A Primer on the Fiduciary's Duty to Diversify Investments And Hedge Concentrated Stock Portfolios

James J. Eccleston, esq.

rustees and other fiduciaries who manage investment portfolios must appropriately manage the risk of those portfolios. That is one of the core principles of the prudent investor rule as codified through the Uniform Prudent Investor Act (UPIA) in 1994. Relying on the UPIA and common law, lawsuits have made it clear that courts will require fiduciaries to diversify investments and to hedge concentrated stock portfolios. Let's examine some court decisions and the UPIA.

The UPIA (as well as the Restatement (Third) of Trusts) requires trustees to diversify trust investments unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying. Court opinions overwhelmingly support the duty to diversify.

In considering whether and how to diversify, it is important to understand the correlation of the investments, in terms of how their risk and return of each investment relates to one other, rather than simply the number of the investments in the portfolio. Although an ERISA case, it is worth noting that in GIW Industries, Inc. v. Trevor, Stewart, Inc. a federal appeals court found liability against the fiduciary for having placed 70% of the plan assets in 30 year treasuries. The court ordered that the manager pay back its fees and assessed damages based upon how prudently managed assets would have performed. Such prudently managed assets could have included short term or staggered maturity bonds to complement the long term treasuries.

Courts and commentators have, over the past decade, recognized that this diversification duty extends to hedging strategies as an alternative to selling or merely holding concentrated stock positions. For example, in Levy v. Bessemer Trust Company, the district court for the Southern District of New York denied a motion to dismiss breach of fiduciary duty and other claims. In that 1997 case, the plaintiff received stock in Corning, Inc. through a stock merger with his privately owned company. The Corning stock was valued at $8 million. The plaintiff was restricted from selling for one year. The Corning stock represented a large portion of the plaintiff's net worth.

The plaintiff was concerned about the stock price volatility of his Corning stock. But when he inquired of Bessemer Trust Company as to what he could do to protect the value of the position, representatives repeatedly advised him that he could obtain no downward price protection given that he had a one-year sales restriction. Such advice plainly was wrong. The court opinion recites that a "collar" could have been placed on the stock, whereby the plaintiff simultaneously purchases a European-style put option on the stock and also sells a European-style call option on the stock, with an exercise date after the stock restriction has lapsed. The plaintiff transferred his account to another firm, where a collar successfully was implemented, but not until after the price of his Corning stock had fallen significantly. He sued for the original value of the Corning stock position that was unable to be protected due to Bessemer Trust Company's ignorance of, and failure to implement, appropriate hedging techniques.

Given that courts will expect fiduciaries to understand and be able to implement hedging techniques, fiduciaries should be aware of several other provisions of the UPIA that bear on the hedging analysis. First, the UPIA imposes a duty upon trustees to consider "the expected tax consequences of investment decisions or strategies." The comments to the UPIA suggest taxable investors, including trust beneficiaries, generally are best served by investment strategies that minimize the recognition of income taxes. Notably, there are many possible strategies that may succeed in hedging a concentrated stock position, but the tax ramifications of each varies considerably. Indeed, some suggest that one of Wall Street's favorite hedging strategies, the so called "prepaid variable forward contract", is, in most situations, the least tax-efficient tool that is available.

Second, the UPIA requires trustees to make reasonable efforts to verify facts relevant to the investment and management of trust assets. That means trustees must analyze the non-tax advantages and disadvantages of each hedging strategy. Among those facts to consider are fees and expenses of each strategy, and the ability to close out the transaction prior to its stated expiration.

Third, the UPIA (and the Restatement (Third) of Trusts) requires the trustee who has special skills and expertise to use those special skills or expertise. Those trustees who do not do so will be held liable.

Fourth, the UPIA imposes a duty of loyalty upon the trustee to work solely in the best interests of the beneficiaries. That means he or she cannot act in his or her own interest or for the interest of third parties. In the hedging context that means the trustee should obtain several competing bids from a number of derivatives dealers, not just his or her own firm. If the pricing, terms or conditions of an outside firm's bid is more advantageous, then the trustee should be prepared to do business with that firm.

Finally, the UPIA (and the Restatement (Third) of Trusts) addresses investment costs. Under the UPIA, trustees must incur only those costs that are appropriate and reasonable in relation to the assets, the purposes of the trust and the skills of the trustee. Trustees thus must attempt to minimize costs associated with implementing hedging strategies.

As one can see, trustees have significant duties in diversifying trust assets, and the duties extend to hedging concentrated positions. The hedging area is complicated and, may as a result, be ripe for appropriate delegation to those who are familiar with the various hedging techniques.

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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.