Trustees Must Be Wary of Concentrated Asset Positions

rustees know that they must invest and manage trust assets in a prudent manner. That is what the Prudent Investor Rule requires. But what is the scope of the trustee's duty to diversify trust assets? To answer that question, let's first examine Modern Portfolio Theory principles. Then we will review some court decisions.

According to Barron's Finance and Investment Handbook (3d Ed.), Modern Portfolio Theory is a "sophisticated investment decision that permits an investor to classify, estimate and control both the kind and the amount of expected risk and return" of a portfolio. The theory departs from individual asset analysis to determine the statistical relationships among the various individual assets. Statistical measures include systematic (market-related) risk, standard deviation of returns and correlation among the various assets in a portfolio. The focus is on the conduct, in attempting to maximize portfolio return while limiting portfolio risk, and not on the performance.

The Third Restatement of Trusts is rooted in Modern Portfolio Theory. Trust law now focuses upon the process, with flexibility being a hallmark feature of that process. That said, sound diversification is fundamental to risk management and ordinarily is required of trustees. This requirement exists even though a trustee has discretion to make investment decisions for the trust.

The Third Restatement provides that trustees must diversify trust assets so as to minimize the risk of large losses unless, under the circumstances, it would be prudent not to do so. According to The Management of Investment Decisions (1996), breaches of fiduciary duty due to lack of diversification generally fall into three general areas: 1) geography; 2) capital markets; and 3) industry. The authors also state that while no specific percentage is established as to what constitutes lack of diversification (because a breach depends upon the facts and circumstances of each case), the Department of Labor has adopted twenty percent as the threshold level of concentration in a particular asset for ERISA plans.

On the other hand, the Third Restatement does recognize certain exceptions. These exceptions may include special interests of the beneficiaries or special objectives of the settlor. However, it is clear that the greater the departure from the diversification norm, the heavier the trustee's burden to justify the strategy in question.

Court opinions of course have varied with the facts and circumstances of each case. But they are instructive. For example, a 1958 court decision found the trustee's complete concentration in low yield government obligations to be prudent given the high income needs of the trust's beneficiaries. By comparison, a 2003 ERISA case held that a plan fiduciary had breached fiduciary duties by investing 80% of the plan's assets in income producing annuities.

Similarly, numerous court decisions also fault the trustee for maintaining a concentrated position in the face of declining values. For example, in Will of Janes, the estate consisted of 70% equities, of which 75% was Kodak stock. The court faulted the co-executor of the estate for his indifference and inaction as he watched the Kodak stock decline in value. Accordingly, the court found liability based upon failure to diversify. By comparison, another court found no liability for failing to diversify a concentrated stock position because of a price decline. The court reasoned that the trustee had believed that the outlook for the stock was positive, and had confirmed that belief by consulting with its own investment analysts as well as with outside analysts.

Trustees must diversify trust assets unless it would be prudent not to do so. Treat concentrated securities positions carefully in an effort to avoid liability!