accused of not taking simple steps to align their portfolios with national equity markets. Prudently constructed equity portfolios may well be down over recent years, but the trustee, as noted in my opening paragraph, does not guarantee gains. If the trustee can demonstrate that proper thought processes have been applied – with the decision making process being properly documented – he will feel confident that no breach of duty has occurred. All that said, where investment losses arising out of what may be termed negligence, as opposed to dishonesty, have been incurred, the limitation period for bringing such claims may be six years. So trustees are not out of the post-credit crunch woods yet!

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