Diversification in investing trust assets has been a default expectation for as long as most anyone in the trust administration business can remember. Even an investment novice understands that diversification reduces risk of loss. An individual investing for himself may choose to invest a disproportionately large amount of his net worth in a single asset or asset class. If the gamble fails, only the individual suffers. The individual owes no duties to anyone. A trustee, however, doesn’t have such latitude. A trustee of a trust owes many duties to its beneficiaries, one of the most important of which is the duty to invest trust property prudently.
The UPIA
The Uniform Prudent Investor Act (UPIA), promulgated by the National Conference of Commissioners on Uniform State Laws in 1994, has been adopted in 43 states1 and the District of Columbia. Section 3 of the UPIA states:
A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.
Even in those states that haven’t enacted the UPIA, the general UPIA standard regarding diversification by trustees is accepted. As the comment appended to Section 3 of the UPIA states: “Case law overwhelmingly supports the duty to diversify.”
Section 3 of the UPIA begins with the affirmative directive: “[a] trustee shall diversify the assets of the trust…” Nothing ambiguous about that. Section 3 is equally clear, however, that there’s one exception to the diversification rule, and that’s where “the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”
Obviously, then, in the jurisdictions that have enacted the UPIA, and probably, at least by analogy, in most if not all of the seven non-UPIA states, a trustee who seeks to avoid the diversification mandate imposed by
Section 3 of the UPIA and the case law with which Section 3 is consistent must determine what may constitute “special circumstances.”
One special circumstance that may obviate the need to diversify is when the trust holds an undiversified block of low basis securities. In such a case, the income tax cost of selling the securities to reinvest in a diversified portfolio may outweigh the advantage of diversifying.2
Express Language
Also recognized as a special circumstance sometimes justifying failure to diversify a trust’s investments is language in the trust instrument that expressly relieves the trustee of a diversification obligation. It’s critical to understand, however, that a trustee’s reliance on poorly crafted language to avoid liability for failure to diversify can be a big mistake.
Wood v. U.S. Bank3 involved a multi-million dollar trust that held a large concentration of stock in Star Bank (now known as U.S. Bank, N.A.). The settlor served as trustee during his lifetime, and Star Bank became trustee at his death. Dana Barth Wood was one of the beneficiaries following the settlor’s death. The trustees were permitted under the trust agreement to retain, manage and invest stock held in the trust “as they deemed advisable or proper.” Dana asked Star Bank to sell some of the Star Bank stock, but Star Bank didn’t comply. By the time Star Bank made final distribution to the beneficiaries, its stock had lost a substantial amount of its value. Dana, alleging Star Bank’s failure to diversify the Star Bank stock caused her to incur losses in excess of $775,000, brought a breach of fiduciary duty action against Star Bank. The trial court found in favor of Star Bank, and Dana appealed.
The Ohio Court of Appeals found the trust instrument was silent as to diversification, and so the duty to diversify set forth in the Ohio UPIA4 applied. The court observed that the only exception to this rule is when the trustee “reasonably” determines that there are “special circumstances.” Star Bank argued that the Ohio UPIA could be expanded, restricted, eliminated or otherwise altered in the trust instrument without express reference to the Ohio UPIA. The court rejected this argument5 and found the retention language in the trust instrument wasn’t specific enough to relieve a trustee of its statutory duty to diversify. The court stated that, to eliminate the duty to diversify, “the instrument creating the trust [must] clearly indicate an intention to abrogate the common-law, now statutory, duty to diversify” and specifically authorize the trustee “to retain in a specific investment a larger percentage of the trust assets than would normally be prudent.” The authorization to retain in this case, the court held, was insufficient to meet this standard.
In Fifth Third Bank v. Firstar Bank,6 Elizabeth Gamble Reagan established a charitable remainder unitrust (CRUT) and named Firstar Bank, N.A. (Firstar), now known as U.S. Bank, N.A., as trustee. When established, the trust’s sole asset was $2 million worth of stock in Procter & Gamble Co. (P&G). The trust instrument provided that “[t]he trustee shall have expressly the following powers…to retain, without liability for loss or depreciation resulting from such retention, original property, real or personal, received from Grantor or from any other source, although it may represent a disproportionate part of the trust.”
Firstar began to reduce the concentration of P&G stock by selling portions of the stock on a monthly basis, but, after a year had passed, the value of the P&G stock held in the CRUT had decreased by 50 percent. Elizabeth sued Firstar, claiming that Firstar had breached its fiduciary duty. After a jury trial, the CRUT was awarded over $1 million in damages. The Ohio Court of Appeals7 concluded that the above-quoted language from the trust instrument allowing the trustee to retain assets didn’t clearly indicate an intention to eliminate the duty to diversify.
