Prudent Investor Rule Changes Investment Duties of Pennsylvania Fiduciaries
|by Daniel M. Miller, Mark Bookman & Carolyn D. Duronio
Spring 2000, Vol. 63, No. 1
On June 25, 1999, Governor Tom Ridge signed into law a new prudent investor rule to govern fiduciary investments by trustees, guardians, directors of charitable nonprofit corporations and charitable trusts.
With a focus on the overall portfolio, the new prudent investor rule codified fundamental changes in the investment duties of Pennsylvania fiduciaries. The most dramatic change involves a shift from an outdated "prudent man" standard, where each investment would individually be judged to be prudent or imprudent, to a modern "prudent investor" standard where:
"A fiduciary's investment and management decisions respecting individual assets should be considered in the context of the trust portfolio as a whole and a part of any overall investment strategy, and not in isolation.
No specific investment or course of action, taken alone, shall be considered inherently prudent or imprudent."1
Thus, the new prudent investor rule embraces the key elements of academic modern portfolio theory and fundamentally changes the manner in which Pennsylvania fiduciaries are permitted to invest. It is now the total portfolio that is reviewed and not any investment in isolation.
The basic investment principles embraced by the new prudent investor rule may be summarized as follows:
Donor's Intent Controls
The new rule is consistent with existing Pennsylvania law that states that any or all statutory investment duties may be modified by the person creating the trust or fund. In short, the new rule applies to trusts only as a default rule that may be altered by the donor (§7202).
Overall Investment Strategy Must Be Prudent
The new rule provides that, in general, "a fiduciary shall invest and manage property held in a trust as a prudent investor would, by considering the purposes, terms and other circumstances of the trust and by pursuing an overall investment strategy suited to the trust" (§7203(a)). For this purpose, a nonprofit charitable corporation is also treated as a trust.
Under the act there is no individual investment that is per se imprudent (§7203(b)). Each investment is analyzed in the context of the entire trust portfolio.
This provides comfort to fiduciaries who desire to diversify their portfolios by investing a portion of the trust in investments that involve a higher degree of individual volatility and risk, such as hedge funds and venture capital funds.
In making investment management decisions, Pennsylvania fiduciaries should now consider, among other relevant considerations, the following factors:
- the size of the trust,
- the nature and estimated duration of the trust,
- any restriction on investments specified by the donor,
- the liquidity and distribution requirements of the trust,
- the expected tax consequences of investment decisions or strategies and of distributions of income and principal,
- the role that each investment or course of action plays in the trust's overall investment strategy,
- an asset's special relationship or special value, if any, to the purposes of the trust or to any one or more of the beneficiaries,
- to the extent reasonably known to the fiduciary, the needs of the beneficiaries for present and future distributions authorized or required by the governing instrument, and
- to the extent reasonably known to the fiduciary, the income and resources of the beneficiaries and related trusts (§7203(c)).
Thus, for example, a fiduciary may take into account the fact that the trust beneficiaries are all employees of a closely held company and, consequently, it may be proper for the fiduciary to hold a disproportionate amount of the stock of such company. In the case of a charitable entity, the appropriate investment considerations may differ depending on whether the fund is wholly charitable or is a split-interest trust, having both charitable and noncharitable beneficiaries. For example, the trustee of a charitable lead trust may take into account the tax consequences to the remainder beneficiaries of a sale of low basis stock.
Also, under the new rule, Pennsylvania fiduciaries are under a duty to "reasonably diversify investments unless the fiduciary reasonably determines that it is in the best interests of the beneficiaries not to diversify . . ." (§7204). This represents a fundamental departure from prior Pennsylvania law that previously allowed a fiduciary to follow the admonition of Andrew Carnegie to: "Put all your eggs in one basket and watch the basket."2
This requirement of reasonable diversification apparently does not apply, however, to (1) assets received directly from the donor, so long as the decision to retain a concentration of assets is made in the exercise of reasonable care, skill and caution (§7206) and (2) trusts that were irrevocable prior to December 25, 1999 or were created under documents signed prior to December 25, 1999 and not amended thereafter. Certain charities, such as private foundations, must also comply, however, with additional investment rules imposed by the Internal Revenue Code that may impose more stringent diversification requirements than the new prudent investor rule.
The new prudent investor rule additionally modernizes Pennsylvania trust investment law in that it expressly authorizes the delegation of discretionary investment authority. Heretofore, existing case law had indicated that delegation of discretionary investment authority by Pennsylvania fiduciaries was prohibited.3 The new express authority to delegate investment authority, however, is not absolute. The new prudent investor rule requires that the scope of delegated authority must be clearly articulated and that the performance of investment managers must be periodically reviewed. For its part, any investment agent undertaking to act for a Pennsylvania fiduciary may be held accountable for its actions in a Pennsylvania court. Investment authority may also be delegated to a co-fiduciary who has greater investment skills (e.g. a corporate fiduciary) (§7206). While most advisors assumed a Pennsylvania court would apply modern investment concepts in cases where investment actions were challenged, the new Pennsylvania prudent investor rule codifies the modernization of Pennsylvania trust investment law and provides greater assurance of uniformity of application by Pennsylvania courts. The new prudent investor rule, however, does not fully embrace all aspects of modern portfolio theory or even the model prudent investor act upon which it is based. Unlike the model act and most academic statements of modern portfolio theory, the Pennsylvania prudent investor rule requires only reasonable rather than the complete diversification of investments and has no requirement that inception assets must be diversified within a fair period of time.
This and other aspects of the new rule will be fully understood only after the new rule has been tested in the courts. The differences from the model act, however, tend to favor and grant more flexibility to Pennsylvania directors and trustees.
- To comply with the new prudent investor rule, all trustees should adopt a written investment strategy explaining the investment goals, the methods they employ and the reasons they are suitable for each particular trust.
- The trustee's written investment strategy should discuss each of those factors that are relevant to the particular fiduciary account.
- If investment authority is delegated, the investment strategy should be articulated in writing to the investment advisor and that investment strategy, as well as the performance of the advisor, should be reviewed and documented on a regular basis. The delegation itself should also be well documented.
- 20 Pa. C.S. §7213.
- Saeger Estate, 340 Pa. 73 (1940).
- Kohler's Estate, 348 Pa. 55 (1943).