Investing Under the Prudent Investor Standard

The prudent investor rule replaced an older approach in which a trustee's investment authority was defined by a list of permitted holdings. The list method was administrable and produced perverse results, because it treated a conservative security held in an unbalanced portfolio as safe and a volatile security held as one component of a diversified portfolio as reckless. Modern statutes discard the list and substitute a standard of conduct applied to the portfolio as a unit.

The standard and its unit of measure

The statutory formulation is that a trustee shall invest and manage trust assets as a prudent investor would, considering the purposes, terms, distribution requirements and other circumstances of the trust, and shall exercise reasonable care, skill and caution. The critical sentence follows: investment and management decisions respecting individual assets are not evaluated in isolation but in the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust.

That sentence decides most disputes before the evidence begins. A beneficiary who identifies the worst-performing holding and asks why it was purchased has framed the wrong question. The question a court will ask is what role that holding played within the strategy, and whether the strategy itself was suited to a trust with these purposes, this distribution obligation and this time horizon. A trustee who cannot state the strategy is exposed even where every individual purchase was defensible.

Diversification as the default

The statute makes diversification an affirmative duty rather than a preference. 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. The burden of the exception sits with the trustee, and the determination has to be reasoned, contemporaneous and recorded. A concentration that was never examined is a concentration for which no exception was invoked.

Recognized special circumstances are narrow. A holding whose disposition would trigger a tax cost disproportionate to the risk reduction, an interest in a family business the trust exists to hold, a security subject to a legal or contractual restriction on sale, or an express direction in the instrument may all support retention. Sentiment does not, nor does the trustee's confidence in the issuer.

Where the concentration arose because the settlor contributed the position, the terms of the trust should be read closely for an authorization. Many instruments contain one, and many that are assumed to contain one do not. A precatory sentence expressing the settlor's hope that a holding be kept is not an authorization to disregard the diversification duty, and a permissive retention clause is generally read as excusing a prompt sale rather than as licensing indefinite inaction.

Delegating the investment function

Older law treated investment discretion as nondelegable. Current statutes reverse that and permit a trustee to delegate investment and management functions that a prudent trustee of comparable skills could properly delegate under the circumstances. The permission is conditional on three continuing duties: reasonable care in selecting the agent, reasonable care in establishing the scope and terms of the delegation consistent with the purposes and terms of the trust, and reasonable care in periodically reviewing the agent's actions to monitor performance and compliance.

Where those duties are met, the trustee is generally not liable to the beneficiaries for the agent's decisions. The agent, in turn, owes the trust a duty to exercise reasonable care to comply with the terms of the delegation, and by accepting the delegation submits to the jurisdiction of the state whose law governs the trust. That submission is what makes the agent answerable directly rather than only through the trustee.

Delegation therefore moves the risk rather than eliminating it, and the residual risk is concentrated in the monitoring obligation, which is the one most often neglected. Cost is part of the review: a delegated arrangement layers the agent's fee on the trustee's own, and the combined charge must remain reasonable in relation to the trust property and the skill required. An arrangement in which discretion is held by a third party under the trust instrument rather than by contract is a different structure, described in directed trusts and divided responsibility.

Documenting the process

Because the standard is one of conduct, the record of conduct is the evidence. An investment policy statement identifying the trust's objectives, time horizon, liquidity needs and risk tolerance is the ordinary way to fix the strategy against which individual decisions will later be measured. Minutes or memoranda of periodic reviews serve the same purpose for retention decisions. Neither document is required by statute, and neither is a defense in itself, but their absence is what turns a contested investment question into a contested question about whether anyone was paying attention.

Costs deserve their own line of attention. The statutes direct a trustee to incur only costs that are appropriate and reasonable in relation to the assets, the purposes of the trust and the skills of the trustee. Layered fees, frequent turnover and products whose expense is not visible in a statement are the recurring subjects of objection, and each of them is easier to defend when the file shows the alternatives that were considered and rejected.

The record also carries into other duties. Allocation choices between current and future beneficiaries surface in impartiality between income and remainder beneficiaries. Fees and transaction costs appear in the annual accounting, where a beneficiary can compare them against the strategy they were incurred to implement. And where a loss has occurred, the reasonableness of the process determines whether the trustee faces a surcharge measured by the value the trust would have had or nothing at all.