The Wood holding isn’t so hard to understand. The language authorizing retention in Wood was tepid to say the least. On the other hand, Fifth Third Bank is, frankly, inexplicable. It’s difficult to imagine governing instrument language that more explicitly allows trust property to be retained without diversification concerns. The court appears completely to have disregarded the portion of the retention authorization stating, “although it may represent a disproportionate part of the trust.” Perhaps the lesson of Fifth Third Bank is that, in a UPIA jurisdiction, to minimize a trustee’s liability potential for not diversifying, the trust instrument should explicitly state that the trustee isn’t obliged to diversify, notwithstanding the diversification directive set out in Section 3 of the UPIA.
Beneficiary Directions
Yet another example of special circumstances that may allow a trustee to retain assets without worries about lack of diversification is when trust beneficiaries have expressed a preference for retaining or given the trustee an affirmative direction to retain. Even when a trust instrument seems clearly and unambiguously to empower the trustee to retain trust property without diversification concerns, the trustee may seek additional protection from liability for not diversifying by requiring the beneficiaries to consent to retaining certain assets.
The primary beneficiaries of the trust at issue in Karo v. Wachovia Bank, N.A.8 were the settlor’s husband, Toney, her son, Drew, and her minor grandson, W.A.K. Toney and Central National Bank (which later became part of Wachovia) were the trustees. Wachovia stock constituted approximately 65 percent of the trust’s assets.
Despite the fact that the trust instrument authorized the trustees “[t]o retain as permanent any now existing investments (including stock of the corporate Trustee or in any of its affiliates and holding companies) of the trust property and any investments hereafter transferred to the Trustees…,” Wachovia on several occasions recommended to Toney and Drew that the trust diversify its assets. Toney and Drew refused to agree to diversify and instead signed Letters of Retention (LORs) that acknowledged Wachovia’s advice (as well as Wachovia’s conflict of interest arising from the trust’s ownership of Wachovia stock) but indicated Toney and Drew’s desire to preserve the trust’s ownership of Wachovia stock. Unsurprisingly, when Wachovia’s share price declined substantially, the beneficiaries brought claims alleging that Wachovia failed to diversify the trust portfolio and breached its duty of loyalty for investing in its own stock.
The U.S. District Court for the Eastern District of Virginia held for Wachovia, finding that the trust instrument effectively waived the requirements of the Virginia UPIA as it related to retention of the trust property at the trust’s creation (including Wachovia stock and related companies) and any investments later transferred to the trust.
The court also upheld the effectiveness of the LORs, stating “[t]here is no evidence that any of these retention documents were returned unsigned or that Toney ever attempted to rescind these retention authorizations.” The court stated that the LORs gave Toney and Drew “the ultimate authority to direct the trustees’ actions” and that “Wachovia fulfilled all duties required under Virginia law and the terms of the trust instrument.”
Adams v. Regions Bank9 is similar to Karo in several salient respects but with a few bizarre facts added in for good measure. Kay Hood Adams borrowed $3 million from Regions and secured the loan with Regions stock held in a limited partnership her family owned. Then, in successive events, a trust became owner of the 99 percent limited partner interest, and Regions became trustee of the trust. The trust instrument vested the trustee with power to “retain, with no obligation to sell, any property coming into their hands as Trustees under the terms of this instrument, including stock in AmSouth Bancorp. [now Regions Bank]…regardless of any lack of diversification or risk, without being liable to any person for such retention unless otherwise specifically provided herein.” Kay signed a retention agreement authorizing Regions, as trustee, to continue to hold the Regions Bank stock. The retention agreement specifically acknowledged Regions’ conflict of interest and its policy, when serving as a trustee, to diversify trust investments. The loan went into default, the Regions bank stock declined significantly in value and Regions seized the Regions Bank stock. Kay and her three children sued Regions, alleging, among several other things, that Regions breached its fiduciary duty to diversify out of Regions Bank stock.
At trial in the U.S. District Court for the Southern District of Mississippi, Kay advanced several arguments to support her contention that she wasn’t bound by the retention agreement. She maintained that, as a spendthrift, she didn’t have legal capacity to sign the retention agreement, that she lacked sufficient information to understand the retention agreement and that she was unaware of her rights as a beneficiary. The court summarily rejected each of these arguments as sufficient to enable Kay to avoid the retention agreement.
The court also noted the provision of the Mississippi UPIA that’s identical to Section 3 of the UPIA10 and found that the following “special circumstances” existed: (1) the trust instrument language specifically authorizing the trustee to hold property coming into its hands (in particular, Regions Bank stock); and (2) Kay’s clear, unambiguous, written approval of Regions’ retention of that stock.
