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Be Careful When Choosing Investments for Your Clients' Trusts
trustee has referred you a new client. It is a sizable trust sure to provide you with current business (the older folks with life estates and income needs) and perhaps future business (the heirs or "remaindermen", looking for growth). You obtain a copy of the trust agreement. Compliance reviews the trust agreement and approves the account. ACATs bring you cash and securities. Now what?
Personal liability. Generally, a trustee and any of his agents (such as you, the broker) are personally liable for any losses caused by negligent or wrongful conduct (as well as for any amounts gained through self-dealing). Most brokers know that. This article explores how best to avoid that liability in choosing the right kinds of investments for the trust.
First, start by reviewing the trust agreement. It may limit the types of permissible investments. It also may instruct as to the degree of permissible risk. Finally, it may prohibit sales of specific assets such as parcels of real estate or interests in a business.
Is that review all that a broker needs to do? Not at all. The second step is to appreciate the flexibility (albeit limited flexibility) that resulted when states moved away from the "Prudent Man Rule" to the "Prudent Investor Rule". The new rule encourages more flexibility in structuring a portfolio of investments, which are reviewed as a whole. The new rule also is a test of conduct (reasonable under the circumstances) and not of resulting performance of each individual investment. Overall, the new rule seems to allow brokers to apply modern portfolio theory.
The third step is to review the trust assets that the broker is "inheriting" from the ACATs. There is a tension between the needs of the life estates (looking for income and safety) and the needs of the remaindermen (looking for growth). The trustee and the broker must make decisions consistent with their duty of impartiality; one cannot be preferred over another. However, when making investment decisions, one may consider other, related trusts as well as the assets of each of the beneficiaries.
Fourth, assuming no contrary provisions in the trust agreement, what kinds of investments are permitted? Broadly, note that you are permitted to consider general economic conditions, possible effects of inflation, expected tax consequences, expected total return and the costs of a given investment. In fact, you have a duty to ensure that the trust incurs only reasonable or appropriate costs. And, absent language in the trust agreement, brokers should diversify investments, among specific types, geographic areas and industries.
Beyond that, an excellent resource for criteria to utilize in selecting investments (or for attempting to absolve yourself of liability in the case of a failed investment) is the Comptroller's Handbook of Fiduciary Activities (now, the handbook is a series of booklets). The booklets are prepared by the Comptroller of the Currency (which regulates and examines trust departments of national banks) to provide guidance to bank fiduciaries by listing the factors they need to consider in selecting a particular investment, such as marketable stocks, corporate debt and non-rated general obligation municipal securities. The booklets also provide guidance as to dealing with closely held companies and real estate. For example, in considering whether to invest in a particular stock, some of the following factors are listed:
Quality and depth of management of the company;
Financial condition and position of the company in its industry;
Assessment of future prospects of the company in terms of sales and earnings, projected price/earnings and price/dividend ratios, existing and potential competition, etc., based upon comparisons with peer companies in the same industry; and
Ability of the market to absorb sales of securities, i.e., whether the security is traded in a "thin" market, as is the case with many insurance and bank stocks and municipal bonds.
Brokers often ask whether they can utilize margin; whether they can short stocks; and whether they can write or buy options. First, the judicial attitude continues to be that margin use is imprudent. The Comptroller also disallows margin unless specifically authorized by the trust agreement.
Likewise, given the unlimited risk associated with short sales, a short sale is considered to be as speculative as a margin transaction. Hence, it would be imprudent.
Finally, options may or may not be imprudent, depending upon the type of option and the language of the trust agreement. In 1973, the Comptroller began to approve the covered call option so long as authority to make that investment was contained in the trust agreement. In 1989, that position was revised to acknowledge that, so long as provided for in the trust agreement, covered call options and other types of options are not inherently imprudent.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment advisor when building and protecting your wealth.
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