Glass v. SunTrust11 also involves a direction from a trust beneficiary to retain assets. At the death of the trust’s settlor, the value of the trust was over $2.5 million, and its assets consisted of SunTrust Bank stock, First Tennessee Bank stock, Security Bancorp of Tennessee stock and a large farm. The trustee sent a remainder beneficiary a letter offering him the option to receive his distribution of assets in cash (following liquidation of assets and investment of the proceeds in interest-bearing securities until the trustee was prepared to make distribution) or in-kind. The letter stated that, if the beneficiary elected to receive an in-kind distribution, he would assume market risk related to fluctuations in security values during the period of trust settlement. The beneficiary elected to receive his distributions in-kind.
The trust instrument conferred on the trustee the power “to retain investments that initially come into the hands of the fiduciary among the assets of the estate, without liability for loss or depreciation or diminution in value resulting from the retention, so long as in the judgment of the fiduciary it is not clearly for the best interests of the estate, and the distributees of the estate, that those investments be liquidated….”
During the trust’s post-death administration period, the value of the SunTrust Bank stock and the First Tennessee Bank stock plummeted, and, of course, the beneficiary filed suit against the trustee for breach of fiduciary duty in failing to diversify the trust’s holdings soon after the settlor’s death.
In ruling in the trustee’s favor, the court apparently wasn’t persuaded that the instrument’s retention language could reasonably have been relied on by the trustee, but the court found determinative the beneficiary’s election to take his distribution in-kind. The court cited and discussed the provision of the Tennessee UPIA that’s identical to Section 3 of the UPIA12 and held that the beneficiary’s election constituted special circumstances within the meaning of that provision. The court further observed that, under the Tennessee UPIA, a trustee may refrain from diversifying trust assets after considering an asset’s special relationship or value to the purposes of a trust or a beneficiary (that is, considering the preferences of a beneficiary, heirlooms, prized assets, etc.).13
Assets Significant to Beneficiaries
Another type of circumstance that has been recognized as overriding a trustee’s general duty to diversify is when a particular trust asset has special significance to the beneficiaries. In Brackett v. Tremaine,14 a trustee sought to sell to himself 42 out of 189 acres of farmland held in the trust. Aside from $300 in cash, the 189 acres comprised all the trust property. The trust instrument permitted the trustee “to retain any … type of personal property or of real property, taken over by it as a portion of the trust, without regard to the proportion such property or property of a similar character so held may bear to the entire amount of the trust,…; intending … to authorize the Trustee to act in such manner as will be for the best interest of the trust beneficiaries.”
Evidence adduced at trial included that: (1) seven of the nine beneficiaries opposed the sale; (2) none of the beneficiaries was concerned about the low amount of income generated by the farmland, and some believed the farmland’s value would increase over time; and (3) the seven beneficiaries who opposed the sale believed the settlor intended the farmland to remain intact in the trust for the whole family to enjoy and asserted that the farmland had sentimental value to the whole family.
Affirming the trial court, the Supreme Court of Nebraska cited the provision of the Nebraska UPIA that’s identical to Section 3 of the UPIA and other Nebraska UPIA provisions and concluded that there was no reason to sell in light of the fact that the beneficiaries “articulated a legitimate interest in maintaining the geographic integrity of the farm….” Additionally, the court expressed concern that the proposed purchaser of the farm was the trustee in his individual capacity.
Exceptions to Diversification Rule
Diversification of investments is a matter all trustees should take seriously. As a general rule, it’s sound fiduciary practice and is required by law. Nevertheless, there are cases in which trust instrument language absolving the trustee from the duty to diversify, expressed beneficiary preferences or directives not to diversify and/or unique characteristics of an asset may enable or even compel a trustee not to diversify.
Endnotes
1. Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Vermont, Virginia, Washington, West Virginia, Wisconsin and Wyoming.
2. Uniform Prudent Investor Act, Section 3, Comment.
3. Wood v. U.S. Bank, 828 N.E.2d 1072 (Ohio App. 1st Dist. May 13, 2005).
4. Specifically, Ohio R.C. Section 1339.54(B), which is identical to Section 3 of the Uniform Prudent Investor Act.
5. Citing Restatement (Third) of Trusts, Section 227(b).
6. Fifth Third Bank v. Firstar Bank, No. C-050518, 2006 WL 2520329 (Ohio App. 1st Dist. Sept. 1, 2006).
7. The same District Court of Appeals that decided Wood.
8. Karo v. Wachovia Bank, N.A., 712 F. Supp.2d 476 (May 12, 2010).
9. Adams v. Regions Bank, 2016 U.S. Dist. LEXIS 1027 (Jan. 26, 2016).
10. Miss. Code Ann. Section 91-9-605.
11. Glass v. SunTrust, 523 S.W.3d 61 (Tenn. App. Ct. May 4, 2016).
12. Tenn. Code Ann. Section 35-14-105.
13. Tenn. Code Ann. Section 35-14-104(c)(8).
14. Brackett v. Tremaine (In re Trust Created by Inman), 269 Neb. 376 (Feb. 25, 2005).